TaxTMI 
TaxTMI 
TaxTMI 
2014 (1) TMI 501
X X X X Extracts X X X X
X X X X Extracts X X X X
....w arise from the appeal: a. Whether the assessment of the Revenue of arm's length price applying the TNMM method was contrary to the transfer pricing provisions under the IT Act and Rules? b. Whether the Transfer Pricing Officer's (TPO's) apportionment by considering the cost plus mark up of 5% on FOB value of goods between third party enterprises, sourced through the appellant is in compliance with the law? 2. The facts that give rise to these questions of law are as follows. LFIL is a wholly owned subsidiary of Li & Fung (South Asia) Ltd., a company incorporated in Mauritius as a captive offshore sourcing provider. Li & Fung (Trading)(the AE),is a group company incorporated in Hong Kong, which enters into contracts with customers viz. retail chains overseas, for rendering sourcing support services for the supply of high volume, time sensitive consumer goods. The appellant entered into an agreement dated 4.12.1997 with the AE, whereby the contract for rendering sourcing services is outsourced or subcontracted to LFIL, for which it is remunerated at cost plus a mark up of 5% for services rendered to the AE, and ultimately, the AE's customers. 3. LFIL previously received buying ....
X X X X Extracts X X X X
X X X X Extracts X X X X
.... credible evidence, the involvement of the AE could not be accepted; c) LFIL had developed several unique intangibles which had given an advantage to the AE in the form of low cost of the product, quality of the product and enhanced the profitability of the AE, though the cost for development and use of intangibles was not taken for computation of routine mark up of 5% considered by LFIL; d) LFIL had crucially developed supply chain management which provided the link between the suppliers and customer to achieve strategic and pricing advantage; e) LFIL owned human capital intangible, developed at their own cost with all related risks in creation and maintenance of such intangible; f) the AE recognised that India offers both cost and operational advantage such as lower salaries for the employees, low cost material and low cost manufacture. LFIL had neither quantified this locational saving nor had the AE attributed any part of the additional profit on account of locational saving to LFIL. 7. The TPO did not, as stated earlier, dispute the analysis undertaken by LFIL, but for the above reasons applied the 5% mark up to FOB value of exports made by Indian manufacturer to overseas....
X X X X Extracts X X X X
X X X X Extracts X X X X
.... mention here that the assessee is the most critical part of global supply chain of the AE. It is responsible for identifying and qualifying the contracted manufacturer, for working with them and other designers to manufacture garments in the technical specifications, for selection of fabrics, for control over the manufacturer, for identifying appropriate sourcing of fabrics and accessories, for quality insurance, for transportation logistics and for coordinating logistics. The compensation model for the assessee which is based on reimbursement of the cost with the percentage mark up has not included locational saving attributable to the assessee. These facts prove that cost plus compensation @ 5% of cost of the assessee is not at arm's length because it does not include profit attributable to the assessee on account of locational saving. 5.3 Whether the assessed commission should be expressed as a percentage of the FOB price of goods sourced through the assessee? In this case the AB has allowed commission of 5% of cost incurred by the assessee for its sourcing activities in India and has not computed commission on FOB price of goods sourced through the buying office. I have exam....
X X X X Extracts X X X X
X X X X Extracts X X X X
....at the assessee functions like an independent entrepreneur. Hence, it takes matching risks. For sake of convenience, risks relevant in the business of the assessee and risks disclosed in T.P. studies are analyzed in the following table:- SI. No. Risk matrix relevant to business of the assessee The risk matrix as disclosed in transfer pricing report under Rule 10D 1 Market Risk Disclosed in transfer pricing report 2 Service liability Disclosed in transfer pricing report 3 Capacity utilization risk Disclosed in transfer pricing report 4 Foreign exchange risk Disclosed in transfer pricing report 5 Credit & collection risk Disclosed in transfer pricing report 6 Scheduling risk Not disclosed in transfer pricing report but actually borne by assessee. 7 Government & institutional risk Not disclosed in transfer pricing report but actually borne by assessee. 8 Operational risk Not disclosed in transfer pricing report but actually borne by assessee. 9 Asset redundancy risk Not disclosed in transfer pricing report but actually borne by assessee. 10 Infrastructure failure risk Not disclosed in transfer pricing report but actually borne by assessee. 11 Human c....
X X X X Extracts X X X X
X X X X Extracts X X X X
....hall be credited to the Profit & Loss Account. After taking into account this gross income, the net operating income is computed at Rs.601,480,000. Thus, the arm's length price is calculated as below: Net Operating income (as calculated above) Rs.601,480,000 Operating income shown by assessee Rs.24,918,814 Difference Rs.576,561,186 Accordingly, the value of the international transaction of the assessee shall be adjusted upward by Rs.576,561,186 to bring it to arm's length. Since the difference computed as a percentage of the Arm's Length Price is more than 5% no benefits under the proviso to Section 92C(2) is available to the assessee. 10. The transfer pricing approach may be summarized as below. (i) The assessee has used TNMM as the method and OP/TC was claimed to be the PLI. (ii) It was noticed that the cost of goods sold through the assessee has not been included in the cost base while computing the margin. (iii) A show cause is this regard was issued to the assessee. The same is reproduced at Para 5.1. (iv) The assessee markup has been calculated on the FOB value of exports made through the assessee. The rationale for this has been given at para 5.3. (v) An adjustm....
X X X X Extracts X X X X
X X X X Extracts X X X X
....such instances, tax administrations would have to determine what the underlying reality is behind a contractual arrangement in applying the arm's length principle. 1.68 In addition, tax administrations may find it useful to refer to alternatively structured transactions between independent enterprises to determine whether the controlled transaction as structured satisfied the arm's length principle. Whether evidence from a particular alternative can be considered will depend on the facts and circumstances of the particular case, including the number and accuracy of the adjustments necessary to account for differences between the controlled transaction and the alternative and the quality of any other evidence that may be available." Therefore, the assessee's claims that it does not bear the risks of a normal trader have to be tested in this light. Accordingly, we are inclined to accept the TPO's conclusion that the FOB value of goods should form part of the cost base for calculating the remuneration that should accrue to the assessee. That leads to the next question as to what should be the correct markup that should be applied. The TPO has applied the markup of 5% because the ass....
X X X X Extracts X X X X
X X X X Extracts X X X X
....lding that assessee is performing all critical functions, assuming significant risks and used both tangibles and unique intangibles developed by it over a period of time. The associated enterprise is not having technical capacity and manpower to assist the assessee in this regard. The assessee has developed several unique intangibles which has been given advantage in the form of low cost of product, quality of the product and enhanced the profitability of AE. These intangibles have developed profit potential of AE. The assessee has developed the supply chain management which gives customer a strategic and pricing advantage. The assessee has also developed its own human capital intangible at its own cost. The cost for the same is born by assessee. The AE has recognized that India offers both cost and operational advantage on account of lower salaries for the employees, low cost material and low cost manufacture. The associated enterprise is charging from the purchasers on the basis of FOB value of exports up to 5%. The total exports effected by the assessee during the year were Rs.1202.96 crores. Assessee has been paid in respect of the international transaction effected in the for....
X X X X Extracts X X X X
X X X X Extracts X X X X
....out the compensation for the services rendered by the assessee to the associated enterprise. In such a situation, mark up on the FOB value of the goods sourced through the assessee shall be the most appropriate method to work out the correct compensation at arms length price. Therefore, the rules of consistency cannot be applied forever when such facts have not been considered/discussed at all in the earlier years. It is also pleaded that the assessee has received 80-O deduction in the earlier years in respect of providing these professional and technical services. In this regard, we hold that every assessment year is a separate assessment year for incometax purposes and the principle of res judicata is not applicable. Further during this year, the assessee has not claimed or entitled for 80-O deduction. Therefore, it cannot be a plea to justify the transaction at the arm's length. Assessee claims that there is no provision in the Rule 10B(1)(e) to include the cost incurred by third parties or unrelated enterprise to compute the net profit margin of the assessee. For this proposition, we do not agree in view of the fact that assessee is providing all critical functions and the ma....
X X X X Extracts X X X X
X X X X Extracts X X X X
....eceipts of assessee then it is much more than the total amount received by associated enterprise regard to these exports. Thus, the way in which this adjustment has been made gives abnormal / absurd results which cannot be sustained. The assessee was performing critical functions with the help of tangible and unique intangibles developed over the period of time and with the help of supply chain management which the assessee had developed, the majority of compensation based on the FOB value of the exports materialized through the assessee must come to the assessee. So the correct compensation at the arms length price based on the FOB cost of the goods sourced from India needs to be decided. The total export during the year was Rs.1202.96 crores. AE received in total of Rs.60.148 crores. The assessee's claim that no agreement was entered by the assessee with the ventures to whom the goods are sourced shall not justify the cost plus mark up. The associate enterprise entered into the agreements for sourcing the goods and the compensation is based on the FOB value of the goods sourced from the India and the assessee performing all crucial and critical function to fulfill the conditions....
X X X X Extracts X X X X
X X X X Extracts X X X X
....on to an international transaction, various methods are prescribed under section 92C(2) of the Act and Rule 10B of the Rules provide the manner in which such methods should be applied by the assessee, assessing officer, Transfer Pricing Officer, etc. 11. Mr. Porus Kaka, learned senior counsel, while stating that the TNMM was chosen by LFIL as the appropriate method to calculate the arm's length, provided the court with an interpretation of the provision. He argued that for applying TNMM, it would be noted that the net profit margin realized from the international transactions by the appellant is to be computed only with reference to the cost incurred by LFIL itself. The provision does not consider or impute cost incurred by the third parties or unrelated enterprises, to compute net profit margin of the appellant enterprise. 12. The learned counsel stated that the TPO, in the impugned order, enhanced the cost base of the appellant enterprise artificially by considering the cost of manufacture and export of finished goods by third party vendors which is clearly inconsistent with the manner of application of TNMM as provided in Rule 10B(1)(e). He argued that the TPO's enhancement of....
X X X X Extracts X X X X
X X X X Extracts X X X X
....different and has nothing to do with manufacture and export of consumer goods by unrelated third parties. Counsel argued that LFIL was merely involved in rendering buying or sourcing support services with regard to such goods and received a handsome remuneration on a cost plus mark-up of 5% which adequately highlights the functions performed, assets utilized and risks borne by the appellant on application of TNMM. 17. It was next urged that the said method of assessment undertaken for determining the arm's length price of international transactions applying TNMM was accepted in the Transfer Pricing assessment consistently year after year. The TPO, in the previous years, did not dispute the functional analysis taken by LFIL and the factors determining LFIL's operations, the functions performed, assets utilized and risk assumed, often having similarities with every year's assessment. Counsel cited Radhasaomi Satsang v. CIT, 193 ITR 321, to argue that where a fundamental aspect permeating through the different assessment years is accepted one way or the other, a different view in the matter is not warranted, unless there was any material change in facts. Similarly, he also cited this....
X X X X Extracts X X X X
X X X X Extracts X X X X
....e TPO/AO would result in LFILF, which is only a subsidiary, ended up receiving higher amount than what has been received by the AE from third party customers in lieu of facilitating the export of finished goods. This can be noted from the fact that such adjustment proposed by the TPO/AO has resulted in the AE retaining only 1% of the FOB value of export on the entire export of Rs 1202.96 crores, with nearly 80% of the remaining consideration on FOB value of export must be borne by LFIL. The counsel for the appellant argued that since substantial functions relating to the buying services, undertaking enterprise risks, utilization of substantial assets as well as bearing L/C charges were borne primarily by the AE. Thus, the TPO/AO has erroneously held that LFIL has developed several unique intangibles and developed a supply chain management, human capital at its own risk without appreciating that the appellant was only a captive offshore service provider not undertaking any independent enterprise risk. For this line of argument, counsel relied on the judgment of the Supreme Court, reported as DIT v. M/s Morgan Stanley & Co., 2007 (7) SCC 1. Revenue's contentions 21. The learned cou....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ed to the AE, would fall outside the tax net, contrary to the purpose of the transfer pricing provisions. Moreover, it was argued that if such services were directly provided by LFIL, without the AE acting as an intermediary, the payment for its services would far exceed the payment it is received from the AE, which is a crucial indicator that the transaction, as it currently stands, is not at arm's length and requires interference. Thus, it was argued by learned counsel that determination of ALP and real income was sound and did not call for interference. Discussion regarding the relevant provisions of the IT Act and Rules 24. Companies with dispersed production facilities or those trading through different units (usually in different countries), employ transfer pricing, a mechanism that involves over or undercharging for goods or services sold between branches or constituent units at a price (usually) determined by the holding company. The main objective of transfer pricing is to take advantage of differential taxation between countries, by structuring transactions such that the legal incidence for tax occurs in a jurisdiction with lower tax rates. Accordingly, the endeavor of ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....an adjustment of prices, and the rule prescribed for estimating profits was not scientific. It also did not apply to individual transactions such as payment of royalty, etc., which are not part of a regular business carried on between a resident and a non-resident. There were also no detailed rules prescribing the documentation required to be maintained. 55.3 With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multi-national enterprises, the Act has substituted section 92 with a new section, and has introduced new Sections 92A to 92F in the Income Tax Act, relating to computation of income from an international transaction having regard to the arm's length price, meaning of associated enterprise, meaning of international transaction, computation of arm?s length price, maintenance of information and documents by persons entering into international transactions, furnishing of a report from an accountant by persons entering into international transactions and definitions of certain expressions occurring in the said sections." 26. Chapter X opens with Section 92 which provi....
X X X X Extracts X X X X
X X X X Extracts X X X X
....the price charged or paid for international transaction has not been determined as prescribed under sub- section (1) and (2) of section 92C or, the assessee has not kept information and documents of its international transactions in the form prescribed under Section 92D (1) and the Rules made in that regard or, the information or data used by the assessee in computing the ALP is not reliable or correct or, that the assessee, failed to furnish, within the specified time the information sought pursuant to a notice issued under Section 92D (3). The first proviso to Section 92 (3) mandates that before the AO proceeds to determine the ALP on the basis of the material or information or document available with him he shall give an opportunity by serving upon the assessee a show cause notice fixing thereby a date and time for the said purpose. Under Section 92C (4) the Assessing Officer is empowered to compute the total income of the assessee only after the ALP has been determined by the Assessing Officer in terms of the provision of sub-section (3) of Section 92C. 28. Under Section 92CA (inserted w.e.f. 1.6.2002), the AO is empowered to refer the computation of ALP, in relation to, an "i....
X X X X Extracts X X X X
X X X X Extracts X X X X
....sessee, several methods are prescribed under Section 92C of IT Act. As per this provision, the arm's length price in relation to an international transaction shall be determined by the "most appropriate method" out of the prescribed methods i.e. a) comparable uncontrolled price method; b) resale price method; c) cost plus method; d) transactional net margin method; e) profit split method and f) any method as prescribed by the Revenue. In case where more than one price can be determined by the most appropriate method, the arm's length price calculated is the arithmetic mean of such two or more prices. Thus, the provision does not entail any preference of methods and adopts the "best method rule". 32. Rules 10B and 10C of the IT Rules prescribe different measures on application of the methods prescribed for calculation of the arm's length price. In terms of Rule 10B (1)(e), while applying the TNMM, the normal margin of profit that is expected in the same line of trade forms the basis of turnover of either purchases or sales, whichever is considered more reliable. It examines the net profit margin relative to an appropriate base that a tax payer realizes from a controlled transactio....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ry in the provision of the service, it is important in applying the cost plus method that, in the ultimate analysis, the return or mark-up is appropriate for the performance of the agency function rather than for the performance of services themselves. Rule 3.41 of the Transfer Pricing Guidelines 2009 state that in applying the TNMM, various considerations should influence the choice of margin used. These include the reliability of the value of assets employed in the calculations is measured and the factors affecting whether specific costs should be passed through, marked up or excluded entirely from the calculation. Under Rule 2.134, while applying a cost based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. It should not be based on the classification of costs as internal or external, but rather on comparability (including functional) analysis, and in particular on a determination of the value added by the tested party in relation to those costs. Rule 7.36 of the Guidelines, further state ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....tance of the transactions. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations too recognize the importance of FAR in the transfer pricing context, with the arm's length compensation between AEs reflecting the functions that each enterprise performs (taking into account the assets used and the risks assumed by either party).In this case, what prevailed with the TPO and all other authorities was the circumstance that LFI, i.e. the assessee, according to them, performed all the critical functions, assumed significant risks and used both tangibles and unique intangibles developed by it over a period of time. These intangibles included supply chain management which is important to achieve the strategic and pricing advantage, as well as human intangibles in the form of technical capacity and owned manpower to perform the critical functions. It was further held that the assessee had performed all critical functions, assumed significant risks and also developed significant supply chain intangibles in India and Li & Fung HK, the AE did not have either any technical expertise or manpower to carry out the sourcing activities in Hong Kong. 39. The TPO's....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ice having regard to the operating profit margin of comparable companies having similar functional profile. LFIL's computation of the operating profit margin (OP/TC per cent) by enhancing the cost base, i.e., by increasing the cost of the sales facilitated by LFIL leads to an arbitrary adjustment of its income, as such an alteration resides plainly outside the Rules and the provisions of the Act. 42. Moreover, there is considerable merit in the submission that the (finding of the) lower authorities, including the Tribunal, misdirected themselves in holding that LFIL assumed substantial risk. Whilst this Court would neither state that LFIL performed functions with a limited risk component, as it does not engage itself in manufacturing of garments (which is LFIL's stance), apart from broad assumptions made by the Revenue, no material on record testifies to that fact such that it can be the basis for an ALP adjustment. Indeed, LFIL has neither made investment in the plant, inventory, working capital, etc., nor does it claim to have any expertise in the manufacture of garments. More importantly, and given no material to the contrary, LFIL does not bear the enterprise risk for manufact....
X X X X Extracts X X X X
X X X X Extracts X X X X
....eighted average OP/OC per cent. Of 26 comparable companies 4.07 per cent. OP/OC per cent. of LFIL 5.17 er cent. This exercise has not been discarded. In other words, the TPO and the appellate fora were aware that in accordance with the rules, a comparison of the profit margin of LFIL with that of other similarly functioning companies was shown, and is, at the first instance, relevant to determine the ALP. The profit margin, as well as the cost plus model adopted by LFIL, was not shown to be distorted or of such magnitude as to persuade the tax authorities into discarding the exercise altogether. Having not contradicted this comparison, the Revenue proceeded to its own determination and calculations. This, however, is improper, given that the assessment carried out by the assessee must first be rejected, for any further alterations to take place. Indeed, it cannot be that the Revenue admits to the correctness of LFIL's assessment but nonetheless proceeds to adopt a different method. 45. Indeed, once the TNMM was deemed most appropriate method, the distortions, if any, had to be addressed within its framework. Here, the unrelated transactions which were compared by LFIL ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....3) of section 92C only under the circumstances enumerated in Clauses (a) to (d) of that sub-section and in the event of material information or documents in his possession on the basis of which an opinion can be formed that any such circumstance exists. In all other cases, the value of the international transaction should be accepted without further scrutiny." The following portions of Circular No. 14 are relevant: "The relevant portions of Circular No. 12 may be usefully referred to as under the new provision is intended to ensure that profits taxable in India are not understated (or losses are not over stated) by declaring lower receipts or higher outgoings than those which would have been declared by persons entering into similar transactions with unrelated parties in the same or similar circumstances. The basic intention underlying the new transfer pricing regulations is to prevent shifting out of profits by manipulating prices charged or paid in international transactions, thereby eroding the country's tax base. The new section 92 is, therefore, no intended to be applied in cases where the adoption of the Arm's length Price, determined under the regulations would result in ....