TaxTMI 
TaxTMI 
2024 (7) TMI 849
X X X X Extracts X X X X
X X X X Extracts X X X X
....alia, in the manufacture and sale of mobile phones under the Samsung brand. Admittedly, STI manufactures and sells mobile handsets in India as well as overseas. The design, know-how and other critical components are provided to it by Samsung Korea in terms of a Technology License Agreement dated 26 February 2006 and which obliges STI to pay for technical assistance as well as royalty. 3. During the A.Y. in question, STI paid a sum of INR 15,59,64,867/- towards technical assistance fee and royalty. A further sum of INR 1,99,57,161/- was paid by it as royalty on sales made to other Associated Enterprises [AE]. For the year in question, a Return of Income was filed on 30 September 2008 which was selected for scrutiny pursuant to which notices under Section 143 (2) as well as Section 142 (1) of the Income Tax Act, 1961 [Act] came to be issued. 4. On 12 September 2011, a Show Cause Notice was issued to STI by the Transfer Pricing Officer [TPO] in the course of examining a reference which was made to it pertaining to the payment of royalty to Samsung Korea. Responding to the same, STI is stated to have submitted that the royalty payment to Samsung Korea was in consideration of receipt ....
X X X X Extracts X X X X
X X X X Extracts X X X X
.... companies. The critical fixed assets etc required for manufacturing are also procured from overseas group entities. The TPO opined that position of the assessee company with regard to manufacturing for the AEs was that of a Contract Manufacturer. That the assessee company is purchasing raw material from the AEs. Goods are manufactured in India and then part of it is exported to AEs. TPO opined that the royalty paid as a percentage of sales to the associated enterprise is not at arm's length because it amounts to collecting royalty on the sales to itself. That all the AEs are typically within the umbrella of the multinational corporation. Even though it appears that the technical know-how is commercially exploited in India, in reality, the price for these activities are not fixed by the market force. xxxx xxxx xxxx "6.4 As against the above, it is the submission of the assessee that royalty is paid by the assessee to SEC Korea for the receipt of technical know-how and expertise. That the Assessee cannot carry out manufacturing activity, (either in the export markets or the domestic market), without access to the technical know-how and expertise developed by SEC Korea. We fi....
X X X X Extracts X X X X
X X X X Extracts X X X X
....note that SEC, Korea keeps a close watch on the quality of the raw-material and the production process. However, it does not determine the quantity of production and the terms of sales. There is no assurance to the assessee company that its entire production will be purchased. Ld. Counsel of the assessee has submitted the sale prices to the AEs are determined by market force and not dictated by the SEC Korea. It is noted that in the relevant assessment year only small portion of assessee's total sales are to AEs (i.e. approx. 33.40% in AY 07-08 and 16.40% in AY 08-09). Bulk of the other sales (i.e 66.60% approx in AY 07-08 and83.60% in AY 08-09) are to non AE's. In these circumstances, assessee cannot be termed as contract manufacturer. Thus, Revenue has not been able to bring on record any evidence that assessee is mandated to sell goods to overseas group companies in any manner. It has been claimed by the Id. Counsel of the assessee that just like in arms length/third party situation, the sales made by the assessee to assessee group company is dependent at the outcome of the negotiation between the overseas group companies and assessee on the terms of the contract. It has f....
X X X X Extracts X X X X
X X X X Extracts X X X X
....d, ld. Counsel of the assessee has rightly pointed that the TPO in his order has not doubted the benefits received by the assessee from the payment of royalty. That in fact by accepting the arms length nature of royalty paid on sales made to third party, the TPO has implicitly accepted the benefit derived by the assessee by making royalty payment (irrespective whether it is made to group companies or third parties). Thus, we agree with the contention of the ld. Counsel of the assessee that in these circumstances, the statement of the TPO that assessee has not been able to demonstrate the benefit is not sustainable and hence reliance placed on para 6.14 is devoid of cogency. 6.11 It has further been pointed by the Id. Counsel of the assessee that para 6.17 of the OECD Commentary states that in some circumstances, the price of the intangibles may stand included in price of goods transacted with AEs and consequently, any additional royalty would have to be disallowed in the case of the buyer. In this regard, we agree with the ld. Counsel of the assessee that in his order the TPO has not provided any specific reason for placing reliance on the above para. Further, the TPO has not dem....
X X X X Extracts X X X X
X X X X Extracts X X X X
....o record any variance with the well reasoned elaborate findings of fact recorded by the ld. CIT(A). The same are hereby upheld. The grievance sought to be raised by the Department is thus found to be without substance and shorn of merit. The same is hereby rejected." 6.13 We find that the facts of the above case are similar to the facts of this case as discussed hereinabove. Hence, the above decision also supports the case of the assessee. 7. In the background of the aforesaid discussions and precedents, we hold that royalty payment on exports sales by the assessee to the AE's @ 8% at Rs. 266,81, 794/- has been rightly paid the royalty paid is at arm's length and no adjustment in this regard is called for." It becomes pertinent to note that although the aforesaid decision of the Tribunal was assailed by way of ITA 324/2017, the said appeal came to be dismissed consequent to the condonation of delay application being rejected by the Court on 28 April 2017. 7. Reverting then to the facts of the present case, we note that the respondent-assessee assailed the directions of the DRP by filing a separate appeal and which has come to be allowed by virtue of the order impugned her....
X X X X Extracts X X X X
X X X X Extracts X X X X
....f legitimate business transaction would be an arbitrary exercise. This legal position stands affirmed in EKL Appliances Ltd. (supra). The decision accepts two exceptions to the said rule. The first being where the economic substance of the transaction differs from its form. In such cases, the tax authorities may disregard the parties' characterisation of the transaction and re-characterise the same in accordance with its substance. The Tribunal has not invoked the said exception but the second exception, i.e., when the form and substance of the transaction are the same but the arrangements made in relation to the transaction, when viewed in their totality, differ from those which would have been adopted by the independent enterprise behaving in a commercially rational manner. The second exception also mandates that the actual structure should practically impede the tax authorities from determining an appropriate transfer price. The majority judgment does not record the second condition and holds that in their considered opinion, the second exception governs the instant situation as per which, the form and substance of the transaction were the same but the arrangements made in r....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ein it was observed that the gross profit earned by STI on the export sales made to the AEs was 19.18%, contrasted with the gross profit of 23.24% made to independent parties demonstrating that STI charged independent entities a price higher than that charged to its AEs. The DRP accordingly held that STI had not charged its AEs' for technical know-how and had embedded the value of the said intangible in the sale price of the goods sold to independent parties. As a result, the DRP concluded that STI was acting as a contract manufacturer because it had not been remunerated as if it were an independent manufacturer that utilized intangibles in the form of technical know-how in its own right to independently manufacture goods which would eventually be sold to group entities. 13. We deem it apposite to extract the said observations rendered by the DRP hereinbelow: "6.3. The Panel has considered the contention of the assessee. As discussed above, OECD guidelines recognizes that payment for intangibles could be embedded in the value of purchases/sales to the AEs. From the table given in para 6 above, it can be seen that gross profit earned by the assessee on the export sales made to th....
X X X X Extracts X X X X
X X X X Extracts X X X X
....tting aside the Draft Assessment Order bearing in mind the undisputed position that STI had exported mobile phones not only to its group companies but also to third parties. Mr. Sinha highlighted the fact that a majority of those export sales had been made to third parties and that a minuscule percentage of the said exports pertained to group entities. 16. According to learned counsel, the AO as well as the DRP had committed a manifest illegality in holding that while affecting sales to group companies, the assessee had acted merely as a contract manufacturer. Mr. Sinha submitted that the aforesaid view is rendered wholly untenable and proceeds in ignorance of the fact that STI operated as a full-fledged licensed manufacturer in its own right and could not be viewed as a contract manufacturer. Sustenance in this regard was also sought to be drawn from the findings which ultimately came to be recorded by the Tribunal and stand embodied in its order of 21 June 2013 pertaining to AY 2007-08. 17. As we peruse the order which was rendered by the Tribunal for the aforesaid year, we find that the Tribunal had on that occasion found that royalty payments were indelibly connected to the r....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ot be determined at 'Nil'. We deem it apposite to extract the following passages from that decision: - "12. The contention that the adjustment on account of expenses as determined by the Transfer Pricing Officer must be attributed entirely to the international transaction is bereft of any merits. During the financial year 2003-04 relating to the assessment year 2004-05, the assessee had reported an operating income of Rs. 72,24,22,000. The total expenses for the said period amounted to Rs. 68,00,88,000. Admittedly, the international transactions in question amounted to Rs. 15,90,66,935 which were only 23.38 per cent. in value of the total expenses. The Transfer Pricing Officer had determined the profit level indicator (operating profit over total cost) of comparable cases at 8.29 per cent. against 6.22 per cent. as declared by the assessee. Applying the profit level indicator of comparable cases, the adjusted total expenses were computed at Rs. 66,71,17,924, thus, indicating an adjustment of Rs. 1,29, 70,076. As is apparent from the above, the said adjustment related to the entire expenses and not just the international transactions alone. Since the international transactions onl....
X X X X Extracts X X X X
X X X X Extracts X X X X
....e entire expenditure or a part thereof on the ground that the assessee has suffered continuous losses. The financial health of the assessee can never be a criterion to judge allowability of an expense; there is certainly no authority for that. What the Transfer Pricing Officer has done in the present case is to hold that the assessee ought not to have entered into the agreement to pay royalty/brand fee, because it has been suffering losses continuously. So long as the expenditure or payment has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the Transfer Pricing Officer to disallow the same on any extraneous reasoning. As provided in the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and then make suitable adjustment but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the Transfer Pricing Officer is not contemplated or authorised." 21. Similar observations pertaining to the powers of the TPO were rendered by a Coordinate Bench of this Court in the case of Commissioner of Income-tax v. Cushman and Wakefield (India) Pvt. Ltd.....
X X X X Extracts X X X X
X X X X Extracts X X X X
....y irrelevant, because whether a particular expense on services received actually benefits an assessee in monetary terms or not even a consideration for its being allowed as a deduction in computation of income, and, by no stretch of logic, it can have any role in determining the arm's length price of that service. When evaluating the arm's length price of a service, it is wholly irrelevant as to whether the assessee benefits from it or not; the real question which is to be determined in such cases is whether the price of this service is what an independent enterprise would have paid for the same. Similarly, whether the associated enterprises gave the same services to the assessee in the preceding years without any consideration or not is also irrelevant. The associated enterprises may have given the same service on gratuitous basis in the earlier period, but that does not mean that the arm's length price of these services is 'nil'. The authorities below have been swayed by the considerations which are not at all relevant in the context of determining the arm's length price of the costs incurred by the assessee in cost contribution arrangement. We have also n....
X X X X Extracts X X X X
X X X X Extracts X X X X
....sessee has not determined the arm's length price. The burden is initially on the assessee to determine the arm's length price. Thus, the argument of the assessee that the Transfer Pricing Officer has exceeded his jurisdiction by disallowing certain expenditure, is against the facts. The Transfer Pricing Officer has not disallowed any expenditure. Only the arm's length price was determined. It was the Assessing Officer who computed the income by adopting the arm's length price decided by the Transfer Pricing Officer at 'nil'." This is a slender yet the crucial distinction that restricts the authority of the Transfer Pricing Officer. Whilst the report of the Transfer Pricing Officer in this case ultimately noted that the arm's length price was 'nil', since a comparable entity would pay 'nil' amount for these services, this court noted that remarks concerning and the final decision relating to, benefit arising from these services are properly reserved for the Assessing Officer. 36. In this case, the issue is whether an independent entity would have paid for such services. Importantly, in reaching this conclusion, neither the Revenue, nor....
X X X X Extracts X X X X
X X X X Extracts X X X X
....tives of Samsung Korea. Those transactions clearly appear to have been guided and informed by STI's business and commercial interests. 25. The mere factum of STI being a wholly owned subsidiary of Samsung Korea does not necessarily entail that it was engaged in the manufacture and sale of mobile handsets solely at the behest and directives of Samsung Korea or having undertaken that exercise as a contract manufacturer. Samsung Korea, during A.Y. 2008-09, was stated to have been in receipt of a technical assistance fee and royalty from STI necessary for the latter to engage in its manufacturing activities. There was no material placed on the record to show that the manufacture and sale of the aforenoted goods by STI was dependent on directives issued by Samsung Korea or even that STI was contractually obliged to manufacture goods on behalf of Samsung Korea. 26. We find that although the Act does not definitionally contemplate the concept of a 'contract manufacturer', the meaning liable to be ascribed to that expression can be safely discerned from the Organisation for Economic Co-Operation and Development-Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrat....
X X X X Extracts X X X X
X X X X Extracts X X X X
....Korea or any of the AEs'. 29. Admittedly, STI is dependent on Samsung Korea for the technological know-how required to manufacture goods out of India, without which STI would not be in a position to manufacture the said goods under the Samsung brand. However, the manufacturing of the goods itself is done by STI at its own behest and there is nothing on the record to demonstrate that the manufacture and sale of goods by STI falls under the discretion or control of Samsung Korea. We also take note of the fact that no evidence had been adduced to show that any of the revenue incurred by STI for the manufacture and sale of mobile handsets is in any way repatriated to Samsung Korea. 30. We also find ourselves unable to agree with the submissions rendered by Mr. Kumar, that the entire transaction between STI and its AEs' was meant to operate as a profit shifting mechanism, merely because independent entities were charged a higher price in comparison with the AEs' of STI. In our view, it would be erroneous to conclude that the sale of goods manufactured by STI to its AEs was done with a view to shift profits across jurisdictions, even if the price of royalty was embedded in the sale pri....
X X X X Extracts X X X X
X X X X Extracts X X X X
....e deprived of the right to obtain an arms' length return on the utilization of its patented or proprietary technology and know-how. This in light of the undisputed fact that the latter could not have engaged in the manufacture and sale of goods without the technological know-how provided by Samsung Korea. 32. We find that the aforenoted position is affirmed by the following guidelines appearing in Chapter VI of the OECD Guidelines, 2022 regarding Special Considerations for Intangibles: "6.48. In identifying arm's length prices for transactions among associated enterprises, the contributions of members of the group related to the creation of intangible value should be considered and appropriately rewarded. The arm's length principle and the principles of Chapters I-III require that all members of the group receive appropriate compensation for any functions they perform, assets they use, and risks they assume in connection with the development, enhancement, maintenance, protection, and exploitation of intangibles. It is therefore necessary to determine, by means of a functional analysis, which member(s) perform and exercise control over development, enhancement, maintenance, prote....