2011 (9) TMI 204 - AT - Income Tax

Arm s length price (ALP) - Transactions with Associated Enterprises (AE) TPO held that cost plus compensation @ 5% of cost of the assessee is not at arm s length and he decided that it is not reflecting the profit attributable to the assessee. -held that - In assessee s case, the associated enterprise has been receiving the mark up as 5% of the FOB value of exports effected by assessee by applying its tangible and intangible capacity. The critical and all crucial work is done by assessee. The AE is paying back to the assessee only on the basis of cost plus 5% mark up. Such an arrangement cannot be said at arms length. In our considered view, such method will go against the basic normal business sense, as inefficient and high cost services provided by assessee shall fetch more revenue to the assessee. Such an arrangement on the face of it cannot be said to be at arm s length. 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 to execute the agreements. Therefore, we find no merits in this plea. The other claim of the assessee that location savings attributable to the end purchaser is also not justified as the assessee has developed many unique intangibles and also human capital intangibles which gives the locational advantage to procure low cost goods which helps the associated enterprise to obtain/retain the business and also benefits the end purchaser. AO as well as the DRP has proceeded on a wrong footing which have given absurd results of adjustments. In view of the fact that majority and crucial services rendered by assessee, the distribution of compensation received by AE @ 5% of the FOB value of the exports between the assessee and the associated enterprise should be in the ratio of 80 20. The assessee must get 80% of the total receipt by AE from the ultimate purchasers. AO is directed to compute the arm s length price in the above manner. - Decided in favor of assessee partly.

Issues Involved:
1. Determination of Arm's Length Price (ALP) for international transactions.
2. Appropriateness of the Transactional Net Margin Method (TNMM).
3. Inclusion of FOB value of exports in the cost base.
4. Markup percentage applicable to the cost base.
5. Consideration of unique intangibles and locational savings.
6. Consistency with previous assessments and application of res judicata.
7. Allocation of compensation between the assessee and associated enterprise (AE).

Detailed Analysis:

1. Determination of Arm's Length Price (ALP) for International Transactions:
The primary issue revolves around determining the ALP for the international transactions undertaken by the assessee, a subsidiary of a Mauritius-based company, providing buying/sourcing services to its affiliate in Hong Kong. The Transfer Pricing Officer (TPO) challenged the cost-plus markup of 5% declared by the assessee, arguing it did not reflect the profit attributable to the assessee due to the critical functions performed, significant risks assumed, and unique intangibles developed by the assessee.

2. Appropriateness of the Transactional Net Margin Method (TNMM):
The assessee applied the TNMM to determine the ALP, comparing its operating profit margin with that of comparable companies. The TPO, however, found the cost-plus compensation method inadequate, arguing that the assessee's functions, risks, and intangibles necessitated a different approach.

3. Inclusion of FOB Value of Exports in the Cost Base:
The TPO included the FOB value of exports in the cost base for calculating the remuneration accruing to the assessee, asserting that the assessee performed all critical functions and developed intangibles that benefited the AE. The Dispute Resolution Panel (DRP) upheld this inclusion but reduced the markup from 5% to 3%, considering 5% excessive.

4. Markup Percentage Applicable to the Cost Base:
The DRP concluded that a 3% markup on the FOB value of exports was reasonable, covering the valuable intangibles developed and the locational savings passed on to the AE. This adjustment resulted in an addition of Rs.33,59,69,186 to the assessee's income.

5. Consideration of Unique Intangibles and Locational Savings:
The TPO and DRP emphasized that the assessee had developed unique intangibles and supply chain management systems, contributing to the AE's profitability and locational savings. The assessee argued that these factors were not adequately considered and that the adjustment was inconsistent with the TNMM application rules.

6. Consistency with Previous Assessments and Application of Res Judicata:
The assessee contended that the TNMM method had been accepted in previous assessments without adjustments, invoking the principle of consistency. However, the tribunal clarified that the principle of res judicata does not apply to income tax proceedings, and each assessment year is a separate unit.

7. Allocation of Compensation Between the Assessee and AE:
The tribunal noted that the AE received 5% of the FOB value of exports, while the assessee was compensated on a cost-plus 5% basis. Given the critical functions and intangibles developed by the assessee, the tribunal held that the majority of the compensation based on the FOB value should accrue to the assessee. The tribunal directed that the compensation should be allocated in an 80:20 ratio between the assessee and the AE, with the assessee receiving 80% of the total receipts by the AE from the ultimate purchasers.

Conclusion:
The appeal was partly allowed, with the tribunal directing the AO to compute the ALP by allocating 80% of the total receipts by the AE to the assessee, ensuring the adjustment does not exceed the amount received by the AE. This decision acknowledges the significant contributions and intangibles developed by the assessee, aligning the compensation more closely with the value provided.

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