2011 (11) TMI 194 - AT - Income Tax

Transfer Pricing Determination of Arm Length price - Transaction by transaction analysis vs Transactional Net Margin Method ( TNMM ) on a company wide basis assessee engaged in manufacture & sale of readymade garments Also engaged in providing buying services to the associated enterprise - Held that - Assessee s different segmental activities viz. manufacturing export activities, buying/sourcing and commission earning activities are independent of each other. Each activity has different factors in respect of source, identification of vendors, merchandise, designs quality control, handling etc. The FAR analysis in each of the activity will have distinct and separate considerations. They are required to be analyzed on transaction to transaction basis and not by combining all activities. Hence, TPO did not appreciate the assessee s transactions correctly and applied entity level benchmarking on TNMM method by combining assessee s all international transactions with associated enterprise without justification. - Decided in favor of assessee.

Issues Involved:
1. Confirmation of the order under section 92CA(3) by the DRP.
2. Rejection of transaction-by-transaction analysis and application of TNMM on a company-wide basis.
3. Non-adjustment for material differences between the appellant and comparable companies.
4. Selection of inappropriate comparables for benchmarking.
5. Adjustment to the arm's length value of international transactions.
6. Non-application of the 5% variation margin in determining the arm's length price.
7. Non-fulfillment of preconditions for making reference to the TPO and lack of opportunity for being heard.

Detailed Analysis:

1. Confirmation of Order under Section 92CA(3):
The appellant contested the confirmation of the TPO's order by the DRP, which upheld the draft order passed by the AO. The DRP's confirmation was challenged on the grounds that the TPO's method of applying TNMM on a company-wide basis was erroneous.

2. Rejection of Transaction-by-Transaction Analysis:
The appellant argued that the TPO and DRP erred in rejecting the transaction-by-transaction analysis and instead applied TNMM on a company-wide basis. The appellant provided detailed justifications for each transaction using the most appropriate method, such as CUP for import of garments, raw materials, and payment of royalty, and TNMM for export of finished goods and receipt of commission. The TPO, however, combined all transactions for benchmarking, which was not in conformity with Income Tax rules and OECD guidelines.

3. Non-Adjustment for Material Differences:
The appellant contended that the DRP failed to direct the TPO to make suitable adjustments for material differences between the appellant and comparable companies. The appellant highlighted that the low profitability was due to substantial expenses incurred in promoting and establishing its business in the domestic market, which were not related to international transactions.

4. Selection of Inappropriate Comparables:
The appellant challenged the selection of certain comparables by the TPO, arguing that:
- Raymond Apparel Limited had substantial related party transactions (26.22%).
- Kewal Kiran Clothing Limited underwent major restructuring during the relevant year.
- Microtex India Limited did not meet the turnover criteria.
- Koutons Retail India Limited underwent major restructuring and its financial statements were not publicly available.

5. Adjustment to Arm's Length Value:
The appellant argued that the TPO's adjustment to the arm's length value of international transactions was unjustified. The TPO combined all international transactions and applied TNMM on an entity-wide basis, leading to an adjustment of Rs. 1,51,62,998. The appellant contended that the international transactions were already at arm's length based on their transaction-by-transaction analysis.

6. Non-Application of 5% Variation Margin:
The appellant argued that the DRP erred in not directing the TPO to allow a downward variation of 5% in determining the arm's length price. The appellant cited the amended proviso to section 92C, which was not applicable to A.Y. 2006-07, and argued that even if all factors were assumed against the appellant, the operating profit margin would still be within the permissible 5% margin.

7. Non-Fulfillment of Preconditions for TPO Reference:
The appellant contended that the AO failed to meet the preconditions for making a reference to the TPO under section 92CA(1) and did not provide an opportunity for being heard before referring the transfer pricing issues to the TPO.

Tribunal's Findings:

- The Tribunal found merit in the appellant's argument that the TPO should have accepted the transaction-by-transaction analysis instead of applying TNMM on an entity-wide basis.
- The Tribunal upheld the appellant's method of benchmarking analysis on a transaction-by-transaction basis for different segments of international transactions.
- The Tribunal noted that the TPO did not correctly appreciate the appellant's transactions and applied entity-level benchmarking without justification.
- The Tribunal supported the exclusion of certain comparables (Raymond Apparel Limited, Kewal Kiran Clothing Limited, Microtex India Limited, Koutons Retail India Limited) due to their high related party transactions, restructuring, and other factors.
- The Tribunal concluded that the appellant's operating profit margin for exports to related parties was higher than the average operating profit margin of comparable companies.
- The Tribunal also accepted the appellant's alternate contention based on the 5% variation margin, noting that the appellant's operating profit margin was within the permissible range.

Conclusion:
The Tribunal allowed the appellant's appeal, upholding the transaction-by-transaction analysis and excluding the inappropriate comparables selected by the TPO. The Tribunal deleted the additions made by the AO and confirmed that the appellant's international transactions were at arm's length.

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