2014 (1) TMI 501 - HC - Income Tax

Whether the arm s length price applying the TNMM method was contrary to the transfer pricing provisions Held that - The tax authorities i.e. the TPO, and the AO (as well as the DRP) and the Tribunal accepted the application of TNMM by LFIL as the most appropriate one - They did not consider the cost plus compensation at 5% at arm s length as the assessee was performing all critical functions, assuming significant risks and 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 - Having determined that (TNMM) to be the most appropriate method, the only rules and norms prescribed in that regard could have been applied to determine whether the exercise indicated by the assessee yielded an ALP. The approach of the TPO and the tax authorities in essence imputes notional adjustment/income in the assessee s hands on the basis of a fixed percentage of the free on board value of export made by unrelated party venders. Lower authorities, including the Tribunal, misdirected themselves in holding that LFIL assumed substantial risk - 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 - LFIL does not bear the enterprise risk for manufacture and export of garments - LFIL s functional and risk profile thus is entirely different and has nothing to do with the manufacture and export of garments by unrelated third party vendors - LFIL renders support services in relation to the exports, which are manufactured independently - Attributing the costs of such third party manufacture, when LFIL does not engage in that activity, and more importantly, when those costs are clearly not LFIL s costs, but those of third parties, is clearly impermissible - LFIL has developed experience and expertise which the Tribunal has held to be human capital and supply chain intangibles But this does not reveal how the assessee borne the risk either enterprise or economic. LFIL s remuneration on a cost plus mark-up of 5 per cent represents the functions performed, assets utilized and risks assumed by it - The TPO s determination that LFIL borne significant risks is not borne out from the records - Its remuneration was based entirely on the costs borne by it - It is a low risk contract service provider exclusively rendering sourcing support to the AE. It does not bear any significant operational risks for its functions, rendered to the third party vendor/customers - Rather, it is the AE that undertakes substantial functions and in fact assumes enterprise risks, such as market risk, credit risk etc. It also bears the letter of credit associated charges and other expenses. 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 - The assessment carried out by the assessee must first be rejected, for any further alterations to take place - Once the TNMM was deemed most appropriate method, the distortions, if any, had to be addressed within its framework - The unrelated transactions which were compared by LFIL have not been adversely commented upon, and neither has the choice of the TNMM - The TPO ignored the relevant and crucial material, and straightaway proceeded to broaden the base for arriving at the profit margin, for attributed income of the assessee - No such adjustment was made in the earlier assessment years, for which assessment orders of previous four years were submitted, wherein the TNMM with operating profit over total cost (OP/TC) as a profit level indicator was accepted previously Consistency should be followed in the assessment unless different facts circumstances are warranted. The TPO is required to scrutinize the various methods that may be employed to evaluate their appropriateness, the correctness of the data, consideration of surrounding factors, etc - The selection of the most appropriate method will depend upon the facts of the case and factors mentioned in rules contained in Rule 10C - The TPO after taking into account all relevant facts and data available to him has to determine arm s length price and pass a speaking order after obtaining the approval of the Department of Income Tax (Transfer Pricing) - The order should contain details of data used, reasons for arriving at a certain price and applicability of methods, subject to judicial scrutiny. The order of the TPO has not provided any substantive reasons for disregarding the TNM method as applied by LFIL - The TPO s arbitrary exercise of adjusting the cost plus mark up of 5% on the FOB value of exports finds no mention in the IT Act nor the Rules - Such an exercise of discretion by the TPO, disregarding the LFIL s lawful tax planning measures with its group companies, is not in compliance with the IT Act and Rules of Income Tax Decided in favour of assessee.

Summary

Issues Involved:
1. 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?
2. 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?

Detailed Analysis:

1. Assessment of Arm's Length Price Using TNMM Method:

The appellant, LFIL, a subsidiary of Li & Fung (South Asia) Ltd., entered into an agreement with its AE for providing sourcing services, remunerated at cost plus a 5% markup. LFIL applied the Transactional Net Margin Method (TNMM) to justify that the transaction was at arm's length, considering its operating profit margin exceeded that of comparable companies.

The TPO, however, disputed LFIL's method, arguing that LFIL performed all critical functions, assumed significant risks, and developed unique intangibles, thus justifying a higher markup based on the FOB value of exports. The TPO's reasoning included factors like LFIL's human capital intangible, supply chain management, and locational savings.

The Tribunal upheld the TPO's view, stating that the compensation model should reflect the critical functions and risks assumed by LFIL, thus justifying a markup on the FOB value of goods sourced through LFIL.

2. TPO's Apportionment and Compliance with Law:

LFIL contended that the TPO's enhancement of its cost base by including the cost of manufacture and export of finished goods by third-party vendors was inconsistent with Rule 10B(1)(e) of the IT Rules. LFIL argued that the TNMM should only consider costs incurred by LFIL itself, not by unrelated third parties.

The court noted that Rule 10B(1)(e) specifies that the net profit margin should be computed with reference to the costs incurred, sales effected, or assets employed by the enterprise itself. The TPO's approach of considering the FOB value of exports by third-party vendors was not supported by the TNMM under Rule 10B(1)(e).

The court further observed that LFIL's functional and risk profile did not involve direct manufacture of goods, and it did not bear enterprise risks associated with such manufacturing. LFIL's remuneration on a cost plus 5% markup was consistent with its functions and risks assumed.

Conclusion:

The court concluded that the TPO's addition of the cost plus 5% markup on the FOB value of exports was without foundation and contrary to the provisions of the IT Act and Rules. The appeal was allowed, and the order of the ITAT Tribunal was set aside. The questions of law were answered in favor of the assessee, LFIL, and against the revenue.