2014 (12) TMI 437 - AT - Income Tax

Transfer pricing adjustment - advertisement, marketing and sales promotion expenses Held that - As decided in LG. Electronics India P. Ltd. Versus Assistant Commissioner of Income-tax 2013 (6) TMI 217 - ITAT DELHI - the transfer pricing adjustment in relation to the AMP expenses incurred by the assessee for creating or improving the marketing intangibles for and on behalf of its foreign associated enterprises, is permissible the question as to whether the assessee should have earned a mark-up from its AE in respect of such AMP expenses incurred for and on behalf of the AE, has also been answered by eventually restoring the matter to the file of TPO for de novo adjudication in the light of certain guidelines outlined in the order thus, the matter is remitted back to the AO for fresh decision Decided in favour of assessee. Computation of ALP - International transaction of payment of Royalty - Whether TNMM can be used on entity level for benchmarking several international transactions including Royalty on a combined basis Held that - The authorities below were justified in rejecting the assessee s point of view of combining several transactions under the TNMM - the CUP is the most appropriate method to determine the ALP of an international transaction provided the appropriate comparable uncontrolled data is available - The CUP is considered as a most preferred method because it seeks to compare the price charged or paid for property transferred or services provided - It is under this method alone that the price charged or paid is directly compared with the price charged or paid in an uncontrolled comparable transaction - Rest of the four specific methods seek to make comparison of the price charged or paid indirectly through the medium of normal profit accruing or arising in a comparable uncontrolled transaction - the appropriate comparable uncontrolled data of the international transaction of royalty payment is available, which was furnished by the assessee and considered by the TPO as well as the DRP - the CUP is the most appropriate method for determining the ALP of Royalty transaction under the present circumstances. Whether rate of Royalty approved by the RBI is binding Held that - Certain benches of the Tribunal have held that the rate of royalty as approved by the Government of India/Reserve Bank of India should be considered at arm s length price, whereas other benches have not affirmed such a view - on the contrary, some of the decisions which have not approved this line of thinking that the rate of royalty as allowed by the Government of India/Reserve Bank of India should be construed as an arm s length rate assessee initially argued and also submitted Synopsis in support of the contention, that if the payment of royalty has been made as per the rate approved by the RBI, then no further benchmarking is required and the question of determination of ALP should be deemed as set to rest. Selection of some companies as comparable Functionally dissimilar company - Held that - The assessee s contention cannot be accepted for including this company in the list of comparables because this company is using technical know-how for manufacture of a component of an air conditioner, whereas the assessee is using technical know-how for the manufacture of air conditioners as such - There can be no comparison of know-how for manufacturing a component of an air conditioner with the manufacturing of AC as such. Since this company is functionally dissimilar, its exclusion from the list of comparables is directed. There can be no hindrance in the assessee urging for the inclusion of new companies in the list of comparables for the first time before the DRP - The only condition is that such companies should actually conform to the comparability criterion with the assessee - the assessee used Royalty stat (not an Indian data base) with certain filters for selecting new comparable companies - The Indian legislation does not admit such interquartile range, which is prevalent in some other countries - The Indian law talks of arithmetic mean of all the potential comparable companies - the DRP was justified in directing the AO to include only three companies in the list of comparables to the exclusion of other companies. Deduction for perpetual agreement Held that - The assessee entered into the Agreement with LG Electronics for supply of technical assistance on perpetual basis - the three companies shortlisted as comparables, entered into agreement for a limited period of time - the assessee entered into a perpetual agreement for getting technical knowhow, to be upgraded from time to time, with the re-negotiable royalty clause and thus paid royalty during the year at the maximum permissible domestic rate of 5% coupled with the payment of Design and Drawing Fees and also undertaking to pay Additional Model(s) fee - It is but natural to factor the effect of such temporary lull in the rate of royalty to be charged as per the commercial realities, so as to set off the possible loss due to temporary non-user of technical information after the termination of the agreement - This tends to increase the rate of royalty in a case of fixed term license - as there can be no such possibility of non-user of technical know-how in the case of an agreement with perpetuity, other things being equal, the rate of royalty in a perpetual agreement is bound to be low. The international transaction is for payment of royalty under a perpetual agreement and the comparable uncontrolled transactions have a fixed term agreements commanding higher rate of royalty, there is a need to adjust the price of such uncontrolled transactions in conformity with subclause (ii) of rule 10B(1)(a) so to bring it at par with the international transaction under consideration - This can be done by suitably reducing the rate of royalty paid by the comparable companies to equalize it with the condition of perpetual agreement commanding relatively low rate of royalty - the authorities below were justified in reducing the average rate of royalty of comparable uncontrolled transactions. Determination of reduction in the rate of royalty Held that - The assessee had a perpetual license, he discounted the uncontrolled royalty rate by 2%, thereby calculating the arm s length royalty rate at 1.5% - the DRP rightly considered three companies as comparable, whose average rate of unadjusted royalty comes at 4.5% within the meaning of subclause (i) of rule 10B(1)(a) - When rate is discounted with 10% under sub-clause (ii), resulting into a deduction of 0.45% (10% of 4.5), the arm s length rate of royalty as per sub-clause (iii) of rule 10B(1)(a) comes to 4.05% (4.5-0.45). It is this rate, which is directed to be applied as arm s length rate of royalty payment. Rule of Consistency Held that - The rule of consistency cannot be stretched so far as to come in the way of the applying the correct provisions of law, if in the earlier year the authorities proceeded on a wrong notion - along with the rule of consistency, there is another equally significant rule of no estoppel against the law - the assessee benchmarked the international transaction of royalty by clubbing it along with the other international transactions, such as, import of raw material and components, service spares, export of finished goods along with commission, training fee, import of software services, etc. - All the international transactions were benchmarked in a combined manner under TNMM on an entity level - royalty is not closely linked with other international transactions and hence should be benchmarked separately in assesse s own case it has been held that each international transaction should be separately benchmarked and not in a consolidated manner, unless these are closely linked transactions. Evidently transaction of royalty cannot be considered as closely linked with the other international transactions as were clubbed by the assessee - the ALP of Royalty payment was required to be determined separately, as has been rightly done by the TPO for the instant year, justifying departure from the contrary view taken in the preceding year thus, the arm s length rate of royalty be taken at 4.05% and the addition on account of transfer pricing adjustment of royalty payment at 5% be made accordingly. International transaction of payment of Export commission Held that - Assessee claimed that LG Korea rendered numerous services for which commission was paid at the rate of 4.5% - in the absence of any positive and speaking evidence of services, there can be no question of allowing any deduction - apart from theoretically listing several activities allegedly performed by LG Korea, the assessee failed to file any evidence worth the name, either before the TPO or the DRP to show that such services were actually rendered - the assessee failed to adduce any positive evidence about the rendering of services by LG Korea - the assessee made a claim made before the DRP about LG Korea having rendered several services to promote the export of Colour TVs in Middle East and South Asian countries - the TPO proposed transfer pricing adjustment with the Nil ALP of the Commission transaction on the ground that no evidence of any services rendered by the foreign AE, was furnished thus, the very factum of the assessee having availed any services from its AE has not been proved with any positive evidence whatsoever, the deduction is held to be rightly denied by the AO Decided against assessee. Royalty to be treated as capital expenses or not Held that - The license was given on non-transferable basis, there is a confidentiality clause prohibiting the assessee from divulging the relevant information during continuation of the agreement or any time thereafter; on the termination of the agreement, respective rights or obligations under the agreement shall cease; and there is no power with the assessee to sub-license - royalty payment is to be treated as revenue nature thus, the total royalty payment, as reduced by the transfer pricing adjustment on this score, be treated as a revenue expenditure Decided in favour of assessee.

Summary

Issues Involved:
1. General and premature grounds.
2. Transfer pricing adjustment for AMP expenses.
3. Transfer pricing adjustment for royalty payment.
4. Transfer pricing adjustment for export commission.
5. Treatment of sales tax subsidy.
6. Disallowance of provision for service warranty.
7. Disallowance of royalty as capital expenditure.
8. Deduction under section 80JJAA.
9. Charging of interest under sections 234B and 234C.

Detailed Analysis:

1. General and Premature Grounds:
- Ground Nos. 1 and 6: General grounds not requiring separate adjudication.
- Ground No. 7: Not pressed by the appellant's representative.
- Ground No. 14: Dismissed as premature.

2. Transfer Pricing Adjustment for AMP Expenses:
- Ground No. 3: Pertains to an addition of Rs. 1,82,71,11,446/- for AMP expenses.
- Special Bench Decision: The Special Bench in LG Electronics Pvt. Ltd. vs. ACIT held that transfer pricing adjustment for AMP expenses is permissible and the matter was restored to the TPO for de novo adjudication.
- Outcome: Matter sent back to TPO/AO for decision in line with the Special Bench verdict.

3. Transfer Pricing Adjustment for Royalty Payment:
- Ground No. 4: Concerns the addition of Rs. 76,50,88,800/- for royalty payment.
- TNMM vs. CUP: The authorities rejected TNMM on an entity level for royalty and applied CUP method.
- RBI Approval: The court held that RBI's approval for royalty rates is persuasive but not binding for transfer pricing adjustments.
- Selection of Comparables: The court upheld the inclusion of three comparables and excluded five others.
- Perpetual Agreement Adjustment: The court agreed with reducing the royalty rate due to the perpetual nature of the agreement but adjusted the reduction to 10%, resulting in an arm's length rate of 4.05%.
- Consistency Principle: The court rejected the argument for consistency, stating the need to correct any mistakes from previous years.
- Outcome: Arm's length rate of royalty set at 4.05%, modifying the addition accordingly.

4. Transfer Pricing Adjustment for Export Commission:
- Ground Nos. 5 and 11: Address the addition of Rs. 11,11,67,130/- for export commission.
- Lack of Evidence: The court found no concrete evidence of services rendered by the AE to justify the commission.
- TNMM on Entity Level: Rejected the application of TNMM on an entity level for this transaction.
- Cushman and Wakefield Principle: The court applied the principle that the TPO determines ALP, while the AO decides deductibility.
- Outcome: The addition was upheld due to the lack of evidence of services rendered.

5. Treatment of Sales Tax Subsidy:
- Ground No. 8: Concerns the treatment of Rs. 61,00,79,579/- as taxable revenue receipt.
- Consistent Tribunal View: The court followed the consistent view of treating sales tax subsidy as revenue receipt.
- Outcome: The ground was dismissed.

6. Disallowance of Provision for Service Warranty:
- Ground No. 9: Relates to the disallowance of Rs. 7,79,04,573/- for service warranty provision.
- Tribunal Precedent: The court followed the precedent of allowing this provision.
- Outcome: The ground was allowed.

7. Disallowance of Royalty as Capital Expenditure:
- Ground No. 10: Pertains to the disallowance of Rs. 81,98,02,800/- as capital expenditure.
- Nature of Royalty: The court held that the royalty payment for the use of technical know-how is revenue expenditure.
- Relevant Judgments: The court cited various Supreme Court judgments distinguishing between capital and revenue expenditures.
- Outcome: The royalty payment was treated as revenue expenditure.

8. Deduction Under Section 80JJAA:
- Ground No. 12: Concerns the restriction of deduction to Rs. 6.80 lakhs.
- Tribunal Precedent: The court followed the precedent of restricting the deduction.
- Outcome: The ground was dismissed.

9. Charging of Interest Under Sections 234B and 234C:
- Ground No. 18: The issue of charging interest is consequential.
- Outcome: The ground was disposed of accordingly.

Conclusion:
The appeal was partly allowed with modifications in the transfer pricing adjustments for royalty payment and disallowance of provision for service warranty, while other grounds were dismissed or upheld as per the tribunal's consistent view and legal precedents.