2015 (9) TMI 609 - AT - Income Tax

Transfer pricing adjustment - deletion of adjustment pertaining to agency services function carried on by the appellant by CIT(A) - whether TPO/CIT(A) were incorrect in not bench-marking the functioning of import of products from M/s Corning SA France and receipt of agency commission from M/s Corning SA France - Held that - The conclusion however of the authorities below is that the distribution function and agency service function are not comparable. It has been found that distribution function involves import of furnished goods, its warehousing, advertisement marketing and distribution/sale of productions; whereas agency function involves coordination between customers and the head office and undertaking certain marketing and logistic services. Furthermore the risks assumed in distribution function are contract risk, marketing risk, credit risk, inventory risk etc.; whereas an agency functions assessee does not undertake contract risk, inventory risk, credit risk, etc. There is no dispute to the above findings arrived at by the authorities below. Having regard to the above factual matrix we are thus inclined to uphold the conclusion of the CIT(A) to benchmark the two independent functions separately. We do not find any merit in the contention raised by the learned counsel that these are closely linked transactions undertaken by the appellant. On the contrary the nature of transactions are functionally different and even the risk assumed are different. We thus negate the stand of the assessee and uphold the findings of CIT(A) in benchmarking the distribution/agency function separately. Allocation of expenses - No infirmity in the approach adopted by the CIT(A). The CIT(A) has correctly held that allocation of expenses in proportion to sales would amount to give equal weightage in terms of functions performed, assets utilized and risks assumed to both distribution function as well as agency service activity, which otherwise involves much lesser functions and utilization of assets and risk. - Decided against revenue. Excluding the custom duties on the import of ROB for benchmarking the arm s price - CIT(A) deleted the addition excluding the increased custom duties out of the cost of import of ROBs for benchmarking the arm s length price of distribution segment - Held that - . It may be taken note that in TNMM, basically a single line item of an expenditure of customs duty should not be excluded from the total cost for computing the operating profit. It is seen that the distributor / respondent has made a operating loss for the distribution business. It is noted that the assessee, TPO in spite of the loss suffered by the distributor, have applied TNMM to bench mark the distribution results. In our view the Revenue authorities and assessee should have looked into the characterization and accordingly pricing policy for the distribution business need to have been made after ascertaining as to whether the remuneration or pricing policy was at gross margin or net margin level in order to examine the reason for the loss. It is only after doing the said exercise the functional profile of the assessee as a normal risk taking distributor, which is capable of suffering a loss or limited risk distributor which generally operates with a steady but routine operating margin, can be ascertained. Thereafter, based upon such exercise, the applicability of the proper transfer pricing methodology namely re-sale price or TNMM may be applied with proper comparables. In the light of the aforesaid opinion of ours, we set aside this issue back to the file of the TPO/AO for fresh adjudication as stated above. - Decided partly in favour of revenue for statistical purpose.

Summary

Issues Involved:
1. Deletion of addition of Rs. 20.87 lakhs by excluding certain items out of cost of expenditure incurred for benchmarking the Arm's length price in respect of agency activities.
2. Deletion of addition of Rs. 1.11 crores by excluding the increased Custom Duties out of the cost of import of Rough Ophthalmic Blanket (ROB) for benchmarking the arm's length price.

Issue-wise Detailed Analysis:

1. Deletion of Addition of Rs. 20.87 Lakhs:
The primary contention revolves around whether the distribution activity and agency service activity should be considered together or separately for determining the arm's length price. The assessee argued that these activities are interlinked and should be evaluated together. However, the TPO and CIT(A) disagreed, stating that the functions and risks involved in distribution and agency services are different. The CIT(A) noted that distribution involves import, warehousing, marketing, and sales, whereas agency services involve coordination and marketing without significant risks.

The CIT(A) concluded that the expenses should be allocated based on the gross margin of distribution function and commission income, rather than sales. The CIT(A) excluded advertisement and insurance expenses from the common expenses and allocated the remaining expenses proportionally. The CIT(A) computed the adjustment after combining agency service activity with marketing service function, concluding that no adjustment was warranted as the total income from market support and agency service activities was higher than the arm's length price.

The Tribunal upheld the CIT(A)'s decision, agreeing that the distribution and agency functions should be benchmarked separately due to their different nature and risks. The Tribunal also upheld the allocation of expenses based on gross margin, finding no error in the CIT(A)'s approach.

2. Deletion of Addition of Rs. 1.11 Crores:
The issue here pertains to whether the increased custom duties should be included in the operating cost for benchmarking the arm's length price of the distribution segment. The assessee excluded foreign exchange loss and abnormal custom duty from the operating expenses, arguing that the significant increase in custom duty could not be passed on to customers and that comparable companies did not incur similar expenses.

The CIT(A) agreed with the assessee regarding custom duty, stating that it should not be taken into account for benchmarking analysis as it would distort the comparison. The CIT(A) excluded the custom duty from the operating cost, resulting in a higher profit margin for the distribution segment.

The Tribunal, however, found that excluding a single line item of expenditure (custom duty) in TNMM is not appropriate. The Tribunal noted that the distributor had made an operating loss and that the characterization and pricing policy for the distribution business should have been examined to ascertain whether the remuneration was at gross margin or net margin level. The Tribunal set aside the issue back to the TPO/AO for fresh adjudication, emphasizing the need to determine the proper transfer pricing methodology based on the functional profile of the assessee.

Conclusion:
The Tribunal dismissed the revenue's appeal regarding the deletion of Rs. 20.87 lakhs but set aside the issue of Rs. 1.11 crores back to the TPO/AO for fresh adjudication. The decision highlights the importance of proper functional analysis and allocation of expenses in transfer pricing cases.