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2015 (11) TMI 26 - HC - Income TaxTransfer pricing adjustment - whether Tribunal erred in replacing the PLI adopted by the Assessee to determine the ALP with another PLI despite not providing any cogent reasons for the same and in fact providing contradictory remarks while rejecting Return on Capital Employed ( ROCE ) as the PLI? - whether the Revenue was right in rejecting ROCE as a PLI - Held that - It appears to the Court that the rejection of ROCE as PLI by the Revenue for the AY in question is a fact that has been accepted and acted upon by JMIPL itself for the subsequent AYs when it changed its PLI to OP/TC-RCM, which appears to have been accepted by the Revenue. Question (i) is accordingly answered in the negative, i.e. in favour of the Revenue and against the Assessee. Not treating the cost of the raw material as a pass through cost - Assessee s contention rejected that cost of the raw material should be excluded from the total cost if the alternate PLI (i.e. Operating Cost as a percentage of Total Cost excluding raw material cost) is adopted even if the raw material was ordered based on recommendations and a confirmed order by the Assessee s customer Maruti Udyog Limited - Held that - In the absence of any reliable comparable data, and in the absence of proper reasons, it would not be justified for the Revenue to simply reject a financial ratio adopted by the Assessee for computing the net profit margin by excluding a pass though cost from the TC in the denominator. The expression any other relevant base occurring in Rule 10 (1) (e) (i) of the Rules is wide enough to encompass a denominator that excludes pass through costs as long it is demonstrated to be at arm s length. It is further importantly pointed out that the very purpose of transfer pricing is to benchmark transactions between related parties in order to discover the true price if such entities were unrelated. If MUL had bought the PGM directly from JMUK there would have been no application of transfer pricing since MUL and JMUK are unrelated entities. MUL would have purchased the PGM just like JMIPL did on negotiated prices. There is merit in the contention that the prices at which JMIPL purchased PGM from JMUK were already at arm s length and that it was for administrative convenience that MUL had outsourced this function to JMIPL. The submission of the Revenue that the accounting entries of JMUK do not treat the cost of PGM as a pass through cost fails to acknowledge that JMUK is in the business of selling PGM. It does not require to charge JMIPL for processing the raw material i.e. PGM as that is passed on to MUL s vendors and thereby to MUL. Finally, the Revenue has been unable to deny that the above alternate computation of the net profit margin by JMIPL for the subsequent AYs 2004-05, 2005-06 and 2006-07 has been accepted by the Revenue. While as a general proposition each assessment year should merit independent consideration, the Court finds no reason why for the AY in question, i.e. 2003-04, with no distinguishing features being pointed out, the Revenue would want to reject the alternate PLI adopted by JMIPL.For the above reasons, Question (ii) is answered in the affirmative, i.e in favour of the Assessee and against the Revenue.
Issues Involved:
1. Whether the Tribunal erred in replacing the Profit Level Indicator (PLI) adopted by the Assessee to determine the Arm's Length Price (ALP) with another PLI without providing cogent reasons. 2. Whether the Tribunal erred in not treating the cost of raw material as a pass-through cost and thus rejecting the Assessee's contention that the cost of raw material should be excluded from the total cost if the alternate PLI is adopted. Detailed Analysis: 1. Replacement of PLI: The first issue pertains to whether the Revenue was justified in rejecting the Return on Capital Employed (ROCE) as the PLI for determining the ALP. The Assessee, a contract manufacturer in a capital-intensive industry, had adopted the Transactional Net Margin Method (TNMM) using ROCE as the PLI for AY 2003-04, which was initially accepted by the Revenue for AY 2002-03 but rejected for AY 2003-04. The Court noted that Rule 10B(1)(e)(i) of the Income Tax Rules, 1962, prescribes the manner of computing net profit margin under TNMM, considering costs incurred, sales effected, or assets employed. The OECD Guidelines suggest that when PLI is "a net profit weighted to assets," it should use "operating assets." The reliability of ROCE as a PLI depends on the similarity in the composition of assets/capital deployed by the tested party and comparables. The Court observed that JMIPL itself recognized the limitations of adopting ROCE as the PLI for subsequent AYs and shifted to OP/TC-RMC, which was accepted by the Revenue. Thus, the rejection of ROCE as PLI by the Revenue for AY 2003-04 was deemed appropriate. 2. Treatment of Raw Material Cost: The second issue revolves around whether the cost of raw material should be considered a pass-through cost and excluded from the total cost when calculating the PLI. The agreement between JMIPL and MUL indicated that JMIPL's profit margin was dictated by negotiations with MUL, and JMIPL was obliged to procure raw materials on MUL's instructions at prices dictated by MUL. JMIPL contended that the entire cost of raw materials was passed on to or recovered from the ultimate customer without any markup. The Court acknowledged the OECD Guidelines, which allow the exclusion of pass-through costs from the denominator of total costs where the financial ratio of OP to TC is used. The Court noted that the Revenue's argument did not account for the actual arrangement between JMIPL and MUL. The Revenue failed to provide convincing reasons for rejecting JMIPL's alternate PLI of OP/TC-RMC, which had been accepted for subsequent AYs. The Court concluded that the Revenue's rejection of the alternate PLI for AY 2003-04 was unjustified, especially when the same had been accepted for subsequent AYs without any distinguishing features. Conclusion: The Court answered the first question in favor of the Revenue, rejecting ROCE as an appropriate PLI for AY 2003-04. However, the second question was answered in favor of the Assessee, acknowledging that the cost of raw materials should be treated as a pass-through cost. Consequently, the impugned order of the ITAT and corresponding orders of the TPO, AO, and CIT (A) for AY 2003-04 were set aside, and the addition to the Assessee's income was deleted. The appeal was allowed with no order as to costs.
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