2016 (7) TMI 1055 - HC - Income Tax

Transfer pricing adjustment - application of berry ratio - Held that - Berry ratio can be used only in very limited circumstances and the limitations that we have listed above are by no means exhaustive. There is also a view expressed that use of Berry ratio as a PLI results in indicating less than fair ALPs in tax jurisdiction where the Assessees have a lower bargaining power. In the aforesaid context, in our view, the TPO had correctly reasoned that Berry ratio could not be used as a PLI in cases of Assessees which were using intangibles. However, we find that there was no cogent material for the TPO to hold that the Assessee had developed supply chain and human resources intangibles. In any event, there was no material to conclude that costs of such intangibles were not captured in the operating expenses. In our prima facie view, the third reason stated by the TPO, that is, the rate of commission paid to the Assessee is based on the value of the goods, would be a valid reason to reject the use of Berry ratio because Berry ratio can only be applied where the value of the goods are not directly linked to the quantum of profits and the profits are mainly dependent on expenses incurred. The fundamental premise being that the operating expenses adequately represent all functions performed and risks undertaken. For this reason Berry ratio is effectively applied only in cases of stripped down distributors; that is, distributors that have no financial exposure and risk in respect of the goods distributed by them. In the present case, the Assessee asserts that its business comprises of two segments, trading segment and indenting segment and the functional risk and the reward in the two segments are different. In the trading segment, the Assessee earns a higher profit margins (calculated on the value of the goods traded) while in the indenting segment its profit margins are lower. Plainly, the use Berry ratio would give unreliable results if the product mix of the comparables is different from the product mix of the Assessee. This would make the task of finding a set of comparables fairly difficult. - Decided in favour of assessee.

Issues Involved:
1. Determination of the Arms Length Price (ALP) for indenting transactions with Associated Enterprises (AEs).
2. Appropriateness of the Transactional Net Margin Method (TNMM) and the use of Berry Ratio as the Profit Level Indicator (PLI).
3. Comparability of indenting transactions with AEs and Non-AEs.
4. Tribunal's method of computing ALP without reference to a specific method.
5. Tribunal's rejection of economic adjustments for volume and product differences.

Detailed Analysis:

1. Determination of the Arms Length Price (ALP) for indenting transactions with Associated Enterprises (AEs):
The core controversy in these appeals relates to the Transfer Pricing Adjustments directed by the Tribunal concerning the commission earned by the Assessee from international transactions with its AEs. The Tribunal directed that the ALP for such transactions be determined based on the average rate of commission earned by the Assessee in transactions with unrelated parties (Non-AEs). The Assessee contended that this direction was erroneous as the indenting transactions with Non-AEs were not comparable with those with AEs due to differences in volume and product types. Additionally, the Assessee argued that the Tribunal did not follow any particular method in determining the ALP, rendering the process arbitrary.

2. Appropriateness of the Transactional Net Margin Method (TNMM) and the use of Berry Ratio as the Profit Level Indicator (PLI):
The Assessee used TNMM with Berry Ratio as the PLI in its transfer pricing report, which was rejected by the TPO. The TPO argued that Berry Ratio was not permissible under Rule 10B(1)(e) of the Income Tax Rules. The Tribunal accepted the Assessee's contention that indenting transactions were different from trading transactions and that the commission/service income from AEs should be compared with similar transactions with Non-AEs. However, the Tribunal did not allow adjustments for differences in volume and associated risks. The Tribunal directed that the commission rate of 2.26% for Non-AEs be used as the benchmark for ALP determination for AEs.

3. Comparability of indenting transactions with AEs and Non-AEs:
The Tribunal found that indenting transactions were different from trading transactions, as the Assessee did not incur significant financial obligations or risks in indenting transactions. However, the Tribunal did not conduct an in-depth inquiry into the similarity between the transactions with AEs and Non-AEs, such as examining the volume and product differences. The Assessee argued that the volume of transactions with Non-AEs was insignificant compared to those with AEs and that the products involved were different, which could affect the commission rates.

4. Tribunal's method of computing ALP without reference to a specific method:
The Tribunal effectively used the Comparable Uncontrolled Price (CUP) Method to determine the ALP but did not conduct a thorough examination of the relevant uncontrolled transactions. The Tribunal should have ensured a high degree of similarity between the controlled and uncontrolled transactions, which it failed to do. The TPO also did not follow any particular method in making the ALP adjustment, leading to the use of a hybrid method that was not permissible.

5. Tribunal's rejection of economic adjustments for volume and product differences:
The Tribunal rejected the Assessee's claim for adjustments based on volume and product differences, reasoning that each transaction was separate and did not warrant volume discounts. However, the Tribunal did not adequately address the Assessee's contention that the product mix and volume differences could significantly impact the commission rates. The Tribunal's approach was found to be insufficient in ensuring a fair comparison between the transactions with AEs and Non-AEs.

Conclusion:
The High Court found that the Tribunal erred in determining the ALP based on the commission rate for Non-AEs without a thorough examination of the similarity between the transactions. The Court held that the TPO and Tribunal did not follow a specific method in making the ALP adjustment and that the use of Berry Ratio as the PLI was not adequately justified. The Court remanded the matter back to the Tribunal for a fresh examination of the issues related to Transfer Pricing in accordance with the law. The Tribunal may further remand the matter to the TPO/AO for a detailed analysis. The parties were left to bear their own costs.

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