2014 (12) TMI 10 - AT - Income Tax

Transfer Pricing Adjustments - Reduction on value of sales as arrived at net sales value Computation of Royalty 2 5% - Held that - As decided in assessee s own case for the earlier assessment year, it has been held that the methodology adopted by the Revenue to rework the net sales value for the purposes of computing royalty payable was not justified - what is liable to be considered as standard bought-out components are such material on which no further processing is required and are directly fitted into the final product and, cost of such material only needs to be deducted from the sale price to compute the royalty payable - it cannot be construed that the so-called constituent material are merely fitted into the final product - on the contrary, it is a case where such material also undergoes a chemical reaction in the process of producing the final product and the same are irretrievable once the finished product is manufactured - the so-called constituent materials classified by the TPO cannot be equated to standard bought-out components so as to reduce their cost from the sales value to compute the royalty payable there was no justification on the part of the TPO in rejecting the methodology adopted by the assessee to calculate net sales for the purposes of computing the royalty payable thus, the action of the AO in considering certain raw materials used in the production process as mere constituent chemicals and equating it to standard bought-out components so as to reduce their cost from the sales value for the purposes of computing net sales value eligible for royalty payment is liable to be set-aside - Decided in favour of assessee. Transfer pricing adjustment for royalty payments to AE - Held that - The appellant company is paying royalty to the AE for transfer of technology in terms of a Foreign Technology Collaboration agreement, which has been duly approved by the Government of India - royalty payments are authorized on domestic sales and on export sales @ 5% and 8% respectively of Net sales , subject to taxes - The items of manufacture covered by the foreign collaboration are polymerization initiators , which is a product manufactured by the assessee for use as catalyst in manufacturing of polymers - The approval prescribes that the royalty payable shall be calculated in accordance with the provisions of the Foreign Exchange Control Manual of RBI and other subsisting instructions of Govt. of India/Reserve Bank of India - the claim of the assessee is that such chemicals are indeed raw materials used by the assessee in its manufacturing process, and for the purpose of computing royalty payable in terms of Foreign Technology Collaboration agreement, cost of raw material is not prescribed as a deductible item in order to calculate Net sales . What is liable to be considered as standard bought-out components are such material on which no further processing is required and are directly fitted into the final product; and, cost of such material only needs to be deducted from the sale price to compute the royalty payable - it cannot be construed that the so-called constituent material are merely fitted into the final product, on the contrary, it is a case where such material also undergoes a chemical reaction in the process of producing the final product and the same are irretrievable once the finished product is manufactured - the so-called constituent materials classified by the TPO cannot be equated to standard bought-out components so as to reduce their cost from the sales value to compute the royalty payable there was no justification on the part of the TPO in rejecting the methodology adopted by the assessee to calculate net sales for the purposes of computing the royalty payable. Rate of royalty payment on export sales - Held that - Assessee has brought out differences between the two agreements i.e. agreement between assessee and the AE and the agreement between TNAPC and the AE on the other hand - The two agreements differ in their period of operation as also the products covered; and such a factual matrix has not been rebutted by the Revenue - the transaction of royalty payment by the Chinese company, M/s TNAPC to the AE cannot be considered as a comparable transaction for the purposes of determining the arm s length price of the international transaction of royalty payment on export sales, under the CUP method applied by the TPO thus, the TPO erred in re-working the stated value of the international transaction of royalty payment based on his interpretation of the expression Net Sales and considering the royalty payment by TNAPC to the AE as a comparable transaction under the CUP method for the purposes of determining the arm s length price of the international transaction of royalty payment claimed by the assessee the AO is directed to delete the adjustment made in respect of royalty payment. Export of certain finished goods Held that - CIT(A) was rightly of the view that there is no infirmity on the part of the TPO in invoking the CUP method because the product sold is identical - a pertinent point has also been made out by the assessee that after export to the AE, the same product has been ultimately sold by the AE to a uncontrolled party at a price, which can be taken to be the then prevailing international prices - Therefore, it is sought to be made out that the maximum price, which assessee could have realized on export of the product to a non-AE would be the prevailing international price, which was the price for which the AE sold the product to the ultimate customer - It was pointed out that the adjustment permissible in order to bring the transaction to the level of arm s length price can it best be restricted to the difference between the price charged by the AE from the ultimate customer and the price charged by assessee to the AE - the AO shall allow the assessee a reasonable opportunity of being heard and only thereafter he shall pass an appropriate order Decided in favour of assessee. Selection of comparables - Marketing and sale support services segment Held that - The claim of the assessee to exclude M/s Agrima Consultants International Ltd. from the list of comparables cannot be shutout merely because at a certain point of time assessee had included it, in the list of comparables - so long as assessee can demonstrate that the concern is not includible on account of its differences having regard to the FAR analysis the same would be liable to be excluded - in-principle it can make out a case for exclusion of M/s Agrima Consultants International Ltd., although the said concern was included by it in its list of comparables in the Transfer Pricing Study the concern has also been found to be excludible by the TPO in AY 2006-07 thus, the matter is to be remitted back to the AO for adjudication Decided partly in favour of assessee.

Summary

Issues Involved:
1. Validity of notice issued under Section 148 of the Income Tax Act.
2. Methodology for computing royalty payable to the associated enterprise.
3. Disallowance of excess provision of royalty payable under Section 40A(2b) of the Income Tax Act.
4. Transfer pricing adjustments for royalty payments.
5. Transfer pricing adjustments for export of certain finished goods.
6. Transfer pricing adjustments for marketing and sales support services.
7. Penalty proceedings under Section 271(1)(c) of the Income Tax Act.

Detailed Analysis:

1. Validity of Notice Issued under Section 148 of the Income Tax Act:
The assessee challenged the validity of the notice issued under Section 148 of the Act. The tribunal noted that since the assessee obtained relief on the primary issue of royalty computation, the ground concerning the validity of the notice under Section 148 was rendered academic and was not adjudicated further.

2. Methodology for Computing Royalty Payable to the Associated Enterprise:
The tribunal examined the methodology adopted by the assessee for computing royalty payable to its associated enterprise. The Assessing Officer (AO) and the Commissioner of Income Tax (Appeals) [CIT(A)] had disallowed a portion of the royalty payment on the grounds that the cost of certain raw materials, termed as 'constituent chemicals,' needed to be deducted from the sales value to arrive at the net sales value for royalty computation. The tribunal referred to its earlier decision where it held that the methodology adopted by the Revenue to rework the net sales value for computing royalty was not justified. The tribunal directed the AO to delete the addition made on account of excess royalty.

3. Disallowance of Excess Provision of Royalty Payable under Section 40A(2b) of the Income Tax Act:
The tribunal addressed the disallowance of Rs. 19,54,132/- made by the AO on account of excess royalty payment. The tribunal found that the AO's action of considering certain raw materials as 'constituent chemicals' and equating them to standard bought-out components was without basis. The tribunal held that the raw materials used in the production process undergo a chemical reaction and are not retrievable, thus they cannot be equated to standard bought-out components. The tribunal directed the AO to delete the disallowance.

4. Transfer Pricing Adjustments for Royalty Payments:
The tribunal considered the transfer pricing adjustment of Rs. 79,96,489/- made by the AO concerning royalty payments. The AO had adopted a lower royalty rate based on a comparable transaction within the group. The tribunal held that the AO's action of reworking the royalty payable based on his interpretation of 'Net Sales' was incorrect. The tribunal also noted that the comparable transaction used by the AO was a controlled transaction and not an uncontrolled comparable transaction as required under the Comparable Uncontrolled Price (CUP) method. The tribunal directed the AO to delete the adjustment.

5. Transfer Pricing Adjustments for Export of Certain Finished Goods:
The tribunal examined the transfer pricing adjustment of Rs. 14,63,820/- for the export of finished goods. The AO had applied the CUP method by comparing the export price to the price charged to third parties in India. The tribunal upheld the application of the CUP method but accepted the assessee's plea for adjustments to account for differences in volumes, geographical factors, and other aspects. The tribunal remanded the issue back to the AO to consider the assessee's working and ensure it conformed to the tribunal's earlier decision.

6. Transfer Pricing Adjustments for Marketing and Sales Support Services:
The tribunal addressed the transfer pricing adjustment of Rs. 5,83,268/- for marketing and sales support services. The assessee sought the exclusion of a comparable, M/s Agrima Consultants International Ltd., which was included in the Transfer Pricing Study. The tribunal agreed with the assessee, noting that the comparable was functionally distinct and had been excluded in a previous assessment year. The tribunal remanded the matter to the AO to verify the functional similarity and decide accordingly.

7. Penalty Proceedings under Section 271(1)(c) of the Income Tax Act:
The tribunal noted that the AO had initiated penalty proceedings under Section 271(1)(c) on the premise of transfer pricing adjustments. However, since the primary adjustments were deleted or remanded for reconsideration, the penalty proceedings were not addressed in detail.

Conclusion:
The tribunal partly allowed the appeals of the assessee, directing the AO to delete the disallowances and adjustments made concerning royalty payments, export of finished goods, and marketing and sales support services. The tribunal also remanded certain issues for further verification and consideration by the AO.