2015 (3) TMI 580 - HC - Income Tax

Transfer pricing adjustment - arm s length pricing of international transactions - Whether the additions suggested by the TPO on account of Advertising/Marketing and Promotion Expenses was beyond jurisdiction and bad in law as no specific reference was made by the Assessing Officer, having regard to retrospective amendment to Section 92CA of the Income Tax Act, 1961 by Finance Act, 2012? - Held that - The majority decision of the Tribunal in L.G. Electronics India Pvt Ltd. 2013 (6) TMI 217 - ITAT DELHI has rightly drawn a distinction between sub-section (2B) and sub-section (2A) to Section 92CA of the Act. - In the present case, the claim of the assessee is that they had disclosed the international transaction in their report under Section 92E which included AMP expenses incurred by them. This aspect relates to merits, i.e. whether or not there was one composite, bundled or a packaged international transaction, but once for the said transaction a report in Form 92E was submitted, separate reference/approval was not required. Reference of the bundled transaction under sub-section (1) to Section 92CA is sufficient. Section 92CA has to be interpreted pragmatically. Therefore, once reference of a composite/bundled or packaged international transaction is made, it will be difficult for the assessee to contest applicability of sub-section (1) in cases of segregation or when the TPO invokes sub-section (2B) to Section 92CA of the Act. This flaw as it existed stands corrected with insertion of Sub-Section (2B) to Section 92CA with retrospective effect. It clarifies and cures the deficiency and shortcoming of the earlier provision. In view of insertion of sub section (2B) to Section 92CA of the Act, the decision of the Delhi High Court in the case of Commissioner of Income Tax versus Amadeus India Pvt. Ltd. 2011 (11) TMI 73 - DELHI HIGH COURT and of the Gujarat High Court in Veer Gems versus Assistant Commissioner of Income Tax 2011 (10) TMI 262 - GUJARAT HIGH COURT would no longer be applicable as the ratio of the said decisions reflects the position of the statute before enactment of Sub-Section (2B) with retrospective effect. - Decided in favour of the Revenue. Whether AMP Expenses incurred by the assessee in India can be treated and categorized as an international transaction under Section 92B? - Transaction and International Transaction; Difference between Section 37(1) and Chapter X of the Act - Held that - The contention that AMP expenses are not international transactions has to be rejected. There seems to be an incongruity in the submission of the assessee on the said aspect for the simple reason that in most cases the assessed have submitted that the international transactions between them and the AE, resident abroad included the cost/value of the AMP expenses, which the assessee had incurred in India. When the assessed raise the aforesaid argument, they accept that the declared price of the international transaction included the said element or function of AMP expenses, for which they stand duly compensated in their margins or the arm s length price as computed. We also fail to understand the contention or argument that there is no international transaction, for the AMP expenses were incurred by the assessed in India. The question is not whether the assessed had incurred the AMP expenses in India. This is an undisputed position. The arm s length determination pertains to adequate compensation to the Indian AE for incurring and performing the functions by the domestic AE. The dispute pertains to adequacy of compensation for incurring and performing marketing and non-routine AMP expenses in India by the AE. The expenses incurred or the quantum of expenditure paid by the Indian assessee to third parties in India, for incurring the AMP expenses is not in dispute or under challenge. This is not a subject matter of arm s length pricing or determination. The fact that this expenditure was incurred and has to be allowed as deduction under Section 37(1) of the Act has not been challenged by the Revenue. Revenue in their written submission accepts and has rightly stated that the test of allowability of expenditure under Section 37(1) is whether the said expenditure is incurred wholly or exclusively for the business consideration. So long as the expenditure is for business consideration, the Assessing Officer cannot question the quantum or the wisdom of the assessee in incurring the expense. Issue of arm s length price, per se does not arise, when deduction under Section 37(1) is claimed. Expenditure and decision of the assessee, whether or not to incur the said expenditure; the quantum thereof, cannot be a subject matter of challenge or disallowance by the Assessing Officer, once it is accepted that the expenditure was wholly, i.e. the quantum of expenditure incurred was fully, and exclusively for business purpose. Whether under Chapter X of the Income Tax Act, 1961, a transfer pricing adjustment can be made by the Transfer Pricing Officer/ Assessing Officer in respect of expenditure treated as AMP Expenses and if so in which circumstances? - Held that - Section 40A(2) clause (b) is a provision for computing arm s length price in case of two related parties as defined and applies even when the conditions stipulated in Section 37(1) of the Act are satisfied. The said provision relates to reasonability of the quantum. Similarly, Chapter X of the Act relates to arm s length pricing adjustment. Chapter X is not concerned with disallowance of expenditure but relates to determination of arm s length price/cost of an international transaction between the two AEs. It relates to income or receipts, and also expenses and interest but in a different context. Thus, Section 37(1) and Chapter X provisions pertain to different fields. As noticed above and subsequently, provisions of Chapter X are applicable to international transactions between two related enterprises. The purpose of determination of arm s length price is to find out the fair and true market value of the transaction and accordingly the adjustment, if required, is made. The said exercise has its own object and purpose. - Decided in favour of revenue. Transfer Pricing of International Transactions, Domestic Law, i.e. the Statutory Provisions of the Act, Section 92(3) of the Act and Bundled / Inter-Connected Transactions, TNM Method Enunciated, Brand and Brand Building, Bright Line Test, Aggregation or Disaggregation of Transactions and Set Off in Segregation of Bundled Transactions; whether Section 92(3) prohibits segregation, Economic Ownership - Held that - The legal ratio accepted and applied by the Tribunal relying upon the majority decision in L.G. Electronics India Pvt. Ltd (2013 (6) TMI 217 - ITAT DELHI) is erroneous and unacceptable. For reasons set out above, we have passed an order of remand to the Tribunal to examine and ascertain facts and apply the ratio enunciated in this decision. For the purpose of clarity, we would like to enlist our findings - In case of a distributor and marketing AE, the first step in transfer pricing is to ascertain and conduct detailed functional analysis, which would include AMP function/expenses. The second step mandates ascertainment of comparables or comparable analysis. This would have reference to the method adopted which matches the functions and obligations performed by the tested party including AMP expenses. A comparable is acceptable, if based upon comparison of conditions a controlled transaction is similar with the conditions in the transactions between independent enterprises. In other words, the economically relevant characteristics of the two transactions being compared must be sufficiently comparable. The assessed, i.e. the domestic AE must be compensated for the AMP expenses by the foreign AE. Such compensation may be included or subsumed in low purchase price or by not charging or charging lower royalty. Direct compensation can also be paid. The method selected and comparability analysis should be appropriated and reliable so as to include the AMP functions and costs. Where the Assessing Officer/TPO accepts the comparables adopted by the assessed, with or without making adjustments, as a bundled transaction, it would be illogical and improper to treat AMP expenses as a separate international transaction, for the simple reason that if the functions performed by the tested parties and the comparables match, with or without adjustments, AMP expenses are duly accounted for. It would be incongruous to accept the comparables and determine or accept the transfer price and still segregate AMP expenses as an international transaction. The Assessing Officer/TPO can reject a method selected by the assessed for several reasons including want of reliability in the factual matrix or lack / non-availability of comparables. (see Section 92C(3) of the Act).When the Assessing Officer/TPO rejects the method adopted by the assessed, he is entitled to select the most appropriate method, and undertake comparability analysis. Selection of the method and comparables should be as per the command and directive of the Act and Rules and justified by giving reasons. Distribution and marketing are inter-connected and intertwined functions. Bunching of inter-connected and continuous transactions is permissible, provided the said transactions can be evaluated and adequately compared on aggregate basis. This would depend on the method adopted and comparability analysis and the most reliable means of determining arm s length price. To assert and profess that brand building as equivalent or substantial attribute of advertisement and sale promotion would be largely incorrect. It represents a coordinated synergetic impact created by assortment largely representing reputation and quality. Brand has reference to a name, trademark or trade name and like goodwill is a value of attraction to customers arising from name and a reputation for skill, integrity, efficient business management or efficient service. Brand creation and value, therefore, depends upon a great number of facts relevant for a particular business. It reflects the reputation which the proprietor of the brand has gathered over a passage or period of time in the form of widespread popularity and universal approval and acceptance in the eyes of the customer. Brand value depends upon the nature and quality of goods and services sold or dealt with. Quality control being the most important element, which can mar or enhance the value. Parameters specified in paragraph 17.4 of the order dated 23rd January, 2013 in the case of L.G. Electronics India Pvt Ltd (supra) are not binding on the assessed or the Revenue. The bright line test has no statutory mandate and a broad-brush approach is not mandated or prescribed. We disagree with the Revenue and do not accept the overbearing and orotund submission that the exercise to separate routine and non-routine AMP or brand building exercise by applying bright line test of non-comparables should be sanctioned and in all cases, costs or compensation paid for AMP expenses would be NIL , or at best would mean the amount or compensation expressly paid for AMP expenses. It would be conspicuously wrong and incorrect to treat the segregated transactional value as NIL when in fact the two AEs had treated the international transactions as a package or a single one and contribution is attributed to the aggregate package. Unhesitatingly, we add that in a specific case this criteria and even zero attribution could be possible, but facts should so reveal and require. To this extent, we would disagree with the majority decision in L.G. Electronics India Pvt. Ltd. (supra). This would be necessary when the arm s length price of the controlled transaction cannot be adequately or reliably determined without segmentation of AMP expenses. The Assessing Officer/TPO for good and sufficient reasons can de-bundle interconnected transactions, i.e. segregate distribution, marketing or AMP transactions. This may be necessary when bundled transactions cannot be adequately compared on aggregate basis.When segmentation or segregation of a bundled transaction is required, the question of set off and apportionment must be examined realistically and with a pragmatic approach. Transfer pricing is an income allocating exercise to prevent artificial shifting of net incomes of controlled taxpayers and to place them on parity with uncontrolled, unrelated taxpayers. The exercise undertaken should not result in over or double taxation. Thus, the Assessing Officer/TPO can segregate AMP expenses as an independent international transaction, but only after elucidating grounds and reasons for not accepting the bunching adopted by the assessed, and examining and giving benefit of set off. Section 92(3) does not bar or prohibit set off. CP Method is a recognised and accepted method under Indian transfer pricing regulation. It can be applied by the Assessing Officer/TPO in case AMP expenses are treated as a separate international transaction, provided CP Method is the most appropriate and reliable method. Adoption of CP Method and computation of cost and gross profit margin comparable must be justified.The object and purpose of Transfer Pricing adjustment is to ensure that the controlled taxpayers are given tax parity with uncontrolled taxpayers by determining their true taxable income. Costs or expenses incurred for services provided or in respect of property transferred, when made subject matter of arm s length price by applying CP Method, cannot be again factored or included as a part of inter-connected international transaction and subjected to arm s length pricing. Selling expenses - whether in the nature of trade/volume discounts, rebates and commission paid to retailers/dealers etc. cannot be included in the AMP Expenses? - Held that - Costs or expenses incurred for services provided or in respect of property transferred, when made subject matter of arm s length price by applying CP Method, cannot be again factored or included as a part of inter-connected international transaction and subjected to arm s length pricing. This situation would possibly result in over, if not double taxation, contrary to the object and purpose of arm s length pricing, which is to tax the real income after correcting the negative impact, if any, of the controlled conditions. Therefore, if entire marketing and distribution expenses, or marketing or AMP expenses are bench marked under CP Method, then it would be injudicious and irrational to apply any other method to compute the arm s length price of a larger composite international transaction, of which the said costs and expenses form only a part. Logically, if the costs or expenses as a function are excluded or included in the cost while computing the arm s length price under the CP Method, the gross profit as a result of such transaction would be lower or higher. This situation would be different from subjecting the same international transaction to arm s length pricing by two different methods, which is permissible, in the manner stipulated in the first Proviso to Section 92C of the Act.In the present case, neither the assessed nor the Assessing Officer/TPO has adopted CUP Method for determination of arm s length price. TNM Method or RP Method has been adopted and accepted as the most appropriate method. TNM Method, as noticed above, obligates analysis of profit and loss account and the test is benchmarking of operating profits with the relevant PLI and comparison with reference to the comparable. Discount and incentives offered, reduce the operating profits and, therefore, the benchmarking exercise with comparables, reflects and accounts for the same. We have examined the impact and consequences of applying CP Method, by factoring and treating AMP expenses and trade discounts and incentives as an independent international transaction, when we continue to treat the said expenses as a component of a packaged international transaction, which is separately benchmarked. This would not lead us to accurate and reliable results. There is need and requirement to check over or double taxation. The prime lending rate cannot be the basis for computing mark-up under Rule 10B(1)(c) of the Rules, as the case set up by the Revenue pertains to mark-up on AMP expenses as an international transaction. Mark up as per sub-clause (ii) to Rule 10B(1)(c) would be comparable gross profit on the cost or expenses incurred as AMP. The mark-up has to be benchmarked with comparable uncontrolled transactions or transactions for providing similar service/product. The Revenue s stand in some cases applying the prime lending rate fixed by the Reserve Bank of India with a further mark-up, is mistaken and unfounded. Interest rate mark-up would apply to international transactions granting/ availing loans, advances, etc. - Decided in favour of the assessee. Transfer pricing adjustment made on account of payment of royalty to an associated enterprise - Held that - On the question whether the royalty should have been paid or not, we are in agreement with the finding of the Tribunal that question of payment of royalty cannot be determined on the basis of profitability or earnings of the assessed, once it is accepted that know-how and technical information was provided. It is not alleged or the case of the Revenue that the technology or know-how was hopeless and useless. The finding of the Assessing Officer/TPO, that the assessee had not derived any commercial benefit as technology and know-how had not resulted in any substantial profit increase, has been rightly rejected as totally unsustainable. Profitability of the assessed could have been lower or varied due to various reasons and lower profitability in one or more years cannot lead to the conclusion that no benefits were derived or technology was unproductive. The justification given by the assessee for lower profits on account of bad debts, high rent, increase in legal cost stand highlighted and accepted by the Tribunal. Royalty payable for availing the right to use would depend upon corresponding price, which would have been paid by an independent or unrelated enterprise. This is judged by applying comparables. TPO has not rejected the quantum of royalty on the said principle. The reasoning given by the TPO is not only erroneous for the reasons stated above, but is also contrary to the Rules. Depending upon the method selected, net profit or gross profit of the assessed has to be compared with profit margins of related enterprise. The formula prescribed under the Rules does not accept the ratiocination adopted and applied by the TPO.The fact that royalty has been paid would be a relevant consideration and factum, when we consider arm s length price of the international transaction of distribution and marketing. Tax treatment of royalty payments being different, the royalty transaction, therefore, may be benchmarked separately. However, payment of royalty even if justified and appropriate on applying arm s length principle, can be a relevant factor when the question of compensation of the domestic AE for undertaking distribution and marketing functions arises for consideration. - Decided in favour of assessee.

Summary

Issues Involved:
1. Jurisdiction of Transfer Pricing Officer (TPO) regarding AMP expenses.
2. Categorization of AMP expenses as an international transaction.
3. Conditions for transfer pricing adjustment of AMP expenses.
4. Application of Cost Plus Method for AMP expenses.
5. Directions for fresh benchmarking/comparability analysis.

Issue-wise Analysis:

1. Jurisdiction of Transfer Pricing Officer (TPO) regarding AMP expenses:
The court held that the TPO has jurisdiction to examine and apply transfer pricing provisions to transactions, which come to his notice, even if the assessee has not furnished a report under Section 92E of the Income Tax Act. This is in line with the retrospective amendment to Section 92CA by the Finance Act, 2012. The TPO can evaluate transfer prices of undeclared international transactions if it is established that there was an international transaction for which a report was not furnished.

2. Categorization of AMP expenses as an international transaction:
The court rejected the contention that AMP expenses are not international transactions. It clarified that the arm's length determination pertains to adequate compensation to the Indian AE for incurring and performing functions, including AMP expenses. The expenses incurred by the Indian assessee for AMP purposes are recognized as international transactions under Section 92B of the Income Tax Act.

3. Conditions for transfer pricing adjustment of AMP expenses:
The court emphasized that AMP expenses should be adequately compensated by the foreign AE. This compensation can be included in the purchase price, lower royalty, or direct payments. The method selected and comparability analysis should appropriately include AMP functions and costs. The court also noted that the TPO can segregate AMP expenses as an independent international transaction if justified by grounds and reasons, ensuring no over or double taxation.

4. Application of Cost Plus Method for AMP expenses:
The court held that the Cost Plus Method (CP Method) is recognized under Indian transfer pricing regulations and can be applied if AMP expenses are treated as a separate international transaction. However, the adoption of CP Method must be justified, and the gross profit of the comparable must be reliable. The court also stated that if the entire marketing and distribution expenses are benchmarked under CP Method, it would be irrational to apply another method for the composite international transaction.

5. Directions for fresh benchmarking/comparability analysis:
The court disagreed with the Tribunal's reliance on the majority decision in L.G. Electronics India Pvt. Ltd. (supra) and the application of the 'bright line test' for AMP expenses. The court directed that the Tribunal should re-examine the factual matrix and apply the legal standards and ratios enunciated in this decision. The Tribunal should ensure that the gross/net profit margin accounts for AMP expenses and, if necessary, remand the case to the Assessing Officer/TPO for re-examination.

Separate Judgment on Royalty Payment by Reebok India Company Ltd.:
The court upheld the Tribunal's decision that the royalty payment was justified and should not be disallowed based on profitability alone. The royalty payment was benchmarked using the CUP Method, and the Tribunal found that the technology and know-how were provided under the licence agreement, justifying the royalty payment. The court emphasized that the financial health of the assessee should not determine the appropriateness of the transfer price paid for royalty.