2015 (7) TMI 81 - AT - Income Tax

Transfer pricing adjustment - selection of comparable - AMP expenses - Held that - Before the PLI determined at entity level is to be taken as the determining factor of bench marking various international transactions along with the AMP expenditure, it is to be clearly demonstrated how the transactions of the advertisement expenditure is closely linked to the other transactions in the distribution segment. Ld. TPO in para 10.4 has observed that assessee company has not been able to demonstrate that there was any prior understanding, design or commercial logic or rational for aggregation of the transactions. He has observed that the assessee company has not been able to demonstrate that there was any logic or rationale for aggregation or that the transactions of the advertisement expenditure and the other transactions in the distribution activity are interdependent. Therefore, the contention of ld. counsel that since PLI at entity level is much more than that of the comparables, therefore, no separate bench marking of the functions is to be carried out, is devoid of any merit. However, at the same time we find that Hon ble Delhi High Court in the case of Soni Erection has rejected the applicability of bright line test and as noted earlier, ld. TPO and ld. DRP have not pointed out the AMP functions being carried out by the assessee, vis a vis the comparables and applied the bright line test. Therefore, in view of the observations it would be proper to restore this issue to the file of Ld. TPO for bench marking the AMP functions, keeping in view the decision of Sony Ericson Mobile (2015 (3) TMI 580 - DELHI HIGH COURT). We may point out that assessee would be free to demonstrate its claim regarding aggregation of AMP functions with other international transactions, particularly in view of the observations of Hon ble Delhi High Court in para 101 of the order. We may further clarify that while computing the components of AMP expenditure, direct selling and distribution have to be excluded in view of the decision in the case of Sony Ericson (supra). AS regards the objections of ld. counsel on selection of comparables, we are of the opinion that whole exercise has to be carried out de novo - Decided partly in favour of assessee for statistical purposes only.

Issues Involved:
1. Determination of the arm's length price (ALP) for international transactions.
2. Consideration of Advertisement, Marketing, and Promotion (AMP) expenses as an international transaction.
3. Application of the Transactional Net Margin Method (TNMM) and Comparable Uncontrolled Price (CUP) method.
4. Selection and rejection of comparables for benchmarking.
5. Application of the bright line test for AMP expenses.
6. Exclusion of selling and distribution expenses from AMP expenses.
7. Aggregation of AMP functions with other international transactions.
8. Rejection of the bright line test by the Delhi High Court.

Detailed Analysis:

1. Determination of the arm's length price (ALP) for international transactions:
The assessee, a wholly-owned subsidiary of a US-based company, engaged in manufacturing and trading of lens care solutions and other ophthalmic products, filed its return of income declaring substantial income under normal provisions and book profit. The Assessing Officer (AO) noticed international transactions with Associated Enterprises (AEs) and examined the assessee's transfer pricing study, which divided the business into vision care and surgical equipment segments, using the TNMM method with adjusted operating profit/sales as the profit level indicator (PLI). The AO proposed filters for comparables and selected only two from the assessee's list, rejecting others for various reasons.

2. Consideration of Advertisement, Marketing, and Promotion (AMP) expenses as an international transaction:
The Transfer Pricing Officer (TPO) considered AMP expenses as an international transaction, noting that the assessee incurred significant expenses on AMP activities, developing marketing intangibles for Bausch & Lomb products. The TPO applied the CUP method, using the bright line test to determine the ALP of AMP expenses, and computed a substantial adjustment. The assessee filed objections, arguing that AMP expenses were for maintaining and increasing its market share in India and had been benchmarked under TNMM.

3. Application of the Transactional Net Margin Method (TNMM) and Comparable Uncontrolled Price (CUP) method:
The TPO rejected the assessee's contention that since TNMM was used for benchmarking, AMP expenses could not be separately benchmarked using the bright line test. The TPO applied the CUP method, considering only two comparables for benchmarking AMP expenses, and computed the ALP with a markup. The Dispute Resolution Panel (DRP) upheld the TPO's action, considering AMP expenses as an international transaction and justifying the bright line test's application.

4. Selection and rejection of comparables for benchmarking:
The TPO and DRP rejected several comparables proposed by the assessee, selecting only two for benchmarking AMP expenses. The DRP directed the TPO to verify the results of the search from the annual reports of comparables for calculating operating margins and AMP by sales ratio. The assessee argued that the DRP and TPO had not correctly applied the trading filter and should have considered the entity-level PLI, which included AMP expenses.

5. Application of the bright line test for AMP expenses:
The TPO applied the bright line test to determine the adjustment required for excessive AMP expenses. The Delhi High Court, in the case of Sony Ericsson Mobile Communications India Pvt. Ltd., rejected the bright line test applied by the Special Bench of ITAT in the case of L.G. Electronics India Pvt. Ltd. The court emphasized that aggregation of transactions is desirable if they are interrelated and cannot be evaluated separately. The assessee argued that AMP expenses should be aggregated with other international transactions and benchmarked at the entity level.

6. Exclusion of selling and distribution expenses from AMP expenses:
The Delhi High Court, in the case of Sony Ericsson, held that selling and distribution expenses should be excluded from AMP expenses. The assessee argued that the TPO should verify whether selling and distribution expenses were considered while computing margins and exclude them from AMP expenses. The court directed the TPO to exclude direct selling and distribution expenses while computing AMP expenses.

7. Aggregation of AMP functions with other international transactions:
The Delhi High Court emphasized that AMP expenses should be aggregated with other international transactions if they are interrelated. The assessee argued that the TPO should consider the entity-level PLI, which includes AMP expenses, and not benchmark AMP expenses separately. The court directed the TPO to benchmark AMP functions, keeping in view the decision in the case of Sony Ericsson, and allow the assessee to demonstrate its claim regarding aggregation.

8. Rejection of the bright line test by the Delhi High Court:
The Delhi High Court rejected the bright line test for determining the adjustment required for AMP expenses. The court directed the TPO to benchmark AMP functions without applying the bright line test and to consider the entity-level PLI, which includes AMP expenses. The court restored the matter to the TPO for fresh consideration, directing the TPO to exclude direct selling and distribution expenses from AMP expenses and to benchmark AMP functions in line with the court's observations.

Conclusion:
The court set aside the assessment order and restored the matter to the AO/TPO for fresh consideration, directing the TPO to benchmark AMP functions without applying the bright line test, exclude direct selling and distribution expenses from AMP expenses, and consider the entity-level PLI, which includes AMP expenses. The assessee's appeal was partly allowed for statistical purposes.

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