9911796707
TMI Blog2012 (9) TMI 766X X X X Extracts X X X X X X X X Extracts X X X X ..... , erred on facts and in law in upholding the Ld. TPO's stance of not appreciating that the appellant is a low risk sourcing support service provider and disregarding the functional asset and risk ('FAR') profit of the appellant, on the basis of pre-conceived notions, surmises and conjectures , and without any cogent evidence, facts or basis whatsoever. 3. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in upholding the Ld. TPO's stance of disregarding the conservative benchmarking approach adopted by the appellant in its TP Documentation report for the year (full fledged distributors converted into service providers after making suitable working capital adjustments) to substantiate the arm's length nature of its international transactions. 4. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in upholding the Ld. TPO's stance of including the value of the goods sourced directly by the AEs of the appellant from third party vendors in the cost base of the appellant, for the purpose of computing the arm's length profit margin of the appellant on the alleged ground t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that the printers, scanners, UPS etc. cannot be said to be part and parcel of computer system and hence higher rate of depreciation is not admissible; - disregarding judicial pronouncements (in favour of the assessee ) while making the proposed adjustment. 12. On the facts and in the circumstances of the case and in law, the Ld. AO erred in initiating penalty proceedings under section 271(1)(c) read with section 274 of the Act." ITA no. 5147/Del/11 (A.Y. 2007-08): "1. The Learned Dispute Resolution Panel ("Ld. DRP') and the Ld. Assistant Commissioner of Income-tax ('Ld. A.O') (following the directions of the Ld. DRP), erred on facts and in law, in enhancing the income of the appellant by Rs. 2,628,618,693/- on account of the transfer pricing ('TP') adjustment u/s 92CA(3) of the Income Tax Act, 1961 ('Act') made by the Ld. Additional Commissioner of Income-tax, Transfer Pricing Officer -1(2) ('Ld. TPO'). 2. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law: 2.1 in upholding the Ld. TPO's stance of not appreciating that the appellant is a low risk sourcing support service provider and disregarding the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssing of the final directions by the DRP. 1.1 This is the second round of proceedings before ITAT in respect of A.Y. 2006-07 and first round for A.Y. 2007-08. In original proceedings for assessment year 2006-07 similar adjustment were proposed by Transfer Pricing Officer (TPO) for the assessment year (AY) 2006-07, which were followed by AO and a draft assessment order was proposed accordingly. Assessee approached the Dispute Resolution Panel (DRP), which confirmed the order of AO by a non-speaking order. The Assessee filed an appeal before the Income Tax Appellate Tribunal (ITAT) in this regard. The ITAT, restored the case back to the DRP for fresh adjudication with directions to pass a speaking and reasoned order after considering the evidence and submissions/ documents presented by the assessee. During the pendency of set aside proceedings for A.Y. 2006-07, DRP upheld similar adjustments for A.Y. 2007-08. Thereafter DRP re-heard the matter for A.Y. 2006-07 and upheld the entire TP adjustments and AOs order thereon. Aggrieved assessee is before us in both the years. 2. Brief facts are assessee (referred to as 'GIS' India) is a wholly owned subsidiary of GAP International Sourcin ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in India which have not been factored into in its remuneration model. TPO thus rejected the assessee's cost plus based remuneration model on the basis of theoretical assumptions, which are unsustainable and not based on any evidence. Accordingly, the Ld. TPO held the remuneration model of cost-plus 15% to be not in line with the arm's length standards. 3.2 TPO reconstructed the Profit & Loss account of the Appellant by notionally bringing the value of goods sourced by overseas AEs from India, which were neither fully sourced through it nor routed through its financial accounts and its Profit & Loss account. This resulted in phenomenally exorbitant TP adjustment of Rs. 2,362,231,473 in A.Y. 2006-07 and Rs. 2,628,618,693 in A.Y. 2007-08. 3.3 Assessee approached DRP where copious written submissions and arguments in support of its FAR profile as a limited risk bearing sourcing support service provider were submitted. It was claimed that assesses primary business activity comprised identification of vendors, provision of assistance to vendors in procurement of raw material, inspection and quality control, and co-ordination with vendors to ensure delivery of goods to GAP Group as per ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Information pertaining to sample development and confirmed sample orders, which includes records on sample developers, sample materials, seasonal samples, and samples of products that has been produced and shipped in accordance with GAP Group's instructions; - Software or other business processes used to order and track merchandise or used in any other way with sourcing activities; - Training materials developed either by GIS India or by GAP Group; - All know-how, processes and trade secrets relating to sourcing activities; - All confidential and proprietary information relating to sourcing activities; - Similar items as now exist or that may exist in the future that are developed either by GIS India, GAP Group or an affiliate of GAP Group in connection with sourcing activities. (iv) Thus the relevant, assets required for the business (including intangible assets) like vendor lists, business information, software, business processes, etc. are developed and owned by GAP Inc. and are provided to the Appellant for the conduct of its business. Thus assessee has to render service o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... no risk is attributable to assessee which is a key factor in determining the FAR. In the sourcing value chain, the Appellant's role is limited to operating within the confines of the requirements/ standards prescribed by overseas AEs. It performs strictly routine/ low value-adding activities and does not bear any of the key business risks such as market risk, product liability risk, product design and development risk, credit risk, price risk, foreign exchange risk etc. (ix) There is neither any basis nor supporting factual data for TPO to reach the conclusion that the Appellant had created any valuable / non-routine intangibles, for which a return on value of goods sourced by overseas AEs was required as consideration. Ld. TPO merely made a bald assumption that the Appellant had created valuable supply chain and human asset intangibles without giving proper reasonings evidential data / proof whatsoever to suggest that any intangibles have been created. (x) It is erroneously presumed that the 210 people employed with GIS India during the year were key decision making employees of the Company. It is emphasized that GIS India's role is to operate strictly within the co ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nditions that in the event of failure to comply with any term or requirement of a Purchase Order, retail companies shall be entitled to cancel, reject shipments, insist on re-performance, withhold payments, recover cost, offset any amounts due, etc. This demonstrates that the product liability in case of defect rests with the vendors and GIS India does not have any role to play in this regard. Thus there is no risk involved on this account. - Sample documents to substantiate that all product liability claims are settled between GAP Group and the vendor and GIS India only acts as a coordinator with no financial impact whatsoever. - Sample documents to substantiate that GAP Group directly maintains all vendor relationships. - Sample documents to substantiate that GAP Group drives all quality control strategy, standard and management requirement, whereas GIS India simply follows the instructions given therein which belies the allegation that assesses employees amounted to a human asset and there was creation of any intellectual property. - Sample documents to substantiate that GAP Group drives all market intelligence and product ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... GAP US stating that the vendor handbook is created only by GAP US and only GAP US is authorized to make any changes to it. - Sample copies of Purchase Orders which clearly establish the fact that the goods are directly sold by GAP Inc. from the third party vendors. - Relevant extracts of the company's website clearly evidencing/ corroborating the fact that the design/ development function is undertaken essentially in US, but certainly not in India. - Process maps which document that design, specification development and fabric development all occur in the US while GIS India plays a limited liaison role. - Spreadsheets that contain the US design, merchandising and sourcing costs for years 2005 and 2006 as well as GIS India operating costs for the same period. The disparity in the costs incurred by US group entities vis-à-vis GIS India indicates the relative value addition done in the US vis-à-vis India. 5.1 There is no substance in TPO's holding that GIS India has also borne major business risks arising from its activities. The Ld. TPO has not given any examples to demonstrate as to which major business risks is ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he valuable intangibles are owned by overseas group companies. As a result, the relative bargaining power of the overseas group companies is significant and not of the assessee. On the contrary, GIS India is a routine support service provider that undertakes routine liaisoning and co-ordination activities. Its bargaining power is negligible as compared to its overseas group companies. 5.6 Given the fact that GIS India does not have any unique intangibles or any distinctive competitive advantage vis-à-vis other similar sourcing companies in the market, which could have led to GIS India wielding significant bargaining power vis-à-vis its overseas group companies, it cannot be entitled to any location savings. 5.7 The DRP, during the remanded proceedings, out of voluminous documents submitted by GIS India referred to only one of the email exchanged between the Appellant and its group company regarding fabric hedging and long term booking. Without appreciating the essence of the same, the Ld. DRP simply held that the functions carried out by GIS India is similar to that of a manufacturer. An out of context reference from this email is uncalled for, more so when the Ld. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ged a mark-up of 15% on the costs incurred by it in connection with its service provision activity (Value Added Costs), which is three times the cost plus margin specified in the aforementioned Dutch Ruling for purchasing coordination/ support services, the scope of which is anyway broader than those provided by the Appellant. 6.1 Ld. TPO while working out adjustments, drew a totally irrelevant reference from the case of an out of court settlement between USA tax authorities & "Tommy Hilfiger". Tommy Hilfiger remunerated its buying agency affiliate on the basis of a commission (10% and subsequently 7.5%) on the value of goods sourced by it. The Ld. TPO thereby claimed that GIS India should also have been remunerated by a commission on value of goods sourced ignoring that the information was not in relation to a judicial pronouncement. The reliance on an out of court settlement between the US revenue authorities and Tommy Hilfiger has no persuasive value as it is not any judicial pronouncement on the matter. It is pertinent to note that this instance does not contain any information about the actual facts and ground realities of the case or the settlement reached, nor does it throw ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he TPO has included the payment reimbursed by the assessee's associate enterprise to the assessee on account of payment made to third party vendor/media agencies......... We have gone through the invoices and purchase orders from third party vendors and find that they contain customers' name, and all the terms of advertisement are finalized after taking the approval from the customers. The assessee simply acts as an intermediary between the ultimate customer and the third party vendor in order to facilitate placement of the advertisement. The payment made by the assessee to vendors is recovered from the respective customers or AEs. In the event customer fails to pay any such amount to the advertisement agency, the bad debt risk is borne by the third party vendor and not by the advertising agency i.e. the assessee. It is, thus, clear that the assessee has not assumed any risk on account of non-payment by its customers or AEs. At this stage a useful reference may be made to ITS 2009 Transfer Pricing Guidelines accepted by the OECD where it is laid down that when an AE is acting only as an agent or intermediary in the provision of service, it is important in applying the cost plus me ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... exposure provided by radio, television or print media". 6.5 It is contended that the Berry ratio is merely a variant of the cost plus method. If one were to think of the gross margins earned by a distributor as analogous to a firm's total revenues available to a distributor, and the operating expenses incurred to distribute products as analogous to the firm's total costs, then the ratio of gross margin to operating expenses would capture the mark-up on operating expenses that is afforded to the distributor. 6.6 The Berry ratio can also be applied to service providers, as it can be conceptualized as the mark-up earned on the costs of provision of services, by subtracting one from the Berry ratio expressed in unit terms as follows:- Berry ratio - 1 = GP/VAE - 1 = (GP-VAE)/VAE = OP/VAE wherein GP = gross profit; OP = operating profit; and VAE = value adding (operating) expenses. The above concept and approach for routine distributors and service providers has also been well accepted by the Organization for Economic Co-operation and Development (OECD) in paras 2.100 to 2.102. 6.7 The search results from each of the regions also corroborate the findings of Dr. Berry with regard ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... reed that Li & Fung India should also receive a remuneration based on a percentage of value of goods sourced by the global customers of Li & Fung HK directly from third party vendors in India. (c) However, the total amount of commission accruing for the Li & Fung Group as a whole, could not exceed 5% of the value of such goods, i.e. Rs 1202.96 crore. (d) Li & Fung HK had already paid remuneration to Li & Fung India under the cost plus 5% model, thus retaining, at its level, about 20% of the total receipts from the customer, i.e. Rs 60.15 crore. (e) The ITAT held that in view of the above factual matrix, Li & Fung India should receive 80% of the total commission given by the end-customer in favour of Li & Fung HK and the balance 20% would be retained by Li & Fung HK and accordingly asked the TPO to recompute the TP adjustment. 7.3 Analysing Li & Fung case further ld. counsel pleads that: (a) instead of 3%, even if entire 5% commission of Rs. 60.15 crore is retained with Li & Fung India, the same would have resulted in an operating profit of Rs. 14.73 crore, after deducting its actual costs of Rs. 45.42 crore or on other words, an OP/VAE of 32.43%, which ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... chain management which is important to achieve the strategic and pricing advantage, as well as human intangibles in the form of technical capacity and owned manpower to perform the critical functions). All intangibles including trademarks, processes, know-how, technical data, operating/quality standards etc. are developed and owned by the overseas GAP Group companies. GIS India does not create any valuable/ non-routine intangible and does not undertake any activity on its account that leads to the development of non-routine intangibles. 3. There have been ample documents filed at various levels (TPO, DRP) to evidence the functional profile of the overseas GAP Group companies and the fact that they own perform critical functions in the supply chain and own significant intangibles and that GIS India primary business activity is to serve as a communication liaison between GIS Inc. and the third-party Indian vendors that manufacture Gap Inc.'s merchandise by leveraging common spoken language and geographic proximity to these vendors. 4. An application of 5% commission on the value of good sourced leads to a cost plus of around 32% which is still not absurd ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the value of goods procured, comes to 3.78%. In real terms, Li & Fung India had carried out virtually five times greater functions as compared to the appellant. The assessee's percentages VAE comes to 0.73% and 0.79% in the case of the appellant for AYs 2006-07 and 2007-08 respectively. Even if the entire commission of Li & Fung Group is assigned to Li & Fung India, then the OP/ VAE of Li & Fung India works out to 32.43%, as compared to 15% adopted by the appellant, which again, is within acceptable limits. looking at the insignificant FAR of the assessee. 7.6 Alternatively it is pleaded that, looking at the 5 times functional intensity of the Li & Fung group of the same can be estimated to a maximum of 1% of FOB value. The assessee's intensity of functions being less than one-fifth of Li & Fung, applying a 1% commission in the case of the appellant would yield in OP/ VAE margins of 36.90% and 26.56% for AYs 2006-07 and 2007-08 respectively. This according to ld. counsel it is maximum to estimate to which T.P. adjustment can be stretched, as opposed to the exorbitantly adjustments s of 830% and 660% as applied by the TPO for AYs 2006-07 and 2007-08 respectively. 7.7 It is contend ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ummarized the arguments as under: - Given the functional, asset and risk profile of the appellant, it is entitled to a remuneration model of a mark up or profit on only its operating expenses or VAE; and not on the value of goods sourced by GAP US from third party vendors in India. - Incidentally, on identical facts, the Dutch Supreme Court had also approved a cost plus remuneration model for a similar procurement company; and not a commission linked to volume of goods procured, as the latter option would have resulted in exorbitant profit margin accruing to the procurement company, namely in excess of 600%. - The appellant's mark up of 15% on operating costs have not been controverted by the TPO, who in fact, committed a grave error in taking the same comparables, as chosen by the appellant, but merely changing the PLI, without even appreciating that the intensity of functions of such comparables were more than 25 times than that of the appellant for applying a turnover linked remuneration model - In the extreme situation, even without admitting a factual similarity to the Li & Fung ruling, the mark-up on operating costs cann ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ta. Thus assessee on its part has failed to give proper comparables. In this situation rule 10B(4) empowers the TPO to apply proper comparables for determinations of ALP. GIS India has used the weighted average of the financial data for the last couple of years to benchmark the international transactions. The provisions of Rule 10B(4) of the Income-tax Act prescribe that for the purposes of benchmarking international transactions the data of comparables used shall be the data for the year in which transaction took place. 8.2 TPO has reasonable indicators that the assessee performed all the critical functions, assumed significant risks and used both tangibles and unique intangible developed by it over a period of time. The critical functions involve great care to be taken while selecting the quality, quantity and its feasibility at the sourcing stage. Any defect or infirmity in these services will result in huge adverse impact on the functions of various entities of GAP, USA. The risk though on paper is transferred to AE, it is to be tested on the basis of realities looking at the control of the AE over assessee subsidiary. Therefore, the real magnitude of risk is to be ascertained ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e strategic and pricing advantage. This supply chain management ('SCM') as developed by the assessee in India is a part of the global supply chain management of the GAP group of the companies. The SCM as developed by the assessee consists of following proprietary informations: - Knowledge of Vendors - Knowledge of products and design - Knowledge of acquisition and supply - Knowledge of quality control - Knowledge of storage - Knowledge of logistic involved in exports of the goods. 8.7 All these activities provide significant value added trade benefit and strategic advantage to the AE. However, the compensation model does not include the benefits attributable to the GIS India on account of location savings also. Globalization and continuous search for lower cost has resulted in transfer of manufacturing and procurement activities from high cost economy like European Union, Japan, UK and United States, to lower cost economics like Indian and china to stay competitive and to increase profits. In this case, GAP Group has recognized that India offers both cost and operational advantage such as lower sal ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed on cost plus markup. In these circumstances TPO was left with no choice but to hold ALP 5.22% on FOB value relying on arithmetic mean of following comparables and working. S. No. Name OP/TC(%) 1. Pantaloon Retail (India) Ltd. 6.70 2. Trent Ltd. 6.19 3. Jaypee Spintex Ltd. 2.77 Arithmetic Mean 5.22 Accordingly, the arms length price is worked out by TPO on FOB value of exports of Rs. 3963,38,34,240/- for A.Y. 2006-07; and Rs. 51,535,602,475/-for A.Y. 2007-08, resulting into respective additions. 8.10 It will be therefore just and proper that GIS India's commission is worked out in terms of percentage of the FOB price of goods sourced through the GIS India. The Indian revenue should not be deprived of due taxes in the pretext of in house convenient arrangements. 8.11 Ld. DR relied on the orders of DRP, TPO and Assessing Officer and out of court settlement between US revenue authorities Li Fung case and Tomy Hilfger comparison. 9. Decision on the Case 9.1 We have heard the rival contentions and perused the material available on record including the written submissions and synopsis filed by the assessee which is placed on the paper book. The Act prescrib ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on trend in garment that goods are generally supplied on credit based which the suppliers have to extend to GAP, USA entities and assessee bears no risk. The assessee' role, functions and activities are limited to scrupulously follow the handbook and other instructions provided by the parent group. These facts and circumstances indicate lack of authority or discretion with assessee in deviating or changing from the policies and procedures prescribed by the parent company. Therefore, we are unable to agree with the view that assessee incurred any significant risk in its functions. v. Coming to the issue about assessee having developed substantial human resources intangibles, there is no supporting material available on record to hold it against assessee. Except generalized assertions nothing reliable is placed on record to support these observations. Assessee had 230 employees on its payroll engaged in execution of preordained support nature activities as per the guidelines. Their qualifications are general and routine in nature and department has failed to demonstrate that any or few of employees were any acclaimed personalities or indispensable in garment procurement trade ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s human resources intangibles along with supply chain resources. The facts and circumstances lead us to a conclusion that assessee is a low risk procurement support service provider only. 9.3 Most Appropriate Method i. From records it is clear that the assessee proposed the use of Transactional Net Margin method ('TNMM') as the Most Appropriate Method with Net Profit/Total Cost as a Profit Level Indicator ('PLI'). Further, the department has accepted the use of TNMM with a percentage of FOB value of goods procured by parent as PLI. Accordingly, we proceed on the basis of TNMM as the most appropriate method without going into analysis or merits of other methods. The dispute is limited to the selection of PLI, where the assessee has proposed use of Net Profit/Total Cost whereas the department has used a percentage of FOB value of goods procured by parent as PLI. Consequently we proceed to deal with the issue of PLI. ii. The selection of most appropriate method and PLI depends upon the FAR and available data of comparables. We have to keep in mind the guiding principles in ALP determination that the method and PLI used should not lead to manifestly absurd results, so as ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er the cost plus model if the service provider feels that reasonable mark-up would be more than the agreed mark-up then the service provider will take appropriate steps to get it corrected. vii. The essence of above discussion is to the effect that market forces will interact in any business model and lead to reasonably acceptable profitability. Considering this we now proceed to decide the PLI which would result in reasonable profitability. 9.4 Li & Fung Case and TPO/DRP Stand i. The PLI of percentage of FOB value of goods procured by parent results in net profit/total cost of assessee at 830% and 660% for AY 2006-07 and AY 2007-08. Without going to any additional fact one can clearly mention that the use of this PLI has resulted in absurd and distorted results. Any business model followed would reflect in bottom line profitability of the assessee. The PLI and percentage proposed by department as the arm's length price may have demanded consideration provided it produces procurement service provider comparables which follow percentage based model and at the same time end up earning exorbitant mark-up over costs. In our considered view the department has failed to pr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the assessee. The department overlooked the other extremely important fact of the profitability earned by Li & Fung through 5% procurement service model. The total remuneration earned by Li & Fung Hong Kong was Rs. 60.15 crores against cost incurred by Indian company of Rs. 45.42 crores and some minor costs incurred in Hong Kong. The ITAT bench held that considering the facts of the case, 80% of commission (Rs. 48.12 crores) earned by Li & Fung Hong Kong should be attributed to Indian company. This attribution resulted in profitability of Rs. 2.72 crores (Rs. 48.12 crores - Rs. 45.42 crores) for the Indian Company resulting in the net profit/total cost of 6%. Department overlooked these important facts which must be taken into consideration using this example as benchmark for determining arm's length price of international transactions for taxpayers. vi. Considering above we conclude that non risk bearing procurement facilitating functions which are preordained by contract and hand book, the appropriate PLI will be net profit/total cost and not the % of FOB value of goods sourced by AE. Accordingly, we uphold the net profit/total cost remuneration model adopted by the asses ..... X X X X Extracts X X X X X X X X Extracts X X X X
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