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TMI Blog2013 (11) TMI 468X X X X Extracts X X X X X X X X Extracts X X X X ..... purchase transaction - Addition of Rs.3,68,986/- made by the AO and the TPO out of which Rs.1 lakh addition was confirmed by the learned CIT(A) – Held that:- when the same material, which is purchased by the assessee from the "AE" is sold to the same "AE", and profit margin on such purchase and sale to the "AE" is considered for working out the addition in the profit of the assessee, no separate addition in respect of purchases can be made, because, once the value of purchase is reduced for making the adjustment as per the TP rules, the margin on its sale to the "AE" will further go up, and therefore, this addition is not sustainable in the facts of the present case – Decided in favor of Assessee. Selection of a company as a comparable – Domestic segment as comparable for a company of export segment – Held that:- The companies chosen for comparision do not have any export business for the year under consideration whereas the assessee company has full-fledged export business. The functions, risks and assets are entirely different – Hence, the chosen company cannot be considered as a comparable company for determining the ALP - Moreover, the Delhi Bench of the Tribunal in the cas ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... bles – Four comparables selected - The arithmetic mean margin of these four comparables comes to 4.27% - Held that:- Assessee-company has to be considered as tested party - Working of the profit margin of the assessee-company, which is 5.29% being gross profit margin on COGS and 1.15% is the operating profit margin on operating revenue and 1.16% is operating profit margin on operating cost – Comparison of these margins of the assessee-company with arithmetic mean - Average of these four companies worked out at 4.27% - Arithmetic mean is within the range of (+/-)5%, and hence, no Transfer Pricing adjustment is called for – Decided in favor of Assessee. - IT Appeal NOS. 945 & 3149 (Ahd.) of 2010 - - - Dated:- 17-4-2013 - A.K. Garodia And Kul Bharat, JJ. For the Appellant : S.N. Soparkar. For the Respondent : Shelly Jindal. ORDER:- PER : A.K. GARODIA There are two cross appeals, by the assessee and Revenue, for assessment year 2005-2006, which are directed against the order of the CIT(A)-VIII, Ahmedabad dated 30.12.2009, and remaining one appeal is filed by the assessee for the assessment year 2006-2007, which is directed against the assessment order passed by ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ffected due to low volume of business as compared to prior years. 2. (a) The Ld. CIT (A) grossly erred In facts and in law, In upholding/recomputing upward transfer pricing adjustment to the extent of Rs.100,000/- on adhoc basis in respect of international transactions of purchase of goods from AE amounting to Rs. 29,276,035/-. (b) The method of recomputation of adjournment is contrary to his own findings in the order in detail and is also contrary to the provisions of law on transfer pricing in India The CIT (A) while appreciating the facts of the case rightly held your appellant to be the wholesale trader insulated from risk and is to be considered as tested party, carries on routine function and employed no substantial assets and hence compared its profitability with a peer in the group on aggregation principle and hence no further addition can be made of Rs.100,000/- 3. The Ld CIT (A) grossly erred in not granting the benefit of arm's length price range of +/-5% as provided for in proviso to section 92C(2) of the Income Tax Act, 1961." 3. The brief facts are that the assessee is a private limited company in the business of procuring the materials (medicines and oth ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... essee is in appeal for the part addition confirmed by the learned CIT(A). 4. It was submitted by the learned DR of the Revenue that on page no.7 in para 6.1 of the TPO's order, it is stated by the TPO that in the business of the assessee, all the functions mentioned by him from para 5.1 to 5.11 are being carried out from India, using resources of Indian subsidiary and supervising role is being carried out by the parent company. In addition to this, he has drawn our attention to page no.22 to 31 of the order of the CIT(A), where the CIT(A) has decided the issue and submitted that the decision of the learned CIT(A) is based on the comparable, adopted by the TPO, of the IDA Foundation is more akin to the assessee, and should be compared with the assessee as a tested party. He submitted that the function of the IDA Foundation is more akin to that of "AE", andhence they are comparable, and therefore this finding of the learned CIT(A) is not correct. 5. Regarding selection of tested parties, he placed reliance on Tribunal decision rendered in the case of Asstt. CIT v. Tara Ultimo (P.) Ltd., [2011] 13 taxmann.com 184/47 SOT 401 (Mum.). He submitted a copy of the Tribunal decision. Reg ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... M/s IDA. The brief functional summary of both these entities is enclosed at Annexure I II. It is also seen that there are no similar comparables performing such activity. The only independent party handling same type of work was IDA which had been selected as comparable to the appellant in the TP documentation. IDA has been, therefore, selected as a comparable, and resale price method as the correct method for determination of arm's length price. The AO conducted TP study at transaction level. Since the comparable margin of IDA was 11.94%, those transactions wherein the margin of MPAS was more than 11.94%, they were adjusted to the benchmark level of 11.94%. The difference was treated as profit of the resident company MPL and adjustment was made accordingly. iii. Functions of the appellant company detailed at para 5. FAR analysis at para 6.2 6.3 of the TP order. The TPO has dealt with the functions of the appellant and MPAS extensively before arriving at the conclusion that it is MPAS which should be treated as tested party. C: Issues dealt with by CIT(A): i. Economic characterization: The assessee has been characterizing itself as a manufacturer. As brought out in detail ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... idea is to arrive at a reasonable conclusion for identification of comparables. For this the TPO's approach should be judicious. Fresh search can be done if it is found that the comparables were not properly selected. v. Selection of MPAS as tested party and IDA as a comparable The CIT(A) has not elaborated on his reason of rejecting comparability of IDA with MPAS although both are exactly in the same business doing same type of activity. Once, MPAS is selected as a tested party, IDA becomes a perfect match as both are in the same business of supplying medical kits to multilateral agencies, In fact, the TPO has correctly followed the decision in the case of Development Consultants Pvt Ltd and Ranbaxy Laboratories Ltd., mentioned by the CIT(A). The CIT(A) has, at no place, discussed the exact business being carried out by MPAS and IDA before summarily rejecting the tested party as well as comparable. vi. Transfer Pricing Analysis on transaction by transaction basis - The reliance placed by the assessee on OECD guidelines para 1.42 in support of aggregation Principle and its support by CIT(A) (para 6 of the CIT(A) order) is not correct. The OECD guidelines state that, "Idea ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... illips Software Centre Pvt Ltd 218/BNG/2008 is not correct as there was no change in the tested party in these cases. Since there is a change in the tested party, it was only proper that the PLI suitable to the tested party is adopted. viii. There is factual error of observation at para 5.29 to para 5.32 of the CIT(A)'s order. The CIT(A) has unduly emphasized the fact that resale price method is used when purchases are from related party and sale is to independent parties. Since the tested party has been altered to MPAS, the tested party has purchased the goods from its AE and has sold these goods to non-AEs and hence resale price method is perfectly applicable. The reliance placed by CIT(A) on Gharda Chemicals is, therefore, wrong and the judgment, in fact supports the action of the TPO. ix. Comparison of margins of tested party with the comparables: The CIT(A) has, while talking of cost plus method, has compared margins at net level. The ideal way of benchmarking transactions i.e. at transaction level, as done by the TPO, has wrongly been rejected. However, the subsequent process adopted by CIT(A) at para 6.1 is without any basis and rationale and hence unacceptable. Transfer ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... it from potential uncontrolled comparables. He submitted that in the present case, the "AE" is being considered as tested party in the present year, for this reason that, the comparable selected by the assessee i.e. IDA is more comparable to the "AE" than the assessee. He submitted that this is like putting the cart before the horse, and should not be permitted. 7. Regarding the selection of comparable, he has placed reliance on Tribunal decision rendered in the case of Stream International Services (P.) Ltd. v. Asstt. CIT, 152 TTJ (Mum) 553.Reliance was placed on this judgment in support of this contention that, it is open to the assessee to seek exclusion of a case from the list of comparables, even if, the same was inadvertently included by the assessee itself in such list. He submitted that although the assessee has included IDA in the list of comparables, but in the light of this decision of the Tribunal, the assessee can very much seek exclusion of this comparable. He further submitted that in the present year i.e. A.Y.2005-06, the addition made by the AO, and proposed by the learned TPO, and confirmed by the learned CIT(A), cannot be sustained once the margin of the "AE" ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed for in this year, even as per the basis adopted by the AO/TPO, i.e. "AE" as a tested party, and IDA as comparable. We, therefore, do not go into this aspect of the matter in this year, as to whether the "AE" should be selected as a tested party or the assessee should be considered as the tested party and whether IDA can be considered as comparable or not. When no addition is justified, even as per the basis adopted by the AO and the TPO, we do not enter into this aspect in the present year, and therefore, the entire addition made by the AO in respect of sales effected by the assessee to the "AE" of Rs.2,65,37,704/- is deleted and consequently, Ground Nos.1, 2 and 3 of the Revenue are rejected and the Ground no.1 of the assessee is allowed. 9. Regarding the addition of Rs.3,68,986/- made by the AO and the TPO out of which Rs.1 lakh addition was confirmed by the learned CIT(A), we are of the considered opinion that when the same material, which is purchased by the assessee from the "AE" is sold to the same "AE", and profit margin on such purchase and sale to the "AE" is considered for working out the addition in the profit of the assessee, no separate addition in respect of purc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he arm's length price in connection with the impugned international transaction, and holding that the Appellant's international transaction is not at arm's length. iii. The Hon'ble DRP/Ld.TPO/Ld. AO erred, in law and in facts, by considering the AE (i.e. MPAS), rather than Appellant, as the tested party. iv The Hon'ble DRP/Ld.TPO/Ld. AO erred, in law and in facts, by considering IDA Foundation Netherlands (a 'not for profit organisation'), as comparable to the AE (i.e. MPAS) for the purpose of economic analysis. v. The Hon'ble DRP/Ld.TPO/Ld. AO erred, in law and in facts, in not considering and making appropriate adjustments for functional, risk and economic differences between the AE (i.e. MPAS) and IDA Foundation Netherlands (a 'not for profit organisation'). vi. The Hon'ble DRP/Ld.TPO/Ld.AO erred, in facts and in law, by not considering that fresh search process conducted by Ld. TPO is unsystematic, vague, erroneous and results into only one alleged comparable and thereby defies the statutory provisions including the proviso to section 92C(2) allowing the variation in arm's length price of upto 5%. vii. The Hon'ble DRP/Ld.TPO/Ld. AO erred, in law and in facts, by not ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the case of Development Consultants (P.) Ltd. (supra) and Ranbaxy Laboratories Ltd., (supra). Regarding selection of IDA as the comparable it was submitted that this company is not for profit making, and therefore, it cannot be considered as comparable. Regarding various comparables cited by the assessee before DRP, as noted by the DRP at page no.68 of his order, being nine comparables, it was submitted that some of the comparables were rejected on this basis that these comparables were having very low turnover or very high turnover, and therefore, the same are not comparable. Regarding the basis given by the DRP for rejecting some comparables, being manufacturing activity undertaken by these comparables, it was submitted that except in one case, there is no significant manufacturing activity undertaken by the comparables, and therefore, the same should also be considered. He submitted that he agrees to the exclusion of one comparable i.e. Sharon Bio-Medicine Ltd., which is a manufacturing company, and he also agrees to exclusion of one comparable i.e. Zydus Pharmaceuticals Ltd., which has related party transactions exceeding 25% of the sales. Regarding third comparable i.e. Earne ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r any loss. However, from perusal of comparable selected by the assessee it is seen that the average margin was found to be (-) 1.56%. If the comparables selected by the assessee were true comparables, there was no reason why the average margin should be a negative figure, or certain risk adjustments are required to be carried out in the case of comparables. No such adjustment was carried out by the assessee in its transfer pricing report, rendering the information used in the determination of arms length price as incorrect. Even though there cannot be a general rule thereby entities making losses are to be rejected but those entities must necessarily need to conform to the FAR of the assessee. As per the assessee's own admission, since, it is a risk protected entity obviously it is clear that any entity making losses is bearing extra risks, leading to the losses. The same is also explained in OECD TP guidelines 2010: 3.65 Generally speaking, a loss-making uncontrolled transaction should trigger further investigation in order to establish whether or not it can be a comparable. Circumstances in which loss-making transactions/ enterprises should be excluded from the list of compara ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... imilarly developed countries like USA, Europe etc, so that the prevailing market conditions in the countries in which the buyer and seller are located are same or similar. Otherwise, adjustments need to be made for the differences in geographical markets,as mandated in rule 10B(2) read with rule 10B(3), which is a difficult task. Since no companies having sufficient export sales have been selected by the assessee,the TP report is faulty from the very beginning. 4.2 The assessee has submitted that he market to which the service provider is selling its services is not important as compared with the location of service provision. This is economically an incorrect proposition. It is common business sense that every entrepreneur tries to source its goods or services from the cheapest possible market and sell the same to the markets where the goods or the services can be sold at the highest price. A businessman who can source his goods or services from the low cost countries but cannot sell the same in the fully developed and expensive markets obviously loses out to the businessman who has access to the both- sourcing of services from low cost countries and selling them at higher rates ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... size of the markets, the extent of competition in the markets and the relative competitive positions of the buyers and sellers the levels of supply and demand in the market as a whole and in particular regions, if relevant, consumer purchasing power, the nature and extent of government regulations of the market, costs of production, including the costs of land, labour and capital, transport costs, the level of market (wholesale or retail) " and "3.34 Prices are likely to be affected by differences in products, and gross margins are likely to be affected by differences in functions, but operating profits are less adversely affected by such differences. As with the resale price and cost plus methods that the transactional net margin method resembles, this, however does not mean that a mere similarity of functions between two enterprises will necessarily lead to reliable comparisons. Assuming similar functions can be isolated from among the wide range of functions that enterprises may exercise, in order to apply the method, the profit margins related to such functions may still not be automatically comparable where, for instance, the enterprises concerned carry on those functi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... extent of government regulations of the market (f) The costs of land, labour and capital in India vis- -vis other markets Therefore the companies that are not predominantly into the domestic market cannot be compared with the assessee who has 100% export oriented transactions. The assessee does not receive any revenue from domestic sales. Another arguments for this proposition is that the main reason for outsourcing activities to low cost countries such as India is to avail the benefit of cost reduction. This effectively means that the revenues which can be earned in exporting goods/services to a developed geography is more as compared to the revenue which can be generated from selling the goods/services in a lesser developed geography. Correspondingly, the costs required to render these services are higher in developed geography as compared to undeveloped country. This is the precise reason why the assessee company is also obtaining the business from the AE. In case the filter adopted by the TPO is not taken into account, it will lead to comparison of revenues and corresponding margins earned by entities rendering services within India with the entities rendering services outs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d to the meaning of the "uncontrolled transaction" as given in Rule 10A of the Income-tax Rules wherein it states that the transaction between enterprise other than the associate enterprise whether resident or non resident. In our considered view, the reference to resident and non-resident in Rule 10A of IT Rules, is related to the residential status and not related to the domestic or export. Moreover, the Delhi Bench of the Tribunal in the case of Mentor graphics (supra) held that the ALP should be determined by taking results of a comparable transaction in comparable circumstances. Rule 10B (2)(d) also emphasizes that the comparability of the transaction should be international transaction. We do not find any merit in the argument of the learned counsel for the assessee that the companies rejected by the TPO operate in similar market condition as that of assessee company due to the fact that the aforesaid companies do not have any international transaction. In view of the above, the reasoning given by the CIT (A) in confirming the action of the TPO in rejecting the aforesaid company as not comparable is justified. In view of the above, five companies listed above shall not be inc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r, para 3.43 of transfer pricing guidelines issued by OECD in 2010 also lists out this criteria as one of the most commonly used qualitative criteria for selection of comparables. 4.5 The statement made by the assessee regarding the fact that the similarity of the geographical market in which the assessee sells its products and the market in which the AE sells its products is misleading. When the assessee has considered itself as the "tested party", the comparison of FAR is to be made between the comparables and the assessee and not between the transactions of the assessee with the AE and the transactions of AE with third-party, for which the similarity is proposed by the assessee. Therefore, the proposition raised by the assessee in this regard is absolutely infructous. RELATED PARTY TRANSACTIONS 4.6 The related party transactions filter of 25% is accepted by the assessee and it is important to note that when an entity having related party transactions is taken out, the average mean margin of the remaining entities fall down to (-) 1.74% from (-) 1.56%, which means that the remaining entities are even making more losses. Since the functional profile of the assessee is differ ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... lakhs only and thus, having difference of about 33 times in turnover from same business, such a case could not be taken as a comparable case - Held, yes." vi. DCIT v. Indo American Jewellery Ltd. [2010 ]14 SOT 1,Mumbai -In this case also the Hon'ble Tribunal upheld the use of turnover criterion. 6.1 From the above judgements, it can be seen that the use of turn over criteria is required to ascertain the comparables engaged in similar activities under similar conditions as that of the assessee company, which is approved by various Tribunals. 6.2 The proposition submitted by the assessee that turnover is irrelevant for you wholesale distributor is also divorced from facts. There are two fundamental ways in which a distributor owns its compensation: i. Through retail markup on sale of products purchased at wholesale prices and ii.. Through commissions received on the sale of products. In the first scenario, in which the products are sold to final customers, the difference between the final sale price and the wholesale purchase price is the quantum of remuneration for the distributor and in the second case the remuneration is linked to the quantum of sale of products. In e ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... purchase chains.As a matter of fact, as already mentioned in the transfer pricing order for AY 2008-09, some of the persons for which the payments are made by the assessee are still listed as procurement team members on the website of the AE. Further, the claim that no such payment was made in AY 2006-07 would not lead to the conclusion that such intangibles were not developed in earlier years. Therefore, if the intangibles had already been developed and the assessee had incurred costs for the same, it would be the owner of such intangibles. Therefore, the claim that the AE was less complex than the assessee is incorrect. 8.1 For the detailed reasons given in the order, the TPO has observed that it was the assessee which is engaged in carrying out the major functions in respect of the purchasing, inspecting and processing of tracks/formulations. Consequently, it cannot be claimed that the assessee was least complex among the two (assessee and AE). 8.2 The assessee has not uttered any word on the single customer risk being borne by it. In respect of market risk also, it is seen that since the assessee is providing goods/services only to its group entity, any adverse market cond ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... parable to the FAR of IDA, as shown below: S.no. Functions Carried out by the AE(As per the FAR analysis in TP report) Whether carried out by IDA (i ) Research Development Development of new medical kits considering development in international market, trend of demand and other relevant factors including improvement of medical kits is undertaken on a continuous basis. Yes. Reason: As it has to bid for tenders and fulfil the requirements of tenders which are driven by market trend. ( ii ) Process engineering and designing of medical kits This function, which was hitherto being carried out by MPAS, has been continued as it has developed expertise in this area. It has applied and developed requisite know how which has been continuously updated, the benefit of which is passed on to MPL. Yes. Reason: As it has to bid for tenders and fulfil the requirements of tenders which are driven by market trend. ( iii ) Market Development and sales execution These activities are carried out by MPAS including registration with governments and international agencies. Yes. R ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y is only for MPAS. Yes. Reason: As it also requires funds for its operations. Risks Whether by assessee or AE Whether borne by IDA? (i) Market risks - Development of market, Promotional expenses, fluctuation in prices, changes in business cycle, etc. All risks connected with market are entirely assumed by MPAS only. All the expenses for business development, procurement, registration and for promotion are fully borne by MPAS. Loss on account of reduction in prices and depressed market conditions are mainly attached to the MPAS. Yes. As mentioned in the website. IDA is incurring risks on account of registration with the governments, on account of competition with others including MPAS for tenders, procurement of medicines as mentioned in the website. (ii) Credit risk The supplies are made to various development/international aid agencies where payment terms involve no/low advance payment. Risk of bad debts/defaults is wholly upon MPAS. Yes. The final clientele for both are same. (iii) Products risk - Design and development product, obsolescence of product after sale ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he assessee's transactions ○ TPO asked the details about the resale price of kits sent by assessee and sold by MPAS,thus earning the gross margin on these kits. No such details were given. Had such details been given, TPO would have applied the margin of IDA on such transactions only as done in AY 2005-06.(Para 5.7 of the order).These details were submitted in AY 2005-06 as mentioned in in para 7.4 and 7.5 of the order. In this year and subsequent years no such details were submitted deliberately which left no choice with the TPO but to apply the same on entity level. 15. He placed reliance on the following decisions: 1. Interra Information Technologies (India) (P.) Ltd., ITA Nos.5568/Del/2010 5680/Del/2011; 2. Chiron Behring Vaccines (P.) Ltd., 2011-TII-30-ITAT-MUM-TP; 3. Dy. CIT v. Deloitte Consulting India (P.) Ltd., of Hyderabad Tribunal; (2011) 61 DTR (Hyd)(Trib) 101; 4. ITO v. CRM Services India (P.) Ltd., 14 taxmann.com 96 (Delhi) 5. Dy. CIT v. Quark Systems (P.) Ltd., , 2010-TIOL-31-ITAT-CHD-SB; 6. E gain Communication (P.) Ltd., 2008-TOL-282-ITAT-Pune; 7. Sony India (P.)Ltd., v. Dy. CIT [2008] 114 ITD 448 (Delhi) 8. Agnity India Technologies (P. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ns undertaken by the Appellant were concluded to be on arms length basis. 4. Approach adopted by the Transfer Pricing Officer in passing the impugned order The TPO has adopted the following approach in passing the impugned transfer pricing order: Considered the AE (MPAS) as the tested party. Has summarily rejected the transfer pricing documentation/approach adopted by the Appellant Has compared the gross margins earned by the AE (MPAS) on a consolidated financial statement basis with the gross margins earned by International Dispensary Association, Foundation (IDA Foundation), Netherlands. The TPO has made an upward transfer pricing adjustment of Rs. 8,45,80.486 to the international transaction of sale of Medical Kits to the AE by factoring the difference in gross margins of MPAS and IDA Foundation on the basis that such differential margins should be attributable to the functions carried out by MPL in India. No adjustment made by the TPO in relation to transactions other than the sale of medical kits to AE 4A Appeal before Dispute Resolution Panel ('DRP') The Appellant filed objections/appeal before Hon'ble DRP, objecting to the TPO's above approach and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hi 2010] 5.1 Approach adopted by the Learned TPO in selecting the Tested Party In passing the transfer pricing order, the TPO has considered MPAS as the tested party on the basis that MPL is more complex of the two entities. In arriving at this conclusion, the TPO has made the following observations in the impugned TP order: MPL has invested substantial amounts in establishing supply line with reputed Indian generic drug manufacturers and other suppliers by negotiating the best prices and confirmed supplies of international standard from approved generic drug manufacturers. To carry out this work, the Appellant has taken services of purchase experts within and outside the company and paid substantial sum in this regard to MPAS. The Appellant has submitted complete details of kit manufacturing process which shows that it was the appellant who was involved in purchasing and inspecting and further processing of drugs/formulations and was carrying out all entrepreneur functions. The disclosures in the financial statements and the tax audit report also support the fact that it is the appellant who is purchasing all these pharmaceutical products. As regards risk assum ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... handled by MPAS. The Appellant performs only routine functions such as receiving the goods from local suppliers, handling packing and labelling of goods and handing over the goods for onward delivery to customers of MPAS. Based on the above, it is contended that the FAR analysis adopted by the TPO is completely in variance to the realities. This shows gross failure on the part of the TPO in understanding the business set up of the Appellant and that of the Missionpharma Group. 5.2.2 Risks Assumed The TPO had stated that the Appellant carries out all entrepreneurial risks attached to a business concern as it bears inventory risk, on account of the huge inventories it carries, is subject to single customer risk and bears significant risk on account of foreign exchange fluctuation. In this regard, Appellant's contentions are as under: The Appellant mostly procures inventories against firm orders placed by MPAS, and the procurement of these inventories is also upfront financed by MPAS. Only in cases where the supplier lot size is bigger than MPAS' order size for the particular product, the Appellant procures products without a confirmed order from MPAS. Even in these case ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the Appellant has huge intangibles in the form of cheap suppliers list and efficient logistics facility. In this regard, the Appellant's contentions are as under: That MPAS has been sourcing materials and products directly from Indian manufacturers/ suppliers for more than three decades i.e. even prior to setting up of the Appellant. Only to ensure timely deliveries and savings in transportation time, the MPL was set up in the year 2001 by the Missionpharma Group to serve as a logistics platform and efficiently service its customers. The entire procurement department is situated in Denmark right from the inception of MPAS till date and all contacts to old/ new manufacturers/ suppliers are established by Procurement Officers sitting in the Denmark office of MPAS, using various tools like the internet, the Indian Pharmaceutical Directory, Member of Indian Pharmaceutical Associations, by attending seminars like CPHI, etc. There is no factual basis for the TPO to claim that Appellant has developed intangible assets in the form of supplier base. To further challenge this assertion of the TPO, the Appellant obtained confirmations from some of the key local suppliers tha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ancial and non financial information related to MPAS and its comparable, IDA (especially the standalone financial statements), is not easily and readily available and whatever information in relation to them is available, such as information available on the Internet, cannot be independently verified. This reduces the reliability and completeness of the information required for carrying out a reliable and valid evaluation under transfer pricing. It is pertinent to mention here that the search process/ detailed accept reject matrix conducted by the TPO for identifying comparable companies to MPAS as was not shared with the Appellant. In comparison, the complete financial and non-financial information related to the Appellant and its comparable companies is readily available and accessible, both to the tax payer and the Appellant, and can be reliably verified from internal as well as external sources, e.g., from public databases such as Prowess. 5.2.5 Order issued by the Commissioner of Income-tax Appeals [CIT (A)] to the Appellant for the AY 2005-06 In relation to similar approach adopted by the TPO for the AY 2005-06, the Appellant had preferred an appeal before the CIT(A ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er, after having selected MPAS as the tested party, the TPO has selected IDA Foundation as the comparable company. In adopting this comparability approach, the TPO has made the following observations: 6.1 Approach adopted by the TPO The TPO has carried out search in the internet/Google in relation to companies dealing in preparing medical kits and selling them in Asia and Africa region and on the basis of this has selected IDA Foundation as the comparable company to MPAS. It is to be noted that despite appellant's request to TPO vide its letter dated 8th September, 2009 (placed at page 97 of the Paper Book), requesting for comparable company search process as done by TPO, the TPO did not furnish to appellant any such search process as claimed to have been done by him. The TPO has stated that both IDA Foundation and MPAS are acquiring medical kits from India and participating in medical tenders of various Government and Non-Government authorities for supply of these medical kits. Even medical kits of both these companies are similar and appear to be standardised and approved from various authorities. Both the companies are having marketing offices in different parts of wor ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... or by investing in the quality and availability of essential medicines." How a charitable organisation with the objective of supplying essential medicines at low prices to under-privileged countries be compared with a 'for profit' commercial organisation? This is more so when the matter concerns the transfer pricing analysis where in an 'apple' shall be compared with an 'apple' only and not with an 'orange'. The Appellant's argument is that the economic profile of MPAS and IDA Foundation is quite different. IDA being a not-for-profit organization does not have to undertake the functions of market development, marketing, business promotion and selling, whereas MPAS has to (and it does undertake) these critical functions and bears the related costs and risks. On account of these functional and risk differences, their costs structures and economic outcome of those structures are bound to be different. It is to be noted that the activities of market development, marketing, business promotion and selling are essential for the survival and growth and therefore assume greater significance in the case of a profit-oriented entity like MPAS while they assume far lesser significance and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... market and margins differ for the same product or services. Hence, economic circumstances are no longer similar and thereby consolidated financial statements cannot be considered for comparability. Furthermore, no reasonable adjustments could be made to account for the differences in business profile of the subsidiaries and also for the differences in the geographies in which such subsidiaries are located. Accordingly, the use of consolidated financial statements is not appropriate for comparability purpose. 7 Comparability of MPL with Indian Wholesale Pharmaceutical Distributors For the purpose of complying with requirement for transfer pricing documentation, the Appellant had conducted a comparable search analysis using data from one of the most widely recognized databases i.e. Prowess and had determined the arm's length price of the impugned international transaction using the financial information of the comparable companies pertaining to FY 2005-06 or near thereto. 7.1 Approach adopted by the TPO The TPO in passing the impugned order has summarily rejected the comparability analysis undertaken by the Appellant on the basis of the following grounds: The Appellant ha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ure of wholesale trading of generic pharmaceutical products. This contention of income-tax department has been upheld by the Hon'ble ITAT in the AY 2003-04 in ITA No. 1337/ADH/2007. Therefore, now it is not open to income-tax department to say that appellant is not a trading organisation but a manufacturer and hence it is functionally different from wholesalers. The Appellant highlighted the fact that in the transfer pricing documentation the Appellant has not compared itself to any generic comparable set of wholesale distributors but has specifically considered wholesale distributors trading in drugs, medicines and allied products. Further, unlike the search process approach adopted by the TPO of selecting comparable companies from internet search, the Appellant has undertaken a detailed search process in Prowess database and has also applied various qualitative and quantitative filters in short listing the comparable companies. Reliance is also placed on the decision of Mumbai Tribunal in the case of M/s Indo American Jewellary (ITA No 6194/Mum/2008) where in Tribunal observed that "We further find that external comparables selected by the Appellant are from public database ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... loss, it cannot be excluded from the list of comparables for the purpose of computation of arms length price" It is also submitted, on without prejudice, that if at all the TPO had concerns on inclusion of loss making companies in the set, the TPO could have disregarded only the loss making companies rather than rejecting the entire comparable set. It is to be noted that, four out of the nine companies selected as comparables have a net operating loss while the remaining five companies have a net operating profit ranging from 4.61% to 0.73%. Even if companies having negative operating margin are excluded, the arithmetic mean would be 1.9%, which is quite comparable to the net margin of the Appellant which is 1.16%. 7.2.4 Geographical differences The TPO has said that the Appellant has selected companies which are engaged in domestic market. In this regard, Appellant contends that: (a) the nature of business activity undertaken is the same irrespective of whether the company caters primarily to the domestic market or to the overseas market. The functions performed and the assets employed do not change depending upon whether the goods are sold locally or to overseas custom ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... arable by the Appellant would satisfy the filter, except Zydus Pharmaceuticals Limited ("Zydus"). The Appellant had fairly admitted this fact before Hon'ble DRP. In the event that Zydus is not considered as a comparable, the arithmetic mean of the net operating margins on cost of remaining comparables will be (-) 1.74%. It may be relevant to note that the Appellant's operating margin is 1.16% on cost for FY 2005-06, therefore, the Appellant's contention that the impugned international transaction is at arm's length, will continue to hold good. 7.2.6 Product differences The TPO has rejected the comparables selected by the Appellant stating that the comparable companies are dealing in different product segments of the pharmaceutical sector as compared to the Appellant. In this regard, the Appellant contends that MPL is predominantly and economically engaged in wholesale trading activities in the pharmaceutical industry. Keeping the broad industry profile of MPL in perspective, companies falling under the economic activity of 'trade in drug and medicine', 'drug and medicine in allied product', 'trade of appliances used in medicine' were extracted from the Prowess database. Vario ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... uld have material impact on the profits of the companies due to under absorption or over absorption of fixed overheads, this phenomena does not exist in case of wholesale trading business, that too in generic pharmaceutical wholesale trading business. (c) Neither the TPO has demonstrated as to how the levels of differences in the turnover have impact on the profit margins as far as wholesalers in the pharmaceutical products are concerned. (d) The differences in level of sales or turnover does not significantly influence the operating margins in the cases of trading/distribution in generic pharmaceutical products so long the company has reasonable operational history, as is evident from perusal of the operating profit margins of the companies selected as comparable companies by the appellant in its transfer pricing study report. There are companies with higher turnover and earning lower as well as higher profit margins. Similarly, there are companies with low turnover but earning higher margin as well as lower margins. Therefore, it can not be said that there is any influence of turnover on the profitability. (e) In this context, it is to be further noted that sales turnover o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... retained at the level of AE 8.1 Hon'ble DRP/TPO held that AE MPAS should not have gross profit more than the gross profit earned by IDA Foundation. Consequently, gross profit earned by AE beyond 15.82% shall belong to the appellant and accordingly such excess profit has been attributed to appellant by way of transfer pricing adjustment amounting to Rs. 8,45,80,486. 8.2 Appellant's Submission Appellant's submissions in this regard are as follows: i. From the analysis documented in its Transfer Pricing Study Report, it is established that appellant has earned profit margin commensurate with the functions it performed, assets it used and risks it has borne. Once the one side of the transaction is arm's length, by necessary and inevitable implication the other side of the transaction shall also be arm's length. Hence, it is not correct to assume that AE MPAS has earned excessive profit. AE has earned the profit commensurate with the functions, assets and risks undertaken by it. ii. Absurdity of TP Adjustment: If Transfer Pricing adjustment is added to the reported profits of appellant, the revised net profit margin (i.e. operating profit/total cost) is 12.11%. This calculati ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d product registrations, governmental and non-governmental approvals etc. in various countries across the world, as developed/secured by MPAS over the past three decades. If the appellant does not provide procurement and related assistance to MPAS, given its limited operational/economic profile, the only realistic alternative available to the Appellant would be to approach MPAS's competitors and offer similar procurement assistance as provided to MPAS currently. In such a scenario, it would be naive to assume a third party competitor would give appellant a share in the excess/residual profits (if any), let alone transfer the entire excess profits to the appellant. Annexure 1 FAR Analysis undertaken by the Appellant for FY 2005-06 We have provided below, the abridged FAR analysis which substantiate that MPL performed limited functions, assumed routine risks and employed routine assets. Functions performed Nature/details of function MPL, INDIA MPAS, DENMARK ( i ) Research Development No function in this area is carried out. Development of new medical kits considering development in international market, trend of deman ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ning proper inventories. They also provide necessary system support and its expertise developed over last thirty years. ( vii ) Logistics The company is handling the inward and outward of goods and materials, delivery of export of consignment to MPAS designated shipping agencies, clearance of goods imported within India. This includes preparation of all office records, statutory documents, timely shipment, etc. MPAS develops logistic framework and engages third party agencies. It also undertakes or arranges for logistic functions outside India and within India. Expert guidance is provided on account of its expertise in logistics developed over more than thirty years. ( viii ) Market and distribution All the orders are placed by MPAS for supply of medical kits. Entire sales of the company are to MPAS only. Therefore, there is no question of development of market by the company. Shipment is also is as per the terms of order with MPAS. The MPAS and its various products are registered in various countries and various developmental agencies. They participate in international tenders. Therefore, MPAS carries out function relating to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... assembling is on MPL's account and compliance of prescribed quality standards is mandatory. All risks connected with rejection of goods, quality issues, shortages at customers place are to be borne by MPAS only. After sales services, if any are to be provided by MPAS at customers place in various countries. The risk of product liability in terms of international regulations as well as in terms of laws of the country where supply is made is on the shoulders of MPAS. Even the risks associated with faulty design or development of kit is with MPAS. ( iv ) Financial risks As mentioned above, the operations are funded from advances received against sales to MPAS. There is no borrowing and therefore there is no cost of interest incurred by the MPL. Even the inventories are funded by MPAS by way of advances towards orders. There is no risk of foreign exchange rate variations. The borrowings are made by MPAS to finance the operations and therefore it incurs borrowing and its cost also. Foreign exchange rate fluctuation risk is with MPAS. ( v ) Entrepreneurial Risk MPL has no risk associated with investment in capital. It is assured of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... created/developed by MPAS over a period of more than three decades and MPAS has to incur significant cost and efforts to ensure that goodwill and credentials so created are maintained. Registration of suppliers with various Governments, UN agencies, NGO's etc as well as product registration in various countries made by MPAS has taken number of years of consistent and reliable supply of quality products in addition to incurring of various expenses." 17. We have considered rival submissions and have gone through the orders of the authorities below and the judgments cited by both the sides. We have to decide the following issues to resolve the dispute in this year. (A) Selection of tested party - whether it should be the assessee or the "AE"; (B) Selection of the comparable - whether the IDA, Netherlands can be accepted as comparable or whether it should be excluded and whether out of none local comparables cited by the assessee before the DRP all or some are acceptable, and which of the comparable should be held to be acceptable. 18. First we decide the issue regarding the selection of the tested party: As per the assessee, the tested party should be the assessee, because, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s submitted that most of the personnel visited India to provide operational support to the assessee-company for training of employees, assistance in establishment of accounting and other controls, formulation of operational guidelines, resolving cultural issues etc., and during the present year, the assessee-company did not make any payment to the "AE" for visits of the expatriate. 19. We find that neither the TPO nor the learned DR of the Revenue could controvert the factual submissions of the assessee before the TPO, DRP and before us. It could not be disputed by the Revenue that the "AE" was sourcing material and products directly from the Indian manufacturers/suppliers for more than three decades i.e. even prior to setting up of the assessee-company. The visits of the expatriate sent by the "AE" to India and making payment for their visits, is also explained by the assessee-company that the same was for the purpose of providing operational support to the assessee-company, and in the present year, no such payment has been made by the assessee-company to the "AE" for visits of the expatriates. Once it is established that no intangible assets was developed by the assessee-compan ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t since the IDA is also having surplus, it cannot be accepted that IDA is not working for profit motive and it is a charitable institution. These arguments of the learned DR of the Revenue are neither here nor there, because even all the charitable trusts and institutions in India are also having some surplus, and for this reason alone, it cannot be said that they are not for charitable purpose, or that, they are working for profit motives. Generating some surplus is a different issue, but whether one is working for profit motive is altogether a different aspect. Some surplus has to be generated even by the charitable institutions, to take care of its requirement of its charitable objectives, and for development and for this reason alone, one cannot say that such charitable institution is working with profit motive. Apart from these arguments, the learned DR could not controvert this contention of the learned AR of the assessee that the IDA is not working with profit motive. The assessee has provided sufficient material on record in support of its contentions that the IDA is not working with profit motive. In the written submissions submitted by the assessee before us, and reproduc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... les Ltd., Adinath Bio-labs Ltd., Rajat Pharmachem Ltd., and Shamrock Industrial Co. Ltd. Regarding the first party, Aditya Medisales Ltd., the objection of the DRP is noted at page no.69 of the DRP order. Regarding this company, one of the objections of the DRP is this that, this company is having very high sale turnover of Rs.959 crores. The second objection is this that this company has no export sales. Now question is whether these objections are sufficient to reject the comparable. 25. The submissions of the learned AR of the assessee are these that about these four comparables, the objections of the DRP are these that these companies are engaged in the manufacturing activity also, or that, the turnover is very high or very low. Regarding Aditya Medisales Ltd., it was submitted that this company is in fact not having any manufacturing activity, and in support of this contention, our attention was drawn to page no.22 of the paper book. From this page of the PB, we find that, in fact this company is not having any manufacturing activity, because against sale of Rs.953.83 crores, cost of goods sold is Rs.916.83 crores, which is opening stock plus purchases less closing stock, an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssessee is neither carrying on inventory risk or any other type of risk. Under these circumstances, how the assessee-company can command export profit, which is generally available to a true exporter ?. A true exporter is in fact locates customers as well as suppliers. He has to make payments to suppliers, and he has to finance supplies till the payment is received from the foreign buyers. He also undertakes the risk of timely delivery, foreign exchange fluctuations, quality, standard etc. If the supplier commits a mistake, the goods will be rejected by the overseas buyer and the exporter will have to bear the risk. In the present case, no such risk is being borne by the assessee-company, and hence, in the present case, this factor is not relevant as to whether comparable is having export turnover or not. This view is being taken by us on the basis of peculiar facts of the present case, in the light of the decision cited by the learned DR of the Revenue rendered in the case of Interra Information Technologies India (P.) Ltd. (supra). The relevant para of the Tribunal decision in para 65 which is reproduced below: "65. Hence, while adjudicating transfer pricing cases, we are of th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... manufacturing turnover of only Rs.798.57 lakhs and hence, it can not be said that manufacturing is the main activity of this company. We have examined relevant pages of the paper book, and we find that this contention of the learned AR of the assessee is correct. The majority of the turnover is in respect of trading activity of pharma products or domestic software sales or the software system services, and since the assessee-company is also rendering the services to its "AE" in respect of pharmaceutical items, which includes medical kits, in our considered opinion, rejection of this comparable is also not justified in the facts of the present case. 29. Third comparable which was not considered is Rajat Phamachem Ltd. Regarding this company, the objection of the DRP is the same that this company is also basically engaged in the manufacture of pharmaceutical generic formulations. In this regard, our attention was drawn by the learned AR of the assessee page no.163 of the paper book which contents the relevant schedules of the profit loss account. He pointed out that since the cost of the material is only opening stock plus purchase less closing stock, it is to be accepted that t ..... X X X X Extracts X X X X X X X X Extracts X X X X
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