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TMI Blog2014 (1) TMI 501X X X X Extracts X X X X X X X X Extracts X X X X ..... is of a fixed percentage of the free on board value of export made by unrelated party venders. Lower authorities, including the Tribunal, misdirected themselves in holding that LFIL assumed substantial risk - LFIL has neither made investment in the plant, inventory, working capital, etc., nor does it claim to have any expertise in the manufacture of garments - LFIL does not bear the enterprise risk for manufacture and export of garments - LFIL s functional and risk profile thus is entirely different and has nothing to do with the manufacture and export of garments by unrelated third party vendors - LFIL renders support services in relation to the exports, which are manufactured independently - Attributing the costs of such third party manufacture, when LFIL does not engage in that activity, and more importantly, when those costs are clearly not LFIL s costs, but those of third parties, is clearly impermissible - LFIL has developed experience and expertise which the Tribunal has held to be human capital and supply chain intangibles But this does not reveal how the assessee borne the risk either enterprise or economic. LFIL s remuneration on a cost plus mark-up of 5 per cent represen ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... details of data used, reasons for arriving at a certain price and applicability of methods, subject to judicial scrutiny. The order of the TPO has not provided any substantive reasons for disregarding the TNM method as applied by LFIL - The TPO s arbitrary exercise of adjusting the cost plus mark up of 5% on the FOB value of exports finds no mention in the IT Act nor the Rules - Such an exercise of discretion by the TPO, disregarding the LFIL s lawful tax planning measures with its group companies, is not in compliance with the IT Act and Rules of Income Tax Decided in favour of assessee. - S. Ravindra Bhat And R. V. Easwar,JJ. For the Petitioner : Mr. Porus Kaka, Sr. Advocate with Mr. Neeraj Jain, Mr. Manish Kanth and Mr. Ramit Katyal, Advocates. For the Respondent : Mr. N. P. Sahni, Sr. Standing Counsel and Mr. Ruchesh Sinha, Advocate. JUDGMENT Mr. Justice S. Ravindra Bhat 1. The present appeal under Section 260A of the Income Tax Act, 1961 (hereafter the IT Act ) impugns the order dated 30.09.2011 of the Income Tax Appellate Tribunal, Delhi Branch D , New Delhi (hereafter the Tribunal ) in ITA No. 5156/Del/2010, for the assessment year 2006-07. The present appeal concerns the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... vider performing limited functions with minimal risk as an offshore provider and substantial functions relating to buying services was performed by the AE, which also assumed various enterprise risks. Thus, the compensation paid to the appellant at cost plus 5% as remuneration was to be considered at arm s length while applying the TNMM. Alternatively, the AE entered into contracts with unrelated third parties for rendering buying services @ 4% to 5% of the FOB value of exports. LFIL had in turn received service fee of Rs.47.69 crores which is equivalent to nearly 4% of the FOB value of the export (by the vendors) from the AE, which constituted 80% of the consideration received by the AE, which, in LFIL s opinion ought to have been considered at arm s length. 5. The Transfer Pricing Officer by an order dated 28.10.09 under Section 92CA(3) of the IT Act did not dispute the selection of the comparable companies for application of TNMM by LFIL. However, he held that the cost plus compensation @ 5% of cost of incurred by LFIL was not at arm s length and applied a mark up of 5% on the FOB value of export of Rs. 1202.96 crores made by the Indian manufacturer to overseas third party custo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s like India to stay competitive and to increase profits. In this case, the AE has recognized that India offers both cost and operational advantage such as tower salaries for the employees, low cost material and low cost manufacture. Accordingly, it has established a trading company in India for procurement of goods. Location savings generally emerge when companies transfer their operation site from high cost economy to economies with low cost. That is, they take advantage of price differences in the factors for production or procurement across the countries. In many cases, the location saving arise from differences of low labour cost, low raw material and finished goods cost, low logistic cost and lower quality control cost. The net location saving represent saving from moving to low cost economy. In this case, the assessee is operating in low cost economy has generated location saving due to huge difference in cost of procurement between high cost economy and low cost economy like India. From a trading pricing prospective the common question in this case is: who is entitled to additional profits in form of locational saving? or which country should tax the profits? In this case, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d through the assessee. (b) The assessee is operating in a low cost country like India and its operating cost is so low that it is a very poor proxy of the value it adds to the sourced goods. (c) The assessee has developed unique intangibles like supply chain management intangibles and Human Asset Intangible which has resulted in huge commercial and strategic advantage to the AE and these intangibles have enhanced the profit potential of the AE. However, these intangibles did not form part of the operating cost. Accordingly, the value addition made by the assessee using intangible, to the FOB value the goods sourced through it remained unremunerated and operating cost plus mark up model does not capture the compensation for value addition made through these intangibles. Accordingly commission should be computed on FOB value of goods. (d) The assessee has generated huge locational saving for the AE as discussion in Para 5.2.5 of this order. However, compensation model based on operating expense of the assessee does not include locational saving attributable to the assessee which could only be capture if commission is calculated on FOB value of goods sourced through the assessee. In ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tested party. (b) No computation of risk adjustment is filed. (c) The onus to support risk adjustment is on the assessee, who has not discharged that onus. ********** ************ 8.1 The assessee has adopted TNMM with a PLI of OP/OC. It may be pointed out that it is not the intention of this order to change the method adopted by the assessee. The method adopted by the assessee is accepted. The only change being made is on the cost base being applied while applying the PLI, chosen by the assessee. It has already been pointed that the costs do not include cost of sales made through the assessee. This being the case, the mark-up of 5% should obviously be calculated on the full FOB value of exports in on Rs.1202.96 Crores. Following the discussion in the preceding paras, the operating income shall be calculated as a mark-up the FOB value of exports that have been facilitated by the assessee. 9. Calculation of arm s length price The assessee has credited total receipt of Rs.476,983,904 on the basis of operating cost of the assessee plus a markup of 5% and at the net level the net operating margin of Rs.24,914,814 comes to 5.22%. This is in consonance with the assessee s claim it is ope ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d. The assessee s plea that the Hon ble ITAT and the Delhi High Court, have held that it is eligible for deduction u/s 80-O of the Income Tax Act has no application in the instant case as the decisions were not rendered in the context of setting the arms length price of the assessee s international transactions. International transactions have to be judged at a different level as opposed to transactions covered by the domestic law. The OECD also recognizes the fact that related parties may fashion their transactions in such a manner that may call for looking at the substance of transactions over the form they are given. The relevant portions of the OECD guidelines issued on 22.07.2010 are as below:- 1.67 Associated enterprises are able to make a such greater variety of contracts and arrangements than can independent enterprises because the normal conflict of interest which would exist between independent parties is often absent. Associated enterprises may and frequently do conclude arrangements of a specific nature that are not or are very rarely encountered between independent parties. This may be done for various economic, legal, or fiscal reasons dependent on the circumstances i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... objections of the assessee are disposed of as above. 9. LFIL preferred an appeal to the Tribunal against the assessment order, which by the impugned order dated 30.09.2011, even while accepting that the TNM Method was the appropriate method for calculation, rejected the LFIL s contention that under Rule 10B (1)(e) of the Income Tax Rules ( the Rules ) made no provision for considering the cost incurred by third parties or an unrelated enterprise to compute net profit margin. The Tribunal by its impugned order held that the appellant was performing all critical functions with the help of tangible and unique intangibles as well as supply chain developed, which helped the AE to enhance its business and resulted in location saving to the consumer, compensation for the services rendered by LFIL to the AE, equivalent to the cost plus 5% markup, was not at arm s length. Since LFIL was providing crucial sourcing services and the AE was remunerated by third parties based on such services, the Tribunal relied upon the mark up on FOB value of goods sourced through LFIL as the appropriate method to work out arm s length compensation. The tribunal accepted the TPO s reasoning for applying the 5 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 2004-05, we find that while accepting profit level indicator nothing has been said about the basis on which the compensation has been received by the associated enterprise on the goods exported from India through assessee. As we have already stated earlier, the associated enterprise was receiving the compensation as a percentage of the FOB value of the goods exported through the assessee and as per the guidelines of the OECD which recognizes that the related party may fasten their transaction in such a manner that may call for looking at the substance of transactions over the form they are given. In this case, the associated enterprise was receiving the compensation on the basis of FOB value while the Indian associate (assessee) was compensated only by cost plus 5% mark up. When the associated enterprise are receiving the compensation at FOB value and the assessee which is providing critical functions with the help of tangible and unique intangibles developed over the years and with the help of supply chain management which are important to achieve the strategic and pricing advantage. All these help the associated enterprise to enhance and retain the business and also contributes ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... order to placement of advertisement. In assessee s case, the associated enterprise has been receiving the mark up as 5% of the FOB value of exports effected by assessee by applying its tangible and intangible capacity. The critical and all crucial work is done by assessee. The AE is paying back to the assessee only on the basis of cost plus 5% mark up. Such an arrangement cannot be said at arms length. In our considered view, such method will go against the basic normal business sense, as inefficient and high cost services provided by assessee shall fetch more revenue to the assessee. Such an arrangement on the face of it cannot be said to be at arm s length. The AE is getting remuneration on FOB value of export for which critical and main functions are performed by assessee. We also uphold that the assessee has developed a technical capacity and owns manpower which had developed human intangibles to perform all the critical functions. These tangible and unique intangible have been developed over the years. In view of these facts, we hold that to arrive at arm s length of these transactions, the mark up must be on the basis of FOB (free on board) value of the exports. Since the AE ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed or on lower side. In view of these facts, we are of the view that the amount of adjustment so computed should not exceed the amount received by the associated enterprise. In our considered view, the AO as well as the DRP has proceeded on a wrong footing which have given absurd results of adjustments. In view of the fact that majority and crucial services rendered by assessee, the distribution of compensation received by AE @ 5% of the FOB value of the exports between the assessee and the associated enterprise should be in the ratio of 80 : 20. The assessee must get 80% of the total receipt by AE from the ultimate purchasers. AO is directed to compute the arm s length price in the above manner. 10. LFIL s counsel argued that the addition of Rs. 33, 59, 69, 186/- made on account of difference in the arm s length price of international transactions of buying/sourcing services is not sustainable for the reason that the TPO applied the TNMM method contrary to the Transfer Pricing Regulations. Section 92 of the Act stipulates that any income arising from an international transaction shall be computed having regard to the arm s length price. Further, Section 92F(ii) defines arm s lengt ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ould artificially enhance the LFIL s cost base for applying the OP/TC margin. He urged that LFIL s compensation model should be based on functions performed by it and the operating costs thereby incurred and not on the cost of goods sourced from third party vendors in India. Thus, allocating a margin of the value of goods sourced by third party customers from exporters/vendors in India is inappropriate and unjustified. 15. Learned senior counsel further argued that in terms of the Transfer Pricing documentation, LFIL had established the international transactions of rendering buying services to be at arm s length price having regard to the operating profit margin earned by comparable companies having similar functional profile. The computation of LFIL s operating profit margin (OP/TC%) by enhancing the cost base i.e. by increasing the cost of sale facilitated by the assessee would lead to an arbitrary adjustment to the income of the appellant which was never intended by the legislation. 16. The learned counsel further contended that LFIL is performing such functions which undertake a limited risk, and do not involve the direct manufacture of goods. This is evident from the fact tha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... neither LFIL nor its AE are parties to such contracts. By providing sourcing support services, none of them have gained any advantage on account of locational saving associated with the export of goods between exporters and overseas customers. Thus, it is submitted that the adjustment made by the TPO on ground of locational saving, is not sustainable and liable to be deleted. 19. The learned counsel also urged that the amount of adjustment computed by the TPO in the order passed cannot exceed the net margin i.e. gross revenue received from the end customers less amount paid to LFIL, i.e. the amount retained by the AE in respect of the transactions. LFIL rendering sourcing services has facilitated exports by the vendors/suppliers of nearly (USD 273.4 million @ Rs.44/$) Rs. 1,202.96 crores in the relevant previous year. The AE entered into the contract with the unrelated party customers for rendering buying services at 4% to 5% of FOB value of exports. The appellant has in turn received services fee (at cost +5%) of Rs. 47.69 crores which is nearly 4% of the FOB value of the export from the AE. However, the TPO/AO in the impugned order has computed the arm s length price of the appe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d, had neither quantified locational saving nor had it attributed any part of its additional profit on account of locational saving to the assessee in India. The assessee, according to counsel, did not show if the AE had any technical capacity or manpower and therefore, LFIL s claim of its involvement in execution of sourcing services could not be accepted. 22. The counsel for the Revenue urged that since the AE was receiving 5% of the FOB value from the purchasers and assessee in performing crucial and critical functions with the use of tangible and unique intangibles developed over a period of time, it is only proper that LFIL must receive the majority of the receipts with regard to the execution of work. Thus, he contends that the markup should be based on the FOB value and on that basis it was argued that the orders of lower authorities were to be sustained. 23. It was lastly argued that OECD also visualizes that AEs can structure their transactions in such manner as may require close scrutiny. The TPO s task is therefore to often look behind the facts as they seem and arrive at the substance of the transaction to compute the value of the transaction. The application of the cos ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... aining the power to benefit from such transactions i.e. the income so generated. Under the original 1961 IT Act, a similar provision was found under Section 92. By Finance Act, 2001 w.e.f. 1.4.2002, Section 92 was substituted by Sections 92 to 92F, provisions in Chapter X of the Act. The Central Board of Direct Taxes ( the CBDT ) by its Circular No. 14/2001 dated 12.12.2001 [2001 252 ITR (ST.) 65] spelt out the scope and effect of these provisions The rationale for substituting the existing Section 92 of the IT Act was explained in the following extract of the said Circular: 55.2Under the existing section 92 of the Income Tax Act, which was the only section dealing specifically with cross border transactions, an adjustment could be made to the profits of a resident arising from a business carried on between the resident and a non-resident, if it appeared to the Assessing Officer that owing to the close connection between them, the course of business was so arranged so s to produce less than expected profits to the resident. Rule 11 prescribed under the section provided a method of estimation of reasonable profits in such cases. However, this provision was of a general nature and li ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e of an international transaction the meaning of which is provided in section 92B one would have to in addition read the definition of transaction given in Section 92F(v). 27. Section 92C is the provision enabling determination of ALP. Section 92C (1) states that ALP in relation to an international transaction could be determined by any of the methods provided in the said sub-section which is most appropriate having regard to the nature of transactions or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors which may be prescribed by the Board. The methods provided being (a) comparable uncontrolled price method; (b) resale price method; (c) cost plus method; (d) profit split method; (e) transactional net margin method and; (f) such other method as may be prescribed by the Board. In determining the most appropriate method, regard is to be had to Rules 10A and 10B of the IT Rules, 1962. Section92C(3) casts the obligation of computing the ALP on the assessee, at the first instance. The AO then would proceed to determine the ALP in relation to an international transaction in accordance with Section 92C (1) and (2) onl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the Assessing Officer and the assessee. Section 92CA (3A) provides the time frame within which the TPO has to pass an order under Section 92CA (3). 29. Prior to the Finance Act, 2007, Section 92CA (4) read as follows: On receipt of the order under sub-section (3), the Assessing Officer shall proceed to compute the total income of the assessee under sub-section (4) of section 92C having regard to the arm s length price determined under sub-section (3) by the Transfer Pricing Officer. 30. It would be useful to recollect that the IT Act draws heavily from the Organization for Economic Co-operation and Development Model Tax Convention s interpretation under Article 9. In terms ofArticle 9, when conditions are made or imposed between two AEs in their commercial or financial relations which differ from those which would have been made between independent enterprises, then any profits which would, but for those conditions, have so accrued, may be included in the profits to bring them to a level that would prevail when independent enterprises would enter into comparable transactions under comparable conditions. Section 92F(ii) specifically defines Arm s Length Price as a price which is ap ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 34. The OECD Guidelines, which are instructive in such cases, clarify that any attempt to use TNMM should begin by comparing the net margin which the tested party makes from a controlled transaction with the net margin it makes from an uncontrolled one (an internal comparable ). If this proves impossible, possibly if there are no transactions with uncontrolled parties, then the net margin which would have been made by an independent enterprise in a comparable transaction (an external comparable ) serves as a guide to determine the ALP. Here, the strict criterion is of an independent enterprise, carrying out a comparable transaction, with the caveat that this will be only a guide. Indeed, the emphasis is very clearly on finding a comparable transaction. In addition, a functional analysis of both the associated enterprise and the independent enterprise is required to determine if the transactions are comparable. It might of course be possible to adjust results for minor functional differences, provided that there is sufficient comparability to begin with, The standard of comparability for application of TNMM is no less than that for the application of any other transfer pricing meth ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the DRP) and the Tribunal accepted the application of TNMM by LFIL as the most appropriate one. Nevertheless, they did not consider the cost plus compensation at 5% at arm s length. The reasoning for not doing so was that LFIL was performing all critical functions, assuming significant risks and used both tangibles and intangibles developed by it over a period of time. Reliance was placed upon the technical capacity, manpower, low cost of product, quality of product in India available to the assessee and the enhanced profit potential the AE. The tribunal held that the cost plus 5% mark up is definitely not on the arms length while working out the compensation for the services rendered by LFIL to the associated enterprise and mark up on the FOB value of the goods sourced through the assessee shall be the most appropriate method for calculation of arm s length price. 38. In scrutinizing Transfer Pricing documents, the TPO undertakes an exercise known as FAR (functions performed, assets owned and risks assumed by the associated enterprises involved). This analysis plays a critical role in determining the arm s length price of an international transaction entered into between AEs. The ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tion entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise ... (emphasis supplied). It thus contemplates a determination of ALP with reference to the relevant factors (cost, assets, sales etc.) of the enterprise in question, i.e. the assessee, as opposed to the AE or any third party. The textual mandate, thus, is unambiguously clear. 40. The TPO s reasoning to enhance the assessee s cost base by considering the cost of manufacture and export of finished goods, i.e., ready-made garments by the third party venders (which cost is certainly not the cost incurred by the assessee), is nowhere supported by the TNMM under Rule 10B(1)(e) of the Rules. Having determined that (TNMM) to be the most appropriate method, the only rules and norms prescribed in that regard could have been applied to determine whether the exercise indicated by the assessee yielded an ALP. The approach of the TPO and the tax authorities in essence imputes notional adjustment/income in the assessee s hands on the basis of a fixed percentage of the free on board value of export made by unrelated party venders. 41. LF ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sets utilized and risks assumed by it. Further, the TPO s determination that LFIL bore significant risks is not borne out from the records. In transactions in which LFIL was a party, it did not bear any financial risk. To the contrary, its costs towards establishment, transportation, salaries, etc. were fully reimbursed, and it was insulated from any economic or financial downside to any particular transaction. In other words, its remuneration was based entirely on the costs borne by it. In essence, it is a low risk contract service provider exclusively rendering sourcing support to the AE. It does not bear any significant operational risks for its functions, rendered to the third party vendor/customers. Rather, it is the AE that undertakes substantial functions and in fact assumes enterprise risks, such as market risk, credit risk etc. It also bears the letter of credit associated charges and other expenses. 44. Another important aspect which cannot be overlooked is that the the transfer pricing documentation maintained in terms of section 92D of the Act read with rule 10B of the Income-tax Rules, determined the arm's length price of the international transaction of the provision ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... quent acceptance of these methods by the appellate authorities, is inconsistent with the IT Rules and the IT Act. 47. At this point, it is useful to note that the TPO is required to scrutinize the various methods that may be employed to evaluate their appropriateness, the correctness of the data, consideration of surrounding factors, etc. The selection of the most appropriate method will depend upon the facts of the case and factors mentioned in rules contained in Rule 10C. It would be useful here to refer to two circulars issued by the CBDT, which prescribe the ground rules defining the powers and jurisdiction of the tax authorities and administrators: Circular No. 12 dated 23rd August, 2001 reads as follows: The aforesaid provisions have been enacted with a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profit and tax in India so that the profits chargeable to tax in India do not get diverted elsewhere by altering the prices charged and paid in intra-group transactions leading to erosion of our tax revenues. .. .. (iii) it should be made clear to the concerned Assessing officer s that where an international transaction has be ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... computation of the Arms length price is not reliable correct; or the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub section (3) of section 92D. If any one of such circumstances exists, the Assessing officer may reject the price adopted by the assessee and determine the Arms length Price in accordance with the same rules. 48. The TPO after taking into account all relevant facts and data available to him has to determine arm s length price and pass a speaking order after obtaining the approval of the Department of Income Tax (Transfer Pricing). The order should contain details of data used, reasons for arriving at a certain price and applicability of methods, subject to judicial scrutiny. The order of the TPO, in the instant case, has not provided any substantive reasons for disregarding the TNM method as applied by LFIL. Further, the TPO s arbitrary exercise of adjusting the cost plus mark up of 5% on the FOB value of exports finds no mention in the IT Act nor the Rules. Such an exercise of discretion by the TPO, disregarding the LFIL s lawful tax planning measures with its group c ..... X X X X Extracts X X X X X X X X Extracts X X X X
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