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TMI Blog2014 (10) TMI 702X X X X Extracts X X X X X X X X Extracts X X X X ..... mstances of the case - referred to in grounds of appeal nos. 1 to 4, and subsidiary grounds of appeal set out in these main grounds of appeal; and (b) whether or not the disallowance of Rs. 102,17,16,483 under section 40(a)(i) is justified on the facts and in the circumstances of the case- referred to in grounds of appeal nos. 5 to 11, and subsidiary grounds of appeal set out in these main grounds of appeal. We will take up these issues in the same sequence. Issue 1: Correctness of ALP adjustment of Rs. 68,15,17,853 Background 3. So far as ALP adjustment of Rs. 68,15,17,853 is concerned, the relevant material facts are like this. Mitsubishi Corporation India Pvt. Ltd. (MCI, in short) is a wholly owned subsidiary of Mitsubishi Corporation Japan (MCJ, in short) - one of the leading sogo shosha establishments in Japan. While 'sogo shosha', a Japanese expression, can be transliterated as a 'general trading' and sogo shosha companies are, therefore, generally described as 'general trading companies', the true connotations of sogo shosha companies are quite different from a typical general trading company as can be discerned from the TPO's observation, set ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... proach so adopted by the assessee was rejected by the TPO. The TPO was of the considered view that under rule 10B(4), the data to be used in comparability of an uncontrolled transaction with an international transaction shall only be of the related financial year, though an exception could be made out for data of two immediately preceding financial years only if such data reveals facts which could have an influence on the determination of transfer prices in respect of international transaction being compared. It was in this background, and supported by a detailed analysis of the legal position as also judicial precedents on this issue, the TPO rejected the use of multiple year data. 6. The TPO was also of the view that since the assessee has used berry ratio as PLI, entire international transactions relating to sales and service of commodities have remained out of PLI, and that, most importantly, the cost of sales is not included in the denominator of PLI used. The TPO was further of the view that the legal provisions, as set out in the Income Tax Act, 1961 or the Income Tax Rules, 1962, do not permit the use of operating expenses in the base as these expenses do not include cost ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssessee in India provides AEs a medium of communication through which they can compete with their competitors eyeing similar business in India". The TPO was of the view that "the assessee has performed all the critical functions, assumed significant risks and used both tangible and unique intangibles developed by it over a period of time". He then summarized the FAR analysis as follows: Functions performed by the assessee: -Purchasing activities: Mitsubishi India places orders with related party vendors after receiving orders or projections from its customers -Distribution activities: In some of the principal transactions, Mitsubishi India warehouses Inventory at public bonded warehouses and maintains sufficient Inventory as per agreement with customers. It performs Inventory control and ships goods to customers. Mitsubishi India's customers sometimes arrange for their own shipping and handling. -Sales marketing and after sales activities: In principal transactions, the Group Companies coordinates in negotiating prices with Mitsubishi India's customers. Mitsubishi India's sales personnel requirements are Identified by Mitsubishi India and also remuneration of sales ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng, (8) quality control, (9) consignment of goods,(9) consignment of the goods, (10) transportation of goods to the port of departure, and (11) random quality check prior to shipping. The TPO observed that "since risks largely follow functions, in this case the assessee has borne all the major risks association with the above referred functions" as also the following major business risks - single customer risk (because, as per contract, the assessee could not work for any unrelated customer), sourcing risk, risk associated with development and use of intangibles, risk associated with quality of service, and capacity utilization risk. The TPO was of the view that that "the assessee has used its assets, including human assets (technical manpower) to discharge the functions referred to above". The TPO was of the view that "the assessee has developed a supply chain management intangible over a period of time which is all about having the right product in the right place, at the right price, at the right time and in the right condition". The supply chain management developed by the assessee, as per the TPO, is management of the link between organization and its suppliers as also custome ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ndia, considerable locations savings have accrued to the AEs but the compensation model, which provides for a mark up on costs, does not take into account the benefits from the locational savings. As for the use of berry ratio, the TPO finally rejected the same for two main reasons - first, that the scheme of section 10B(1)(e)(i) does not permit the same, and - second, that berry ratio is unsuitable for the situations involving unique intangibles (like supply chain intangibles and human assets intangibles) and since it is highly sensitive to the costs and the treatment of costs may vary from accounting policies in different comparables and it is difficult to make appropriate adjustments in respect of such variations in accounting treatment. The TPO was of the view that berry ratio is de facto cost plus method, as accepted in one of the observations made by Charley H Berry, author of this ratio, himself - which was reproduced by the TPO, the assessee cannot resort to the use of this ratio when the assessee has consciously chosen the TNMM as most appropriate method. 11. It was in this background, and having arrived at an arithmetic mean of 2.49% in respect of the OP/OE in respect of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... and Shri Peeysh Jain and Shri Y K Verma, Commissioner - Departmental Representatives, appeared for the revenue. The position in the immediately preceding assessment year- views of the coordinate bench: 14. We must begin by taking note of the fact that an identical adjustment, so far as buy-sell segment is concerned, made by the Assessing Officer in the assessee's own case for the immediately preceding assessment year, had come up for consideration before a coordinate bench of this Tribunal, and the coordinate bench, vide order dated 23rd August 2013 (now reported as 63 SOT 162), has remitted the matter back to the assessment stage by observing as follows: 10. The second ground of the assessee is on the issue of transfer pricing adjustment. The nature of assessee's business as described in the DRP order is to undertake (sogo shosha) activities i.e. role of a trade intermediary. The purchases are made by the assessee are recorded as such in its books of accounts and there after when sold, the sales recorded as such. The title in the goods is held by the assessee for some time. The assessee deals on a principle to principle basis. Though it is claimed that it is intermedia ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for purchase with its parent company on the basis of confirmed orders from its customers. It was submitted that in substance the assessee only front ends the transactions of its parent company. The assessee is, thus, not exposed to the risk of carrying any inventory and/or deploying any significant working capital. Accordingly, it was claimed by assessee that the cost of goods sold should not be taken into consideration while computing the profit margins which should be calculated on the operating costs and the appropriate ratio to be considered for comparing with other entities would be the ratio of net revenue to operating costs. 9. The said contentions had also been advanced by the assessee before the ITAT. In the alternative, the assessee had submitted, before the ITAT, that if the transactions of buying and selling were considered to be trading then the ALP should be determined in comparison with companies which were similarly situated. 10. The Tribunal had considered the submissions of the assessee and held as under:- "10. The second ground of the assessee is on the issue of transfer pricing adjustment. The nature of assessee's business as described in the DRP order i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tions, i.e. - (a) service/commission transactions, in which MCI has acted as a mere facilitator for transactions; and (b) trading/buy sell transactions, i.e. where assessee takes flash title of the goods momentarily while buying the goods against confirmed orders and then selling the same to third parties. As regards service/commission transactions, the assessee collects information such as market data and financial conditions of such entities, and these activities are carried on by the assessee based on broad strategies and guidelines provided by the AEs. These are the activities, according to the learned counsel, in which functions and risks are minimal. As regards the trading transactions, the assessee enters into transactions on principal to principal basis with AEs as also non AEs but as the assessee takes flash title of the goods only momentarily and buys goods based on confirm back to back orders, the value addition, even in buy sell segment, is akin to that of service or commission segment. Learned counsel's basic argument is that even though the above issue is now covered to the limited extent that trading activities carried out by the assessee are to be treated as nor ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... take into account, in computing the PLI, the cost of goods sold or value of goods sold. Learned counsel then points out that the reasons assigned for rejecting the berry ratio are not legally sustainable. He submits that it is incorrect that use of berry ratio is not permitted under rule 10B(1)(e)(i) as there is no specific prohibition on use of berry ratio, and that since the so called unique intangibles on account of supply chain and human assets are pure figments of imagination of the TPO and these vague allegations cannot restrict the use of berry ratio. Learned counsel submits that there is nothing unique about these intangibles of supply chain and human assets, as anyone engaged in trading will have a vendor development and the human resources taking care of this aspect of the matter. He points out that the intangibles, in order to be taken into account for profitability of the assessee on trading with its AEs, should be unique intangibles, not present in the business of the comparables, owned by the assessee and not the AEs. He also points out that as regards the berry ratio being unworkable due to variations in accounting policies, no specific issues are raised by the TPO ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , Hon'ble High Court has rejected similar contentions, which were also raised without any cogent material to support the same, raised in that case. In any event, as per provisions of Section 92 C(3) r.w.s. 92CA(1), the TPO can determine the ALP of a transaction only when there is any material nor information so as to satisfy fulfilment of conditions set out in 92 C(3) (a) to (d). In support of this proposition, reliance is placed on a decision of the coordinate bench in the case of Mentor Graphics v. DCIT (18 SOT 76). It is thus urged that while the matter can indeed be remitted to the file of the Assessing Officer, clear directions need to be given in the light of the settled legal position as set out above and treating the commission and service fee segment as per the settled legal position. 18. Learned Departmental Representative, on the other hand, relied upon the orders of the authorities below and took us through the same. He contended that since the matter in the immediately preceding assessment year has been remitted to the file of the Assessing Officer for fresh consideration and there is no reason to give a different treatment in this year, he has no objection to the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on legal issues from the Hon'ble Courts above as also by the coordinate benches, and that, therefore, simply remitting the matter to the assessment stage will result in inordinate delays in resolving the core dispute. It is also submitted that now that we are in seisin of the matter, and it is clearly discernible that perceptions of the parties on some peripheral key issues do not have any meeting ground, the right course will be to give specific directions in the matter so as the assessment reaches finality sooner rather than later. Our analysis: Disparities in facts of the immediately preceding assessment year and the assessment year before us: 20. We find that, as learned counsel rightly points out, so far as the decision for the assessment year 2006-07 is concerned, it is confined only to the trading activities of the assessee and it does not deal with service fee/commission segment. As the coordinate bench itself has observed in so many words, the activity in question pertains to the situation in which "purchases are made by the assessee are recorded as such in its books of accounts and thereafter when sold, the sales recorded as such" and in which "title in the goods i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... industrial equipment. 'Sogo' means general and 'shosha' is a trading company, hence the sogo shosha handle a wide range of products. They are characterized firstly by colossal sales, secondly by diversity of goods traded (from noodles to missiles), engage in both import and export with every major market in the world, and thirdly by global reach of their network 2.3 Profile of Mitsubishi India MCI is wholly owned subsidiary of MCJ. MCJ is a general trading company and the group plays an important role in linking buyers and sellers for products in a variety of industry segments. MCI is considered to be a low risk activity and the primary source of activity is in the nature of commission earned on the traded goods. (Emphasis by underling supplied by us) 23. A plain look at the above analysis of profiles shows that even the TPO does not dispute that (a) MCI is a low risk activity in the field of trading, (b) MCJ group is primarily involved in high volume sales, or 'colossal sales' - as TPO's profile analysis puts it, of a wide range of merchandise; (c) MCJ, following the sogo shosha business model, has global network and MCI is a part of this network. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... shares. For example, a sogo shosha may control about 10 percent of Japan's trade, handle a range of 10,000 to 20,000 products including food, clothing, automobiles, and appliances, and have a network of over 200 offices throughout the world. Although developing and industrial countries have experimented with the sogo shosha system, few, if any, have succeeded in completely replicating the Japanese organization. The major sogo shosha include Mitsubishi, Mitsui, C. Itoh, Sumitomo, Marubeni, Nichimen, Kanematsu-Gosho, and Nissho Iwai Corp. In the late 1990s the sogo shosha controlled about 10 percent of the world's exports and over 50 percent of Japan's overall trade, according to Marketing Intelligence and Planning. The sogo shosha are also characterized by their ability to issue large volumes of credit and to help small manufacturers buy and sell goods in the global market. These trading companies serve as intermediaries for distribution at home and abroad for Japanese companies. Nevertheless, the sogo shosha's responsibilities extend beyond trading because they take active measures to ensure stable levels of supply and demand over long periods. In addition to thei ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ated link it provides between the buyer and seller. When such is the description of the core business activity of the MCJ, and the role of the assessee is restricted to a support function by way of a trading, as it is held to be, this kind of a trading, as assessee is held to have carried out, cannot be equated with activities of a normal trader. If there is no parallel to sogo shosha as a business model, there cannot obviously be a parallel to trading activity under this business model. 27. No doubt that the assessee before us, i.e. MCI, is playing only a small role of linking the buyers with sellers, either as a service activity or even as a trader, but the importance of the activity of sogo shosha being pursued by the group lies in the admittedly lower trading margin that sogo shosha trading operates on and in relatively lesser importance of the trading activity in overall scheme of a complex interdependent set of sogo shosha business activities. When the operating margin in the sogo shosha are typically characterized by "extremely thin margins", it is a natural corollary thereto that even the support trading function carried on by the assesse, i.e. MCI, will have lower margins ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y adjustments between a normal trader and sogo shosha 30. We are alive to the fact that, in the immediately preceding assessment year, decision of the Tribunal was against the assessee on this issue inasmuch reconsideration of functional profile of the assessee was specifically rejected in the order dated 4th April 2014 passed by the Tribunal, on rectification petition filed by the assessee. However, we have also noted that Hon'ble High Court, in order dated 4th July 2014, have construed Tribunal's observations to the effect that "appropriate comparables would have to be considered for determination of the ALP" as implying that "entities which are similarly placed as the assessee including in respect of their functional and risk profile as well as working capital exposure would be chosen as comparables" which essentially involves reconsideration of profile of the assessee vis-à-vis the profile of comparables, and making such adjustments in the comparables as may be warranted due to variations in these profiles. 31. As there has been no adjudication on the suitable profit level indicator, including on account of taking care of vital dissimilarities between the teste ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... takes into account the impact of inventories or cost of inventories, will, therefore, end up making the comparison useless. Does zero inventory level affect exclusion of cost of inventories in PLI determination 34. Once it is not in dispute, as is the position in that case, that the trading activity involved carried on by the assessee is a back to back operation, without any value addition to inventories or without any functions performed on the inventories, and is, that sense, without any risks associated with inventories, the cost of inventory being included in the cost base of the assessee cannot be justified on the economic principles, even as this cost of sales may have to be entered into books of accounts in compliance to the accounting principles and accounting standards. 35. In the cases in which no economic risk for inventories is assumed, in which these inventories do not even find their way to the current assets, and in which no functions are performed in respect of these inventories, except to facilitate trading in respect of the same, the very raison d'être for the cost of inventories being included in the cost base ceases to exist. The FAR analysis set o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y 40. The fact that there is a clear relationship between the inventory levels and margin levels is also evident from the stand taken by the CBDT that where inventory levels are 10% of turnover or less, the permissible tolerance range is much less at 1/3 of permissible range where the inventory levels are more than 10% of the turnover. On economic principles, profit is reward for the functions performed, assets employed and risks assumed, and, going by that principle, for the same functions of trading performed, when assets employed are lesser and risks assumed lower, the profit reward should also be correspondingly lower. In the case of the assessee before us there are no functions performed with regard to inventory and no risks assumed with respect to inventory. To that extent, going by the pure economic theory, profit, which as we have noted above is nothing but a reward for the risks assumed, functions performed and assets employed, the assessee's normal profits should be corresponding than normal comparable trading entities. 41. It is thus clear that a zero inventory level, or even a low inventory level, is a significant factor in TP analysis and the methodology adopted ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... use of this ratio worldwide, and for the reasons we will set out in detail in a short while, the use of this ratio cannot be eliminated from the India transfer pricing practices altogether. 46. In the July 2010 version of OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, berry ratio is specifically recognized as follows: 2.100 "Berry ratios" are defined as ratios of gross profit to operating expenses. Interest and extraneous income are generally excluded from the gross profit determination; depreciation and amortisation may or may not be included in the operating expenses, depending in particular on the possible uncertainties they can create in relation to valuation and comparability. 2.101 The selection of the appropriate financial indicator depends on the facts and circumstances of the case, see paragraph 2.76. Concerns have been expressed that Berry ratios are sometimes used in cases where they are not appropriate without the caution that is necessary in the selection and determination of any transfer pricing method and financial indicator. See paragraph 2.92 in relation to the use of cost-based indicators in general. One common difficul ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in the controlled transactions is not proportionate to sales and when the entity does not perform any significant operations such as manufacturing or processing. Typically, a low risk high volume trading business involving back to back trading without any value addition to the goods traded, which is what MCJ is engaged in and the MCI is contributing to, satisfies all these tests. We are in agreement with the approach adopted by the OECD document in this regard. Going by this approach, and, applying the tests laid down above, it does indeed seem that berry ratio could be appropriate in the present case. 48. Berry ratio is increasingly finding specific acceptance in many jurisdictions. While it is use in US for long, in Japan, even as berry ratio was used in APAs earlier as well, the 2013 amendment to the transfer pricing regulations, with effect from 1st April 2013, now specifically list berry ratio as acceptable in appropriate cases. In India, there have been several recent judicial precedents, which we will deal with a little later, upholding the use of berry ratio as a PLI. 49. Lets take a pause here and take a look at the circumstances in which berry ratio came into existence ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for this purpose. While this proposition so laid down was in the case of a limited risk distributor without any value addition to the goods or significant risks associated with inventories, we are of the considered view that it is equally useful in a case in which the business entity is engaged in trading, with zero or low inventory levels, and particularly as it does not involve any unique intangibles or value addition to the goods traded. 52. The answer to the fundamental question of whether a taxpayer should be entitled to a return on the value of goods handled by it, would actually depend on the functions performed and the related risks borne by it, with respect to the goods; and not on whether the taxpayer has taken title to the goods, shorn of the assessee's FAR profile. 53. Clearly and undisputedly, on the facts of this case, neither the assessee has performed any functions on or with respect to the goods traded by it, beyond holding flash title for the goods in some of the cases, nor has the assessee borne any significant risks associated with the goods so traded. All the functions, assets and risk of the assessee are quite reasonably reflected by the operating costs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... re 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. 55. In the case before the coordinate bench, it was noticed that the berry ratio is used for distributorship functions, though, as a variant of the berry ratio, its application could also be related to the service providers. This decision, however, is important for the short reason that it recognizes a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ting profits. Therefore, except in a situation in which significant trade or marketing intangibles are involved or in a situation in which there is further processing of the goods procured before selling the same or in a situation which necessitates employment of assets in infrastructure for processing or maintenance of inventories, the use of berry ratio does seem to be quite appropriate. 59. As we make the above observations, we also make it clear that in case the assessee is not able to find other comparables with significantly low or zero inventory levels, it does not prejudice the interests of the revenue authorities in any manner. The reason is this. When a comparable has an additional risk associated with inventories, which is not present in the case of the assessee, the profits achieved by the comparables can only be higher than the profits achieved by the assessee. As is elementary, higher the functions performed, risks assumed and assets employed, higher the profits. A comparables, with economic justification for higher profits, cannot be rejected on the ground of being eligible for higher profits. The stand of the coordinate bench on the use of the berry ratio 60. As ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s, are thus irrelevant and ill conceived. As a matter of fact, if this TP report at all indicates anything in this regard, it indicates that even when assessee selected TNMM, the assessee was very well aware that TNMM with berry ratio will be most suitable in the present case, and there is no legally sustainable objection to the stand so taken by the assessee in the TP study. TPO's other objections to application of Berry Ratio 63. We have noted that the TPO has raised three other objections with respect to the berry ratio, i.e. (a) use of berry ratio is not permitted under rule 10B(1)(e)(i) as it does not deal with costs incurred, sales effected or assets employed or to be employed; (b) use of berry ratio is not appropriate to the facts of this case as there are unique intangibles like supply chain intangibles and human assets intangibles; and (c) use of berry ratio is unworkable due to adjustments for variations in accounting policies for recording costs. 64. None of these objections, for the reasons we will set out now, merits acceptance. Rule 10B(1)(e)(i) and use of berry ratio 65. As for the objection that use of berry ratio is not permitted under rule 10B(1)(e)(i) as ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o the assessee which are not found in the comparables. A trained workforce, unless it has significant development cost or replacement cost, is a routine business intangible which almost all comparables will have. Cost classification issues in application of berry ratio 67. As regards the alleged unsuitability of use of berry ratio due to operational difficulties due to variations in accounting policies, it is sufficient to take note of the fact that coordinate benches of the Tribunal have upheld the use of berry ratio in appropriate cases, including the case of GAP International Sourcing India Pvt Ltd (supra), and that no specific issues are raised by the TPO with regard to operational difficulties in the cases of selected comparables. The problem, thus, is hypothetical problem at this stage which may arise in case there are significant issues in the accounting policies of the comparables vis-à-vis the assessee. That stage has not yet come as the comparables are yet to be finalized, and no such specific issues are raised with respect to the comparables used in the analysis so far. 68. In any case, when we are dealing with business entities engaged in the trading activitie ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng the domicile jurisdiction, such purchases of goods or services per se donot give rise to a locational saving for the purpose of ALP determination. In the present case, the price advantage to the assessee, on account of sourcing his purchases from India, thus may not amount to any locational savings at all, but then, as we could make out from a perusal of material on record, that precisely is the case of the TPO. No doubt "United Nations Practical Manual on Transfer Pricing for Developing Countries" does include 'locational savings' in its comparability analysis and defines it as "net cost savings that an MNE realizes as a result of relocation of operations from a high cost jurisdiction to a low cost jurisdiction" but then it is not even TPO's case that any business operations have been relocated from another location to this location. There is no specific identification of locational savings or even efforts to compute the same. In any event, locational savings in procurement of goods, even if any, will arise to the AEs actually buying the goods and not the assessee assisting such buying by way of acting as an intermediary. In a recent OECD report, released as part of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... developed only during the course of work carried out by the assessee and any other intangibles, other than the ones developed in the course of this business, are owned by the AEs and not the assessee company. It is only when intangibles are owned by the person, using these intangibles or transferring these intangibles per se, that the question for compensating for use or transfer of intangibles arise. There is nothing to corroborate and support the vague generalization that cost plus method does not "capture the compensation for development and use of intangibles". It is not even the case of the TPO that these intangibles were acquired or developed by the assessee by incurring certain specific costs and such costs are not taken into account in the compensation model. In the process of carrying on a business activity, an assessee may develop certain intangibles but that is quite different from the intangibles that the assessee uses in the business activities as an input or at the starting point, and, even if there were any such intangibles at the starting point, these intangibles could only have belonged to the AEs of the assessee. The value of intangibles created in the process of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... situation before us as well. As learned counsel for the assessee very aptly puts it, all these intangibles, as perceived by the TPO, are more of his figment of his imagination rather than based on any cogent material. The use of intangibles cannot be inferred or assumed. It is to be demonstrated, on the basis of cogent material, by the revenue authorities. Itacha Industries decision by the US Court of Appeal and its relevance to the ALP determination: 74. As for the US Court of Appeal decision in the case of Ithaca Industries (supra), referred to and relied by the TPO in support of the proposition that a trained workforce is also an intangible asset and it should be factored in the TP analysis, this decision was concerned with the question, as this judgment states in so many words, "whether an assembled workforce is an intangible asset having an ascertainable, limited useful life over which the value of the asset may be amortized". It is important to bear in mind that in the said case, the assessee had taken over the business and one of the asset taken over was "assembled workforce of 5,153 hourly production workers and 212 staff employees" and the appraiser had assigned this "w ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... pact on determination of arm's length price. An assembled workforce, even without any identifiable direct costs in raising the same, can at best be taken into account only when it has significant replacement costs, such as in the case of construction activities, for determination of the arm's length price. The situation that we are dealing with is qualitatively different. 78. Learned TPO's reliance on Itacha Industries decision (supra) is thus wholly irrelevant for the purpose of the determination of ALP which is the issue in appeal before us. While assembled workforce could always be an intangible asset, as held in the said case, such an intangible asset gets into ALP computation only when such an intangible asset has a significant value such as by way of replacement cost, cost of acquiring the same or cost of developing this intangible. Conclusion on trading segment of assessee's activities 79. In view of these discussions, in our considered view, the use of berry ratio as PLI is appropriate to the facts and circumstances of this case, the objections taken by the authorities below to the use of berry ratio are unsustainable in law, and the adjustments for use o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rnational transaction 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. 81. Clearly, therefore, it is impermissible to make notional additions in the cost base and thus take into account the costs which are not borne by the assessee. It is so opined by Hon'ble jurisdic ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rvice Asia (Thailand) 489,550,760 3. Metal One Corporation, Japan 497,373,422 4. Mitsubishi Corporation, Singapore 93,345 5. Metal One Asia Pte Ltd, Singapore 17,472,633 6. MC Tubular Inc, USA 3,376,808 7. Thai MC Company Ltd. Thailand 2,373,391 8. Petro Diamond Japan Corporation, Japan 2,295,618 Total 1,021,716,483 85. The Assessing Officer begun by taking note of the tax history of the case of Mitsubishi Corporation- Japan, parent company of the assessee company, in India. It was noted that MCJ had a liaison office in India but when a survey was conducted in the business premises of this liaison office, it was found that the liaison office was carrying on core business activity, and, accordingly, MCJ conceded taxability of its business profits in India. The AO noted the MCJ typically operates worldwide through its small business segment units called divisions and the liaison office in India was structured in such a way that it corresponds to the structure of MCJ. These divisions in the liaison office were maintained in such a way that these divisions were virtual projections of corresponding divisions of MCJ. The AO was of the view that even ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of India Ltd v. CIT (239 ITR 587). As regarding assessee's contention that section 40(a)(i) was discriminatory in character as no such disallowance was required to be made if the payments for purchases are made to a resident, and as such liable to be read down by the virtue of non-discrimination provisions set out in the respective tax treaties, the Assessing Officer contended that neither such a disallowance constituted a discrimination, nor, in any event, it was open to a resident assessee to invoke provisions of a tax treaty. As regards assessee's reliance on a decision of the coordinate bench, in the case of Herbalife India Pvt Ltd v. ACIT (101 ITD 450), the same was rejected by placing reliance on decision of another coordinate bench in the case of Automated Securities Clearance Inc v. ITO (49 SOT 333) wherein in the context of this decision, it was, inter alia, observed that, "neither the Bench had an occasion to consider the impact of Technical Explanation to the US Model Convention issued by the treaty partner State, nor the question whether or not differential treatment, de hors the justification for such differential treatment, came up for consideration for the B ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... orities 88. Let us first take up the first segment i.e. disallowance in respect of payments made to the foreign entities which did not have any permanent establishment in India and there is material on record to show that revenue's claim of their having PE in India is negated by the judicial authorities . We find that so far as payments made to the non-resident entities, set out at point no. 2,3 and 5 of the chart reproduced earlier, i.e. payment of Rs. 48,95,50,760 to MC Metal Services Asia (Thailand), payment of Rs. 49,73,73,422 to Metal One Corporation (Japan) and payment of Rs. 1,74,72,633 to Metal One (Asia) Pte Ltd (Singapore) are concerned, there is a categorical finding that these entities had not have any permanent establishment in India. Dealing with this aspect of the matter, a coordinate bench of this Tribunal, for the immediately preceding assessment year, opined as follows: 9.5 Now we take up the issue of P.E. in the case of MC Metal Services Asia, which is a Resident of Thailand and Metal One Asia P.Ltd. which is a Resident of Singapore. The Assessing Officer in his assessment order passed u/s 143(3) r.w.s. 144C of the Act dt. 25.10.2010 at para 4.13 page 17 an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sing Officer. In this case the Assessing Officer has ruled that only selective and sketchy information has been furnished by the assessee in the course of assessment. This is in fact correct, and it may be a cleaver way of presenting facts. However, the Assessing Officer has not taken any step to bring on record information that the activity was beyond the limit prescribed by the RBI. No doubt that the ld. CIT, DR referred to three pages in the paper book which, according to him, furnish a definite clue that India office was engaged in price negotiation. However, that is not correct as quotations were made on the basis of instructions from the Head Office. Some more information was added about internal dispute in the case of TOPY. But that does not form an essential part of the business of the sale of iron/iron material and iron product by the assessee in India. 6.7 On the basis of aforesaid discussion it can be concluded that the presumption which can validly be raised in this case that India office does not constitute a PE as no violation was noticed by the RBI. This presumption has not been rebutted by the Assessing Officer by bringing any positive material to show that any sub ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e Tribunal, on this aspect of the matter, will hold good for this assessment year as well. He, however, made it clear that he is not conceding the point as it may be further in appeal and he nevertheless places his reliance on the orders of the Assessing Officer and the DRP in this regard. 90. We find that once it is an undisputed position that the recipient entities did not have any permanent establishment in India and the transactions in question, as in these cases, are of purchases simplictor, the payments made to entities cannot give rise to any income taxable in India. It is so for the reason that it is only when the recipient has a PE in India under article 5 of India Japan tax treaty, it's income from trading can be brought to tax in India only when such an income is "directly or indirectly" attributable to such a PE. This condition cannot be satisfied in these two cases. It is also well settled in law, as very well set out by Hon'ble Supreme Court in the case of GE Technology Center Pvt Ltd. v. CIT (327 ITR 456) that unless the non-resident has a tax liability in respect of income embedded in the payment, tax deduction obligation under section 195 cannot come into ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that its income is exempt under DTAA". It is thus wholly inappropriate to proceed on the basis of assumption that since the recipient entities were following certain business model, these entities must be having a PE in India. Such an approach, as adopted by the revenue authorities on this aspect of the matter, cannot meet any judicial approval. 93. In any case, as has been observed by Hon'ble Supreme Court, in the case of KP Varghese v. ITO (131 ITR 597), nobody can be expected to prove a negative as it would be to cast an impossible burden upon him to establish a negative. Expecting the assessee to prove that the recipient did not have a PE in India is also expecting the assessee to establish a negative, which, as noted above, is an impossible burden to discharge. 94. We have noted that in the DRP order, there is also a mention about the limited force of attraction rule in view of the words profits 'directly or indirectly' attributable to the PE, appearing in Article 7(1) of India Japan tax treaty, and it is noted that, in the light of Tribunal decision in the case of Linklaters LLP v. ITO [ 9 ITR (Trib) 217], the mere existence of a PE in India will result in taxa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , without deduction of tax at source, to a foreign entity which has a PE in India and which is taxable in India in respect of such payments 96. That leaves us with only disallowance under section 40(a)(ia) in respect of one payment of Rs. 91,80,507 to MCJ. 97. So far disallowance of payments made, without deduction of tax at source, to an entity which have a PE in India and which has accepted the tax liability in respect of the transactions in question, is concerned, i.e. MCJ, assessee's defence is in seeking deduction neutrality, so far as payments made to these Japanese tax residents are concerned, vis-à-vis payments made to the resident entities. It is in this respect that the assessee's case hinges on non-discrimination clause. The position in the immediately preceding assessment year 98. We find that so far as the issue on non-discrimination, seeking deduction parity, is concerned, it is covered in favour of the assessee, by decision of a coordinate bench, in assessee's own case for the immediately preceding assessment year. While deleting similar disallowance, the coordinate bench has, inter alia, held as follows: 9. On the first issue of disallowance ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... uld not be taxed because 'fees for technical services' and 'fees for included services' under India-US DTAA had different meaning and they were not one and the same. If the revenue wanted to tax the payment by assessee to 'H' in the hands of 'H' in India, it had to bring its case within the ambit of article 12(4) of the DTAA, i.e., fees for included services. The payment in question would, therefore, have to be judged in the context of the DTAA as to whether it was taxable in India or not. [Para 24]. The provisions of section 40(a)(i), as it existed prior to it's amendment by Finance Act, 2003 with effect from 1-4-2004, provided for disallowance of payment made to a non resident only where tax is not deducted at source on such payment at source. A similar payment to a resident does not result in disallowance in the event of non-deduction of tax at source. Thus, a resident left with a choice of dealing with a resident or a nonresident in business, would opt to deal with a resident rather than a non-resident owing to the provisions of section 40(a)(i). To that extent, the non-resident is discriminated. Article 26(3) of Indo-US DTAA seeks to provid ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... cial to the person. In a nutshell, this provision makes it obligatory in respect of a person to whom the DTAA applies that the assessment shall be made in accordance with the DTAA, but if any provision of the Act is more beneficial to the person, then he shall be granted benefit under the Act. In common parlance this principle is known as 'Treaty Override". What it means is that the assessment of such a person shall be made in accordance with the provision contained in the DTAA. However, if any provisions of the Act are found to be more beneficial, then the assessment shall be made in accordance with the provisions contained in the Act. Since according to the assessee, the provisions of the Act were not more beneficial to him, he was to be assessed under the DTAA. In this connection, article 26(2) provides that except where the provisions of paragraph (3) of article 7 (business profits) apply, the taxation of a PE of an enterprise of a Contracting State in the other Contracting State shall not be less favourably levied in that other Contracting State than the tax levied on enterprises of that other Contracting State carrying on the same activities. While interpreting this parag ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... de of computation of income, the same should be followed, irrespective of the provisions in the Income-tax Act, which is the basic law, i.e., the Income-tax Act will govern taxation of income. The case of the revenue on the basis of this Circular was that since there was no provision in the DTAA analogous to section 80HHE, the assessee was not entitled to the deduction. The interpretation placed on the circular by the revenue was misplaced. The reason is that the wording of article 26(2) of the DTAA is to the effect that if a US enterprise is carrying on a business in India, it shall not be treated less favourably than an Indian enterprise carrying on the same business for the purpose of taxation. It follows automatically that exemptions and deductions available to an Indian enterprises would also be granted to the US enterprises if they are carrying on the same activities. [Para 8.4]" In this decision the Tribunal at para 9 page 162 held that the decision in the case of Automated Securities Clearance Inc. (supra) is not in conformity with the provisions contained in Article 26(2) of the Indo-US DTAA. Hence this decision in the case of Automated Securities Clearance Inc. (supra) ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nation, according to the learned counsel, that the assessee is aggrieved of. 100. Learned Departmental Representative, however, does not give up even as he recognizes that there is a direct decision on this assessee, in assessee's own case, in favour of the assessee. While he admits that the issue is indeed covered in favour of the assessee by coordinate bench's decision for the immediately preceding assessment year, he submits that this aspect of the matter deserves reconsideration. In addition to the elaborate submissions made by the learned Departmental Representative during the course of the hearing, he has also filed exhaustive written submissions. The thrust of his argument that there are no independent findings on the non-discrimination issue by the coordinate bench and the coordinate bench has simply relied upon the Herbalife decision (supra) of the Tribunal but, in doing so, what it has overlooked is that post insertion of sub section 40(a)(ia), Herbalife is no longer good in law. It is pointed out that in the case of the Herbalife, the Tribunal was dealing with the assessment year 2001-02 and that was the point of time when section 40(a)(ia) was not on the statut ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ITAT cannot be relied for this year for the reasons given below. 4. The reasoning of the Hon'ble ITAT is given in paragraphs 9.1 to 9.4 of the order for assessment year 2006-07. The sole basis of the Hon'ble ITAT for deciding the issue is the order of the Hon'ble ITAT Delhi Bench in the case of Herbalife International India Private Limited (101 ITD 450 (Del) = (2006-TII-ITAT-INTL). Paragraph 22 of that order is reproduced in paragraph 9.1 and 9.2 hold that the propositions laid down I this decision are squarely applicable to the transactions with MC. Tubular Inc. USA, as this covered by the Indo-US DTAA. Paragraph 9.3 holds that the wording of non-discrimination Clause in Indo-Japan DTAA is para materia with the wording used in Non-discrimination clause in the Indo-US DTAA and this is not disputed by the Revenue. Hence, we hold that the propositions laid down in the case of Herbalife apply to all the entities which are governed by the Indo-Japan DTAA. 5. Therefore, there is no independent finding except following the order of the Hon'ble ITAT in the case of Herbalife. It is respectfully submitted that the reasoning given in the order of Herbalife is not applicabl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sed on mistaken assumption and not considering the applicability of amended law for AY 2006-07. 8. In the above matter, the Revenue also relies on the judgment of the Hon'ble Apex Court in the case of Sun Engineering Works (P) Ltd [1992] 198 ITR 297 (SC). Paragraph 37 on page 12 of the order is relied upon. 9. It is further submitted that paragraph 9.4 of the order of the ITAT in case of the assessee for AY 2006-07 refers to the decisions in cases of Automated Securities and Rajeev Sureshbhai Gajwani dealt with non-discrimination issues in relation to taxation of permanent establishment (pargarph2 of the Article) whereas the present case deals with paragraph 3 of the Article therefore those decisions are not all relevant to the case and not applicable. 101. Learned Departmental Representative then addressed his arguments on merits and contended that the decision of the coordinate bench in the case of Herbalife was inappropriate and contrary to the first principles of international taxation. It was also pointed out that assuming that the assessee is aggrieved of discrimination in respect of purchases from resident assessees vis-à-vis Japnese non-resident assessees, eve ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... es and other disbursements are restricted or prohibited. This refers to regulatory restrictions like imposed by the Central Bank of a country or under any other law or regulations. For example say payments were earlier restricted under RBI Regulations in regard to royalties (kindly see pages 114 to 125 of the revenue's PB). In view of the provisions of paragraph 4, the deduction for claims could have been made even if the payments of royalties or interest or fee for technical services could not be allowed under FEMA Regulations. 15. Paragraph 74 of the Commentary (page 108 of Revenue's PB) clearly mentions that application of thin capitalization rules provided in domestic rules are not covered by paragraph 4 of the Article. This indicates that domestic rules do not automatically results into discrimination if the purpose is well established. 16. Similarly, paragraph 75 of the Commentary refers to additional information requirements for ensuring similar levels of compliance. In the present case it is submitted that disallowance under section 40a (i) are to ensure compliance of the provisions of deduction of tax at source and payments thereof. This is separately discussed b ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... g the expenses. This indicates that the paragraph covers expenses which may be subjected to restrictions/prohibitions but does not cover any temporary disallowances that are made to ensure compliance of the provisions of tax laws. Disallowances under section 40a (i) are to ensure compliance 22. Provisions of section 40a (i) of the Act are to ensure compliance of TDS provisions. It covers cases where the tax is either not deducted or after deduction is not paid as required under the provisions of Chapter XVVII-B of the Act. In this regard reference is made to Circular No. 528 dated 16th December, 1988 explaining the scope and effect of section 40(a)(i) of the Act (page 159 to 161 of the Paper Book). This circular explicitly states that " in order to ensure effective compliance of the provisions of section 195 of the Act relating to deduction of tax at source in respect of payments made outside India. The law as well as circular provides that if in any subsequent year, tax is deducted at source or paid; such sum will be allowed as deduction in computing the income chargeable to tax for that year. Therefore, the purpose of these provisions is not to provide a different taxation syst ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ance under section 40(a)(ia) will be made in case of residents as well as non-residents. It cannot be the case that disallowances are made in case of residents only. Such disallowances are also required to be made in case of non-residents if they fail to deduct or deposit the TDS as required by provisions of section 195 of the Act. 29. The contention that a resident will not make a purchase from nonresident vis-à-vis resident because in case of non-resident tax is required to be deducted and if not paid disallowance will be made. This contention is farfetched and has no basis because in that case business decisions are considered to have been dictated for the reason of tendency of a taxpayer for not obeying the law. There is no justification for no-deduction and after deduction non-payment of tax when these functions are performed in a fiduciary capacity and acting as a part of government tax collection machinery. Deductible under the same conditions 30. The deduction of tax out of payments from non-residents and residents are not under the same conditions. Residents and non-residents are subjected to different requirements and enforcement provisions. Question of territor ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ". (Page 174 of the Book). Effect of insertion of second proviso to Section 40(a)(ia) and impact of non discrimination clause, in India Japan DTAA, on extending this benefit to the Japanese tax resident entities receiving payments from India 102. During the course of this hearing, learned Departmental Representative was asked whether, given the facts of this case and given the developments in law, this issue has not become academic. It was pointed out to the learned Departmental Representative that there is only one case of non-resident recipient in which the existence of PE is established and of the recipient having filed its return of income in India, and even in that case recipient is admitted to have taken into account the impugned receipt of Rs. 91,80,507 in its computation of business income. It was also put to the learned Departmental Representative that when the recipient non-resident has already included the receipt in question in computation of its business income in India and paid taxes thereon, and in the light of second proviso to Section 40(a)(ia) having been held to be retrospective with effect from 1st April 2005, there seems to be no valid ground to discriminate ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... He accepts that similarly placed assesses making payments to non-residents, i.e. where recipients have taken into account the related receipts in computation of their income and duly filed their income tax return under section 139(1) in respect of the same, will be placed at a disadvantage but hastens to add that it cannot be for this Tribunal to supply casus omissus, even if there be any. As regards the principles laid down by the coordinate bench in the case of Gupta Overseas (supra), so far as impermissible non-discrimination with regard to deductibility conditions in respect of payments to non-residents, learned Departmental Representative once again relied upon the stand of the Assessing Officer and his detailed note reproduced earlier in this order. Learned Departmental Representative reiterated that post insertion of Section 40(a)(ia), there is no discrimination in disallowing payments made to non-residents without deduction of tax at source. In rejoinder, learned counsel for the assessee reiterated that it is indeed true that the decision of Tribunal, in the case of Automated Securities Clearance (supra), is not relevant for deciding the issue in appeal before us but then t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f had authored a few years ago. As for the argument that the issue of deductibility of purchases from non residents being discriminatory not having been dealt with in the order of the coordinate bench, learned counsel submits that a judicial authority can only decide an issue on which there is a difference in the stand of the parties and when assessee's claim of this discrimination was not disputed by the Assessing Officer on this count, there could not have been any occasion to adjudicate on this aspect of the matter. What has been accepted by the AO himself in the preceding assessment year cannot be disputed now. In any case, even on merits, the discrimination is glaring inasmuch as when payments are made from a resident assessee, which essentially has an income embedded in it, there is no tax deduction at source requirement, whereas when payment is made to a non-resident Japanese assessee, whether or not there is any income embedded in it, tax is required to be deducted at source. If this kind of a discrimination is permitted, non-discrimination clauses in the tax treaties will be rendered meaningless. Learned counsel then moves on to legislative amendments in section 40(a)( ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... (a)(ia) is discriminatory inasmuch as it only applies to the resident taxpayers . It is pointed out even if a non resident taxpayer files his return of income in India and takes into account the payments, from which taxes were not deducted at source, in his computation of income, the payments made to such non resident taxpayer will continue to be hit by the disallowance under section 40(a)(i) while similarly placed domestic enterprises will not be hit by disallowance under section 40(a)(ia) in view of application of second proviso to Section 40(a)(ia) which has been held to be retrospective in effect by a coordinate bench decision in the case of Rajeev Kumar Agarwal v. (supra). He submits that for this reason also the impugned disallowance is discriminatory in nature and it should be read down in the light of the Article 24(2) of the Indo Japan tax treaty. In his short rejoinder on this proposition put to the parties, learned Departmental Representative reiterated his earlier submissions and contended that a differentiation in treatment for deductibility particularly when it is warranted by reasonable basis, as is the case, cannot be treated as differentiation and that it is not op ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... up for adjudication before a coordinate bench of this Tribunal, in the case of DaimlerChrysler India Pvt Ltd (supra), and the coordinate bench, rejecting this objection, observed as follows: ......A plain reading of the above treaty clauses shows that, in broad terms, the discrimination, which is prohibited under the treaty, is (a) nationals of the other Contracting State vis-a-vis nationals of the host State in the same circumstances and same conditions; (b) PE of the other Contracting State vis-a-vis enterprises of the host State carrying out the same activity; (c) payments made to the residents of the other Contracting State vis-a-vis payments made to the residents of the host State-so far as deductibility in computation of business profits is concerned; and (d) enterprises of the host State in which capital is, partly or fully directly or indirectly, held by one of more residents of the other Contracting State vis-a-vis other similar enterprises of the host State. These four types of discriminations are quite distinct in character and in scope. In the first category of discrimination, which is sought to be prohibited by art. 24, all that is relevant is that national of one of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e to accept the plea of Mr. Kapila that since assessee before us is not resident of the other Contracting State, the assessee cannot seek treaty protection against discrimination, even if there be any. (Emphasis, by underlining, supplied by us) 107. We are in considered agreement with the views so expressed by the coordinate bench. In any case, the stand of the AO proceeds on the fallacy that non-discrimination protection is being invoked for the assessee before us, though, as a matter of fact, non-discrimination protection is being invoked in respect of the payments made to a tax resident of treaty partner country, i.e. Japan in this case. What is being sought by the assessee in the present case is deduction neutrality so far as payments made to the resident taxpayers in India vis-à-vis payments made to non-residents fiscally domiciled in Japan are concerned. The treaty protection is thus being sought in respect of the Japanese tax residents- even though it does affect deductibility of payments made to them in India, and, to that limited extent, it has impact on determination of taxable income in the hands of the Indian tax residents. The benefit of deduction neutrality, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... racting State shall not be less favourably levied in that other Contracting State than the taxation levied on enterprises of that other Contracting State carrying on the same activities. This provision shall not be construed as obliging a Contracting State to grant to residents of the other Contracting State any personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents. 3. Except where the provisions of article 9, paragraph 8 of article 11, or paragraph 7 of article 12, apply, interest, royalties and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned Contracting State. 4. &n ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ing supplied by us) 110. We are in considered agreement with the above analysis of the scope of the deduction neutrality clause in non-discrimination provision in the Indo Japan DTAA. 111. It is thus clear that so far as payments made to Japanese non-residents is concerned, there cannot be any discrimination so far as deductibility of the payments in the hands of the person making the payment is concerned. If appropriate tax withholding by the person making the payment is a sine qua non for business deduction so far as payments to non-residents are concerned, unless there is a similar pre-condition for deductibility of related expenses to the payments to residents as well, that disabling provision cannot be enforced in respect to payments made to non-residents either. It is not a question of applying the casus omissus, which could have been relevant in the case of supplying something in the process of interpretation of statute, but it is giving life and practical effect to a treaty provision, which has overriding effect on the provisions of domestic tax legislation, specifically providing for ensuring non-discrimination against the tax residents of the treaty partner jurisdiction ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... not therefore necessarily apply to other tax treaties. Be that as it may, in the case of the Automated Securities Clearance (supra), the Tribunal had, inter alia, observed as follows: Scope of non-discrimination clauses in the tax treaties 34. The expressions 'discrimination' and 'non-discrimination' are not defined in the tax treaties, but, as noted by Brian J. Arnold and Michael J. McIntyre, in their oft referred book 'International Tax Primer' (Second Edition @ p. 128), "in general, discrimination means distinguishing between persons adversely on the grounds that are unreasonable, irrelevant, or arbitrary". 'Conversely', according to distinguished authors, 'non-discrimination means equal (functionally equivalent) or neutral treatment'. Prof. Kees Van Raad, in his book 'Non-discrimination in International Tax Laws', notes that while the original meaning of the expression 'discrimination', which refers to 'distinction' and 'differentiation', is neutral, in modern parlance the neutral meaning of the word 'discrimination' has virtually disappeared. He then proceeds to make following important observat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... orm of discrimination within the meaning of para 2 of the article. No distinction is made between US and non-US partnerships, since the law requires that partnerships of both US and non-US domicile withhold tax in respect of the partnership shares of non-US partners. Furthermore, in distinguishing between US and non-US partners, the requirement to withhold on the non-US but not the US partner's share is not discriminatory taxation, but, like other withholding on non-resident aliens, is merely a reasonable method for the collection of tax from persons who are not continually present in the US, and as to whom it otherwise may be difficult for the US to enforce its tax jurisdiction. . " 37. The Technical Explanation issued by the USA, which is treaty partner State in the present case, is of very significant persuasive value. When the treaty partner State takes the stand that a differential treatment, which meets the test of reasonableness, cannot be construed as discrimination under art. 26(2), and with a view to ensure reciprocity in treatment, the same stand should ideally be followed by the other treaty partner State. 38. It is also interesting to note that art. 26(5) of the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ion of India does not mean that all laws will have to be general in character and universal in application and that the State is no longer to have the power of distinguishing and classifying persons or things for the purposes of classification". A valid classification must be reasonable, and it must always rest upon some real and substantial distinction bearing reasonable and just relation to the needs in respect of which classification is made. As held by the Hon'ble Supreme Court, in the case of State of West Bengal v. Anwar Ali Sarkar AIR 1952 SC 75 and reiterated thereafter in several judgments, in order to pass the test of permissible classification, two conditions must be fulfilled, namely (i) the classification must be founded on an intelligible differentia which distinguishes persons or things that are grouped together from others left out of the group, and (ii) the differentia must have a rational relation to the object ought to be achieved by the legislation in question. Unless, therefore, a case is made out that the basis for differentiation has no rational relation to the object sought to be achieved by the legislative provision, it cannot be said that there is inde ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... n as an argument by the assessee but finally, it will be for the Courts or the quasi judicial authorities in India to decide as to whether the views expressed by the author are in conformity with the intent and purpose of the DTAA or not. In the case of P.V.A.L. Kulandagan Chettiar (supra), the Hon'ble Supreme Court has held that taxation policy is within the power of the Government and s. 90 of the IT Act enables the Government to formulate its policy through treaties entered into by it and even such treaties contain provision for deciding fiscal domicile in one State or the other and thus prevail over other provisions of the IT Act. It would be unnecessary to refer to the terms addressed in the OECD or in any of the decisions of the foreign jurisdictions. This can also be illustrated by examining the contents of para No. (2) of art. 26 of the treaty with United Kingdom of Great Britain and Northern Ireland, which permits the levy of higher rate of tax on the profits of the PE of that country in India. This para is reproduced below: "2. The taxation on a PE which an enterprise of a Contracting State has in the other Contracting State shall not be less favourably levied in tha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... enterprise is carrying on a business in India, it shall not be treated less favourably than an Indian enterprise carrying on the same business for the purpose of taxation. It follows automatically that exemptions and deductions available to Indian enterprises would also be granted to the US enterprises if they are carrying on the same activities. Thus, following the decision in the case of P.V.A.L. Kulandagan Chettiar (supra), there is no further need to discuss the case of Gracemac Corporation (supra). Otherwise also, the ruling rendered by the Authority for Advance Rulings is with reference to the facts of that case and is not applicable to any other case as a precedent. Similarly, it is also not necessary to go into the ruling in the case of Dassault Systems K.K., In re [2010] 229 CTR (AAR) 105 : [2010] 34 DTR (AAR) 218. 8.5 At this stage, we may also examine the decision of Mumbai Tribunal in the case of Metchem Canada Inc. (supra). The crux of the decision is that restriction placed on deduction of head office expenses under s. 44C will not be applicable in the case of a Canadian company in view of art. 24 contained in the treaty between India and Canada. The decision has bee ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o an Indian company or a person resident in India will be allowable to the assessee also. (Emphasis by underlining supplied by us now.) 114. The views so expressed by the special bench bind us in the division bench. The strength of the hierarchical judicial system that we have in India is in each lower tier of judicial forum giving way to the higher wisdom of the superior judicial forum. It is duty of the division bench to loyally follow the views of the special bench. When this is the view taken by the special bench with regard to the non-discrimination provisions in the Indo US tax treaty, in which the emphasis on valid differentiation due to reasonableness is perpetuated in the treaty itself- as also in the US Technical Explanation, it is stretching the things too far to suggest that such reasonableness criterion should also be read into non-discrimination provisions of all the tax treaties. Learned Departmental Representative's plea, therefore, does not merit acceptance. Accordingly, in our considered view, a different treatment to the foreign enterprise per se is enough to invoke the non-discrimination clause in the Indo Japan DTAA. Clearly, therefore, it will be contrar ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d the tax on such sum on the date of furnishing of return of income by the resident payee referred to in the sa id proviso". In other words, as long as the assessee cannot be treated as an assessee in default, the disallowance under section 40(a)(ia) cannot come into play either. To understand the effect of this proviso, it is useful to refer to first proviso to section 201(1), which is also introduced by the Finance Act 2012and effective1st July 2012, and which provides that "any person, including the principal officer of a company, who fails to deduct the whole or any part of the tax in accordance with the provisions of this Chapter on the sum paid to a resident or on the sum credited to the account of a resident shall not be deemed to be an assessee in default in respect of such tax if such resident-(i)has furnished his return of income under section 139; (ii) has taken into account such sum for computing income in such return of income; and(iii) has paid the tax due on the income declared by him in such return of income, and the person furnishes a certificate to this effect from an accountant in such form as may be prescribed." The unambiguous underlying principle seems to be t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ns, the assessee suffers disallowance of any amount in the year of default, which is otherwise deductible, the legislature allowed it to continue ". It was further observed that "this is the cost which parliament has awarded to those assessees who fail to comply with the relevant provisions by considering overall objective of boosting TDS compliance"(Emphasis by underlining supplied by us). In other words, the amendment was held to be prospective because, in the wisdom of the special bench, the 2010 amendment to Section 40(a)(ia) by inserting first proviso thereto, which is what the special bench was dealing with, was an " intended consequence" of the provision of Section 40(a)(ia). 6. However, the stand so taken by the special bench was disapproved by Hon'ble Delhi High Court in the case of CIT v. Rajinder Kumar (362 ITR 241). While doing so, Their Lordships observed that, "The object of introduction of Section 40(a)(ia) is to ensure that TDS provisions are scrupulously implemented without default in order to augment recoveries.......Failure to deduct TDS or deposit TDS results in loss of revenue and may deprive the Government of the tax due and payable" (Emphasis by underlin ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... en a short while ago, Hon'ble Delhi High Court has visualized the scheme of things - as evident from Their Lordships' reference to augmentation of recoveries in the context of "loss of revenue" and "depriving the Government of the tax due and payable". 8. With the benefit of this guidance from Hon'ble Delhi High Court, in view of legislative amendments made from time to time, which throw light on what was actually sought to be achieved by this legal provision, and in the light of the above analysis of the scheme of the law, we are of the considered view that section 40(a)(ia) cannot be seen as intended to be a penal provision to punish the lapses of non-deduction of tax at source from payments for expenditure- particularly when the recipients have taken into account income embedded in these payments, paid due taxes thereon and filed income tax returns in accordance with the law. As a corollary to this proposition, in our considered view, declining deduction in respect of expenditure relating to the payments of this nature cannot be treated as an "intended consequence" of Section 40(a)(ia). If it is not an intended consequence i.e. if it is an unintended consequence, ev ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on of second proviso thereto, went much beyond the obvious intentions of the lawmakers and created undue hardships even in cases in which the assessee's tax withholding lapses did not result in any loss to the exchequer. Now that the legislature has been compassionate enough to cure these shortcomings of provision, and thus obviate the unintended hardships, such an amendment in law, in view of the well settled legal position to the effect that a curative amendment to avoid unintended consequences is to be treated as retrospective in nature even though it may not state so specifically, the insertion of second proviso must be given retrospective effect from the point of time when the related legal provision was introduced. In view of these discussions, as also for the detailed reasons set out earlier, we cannot subscribe to the view that it could have been an "intended consequence" to punish the assessees for non-deduction of tax at source by declining the deduction in respect of related payments, even when the corresponding income is duly brought to tax. That will be going much beyond the obvious intention of the section. Accordingly, we hold that the insertion of second proviso ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s. Clearly, therefore, it will be contrary to the scheme of the tax treaties in question that if rigour of disallowance of a payment, on account non-deduction of tax at source from the related payment, is to be relaxed in the situations in which the resident recipient has taken the said amount into account in computation of income, paid taxes on the income so computed and filed, under section 139(1), related income tax return, and yet the rigour of disallowance in respect of payments made, without appropriate deduction of tax at source, to the non-residents are concerned, is not relaxed in the cases in which the non-resident recipient has taken such receipts into account in computation of income, paid taxes on the income so computed and filed, under section 139(1), related income tax return. Article 24(3) of the India Japan DTAA requires similar relaxation in respect of the rigour of disallowance for payments made to the Japanese entities. Accordingly, the relaxation under second proviso to Section 40(a)(ia) is to be read into Section 40(a)(i) as well and it is required to be treated as retrospective in effect in the same manner as second proviso to Section 40(a)(i) has been treate ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... h a policy motivated deduction restrictions should, therefore, not come into play when an assessee is able to establish that there is no actual loss of revenue. This disallowance does indeed deincentivize not deducting tax at source when due for deduction, but, so far as the legal framework is concerned, this provision is not for the purpose of penalizing for the tax deduction at source lapses. There are separate penal provisions to that effect. Deincentivizing a lapse and punishing a lapse are two different things and have distinctly different, and sometimes mutually exclusive, connotations. The scheme of Section 40(a)(ia), as the coordinate bench concluded, is aimed at ensuring that an expenditure should not be allowed as deduction in the hands of an assessee in a situation in which income embedded in such expenditure has remained untaxed due to tax withholding lapses by the assessee. It was not seen as a penalty for tax withholding lapse but it is a sort of compensatory deduction restriction for an income going untaxed due to tax withholding lapse as penalty for tax withholding lapse per se is separately provided for in Section 271 C, and, section 40(a)(ia) does not add to the s ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... part with the matter, we would like to place on record our appreciation for very able assistance by both the parties before us. We may add that even though learned Departmental Representative did very vehemently contended that we should simply remit the matter to the assessment stage, on the same lines as in the immediately preceding assessment year and without giving any findings on the specific points on which perceptions of the parties clearly do not have any meeting ground, we do not think that would have been the appropriate course of action. At a time when there is a clarion call by the Government of India, at the highest level, to simplify the process of implementing the laws, and ensure certainty friendly measures to the foreign enterprise doing business in India, we would perhaps fail in our duty if we do not, though within whatever be our inherent limitations, rise to the occasion and discharge our judicial functions in a comprehensive, rather than superficial, manner, and contribute to the dispute reaching finality sooner rather than later. There is no point in our simply remitting the matter to the assessment stage when it is clear that there is no meeting ground on th ..... X X X X Extracts X X X X X X X X Extracts X X X X
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