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TMI Blog2014 (12) TMI 10X X X X Extracts X X X X X X X X Extracts X X X X ..... o as to reduce their cost from the sales value to compute the royalty payable there was no justification on the part of the TPO in rejecting the methodology adopted by the assessee to calculate net sales for the purposes of computing the royalty payable thus, the action of the AO in considering certain raw materials used in the production process as mere 'constituent chemicals' and equating it to standard bought-out components so as to reduce their cost from the sales value for the purposes of computing net sales value eligible for royalty payment is liable to be set-aside - Decided in favour of assessee. Transfer pricing adjustment for royalty payments to AE - Held that:- The appellant company is paying royalty to the AE for transfer of technology in terms of a Foreign Technology Collaboration agreement, which has been duly approved by the Government of India - royalty payments are authorized on domestic sales and on export sales @ 5% and 8% respectively of 'Net sales', subject to taxes - The items of manufacture covered by the foreign collaboration are 'polymerization initiators', which is a product manufactured by the assessee for use as catalyst in manufacturing of polym ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o the AE as a comparable transaction under the CUP method for the purposes of determining the arm's length price of the international transaction of royalty payment claimed by the assessee the AO is directed to delete the adjustment made in respect of royalty payment. Export of certain finished goods Held that:- CIT(A) was rightly of the view that there is no infirmity on the part of the TPO in invoking the CUP method because the product sold is identical - a pertinent point has also been made out by the assessee that after export to the AE, the same product has been ultimately sold by the AE to a uncontrolled party at a price, which can be taken to be the then prevailing international prices - Therefore, it is sought to be made out that the maximum price, which assessee could have realized on export of the product to a non-AE would be the prevailing international price, which was the price for which the AE sold the product to the ultimate customer - It was pointed out that the adjustment permissible in order to bring the transaction to the level of arm's length price can it best be restricted to the difference between the price charged by the AE from the ultimate customer an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... vision of technology) needs to be computed by deducting the cost of bought out components from the sales value, thereby rejecting the methodology adopted by the appellant for computing royalty payable to the associated enterprise. in confirming the disallowance of excess provision of royalty payable to the associated enterprise the extent of ₹ 1,954,132 under section 40A(2b) of the Act. 4. The appellant, before us, is a company incorporated under the provisions of the Indian Companies Act, 1956 and is, inter-alia, engaged in the business of manufacture and sale of organic peroxides, which acts as initiators in polymerization reactions and are used in making of polymers like PVC, LDPE, HDPE, Polyacrylite, ABS, etc.. For the assessment year under consideration i.e. 2001-02, it filed a return of income on 29.10.2001 declaring total income of ₹ 4,76,81,780/-, which was subject to a scrutiny assessment u/s 143(3) of the Act dated 23.02.2004 which resulted in assessed income of ₹ 12,96,91,700/-. In such assessment expenditure of ₹ 90,80,278/- claimed by the assessee as royalty was disallowed on the ground that it was only a Provision in nature. Subsequent ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... arrive at net sales value on which royalty @ 5% is to be computed. The CIT(A) has also affirmed the action of the Assessing Officer against which the assessee is in appeal before us. 7. On this aspect, it was a common point between the parties that similar stand of the Assessing Officer, based on the order of the Transfer Pricing Officer in assessment years 2006-07 and 2007-08 was a subject- matter of consideration of the Tribunal in assessee's own case vide ITA No.1477/PN/2010 and ITA No.1659/PN/2011 dated 11.02.2014. As per the Tribunal, the methodology adopted by the Revenue to rework the net sales value for the purposes of computing royalty payable was not justified. In this context, the relevant discussion in the order of the Tribunal dated 11.02.2014 (supra) reads as under : 17. Even otherwise, the action of the TPO in considering certain raw materials used in the production process as mere 'constituent chemicals' and equating it to standard bought-out components so as to reduce the cost of such material from the sales for the purposes of computing net sales eligible for royalty payment, is without any cogent basis. At the time of hearing, assessee was ask ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ambient immiscible with water and reacts 98% to manufacture organic chemicals clear liquid Toxic (6.1) -15 Deg C max miscible with water 50 to 60% initiator to PVC polymerization white emulsion Oxidising agent (5.2) 19. On the basis of the above, it was sought to be canvassed that the chemicals sought to be classified by the TPO as constituent material are indeed raw materials. It is canvassed that the raw materials used by the assessee in its production process including the so-called 'constituent chemicals' classified by the TPO, undergo a chemical reaction in the manufacturing process, which is irreversible. It is further explained that the properties and usage of the finished goods achieved, namely, polymerization initiators, is quite, distinct from the raw materials consumed and none of the raw materials, including the so-called 'constituent chemicals' used in the manufacture of finished goods, can be retrieved after the end of the manufacturing process. 20. The effort of the TPO to classify certain input material as 'constituent chemicals' (instead of raw material) and equate it to 'standard bought- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the imported components/ bought-out components? and be deducted from sale price to calculate royalty. Would highly appreciate your guidance on the same. Reply : Dear sir, In our opinion, No. Regards BB Sharma. Query : Thanks for the reply. Just to confirm your view on computation, does it mean that only bought out components on which no further processing is required in the company and are directly fitted into the final products are to be subtracted from the selling price? Your guidance in this regard would be highly appreciated. Reply : Dear sir: Your understanding seems to be correct Regards B B Sharma 23. From the aforesaid, it is clear that what is liable to be considered as standard bought-out components are such material on which no further processing is required and are directly fitted into the final product; and, cost of such material only needs to be deducted from the sale price to compute the royalty payable. Applying the said clarification to the present situation, considering the manufacturing process explained, it cannot be construed that the so-called constituent material are merely fitted into the final product; on the contrary, it is a case where such m ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... -mutandis in this appeal also. 14. In the result, the appeal of the assessee for assessment year 2002-03 vide ITA No.668/PN/2012 is partly allowed in the same manner as the appeal for assessment year 2001-02. 15. Now, we may take-up the appeal of the assessee in ITA No.2181/PN/2012 for assessment year 2008-09, which is directed against the order of the Dy. Commissioner of Income Tax, Circle- 1(1), Pune (in short 'the Assessing Officer') passed u/s 143(3) r.w.s. 144C(1) of the Act dated 03.10.2012, which is in conformity with the directions given by the Dispute Resolution Panel, Pune (in short 'the DRP') dated 05.09.2012. 16. In this appeal, the Grounds of Appeal raised by the assessee read as under : The Ld. Assessing Officer ('AO'), pursuant to the directions given by the Ld. Dispute Resolution Panel ('DRP'), erred in ruling that the transactions pertaining to royalty payment, export of certain finished goods and provision of marketing and sales support services have not been conducted at arm's length, and thereby making a transfer pricing adjustment of ₹ 1,00,43,577/- to the income of the appellant. In doing so, the Ld AO/DR ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as a consequence of a reference made by the Assessing Officer in terms of section 92CA(1) of the Act. The TPO vide his order dated 17.10.2011 passed u/s 92CA(3) of the Act proposed an adjustment of ₹ 97,43,577/-towards transfer pricing adjustment to the stated values of international transactions undertaken with the associated enterprises so as to bring them at an arm's length price. The Assessing Officer has thereafter proposed a draft assessment order u/s 143(3) r.w.s. 144C(1) of the Act dated 20.12.2011 proposing to compute the arm's length price of the international transactions by making adjustment of ₹ 97,43,577/-. The assessee filed objections before the DRP against the draft assessment order proposed by the Assessing Officer. The DRP vide its order dated 05.09.2012 disposed of the objections raised by the assessee and accordingly the Assessing Officer passed the final assessment order giving effect to such directions. The additions made by the Assessing Officer on account of the transfer pricing adjustment to the stated value of the international transactions have been assailed by the assessee by way of the aforesaid Grounds of Appeal. 18. It is noti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... bunal vide order dated 11.02.2014 (supra). 20. In the above background, the learned counsel for the assessee has referred to the facts of the present year to point out that the stand of the Revenue as well as the submissions and material furnished by the assessee to the lower authorities in this year stand on the similar footing as was in assessment year 2006-07. The learned CIT-DR, while referring to the order of the authorities below has not controverted the factual matrix that the issues and the rival stands are similar to those in the assessment year 2006-07. Thus, the issues in the instant year are liable to be decided in the light of the precedent in the assessee's own case vide order of the Tribunal dated 11.02.2014 (supra). 21. The first issue is with regard to an addition of ₹ 79,96,489/- made on account of international transactions of payment of royalty to the associated enterprises. In this context, we reproduce hereinafter the following portion of the order of the Tribunal dated 11.02.2014, which brings out the controversy as well as the adjudication by the Tribunal thereof : 7. The first subject-matter of the dispute is with regard to an addition ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Akzo group company i.e. Tianjin Akzo Nobel Peroxides, China (hereinafter referred to as 'TANPC') to the same AE was @ 5%; and, therefore the TPO adopted the rate of 5% to determine the arm's length royalty payable by assessee to the AE on the export sales. The aforesaid position has since been affirmed by the DRP also. 8. On both the aforesaid aspects, the learned counsel for the assessee vehemently submitted that the lower authorities have erred in law as well on facts. Firstly, it is contended that the expression 'Net Sales', was required to be interpreted in terms of the standard terms and conditions prescribed by the Reserve Bank of India, which are applicable to all agreements pertaining to royalty payments on technology transfers to Indian companies. In this regard, our attention was drawn to the meaning of expression 'Net Sales' provided in para 3.3 of Chapter III of the Manual for Foreign Direct Investment Policy Procedures issued by Department of Industrial Policy Promotion, Ministry of Commerce Industry, Government of India, in terms of which only the cost of standard bought-out components and the landed cost of imported components was ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Paper Book for assessment year 2007-08 respectively. In this context, it is sought to be made out that the period of the agreement and the products covered are different inasmuch as the Indian agreement is for seven (7) years whereas the China's agreement is for twenty (20) years. The products covered under the two agreements are also different inasmuch as the Indian agreement has 22 products whereas China's agreement has 33 products. It is submitted that where the period and the products covered are different, such transactions cannot be considered as comparable and reference has been made to the decision of the Pune Bench of the Tribunal in the case of Kirloskar Ebara Pumps Ltd. 47 SOT 20 (Pune) in this regard. Thirdly, it is sought to be made out that there is an error in the addition made on account of royalty inasmuch as a sum of ₹ 3,07,170/- has been added in excess, even if the stand of the TPO was liable to be upheld. 10. On the other hand, the learned CIT(DR) appearing for the Revenue has referred to the orders of the authorities below in support of the case of the Revenue. The learned CIT(DR) submitted that the methodology adopted by the assessee for comp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sought to be justified. 11. We have carefully considered the rival submissions on this aspect. Before proceeding to adjudicate the addition of ₹ 91,66,061/- made on account of royalty payment, it would be relevant to note the pertinent facts. The appellant company is paying royalty to the AE for transfer of technology in terms of a Foreign Technology Collaboration agreement, which has been duly approved by the Government of India, a copy of such agreement is placed at pages 259 to 261 of the Paper Book. In terms of the said agreement, royalty payments are authorized on domestic sales and on export sales @ 5% and 8% respectively of 'Net sales', subject to taxes. The items of manufacture covered by the foreign collaboration are 'polymerization initiators', which is a product manufactured by the assessee for use as catalyst in manufacturing of polymers. The approval prescribes that the royalty payable shall be calculated in accordance with the provisions of the Foreign Exchange Control Manual of RBI and other subsisting instructions of Govt. of India/Reserve Bank of India. In this context, a reference has been made to the Chapter III of the Manual for Foreign ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... this aspect, it would be appropriate to refer to a pertinent point asserted by the appellant, which is to the effect that the amount of royalty remitted to the foreign collaboration, i.e. the AE, is as per the provisions of Foreign Exchange Control Manual of RBI. Notably, the approval by the Department of Industrial Policy Promotion (Secretariat for Industrial Assistance) dated 11.02.2005 itself prescribes that royalty shall be payable in accordance with the provisions of Foreign Exchange Control Manual of RBI and other subsisting instructions of the Govt. of India/Reserve Bank of India. There is no material on record to suggest that the calculation of royalty made by the assessee has been found to be violative of the respective provisions of FEMA or other subsisting instructions of the Govt. of India/Reserve Bank of India. In this background, a moot question which arises is whether the TPO is competent to rework the 'royalty payment' on the basis of his interpretation of the meaning of expression 'Net Sales', for the purpose of determining its 'arm's length price' under the CUP method. 13. In our considered opinion, the action of the TPO in re-work ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... be taken as 'NIL'. The Hon'ble High Court disapproved the action of the TPO, and after referring to the OECD's transfer pricing guidelines observed that the TPO was expected to examine the international transactions as he actually found them. In our considered opinion, the aforesaid parity of reasoning laid down by the Hon'ble Delhi High comes into play in the present fact-situation also, as our following discussion would show. 15. In the case before the Hon'ble Delhi High Court, the TPO had applied the CUP method while examining the payment of brand fee/royalty, which also is the position in the case before us. The Hon'ble High Court referred to the OECD's transfer pricing guidelines for multinational enterprises and tax administrations, and reproduced paras 1.36 to 1.41 of such guidelines, which provide for recognition of the actual transactions undertaken . Thereafter, the Hon'ble High Court opined as under :- 17. The significance of the aforesaid guidelines lies in the fact that they recognise that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions for them ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o re-write the transaction or to disregard actual transactions. Considered in the context of the OECD guidelines which have been exhaustively referred by the Hon'ble Delhi High Court in the case of EKL Appliances Ltd. (supra) the impugned situation does not fit into the two exceptions. Firstly, neither the Revenue has alleged and nor is there any material on record to suggest that the economic substance of the impugned transaction differs from its form. Secondly, there is no material on record to suggest that there is an arrangement between assessee and the AE made in relation to the impugned transaction which would differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner. We say so for the reason that the entire gamut of royalty payment by the assessee to the AE is in terms of the Foreign Technology Collaboration agreement, which is duly approved by Govt. of India in terms of its Policy, which is applicable across the spectrum. Moreover, it is not the case of the TPO or even of the Revenue before us that the royalty remitted by the assessee to the AE has been found to be inconsistent or violative of the respective Go ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rsible in nature. Only thermal decomposition is possible. Decomposition : The product can decompose at certain temperature. Such decomposition can produce products like Carbon Dioxide (CO2), Carbon Monoxide and 2- ethylhexanol. However none of the original raw materials like Hydrogen Peroxide or Chloroformates can be retrieved. 18. Further, the difference between the key raw material and the finished goods have also been brought out as follows :- Criteria Chloroformate Finished Good storage conditions miscible/reactivity in water purity application appearance Hazard class ambient immiscible with water and reacts 98% to manufacture organic chemicals clear liquid Toxic (6.1) -15 Deg C max miscible with water 50 to 60% initiator to PVC polymerization white emulsion Oxidising agent (5.2) 19. On the basis of the above, it was sought to be canvassed that the chemicals sought to be classified by the TPO as constituent material are indeed raw materials. It is canvassed that the raw materials used by the assessee in its production process including the so-calle ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Up Computation of royalty Query : Dear Sir, One of our Corporate client wants to remit royalty (No Technical Knowhow paid and royalty rate is 5%, hence covered under Automatic route) to its parent company abroad. For calculation of royalty, among other deductions, landed cost of imported components, standard bought out components used in the manufacture of the final product have to be reduced from the sale price, on which royalty is payable. The query is: Our client is a manufacturing company, in which it is using imported raw materials, which are mixed and used to manufacture the final product. Should this raw materials also be treated at par with the imported components/ bought-out components? and be deducted from sale price to calculate royalty. Would highly appreciate your guidance on the same. Reply : Dear sir, In our opinion, No. Regards BB Sharma. Query : Thanks for the reply. Just to confirm your view on computation, does it mean that only bought out components on which no further processing is required in the company and are directly fitted into the final products are to be subtracted from the selling price? Your guidance in this regard would be highly appreci ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market; (iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm's length price in respect of the property transferred or services provided in the international transaction; 25. The aforesaid three steps would reveal that the action of the TPO in the present case is contrary to the prescription contained in sub-clause (i) of clause (a) of sub-rule (1) of rule 10B of the Rules. Ostensibly, in terms of sub-clause (i), the price charged or paid in a comparable uncontrolled transaction is to be identified for the purpose of determining the arm's length price of the international transaction being tested. It is starkly evident that in the present case, the comparable transaction picked-up by the TPO, namely, royalty payment by TANPC to the AE is a transaction between two related/associated enterprises and therefore it is a controlled transaction and not a uncontrolled transaction . Such a transac ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the stated value of export sales corresponding to the difference between the price charged to the third parties in India and that charged to the associated enterprises. Thus, an adjustment of ₹ 14,63,820/- has been worked out. 24. Briefly put the objection of the assessee to the action of the TPO are two fold. Firstly, according to the assessee, the TPO was not justified in applying the CUP method whereas assessee had applied the TNM method for determining the arm's length price in relation to the transactions of export of finished goods to the associated enterprises. Secondly, it was submitted that the transaction of export to the associated enterprises and domestic sale of the product to third parties cannot be considered as comparable on account of differences in volumes, geographical factors, functions and risks involved. Both the aforesaid points were raised by the assessee against similar action of the TPO in assessment year 2006-07 also. The rival stand has been considered by the Tribunal in its order dated 11.02.2014 (supra), and the relevant discussion in the order of the Tribunal dated 11.02.2014 (supra) reads as under : 31. Factually speaking, in the pr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Paper Book wherein is placed the copy of export invoices/delivery details of the product exported to the AE. The AE on its part, sold the goods to the ultimate consumer at a price equivalent to ₹ 288/- per kg., after buying from the assessee at ₹ 239/- per kg.. The local sale, on the other hand, is claimed to have been made to a customer, who has utilized it for its own consumption. Fourthly, assessee has pointed out that the sales to third parties require certain level of additional costs, viz. selling, marketing, payment follow-up etc., which is not so in case of export to the AE. Fifthly, it is pointed out that the export made to the AE has resulted in an indirect economic benefit by way of obtaining advance license for duty free imports. A rough calculation in this regard has been furnished at the time of hearing in terms of which it is pointed out that such economic benefit was to the tune of ₹ 10-11 per kg.. The aforesaid points brought out by the assessee, in our view, are bonafide grounds to permit adjustment to the comparable uncontrolled price being considered in order to benchmark the transaction of export. Notably, such adjustment is called for, havin ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... restrict the adjustment on account of international transaction of export to the AE to ₹ 5,49,000/- instead of ₹ 11,34,000/-. Thus, on this aspect, assessee partly succeeds. 25. In the light of the aforesaid, it is evident that the Tribunal did not interfere with the action of the TPO in benchmarking the impugned international transactions by applying the CUP method. So however, with regard to the alternative plea of the assessee seeking adjustment in the price charged from the domestic buyers so as to account for differences with the international transactions of export of products to the associated enterprises was accepted so as to facilitate their comparability. At the time of hearing, learned counsel for the assessee furnished a working, based on the order of the Tribunal dated 11.02.2014 (supra) whereby an adjustment was made to the price charged to the third parties so as to make it comparable with the price charged from the associated enterprises. In terms of the said working, it is submitted that in the instant year, the adjusted price would compare favourably with the export price charged from the associated enterprises and therefore no further adjustment ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s are indeed engaged in providing an array of services in the field of market research and intelligence gathering, which is quite distinct from the activity of marketing of products. Therefore, while the TPO was justified in rejecting M/s Gaur Nagi Ltd. and Agrima Consultants International Ltd. as being functionally incomparable, however in the case of IDC (India) Ltd. the functional profits is different as it is engaged in the field of marketing activity alone. Perhaps, the above distinction escaped the attention of the TPO for the year under consideration because in the next assessment year 2007-08 the said concern has been accepted as functionally comparable. Thus, for the aforesaid reasons, we hold that assessee is justified in claiming that concern IDC (India) Ltd. be considered as a comparable for the purposes of benchmarking international transactions of Intending commission and marketing support fees. The TPO is directed to re-work the adjustment, if any on this aspect and accordingly assessee partly succeeds. 27. Ostensibly, in assessment year 2006-07 (supra) the Tribunal approved the stand of the TPO in excluding M/s Agrima Consultants International Ltd. from the li ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... matter back to the file of the Assessing Officer. The Assessing Officer shall allow the assessee an opportunity to submit material and information to show that the functions and other necessary factors in the case of M/s Agrima Consultants International Ltd. in this year are similar to those in assessment year 2006-07 wherein such a concern has been found to be excludible from the list of comparables. After considering the submissions of the assessee, the Assessing Officer shall pass an appropriate order on this aspect. No other objection has been raised by the assessee on this aspect, therefore, Ground of Appeal No.2 is accordingly partly allowed. 30. In the result, the appeal of the assessee for assessment year 2008-09 in ITA No.2181/PN/2012 is partly allowed. 31. Now, we may take-up the appeal of the assessee in ITA No.83/PN/2014 for assessment year 2009-10, which is directed against the order of the Dy. Commissioner of Income Tax, Circle- 1(1), Pune (in short 'the Assessing Officer') passed u/s 143(3) r.w.s. 144C(13) of the Act dated 29.11.2013, which is in conformity with the directions given by the Dispute Resolution Panel, Pune (in short 'the DRP') dat ..... X X X X Extracts X X X X X X X X Extracts X X X X
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