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TMI Blog2016 (7) TMI 1055X X X X Extracts X X X X X X X X Extracts X X X X ..... the Arms Length Price (hereafter "ALP") in respect of such transactions be determined on the basis of the average rate of commission earned by the Assessee in respect of transactions with unrelated parties ('Non-AEs'). The Assessee claims that the said direction is patently erroneous as the indenting transactions with Non-AEs are not comparable with indenting transactions with its AEs; the volume of the indenting transactions with Non-AEs is only a small fraction of such transactions and the concerned products are also different. It is also the case of the Assessee that the Tribunal has not followed any particular method in directing the determination of ALP and as such, the same is wholly arbitrary. The Assessee urges that it is incumbent on the Tribunal to first determine the most appropriate method for determining the ALP and, thereafter, compute the ALP in conformity with the discipline of that method. 3. The controversies involved in these appeals as well as the material facts are similar. The questions of law framed in these appeals are also identical and read as under: "(1) Whether the Income tax Appellate Tribunal was right in applying and computing arms le ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 62 (hereafter 'the Rules'), the Assessee furnished the transfer pricing report in respect of its international transactions with AEs. The Assessee considered Transactional Net Margin Method (hereafter 'TNMM') as the most appropriate method and selected the ratio of gross profit to operating costs - Berry Ratio - as the Profit Level Indicator (hereafter 'PLI'). The Assessee computed its gross profit on trading transactions (sales on principal to principal basis) by reducing the cost of sales from the aggregate value of sales made to AE as well as Non-AEs. The gross profit on trading segment so computed was then added to commission earned to compute the total gross profits. This amount was taken as the numerator and was divided by operating expenses to compute the Berry Ratio (the PLI selected by the Assessee) at 1.79% 10. The Assessee claimed that its transaction with the AE's were on arms length basis and supported this claim by the data relating to a set of 23 comparable companies. The weighted average arithmetic mean (adjusted using data for financial years 2004-05, 2005-06 and 2006-07) of the PLI of these comparable companies was computed at 1.18%. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d developed unique intangibles like supply chain intangibles and human assets intangibles, which according to him had resulted in huge commercial and strategic advantage to the AE and had enhanced the profit potential of the AE. The Berry Ratio could not be used in cases where the Assessee was using valuable and unique intangibles. Secondly, he held that Berry Ratio was very sensitive to cost base and it was difficult to accurately compute the cost base of comparable companies on the basis of the available data as different companies had accounted for their costs differently. 15. The TPO finally concluded that the gross margin earned by the Assessee in its trading segment with Non AEs - computed at 4.45% - ought to be taken as the rate of commission on the FOB price of the goods sourced through the Assessee in respect of indenting transactions with the AEs. He, accordingly, computed the arms length commission income from indenting transaction with AEs at Rs. 85,68,44,783/- (being 4.45% of Rs. 19,25,49,38,946) and accordingly directed enhancement of Assessee's income by an amount of Rs. 55,26,16,748/- after reducing the commission of Rs. 30,42,28,035/- as declared by the Assess ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ribunal accepted the Assessee's contention that the nature of indenting transactions were different from trading transactions. The trading transactions involved certain risks and finances whereas in respect of indenting transactions, the Assessee did not incur any financial obligation or carry any significant risks. The Tribunal found that the indent business of the Assessee was nothing but trade facilitation, both in form as well as in substance. It further noted that there was no material on record to regard the indent transactions as trading transaction. The Tribunal further proceeded to note and accept the Assessee's contention that it would be appropriate to compare commission/service income earned by the Assessee in respect of transactions with AEs with the similar transactions with Non-AEs. However, the Tribunal rejected the Assessee's claim for an appropriate adjustment on account of difference in volumes as well as the associated risks. The Tribunal held that in the facts and circumstances of the case, no adjustment as to the extent of volume was necessary as the Assessee had entered into separate contracts for each transaction and it was not the Assessee's ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... inted out that in respect of products classified under the automotive, chemicals (plastic), construction, machinery, minerals and energy, power, steel pipes, etc. divisions, there were no indenting transactions in the Non-AE segment and, therefore, there would be no comparable standards on the basis of which an ALP adjustment could be made. 26. Mr Manchanda, learned Senior Standing Counsel countered the submissions made by Mr Aggarwal. He earnestly contended that the Tribunal had applied the Comparable Uncontrolled Price (CUP) Method and had used an internal comparable transaction, which was from the same company and the same industry, for determining the ALP. He submitted that this was the most reliable method for computing the ALP and the Assessee could not be heard to dispute the same. He earnestly contended that the above method was proposed by the Assessee with certain economic adjustments which, the Tribunal found were not justified. He submitted that the Assessee had canvassed an adjustment on account of volume of transactions between AE and Non-AEs segment and in support of its claim had produced the brokerage rates for transactions in the security markets. The Tribunal h ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 9;s length price, in the manner as may be prescribed : Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices: Provided further that if the variation between the arm's length price so determined and price at which the international transaction or specified domestic transaction has actually been undertaken does not exceed such percentage not exceeding three per cent of the latter, as may be notified by the Central Government in the Official Gazette in this behalf, the price at which the international transaction or specified domestic transaction has actually been undertaken shall be deemed to be the arm's length price: Provided also that where more than one price is determined by the most appropriate method, the arm's length price in relation to an international transaction or specified domestic transaction undertaken on or after the 1st day of April, 2014, shall be computed in such manner as may be prescribed and accordingly the first and second proviso shall not apply. Explanation.-For the removal of doubts, it is hereby clarified that the provisi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ppropriate method for computation of ALP. This, in our view, would be essential as the reliability of the determination of the ALP is in turn dependent on the effectiveness of the method in relation to the controlled transaction being tested. In the present case, the dispute essentially relates to the commission earned by the Assessee in respect of transaction with its AEs. 32. We are inclined to accept Mr Aggarwal's contention that although the TPO had discarded the method adopted by the Assessee, it had not followed any particular method in making the ALP adjustment. It appears that the TPO has adopted a hybrid method. He imputed the character of trading transactions to the indenting transactions entered into by the Assessee with its AEs. Having done so, he compared the profit margin realized by the AE from such transactions with profit margin realized by the AE from a comparable uncontrolled transaction. The said approach was rejected by the Tribunal - and, in our view, rightly so - as it was not permissible for TPO to re-characterize the tested transaction. 33. We find no infirmity with the Tribunal's finding that indenting transactions reported by the Assessee were p ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d appropriate as had been done in the preceding years. He contended that on principles of consistency, he was required to follow the TNMM method. There is much merit in the contention that a method once considered appropriate should be consistently applied unless for good reasons, the TPO decides otherwise. However, this is a salutary guiding principle and would not fetter the TPO from independently examining the transfer pricing approach reported by the Assessee. The purpose of imputing ALP to international transactions is to ensure that the real income of the Assessee in respect of international transactions (and with effect from 1st April, 2013 certain domestic transactions) are charged to tax under the Act. It is thus, implicit that the exercise to determine such income be undertaken for each assessment year. 36. The special provisions for assessing income from international transactions having regard to ALP is of a recent vintage and was introduced by the Finance Act, 2001. The provisions under Chapter X of the Act have undergone significant changes over a period of time. The principles for computation of ALP are also evolving and as such, we are not persuaded to accept that ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... es effected or assets employed could be used as denominator of the ratio chosen as the PLI. This is plainly erroneous. Rule 10B(1)(e)(i) of the Rules reads as under:- "10(e) transactional net margin method, by which,- (i) the net profit margin realised by the enterprise from an international transaction or a specified domestic 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 or having regard to any other relevant base;" 40. It is clear from the plain language of the above quoted clauses that the net profit margin realised could be computed having regard to "any other relevant base". Berry ratio is a ratio of operating profits to operating expenses. In cases where operating expenses is considered as a relevant base, there would be no difficulty in using Berry ratio as the PLI in terms of Rule 10B(1)(e)(i) of the Rules. 41. Insofar as the other two reasons are concerned, it is necessary to understand the substratal rationale of using Berry ratio as the PLI. The said ratio was used by the Internal Revenue Service (IRS) in the USA in the case of E.I. Du Pont DE ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... atio in the case of 21 distributors was 129.3% and in the case of DISA, it was 281.5% for the year 1959 and 397.1% in the year 1960. It is relevant to note that in that case also the Commissioner of Revenue did not reallocate the profits between DISA and Du Pont on the basis of Berry ratio but on the basis of applying the resale price method. Berry ratio was only introduced as an expert evidence by IRS to defend the challenge to such reallocation. In other words, the said ratio was only used to show that DISA had made extraordinarily high profits and IRS had rightly exercised its jurisdiction to reallocate such profits of DISA to Du Pont. The Du Pont's challenge to the said ratio as being inappropriate measure was rejected by the Court in the following words:- "Whatever the general limits of any particular gauge of industry profitability, plaintiff cannot escape the basic thrust of defendant's proof. Defendant has shown that DISA made extraordinarily high profits which the Commissioner reallocated to an economically reasonable level." 44. Subsequently, in 1990, Berry ratio was included as an acceptable PLI in certain circumstances under the Treasury Regulations in USA. O ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ion paid to the Assessee is based on the value of the goods, would be a valid reason to reject the use of Berry ratio because Berry ratio can only be applied where the value of the goods are not directly linked to the quantum of profits and the profits are mainly dependent on expenses incurred. The fundamental premise being that the operating expenses adequately represent all functions performed and risks undertaken. For this reason Berry ratio is effectively applied only in cases of stripped down distributors; that is, distributors that have no financial exposure and risk in respect of the goods distributed by them. 48. In the present case, the Assessee asserts that its business comprises of two segments, trading segment and indenting segment and the functional risk and the reward in the two segments are different. In the trading segment, the Assessee earns a higher profit margins (calculated on the value of the goods traded) while in the indenting segment its profit margins are lower. Plainly, the use Berry ratio would give unreliable results if the product mix of the comparables is different from the product mix of the Assessee. This would make the task of finding a set of comp ..... X X X X Extracts X X X X X X X X Extracts X X X X
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