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TMI Blog2018 (4) TMI 688X X X X Extracts X X X X X X X X Extracts X X X X ..... ransactions involving third parties. 4. The CIT(A) erred in making the deletions without appreciating the observations made by the TPO that the impugned expenditures are not recovered from the AE by way of sales price of finished products, charged to the AE. 5. The CIT(A) erred in mis-interpreting the action of TPO in determining of ALP w.r.t. international transactions at NIL as against the observation of TPO in the order, that it resulted in suppression of profit. 6. The CIT(A) ought to have appreciated that the facts in all the relied upon cases and the assessee's case are distinguishable and distinct in so far as determination of ALP of the license fees and management fee by the TPO is on account of non-recovery of amounts by way of sales price and not due to reasons given in the cited cases. 7. The CIT(A) was not correct in deleting the adjustment made without appreciating the fact that even otherwise, these expenses would have been disallowed u/s. 37(1) of the Income tax Act, as the conditions of said section 37(1) of the Income tax Act were not met. 8. For these and such other ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... uch other grounds that may be urged at the time of hearing, it is humbly prayed that the order of the CIT(A) be reversed and that of the Assessing Officer be restored. 10. The appellate craves leave to add, to alter, to amend or delete any of the grounds that may be urged at the time of hearing of the appeal. IT(TP)A No.1039/Bang/2015 : 04. Ground nos.1, 2, 8 and 9 are general in nature. Ground nos.3, 4, 5 & 6 deal with the issue of licence fee and management fees. Brief facts relevant to decide the present appeal are as follows. The assessee is a company incorporated in India and is engaged in manufacture of pharmaceutical formulations for Adcock Ingram Health Care (Pty)Ltd, South Africa (AIHPL) and providing outsourced formulation manufacturing services to domestic pharmaceutical companies. The assessee was established as a joint venture company on 05.02.2007 between Medreich SA (Indian company) and AIHPL (AE) for the purposes mentioned in the joint venture agreement with shareholding of 50.1% and 49.9% of Medreich and AIHPL respectively. 05. The assessee company (resident) entered into various arrangements with AIHPL in the form of business agreement dt.31 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 83,950,298 2,813,821 38,822,630 614,553,039 On the basis of the above, it was submitted by the assessee that operating profit / operating cost at the entity level was 25.49% as against the non-AE it was 5.26 %. Thus it was submitted that the international transactions at the entity level for the 'Manufacture and export of drug formulations', was as under : International Transactions Received Paid 1. Sales of Manufactured Products 603003808 2. Licence Fee 16100000 3. Service Fee 3320309 4. Purchase of Raw Material 15760215 5. Purchase of Fixed assets 2793316 6. Reimbursment of Expenses 3284877 1134874 7. Management Fees 16592899 Total 606324117 55666181 Total Intl. Transactions: 661990298 08. The TPO was not satisfied with the MAM adopted by the assessee as TNMM and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ere is commercial need for the payment of the management fee since the payments directly benefit the Company by enabling it to carry out its business operations more efficiently. - Your approach of enquiring on commercial expediency of the impugned payment is incorrect in law. - In the pharmaceutical industry it is common to procure the services for which the management fee payout is made. 1.7 Transactions relating to license fee and management fee are closely linked to the principal transaction of manufacture and export of drug_ formulations. In this regard, your goodself should note that the license fee and management fee payments are on account of the principal transaction. License fee transaction is at arm's length since the principal transaction to which the payment relates to is at arm's length 2.11 In addition to the above, it is submitted that since the principal transaction to which the license fee is closely linked is at arm's length (with an operating profit margin on operating cost of 19.24% vis-à-vis 8.57% being the operating profit margin of the comparable companies), the license fee transaction would also be at arm's length. We request you to take cog ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... license fee paid by the Company is determined as a percentage of the Net Sales Price as defined in the agreement (and thus, variable) and is not a fixed lump sum. Such an approach for determining license fee payments is typically adopted in independent market conditions. This would have been the scenario even where the know-how had been obtained by the Company from an alternative source (subject to such alternative source being available for the nature of products that are manufactured by the Company). 2.16 It is also submitted that had an alternative know-how source been available from a comparable unrelated party, similar restrictive conditions on the exploitation of the know-how would typically be imposed by the unrelated party on the Company to protect the nature and quality of its rights in such know-how. Such restrictions could relate to the geography in which the finished products are sold, the nature of customers to whom the products are sold, the price at which it is to be sold etc. In light of the above, the Company submits that your contention that the license fee payment does not meet the market conditions is incorrect. Transactions relating to license fee and manage ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the inter-company agreement). It can be seen that the royalty is computed having regard to the sale price that relates to the principal transaction relating to manufacture and export of drug formulations to AIHPL. It can also be seen that the royalty is paid to a common source, that is, AIHPL. 4.5 The Company pays management fees to MSPL to liaise with AIHPL and keeping the Company informed of developments within the South African pharma industry. The management fee payable is determined at 3% of the net sales. It can be seen that the remuneration is computed having regard to the principal transaction. 4.6 In light of the above, the Company had submitted that the license fee and management fee transaction are closely linked to the principal transaction of manufacture and export of drug formulations. Two transactions are said to be closely linked when, inter alia, one transaction arises on account of the main transaction and such transaction has its source in the main transaction. This principle was applied by the Pune Income-tax Appellate Tribunal ('ITAT') in Demag Cranes & Components (India) Pvt. Ltd. v. DCIT (30 taxmann.com 364)." 09. The sum and substance of the submissions ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s such, the ground no.2 raised by the Appellant is allowed. Similarly, having regard to the above discussion which covers the ground Nos.4.1,4.2,5.1 and5.2,the said grounds are also allowed. Thereafter the appeals of the assessee were allowed by the CIT (A). Feeling aggrieved by the order passed by the CIT (A), the Revenue is in appeal before us on the grounds mentioned herein above. 12. The Ld. DR pointed out that in the show-cause notice (page 5), the TPO has mentioned giving the show-cause notice to the assessee, as to why the ALP of the licence fee should be treated as nil. Similarly at page 14 of the show-cause notice, it was mentioned that the management fee is a class of its own and is therefore required to be separately analysed and therefore mentioned that the management fees is analysed separately under the CUP method. 13. The argument of the learned DR was that the assessee being a contractual manufacture of its AE and therefore it is inconceivable for third party who is contractual manufacturer to pay the licence fee to the Principal for which it is manufacturing the pharmaceutical products. For that purpose, the TPO relies upon the definition of 'licence fees' and i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... IT [IT Appeal No. 923 (Bang.) of 2012] 10. Luwa India Pvt. Ltd. v. ACIT (568/Bang/2012) - Bangalore ITAT 16. We have heard the rival contentions, perused the records as also the case laws cited by both the parties. From a reading of the effective grounds raised by the Revenue, it is clear that the finding of fact recorded by the CIT (A) in paras 15 and 16 (reproduced above) have not been refuted by the Revenue by way of challenging that the management fees and licence fees paid by the assessee were not inter linked, interrelated or inter connected with the primary activity of the assessee i.e the approach of assessee as well as CIT(A) in aggregating the transactions were wrong . In our view, aggregation of transaction is permissible under income tax Act and rules framed there under . In this regard, we may conveniently rely upon the recent judgment of Hon'ble Delhi High Court in Sony Ericsson Mobile Communication India (P.) Ltd. v. CIT [2015] 374 ITR 118/231 Taxman 113/55 taxmann.com 240 wherein it was held that aggregation of such transaction is permissible and relied upon the OECD Commentary in this regard. 80. The use of expression 'class of transaction', ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for the purpose of rule 10A and rules 10 B to 10E, 'transaction' includes a number of closely related transactions" and that "Thus, the closely linked transactions can, in a given situation, be components of single composite transaction". Their Lordships have then added that "The assessee would, however, have to prove that although each sale and each provision of service is priced separately, they were all provided under one composite agreement which constitutes one international transaction". Similarly, in the case of Sony Ericsson Mobile Communications India (P.) Ltd. v. CIT [2015] 374 ITR 118/231 Taxman 113/55 taxmann.com 240 (Delhi), Hon'ble Delhi High Court has observed that, "There is considerable tax literature and text that CUP method, i.e. comparable uncontrolled price method, RP method, i.e. resale price method, and CP method (i.e. cost plus method) can be applied to a transaction or a closely linked or continuous transactions". Their Lordships have, in this backdrop, put in a word of caution that "thus, it would be inappropriate to proceed with the arm's length price computation methods with a preconceived notion of singularity as a statutory mandate" and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... recise approximation of arm's length conditions, the arm's length principle should be applied on a transaction-bytransaction basis. However, there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis. Examples may include 1. Some long term contracts for the supply of commodities or services; 2. Rights to use intangible property; and 3. Pricing a range of closely linked products (e.g. in a product line) when it is impractical to determine pricing for each individual product or transaction. Another example would be the licensing of manufacturing know-how and the supply of vital components to an associated manufacturer; it may be more reasonable to access the arm's length terms for the two items together rather than individually. Such transactions should be evaluated together using the most appropriate arm's length method. A further example would be the routing of a transaction through another associated enterprise; it may be more appropriate to consider the transaction of which the routing is a part in its entirety, rather than consider the individual transactions on a separat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... anate from a common source being an order or a contract or an agreement or an arrangement and the nature, characteristics and terms of these transactions are substantially flowing from the said common source. For example, a master purchase order is issued stating the various terms and conditions and subsequently individuals orders are released for specific quantities. The various purchase transactions are closely linked transactions. 13.8 It may be noted that in order to be closely linked transactions, it is not necessary that the transactions need be identical or even similar. For example, a collaboration agreement may provide for import of raw materials, sale of finished goods, provision of technical services and payment of royalty. Different methods may be chosen as the most appropriate methods for each of the above transactions when considered on a standalone basis. However, under particular circumstances, one single method maybe chosen as the most appropriate method covering all the above transactions as the same are closely linked." (Underlined for emphasis by us)." 17. In view of the above we hold that the aggregation of transaction's as done by the assessee and as upheld ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... se , the licence is required for long term manufacturing of drugs and formulation within know how of the AE further the assessee is Joint venture company therefore TPO cannot lose sight of various benefit which may flow to Indian partner in the absence of provision for making the payment for the use of license In the case in hand TPO has concluded that no licence fee should have been charged by AIHPL as all the manufactured drugs formulations are exported to AIHPL which is an associate entity of the assessee company and on manufactured drug formulation was sought to any other entity therefore AE, to not have charged any amount from assessee in the nature of licence fee as the entire manufactured drug formulation have been exported to it and thereafter TPO had recorded that there is a huge difference in profit margin of a related party sales and the contract manufacture . in our vie the approach of TPO was not correct as it is contrary to law laid in the case of EKL Appliances, Delhi High Court, 345 ITR 241 and Dresser Rand , Mumbai Tribunal, 13 taxmann.com 82 (Mumbai) where Hon'ble court and tribunal had held i) Not necessary for the assessee to show that any legitimate expenditu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s prices as that of the assessee without separately charging the license fee, therefore the approach of the Transfer Pricing Officer to compute NIL charges for the license fee cannot be uphold as transfer prices adjustment can be made in accordance with the one of the method provided under the rules framed under the income tax act. In view thereof, we find no merit in the analysis carried out by the TPO by benchmarking the licence fee. In fact assessee by aggregation of transactions in the TP study had benchmarked the arm's length price of all the transactions by comparing operating profit / operating cost at the entity level was 25.49% as against the non-AE it was 5.26 % .However, we observe that the comparability analysis in the TP study carried out by the assessee by aggregation of transactions adopting TNMM as the most appropriate method has not been examined by either of the authorities below who have merely concentrated merely on the issue of aggregation / segregation of transactions. The CIT (A) has mechanically accepted the results of the assessee to be at arm's length by accepting the operating profit / operating cost of the assessee as 25.49% as against non-AE at 5.26 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t acceptable. In all. We find that in a materially identical situation in the case of Merck Ltd. v. Dy. CIT [2016] 69 taxmann.com 45 (Mum.), a coordinate bench, has observed, inter alia, as follows: '9. We find that there is a clear contradiction in the findings of the authorities below. On one hand, the stand of the authorities below is that no services are rendered, and, on the other hand, there are categorical findings that the services rendered are so general in nature that even an employee of the assessee could have rendered the same. In the event of no services actually having been rendered, there cannot be any occasion for the same services being rendered by a person without specialized knowledge. On the one hand, it is held that arm's length price of these services is zero value, and, in the same breath, it is held that "there would hardly be any substantial payment" for these services. Clearly, services are rendered on the facts of the present case. There is sufficient material on record to show that the assessee was, under the agreement, entitled to receive a package of services on as and when required basis. The emails and other documentary evidences show that t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... will be more appropriate a method of ascertaining the arm's length price, the TNMM cannot be discarded. Dealing with almost a similar situation, as we are in seisin of, a coordinate bench of this Tribunal, in the case of AWB India (P.) Ltd. v. Dy. CIT [2015] 152 ITD 770, has observed as follows: "11. In ground nos. 5 to 9, which we will take up together, the assessee has raised the following grievances: 5. That, on the facts and circumstances of the case, the DRP and TPO/AO have failed to appreciate the business model and business realities of the appellant and role of its AE, while conducting the economic analysis, and concluding that no service is received or no benefit, and/or services received are duplicative in nature. 6. That, on the facts and circumstances of the case, the DRP and TPO/AO erred in presumptively holding that the revenue authorities are empowered to question the commercial decision of the appellant and in not appreciating the jurisprudence that the DRP and the AO/TPO cannot go beyond their powers to question the business decision of the company. 7. That, on the facts and circumstances of the case, the DRP has erred in confirming that the TPO has discha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... development of human resources and it is also noticed that these services are of routine nature and duplicate at best". Accordingly, the TPO also treated ALP of these services as 'NIL'. As regards the payment of Rs. 96,355 towards 'legal services', the TPO did take note of the services that the assessee was entitled to under these arrangements but as there is no evidence of any services having been actually rendered by the AE, the TPO concluded that it does not have any value in an arm's length situation. The value of this service was also taken as NIL. The same was the case with respect to the payments for other services. Accordingly, no arm's length value was assigned to these services also. In respect of these cases TNMM was rejected and CUP was applied though, even under CUP method, value assigned was nil as, in the opinion of the TPO, these services were worthless. 13. When Assessing Officer proposed to make disallowance in respect of payments for the above services, arm's length value of which was taken at 'zero', aggregating to Rs. 31,23,325, as against total management fees of Rs. 58,20,571 paid by the assessee, assessee carried the matt ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... imilar services, whatever be the worth of such services, are actually rendered in the uncontrolled conditions. 17. As for the evidence for each of the service stated in the agreement, it is not even necessary that each of the service, which is specifically stated in the agreement, is rendered in every financial period. The actual use of services depends on whether or not use of such services was warranted by the business situations whereas payments under contracts are made for all such services as the user may require during the period covered. As long as agreement is not found to be a sham agreement, the value of the services covered under the agreement cannot be taken as 'nil' just because these services were not actually required by the assessee. In any case, having perused the material on record, we are satisfied that the services were actually rendered under the agreement and these services did justify the impugned payments. 18. We are also of the considered view that in the absence of prerequisites for application of CUP methods being absent in the present case, it was not open to the TPO to disregard the TNMM employed by the assessee. No defects have been pointed o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ices are worthless in the eyes of the revenue authorities, the arm's length price of these services cannot be held to be NIL. Similarly, the findings that no services were rendered and that the assessee could have performed these services on its own are contradictory. If no services were rendered, which services the authorities below hold that the assessee could have performed on its own. Even the agreement for Management services provided for cost allocation based on turnover at the rate of 3 percent. For the sake of repetition approach of the assessee as well as the Commissioner has not been challenged by the revenue before us whereby by the aggregation of transactions has been done. The computation of nil for Management services by the TPO was done on the basis of method not permissible under the laws by bringing in the comparable uncontrolled transaction by the TPO. These are at has to be done on the basis of a permissible method of ascertaining the arm's length price. It cannot be open to the TPO to reject a method of ascertaining the arm's length price without applying a legally permissible method to substitute for the method of ascertaining ALP as adopted by the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... AE may have given the same service on gratuitous basis in the earlier period, but that does not mean that arm's length price of these services is 'nil'. Thus, it becomes important to clarify the extent of the TPO's authority in this case, which is to determining the ALP for international transactions referred to him or her by the AO, rather than determining whether such services exist or benefits have accrued. That exercise - of factual verification is retained by the AO under Section 37 in this case. Indeed, this is not to say that the TPO cannot - after a consideration of the facts - state that the ALP is 'nil' given that an independent entity in a comparable transaction would not pay any amount. However, this is different from the TPO stating that the assessee did not benefit from these services, which amounts to disallowing expenditure. That decision is outside the authority of the TPO. Whilst the report of the TPO in this case ultimately noted that the ALP was 'nil', since a comparable entity would pay 'nil' amount for these services, this Court noted that remarks concerning, and the final decision relating to, benefit arising from th ..... X X X X Extracts X X X X X X X X Extracts X X X X
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