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TMI Blog2019 (3) TMI 1837X X X X Extracts X X X X X X X X Extracts X X X X ..... der passed by the Deputy Commissioner of Income Tax, Circle 3(1), Gurugram [hereinafter referred to as the 'AO'] pursuant to directions issued by the Hon'ble Dispute Resolution Panel [hereinafter referred to as 'DRP'] under section 143(3) read with Section 144C of the Income-tax Act, 1961 (hereinafter referred to as the 'Act') on the following grounds: GENERAL GROUNDS 1. On the facts and circumstances of the case and in law, the assessment order/directions passed by the Id. AO / Transfer Pricing Officer ("TPO") / DRP are bad in law. 2. On the facts and circumstances of the case, the DRP has failed to adjudicate critical grounds of objections raised by the Appellant and thereafter has issued non-speaking directions. 3. On the facts and circumstances of the case, the DRP has made various factual inaccuracies in its direction leading to misinterpretation of facts of the Appellant and incorrect findings. GROUNDS AGAINST ADJUSTMENT MADE IN RELATION TO ADVERTISEMENT, MARKETING AND PROMOTION ("AMP") EXPENSES 4. That on the facts and circumstances of the case and in law, Ld. AO / TPO/ DRP erred in treating the routine selling expenses incurred by the Appellant as non-routine Ad ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t of TNMM analysis while benchmarking import transaction which was not controverted by the DRP. Without prejudice to the other grounds, having regard to the jurisprudence laid down by Delhi HC in Sony Ericson Mobile Communications India Pvt. Ltd., once the TPO has aggregated AMP expense under Transactional Net Margin Method TNMM, it is not open to the AO / TPO / DRP to segregate the same and benchmark it separately. Hence, the segregated approach of the AO / TPO / DRP is flawed and bad in law. 10. Without prejudice to the above grounds and the contention that AMP/Sales ratio is not a measure of intensity of AMP function, the AO / TPO / DRP failed to take note of companies which had same level of AMP expenses. 11. Without prejudice to the above grounds and the contention that AMP/Sales ratio is not a measure of intensity of AMP function, even if the alleged intensity of AMP functions of the Appellant did not match- that of comparables, the AMP expenses could have been aggregated along with other international transactions and tested under TNMM at entity level using intensity adjustment. The Appellant will be at arm's length under such an approach. Such an approach was propos ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... les for the mark-up on alleged brand building/AMP expenditure while computing adjustment in protective assessment. 21. Without prejudice to the other grounds, the Ld. TPO/AO have erred in facts and circumstances of the case and in law by ignoring the fact that even if the Appellant's remuneration model is to be recharacterized to a service fee for alleged brand building/AMP activities, the profit earned by the Appellant over and above the return earned by a distributor undertaking no or limited AMP activities should be considered as a remuneration for its alleged AMP activity as stipulated by the Hon'ble Delhi High Court in the in the case of Sony Ericson Mobile Communications India Private Limited Further, since the above-mentioned approach has been followed at present only on protective basis, the Appellant reserves all rights in law to raise suitable objections in future, if office of Ld. TPO propose any adjustment to the Assessee's income using Bright Line / or any other variant of the same approach GROUNDS PERTAINING TO PENALTY PROCEEDINGS 22. That on facts and in laws, the AO erred in holding that the Appellant has furnished inaccurate particulars of income in respect ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... learned TPO noted that in view of section 92F(v) of the Act, any transaction includes an arrangement, understanding or action in concert, whether or not such arrangement, understanding or action is formal or in writing and in view of the Rule 10 B(2)(c) of Income Tax Rules, 1962, the expenditure incurred on AMP by the taxpayer and thereby promoting the brand/trade name owned by the AEs, is an international transaction, which has not been reported in foreign No. 3CEB and assessee was required to benchmark this international transaction. The Assessing Officer proposed the assessee to benchmark this international transaction. After considering the submission of the assessee objecting to benchmark this international transaction of AMP expenses, the learned TPO, held the incurring of expenses on AMP as international transaction and benchmarked following the BLT (Bright Line Test) on protective basis and following cost plus method on substantive basis. 2.2 For benchmarking on protective basis, the learned TPO computed the AMP expenses in terms of sales as under: Expenditure on AMP 8,57,15,671 Value of Gross Sales 1,70,95,95,399 AMP/Sales % 5.01% 2.3 The learned TPO extracted, the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t adjustment of Rs. 4,57,85,009/- following the bright line test on protective basis. 2.7 The learned TPO alternatively also proposed substantive adjustment using cost plus method, following the decision of the Hon'ble Delhi High Court in the case of Sony Ericsson Mobile Communications India Pvt. Ltd. Vs. CIT, ITA No.16/2014 (order dated 16.03.2015) as under : Total Expenditure on AMP by the assessee 8,57,15,671 Mark-up @ 12.82% 1,09,88,749 Adjustment u/s 92CA 9,67,04,420 2.8 Accordingly, the learned TPO proposed adjustment of Rs. 9,67,04,420/-on substantive basis. 2.9 In the draft assessment order issued on 12/12/2017, the learned Assessing Officer included the addition for transfer pricing adjustment of Rs. 9,70,55,020/- on substantive basis and Rs. 4,57,85,009/-on protective basis. 2.10 Aggrieved, the assessee filed objection before the learned DRP. After considering submission of the assessee, the learned DRP noted that the assessee did not file copy of any agreement or arrangement with M/s. J Mitra, i.e., an entity prior to 2009 with whom, the parent company was trading the products in India, to demonstrate that similar terms of agreement exists with the assessee wit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o approximately 5% of the sales turnover. According to the learned counsel, the AMP expenses have been incurred for augmenting sales revenue of the product sold by the assessee and not for the brand promotion as alleged by the Ld. TPO. The learned counsel referred to page 34 of the order of TPO wherein detail of expenses of Rs. 8,57,15,671/- incurred on AMP have been analyzed by the learned TPO. According to the learned counsel, the expenses have been incurred mainly on conference and seminar's, demo and loaner expenses and sales promotion expenses, which in any way has not benefited the brand of the AE. The learned counsel submitted that the assessee has compared its margin under the TNMM with other comparables having similar functions. The Learned counsel referred to page 7 of APB-II and submitted that adjusted margin of the assessee is 8.69% as compared the adjusted average margin of the comparables, which is 0.609% percentage and, thus, the margin of the assessee being higher then the comparables, no AMP adjustment was required in the case of the assessee. 5.2 In support of the contention that incurring AMP expenses by the assessee, which according to the learned TPO is in exc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d brand building expenses. The learned DR referred to page 8- 652 of the paper book volume II, wherein the assessee has filed details of the AMP expenses. The learned DR referred to page 197 specifically and submitted that name of the "Olympus" brand was displayed prominently in all conferences/seminar or workshops organised for the doctors and other technical persons. He submitted that the assessee was entitled for distribution commission on sale of the products whereas the AE who has manufactured the products would be benefited more as compared to the assessee. He referred to page 173 of the paper book volume II, wherein the assessee has been claimed to have been engaged in the business of developing, manufacturing and selling of various medical equipment and accessories under the brand name "Olympus" in and outside India. The learned DR submitted that the assessee is claiming to be one of the main distributor for distributing the products to various distributor and dealers. The learned DR pointed out that assessee has not brought out any comparison of the expenses incurred by those other dealer/distributor of the assessee viz-a-viz the assessee because those distributor/dealers ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 53 as under: "53......................................................................................... This definition of transaction has to be read in conjunction with the definition given in section 92 B, which means that the transaction has to be first in the nature given in Section 92B (1); and then when such transaction includes any kind of arrangement, understanding or action in concert amongst the parties, whether in writing or formal, then too it is treated as international transaction, Here the conjoint reading of both the sections lead to an inference that in order to characterized as international transaction, it has to be demonstrated that transaction arose in pursuant to an arrangement, understanding or action in concert. Such an arrangement lias to be between the two parties and not any unilateral action by one of the parties without any binding obligation on the other or without any mutual understanding or contract. If one of the party by its own volition is entering any expenditure for its own business purpose, then without there being any corresponding binding obligation on the other or any such kind of an arrangement actually existing in writing or oral or ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ase of finished goods, export of finished goods, support services or whether there is any direct sales by AE in India. Further it needs to be seen, whether marketing activities relating to DEMPE functions reflected in any such expenditure incurred by the resident tax payer company and the non-resident AE in India are in conformity with the functions and risk profiles and the benefit derived by the tax payer company and the AE. It is also very relevant to examine, whether the AE is assuming any kind of risk in the Indian market or is benefitting from India in one way or the other. Thus, FAR analysis is the key which needs to be seen what kind of functions is being carried out by the AE in India, the nature of assets which have been deployed and the risk which have been assumed. If there is no risk of such attributes which is being carried out by the non-resident AE in India then there is no question of AE compensating to its subsidiary in India for any marketing expenses. Here, we have already stated at several places that parent AE of the assessee-company has not carried out any function in India and had not assumed any risk in India and even for the license for use of trademark, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 198 of the paper book-I reads as under: "4.1.3.3 Product liability risk Product liability risk refers to the risk associated with failure of a product or the possibility of facing legal action from customers due to defects in the products provided. In case of inherent default in the manufactured product, the AEs are responsible for repair cost. Further, the risk of legal suits is covered by way of insurance policy taken by the AEs of OMSI." 5.9 As we find that the AE, who is assuming the risk of the legal dispute with respect to the products sold in India. According to us, it is the reason as the why AE is interested in increasing technical awareness of its products among the doctors and the hospital, for which the assessee has incurred expenses on seminars and conferences. And this reason, the assessee must have been suitably compensated by the AE for the expenses incurred on seminars and conferences. 5.10 Further, it is undisputed that seminars and conferences have been organised for the doctors in the hospital, who were instrumental in prescribing the product of the AE to the final customers i.e. patients , has played a dominant role in increasing sale of the products, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tisements, etc. would necessarily involve expenditure both in terms of third party expenditure which the Indian assessee would liable to incur, as also towards the office maintenance and other overhead expenses. Even as one package or a bundle, the Indian subsidiary, i.e. an assessee, must be adequately compensated by adhering to the arm's length price. This is the core of the transfer pricing adjudication. Price paid by or compensation paid to the domestic AE must complement and reciprocate for the functions performed." 6.1 In para 119 of the order, the Hon'ble High Court has further emphasized that while computing arm's-length price of the International transaction the AMP expenses should be considered in case of distribution companies. The relevant finding of the Hon'ble High Court is reproduced as under: "119. A pure distribution company would be a comparatively low risk company as compared to a marketing and distribution company. The profits and earnings or arm's length price would accordingly vary. The arm's length price in case of a pure distribution company would enure lower price/profit as compared to a company engaged in distribution and marketing. In most ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ow or no risk distributor and he virtually acts as an agent for the loss and gain is that of the manufacturer. There is no economic risk on distribution of profits. He is, therefore, entitled to fixed remuneration for the self efforts, i.e., relating to the task or function of distribution. Similar will be the position of a low risk distributor with marketing functions, except that the said distributor should be compensated for the marketing, including AMP function. A distributor with marketing function can be normal or a high risk distributor. Such distributors should be compensated but the quantum of compensation would be higher. Such cases have to be distinguished from cases of a true distributor, who is in an independent business, uses his own money for purchasing at a low price and selling at a high price and accordingly shoulders the burden in case of a bad judgment. Profits or losses, therefore, correspond to the risk and market consideration. There is also functional incompatibility between a distributor and a retailer. Retailers cannot be compared with distributor also performing marketing functions. Foreign global enterprises frequently adopt a subsidiary model, i.e. the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... . The question, therefore, when a subsidiary entity engaged in distribution and marketing incurs AMP expenses, is to ascertain whether the subsidiary AE entity has been adequately and properly compensated for undertaking the said expenditure. Such compensation may be in the form of lower purchase price, non or reduced payment of royalty or by way of direct payments to ensure adequate profit margin. This ensures proper payment of taxes and curtails avoidance or lower taxes of the Indian subsidiary as a separate juristic entity. 127. We agree and accept the position in the portion reproduced above in bold and italics. The object and purpose of Transfer Pricing adjustment is to ensure that the controlled taxpayers are given tax parity with uncontrolled taxpayers by determining their true taxable income. There should be adequate and proper compensation for the functions performed including AMP expenses. Thus, we disagree with the Revenue and do not accept the overbearing and orotund submission that the exercise to separate ‗routine' and ‗non-routine' AMP or brand building exercise by applying ‗bright line test' of noncomparables and in all case, costs or ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... by the enterprise in connection with the purchase of property or obtaining of services; (iv) the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction or the specified domestic transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market; (v) the adjusted price arrived at under sub-clause (iv) is taken to be an arm's length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise; xxx‖ 158. RP Method as an axiom, the United Nations' Manual exposits: 6.2.6.3. Consequently, under the RPM the starting point of the analysis for using the method is the sales company. Under this method the transfer price for the sale of products between the sales company (i.e. Associated Enterprise 2) and a related company (i.e. Associated Enterprise 1) can be described in the following formula: TP = RSP x (1-GPM), where: * TP = the Transfer Price ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e less likely to have material effect on the profit margins as they do on the price. Compensation for performing similar functions tends to equalise across different activities, whereas in case of products, the equalisation is normally possible to the extent that products are substitute for each other. Nevertheless, similarity of the property as transferred in the controlled transaction for closer comparability of products/services would produce more accurate results. Sometimes, RP Method is adopted as more accurate or best method where controlled and uncontrolled transactions are comparable in all characteristic, other than the product itself. In some cases, it may be a preferable and more reliable method in comparison to the CUP Method or CP Method. However, RP Method has its weaknesses. It loses its accuracy and reliability where the reseller adds substantially to the value of the product or the goods are further processed or incorporated into a more sophisticated product or when the product/service is transformed. In the OECD Commentary on Transfer Pricing Guidelines it has been observed: "... Another example where the resale price margin requires particular care is where the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... od, RP Method requires less direct transactional (product) comparability than CUP Method. However, there must be functional comparability. A similar level of compensation is expected for performing similar functions across different activities. This uniformity and similitude is necessary because similar gross profits are being compared. If there are material differences that reflect in the gross profit margins between the controlled and uncontrolled transaction, adjustments should be possible on account of such differences. Functions performed can be simple and cover a limited field of sales, general or administrative expenses; to more complex one, adding substantially to the gross profit margins. The latter may happen if the reseller adds substantially to the value of the product by assisting considerably in creation and maintenance of intangible products or where the goods are further processed into a more valuable or complicated product. Referring to the weaknesses of the said method, the commentary states:- "The method can be used without forcing distributors to inappropriately ―make profits‖. The distributor earns an arm's length gross profit margin, however, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s including AMP expenses would give more accurate and precise results. 164. However, it would be wrong to assert and accept that gross profit margins would not inevitably include cost of AMP expenses. The gross profit margins could remunerate an AE performing marketing and selling function. This has to be tested and examined without any assumption against the assessed. A finding on the said aspect would require detailed verification and ascertainment. 165. An external comparable should perform similar AMP functions. Similarly the comparable should not be the legal owner of the brand name, trade mark etc. In case a comparable does not perform AMP functions in the marketing operations, a function which is performed by the tested party, the comparable may have to be discarded. Comparable analysis of the tested party and the comparable would include reference to AMP expenses. In case of a mismatch, adjustment could be made when the result would be reliable and accurate. Otherwise, RP Method should not be adopted. If on comparable analysis, including AMP expenses, gross profit margins match or are within the specified range, no transfer pricing adjustment is required. In such cases, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... stic distributor and marketing company that does not own intangible brand rights. Contract value would be treated as NIL. In terms of our finding recorded above, the said finding would not be correct. The approach and procedure for ascertaining /determining arm's length price under the RP Method is different. For this reason, and other grounds recorded, we have passed an order of remit to the Tribunal for examination of the factual matrix." 6.6 The finding of the Hon'ble High Court with reference to cost plus method is reproduced as under: "O. Cost Plus Method 169. CP Method as stipulated in Rule 10B (1)(c) is as under: "10B. (1) For the purposes of sub-section (2) of section 92C, the arms length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely : Xxx (c) cost plus method, by which, (i) the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined; (ii) the amount of a normal gross profit mark-up to such costs (computed according to the s ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t the gross profit mark up or when reasonably accurate adjustments can be performed. Thus, CP Method requires functional comparability. This comparability analysis would necessarily imply that the comparable must and should be performing similar functions, including the nature of costs and expenses incurred. If the discounts/incentives and for that matter entire distribution and marketing expenses are treated as costs, functional and comparable analysis comparison should be similar. Thus, the entire cost, i.e. marketing expense or distribution and marketing expense, can be made subject matter and included in ‗cost', for determining arm's length price by applying CP Method. 172. The United Nations' Manual discourages application of CP Method in transactions involving full-fledged manufacturer who owns valuable product intangibles i.e. a manufacturer who has incurred considerable cost on Research & Development, patent, technology etc. for the reason that it is difficult to locate a similar independent manufacturer owning comparable. There is no finding or examination on this aspect by the Tribunal. We caution, the reference above is to valuable product intangibles ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e assessee, however, as far as benchmarking of the said transaction is concerned, we find that the Ld. Transfer Pricing Officer has claimed to have followed the directions of Hon'ble Delhi High Court in the case of Sony Ericsion (supra). The assessee is aggrieved with not considering the AMP expenses in aggregated manner with imports of goods under TNMM. The assessee is also aggrieved with cost plus method in segregated manner without properly comparing the functions of the comparable companies. In such circumstances, we feel it appropriate to restore the issue to the file of the Ld. TPO for following the direction of the Hon'ble Delhi High Court for benchmarking under TNMM in aggregated manner along with the purchase of goods from the AE or in the segregated manner, after taking into account appropriate comparables or applying of resale price method or cost-plus method keeping in view the finding of the Hon'ble Delhi High Court after appreciation of the facts and circumstances of the case vis-à-vis various situations pointed out by the Hon'ble High Court. We are restoring this issue to Ld. Transfer Pricing Officer because factual information on the issues raised by the Hon' ..... X X X X Extracts X X X X X X X X Extracts X X X X
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