• Nov
  • 19
  • 2012

Validity of filtration criteria for selection process adopted by TPO to Compute ALP

IN THE ITAT MUMBAI BENCH ‘L’

Assistant Commissioner of Income-tax, Range 7(2)

versus

Rhoida Chemicals India (P.) Ltd.

IT Appeal No. 4201 (Mum.) of 2007

[Assessment year 2003-04]

SEPTEMBER 28, 2012

ORDER

Amit Shukla, Judicial Member  

The aforesaid appeal preferred by the Revenue, is directed against the impugned order dated 30th March 2007, passed by the learned Commissioner (Appeals)-VII, Mumbai, for the quantum of assessment passed under section 143(3) of the Income Tax Act, 1961 (for short “the Act”), for assessment year 2003-04.

2. The sole dispute in this appeal is with regard to transfer pricing adjustment of Rs. 34,20,335, made by the Transfer Pricing Officer (for short “TPO”) in his order passed under section 92CA(3) of the Act.

3. Briefly stated the facts of the case are that the assessee is an indirect subsidiary of Rhodia S.A. France. The assessee, which is incorporated in India, is primarily involved in canvassing of Rhodia Products from and around the world to the various customer of India. It is also involved in distribution of specialties chemicals imported from various associated enterprises and to some extent manufacturing certain Rhodia Products in India. During the course of assessment proceedings, the Assessing Officer referred the matter to the TPO for computation of Arm’s Length Price in relation to the international transactions undertaken by the assessee during the year. The assessee has undertaken following international transactions and the methods employed for determining the Arm’s Length Price during the year under consideration:-

S. no. Particulars Value (Rs.) Method
1. Receipt of indenting commission 3,05,25,968 Comparable Uncontrolled Price Method (CUP)
2. Import of raw materials 7,15,868 Resale Price Method
3. Sale of finished goods 1,39,40,532 Resale Price Method
4. Purchase of finished goods 6,31,10,452 Resale Price Method
5. Payment for intranet services to Equant a deemed associated enterprise 10,83,449 CUP
6. Payment of interest to Societe Generale Bank 35,46,870 CUP
7. Reimbursement of travel, hotel and mobile expenses (payment) 5,40,497 CUP

4. Out of the above transactions, marketing service segment i.e., indenting commission and other transactions relating to payment of internet service, reimbursement and interest payment (as mentioned at serial number 1, 5, 6 & 7 of the above table), there is no dispute as the TPO has accepted the Arm’s Length Price (for short “ALP”) as shown by the assessee. However, with regard to the distribution segment i.e., import of raw materials, sale and purchase of finished goods, the TPO did not accept the assessee’s gross profit margin with that of with the comparable companies. The assessee has used “Resale Price Method” for bench marking its gross profit margin with that of the comparable companies, for which it had selected six companies with following gross profit on sales:-

S.no. Company’s Name Gross Profit/Sales
1. Anukaran Commercial Enterprises Ltd. 3.80%
2. Bijoy Hans Ltd. 10.13%
3. Daga Global Chemicals Ltd. 3.53%
4. Indian Potash 12.79%
5. Nikhil Adhesives Ltd. 8.57%
6. Oregon Commercials Ltd. 0.57%
Arithmetic Mean 6.56%

5. As against the above arithmetic mean, the assessee’s result for distribution segment i.e., import of raw material, sale and purchase of finished goods, were shown as under:-

Gross Sales 12,90,25,000
Cost of goods sold 11,83,30,000
Gross Profit 1,06,59,000
G.P. / Sales 8.29%

Since the assessee’s gross profit margin was better than the average gross profit mean of comparable companies, it showed that its transactions with A.Es were at arm’s length price.

6. The Assessing Officer, however, rejected most of the assessee’s comparable companies and the reasons for not accepting the assessee’s such comparables was that the assessee has taken the criteria of filtration, the ratio of sales in trading upon gross sales which are less than 90%, whereas, it should have been less than 75%. Based on the said search criteria, the following additional comparables were found by the TPO for bench marking.

  ♦  Arvind Chemicals Ltd.

  ♦  Heetu Chemicals & Alkalies Ltd.

  ♦  K.P.L. International Ltd.

  ♦  Parry Chemicals Ltd.

7. The second filtration criteria which was used by the assessee for selection of comparable cases were the companies which were having export turnover of 20% out of gross sales. This, as per the TPO, should have been Nil i.e., zero percentage, as assessee’s exports were neglible. With regard to a particular company, Oregon Commercials Ltd., a comparable company short listed by the assessee, the TPO observed that the same cannot be used as comparable because the sales of the said company has dipped year-after- year, which indicates some abnormality in the business and also the operating profit of the company is consistently loss making. Thus, after rejecting the above criteria adopted by the assessee for searching of comparable companies, the TPO finally short listed three companies with the following gross profit ratio.

Daga Global Chemicals Ltd. 3.53%
Indian Potash Ltd. 12.79%
K.P.L. International Ltd. 27.50%

8. According to the above, the average gross profit margin was taken at 14.60% and arm’s length price was determined at Rs. 1,88,37,650, and the enhancement was made at Rs. 81,78,650. Subsequently, in rectification proceedings under section 154, enhancement on account of arm’s length price was reduced to Rs. 34,20,338, after taking the gross profit margin of 10.94%.

9. Before the Commissioner (Appeals), it was contended by the assessee that it is pre-dominantly a trading company and has negligible exports in the distribution segment and, hence, has chosen one of the criteria for selection process as “Sales trading / Gross sales > 90%”, whereas, the TPO, without assigning any reason or justification has changed the criteria to “Sales trading / Gross sales” > than 75%. By doing that the TPO has erred in including the list of comparables of those companies which are also having substantially other activities. With regard to the inclusion of comparables by the TPO and exclusion of the comparable companies selected by the assessee, detail submissions were made with regard to each and every company and the selection criteria adopted by the TPO which has been elaborately discussed from Pages-2 to 4, of the appellate order.

10. The Commissioner (Appeals), duly accepted the assessee’s contentions and deleted the entire adjustment made in the ALP after observing and holding as under:-

“2.3 The argument of the appellant and facts of the case have been considered. After the rectification order passed by the TPO, vide order dated 11/12/2006, the rectified enhancement is Rs. 34,20,335 as against Rs. 81,78,650, determined in the original order being due to the import of finished goods not having been at arm’s length. Further, the A.O. has also passed a rectification order dated 22.6.2006 and allowed set-off of business loss brought forward and the assessed income became nil. The transfer pricing adjustment has been made in respect of the distribution segment of the appellant. There is no dispute as to the resale price method used by the appellant. The dispute is regarding the bench marking the G.P. margins with the comparable companies. It is interesting to note that both the TPO and the appellant have used the same date based but they reached to different results. It is simply because the TPO has removed the comparable companies and also included some other from the comparable companies used by the appellant. To come to the conclusion as to the justification of the transfer pricing adjustment, one has to look into the reason as to why the TPO has deviated from the comparable companies used by the appellant. As the appellant is almost wholly engaged in trading activities, it selected the criteria of sale trading / gross sales > 90% to filter the companies whilly or substantially engaged in Trading activities as comparable companies. The TPO, without assigning any reasons, changed this criterion to 75% by merely stating that it is a reasonable enough indicator. Nowhere is his order, has he satisfied the criterion change, made by him. Moreover, the TPO mentions that qualitatively he has selected companies completely engaged in Chemicals Trading activities, which contradicts the above criterion of 75% selected by him. Due to the above change of criterion by the TPO, he concluded LPL International Ltd. as a comparable company. It is observed that in the appellant’s transfer pricing analysis, this company had got rejected as a comparable company as it failed the quantitative screening test. Obviously, therefore, KPL International is engaged in activities other than Trading i.e., it is not wholly or substantially in trading activities. On the other hand, the TPO deleted the following four companies from the list of comparable companies selected by the appellant viz Oregon Commercial Ltd., Anukaran Commercial Enterprises Ltd., Bijoy Hans Ltd., Nikhil Adhesives Ltd. For rejecting Oregon, the TPO has clearly relied on the data of that company for F.Y. 2003-04, which is clearly violative of Rule-10B(4), which prescribes that the data to be used for comparison shall relate to the financial year of International Transaction and data relating to not more than two years prior to such F.Y. The remaining three companies viz. Anukaran Commercial Enterprises, Bijoy Hans Ltd. and Nikhil Adhesives Ltd. were rejected by the TPO, as these companies have no export transactions. It is observed that the appellant’s exports in this segment are insignificant and therefore, it had used the filter export sales / total sales > 20%, thereby eliminating all companies having meaningful exports. Hence the above companies have been rightly been identified as comparable companies by the appellant. Considering the above discussion, it is quite clear that the TPO is not justified in including KPL International Ltd. and deleting Oregon Commercial Ltd., Anukaran Commercial Enterprises, Bijoy Hans Ltd. and Nikhil Adhesives Ltd. from the list of comparables. Hence, it is directed that the comparable companies selected by the appellant in its transfer pricing study report should be accepted. As such, the adjustment of Rs. 34,20,335, made to the ALP is deleted.”

11. Before us, the learned Departmental Representative, appearing on behalf of the Revenue, submitted that assessee’s gross turnover i.e., total sales was at Rs. 168.44 millions, out of which, sales on account of trading i.e., distribution segment is Rs. 129.02 millions, which comes to 77% of the total sales. Thus, the TPO was wholly justified in taking the filtration criteria of “Sales trading / Gross sales” > 75% and the findings of the Commissioner (Appeals) in accepting the assessee’s contentions on this score is not only erroneous but also incorrect. Besides this, the second filtration of “Export sales / Total sales is > 20%” adopted by the assessee for selecting the comparables is also not correct, as the assessee’s export is around 8% only. He submitted that if these two criteria are taken into consideration for selection of comparable companies, the order of the TPO would, by and large, be justified and the findings given by the Commissioner (Appeals) are wholly divorced from the actual facts and figures and, therefore, cannot be sustained. Lastly, with regard to the inclusion of Oregon Commercials Ltd., as accepted by the Commissioner (Appeals) which has been rejected by the TPO, he relied upon the reasoning given by the TPO that it sales has been going down year-after-year and there was huge losses in the said company.

12. The learned Counsel, on behalf of the assessee, on the other hand, submitted that insofar as the rejection of Oregon Commercials Ltd. by the TPO, the same is not correct, as the turnover of the company dipped only after financial year 2002-03 and subsequent circumstances after the financial year 2002-03, are not relevant and, therefore, such a basis is not called for. He further clarified that insofar as filtration criteria of less than 20% of the export of the total turnover, he submitted that the assessee’s export turnover is around 13% and not 8% as submitted by the learned Departmental Representative, which is evident from the Schedule-XII of Profit & Loss Account. Lastly, he heavily relied upon the findings and the conclusion drawn by the Commissioner (Appeals) which has been arrived at after considering the entire argument and the facts of the assessee’s case.

13. We have carefully considered the rival contentions of the parties, perused the orders of the authorities below and the material placed on record. Insofar as application of “Resale Price Method” to bench mark the gross profit margin with that of comparable companies is concerned, there is no dispute. The main issue, in the present case, revolves around the inclusion and exclusion of the various comparable companies by the assessee as well as by the TPO by applying different filtration criteria in search for the comparable companies. The assessee has adopted the criteria of filtration for search of the companies having sales trading less than 90% of the gross sales, whereas the TPO had applied less than 75%. Other criteria for selection of comparable companies by the assessee is Export sales / Total sales > 20%. As brought out on record, it is seen that, insofar as the first selection criteria for the comparable companies, the contention of the learned Departmental Representative appears to be correct as the assessee’s sales on account of trading, accounts for 77% of its gross sales which is almost very near to the filtration criteria adopted by the TPO. Accordingly, such a criteria adopted by the TPO for selection of comparable companies is absolutely correct. Insofar as the rejection of other filtration criteria adopted by the assessee with regard to the companies having export sales being less than 20% of the total sales, it is seen that assessee’s exports are around 13%, therefore, the selection criteria of 20% of the export does not seems to be correct one. At the same time also, the TPO’s rejection of this criteria is also not correct that it should be taken as “Nil” or zero percentage. Therefore, we are of the considered opinion that the second criteria for selection of comparable companies should be the companies having export sales of in and around 13% which would be quite appropriate. Thus, we direct the TPO to look for the comparable companies, which are having export turnover percentage of around 13% of the total sales and accordingly, select the comparable companies using this criterion. While doing so, the TPO will take into account the export turnover out of total sales, gross of excide duty excluding commission and other income.

14. Finally, in our conclusion, we hold that the first criterion of filtration adopted by the TPO for selecting the comparable companies by applying a search criteria of “Sales trading / Total sales > 75%” is correct and the second filtration criterion for selection of comparables should be the companies having export sales of around 13% of the total sales be adopted. With regard to the elimination of Oregon Commercials Ltd., by the TPO, we find that the reasoning given by the TPO is not correct and, therefore, the said company should be taken into consideration after adopting the above two selection criteria. In view of these observations, we set aside the impugned order passed by the Commissioner (Appeals) and restore the matter to the file of the TPO and direct him to compute the assessee’s average gross profit margin in determining the ALP in accordance with the observations made by us above. We order accordingly.

15. In the result, Revenue’s appeal is partly allowed for statistical purposes.

Sandeep Kanoi

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