Markup on costs incurred is not an arm’s length remuneration for sourcing support service and the taxpayer should be compensated on the basis of value of the goods sourced through it
Li & Fung (India) Pvt. Ltd. v. DCIT (ITAT Delhi – ITA No. 5156/Del/2010]
Tribunal ruling that the amount of compensation to be received ought to be a reflection of the functions performed, assets deployed and risks assumed by the associated enterprises (‘AE’) whilst discharging the business. On the concept of location savings the Tribunal held that the entire savings are passed on to customers, a part of it is retained by the AE, and the same should be factored in while determining the intercompany transfer price.
Facts of the case
Li & Fung (Trading) Ltd., Hong Kong (“HK AE”) entered into contracts with its global third party customers for provision of sourcing services with respect to products2to be sourced by such global customers directly from third party vendors in India. For the sourcing services, the HK AE received a commission global customers at 5 percent of the FOB value of goods sourced. The taxpayer was engaged in providing sourcing support services to the HK AE, and was remunerated by the HK AE at cost plus 5 percent mark-up for provision of these services.
In order to determine the arm’s length price (“ALP”) of its international transactions, the taxpayer applied the Transactional Net Margin Method (“TNMM”) as the most appropriate method using Operating Profit/ Operating Cost (“OP/OC”) as the Profit Level Indicator (“PLI”) and compared an OP/OC of comparables at 4.07 percent as against its own OP/OC of 5.17 percent.
The Transfer Pricing Officer (“TPO”) challenged the cost plus 5 percent model of Li & Fung India and held that Li & Fung India should receive 5 percent not on its own costs but on the FOB value of goods sourced from India by the third party customers.
Further to this, the taxpayer approached the Dispute Resolution Panel (“DRP”), which upheld the TPO’s action but gave partial relief, by reducing 5 percent applied by the TPO (on the FOB value of goods) to 3 percent. The DRP believed that since the cost base was being increased manifold, 5 percent seemed excessive and 3 percent was more reasonable. Aggrieved, the taxpayer appealed to the Tribunal.
- The taxpayer’s contention that it did not enter into any agreements with the third parties did not hold merit since the taxpayer performs all the critical functions to fulfill the conditions of the agreements entered into by the AE with the third parties.
- The taxpayer’s contention that there is no provision in TNMM to include the cost incurred by third parties to compute the NPM of the taxpayer does not hold good in this case. The AE is charging from third party at 5 percent of the FOB value of the exports from India. Such exports are made possible because of the efforts of the taxpayer. Therefore, the taxpayer’s remuneration should also be based on the FOB value of the exports.
- The cost plus markup approach rewards inefficiency and is therefore against basic normal business sense.
- The amount of adjustment cannot exceed the amount that has been retained by the AE out of the total remuneration received from third party customers. Since the majority of the functions and all the crucial functions are performed by the taxpayer therefore the distribution of compensation received by the AE (i.e. 5 percent of the FOB value of exports) between the taxpayer and the AE should be in the ratio of 80:20. The Tribunal directed the AO to compute the ALP in such manner.