ITAT upheld Application of controlled transaction in specific circumstances

Bayer Material Science Private Limited Vs Additional CIT (ITAT Mumbai)

Facts of the case:

• The taxpayer is engaged in the business of manufacturing, trading and indenting of chemical products. The taxpayer had clubbed the trading and indenting activity for the purpose of benchmarking.
• However, since the functions, assets employed and risks undertaken in indenting business are completely different from trading, the Transfer Pricing Officer (“TPO”) held that both the activities should be benchmarked separately and asked the taxpayer to furnish segmental accounts for the same.
• The taxpayer had allocated all the expenses in the ratio of turnover between trading and indenting segment except employee cost and rent which was allocated in the ratio of 1:1. The TPO did not accept the allocation of employee cost and rent and revised the segmental to apportion aforesaid expenses also in the ratio of turnover.
• Based on the same, the operating profit to sales in trading segment and indenting segment was arrived at 9.63% and 0.04% respectively.
• In the aforementioned calculation, the TPO rejected the taxpayer’s contention of considering the gross commission as the turnover rather than turnover achieved by taxpayer’s associated enterprise (“AE”) through its efforts. The TPO accepted the net profit margin in trading activity as being arm’s length. As regards the indenting activity, the TPO gave opportunity to the taxpayer to submit the comparable companies to justify that indenting commission earned from its AEs is at arm’s length.
• The taxpayer did not provide any comparable companies and hence the TPO himself undertook the exercise of identifying comparable companies. However, as no data for the uncontrolled transactions of similar nature was readily available, the TPO considered it appropriate to apply data of controlled transactions.
• Accordingly, TPO identified three comparables cases, namely, Huntsman International Pvt. Ltd.; M/s INEOS ABS (India) Ltd. and M/s Rathi Bros. Madras Ltd., who all were earning indenting commission in the range of 5% to 6% of indenting turnover. In light of these comparable cases, the TPO held the ALP of the indenting commission should be @ 5% of the indenting turnover as against the indenting commission @ 1.5% of the indenting turnover of the tax payer and made the consequent adjustment.
• The TPO rejected the Transactional Net Margin Method (“TNMM”) and applied Comparable Uncontrolled Price (“CUP”) Method.

Ruling of the Tribunal:

• If the FAR analysis indicates diversion in two activities, then benchmarking should be done on separate basis. In the present case, trading and indenting activities are quite distinct from each other and hence, benchmarking is also required to be done separately.
• It is wholly unrealistic to compare the gross indenting commission with the turnover in the trading activity for comparing the ratio of operating profit to turnover.
• The allocation of employee cost and rent on an adhoc basis i.e. 1:1 is not acceptable and in the absence of any other reasonable basis, the bifurcation in the ratio of turnover in the two segments i.e. Trading and Indenting, is quite appropriate.
• If the taxpayer failed to provide any comparable companies even after getting the opportunity, then the TPO is justified in undertaking the exercise of identifying comparable cases on his own for the purpose of making comparison with taxpayer’s results.
• Where it is an admitted position between the tax payer and the tax collector that there is no comparable uncontrolled transaction due to the nature of transaction being such that it is ordinarily between associated enterprises, in such a case, a transaction between two associated enterprises at arm’s length price, though technically called „controlled transaction‟, would partake of the character of `uncontrolled transaction‟ for the purposes of determining the ALP in a later international transaction between two AEs. Thus, in absence of comparable uncontrolled transactions, it would be in order to consider a comparable controlled transaction at arm’s length for the purposes of benchmarking.
• The Tribunal rejected the TNMM and applied CUP Method on the basis that commission income is normally allowed as a percentage of turnover, hence the ratio of net profit to sales cannot be held as appropriate.

Conclusion

This decision highlights the fact that the taxpayers need to meticulously analyze the functions, assets and risks of activities undertaken. Pursuant to that, the taxpayers need to determine whether the activity can be clubbed or should be benchmarked separately. Further, application of controlled transactions is prohibited by law. However, under the facts of the case, since the taxpayer did not provide the comparables called for by the TPO, Tribunal upheld the action of the TPO of selecting controlled transactions as comparable.