Brief of the Case
Delhi High Court held In the case of Johnson Matthey India Pvt. Ltd. vs. DCIT that the purpose of transfer pricing is to benchmark transactions between related parties in order to discover the true price if such entities were unrelated. If Maruti Udyog Ltd. (MUL) had bought the goods directly from party named JMUK there would have been no application of transfer pricing since MUL and JMUK are unrelated entities. MUL would have purchased the goods just like JMIPL did on negotiated prices. There is merit in the contention that the prices at which JMIPL purchased PGM from JMUK were already at arm‟s length and that it was for administrative convenience that MUL had outsourced this function to JMIPL.
The fact that JMIPL is paid a fixed manufacturing charge per unit shows that costs associated with the possible fluctuations in the price of the raw material is passed on to the customers and does not affect the profits of JMIPL.
Facts of the Case
The assessee (JMIPL) is engaged in the business of manufacture and sale of automobile exhaust catalysts. 90% of the shares of the Assessee Company are held by Johnson Matthey Plc. UK (JMUK) through Matthey Finance, BV, Netherlands. JMIPL’s manufacturing unit is located at IMT, Manesar in Haryana. Maruti Udyog Limited (MUL) is a major customer of JMIPL accounting for most of its sales.
JMIPL and MUL agreed on an arrangement where JMIPL would sell finished catalysts to the vendors of MUL under the instructions of MUL. JMIPL used two basic raw materials for the manufacture of the catalyst i.e. precious metals and wash coated substrates. JMIPL procured the precious metals (such as Platinum, Palladium and Rhodium) from one of its associate enterprises JMUK and the wash coated substrates from another AE, Johnson Matthey Malaysia (JMM). JIMPL states that since the prices of precious metals in the market fluctuate heavily, it entered into a Platinum Group Metals (PGM) Forward Cover Agreement with MUL on 6th September 2002.
JMIPL filed its return of income for AY 2003-04 on 2nd December 2003 declaring a total income of Rs.6,36,76,260. The case was picked up for scrutiny. Subsequently, the AO referred the case to the TPO under Section 92 CA (3). The TPO by dated 22nd March 2006 concluded that JMIPL‟s international transaction with JMM was not on an arm’s length basis. He re-determined the value of the international transaction at Rs.62,49,06,744 instead of the reported value of Rs.70,82,93,603. He recommended an addition of Rs.8,33,86,859 to the income of JMIPL. Finally the AO passed the assessment order on 29th March 2006 accepting the order of the TPO and concluding that the difference between the average OP/TC of the comparable companies (16.85%) and that of JMIPL (6.79%) was 10.06% which was double the normal acceptable range of +/-5%. Accordingly, JMIPL’s income was enhanced by Rs.8,33,86,859.
Contention of the Assessee
The ld counsel of the assessee submitted that the cost of the raw material is prone to price fluctuations. In order to ensure that JMIPL does not lose money on sales if the prices of raw materials increase drastically after the placement of the order, the prices at which such raw materials are to be purchased are frozen. This is an established industrial practice which ensures that both parties do not suffer on account of the frequent fluctuations in the PMG market. He submitted that a manufacturer never purchases and stocks the raw material until and unless there is a confirmed order.
He referred to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010 (OECD Guidelines), the United States Regulation on Transfer Pricing and the Taxation Ruling TR 97/20 issued by the Australian Tax Office as well as the ICAI Guidance note on Transfer Pricing, and submitted that given that JMIPL was a contract manufacturer in a highly capital intensive industry, an asset based PLI would be appropriate. Therefore, ROCE was an appropriate PLI. ROCE would be the best indicator of profitability as long as the risks are properly accounted for. In the case of JMIPL for AYs 2002-03 to 2011-12, the Revenue had accepted that it was a contract manufacturer. Therefore any departure from the PLI employed by JMIPL, keeping in line with the guidelines aforementioned, required cogent reasons to be given.
Under the economic theory of capital, capital always flowed from low return to high return activities and in time risk-adjusted return on capital would be equalized. Therefore, ROCE would be the best indicator of profitability in spite of variations in comparable functionalities as long as risks are properly accounted for. He submitted that neither the TPO nor the CIT (A) have offered any cogent reasons for rejecting ROCE as the appropriate PLI.
Alternatively he submitted that if ROE was not acceptable as the PLI, the PLI of OP/TC-RCM should be used. With regard to the raw material, no function was performed by JMIPL, no risk was undertaken and no assets were employed. Therefore, no return could be expected on the raw material purchased by JMIPL. He submitted that the findings of the TPO, CIT (A) and ITAT do not take into account the fact that JMIPL was operating on a fixed manufacturing charge per unit model, being a contract manufacturer. JMIPL’s profit margin was dictated by the negotiations with MUL. JMIPL cannot possibly earn a profit based on a percentage of the raw material used in manufacturing. JMIPL has to procure raw material on the instructions of MUL, at a price dictated by it and from the source selected by MUL. If MUL had bought PGM directly from JMUK, there would have been no application of transfer pricing as MUL and JMUK were unrelated entities. MUL would have purchased PGM at the negotiated prices, as JMIPL was doing presently. Therefore, the price at which JMIPL purchased PGM from JMUK are already at arm’s length. It was only for administrative convenience that MUL has outsourced its function of purchase of raw material to JMIPL but still controlled every element of such raw material, i.e. quantity, price, mode of purchase (spot/forward) etc.
Finally it was submitted that if an enterprise bears no risk in terms of inventory, raw materials etc. and these do not contribute to its returns, such items should be excluded from calculations. If, at all, the PLI of OP/TC had to be used then it had to be after deducting the cost of raw material from the total cost. The said PLI of OP/(TC-RMC) had been in use by JMIPL for AY 2004-05, 2005-06 and 2006-07 and this was accepted by the tax authorities without challenge. Invoking the rule of consistency, as expostulated in Radhasoami Satsang v. CIT (1992) 193 ITR 321 (SC); CIT v. Ashok Mittal (2014) 360 ITR 12 (Del); CIT v. Mohan Meakin Ltd.  189 Taxman 377 (Del) and DIT v. India Habitat Centre  203 Taxman 510 (Del), it was submitted that no departure ought to have been made for the AY in question i.e. 2003-04.
Contention of the Revenue
The ld counsel of the revenue submitted that the attempt by JMIPL at adopting ROCE as the PLI was contrary to Rule 10 B (1) (e) (i) because assets (or capital employed) had no relationship to the international transactions, which were essentially purchase transactions. For making purchases, no assets or capital was required. Thus, cost employed was the appropriate base for calculating the net profit margin under TNMM. This approach had been adopted and upheld by the lower authorities. The fallacy in JMIPL’s approach throughout was to select a base/denominator by referring to what it did as a whole enterprise instead of referring to the international transactions that it had undertaken.
Further he submitted that the purchase of PGM by JMIPL from JMUK was not a pass through transaction since the sale of raw material was not directly made by JMUK to MUL but it was a sale first made to JMIPL which in turn sold it to vendors of MUL. He submitted that a true pass through cost would have been where the purchasers of the final product viz. the automotive catalysts would themselves purchased the raw materials, handed it over to JMIPL as a bailee to utilize it in the manufacture of the products and then purchase the final product by paying to JMIPL a price per unit. In the present case, even through MUL had fixed the price for the precious metals and paid JMIPL the fixed price, there was nothing on record to show that JMIPL was purchasing the precious metals at the same price from its overseas AE. While MUL might finally obtain the precious metals at ALP, the international transaction between JMUK and JMIPL with regard to sale of precious metals may not be at ALP because JMIPL was a wholly owned subsidiary of JMUK. Referring to the order of the CIT (A) he pointed out that the CIT (A) had noted that JMUK at the time of selling the precious metals to JMIPL included it in its turnover and JMIPL included the corresponding purchase in its expenditure side. Once the material was processed and sold to the vendors of MUL, JMIPL included the total sale value in its turnover. Nowhere, did the accounting entries show that the materials purchased were to be treated as a pass through cost.
He too referred to Rule 10B(1)(e)(i) and submitted that in the absence of the agreement between JMIPL and the vendors of MUL being placed on record it could not be said that there was no value addition to the catalyst in question at the time of its sale to the vendors of MUL. If RMC was excluded from TC cost, calculation of the net margin would be a futile exercise. This was because during the year under consideration JMIPL had total revenue of Rs. 88.49 crores against which raw material consumption was Rs. 75.85 crores. Out of total raw material consumption, purchase worth Rs. 69.28 crores was from JMUK. Thus if RMC from JMUK was excluded, very little would remain on which net margin could be computed. It was further submitted that JMIPL’s argument was unsupported by the provisions of the Act and the Rules. They did not envisage removing any element from the appropriate base. Further, it would be self-contradictory to compute ALP of international transaction between JMUK and JMIL on the one hand and remove the figures pertaining to the international transaction from the computation on the other hand.
He further contended that the principle of res judicata may not apply and merely because in the earlier or subsequent AYs JMIPL’s position had been accepted, it did not imply that the same must be adopted for the AY in question as well. Each year had to be considered separately. Further the principle of res judicata did not apply to decisions of the income tax authorities. Reliance was placed on the decisions in New Jehangir Vakil Mills Co. Ltd. v. CIT (1963) 49 ITR 137 (SC) and ITO v. Murlidhar Bhagwan Das (1964) 52 ITR 335 (SC).
Held by CIT (A)
CIT (A) dismissed the appeal of assessee. It was held that since the appellant is not engaged in a seasonal business and the appellant is engaged in the manufacturing of automobile exhaust catalysts and making import of raw-material from its AE, in these circumstances, Return on Capital Employed is not an appropriate PLI in the case of appellant and thus the TPO was right in rejecting such PLI.
Held by ITAT
ITAT upheld the CIT (A) order. It was held that the accounting of the Assessee shows that the cost of raw material is to be treated as a value added cost and not as a pass through cost. Even the AE which are using the precious metal for manufacturing catalyst raw material and they are also accounting the precious metal in the same manner in which the Assessee was doing and nowhere was it being treated as a pass through cost. All these factors showed that the Assessee’s claim to treat the cost of purchase of precious metal as a pass through cost has no basis. Consequently, the ITAT rejected the plea of JMIPL that the cost of raw material should not be added to the total cost.
Held by High Court
The OECD Guidelines state that where PLI is “a net profit weighted to assets” it is the “operating assets” alone that should be used. These include “tangible operating fixed assets, including land and buildings, plant and equipment, operating intangible assets used in the business, such as patents and know-how, and working capital assets such as inventory and trade receivables (less trade payables).” The OECD Guidelines point out that “investments and cash balances are generally not operating assets outside the financial industry sector.” As pointed out by the TPO in the instant case, reliability of ROCE as a PLI depends upon the extent to which the composition of assets/capital deployed by the tested party and their valuation is similar to that of comparables. If operating assets reported in balance sheet do not reliably measure the capital employed, ROCE would be less reliable than financial ratios. If the balance sheet does not accurately reflect the average use of capital throughout year, ROCE would be less reliable.
JMIPL appears to have itself realised the limitations of adopting ROCE as the PLI for the subsequent AYs. It states that it improved upon the PLI used in AY 2003-04 taking into account the economic realities in AY 2004-05. It explains how it arrived at the PLI of OP/TC-RMC after excluding the cost on which no risk was undertaken by the Appellant which is also appropriate for contract manufacturers in terms of the OECD Guidelines. In its written submissions JMIPL itself explains: “The exclusion of cost of raw material in respect of which the Appellant bears no costs or risks presents a very accurate picture of the profit margins of the Appellant. The exclusion of factors which do not affect returns is allowed under all the guidelines mentioned above. This PLI used in AYs 2004-05, 2005-06 and 2006-07 was accepted without any objection by tax authorities.”
Based on above submission, it appears to the Court that the rejection of ROCE as PLI by the Revenue for the AY in question is a fact that has been accepted and acted upon by JMIPL itself for the subsequent AYs when it changed its PLI to OP/TC-RCM, which appears to have been accepted by the Revenue. Accordingly Question (i) is answered in the negative, i.e. in favour of the Revenue and against the Assessee.
The clauses of the agreement between JMIPL and MUL indicate that JMIPL’s profit margin is dictated by its negotiations with MUL. The clauses do bear out the submission of JMIPL that it is obliged to procure the raw material on instructions of MUL at a price dictated by MUL from the source selected by MUL. JMIPL is entitled to a per unit fixed manufacturing charge over and above the actual cost of the raw material. The submission of JMIPL that entire cost of raw materials comprising of precious metals and substrates is passed on to or recovered from the ultimate customer without any mark up has not been able to be countered b the Revenue. In other words the contention of JMIP that its profit is not at all affected by the cost of raw materials remains uncontested. The submissions of the Revenue as to what are true pass through costs fail to acknowledge the actual arrangement between JMIPL and MUL as reflected in the clauses of the agreement as well as in other documents and letters placed on record.
The exclusion of pass through costs from the denominator of total costs where the financial ratio of OP to TC is used is acknowledged in para 2.93 and 2.94 of the OECD Guidelines. Para 2.93 states that the extent to which it would be acceptable “at arm’s length to treat a significant portion of the tax payer’s costs as pass-through costs to which no profit element is attributed (i.e. costs which are potentially excludable from the denominator of the net profit indicator)” would depend on the extent to which “an independent party in comparable circumstances would agree not to earn a mark-up on part of the costs it incurs.
Para 2.94 of the OECD Guidelines further acknowledges that comparability issues may arise in practice where limited information is available on the breakdown of the costs of the comparables. This Court has in CIT v. EKL Appliances Ltd. (2012) 345 ITR 241 (Del) has noted that the OECD Guidelines have been recognised in our tax jurisprudence. What is however, is significant is that in the absence of any reliable comparable data, and in the absence of proper reasons, it would not be justified for the Revenue to simply reject a financial ratio adopted by the Assessee for computing the net profit margin by excluding a pass though cost from the TC in the denominator. The expression “any other relevant base” occurring in Rule 10 (1) (e) (i) of the Rules is wide enough to encompass a denominator that excludes pass through costs as long it is demonstrated to be at arm’s length.
It is further importantly pointed out that the very purpose of transfer pricing is to benchmark transactions between related parties in order to discover the true price if such entities were unrelated. If MUL had bought the PGM directly from JMUK there would have been no application of transfer pricing since MUL and JMUK are unrelated entities. MUL would have purchased the PGM just like JMIPL did on negotiated prices. There is merit in the contention that the prices at which JMIPL purchased PGM from JMUK were already at arm‟s length and that it was for administrative convenience that MUL had outsourced this function to JMIPL. The submission of the Revenue that the accounting entries of JMUK do not treat the cost of PGM as a pass through cost fails to acknowledge that JMUK is in the business of selling PGM. It does not require to charge JMIPL for processing the raw material i.e. PGM as that is passed on to MUL’s vendors and thereby to MUL. The fact that JMIPL is paid a fixed manufacturing charge per unit shows that costs associated with the possible fluctuations in the price of the raw material is passed on to the customers and does not affect the profits of JMIPL. The submission of the Revenue that the international transaction between JMUK and JMIPL with regard to sale of precious metals may not be at ALP because JMIPL was a wholly owned subsidiary of JMUK does not appear to be based on any definite information but on suspicion. No convincing reason is forthcoming in the orders of the TPO, the CIT (A) or the ITAT for rejecting the alternate plea of JMIPL as regards the PLI being OP/TC-RM.
Also the Revenue has been unable to deny that the above alternate computation of the net profit margin by JMIPL for the subsequent AYs 2004-05, 2005-06 and 2006-07 has been accepted by the Revenue. While as a general proposition each assessment year should merit independent consideration, the Court finds no reason why for the AY in question, i.e. 2003-04, with no distinguishing features being pointed out, the Revenue would want to reject the alternate PLI adopted by JMIPL. For the above reasons, Question (ii) is answered in the affirmative, i.e in favour of the Assessee and against the Revenue.
Accordingly, appeal of the assessee allowed.