Applicability of Resale price method (RPM) in case of a Distributor: Critical Analysis of ITAT Delhi order in case of Karcher India Pvt. Ltd.
Introduction
Indian Transfer Pricing landscape has undergone significant shifts in the last decade, these constant changes and trends make it one of the most Dynamic legal fields which keeps evolving due to changes in global market conditions. The staple question of any Transfer pricing litigation surrounds the choice and applicability of the Most Appropriate Method (MAM) utilised by the Assessee in its Transfer Pricing Report to Benchmark its international transactions with its Associated Enterprises. The Applicability of each of MAM is contingent upon a number of factors. These factors have been codified as criterion for selection of each MAM under the Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines for Multi National Enterprises and Tax Administrations, United Nations Transfer Pricing (TP) Manual and the Income Tax Act, 1961. This Article aims to highlight the legal position surrounding the question of selection and choice of MAM in case of a Plain risk Distributor which purchases finished goods for the purpose of reselling in the domestic market by critically analysing the recent Judgement of Hon’ble Income Tax Appellate Tribunal Delhi pertaining to the Assessment done in the case of Karcher Cleaning Systems Pvt. Ltd.
Brief Facts
1. Karcher India (The Assessee) is a fully owned subsidiary of Karcher Beteilgungs GmbH and was engaged in trading in cleaning equipment, providing after sale services and reselling it.
2. The Assessee purchased cleaning equipment to the tune of Rs. 17,72,27,847/- during Financial Year (F.Y.) 2011-2012 from its Associated Enterprises (AEs). For assessment year 2012-13 the company filed its return of income in which it declared a loss of Rs. 7,89,87,580/- and income from other sources at Rs. 13,14,740/-.
3. The company’s case was selected for scrutiny under CASS, under section 143(2) of Income Tax act, 1961. As the value of international transactions of the assessee was more than 5 crores.
4. The assessee submitted its detailed break-up of the exceptional expenditure before the TPO. The TPO through his order under section 92CA (3), made an adjustment of Rs. 3,50,88,517/-, to the income of the Assessee and also rejected the RPM analysis that was carried out by the assessee and proposed application of Transactional Net Margin Method (TNMM).
5. The Ld. DRP also rejected the objections of the assessee company, filed by it against the draft assessment order.
6. The assessee company filed an appeal before the Income tax Appellate Tribunal (ITAT) against the Additional Commissioner of Income Tax’s order, that was framed u/s 143(3) r.w.s. 144(13) of the Income Tax Act.
Legal Issues
1. Whether RPM method should be regarded as the MAM for benchmarking international transaction?
The Assessee in its Transfer Pricing Study utilised the Resale Price Method for Benchmarking International Transaction of Purchasing Cleaning Systems from Karcher Germany. The applicability of RPM as the MAM was questioned by the Ld. TPO and the same was rejected, instead, TNMM was selected as the MAM by the Ld. TPO stating that in case of the Assessee, Net margins will be more appropriate to benchmark the transaction rather than Gross margins as opted by the Assessee.
2. Whether incurrence of Distribution expenses, Selling expenses and Employee costs would significantly affect the determination of PLI under RPM Method?
The Department rejected the TP study furnished by the Assessee by stating that assessee has incurred significantly high employee costs along with Selling and Distribution costs and as a result of this RPM method and Gross margins for the Profit Level Indicator will furnish unreliable results.
Party Contentions
Assessee’s submissions
1. The Ld. TPO didn’t appreciate the characterization of the appellant as a normal distributor.
> The Appellant highlighted its agreement with the AE which clearly shows its position as distributor and reseller and also that no value addition was done to the products.
> The Appellant pointed to its Functional and Risk Analysis (FAR) as per which imported goods were not for local assembly into finished goods.
> Furthermore, The Appellant submitted that the decision regarding incurring expenses for performing functions like advertising, and marketing, is the decision of a company’s management.
> And the expenditure of INR 1,61,62,594/- was exceptional and non-repetitive and was mainly for establishing market presence.
2. The TPO disregarded the application of RPM by the appellant company and applied TNMM for determining arm’s length price without any cogent reasons.
> The appellant has relied on various versions of guidelines issued by the OCED and the UN, which has mentioned about the applicability of RPM in case of a normal risk distributor.
> The primary function of Appellant is of reselling the products purchased from the AE. And the same function is performed by the comparable that were selected by the appellant.
3. The TPO erred in disregarding the corroborative analysis that was undertaken by the applicant of the CUP method.
> Man Machine India Pvt. Ltd. was the one to work as an authorised distributor of Alfred Germany and Comparable Uncontrolled Price method (CUP) was used by the Man Machine and also by Appellant for analysing transactions pertaining to the purchase of goods for resale in India.
> The Ld. Dispute Resolution Panel (DRP) denied application of CUP method by appellant saying it to be unreliable as according to DRP appellant is different from Man Machine owing to the value addition activities that the appellant undertakes, whereas Appellant submits of no involvement in any value addition activity.
4. The Ld. TPO erred in including non-operating and non-recurring items in the cost base of the company for computing its operating margin and proposing adjustment on the basis of the same.
> The appellant submitted that the expenses incurred by it of INR 16,162,594/- were of exceptional nature, and sought to have been excluded from the Arm’s Length Price (ALP) computation. The financial statements of the year that ended March 31, 2012 made it evident that appellant was in its first year of operations.
> Such huge costs were not incurred by the appellant in the subsequent year. The details of the same are provided as additional evidences.
> Also, the assessee on the basis of its first year of operations, can’t be compared to other companies that has been in existence for many years and can be said to apply TNMM method.
Department Submissions
5. RPM method as adopted by the Appellant is not viable in case of the Appellant
> Under RPM less product comparability may be required but a closer comparability of products will produce a better result. The reliability of RPM may be affected if there are material differences in the way the associated Enterprises control and manage the business.
> RPM is more accurate if the realization of reseller good can be done within a short period time as the resale price might be affected due to factors like change in market condition change in the exchange rate and cost etc. with more lapse of time.
> Expected resale margin will be influenced by the level of activities performed by the reseller and making adjustments for those differences is not possible in the case a of comparable company selected by the people based on information available in public domain.
6. RPM method cannot be applied due to extraneous factors which affect the Gross Margins
> The resale price margin expected to vary according to the exclusivity right to resell the goods as a value to be attributed to such exclusive right will depend to some extent upon the geographical scope and the existence and relative competitiveness of possible substitute on the appropriate resale price margin to examined carefully in each case.
> If the assessee is dealing in branded product, comparability should be done with comparable which are dealing with branded products.
> The function performed which affect the resale price margin should be similar to what it should be possible to make an adjustment for such differences, if the cost of these functions are accounted for as the cost of cost of goods are accounted for as part of cost of goods no separate adjustment are required as the gross profit would include the cost of function also how were the cost of opposite functions are accounted for as a part of operating expenses that there will be distortion in the gross profit margin and entities to be corrected
> Functional profile of the supplier is important under RPM as when a function is performed by the supplier and not by the distributor then the purchase price will be enhanced in comparison to case where distributor is performing such function.
> Selling and distribution expenses that are directly connected with selling and distribution function of the assess are not considered for comparable neither in case of assess nor in case of comparable hence RPM applied does not give true picture of comparative analysis.
Court Analysis
The Hon’ble ITAT observed that it is not in dispute that the assessee is engaged in trading of goods, and does not add value to the goods purchased from related parties. The ITAT for the relationship of Appellant with Karcher Germany as that of a manufacturer and distributor relied on the inter-company agreement.
Reliance was placed on the observations of TPO himself that reseller generally performs the functions of advertising, marketing, distribution and guaranteeing the goods, financing the stocks and warranty risk. ITAT was of the opinion that the assessee also performs all these functions, which a normal distributor/reseller would undertake in a comparable uncontrolled transaction.
The Hon’ble court was of the view that the extent of incurring expenses including employee costs is based on the decision of a company’s market penetration policies that have been adopted by a company.
The characterization of a reseller, who doesn’t add value to the products would not change owing to the mere fact that the tested party and comparables have incurred varying levels of employee costs, for boosting company’s own sales volume.
The Hon’ble ITAT relied on the case of M/s Videojet Technologies [I] Pvt. Ltd. (ITA no. 6956/MUM/2012) where the hon’ble tribunal laid down that a normal distributor will undertake all such functions which are related to sales of a product and the tribunal was not able to accept the TPO’s reason that the assessee performing these functions which would involve huge costs and that RPM method will not represent the correct gross profit margin.
The Hon’ble Tribunal was of the view that for application of RPM method what is relevant is whether there is any value addition or not to the goods purchased for resale or not. In case of no value addition, and of purchased goods being resold in the market in the same form, the gross profit margin earned from such transactions is the benchmark for the international transaction of the assessee, by taking RPM as the most appropriate method. The Hon’ble Tribunal held the view that only the transaction of import of goods were to be benchmarked and all other functions carried out by assessee have no nexus with the import transactions, and are not relevant for benchmarking analysis.
The Hon’ble Tribunal supported its view by the order of ITAT Pune Bench in the case of Fresenius Kabi India (P) Ltd. Vs. DCIT (ITA No. 235/Pun/2013), wherein it was held that in case of a distribution activity, the selling and marketing expenses which are borne by the assessee would not lead to any value addition to the product in question.
The Hon’ble ITAT Delhi also relied on the case of Nokia Pvt. Ltd. 153 ITS 508 where the tribunal held that Marketing and Advertisement expenses by the assessee and other comparables don’t affect the determination of ALP under RPM in any manner.
This Tribunal held that the Appellant is a pure trading company involved in the distribution activity without adding any value to the purchased product and hence RPM is the most appropriate method.
Conclusion
From perusal of the above highlighted adjudication done by the Hon’ble ITAT Delhi, the following position of law can be inferred:
1. The characterisation of the Assessee primarily depends upon its agreement with its Associated Enterprises.
2. If the Assessee who is engaged in trading of goods and reselling operates as a Plain risk Distributor then the characterisation of the Assessee as a reseller would not change owing to the fact that the tested party and comparables have incurred varying levels of employee costs for increasing Assessee’s own sales.
3. Normal Distributor will undertake all such functions which are related to the sales of a product. The extent of expenses incurred including employee costs is the sole prerogative of management of the Assessee company.
4. RPM’s applicability as the MAM solely depends upon whether there was any value addition done by the Assessee to the goods purchased for reselling in the Domestic market.
The Hon’ble ITAT Delhi accepted the submissions of the Appellant and ruled in favour of the Appellant, accepting the TP report and RPM as the Most Appropriate Method in the instant case.
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