Lenovo (India) Pvt Ltd Vs ITO (ITAT Bangalore)
ITAT Bangalore held that Comparable Uncontrolled Price (CUP) is the most appropriate method for determining the Arm’s Length Price of the assessee for the importing of goods for manufacturing segment.
Facts- The assessee company is engaged in the business of trading, manufacture and sale of desktops, lap tops, servers and smart phones.
The case was selected for scrutiny through CASS for complete scrutiny. Accordingly, statutory notices were issued to the assessee and various details were called for. In response to notice issued, the assessee company submitted details from time to time which were examined from documents submitted. It was noted that the company had international transactions exceeding Rs.10 crores, therefore, the case was referred to the TPO u/s 92CA of the Act for determination of arms length price after obtaining prior approval from the competent authority. The ld. TPO after receipt of reference, called the documents maintained u/s 92D(3) of the Act.
The ld.TPO from tax payers study report noticed that the assessee had adopted CUP method as the most appropriate method for import of parts of manufacture of personal computers for determination of PLI. The ld.TPO after considering the written submissions, computed the adjustment of ALP after applying TNMM as the most appropriate method and determined the adjustment for Manufacturing segment. The DRP also accepted the reasons given by the TPO for applying the TNMM as most appropriate method for computation of Arms Length Price.
The assessee contested as per grounds of appeal for TP adjustment of Rs. 4,27,47,621/- for the manufacturing segment after passing the final assessment order.
Conclusion- We noticed from the documents submitted by the assessee that this issue has been continuously held in favour of the assessee that the CUP is the most appropriate method for determining the ALP of the assessee for the importing of goods for manufacturing segment.
Respectfully following the judgment of the coordinate bench of the Tribunal in assessee’s own case, we allow the grounds raised by the assessee that the CUP is MAM for the determination of international transactions for the computation of PLI in above terms.
FULL TEXT OF THE ORDER OF ITAT BANGALORE
This is an appeal filed by the assessee against the order passed by the NFC dated 28-04-2021 DIN ITBA/AST/S/143(3)/2021-22/1032713409(1) with the following grounds of appeal :-
I. General Ground:
1. The final assessment order dated 28 April 2021, passed by the learned AO under section 143(3) read with section 144C(13) of the Income-tax Act, 1961 (“the Act”), the directions issued by the Honourable Dispute Resolution Panel (“DRP”) under section 144C(5) and the order passed by the learned Transfer Pricing Officer (“TPO”) under section 92CA(3) of the Act, to the extent prejudicial to the Appellant, are not in accordance with the law and made in violation of the principles of equity and natural justice and are contrary to the facts and circumstances of the present case.
II. TP adjustment of INR 4,27,47,621 in relation to manufacturing segment:
2. The Honourable DRP and the learned AO / TPO have erred in law and on facts in making transfer pricing (“TP”) adjustment of INR 4,27,47,621 to the returned income of the Appellant and in holding that the international transactions undertaken by the Appellant with its associated enterprises (“AEs”) in the manufacturing segment were not at arm’s length.
Rejection of Internal Comparable Uncontrolled Price Method adopted as the most appropriate method by the Appellant:
3. The Honourable DRP and the learned AO / TPO have erred in law by rejecting the application of Internal Comparable Uncontrolled Price (“Internal CUP”) method selected as the most appropriate method (“MAM”) by the Appellant for benchmarking the international transaction of import of raw materials in relation to manufacturing segment, without giving any cogent and valid reasons for such rejection.
4. The Honourable DRP and the learned AO / TPO have erred in rejecting the Internal CUP method as MAM when the same has been upheld in Appellant’s own case in preceding years as below:
a. Upheld by the jurisdictional bench of Honourable Income-tax Appellate Tribunal (“ITAT”) for AY 2006-07 (1st and 2nd round), AY 2009-10, AY 2010-11 and AY 2015-16;
b. Upheld by the Honourable DRP for AY 2006-07 (2nd round) and AY 2010-11; and
c. Accepted by the learned TPO for AY 2007-08 and AY 2008-09.
5. The Honourable DRP and the learned AO / TPO have erred in not following the settled principle based on the rulings of the Honourable Supreme Court (“SC”) that where a fundamental fact permeates through more than one year and is accepted by the Revenue authorities, it should not be arbitrarily rejected.
6. The Honourable DRP and the learned AO / TPO have erred in rejecting Internal CUP as MAM by providing following reasons which are incorrect and contrary to facts of the present case:
a. This method is applied by using weighted average billing rate; and
b. There is no publicly available information on prices charged in independent transactions of similar or identical nature, so External CUP cannot be applied.
Notwithstanding and without prejudice to the above grounds that the Internal CUP is the MAM,
7. The Honourable DRP and the learned AO / TPO have erred in law and on facts by adopting the Transactional Net Margin Method (“TNMM”) as the MAM for benchmarking the international transaction of import of raw materials in relation to manufacturing segment.
8. The Honourable DRP and the learned AO / TPO have erred in law in rejecting the TP documentation maintained by the Appellant:
a. Rejecting the TP documentation without providing cogent reasons, which has been prepared by the Appellant in the manner contemplated under the relevant provisions of the Act and the Income-tax Rules, 1962 (“the Rules”).
b. Rejecting the TP documentation of the Appellant as “not reliable or correct”, under Section 92C(3) of the Act, merely because the learned TPO did not agree with the method adopted by the Appellant in its the TP documentation.
9. The Honourable DRP and the learned AO / TPO have erred in law in adopting the below filter for conducting TP analysis:
a. Rejection of comparable companies having different financial year ending (other than March 31, 2016)
b. Rejection of companies having persistent losses
10. The Honourable DRP and the learned AO / TPO have erred in law and on facts in not rejecting the following companies which are not comparable to the Appellant due to reasons including functional dissimilarity, presence of significant R&D etc.:
a. Bhagwati Products Limited
b. Exicom Tele-Systems Limited
11. The learned AO / TPO has erred in law and on facts in not accepting the following companies which are comparable to the Appellant and thereby not considering the detailed submissions of the Appellant. Further, the learned TPO has not provided any reasons for the same in the TP Order:
a. Hitachi Hi-Rel Power Electronics Pvt. Ltd
b. Powersonic Electric Solution India Pvt. Ltd
c. V X L Instruments Ltd
d. CCS Infotech Limited
e. TVS Electronics Limited
12. The Honourable DRP and the learned AO / TPO have committed arithmetical errors in computing the margin of the following company:
a. Exicom Tele-Systems Limited
13. The Honourable DRP and the learned AO / TPO have erred in law by not granting appropriate favourable economic adjustments (including the working capital adjustment) while calculating the arm’s length margin for final set of comparable companies under the TNMM for the manufacturing segment.
III.TP adjustment of INR 125,54,51,517 on account of alleged excess AMP expenditure pertaining to trading segment:
14. The Honourable DRP and the learned AO / TPO have erred in law and on facts, in making TP adjustment of INR 125,54,51,517 to the returned income of the Appellant by assuming the existence of an alleged international transaction of brand promotion services to AE and alleging the same to be not at arm’s length in terms of the provisions of sections 92C(1) and 92C(2) of the Act read with Rule 10D of the Income tax Rules, 1962 (“the Rules”).
AMP expenditure not an international transaction
15.The Honourable DRP and the learned AO / TPO have erred in law and on facts by alleging that the unilateral Advertising, Marketing and Promotion (“AMP”) expenditure, being payments made to third parties, is an “international transaction” as per the provisions of section 92B of the Act, without appreciating that they had not incurred any expenditure on the directions of the AE.
16. The learned TPO erred in suo-moto benchmarking the alleged international transaction related to the AMP expenses without there being any order or reference from the AO in relation thereto.
17. The Honourable DRP and the learned AO / TPO have erred in unilaterally re-characterizing the AMP expenses being payments made by the Appellant to independent third parties as an ‘international transaction’ under chapter X of the Act, and particularly when the jurisdiction of the TPO is only to compute arm’s length margin of the international transaction.
18. The Honourable DRP and the learned AO / TPO have erred in law and on facts by not appreciating that no such TP adjustment can be made in respect of AMP expenses (being legitimate, bona fide and deductible business expenditure) incurred by the Appellant towards payments to independent parties, the benefit of which accrues to the Appellant alone.
19. In this regard, the Honourable DRP and the learned AO / TPO have failed to consider that the alleged AMP expenses were incurred exclusively in relation to the Appellant’s business, which is also evident from the fact that the expenditure has been accepted by the AO under section 37 of the Act.
20. The Honourable DRP and the learned AO / TPO have erred in law and on facts in concluding that the “conduct of the Appellant clearly shows the presence of an arrangement for promotion of marketing intangibles”.
21. The Honourable DRP and the learned AO / TPO have erred in law and on facts by not appreciating that the Appellant is a distributor of products imported from its AEs on a principal-to-principal basis, and hence has incurred the AMP expenses solely for improving its business market and increasing the sales of its products in India.
22. The Honourable DRP and the learned AO / TPO have failed to appreciate that the Appellant has been uninterruptedly using the said brand for the last several years and till date, thus, all benefits endured to the Appellant, for which the Appellant has not even been paying any royalty to its AE. Consequently, for all purposes the Appellant is the sole beneficiary of all the benefits of AMP expenditure incurred during financial year ending 31 March 2016.
23. The Honourable DRP and the learned AO / TPO have erred in law and on facts, byholding that the Appellant by incurring excessive AMP expenditure has resulted in creation of marketing intangible in favor of the AE, for which it should be compensated by the AE.
24. The Honourable DRP and the learned AO / TPO have erred in law and on facts by disregarding judicial pronouncements in undertaking TP adjustments in relation to AMP.
Notwithstanding and without prejudice to the above grounds that the AMP expenditure incurred by the Appellant does not constitute an international transaction under Chapter X of the Act, the Appellant craves to raise following grounds of objections on merits.
25. The Honourable DRP and the learned AO / TPO have erred in disregarding the Appellant’s submission that the Appellant would operate at arm’s length under following scenarios using RPM and TNMM for trading segment and hence no adjustment is warranted in this regard:
a. Scenario 1 – Adjusted gross margin approach: The adjusted gross profit margin of the Appellant after considering AMP expenditure is compared with the adjusted gross profit margin of the comparable companies.
b. Scenario 2 – Adjusted marked-up gross margin approach: The adjusted gross profit margin of the Appellant after considering AMP expenditure along with mark-up is compared with the adjusted gross profit margin of the comparable companies.
c. Scenario 3 – Net profit margin approach: The net profit margin of the Appellant is compared with the net profit margin of the comparable companies.
d. Scenario 4 – Adjusted marked-up net margin approach: The net profit margin of the Appellant after considering AMP expenditure along with mark-up is compared with the net profit margin of the comparable companies.
26. The Honourable DRP and the learned AO / TPO have erred in not considering scenario 3 approach as depicted in Ground 25 above, when the said approach has been upheld in Appellant’s own case by the jurisdictional bench of Honourable ITAT for AY 201516.
27. The Honourable DRP and learned AO / TPO have erred in law in not considering the detailed submissions of the Appellant that even after performing an AMP expense intensity adjustment to the comparable companies, the adjusted net margin earned from the trading activity by the Appellant is at arm’s length.
28. The Honourable DRP and learned AO / TPO have erred in not appreciating that if for the comparable trading companies selected by the Appellant and accepted by the learned TPO, an additional revenue (AMP expenditure incurred plus a mark-up as determined by the learned TPO) is imputed to the respective revenues of comparable companies on account of the alleged brand building activity, the net margin earned by Appellant will still be within the tolerance band of the adjusted net margin of the comparable companies.
29. The Honourable DRP and learned AO/TPO have erred in applying the Bright Line Test as a methodology to quantify the brand promotion service alleged to have been rendered by the Appellant to its AE. Further, the Honourable DRP and learned AO / TPO have erred in selecting companies that are not comparable to the intensity of AMP functions of the Appellant for computing the AMP/Sales ratio and thereby considered companies that have very low AMP/Sales ratio.
29.The Honourable DRP and the learned AO / TPO have erred in law and on facts in concluding that the distribution and AMP are two distinctive functions and requires to be remunerated separately.
30. The Honourable DRP and the learned AO / TPO have erred in law and on facts by characterizing the incurrence of AMP expense as a provision of brand promotion services by the Appellant to its AE requiring a mark-up.
31. Without prejudice to the other grounds, the Honourable DRP and the learned AO / TPO have erred in law and on facts in not appreciating that the Appellant has not provided any value added / brand building services to its AE by incurring AMP expenses, and therefore, no mark-up could have been charged / levied on such expenses, even if the same was to be characterized as an ‘international transaction’.
32. Without prejudice to the other grounds, the Honourable DRP and the learned AO / TPO have erred in not appreciating that in view of the Appellant being contractually assured of a margin after cost recovery, the entire AMP expenditure has in fact been recovered from the AE and hence adjustment could only be restricted to markup, that too if the operating margin of the company was not at arm’s length.
Benchmarking analysis undertaken in determining the mark-up to be charged on the alleged brand promotion services
33. The Honourable DRP and the learned AO / TPO have erred in carrying out a search for comparable companies in order to determine the mark-up that the Appellant should have recovered from the AE in relation to the alleged AMP expenses considered to be in the nature of brand promotion service.
34. The Honourable DRP and the learned AO / TPO have erred in determining the mark-up for the alleged international transaction of brand promotion services by selecting following companies which are not comparable to the Appellant due to reasons including functional dissimilarity, failing quantitative filters, etc. Further, the learned TPO has not provided any reasons for the same in the TP Order:
a. Killick Agencies & Marketing Limited
b. Scarecrow Communications Limited
35. The Honourable DRP and the learned AO / TPO have erred in law and on facts in not accepting the following companies which are comparable and thereby not considering the detailed submissions of the Appellant. Further, the learned TPO has not provided any reasons for the same in the TP Order:
a. Showhouse Event Management Private Ltd
b. MCI Management India Private Limited
c. Quadrant Communication Limited
d. Esha Media Research Limited
e. Nielsen (India) Private Limited
IV Other TP related grounds
36. The Honourable DRP and the learned AO / TPO have erred by not carrying out the determination of arm’s length price as required under section 92C of the Act read with Rule 10D of the Rules.
37. The Honourable DRP and the learned AO / TPO have failed to appreciate the Appellant’s commercial judgment about the application of arm’s length principle which is tied to the business realities.
38. The Honourable DRP and the learned AO / TPO have erred in law and on facts, in making several observations and findings, which are based on incorrect interpretation of law and contrary to facts of the case.
V. Disallowance of provision for warranty
39. The Honourable DRP and the learned AO have erred in law in arbitrarily disallowing the provision for warranty amounting to INR 185,94,26,047 claimed as a deduction by the Appellant, holding the same to be contingent and unascertainable in nature.
40. The Honourable DRP and the learned AO have erred in law by not following the order of the Honourable Karnataka High Court (“HC”) in the Appellant’s own case for AY 2007-08 and AY 2011-12 and Honourable ITAT in the Appellant’s own case for the AY 2006-07, AY 2007-08, AY 2010-11, AY 2011-12 and AY 2015-16, wherein it was held that the provision for warranty has been created on a scientific basis and that the same should be allowed as a deduction.
41. The Honourable DRP and the learned AO have not appreciated the fact that the Appellant maintains its books on a mercantile basis of accounting and that the said warranty provision has been created on a scientific manner followed consistently over the years, having due regard to the nature of activity, its global warranty accrual processes and the industry requirement in which the Appellant operates.
42. The Honourable DRP and the learned AO have erred on facts in failing to consider that the Appellant has provided for warranty on a scientific and consistent manner every year applying the principles laid out by the Honourable SC in the case of Rotork Controls India Private Limited1 and therefore such expenditure is an allowable deduction under section 37 of the Act.
43. The Honourable DRP and the learned AO have erred in appreciating that the Appellant provides warranty for a period from one year to three years on its products and accordingly, the entire provision could not be utilized in one year and has to be spread over multiple years.
VI. Addition of provision for warranty to the book profits
44. The Honourable DRP and learned AO have erred in adding back the warranty provision created during the relevant AY amounting to INR 185,94,26,047 to the book profit of the Appellant.
45. The Honourable DRP and the learned AO have erred in law and on facts in holding that the warranty provision of INR 185,94,26,047 is an unascertained liability and therefore, not appreciating that the warranty provision is created on a scientific basis after considering technical estimates which is consistently followed by the Appellant year on year.
46. The Honourable DRP and the learned AO have erred in law by not following the order of the Honourable Karnataka HC in the Appellant’s own case for AY 2007-08 and AY 2011-12 and Honourable ITAT in the Appellant’s own case for the AY 2006-07, AY 2007-08, AY 2010-11, AY 2011-12andAY 2015-16, wherein it was held that the provision for warranty has been created by the Appellant on a scientific basis and that the same should not be treated as an unascertained liability and therefore, provision for warranty should not be added back while re-computing book profits under section 115JB of the Act.
VII. Disallowance of unrealized foreign exchange loss
47. The Honourable DRP and learned AO have erred in disallowing the unrealized foreign exchange loss amounting to INR 17,55,00,000 claimed as a deduction under section 37 of the Act while computing the taxable income.
48. The Honourable DRP and learned AO have erred in law and on facts by treating the unrealized foreign exchange loss as marked-to-market loss, arising to the Appellant on account of restatement of financial instruments, i.e., forex derivatives/ forward contracts and thereby, categorizing the same to be ‘speculative’ under section 43(5) of the Act, disregarding the fact that the unrealized foreign exchange loss is on account of restatement of debtors, creditors and other trade advances, which does not fall under the purview of section 43(5) of the Act.
49. The Honourable DRP and learned AO have erred in not appreciating that the unrealized foreign exchange gain at the time of realization, if any, would be duly offered to tax.
50. The Honourable DRP and learned AO have not appreciated the fact that the treatment of unrealized foreign exchange loss is in line with Accounting Standard (“AS”)-11 and also, the principles of ‘prudence’ provided in AS-1, which is required to be complied by the Appellant under section 145(2) of the Act.
51. The Honourable DRP and learned AO have erred in not appreciating the fact that the foreign exchange loss incurred in the course of Lenovo India’s business operations and is in the nature of revenue expenditure deductible under section 37 of the Act in the year of fluctuation in the rate of exchange and not in the year of settlement of such amount.
52. The Honourable DRP and learned AO have erred in disregarding the decisions of the SC and various other courts relied on by the Appellant in support of its arguments during the course of assessment proceedings.
53. The Honourable DRP and learned AO have erred in law and on facts by placing reliance on the decision of the SC in the case of Sanjeev Woolen mills2 which dealt with valuation of closing stock and also, the decision of Allahabad HC in the case of Oriental Motors Car Co P. Ltd.3which dealt with allowability of infringement commission and therefore, the said cases could be distinguished from the facts of the Appellant.
54. The Honourable DRP and learned AO have erred in law and on facts by relying on the Instruction No 17/2008issued by the Central Board of Direct Taxes (“CBDT”) which provides for guidelines for conducting assessment of banks and hence, not relevant to the present case. Further, the Honourable DRP and learned AO have erroneously concluded that unrealized foreign exchange loss is a contingent liability without appreciating that the same is computed as per the principles laid down in AS-11.
55. The Honourable DRP and learned AO have erred in law and on facts by relying on the Instruction No 3/2010issued by CBDT which provides for allowability of losses on account of forex derivatives and hence, not relevant for the facts of the Apellant’s case.
VIII. Addition of unrealized foreign exchange loss under section 115JB of the Act
56. The Honourable DRP and learned AO have erred in law and on facts by adding back the unrealized foreign exchange loss amounting to INR 17,55,00,000 to the book profit of the Appellant.
57. The Honourable DRP and learned AO have erred in concluding that unrealized foreign exchange loss is an unascertained liability without appreciating the fact that the treatment of unrealized foreign exchange loss is in line with AS-11 issued by ICAI and also, the principles of ‘prudence’ prescribed in AS-1, which is required to be complied by the Appellant under section 145(2) of the Act.
58. The Honourable DRP and learned AO have erred in not appreciating the fact that the foreign exchange loss has been incurred by Lenovo India in the course of its business on account of restatement of debtors, creditors and other trade advances which is not an unascertained liability and therefore, should not be added back while computing book profits under section 115JB of the Act.
59. The Honourable DRP and learned AO have erred in disregarding the decisions of the SC and various other courts relied by the Appellant in support of its arguments during the course of assessment proceedings.
60. Without prejudice to the above, the learned AO has erred in law and on facts in not providing the Assessee an opportunity of being heard before making an addition to the book profits under section 115JB of the Act for the subject AY, thereby violating the principles of equity and natural justice.
IX. Other grounds
61. The learned AO has erred in law and on facts by not granting appropriate credit of the Tax Deduction at Source (“TDS”), as claimed by the Appellant in the return of income.
62. The learned AO has erred in law and on facts in levying interest under section 234A of the Act even though the Return of Income was filed within the due date, and has also erred in recomputing interest under section 234C of the Act.
63. The learned AO has erred in law and on facts in initiating penalty proceedings under section 271(1)(c) of the Act without concluding that the Appellant has furnished inaccurate particulars of income or has not acted in good faith and has not exercised due diligence.”
2. The brief facts of the case are that the assessee filed revised return of income electronically for the assessment year 2016-17 on 29/03/2018 declaring Nil income. The case was selected for scrutiny through CASS for complete scrutiny. Accordingly, statutory notices were issued to the assessee and various details were called for. In response to notice issued, the assessee company submitted details from time to time which were examined from documents submitted. It was noted that the company had international transactions exceeding Rs.10 crores, therefore, the case was referred to the TPO u/s 92CA of the Act for determination of arms length price after obtaining prior approval from the competent authority. The ld. TPO after receipt of reference, called the documents maintained u/s 92D(3) of the Act. From the documents submitted, the ld. TPO noticed that the assessee company is engaged in the business of trading, manufacture and sale of desktops, lap tops, servers and smart phones. The company has its manufacturing unit at Pondicherry, India. The business operations of Lenovo India are primarily divided into following categories:-
“Manufacture/Assembly
Under this segment, Lenovo India imports parts for the manufacture/ assembly of PCs and notebooks (Lenovo ldeapad range) from the group companies as well as thirdparty vendors. The manufactured! assembled PCs and notebooks are sold to third party customers in India.
Trading
Under this segment. Lenovo India imports finished products from Lenovo Group such as desktops, notebooks, mobile phones. computer peripherals and servers from its AEs and resells the same to local customers in India through its distribution network.
Further. Lenovo India has the following business verticals:
Commercial – Caters to private institutional customers and government orders through standard tendering process.
Home and small business – Caters to retail customers. The distribution is carried out through channel partners (Tier 1). They sell onward to Tier 2 and Tier 3 distributors.
Enterprise business – Consists of the server business, currently Model X86. Very large business – Caters to corporate customers such as Infosys. TCS etc. Smart phone business
Lenovo India currently has a workforce of about 700 people. About 350 are housed at headquarters i.e. Bangalore and balance are spread across locations in India.
Budgets and forecasts
Lenovo India does not prepare economic and market analyses in the form of forecasts which have bearing on the pricing of the
international transactions entered into during the year under review.”
21. During the impugned assessment year, the following international transactions were undertaken by the assessee:-
International Transactions
