Lenovo India Pvt. Ltd. Vs ITO (ITAT Bangalore)
Conclusion: Provision for warrant expenses was not contingent and had to be allowed as deduction while computing income under the head Income from Business & Profession. Thus, the addition made to the book profits under section 115JB was to be deleted because the liability could not be said to be contingent.
Held: Assessee was a renowned company Lenovo engaged in the business of manufacturing and distribution of desktop, laptop, servers and smartphones. It sold products and as per the terms of sale, assessee provided warranty for performance, replacement etc. Based on the past experience i.e., historical data, liability on account of probable warranty claims was provided in the books of accounts of the assessee. During the relevant previous year, assessee debited an expenditure under the head ‘Warranty Expenses. AO made addition made to the book profits u/s.115JB on account of provision for warranty liability treating the same to be a liability of a contingent nature and hence liable to be added to the profit as per profit and loss account prepared in accordance with companies act to arrive at the book profit of the assessee for the purpose of levy of tax on book profit under Sec.115JB. It was held that the provision for warrant expenses was not contingent and had to be allowed as deduction while computing income under the head “Income from Business & Profession”. Thus, the addition made to the book profits was to be deleted because the liability could not be said to be contingent.
FULL TEXT OF THE ITAT JUDGEMENT
This is an appeal by the Assessee against the final order of assessment dated 30.10.2019 of Income Tax Officer, Ward-4(1)(1), Bangalore, passed u/s.143(3) read with Sec.144C of the Income Tax Act, 1961 (the Act) relating to assessment year 2015-16.
2. The grounds of appeal raised by the Assessee in this appeal reads as follows:-
“I. General Ground:
1. The Final Assessment Order dated 30 October 2019 (received on 4 November 2019), passed by the learned Income Tax Officer, Ward 4(1)(1), Bangalore (“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 of the Act 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 7,96,04,375 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 7,96,04,375 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 Assessee:
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 ITAT for AY 2006-07 (1″ and 2nd round), AY 2009-10 and AY 2010-11;
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 industry average rates; 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 adopting the following filters for conducting TP analysis:
a. Rejection of comparable companies having different financial year ending (other than 31 March 2015);
9. The learned AO / TPO has erred in law and on facts in not rejecting the following companies which are not comparable to the Assessee due to reasons including functional dissimilarity, presence of significant R&D etc.:-
a. Apollo Micro Systems Limited
b. Zen Technologies Limited
10. The learned AO / TPO has erred in law and on facts in not accepting the following companies which are comparable to the Assessee and thereby not considering the detailed submissions of the Assessee:
a. VXL Instruments Limited
b. CCS Infotech Limited
11. 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 1,18,60,27,058 on account of alleged excess AMP expenditure pertaining to trading segment:
12. The Honourable DRP and the learned AO / TPO have erred in law and on facts, in making TP adjustment of INR 1,18,60,27,058 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,
13. 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.
14. 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.
15. 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.
16. 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.
17. 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.
18. 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”.
19. 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 and these transactions are carried out on a principal-to-principal basis, and is solely responsible for improving its business market in India and increasing the sales of its products in India. The Appellant had incurred expenditure on AMP to cater to local market needs. AMP expenditure has been incurred in relation to local product advertisements and towards domestic independent third parties, thus the domestic unilateral expenditure incurred by the Appellant for the purpose of its business cannot as a deemed international transaction under section 92B(2) of the Act.
20. 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 2015.
21. The Honourable DRP and the learned AO / TPO have erred in law and on facts, by holding 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.
22. 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.
23. 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.
24. 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. The AMP expense intensity adjustment was affirmed by the Honourable ITAT in cases of Luxottica India Eyewear Pvt Ltd Vs. ACTT’ and BMW India Private Limited Vs. DCIT2 wherein the AMP intensity adjustment is performed on the profit levels of comparable companies so as to bring them to the level of the Appellant after factoring in the differences in the intensities of AMP expenditure of the comparable companies vis-a-vis the AMP expenditure incurred by Appellant.
25. The Honourable DRP and the 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.
26. Further, the Honourable DRP and the 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.
27. 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.
28. 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.
29. 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’.
30. 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.
That the Honourable DRP and the learned AO / TPO have erred in not appreciating that the cost is recovered is evident from its contract, and the extract from the inter-company distribution agreements is reproduced below for your Honours ready reference:
“The parties intend to set the prices for sale of Products by Supplier to Distributor at levels that will results in Distributor earning annual operating income, determined under local generally accepted accounting principles, with respect to the Products (after taking into account all expenses and reimbursements attributable to the Products)”
Benchmarking analysis undertaken in determining the mark-up to be charged on the alleged brand promotion services,
31. 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.
32. 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.
a. Irunway India Private Limited
b. Just Dial Limited
33. Further, the learned AO / TPO has erred in law and on facts in not accepting the following companies which are comparable and thereby not considering the detailed submissions of the Assessee:
a. MCI Management India Private Limited
b. Supernova Advertising Limited
c. Concept Communication Limited
d. Quadrant Communications Limited
34. The Honourable DRP and the learned AO / TPO have erred in not granting appropriate favorable economic adjustments (including the working capital adjustment) when computing the arm’s length nature of alleged international transaction.
IV. Transfer pricing adjustment of INR 8,69,03,763 in relation to the Sales Facilitation Services segment and INR 6,30,82,889 in relation to Administrative and Business Support Services segment
35. The Honourable DRP and the learned AO / TPO have erred in law and on facts in making TP adjustment of INR 14,99,86,652 to the returned income of the Assessee and in holding that the international transactions undertaken by the Assessee with its AEs in the Sales Facilitation Service segment and Administrative and Business Support Services segment were not at arm’s length.
36. The Honourable DRP and the learned AO / TPO have erred in law and on facts in undertaking a composite benchmarking for both the segments and thereby failing to appreciate that the services rendered by the Appellant to its AEs in each of these segments are separate and distinct and accordingly needs to be benchmarked separately.
37. The Honourable DRP and the learned AO / TPO have erred in law in 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 positions and filters adopted by the Assessee in its TP documentation, and adopted certain additional filters / modified filters in selecting the comparable companies by using non contemporaneous data of the said companies.
38. 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 31 March 2015)
39. The Honourable DRP and the learned AO / TPO have erred in not rejecting the following companies despite the same not being comparable to that of the Assessee due to various factors such as functional dissimilarity, product / intangible led revenues, failing learned TPO’s own filters, use of unreliable segment financials etc.
a. Irclass Systems and Solutions Limited
b. Ugam Solutions Private Limited
c. Axience Consulting Private Limited
d. Axis Integrated Systems Limited
e. India Trade Promotion Orgn.
40. Further, 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:
a. MCI Management (India) Limited
b. Crayon Advertising Limited
c. Supernova Advertising Limited
41. 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 for these segments.
V. Other TP related grounds
42. 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.
43. 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.
44. 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.
VI. Disallowance of Provision for warranty
45. The Honourable DRP and the learned AO have erred in law in arbitrarily disallowing the provision for warranty amounting to INR 73,93,02,026 claimed as a deduction by the Appellant.
46. The Honourable DRP and the learned AO have erred in law by not following the order of the Honourable ITAT in the Appellant’s own case for the AY 2006-07, AY 2007-08, AY 2010-11 and AY 2011-12, 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.
47. 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.
48. 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 Supreme Court (“SC”) in the case of Rotork Controls India Privat and therefore such expenditure is an allowable deduction under section 37 of the Act.
49. The Honourable DRP and the learned AO have erred in appreciating that the Appellant provides warranty for a period from one year to four years on its products and accordingly, the entire provision could not be utilized in one year and has to be spread over multiple years.
VII. Addition of provision for warranty to the book profits
50. The learned AO has erred in adding back the warranty provision created during the relevant AY amounting to INR 73,93,02,026 to the book profit of the Appellant.
51. The Honourable DRP and the learned AO have erred in law and on facts in holding that the warranty provision of INR 73,93,02,026 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.
52. The Honourable DRP and the learned AO have erred in law by not following the order of the Honourable ITAT in the Appellant’s own case for the AY 2006-07, AY 2007-08, AY 2010-11 and AY 2011-12, 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.
VIII. Other grounds
53. 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.
54. The learned AO has erred in law and on facts in computing interest under section 234B of the Act and section 234C of the Act.
55. The learned AO has erred in law and on facts in initiating penalty proceedings under section 271(1)(c) of the Act without concluding on whether the Appellant has concealed any particulars of income or has furnished inaccurate particulars of income or has not acted in good faith and has not exercised due diligence.
The Appellant craves leave to add, alter, vary, omit, substitute or amend the above grounds, at any time before or at the time of hearing of the appeal. Each of the above objections is independent and without prejudice to the other grounds preferred by the Appellant.”
3. Ground I raised by the Assessee is general and requires no specific adjudication.
4. Ground No.II raised by the revenue is in relation to determination of Arm’s Length Price in respect of an international transaction of import of parts and components from its Associated Enterprise (AE). The Assessee is a company incorporated in India. It is engaged in the business of trading, manufacture and sale of desktops, laptops, servers and smartphones. It has a manufacturing facility in Pondicherry, India.
5. During the FY 2014-15, the assessee imported certain parts and components from its Associated enterprises (“AEs”) for purpose of manufacturing of Personal Computers (PCs). The transaction of import of parts and components was an international transaction and therefore income from such international transaction has to be determined have regard to Arm’s Length Price (ALP) as laid down in Sec.92 of the Income Tax Act, 1961 (Act). The Assessee also imported parts and components from third parties. The methodology adopted by the Assessee for benchmarking the price paid to the AE for import and components was as follows:
