Determining the characterisation of an entity before the selection of most appropriate method is critical

IN THE INCOME TAX APPELLATE TRIBUNAL
MUMBAI BENCH “G”

I.T.A.No 8312/Mum/2010

(Assessment year: 2006-07)

Fulford (India) Ltd. Vs. DCIT

 

ORDER

Per R.K. Panda (AM):-

This appeal filed by the assessee is directed against the order dated 28.9.20 10 of the Dispute Resolution Panel-1, Mumbai relating to A.Y. 2006-07.

2. The assessee in the grounds of appeal has challenged the order of DRP in confirming the action of the Assessing Officer in re-computing the ALP of the International transaction in relation to import of Active Pharmaceutical Ingredients (API) and in relation to import of formulations and thereby making adjustment of 3,09,21,351/- and 4,13,72,000/- respectively.

2. Facts of the case in brief are that the assessee is engaged in the business of manufacturing and sale of pharmaceutical products and formulations. During the year under consideration, the assessee has shown net turnover (after reducing excise duty) of 154.39 crores, other income of 1.85 crores and declared net profit of 15,99,10,420/-. During the course of assessment proceedings, the assessee-company furnished various details in support of income declared and claims made in the return of income. The Assessing Officer noted that the assessee had entered into international transaction with Associated parties which can be summarized as under:

S.No.	Nature of Transaction	A.Y. 2006- 07	Method      used by the assesseeto      determined the ALP
1	Import of raw material	3,50,65,837	TNMM
2	Purchase of finished goods	248828463	RPM
3	Reimbursements received	441471	CUP
4	Reimbursement paid	1168690	CUP
5	Facilitation of software testing services	1989517	–

3.1 A reference was made to the transfer pricing officer for computing the arms length price u/s. 92CA(1) on 6.10.2008. The TPO vide his order dated 29.10.2009, which was received by the Assessing Officer on 4.11.2009 had made upward adjustment of 7,22,93,351/- on following grounds :-

i)             Purchase of Netilimicin Sulphate and Mometasone Furoate 3,09,21,351/-.

ii)          Variation in the margins of the AE segment and the Non-AE segments- 4,13,72,000/-.

3.2 It was found by TPO that the assessee has over invoiced purchases from its AEs with respect to Netiimicin Sulphate and Mometasone Furoate. Details were gathered from customs data available on public domain through Tips Software and from inquiries made under section 133(6) of the Income Tax Act, 1961. A copy of the inquiries was provided to the assessee along with the show-cause for making an adjustment similar to that of last year.

3.3 The assessee vide reply dated 28.7.2009 objected to such proposal on the following grounds:

(a) Standard of comparability under CUP method is very high. Prices paid by unrelated parties may not be for similar product.

b) Other manufacturer does not maintain the same quality standard as Schering Plough Group.

c)  Original Researched/developed drugs are costly than generic drugs are also better.

d)  There may be transactional differences such as volume/contractual terms etc.

e) The APIs have been supplied to the assessee at a price that is lower than the price at which the other entities of the Schering Plough are sold.

3.4 It was accordingly submitted that the TNMM method followed by the assessee is the most appropriate method and not the CUP method as proposed by the TPO.

3.5 The TPO noted that identical submissions were furnished during the preceeding years which were duly considered in A.Ys. 2003-04, 2004- 05 and 2005-06. The arguments were found to be without merit and were rejected. The assessee had not demonstrated that the so called generic products imported in the other companies were of inferior quality and there were transactional differences. The TPO noted that the assessee in its transfer pricing study report has benchmarked the internal transactions of imports of finished goods for distribution by comparing its distribution activities at the entry level with the companies engaged in similar activities and has concluded that the international transactions are at arms length.

3.6 Rejecting the various arguments advanced by the assessee the TPO made an adjustment of 3,09,21,351 / – on account of over invoicing of purchases.

3.7 The TPO noted that the assessee in its transfer pricing study report for the distribution segment has benchmarked the international transactions of import of finished goods for distribution by comparing its distribution activities at the entry level with the companies engaged in similar activities and concluded that the transactions are at arm’s length. The TPO discussed the various methods prescribed u/s. 92C of the Income Tax Act to find out the most appropriate method applicable to the assessee. He noted the various shortcomings in the calculations of the arms length price. He noted from the segmental accounts furnished by the assessee that while rent, depreciation marketing and distribution have been allocated on the basis of the net sales, promotion expenses has been allocated on actual basis. However, salaries, traveling and miscellaneous expenses have been allocated on the criteria of “Fair Allocation”. No such explanation has been given as to what is a ‘fair allocation’ or how the same has been arrived at. According to the TPO under normal circumstances if separate accounts have been maintained, the distribution of common expenses has to be carried out on the basis of turnover, unless there are specific instance to assign something on specific basis. An allocation based on turnover would normally be a fair allocation. In absence of any plausible explanation, the TPO allocated these expenses on net sales basis and accordingly made an adjustment of   4,13,72,000/-. Thus, the TPO made total adjustment of 7,22,93,361/-.

3.8 During the course of assessment proceedings, the Assessing Officer asked the assessee to show-cause as to why the adjustments of 7,22,93,361/- as per Transfer Pricing Order should not be made. In response to the same the assessee vide its letter dated 23.11.2009 submitted objections for the above said adjustments in Transfer Pricing Order as detailed above. The contents of the letter of the assessee company as extracted in the assessment order reads as under :-

“We refer to the last hearing with our authorized representatives on the captioned matter wherein your goodself has asked the assessee to file the submissions as to why the amount of 72,293,351/- determined by learned Transfer Pricing Officer (TPO), being the difference between transaction price as per books and arm’s length price, shall not be assessed as income under section 143(3) of the Income Tax Act, 1961.

In this regard, we would like to bring to your good self’s kind attention the relevant provisions of the Act introduced by the Finance Act 2007 effective from June 1, 2007. The relevant extract from the Act is reproduced below for your good self’s reference :

Quote:

Section 92(C)(4)

On receipt of the order under sub-section (3), the Assessing Officer shall proceed to compute the total income of the assessee under sub-section (4) of section 92C in conformity with the arm’s length price as so determined by the TPO. Unquote.

“Thus, though the assessee does not agree with the TP adjustment recommended by the TPO since the same is not in accordance with the Indian TP regulations contained in the Act and is highly disputed, however, we understand that, in line with the aforementioned amended requirement of the law, your goodself would proceed to issue a draft order and assess the total income of the assessee in conformity with the arm’s length revenue determined by the TPO in his TP order dated 29.10.2009. However, should your goodself wish to reconsider the determination/re-determination of the arm’s length revenue for the assessee on the merits of the instant case, we request you to give the assessee an opportunity to discuss the same in detail. In this regard, the detailed submissions dated 2)^th July 2009, submitted by the company to the learned TPO are attached herewith, for your good self’s kind perusal.

Further, and in accordance with section 1 44C of the Income Tax Act, 1961 (as amended by the Finance Act 2009), the company requests your good self to kindly share with it, a draft of the proposed order of assessment if your goodself proposes to make any addition to the returned income of the company for the year. This would enable the company to examine the same as well as its response thereto, including filing of objections before the learned Dispute Resolution Panel.”

3.6 However, the Assessing Officer was not satisfied with the above explanation. He noted that the assessee’s submissions were already considered by the TPO in detail, before finalization of the order u/s. 92CA(3). Following the order of the TPO the Assessing Officer made an upward adjustment of 7,22,93,351/- to the total income.

3.7 Before the Dispute Resolution Panel, the assessee made various submissions, the gist of which can be summarized as under :-

i) That the TPO rejected the TP documentation maintained by the assessee i.e. rejected TNMM and considered CUP as most appropriate method.

ii)       That the TPO placed reliance on customs data and compared the purchase price of originally researched API imported by FIL with the purchase price to generic medicines purchased by third party.

iii)      That the TPO did not consider difference between originally researched and generic drugs.

iv)         Business rationale for imports of API.

v)          Opportunity to refute comparability.

vi)         Reliance on the Judgment of UCB India Pvt. Ltd.

vii)         Reliance on the decision of Supreme Court of Canada in the case of GlaxoSmithKline Inc.

viii) TPO ignored significant differences between original researched/developed drugs and generic drugs and thus violate comparability required for the use of CUP method.

3.8 However, the Dispute Resolution Panel was not convinced with the arguments advanced before them. They noted that the TPO analyzed the facts and did not find them acceptable since similar arguments were rejected in the preceeding assessment years. The assessee has not demonstrated before the TPO that the so called generic drug imported by other companies were of inferior quality and there were transactional difference. The DRP noted that in the case of manufacture and sale of medicines, they have to go through stringent quality control norms in respect of each medicine whether general or otherwise irrespective of the cost to user of the medicines and, therefore, the argument that manufacturers which were considered as comparable were of inferior quality is not a valid argument.

3.9 The DRP also was of the opinion that the CUP method adopted by the TPO was more appropriate as against the TNMM method adopted by the assessee. According to DRP the assessee may be justified in claiming that generic own researched medicine should fetch high profit margin, but the same has to be supported by adequate fact and each and every medicine has to be shown with respect to back-up of research and development to justify the margin. According to the DRP, the profit margin in respect of these medicines vis-à-vis consumer, i.e. profit margin from the business to business and business to consumer is to be suitably allocated so as to account for adequate sharing of profits. The transfer pricing analysis is of about providing for adequate sharing of profits between various tax jurisdictions. It is because of the ultimate profit earning arises from the sale of product to the consumer and, therefore, the associate enterprise of the assessee should be earning that amount of profit which a business to consumer transaction will earn in the case of a high value medicine. In view of the above the DRP was of the opinion that the adjustment in respect of imported active pharmaceutical ingredients does not call for any interference. According to the DRP the assessee’s case could have been of merit if specific active ingredients should have been sold to Indian entity and sold to any other not related enterprises were shown to be equal. In absence of any such data being provided either in the proceedings of transfer pricing or during proceedings before it, the DRP confirmed the arm’s length price as determined by the TPO at 3,09,21,361/-.

4. So far as the adjustment in the value of import formulations, the DRP noted that this segment is the distribution segment of the company. They noted that the company imports both from AEs and non-AEs (third parties) and sell the products in the local markets. The DRP justified the comparison of the internal margin by the TPO which could provide better comparison rather than external comparable companies because internal margin eliminate the valuation in functioning assets profiles of other companies which are taken as comparable. The DRP rejected the contention of the assessee that benchmarking should be done as a whole and not on segmental basis on the ground that the same is against the Transfer Pricing Regulations according to which Benchmarking has to be done in respect of international transactions and not the business as a whole. The DRP noted that in form No. 3CEB the details in respect of each associate enterprise and each transaction within the class of transactions are required. Rejecting the various submissions of the assessee, the DRP upheld the action of the TPO in making the adjustment of 4,13,72,000/-

5. Aggrieved with such order of the DRP, the assessee is in appeal before us.

6. Learned counsel for the assessee submitted that the TPO applied comparable uncontrolled price (CUP) method for active pharmaceutical ingredients (APIs) imported from associated enterprises by comparing generic APIs identified from the customs database, etc., thereby imputing an operating margin of 32.09%. He submitted that the assessee acts as a secondary manufacturer which is akin to a value added distributor. He submitted that the TPO adopted the Canadian Federal court decision in the case of Glaxo Canada. He referred to the FAR profile of the AE segment and non-AE segment as per the synopsis and submitted that looking at the functions, asset and risk profile of secondary manufacturer or value added distributor in the context of license arrangement one cannot blindly apply CUP method. He submitted that the decision of Canadian Court has since been reversed by the Federal court. He submitted that the Mumbai Bench of the Tribunal in the case of Serdia Pharmaceuticals has acknowledged it. However, in the absence of any arguments made by the assessee, the Tribunal did not decide on that aspect and left it open for future adjudication. He submitted that based on the FAR analysis, the assessee is a value added distributor in the segment of import of API for distribution in India after converting it into formulations. Thus, it is entitled to return for distribution functions and secondary manufacturing functions commensurate to its level of involvement for the relevant product. He submitted that when in the non-AE segment, the assessee get operating profit margin of 8.69% as compared to operating margin of 11.37% made in the AE segment, its profitability under AE segment is higher. Therefore one case safely conclude that the terms of import of API from AE are at arm’s length consideration for its functions as a value added distributor.

7. As regards the reference is the TPO’s order that identical submissions made in past years were duly considered in detail during the course of assessment proceedings, learned counsel for the assessee submitted that the issue relating to past year has not yet been decide by learned CIT(A). There is no consistency in the approach followed by the TPO over the period of time since he has shifted from using section 133(6) to TIPS database. Without prejudice he submitted that TPO has to apply his mind afresh every year.

8. As regards comments of the TPO that the assessee has not demonstrated that so called generic products imported by the other companies were of inferior quality, the learned counsel for the assessee submitted that the assessee was not provided with either the samples for laboratory testing or the test report from a laboratory certifying the technical qualities of the generic products. He submitted that the onus was on the TPO to demonstrate the comparability. According to learned counsel for the assessee, CUP requires stringent comparability and any differences in the third party price and the international transaction price which could materially affect the price in the open market, warrant appropriate adjustments to such third party prices.

9. As regards comments of the TPO that the assessee was seeking various details and thereby trying to delay the proceedings and also divert the attention from the main issue, learned counsel submitted that the assessee was seeking information so as to analyze the comparability of the proposal by the TPO. He submitted that the bonafide intention of the assessee should not have been challenged and the onus was on the TPO to demonstrate the comparability.

10. As regard observations of TPO that two companies can have different methodology for making the same product and, therefore, it is not necessary that the material used or tests conducted should be the same, he submitted that difference in manufacturing processes will lead to difference in cost of production and accordingly, difference in final selling price. He submitted that in pharmaceutical world APIs, with similar names have different therapeutic applications and therefore the two products cannot be compared. He submitted that the assessee is the market leader with maximum market share of about 48% and the balance market share is held by a number of entities. This demonstrates that irrespective of the high cost of the product, the assessee enjoys premium position in the market on account of high quality and effectiveness of the drugs. Refuting observation of the TPO that the generic products have similar properties, learned counsel for the assessee submitted that the generic APIs may have similar properties but still could be different on quality efficacy and level of impurities present in the drug amongst other things.

11. As regard of the observation of TPO that an AE can continue to have the benefits at benchmarked costs due to benefit of clinical testing, however, this facility does not permit the AE to over invoice the product cost by almost 10 times of the comparables, learned counsel for the assessee submitted that all information which are required to be filed with the Indian Regulatory authorities for taking approval etc. was provided by the assessee-overseas affiliates who have undertaken research and development to develop the products. The clinical trials benefits made available to the assessee cannot be said to be of passive nature. He submitted that the product patents are obtained only if drugs pass the stringent clinical trials. This typically costs US$ 1 to 1.5 billion per molecule. Formulations based on such originally researched molecule have a higher acceptability in terms of quality and efficacy.

12. As regards rejection of TNMM adopted by the assessee and CUP method adopted by the TPO, he submitted that in TNMM method many such differences get evened out. Further, application of a robust search process, which involves appropriate quantitative and qualitative filters, supports the proximity to the FAR analysis based on the available data. However, the TPO has not discharged similar onus whilst applying CUP. He submitted that the TPO cannot dictate what the assessee should do. He submitted that if the method adopted by the TPO is accepted, then it gives more than 30% margin which is just not possible in such type of business. He submitted that the CUP method cannot be applied here because a method has to be adopted on the basis of characteristic. The assessee has got internal comparables. He submitted that the TPO’s action of applying CUP is blatantly absurd, which results in an operating margin of 32.09% which is by far higher than what is earned by FIL in its own non-AE segment i.e. 8.69% by doing exactly similar functions.

13. As regard adjustment made on account of import formulations, learned counsel for the assessee submitted that the assessee imports the same from outside and sell in Indian market. The TPO compared margin with that of Zyg Pharma Segment and determined the margin at 21.70% as against 14.43% disclosed by the assessee. He submitted that these are characteristically two different segments. Learned counsel for the assessee filed some fresh comparable companies like Gujarat Terce Laboratories Ltd., J.K. Helene Curtis Ltd., Lotus Herbals Ltd., Lyka Exports Ltd., Serum International Ltd., Brushman (India) Ltd., J.L. Morison (India) Ltd., T.T.K. Healthcare Ltd. and submitted that arithmetic means of OP/Sales is 1.32%. He submitted that the above companies are comparable companies for distribution segment with financial data for F.Y. 2005-06. He accordingly submitted that the method adopted by the assessee should be accepted.

14. The learned Departmental Representative on the other hand while supporting the order of the Assessing Officer and the DRP submitted that the order of the TPO is based on the earlier 3 years and those orders are pending with the learned CIT(A). For the impugned assessment year, the assessee has come through the DRP. As regards the voluminous papers filed by the learned counsel for the assessee to substantiate its case, learned Departmental Representative submitted that the assessee can be permitted to file those papers if justifiable reasons can be given as to why these were not furnished before the lower authorities. However, the assessee has not given any such reasons. He submitted that the reply by the assessee is general in nature. It has not substantiated as to how it’s product is better. The assessee should have shown volume of production, contractual forms etc. He submitted that certain new facts have been stated in the written submission filed by the assessee. He submitted that the agreement with Zyg Pharma is subsequent to the assessment. Therefore, it cannot be the basis of transaction at the time of agreement for the impugned assessment year. Therefore, the same cannot be relied upon. As regards the submission of the learned counsel for the assessee that it is a licenced manufacturer, he submitted that this fact was not before the Assessing Officer or TRP or DRP. The case of the assessee is simply that of an importer. Therefore, the arguments of the learned counsel are without much force. He accordingly submitted that the order of DRP to be upheld.

15. Learned counsel for the assessee in his rejoinder submitted that various details were before the TPO. As regards the objection of learned Departmental Representative that new pleas are being taken before the Tribunal, learned counsel for the assessee referred to the decision of Chandigarh Bench of the Tribunal in the case of Quark Systems Pvt. Ltd., 132 TTJ 1 and decision of Pune Bench of the Tribunal in the case of Skoda Auto India Vs. ACIT, 30 SOT 319. Referring to the above decisions, he submitted that under identical circumstances the Tribunal has restored the matter to the file of the Assessing Officer for fresh adjudication in the light of the fresh searches and assessee was permitted to take a new plea on the basis of fresh searches.

16. We have considered the rival arguments made by both the sides, perused the orders of the revenue authorities and the voluminous paper books filed on behalf of the assessee. We have also considered the various decisions cited before us. There is no dispute to the fact that the assessee-company during the year has entered into international transactions with its AEs, the details of which are already given at para 2 of this order. We find the TPO in his order passed u/s. 92CA(3) computed the ALP of the international transaction in relation to import of API,   i.e. the manufacturing segment and made adjustment of 3,09,21,351/-. While doing so, he applied CUP method as most appropriate method as against TNMM adopted by the assessee. He also rejected the various objections raised by the assessee on the ground that all those objections were considered by the TPO in the A.Y. 2002-03 to 2004-05. Similarly while making adjustment of 4,13,72,000/- in the distribution segment, the TPO decided to compare the internal margin which could provide better comparison rather than external comparable companies because internal margin eliminate the variation in functioning assets profiles of other companies which are taken as comparables. We find the Assessing Officer rejected the various arguments put forth by the assessee and followed the order of the TPO and made upward adjustment of 7,22,93,351/- (i.e. 30921351+41372000) which has been upheld by the DRP.

17. In our opinion the matter requires fresh adjudication at the level of the Assessing Officer. We find the DRP while upholding the ALP adjustment of 30,9,21,351/- on account of international transaction in relation to APIs at para 5.2 of the order has observed as under :-

~……The assessee may justified in claiming that generic own researched medicine should fetch high profit margin, may be justifiable arguments, but the same has to be supported by adequate fact and each and every medicine has to be shown with respect to back-up of research and development to justify the profit margin….”

Similarly in the said paragraph the DRP has further observed as under :-

^a…..Theassessee’s case could have been of merit if specific active  ingredients should have been sold to Indian entity and sold to any other not related enterprises were shown to be equal. In absence of any such data being provided either in the proceedings of transfer pricing or during proceedings before the DRP, there is no justification to interfere with the arm’s length price as determined by the TPO…..”

18. It is an undisputed fact that similar issue that arose in the preceeding years has not yet attained finality and is pending before learned CIT(A). In the impugned assessment year, the assessee came to the ITAT because of the order passed by the DRP. We therefore find force in the arguments of learned counsel for the assessee that the TPO should apply his mind afresh every year and should not have relied on the orders of the TPO for the preceeding years. Similarly the submission of learned counsel for the assessee that the assessee-company acts as a secondary manufacturer which is akin to a value added distributor also needs verification at the level of the Assessing Officer since according to the learned Departmental Representative this fact was not before the Assessing Officer or TPO or DRP. Since the various arguments now putforth by the learned counsel for the assessee requires verification at the level of the Assessing Officer, we in the interest of justice deem it proper to restore the issue relating to ALP adjustment of 3,09,21,351/- to the file of the Assessing Officer for fresh adjudication.

19. So far as the upward adjustment of 4,13,72,000/- in relation to international transaction of import of formulations is concerned, this in our opinion also requires fresh adjudication at the level of the Assessing Officer in view of various distinguishing features brought before us by learned counsel for the assessee in the synopsis and the list of fresh searches for the same financial year.

20. Considering the totality of the facts of the case and considering the fact that various submissions made by the learned counsel for the assessee need verification at the level of the Assessing Officer/TPO, therefore, we, in the interest of justice deem it proper to restore both the issues to the file of the Assessing Officer for fresh adjudication. Needless to say, the Assessing Officer shall give due opportunity of being heard to the assessee and decide the issue afresh as per law. We hold and direct accordingly. The grounds raised by the assessee are accordingly allowed for statistical purposes.