DHL Lemur Logistics (P) Ltd. Vs DCIT
ITA No. 7361 (Mum.) of 2010
Assessment Year: 2006-07
Decided on: 18 May 2011
P.M. Jagtap, AM
1. This appeal filed by the assessee is directed against the order of Dy. Commissioner of Incometax-
8(1), Mumbai dated 20th August, 2010 passed under section 143(3) read with section 144C(13) whereby he made an addition to the total income of the assessee by way of transfer pricing adjustments under section 92CA.
2. The assessee in the present case is a company which is engaged in the business of providing logistic and related services. The return of income for the year under consideration was filed by the assessee on 30-12-2006 declaring a total income of Rs.23,73,88,170. During the said year, the assessee company had entered into international transactions involving freight expenses and freight receipts with its associated enterprises. For the purpose of bench marking the said transactions, the assessee company prepared a detailed T.P. study by applying Transactional Net Margin Method (TNMM) and using “operating profit to value added expenses” (OP/VAE) as the price level indicator. For comparative analysis, the assessee company identified four comparable companies engaged in the business of providing logistic services which had earned a mean operating OP/VAE margin of 23.67% as against the OP/VAE of 65.25% of the assessee. The assessee company accordingly claimed that its international transactions were at Arm’s Length.
3. The Transfer Pricing Officer (TPO) rejected the OP/VAE taken by the assessee as profit level indicator and adopted operating profit to total cost (OP/TC) as the price level indicator. He also required the assessee to undertake a fresh search for comparable companies using the financial data of the year under consideration. A fresh search accordingly was undertaken by the assessee which gave a set of 22 comparable companies. Out of the said 22 comparable companies, the TPO rejected four companies being consistent loss makers and further rejected one more company being functionally different. As the main operating margin of the remaining comparable companies taking OP/TC as the price level indicator was found to be higher than that of the assessee, TP adjustment of Rs.25,21,77,854 was sought to be made to the total income of the assessee in the draft order proposed by the AO. Against the said order, the assessee approached Dispute Resolution Panel-1 (DRP) raising various objections. The DRP, however, did not find merit in the said objections and overruling the same, it confirmed the TP adjustment proposed by the AO vide an order dated 5-8-2010 passed under section 144C(5). Accordingly, assessment order under section 143(3) read with section 144C was passed by the AO making addition on account of TP adjustment of Rs.25,21,77,854. Aggrieved by the said order, the assessee has preferred this appeal before the Tribunal.
4. Although several grounds are raised by the assessee in this appeal, the learned counsel for the assessee has submitted that the main preliminary issue involved in this case is raised in ground No. 2.4 which reads as under:
“The Ld. DRP has grossly erred in agreeing with the Ld. Transfer Pricing Officer’s (TPO) action of failing to appreciate the economic rationale of using “Operating Profit/Value Added Expenses” as the Profit Level Indicator (‘PLI’), and instead using “Operating Profit/Total Cost” as the PLI. The said approach is not in accordance with section 92 of the Act read with Rule 10B(1)(e) of the Rules, and the OECD TP Guidelines.”
5. The learned counsel for the assessee submitted that the main preliminary issue involved in ground No. 2.4 relates to the determination of proper and appropriate “price level indicator” that is to be applied in the facts of the assessee’s case for doing exercise of transfer pricing applying Transactional Net Margin Method. He contended that if “operating profit to value added expenses” (OP/VAE) is taken as more appropriate and correct price level indicator than the “operating profit to total cost” (OP/TC) adopted by the AO/TPO, the same shown by the assessee being higher than the mean OP/VAE of the comparable companies, no TP adjustment is required to be made and accordingly other issues involved in this case will become academic only. He then proceeded to make various submissions in support of the assessee’s case that the OP/VAE is the most appropriate and correct price level indicator taking into consideration all the facts of the case including especially the nature of assessee’s business. He also filed a written note summarizing all his submissions as under:
As detailed in paragraph 5.11 of the TP study report (filed with the TPO vide submission dated January 27, 2009), the Appellant had considered Operating Profit/Value Added Expenses (‘OP/VAE’) as the appropriate PLI to determine the arm’s length price of the international transactions [Please refer Page No.42 of the paper book for the relevant reference in the TP report].
For your kind reference, the Appellant has detailed below the rationale for the use of PO/VAE as the PLI to benchmark the international transactions. Costs in logistics companies typically comprise of direct costs and value adding costs. Direct costs are expenses incurred by a Logistics company to procure services from third party service providers such as shippers/airlines, clearing and forwarding agents, transporters etc. On the other hand, value adding expenses are incurred by a logistics service provider on a day to day basis in support of its own operations. Personnel cost, selling costs, establishment and administrative costs etc. are examples of value adding expenses.
The TP treatment of any expense is based on principles of business economics. The question is “what is the appropriate PLI to be used in TP analysis that would best measure the relationship between profits of the controlled taxpayer (assessee in this case) on one hand, and the functions performed by such taxpayer on the other hand.”
In the instant case, it is imperative to measure value adding expenses (costs associated with the Company’s own functions) separately since a logistics service provider’s efficiency can be measured by the adequacy of the gross margin (Service income less direct third party costs) over value adding expenses.
However the return on total costs does not measure this efficiency as it disregards the composition of costs. It effectively assumes a common markup on all costs including direct costs, which may differ from time to time depending on the volume of business. This will present a skewed picture of the Appellant’s profitability and therefore cannot be considered as an appropriate PLI. [Please refer Page No. 271 of the paper book for the analysis of the direct costs and total costs].
The return on value-adding expenses is an appropriate measure for companies where the cost of service inputs obtained from third parties is significant (however, little or no value is added by the company in respect of such inputs-as is the case of the Appellant). A variation in value-adding expenses reflects different levels of operating capacity employed by the Appellant to arrange/coordinate the services of third parties. Therefore, this measure can be thought of as an approach to account for differences in nature and scale of functions/activities of a Logistics company.
In the Logistics industry, Direct Costs in the nature of freight paid to airlines, customs clearance costs etc. are “pass-through” costs for a Logistics company. The Appellant need not measure its operating efficiency in relation to these “pass-through” costs. This is for the reason that little or no value is added by the Company in relation to such services obtained from third parties. Such services are relayed to the customer on an “as is” basis.
The above principle is fully supported by the OECD TP Guidelines, which explain that agency/intermediary service providers need not apply a markup to “pass-through” expenses, which are passed on to customers. We have reproduced below the relevant extract (para 7.36) of the OECD Guidelines which for your ready reference.
In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at arm’s length to treat a significant portion of the taxpayer’s costs as pass-through costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit indicator). This depends on the extent to which an independent party in comparable circumstances would agree not to earn a mark-up on part of the costs it incurs. The response should not be based on the classification of costs as “internal” or “external” costs, but rather on a comparability (including functional) analysis. See para 7.36.
Where treating costs as pass-through costs is found to be arm’s length, a second question arises as to the consequences on comparability and on the determination of the arm’s length range. Because it is necessary to compare like with like, if pass-through costs are excluded from the denominator of the taxpayer’s net profit indicator, comparable costs should also be excluded from the denominator of the comparable net profit indicator. Comparability issues may arise in practice where limited information is available on the breakdown of the costs of the com parables.
“When an associated enterprise is acting only as an agent or intermediary in the provision of services, it is important in applying the cost-plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves. In such a case, it may not be appropriate to determine arm’s length pricing as a mark-up on the cost of the services but rather on the costs of the agency function itself, or alternatively, depending on the type of comparable date being used, the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. For example, an associated enterprise may incur the costs of renting advertising space on behalf of group members costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a markup, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function.”
The facts of the Appellant are similar. To illustrate this point, when the assessee delivers goods by air for a customer, it contracts with the customer in the capacity of an agent of the airline or the shipping line. The functions that are performed by the Appellant as an agent are co-ordination functions, where it is responsible for bringing various third party service providers (such as a airlines, transporters, clearing and forwarding agents, warehouse keepers) to a common platform to provide integrated logistics services to a customer. The costs associated with such coordination (agency) functions are embedded in the Company’s own personnel cost, selling costs and administrative costs (value added expenses).
The Appellant would like to submit that the choice of the PLI should be determined by the type of activity performed by the tested party and the economic circumstances of the related party transactions, as well as the reliability of available data for third party comparables. Also, the Appellant would like to submit that while undertaking the benchmarking analysis, the Appellant has excluded third party costs from its cost base as well as that of the comparable companies. The Appellant would like to humbly submit that its approach of undertaking the economic analysis is in line with the approach suggested by the OECD TP Guidelines.
The Appellant would like to submit that for the service providers such as the Appellant, the ratio of OP/VAE is the appropriate yardstick to judge its profitability. At this stage, the Appellant would like to draw your kind attention to the concept of Berry Ratio which is a ratio of Gross Profit to Value Added Expenses (‘GP/VAE’). In essence Berry Ratio considers the relationship between the level of VAE and the level of Gross Profits earned by the service providers. Conceptually, the Berry Ratio represents a return on the company’s internal functions and assumes that those functions are captured in VAE. In other words, the Berry Ratio can be a useful measure of the mark-up earned on the VAE or the ‘cost of provision’. To better understand that relationship, it may be prudent to reduce the Berry Ratio in terms of operating profit by subtracting one from the Berry Ratio as follows:-
Berry Ratio – 1 = GP/VAE-1
Wherein GP=Gross Profit; OP=Operating Profit; and VAE=Value Added Expenses.
Thus, the Appellant would like to submit that the ratio of OP/VAE is merely an alternative way to conceptualize the Berry Ratio.
The Appellant would also like to draw your kind attention to the relevant extract of the revised OECD Guidelines wherein the concept of Berry Ratio has been deliberated:
2.100 “Berry ratios” are defined as ratios of gross profit to operating expenses. Interest and extraneous income are generally excluded from the gross profit determination;
depreciation and amortization may or may not be included in the operating expenses, depending in particular on the possible uncertainties they can create in relation to valuation and comparability.
2.101 The selection of the appropriate financial indicator depends on the facts and circumstances of the case.
In order for a Berry ratio to be appropriate to test the remuneration of a controlled transaction (e.g. consisting in the distributor of products), it is necessary that:
The value of the functions performed in the controlled transaction (taking account of assets used and risks assumed) is proportional to the operating expenses.
The value of the functions performed in the controlled transaction (taking account of assets used and risks assumed) is not materially affected by the value of the products distributed, i.e. it is not proportional to sales, and
The taxpayer does not perform, in the controlled transactions, any other significant function (e.g. manufacturing function) that should be remunerated using another method or financial indicator.
The Appellant would like to submit that having regard to its functional analysis, it can be concluded that the Appellant’s case satisfies all the above tests. Accordingly, since the facts of the Appellant are similar to the principle stated above, the Appellant submits that use of OP/VAE as the PLI is the most appropriate approach.
In view of the above discussion, a qualitative analysis of costs by differentiating between passthrough and agency/value adding costs is essential, so as to reach correct TP conclusions. This situation is also envisaged in Rule 10B(e)(i) of the Rules, which sets out the manner of application of the Transactional Net Margin Method (‘TNMM’) “(e) transaction net margin method, by which,-
The net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base:….
As can be seen above, both the Rules and the OECD Guidelines envisage the determination of the PLI, viz., net profit margin in relation to different bases depending upon the facts and circumstances of each case, the intent being to select the appropriate PLI that best measures the relationship between profits of the controlled taxpayer and the functions of such taxpayer. Nowhere has it been mandated that in all cases, the net profit margin should be computed only in relation to the total costs incurred by a controlled taxpayer.
In view of the aforesaid discussion, the Appellant reiterates that in the Logistics industry, direct third party costs (such as freight, cargo handling charges paid to ports, clearing and forwarding costs etc.) incurred by a Logistics company are in the nature of pass-through expenses, which ought to be excluded to determine the profitability of a Logistic service providers operations. Accordingly, the Appellant respectfully, submit that OP/VAE should be used as a PLI for application of the TNMM to benchmark the international transactions undertaken by the Company during the year.
6. The learned DR, on the other hand, mainly relied on the order passed by the DRP overruling the objections raised by the assessee in this regard and upholding the action of the AO in adopting the OP/TC as the correct and appropriate price level indicator. The relevant portion of the order of the DRP dealing with this issue, as relied upon by the learned DR, is reproduced here under:
“The assessee has objected to the AO’s method, on the ground that there is no element of profit in the freight. The DRP does not agree with the view of the assessee, because for working out proper margins, the gross receipts and the gross expenses are the proper figures and there is no provision for excluding any item of expenses or receipt from the gross sales or gross expenses on the ground that such receipts or expenses does not represent any element of profit. There is no provision for segregating the accounts for excluding such items because it will give distorted picture and comparison will not be possible with the others who are dealing in the similar activity not following such method. Thus, the AO has rightly rejected the method of working out profit margin by the assessee.”
7. We have heard the arguments of both the sides on this preliminary issue and also perused the relevant material on record. It is observed that the elaborate submissions made by the learned counsel for the assessee in support of the assessee’s case on this issue were also made before the DRP in sum and substance. A perusal of the relevant portion of the DRP’s impugned order as reproduced above, however, shows that the same have been brushed aside without giving proper and sufficient consideration. Most of the relevant points raised on behalf of the assessee on this important issue even do not find any mention in the order of the DRP, much less any discussion or consideration. In the case of Gap International Sourcing India (P.) Ltd. v. Dy. CIT  44 SOT 56/ 8 taxmann.com 294 (Delhi), the coordinate bench of this Tribunal came across a similar situation wherein voluminous submissions made by the assessee were found to be brushed aside by the DRP without even a whisper in the order. The order passed by the DRP, therefore, was held to be laconic by the Tribunal and the matter was remitted back to the DRP to consider the same again and to pass a proper and speaking order. A similar situation arose in the case of Vodafone Essar Ltd. v. Dispute Resection Panel-II  196 Taxman 423 (Delhi) wherein the order passed by the DRP was quashed by the Hon’ble Delhi High Court and the matter was remanded for fresh adjudication observing that when a quasi judicial authority deals with a lis, it is obligatory on its part to ascribe cogent and germane reasons as the same is the heart and soul of the matter. The Hon’ble Delhi High Court further observed that a well reasoned and well discussed order also facilitates appreciation when the same is called in question before the superior forum. Keeping in view the decision of the Hon’ble Delhi High Court in the case of Vodafone Essar Ltd. (supra) as well as that of the coordinate bench of this Tribunal in the case of Gap International Sourcing India (P.) Ltd. (supra) and having regard to the fact that the DRP has passed the order giving directions to the AO under section 144C without giving proper consideration to the elaborate submissions made on behalf of the assessee on the main preliminary issue, we set aside the said order and remit the matter to the file of the DRP with a direction to consider the objections of the assessee on this issue as well as the other issues once again and pass a proper and speaking order giving direction under section 144C.
8. In the result, the appeal of the assessee is treated as allowed for statistical purposes.