The Mumbai Bench of the Income Tax Appellate Tribunal (‘Tribunal’) in the case of T Two International Pvt. Ltd., Tara Jewels Exports Pvt. Ltd. and Tara Ultimo Pvt. Ltd. (See Note- 1) (‘the ‘Company’ or ‘taxpayer’), held that in order to determine the arm’s length price of the international transaction, the arm’s length margin should be applied only on the international transaction and not on the entire costs/ sales of the taxpayer, as the case may be.
Facts of the case
- The taxpayer is engaged in the business of sale of finished jewellery to its Associated Enterprises (AEs) and third party customers (NonAEs) and enjoys 100% tax holiday under Section 10A of the Income-tax Act, 1961 (‘the Act’).
- The taxpayer selected the Cost Plus Method (‘CPM’) as the most appropriate method (‘MAM’) to benchmark its international transaction of sale of finished jewellery to its AEs and held that as the gross profit margin (‘GPM’) earned from its transaction with AEs (19.37%) is higher as compared to the GPM earned from its transactions with Non-AEs (16.95%), accordingly such transaction is at arm’s length.
- In the course of transfer pricing assessment, the TPO rejected CPM as the MAM on the ground that the taxpayer could not provide detailed calculations of the margin. Moreover the TPO observed that the Non-AE transactions of the taxpayer were functionally different in terms, conditions and risks undertaken when compared to the AE transaction.
- Accordingly the TPO considered the Transactional Net Margin Method (‘TNMM’) as the MAM, provided a set of comparable companies with arithmetical mean of 7.25 % (Operating Profit/ Total Costs) and made an addition of Rs. 25,726,138 by applying 7.25 % on the total costs (AE + non AE) of the taxpayer to find out the sales and then deducted the uncontrolled sales to determine the Arms Length Price (‘ALP’) for the AE transaction.
- The taxpayer while accepting the application of TNMM as the MAM and the arithmetical mean of 7.25%, contended that the TPO erred in computing the adjustment amount on total sales and should have computed the same on the AE sales only. Accordingly the taxpayer filed a rectification application under Section 154 of the Act in respect of computation of the adjustment amount. This application was however rejected by the TPO.
- The aggrieved taxpayer filed an appeal with the Commissioner of Income-tax (Appeals) (‘CIT(A)’) against the above rejection of the TPO, which was granted in the taxpayer’s favor.
- The Revenue aggrieved by the above order, appealed to the Tribunal against the same.
Taxpayer’s Contentions:- The taxpayer while accepting the application of TNMM as the MAM and the arithmetical mean of 7.25%, held that the transfer pricing adjustment made by the TPO ought to be computed on the amount of the international transaction only, and not on all transactions (including AE and non-AE transactions).
TPO’s Contentions:- The TPO rejected the application filed by the taxpayer under Section 154 of the Act on the ground that the taxpayer failed to give separate details for GPM on sales to related and unrelated parties. Accordingly, the same cannot be reviewed in the garb of rectification application filed under Section 154 of the Act.
CIT(A)’s Order
The CIT(A) held that as per Section 92C(3) of the Act, the Revenue should determine the arm’s length price in relation to the AE transactions only and not with the third parties.
Accordingly, the CIT(A) recomputed the ALP by applying 7.25 % on the AE cost (arrived at by apportioning the total costs in the sales ratio) and observed, that after considering the +/- 5 % range, the international transaction was within the arm’s length range and therefore no adjustment was warranted.
Tribunal’s Ruling
- The Tribunal agreed with the taxpayer’s contentions that the TPO’s original order was erroneous because he had applied the net profit margin of 7.25% on the gross sales and followed a complicated procedure to arrive at the amount of the adjustment.
- However, the Tribunal not being convinced with the order of the CIT(A) that no adjustment could have been made, set aside the CIT(A)’s order and remitted the matter back to the Assessing Officer on the following grounds:
– There was no clarity on whether the margins computed by the TPO were operating margins or net margins (the Tribunal observed that as per Rule 10B of the Income-tax Rules 1962, only net profit margin should be considered for TNMM, and there is no scope for reducing interest or other overheads);
– Additional details regarding break-up of costs between AE and non AE had not been made available.
Accordingly, the Tribunal remitted the matter back to the AO to confirm the factual details of the case and also directed the AO to follow the TNMM as the MAM to benchmark the international transaction of the taxpayer. The Tribunal further directed the AO to calculate the adjustment by reducing the net profit declared by the taxpayer from the gross sales, dividing the same in the controlled and uncontrolled sales ratio and applying the net profit rate. (Interestingly, the methodology suggested by the Tribunal for computation of the adjustment, results in the same outcome as arrived at by the CIT(A)).
Our Comments
The above ruling has in a way reiterated that the computation of the transfer pricing adjustment should be restricted only to the international transactions of the taxpayer and not on the entire company. This has also been brought out in a recent decision of the Delhi Tribunal in the case of IL Jin Electronics (I) Pvt. Ltd. (ITA No. 438/Del/2008).
Further in respect of the issue of considering ‘net profit’ vis-à-vis ‘operating profit’ to arrive at the arm’s length price under the TNMM, the Tribunal’s view of applying only the ‘net profit margin’ and that there is no scope for reducing interest and other overheads there-from, is a very strict interpretation of law and warrants the taxpayer to document the reasons for adopting a profit indicator different from the net profit margin to benchmark its international transaction(s).
Note-1
T-Two International Pvt. Ltd. Tara Jewels Exports Pvt. Ltd. and Tara Ultimo Pvt. Ltd Vs. ACIT (2010-TIOL-166-ITAT-Mum). This appeal filed by the revenue is against separate orders passed by the CIT (A) XXXII in respect three different taxpayers for the Assessment year (AY) 2004- 05. As the facts of all the three cases were identical except the amounts involved, only one appeal is taken up as agreed by the taxpayers and the conclusion applied to all three cases.
