ITAT Orders Fresh Benchmarking of Royalty Payments, Prefers Traditional Methods Over TPM

Marks and Spencer (India) Private Limited Vs ACIT (ITAT Delhi)

ITAT: Orders fresh benchmarking of royalty payments, prioritizing traditional methods over the transactional profit method

Facts:

• The assessee “Marks and Spencer (India) Private Limited” was incorporated on 01.04.2005 and is a wholly owned subsidiary of Marks and Spencer Investments Pte. Ltd., Singapore (“M&S Singapore”). The assessee is engaged in the wholesale business of procuring and selling branded apparel and accessories, including leather products and toiletries. In addition to its trading activities, the assessee also renders sourcing support services to its Associated Enterprises (AEs). The core business model of the assessee involves procurement of branded products from third-party manufacturers who manufacture goods for and on behalf of the assessee, which are thereafter resold to an affiliated joint venture entity in India.
• In order to facilitate manufacturing, procurement, branding, and trading operations in India, Marks and Spencer plc, United Kingdom (“M&S plc”), the group’s principal entity and AE, licensed multiple rights and provided bundled business services to the assessee. These included the right to use the “Marks and Spencer” trademark, assignment of product know-how and specifications, access to design patterns, supplier information, business networks, and the right to sell branded products to the Marks and Spencer joint venture in India. In addition to intellectual property rights, the assessee also availed services relating to strategy and business development, marketing, buying and merchandising, logistics, IT and supply chain management, human resources, finance, and legal functions from its AE.
• For these bundled rights and services, the assessee entered into a formal Services and Trademark License Agreement dated 10.07.2014 with Marks and Spencer plc, under which it was obligated to pay a consolidated charge at the rate of 6% of its trading sales revenue. During the AY 2018–19, the assessee recorded total trading revenue of Rs.298,97,68,941, and accordingly paid a sum of Rs.17,93,86,136 to its AE towards business services and license of proprietary marks, calculated at 6% of total revenue. This payment was reported as an international transaction in Form 3CEB filed along with the return of income.
• The assessee benchmarked this international transaction by adopting the Transactional Net Margin Method (TNMM) as the most appropriate method, treating itself as the tested party and using Operating Profit to Operating Revenue (OP/OR) as the Profit Level Indicator (PLI). Under this analysis, the assessee reported an operating margin of 11.47%, while comparable companies reflected margins in the range of 2.60% to 2.65%, thereby concluding that the international transaction relating to payment for business services and license of proprietary marks was at arm’s length.
• During the course of assessment proceedings, the Transfer Pricing Officer (TPO) called for detailed information and documentation in respect of the international transaction relating to payment for business services and license of proprietary marks. The assessee furnished agreements, transfer pricing study, functional analysis, benchmarking analysis, and supporting documentation in response to the queries raised by the TPO.
• However, the TPO rejected the TNMM adopted by the assessee and disregarded the economic analysis carried out in the transfer pricing study report. The TPO also rejected the corroborative CUP analysis submitted by the assessee without accepting the supporting royalty agreements produced by it. The TPO proceeded to apply the CUP method in an independent manner and selected three comparable companies to compute an arm’s length royalty rate. Based on this analysis, the TPO determined the arm’s length rate at 3.92% and proposed a transfer pricing adjustment of Rs.6,21,87,194 on the payment of Rs.17,93,86,136 made by the assessee to its AE.
• Subsequently, the AO, acting through the National Faceless Assessment Centre (NFAC), passed a draft assessment order under section 143(3) read with section 144C of the Income-tax Act, incorporating the adjustment proposed by the TPO. Aggrieved by the draft assessment order, the assessee filed objections before the DRP. The DRP upheld the transfer pricing adjustment and confirmed the findings of the TPO. Pursuant to the DRP’s directions, the final assessment order was passed, making an addition of Rs.6,21,87,194 to the income of the assessee on account of transfer pricing adjustment.
• The assessee challenged the final assessment order before the ITAT, Delhi, inter alia, contending that the bundled rights and services were inextricably linked to its trading operations, that TNMM was the appropriate method for benchmarking the transaction, that CUP had been arbitrarily applied, that improper comparables had been selected by the TPO, and that corroborative royalty benchmarking data submitted by the assessee had been wrongly rejected. The assessee also raised a jurisdictional objection that the final assessment order had been passed by the Jurisdictional Assessing Officer instead of the National Faceless Assessment Centre without prior approval of the CBDT, as required under section 144B of the Act.

Issue:

• Whether the international transaction of payment for business services and license of proprietary marks @ 6% of sales should be benchmarked by applying TNMM on an aggregated basis with the trading segment, or by applying the CUP method.
• Whether the CUP analysis carried out by the TPO, including the selection of comparables, was proper for determining the arm’s length price of the transaction and the transfer pricing adjustment of Rs.6,21,87,194 was sustainable.

Observations

• The Hon’ble Tribunal acknowledged that the services and rights are interlinked and bundled with the assessee’s business operations. However, it observed that mere interlinkage and continuous provision of services do not automatically mandate benchmarking only through aggregation and profit-based methods. The Hon’ble Tribunal recorded that since the AE itself had chosen to charge a standard consolidated rate of 6% of sales, there was no inherent complication in applying a traditional transaction method for benchmarking the transaction and that where the transaction is priced as a direct percentage of sales, a traditional transactional method can be applied if proper comparable data is available.
• The Hon’ble Tribunal considered the reliance placed by the assessee on the decision of the Hon’ble Delhi High Court in Sony Erricsson Mobile Communications India Pvt. Ltd. (ITA No. 16/2014) and observed that although aggregation is permissible where transactions are inextricably linked, in the present case there is no complexity preventing the application of a direct transactional method, provided comparable data exists. The Hon’ble Tribunal therefore held that aggregation is not the only legally permissible approach in such circumstances.
• The Hon’ble Tribunal observed that the bundled transaction provided by Marks & Spencer could be benchmarked by adopting a direct transactional method, and that under the Income Tax Rules, the most appropriate traditional transaction method available is the CUP method, provided exact or proper comparables are available. It expressly recorded that the CUP method is conceptually suitable for benchmarking such transactions where royalty and bundled service charges are directly linked to sales and charged at a fixed percentage. The Hon’ble Tribunal clarified that the applicability of CUP is conditional upon availability of proper and functionally comparable data.
• The Hon’ble Tribunal examined the comparables adopted by the TPO and the comparables selected were primarily Indian entities involved in manufacturing of relevant products and local brand development. It observed that the selected comparables were not proper comparables for benchmarking the assessee’s transaction involving bundled trademark rights and business services from a foreign AE. The Hon’ble Tribunal accepted the assessee’s contention that the comparables used by the TPO were not functionally similar and did not properly reflect transactions involving bundled rights and services of the nature provided by Marks & Spencer.
• The Hon’ble Tribunal observed that there exist several companies and joint ventures in India which receive similar trademark rights and bundled services from foreign AEs for execution of business operations in India. It recorded that such entities would be more appropriate comparables for benchmarking this type of transaction. The Hon’ble Tribunal therefore concluded that the benchmarking exercise had not been properly carried out with reference to appropriate comparables reflecting similar business models.
• The Hon’ble Tribunal held that although CUP is conceptually the most appropriate method, the comparables selected by the TPO were not proper, and therefore the benchmarking exercise could not be sustained in its present form. The Hon’ble Tribunal directed that the matter be remitted back to the file of the AO/TPO for fresh benchmarking and ordered that the AO/TPO should undertake de novo benchmarking after giving proper opportunity of hearing to the assessee.

FULL TEXT OF THE ORDER OF ITAT DELHI