CIT Vs Cisco Systems (India) Pvt. Ltd. (Karnataka High Court)
FUNCTIONAL PROFILE PREVAILS OVER FORM—CISCO’S SPARE-REPLACEMENT ACTIVITY IS A SERVICE, NOT TRADING: KARNATAKA HIGH COURT UPHOLDS TNMM
The Karnataka High Court has held that the most appropriate transfer-pricing method must be selected on the basis of the assessee’s actual functions, assets employed and risks assumed, and not merely because goods physically pass through the assessee.
Cisco Systems India was held to be a captive service provider in respect of its spare-parts replacement activity and not a trader. It did not acquire ownership of the spares, determine their resale price, select customers or assume inventory and obsolescence risks. The High Court consequently upheld the Tribunal’s direction to apply the Transactional Net Margin Method instead of the Resale Price Method.
Facts of the case
Cisco India entered into international transactions with its associated enterprise in relation to product-replacement services. The company furnished a transfer-pricing study applying the Transactional Net Margin Method—TNMM as the most appropriate method, with operating profit/value of services as the profit-level indicator.
The Transfer Pricing Officer rejected TNMM. According to the TPO, Cisco India was essentially carrying on a trading activity by purchasing products from its associated enterprise and reselling them to the AE’s customers in India. Based on this characterisation, the TPO applied the Resale Price Method—RPM and proposed a transfer-pricing adjustment of ₹26,86,57,520.
The DRP upheld the TPO’s approach, following which the Assessing Officer incorporated the adjustment in the final assessment order.
Nature of Cisco India’s activity
Cisco India contended that it was not purchasing and reselling products as an independent trader. Cisco’s overseas entities had supplied equipment to customers in India and were responsible for warranty and annual-maintenance obligations. Replacement spares were routed through Cisco India only to ensure prompt delivery to the customers of the foreign associated enterprise.
The replacement parts were supplied by the associated enterprise and were delivered by Cisco India to the designated customers at a nil sale price. Cisco India had no authority to select the customers, decide which spare part was to be supplied or determine any resale price.
Cisco India also did not bear the inventory, rejection or obsolescence risks. If a replacement was rejected or a part became obsolete, the company was required to return or scrap the item according to the associated enterprise’s directions. Even the customs duties paid on import were reimbursed by the associated enterprise.
For performing these functions, Cisco India received a markup of 1% on the cost of importing the goods.
Tribunal’s findings
The Tribunal examined the functional profile and held that Cisco India’s activities were not comparable to those of a trader.
A trader ordinarily purchases goods by obtaining ownership, assumes the risks attached to the goods, selects customers and independently determines the resale price. Cisco India possessed none of these features. It merely held the imported parts as a custodian until delivery to the customers identified by its parent company.
The Tribunal therefore held that RPM was not the appropriate method. It directed the TPO to recompute the arm’s-length price by applying TNMM and selecting proper comparables.
Out of the comparables chosen by the TPO, the Tribunal accepted M/s Iris Computers but rejected the others based on differences in their functions, assets and risks.
The Tribunal also directed the TPO to examine the assessee’s entitlement to the erstwhile 5% tolerance range under the proviso to section 92C(2).
Earlier High Court order and Supreme Court remand
The Revenue’s appeal was initially dismissed by the Karnataka High Court on 11 July 2018 by relying upon PCIT v. Softbrands India Pvt. Ltd. The High Court had then taken the view that issues relating to selection of comparables and application of filters ordinarily involved questions of fact and would not give rise to a substantial question of law unless the Tribunal’s findings were perverse.
The Supreme Court subsequently disapproved such a broad proposition in the batch led by SAP Labs India Pvt. Ltd. It held that High Courts cannot refuse to examine transfer-pricing appeals merely by labelling comparability and ALP questions as factual. If the Tribunal determines the ALP contrary to Chapter X or Rules 10A to 10E, its conclusion may be perverse and can give rise to a substantial question of law.
The matter was therefore remanded to the Karnataka High Court for fresh consideration.
High Court’s decision after remand
The High Court reconsidered the Tribunal’s decision in the light of the Supreme Court’s directions.
It held that the selection between TNMM and RPM necessarily depended upon Cisco India’s actual functional profile. The Tribunal had examined the functions performed and risks assumed and recorded specific findings that the company was a service provider and not a trader.
Cisco India did not bear any commercial or inventory risk, did not determine the resale price, supplied the parts at nil value, had no discretion to select customers and could not independently decide which replacement parts should be supplied.
The Revenue did not establish that these factual findings were perverse. Once Cisco India’s functional profile was accepted as that of a service provider, RPM could not be regarded as an appropriate method.
The High Court consequently found no fault with the Tribunal’s reasoning and dismissed the Revenue’s appeal.
Author’s comments
The important ratio is that the physical import and onward delivery of goods do not, by themselves, make an entity a trader. Transfer-pricing characterisation must follow economic substance and the complete FAR analysis.
RPM is ordinarily appropriate where goods are purchased from an associated enterprise and resold to an independent party without substantial value addition. Here, however, there was no real “resale”: the replacement parts were supplied at nil value, Cisco India could not determine a resale price, and it functioned only as the AE’s logistical and replacement-support arm. Applying RPM to such a transaction would be conceptually difficult because there was no independent resale price from which an arm’s-length gross margin could meaningfully be worked backwards.
The decision is also significant after the Supreme Court’s ruling in SAP Labs. The Karnataka High Court did not dismiss the appeal merely because selection of the method was factual. It examined whether the Tribunal had applied the statutory transfer-pricing framework and whether its factual conclusion was perverse. The appeal failed because the Tribunal’s FAR analysis was supported by the record and the Revenue did not demonstrate perversity.
Certain limitations must nevertheless be noticed. The judgment does not lay down that TNMM must always be used for replacement-parts arrangements. If the Indian entity acquires title, fixes prices, selects customers or assumes inventory and market risks, RPM may still be appropriate.
Further, the first question concerning exclusion of freight and insurance from total turnover under section 10B was expressly not pressed and was not decided. The judgment therefore cannot be cited as authority on that issue.
Similarly, the direction concerning the erstwhile 5% range under section 92C(2) relates to the historical provision applicable to AY 2006-07. The 5% was not an automatic standard deduction from the ALP adjustment; its application depended upon the statutory provision applicable for the relevant year.
The ruling ultimately reinforces a basic but important transfer-pricing principle: the method must follow the transaction’s real economic character—labels such as “purchase”, “import” or “inventory” cannot substitute for a proper FAR analysis.
Cases Discussed
- Principal Commissioner of Income Tax and another v. Softbrands India Pvt. Ltd.
- SAP Labs India Pvt. Ltd. v. The Income Tax Officer and other connected matters
FULL TEXT OF THE JUDGMENT/ORDER OF KARNATAKA HIGH COURT
1. The Revenue has filed the present appeal under Section 260A of the Income Tax Act, 1961 [the Act], impugning the order dated 30.08.2011 passed by the Income Tax Appellate Tribunal, Bengaluru [the Tribunal] in ITA No.1410/BANG/2010 for the Assessment Year [AY] 2006-07. The respondent [Assessee] had preferred the appeal before the Tribunal, impugning the order dated 24.01.2009 passed by the Assessing Officer [AO].
The Assessment Order dated 25.10.2010 was passed under Section 143(3) of the Act. The Assessee had disclosed certain transactions with its Associated Enterprise [AE]. Accordingly, the AO referred the matter to the Transfer Pricing Officer [TPO] under Section 92CA of the Act. The learned TPO had passed the order dated 30.10.2009 making a transfer pricing adjustment in the sum of `26,86,57,520/- in respect of Arm’s Length Price [ALP] for spare replacement services rendered by the Assessee.
2. The AO passed the draft assessment order, which was forwarded to the Assessee on 24.12.2009. The AO, in addition to determining the ALP in respect of the international transactions, also proposed certain additions.
3. The Assessee instituted proceedings before the Dispute Resolution Panel [DRP] assailing the said draft order. The DRP passed an order under Section 144C(5) r/w Section 144C(8) of the Act on 09.09.2010 issuing certain directions. The DRP, inter alia, held that the approach of the TPO was in accordance with the correct interpretation of law.
4. In view of the directions issued by the DRP, the AO framed the assessment order dated 25.10.2010, inter alia, adding a sum of `26,86,57,520/- on account of the transfer pricing adjustment as determined by the TPO.
5. Aggrieved by the said assessment order, the Assessee filed an appeal before the Tribunal on various grounds, including the ground that the AO/TPO erred in making any transfer pricing addition.
6. The Assessee furnished the transfer pricing study, which established that the transactions were at ALP. The Assessee used the Transaction Net Margin Method [TNMM] as the most appropriate method, with operating profit/ value of services as the Profit Level Indicator [PLI]. The learned TPO faulted the Assessee for adopting the TNMM as the most appropriate method and held that, given the functional profile, the Assessee was carrying on the activities as a trader by purchasing products from its AE and re-selling them to the AE’s customers in India. The learned TPO held that given the FAR1 analysis, the Resale Price Method [RPM] is the most appropriate method.
7. The Asseesee disputed that its functional profile was that of a trader. It claimed that it provided product replacement services and, therefore, the international transactions should be benchmarked with other service providers, not with an entity engaged in trading activities.
8. The FAR analysis furnished by the Assessee set out that it is a captive service provider for its AE and assumes no risks. It explained that the AE had supplied equipment to the customers in India and AE undertakes the services of providing the replacement parts from its AE in US (CISCO US). It imports the replacement parts from its AE and supplies the same at nil value to the AE’s customers in India. It claimed that it does not hold any inventory on its own behalf and undertakes no attendant risk. Additionally, all intangibles and IPR belong to the CISCO group.
9. The Assessee stated that the CISCO group provides a warranty for its products and also sells AMC to its distributors. For these purposes, it supplies spare parts through the Assessee.
The Assessee supplies the products received from its AE free of cost to customers and sends back product replacements to its AE. For its services, the Assessee is entitled to a markup of 1%.
10. The Assessee also explained that it only ensures the prompt delivery of spares to the customers of its AE. Importantly, it does not sell the product to customers at a price, but provides parts to AE customers at a NIL sales price. It also does not bear any risk regarding spare parts deliveries, as the AE supplies them at its own risk. In the event that product replacement is rejected or the product becomes obsolete, the Assessee arranges for its return or scraps such products, as directed by its AE. The customs duties paid by the Assessee on import are also reimbursed by its AE.
11. The learned TPO examined the Assessee’s functional profile but did not accept that the Assessee’s functions were akin to those of a trader. The learned TPO proceeded on the basis that the Assessee purchases goods, holds inventory, and sells them to customers.
12. The learned TPO rejected TNMM as the most appropriate method and used RPM instead.
13. The learned Tribunal examined the Assessee’s functional profile and did not concur with the TPO’s finding. The Tribunal accepted that the functions of the Assessee were not akin to those of a trader. The Tribunal noted that a trader purchases goods by transfer of ownership and is free to fix the resale price and choose the customers to whom the goods are sold. The Tribunal found that the Assessee has no right to fix the resale price or to select its customers to whom the products are sold. The Assessee procures the spare parts to be supplied and earns a 1% markup on the cost of importing goods.
14. The learned Tribunal found that the Assessee was only a custodian of the goods imported until they were delivered to the clients or customers of its parent company, and under its directions. On the aforesaid factual conclusion, the Tribunal held that the RPM method would not be an appropriate method for determining the ALP.
15. Out of the comparables selected by the TPO, the learned Tribunal found that one of the entities, M/s Iris computers could be accepted as a comparable, but the other entities were not comparable on the basis of the FAR analysis.
16. In the aforesaid view, the learned Tribunal remanded the matter to the TPO/AO with directions to re-compute the ALP by adopting proper comparables and using the TNMM method to arrive at the ALP. Additionally, the Tribunal directed the AO/TPO to consider the issue of allowing the benefit of the 5% range as provided under the erstwhile proviso to Section 92C(2) of the Act, in light of the judicial precedents thereon.
17. In view of the above, CIT has filed the present appeal and has projected the following questions of law:
1. “Whether the Tribunal was correct in holding that the freight and insurance expenses are required to be reduced from the total turnover also in the absence of any provisions to this effect in section 10B of the Act?
2. Whether the Tribunal was correct in holding that the Resalae Price Method (RPM) as adopted by the TPO is not applicable in the case of the assessee on the ground that the purchase and transactions are with the same associated enterprise and that TNMM is the right method to be adopted?
3. Whether the Tribunal was correct in holding that the tax payer is not a trader merely because it has no right to fix the resale price and that the assessee is performing functions akin to those of C & F agents?
4. Whether the Tribunal was correct in holding that the comparables adopted by the TPO are to be rejected while upholding one of the comparables of the TPO whereas there is no significant difference between the other 3 comparables of the TPO and this company in terms of functions performed assets owned and risk undertaken?
5. Whether the Tribunal was correct in holding that the benefit of 5% range as provided under the erstwhile proviso to Section 92C(2) of the Act is to be granted to the assessee?”
18. This Court considered the present appeal and, on 11.07.2018, dismissed it, holding that no substantial question of law arose for consideration in the present case. This Court also referred to its earlier decision in Principal Commissioner of Income Tax and another v. Softbrands India Pvt. Ltd.: ITA No. 536/2015 c/w No. 537/2015, dated 25.06.2018, and observed that unless the findings of the learned Tribunal were found to be perverse, no question of law would arise.
19. This Court held that the question of whether comparables have been rightly selected, or whether the filters for arriving at the correct list of comparables have been applied, would not give rise to any substantial question of law.
20. The Department preferred an appeal against the judgment rendered by this Court, which is tagged along with the batch of matters, where this Court has followed the earlier decision in Softbrands (supra).
21. The Supreme Court did not accept the proposition as set out by this Court in Softbrands (supra). The Supreme Court held that the Tribunal has to follow the guidelines stipulated under Chapter X IT Act and Rules 10(a) to 10(e) of the Income Tax Rules, 1962. Any determination of ALP under Chapter X dehors the relevant provisions of the guidelines can be considered as perverse and may be considered as a substantial question of law. The Supreme Court remanded the batch of matters to the Court to examine whether the guidelines laid down under the Act and Rules would be followed while determining the ALP.
22. The learned counsel appearing for the Department fairly stated that question No.1 is not required to be considered as the directions issued by the Supreme Court in Sap Labs India Pvt. Ltd. v. The Income Tax Officer and other connected matters : ITA No.10/2011 were to examine whether the guidelines laid down in the Act and the Rules have been followed for determining the ALP. He also submitted that in addition to the questions of law as projected in the appeal, the following question of law may also be considered:
“Whether on the facts and in the circumstances of the case, the Tribunal’s order can be said as perverse in nature in holding that Transaction Net Margin Method is the Most Appropriate Method applicable for arriving at Arms Length Price in respect of product replacement segment contrary to provisions of Section 92C(2) of the Act read with Rule 10B of IT Rules and ignoring findings of the Transfer Pricing Officer which are based on consideration of Annual reports, clauses in ‘Product Replacement Agreement between the assessee and its Associated Enterprise?”
23. Concededly, the question whether TNMM or RPM is the most appropriate method, would depend on the functional profile of the assessee. The Tribunal examined the functional profile and the risks undertaken and found that the Assessee’s functional profile was akin to a service provider and not a trader. As noted, the
Tribunal also explained that the Assessee cannot be considered as a trader as it undertakes no risks; it does not determine the resale price, it supplies the product at NIL sale price to the AE’s customers; and it has no discretion to select its customers, or which particular spare part is to be supplied.
24. We find no fault with the learned Tribunal’s reasoning. The learned counsel appearing for the Department also does not argue that the learned Tribunal’s decision in regard to the functional profile of the Assessee is perverse.
25. Concededly, if it is accepted that the functional profile of the Assessee is akin to a service provider, RMP would not be an appropriate method for determining the ALP.
26. Insofar as question No.4 is concerned, the same is covered by the decision of this Court in Sap Labs (supra) and other connected matters decided on 28.08.2026.
27. We may note that the Tribunal mainly directed the TPO/AO to consider allowing the benefit of the 5% range as provided under the erstwhile proviso to Section 92 (c)(2) of the Act, in the light of the judicial proceedings. The manner in which the 5% tolerance limit is to be applied is now no longer res integra and is covered by the decision of this court in Sap Labs (supra) and other connected matters.
28. In view of the above, no question of law arises for the consideration of this Court. The appeal is accordingly dismissed.
Note:
1 Functions, Assets and Risks
