ITAT acknowledged the fact that the Resale Price Method (RPM) is one of the standard methods in case of distribution and marketing activities i.e. when goods are purchased from Associated Enterprises (AEs) and sold to unrelated parties.
INCOME TAX APPELLATE TRIBUNAL,MUMBAI
ITA No. 5423/Mum/2009 – Assessment Year: 2003-04
I.T.O. Vs. L’oreal India P. Ltd.
Date of pronouncement: 25.04.2012
Per B.R.MittaI, JM
The department has filed this appeal for the assessment year 2003-04 against the order of the CIT(A)-XIX, Mumbai dated 24.7.2009.
2. Ground No.1 is as under:
“Whether on the facts and in the circumstances of the case and in law, ld CIT(A) erred in deleting the expenditure of Rs.2,07,58,119(correct amount is Rs.2,70,58,119) incurred on advertisement under the head Media-Technical ignoring the fact that the said expenditure resulted in creating a benefit of enduring nature and thus is capital in nature and cannot be allowed as deduction u/s.37(1) of the Income tax Act, 1961.”
3. The relevant facts are that the assessee company is in the business of manufacturing & trading in cosmetics. For the assessment year under consideration, the assessee incurred an expenditure of Rs.2,70,58,119 under the sub-title ‘Media-Technical’. During the course of assessment proceedings, it was stated that the said expenditure was on the production of films and on models. The Assessing Officer stated that the said expenditure resulted in creating benefit of enduring nature and relying on the decision of Hon’ble apex Court in the case of Alembic Chemical Works Co. Ltd vs CIT(1989) 177 ITR 377(SC), held that the said expenditure is capital in nature and cannot be allowed as deduction under section 37(1) of the Act. Being aggrieved, the assessee filed appeal before the first appellate authority.
4. Before the CIT(A), on behalf of the assessee, it was contended that considering the business of the assessee of manufacturing and trading in cosmetic products i.e. Fast Moving Consumer Goods(FMCG), there is a cut-throat competition and it was imperative for the assessee to come out with a new and better advertisement films on a continuous basis to attract, retain-customers. It was contended that advertisement does not result in creation of any new asset and/or benefit of enduring nature as these advertisements only increases the basic awareness of the products. It was further contended that the advertisements relate to brands which are only licensed to the assessee. On behalf of the assessee, reliance was place on the decision of Hon’ble Jurisdictional High court in the case of CIT vs. Geoffrey Manners & Co. Ltd., 315 ITR 154(Bom) and also the decision of Mumbai Tribunal in the case of DCIT vs Metro Shoes P Ltd., 258 ITR 106(AT). Ld CIT(A) after considering the submissions of the assessee held that the advertisement expenditure of Rs.2,70,58,119 is revenue in nature and incurred wholly and exclusively for the purpose of business of the assessee. Hence, department is in appeal before us.
5. During the course of hearing, learned Departmental Representative supported the order of Assessing officer. He submitted that ld CIT(A) has not considered the decision of Hon’ble apex Court in the case of Alembic Chemical Works Co. Ltd (supra). On the other hand, learned A.R. of the assessee made his submissions on the lines of the submissions made before the CIT(A).
6. We have carefully considered the submissions of representatives of the parties and orders of the authorities below. We observe that reliance placed by ld D.R. on the judgment of Hon’ble apex Court in the case of Alembic Chemical Works Co. Ltd (supra) supports the case of the assessee. In that case, Their Lordships have stated that there is no single definitive criterion which, by itself, is determinative as to whether a particular outlay is capital or revenue. It was further stated that the question of each case as to whether the expenditure is capital or revenue in nature would depend on the facts of a particular case. It was held that even the idea of ‘once for all’ payment and “enduring benefit” are not to be treated as something akin to statutory conditions; nor are the notions of “capital” or “revenue” a judicial fetish. It was held that what is relevant is the purpose of the outlay and its intended object and effect and to consider in a commonsense way having regard to business realities. In a given case, the test of “enduring benefit” might break down. However, the similar issue has been considered by Hon’ble Jurisdictional High Court in the case of Geoffrey Manners & Co. Ltd.(supra), which has been considered by ld CIT(A). In the said case, the assessee incurred expenditure on film production by way of advertisement in the marketing products manufactured by it. The AO disallowed the expenditure incurred by the assessee for promotion films, slides, advertisement films and treated as capital expenditure. In appeal, ld CIT(A) held that the films were in the form of advertisement whose life term could not be ascertained and, therefore, they could not be held as capital expenditure. The Tribunal upheld the order of ld CIT(A). In further appeal before Hon’ble High Court, it was held that the expenditure was incurred in respect of promoting ongoing products of the assessee and, therefore, the expenditure is for promotion of the products of the assessee which is revenue in nature. In the case before us also, the expenditure has been incurred by the assessee for production of ‘ad-films’, advertisement in electronic and print media, in respect of promotion of its ‘on-going products’. Hence, we hold that the said expenditure has rightly been treated as revenue in nature by CIT(A) , which was incurred by the assessee wholly and exclusively for the purpose of its business. We, therefore, uphold the order of ld CIT(A) and reject the ground No.1 taken by the revenue.
7. Ground No.2 is as under:
“Whether on the facts and in the circumstances of the case and in law, the ld CIT(A) erred in holding that the resale price method (RPM) was the most appropriate method for determining the arms length prices of the assessee’s international transaction in respect of imports of finished goods.”
8. Facts are that assessee is a 100% subsidiary company of L’Oreal SA France and is engaged in the business of manufacturing and distribution of cosmetics and beauty products. The assessee company has exclusive rights to import, manufacture, market, distribute and sell of branded products of consumer products and the professional products relating to L’Oreal Group. The assessee company has its business into two segments namely; (i) manufacturing and (ii) distribution. A reference was made to Transfer Pricing Officer (TPO) under section 92CA(1) of the I.T.Act. The TPO has not made any adjustment in respect of business of manufacturing segment of the assessee. However, in respect of business of distribution, the TPO has suggested adjustment of Rs.4,90,07,000 by applying Transactional Net Margin Method(TNMM) in respect of international transactions relating to purchase of finished goods by rejecting the Resale Price Method (RPM) adopted by the assessee for determining Arm’s Length Price. It is relevant to state that the assessee has adopted Cost Plus Method of purchase of raw material in respect of manufacturing segment and as mentioned hereinabove, no adjustment was made because it was found by TPO that the gross margin of the assessee in the said segment was commensurate with the gross margins of the comparable companies. The TPO while rejecting the RPM as adopted by assessee and in applying TNMM stated the following grounds:
“(i) The appellant is consistently incurring losses in India and hence the pricing policy is not at arm’s length.
(ii) Gross margin in case of comparable cases cannot be relied upon because of product differences of comparable companies.
(iii) The degree of similarity in the functions performed, assets employed and risks assumed between the assessee and the comparable companies identified by the appellant is not sufficient for the application of resale price method but is sufficient for application of TNMM.
(iv) Adjustment of the margin/profits of the appellant is not permissible under rule 10B.”
9. The TPO observed that the operating margin of the assessee under distribution segment was (-) 19.84%, which was less than the average profit margin of comparable companies of 0.36% on sales. Accordingly, the TPO applied profit margin of 0.36% on sales in respect of distribution segment and computed the ALP for the purchase of finished goods at Rs.2,70,81,000 as against the actual value of Rs.7,60,88,729 to arrive at addition of Rs.4,90,07,000. The AO made the addition as suggested by TPO. Being aggrieved, assessee filed appeal before the CIT(A).
10. On behalf of the assessee, it was submitted that as per OECD Guidelines and the guidance note issued by the ICIA, RPM is the most appropriate method in case of distribution and marketing activities, especially when the goods are purchased from Associated Enterprise(AE) and resold to unrelated parties. The OECD Guidelines in para 2.22 was referred to, which has been reproduced by ld CIT(A) in para 7.11 of the impugned order, which reads as under:
“2.22 An appropriate resale price margin is easiest to determine where the reseller does not add substantially to the value of the product. In contrast, it may be more difficult to use the resale price method to arrive at an arm’s length price where, before resale, the goods are further processed or incorporated into a more complicated product so that their identity is lost or transformed.”
11. It was contended that assessee merely buys the products from its AE and sells to unrelated parties without any further processing and, therefore, RPM has correctly been applied. It was also contended that the products of comparables selected by the assessee fall under the category of FMCG products and are for the personal consumption of an individual. The assessee also referred FAR analysis. The assessee further submitted before ld CIT(A) that the margin workings after making adjustment for marketing and selling expenses is the profit of the comparable companies to make it comparable to the profits of the assessee and operating margin works out to approximately (-) 23.55% on sales for comparable companies as against (-) 19.84% on sales for the assessee. Thus, the net margins of the assessee are higher than the margins of the comparables even based on TNMM and hence, the assessee has justified the arm’s length price of the purchase price of goods. The assessee further contended before ld CIT(A) that it has been following market penetration strategy since the commencement of its distribution segment in 2001 and on the contrary, competitors/comparables considered by TPO had their presence in the Indian market since 1980’s and early 1990’s and having established themselves firmly in the Indian market. It was also contended that net losses of the assessee in the distribution segment are only for three years and after which the assessee has been earning increasing profits. The comparative table giving profit analysis for the last 7 years was furnished before ld CIT (A) and is referred to in para 7.19 of the impugned order of ld CIT(A). The assessee also furnished certificates from overseas Associates Enterprises confirming that the margin earned by the AEs on supplies to the assessee is only 2% to 4% or even less. Hence, the assessee contended that TPO’s contention that the goods purchased from its AEs at a higher price than the ALP and that AEs earned higher profit is not justified. The assessee also submitted that TNMM is not the appropriate method and the grounds taken before ld CIT(A) are mentioned by ld CIT(A) in para 7.23 of the impugned order, which are as under:
“As per the OECD guidelines, TNMM is a residuary method and must be used as a last resort for calculating the arm’s length price because the arm’s length price in case of TNMM is determined in an indirect manner from net margins.
A significant weakness of TNMM has been highlighted in paragraphs 3.29 and 3.35 of the OECD guidelines, which states that the net margins of a taxpayers can be influenced by various factors that either do not have an effect, or have a less substantial effect on price or gross margins, because of the potential for variation of operating expenses across enterprises.
The appellant has submitted that the TPO made a huge adjustment of approx. 67% to the value of imports results in an anomalous situation. The appellant has further assumed a hypothetical situation where if the net margins of the comparable companies were to be 10.36%, the adjustment made would be of entire purchase value (i.e. more that 100% addition) thereby implying that the appellant should have procured the goods at nil cost/price. This is because net margins is affected by several factors and not only purchase price.”
12. Ld CIT(A) after considering above submissions of the assessee has held that RPM is the appropriate method and, accordingly, deleted the entire addition of Rs.4,90,07,000 made by TPO, inter alia, observing at paras 7.24 and 7.25 as under:
“7.24 I have perused the assessment order, TPO order and submission of the appellant. There is no order of priority of methods which the tax payers must follow. Transactional profit Method (TNMM/PSM) are treated as methods of last resort only when the standard method for CUP, RPM, CPM cannot be reasonably applied. The appellant has adopted the RPM which is a Standard Method.
• RPM adopted by the appellant appears to be the most appropriate method as it is based on the similarity of functions performed by it and not on the similarity of product distributed.
• Even OECD guidelines prefer methods which require computation of ALP directly based on gross margin over a method which requires computation of ALP in an indirect manner because, comparing gross margins extinguishes the need for making adjustments in relation to differences in operating expenses, which could be different from enterprise to enterprise.
• The contention of the TPO that the comparable companies selected by the appellant for the distribution segment should not be allowed on the ground of product differentiation cannot be accepted because the TPO has itself selected comparable companies for manufacturing segment from the category of FMCG products that are used for personal consumption.
• The losses incurred by the appellant are on account of business strategy of the appellant and can also be attributed to the initial years of the distribution segment. The TPO has erred in relating the losses to the transfer pricing policy of the appellant.
• The profit margin earned by the AE need to be considered for an all round approach in transfer pricing. The fact that appellant was incurring losses and its AEs were earning low profits establishes that there is no motive on the part of the appellant to transfer profits to its AE.
7.25. Based on above discussions, it is held that RPM is the most appropriate method and accordingly the appellant’s international transaction in respect of imports of finished goods can be said to be at arm’s length . Thus, the entire addition made by TPO of Rs.4,90,07,000 is deleted.”
13. Hence, the department is in appeal before the Tribunal.
14. At the time of hearing, learned Departmental Representative referred to para 6.4 of the order of TPO and submitted that the assessee has given gross profit margin of 40.80% and reduced cost of goods sold from net sale. He submitted that the assessee has not reduced operating expenses from cost of goods sold. Ld D.R. submitted that the assessee is incurring huge expenses on selling and distribution i.e. about Rs.7,62,05,000/- and hence there is a substantial value addition to the goods sold. Therefore, RPM is not the right method to determine ALP. Ld D.R. referred to the decision of ITAT in the case of M/s. Star Diamond Group vs. DIT in I.T.A. No.3923/M/2008 dt.28.1.2011 and submitted that it was held that RPM is the most appropriate method for determining the ALP with respect to AEs if there is no value addition to the goods. When there is a value addition to the product, RPM cannot be adopted. Ld D.R. also referred to para 2.29 of OECD Transfer Pricing Guidelines 2010 and submitted that with reference to RPM it is provided as under:
“An appropriate resale price margin is easiest to determine where the reseller does not add substantially to the value of the product. In contrast, it may be more difficult to use the resale price method to arrive at an arm’s length where, before resale, the goods are further processed or incorporated into a more complicated product so that their identity is lost or transformed (e.g. where components are joined together in finished or semi-finished goods). Another example where the resale price margin requires particular care is where the reseller contributes substantially to the creation or maintenance of intangible property associated with the product (e.g. trademarks or trade names) which are owned by an associated enterprise. In such cases, the contribution of the goods originally transferred to the value of the final product cannot be easily evaluated.”
15. Ld. D.R. submitted that since the assessee has spent huge sum on selling and distribution of the products which have a trade name “L’Oreal”, TPO has rightly held that RMP method cannot be applied to determine the ALP. Ld D.R. also referred to Rule 10B(1)(b)(iii) and submitted that in case of RPM, the price so arrived at has to be reduced by the expenses incurred by the enterprises in connection with purchase of property or obtaining of services. Therefore, the operating expenses incurred by the assessee in connection with purchase of goods or providing services have to be reduced alongwith cost of traded goods and services paid while computing the gross profit margin. He submitted that the assessee only included purchase of cost of traded goods in the cost base excluding operating expenses incurred in connection with purchase of goods and thus the cost base followed by the assessee is wrong. Ld D.R. submitted that in the facts of the case, TNMM is the most appropriate method and, therefore, the adjustment suggested by TPO is to be confirmed.
16. On the other hand, ld A.R. supported the order of ld CIT(A) and to justify the order of ld CIT(A) made his submissions on the lines of submissions made before TPO as well as ld CIT(A). He submitted that there is no value addition to goods purchased by the assessee. He referred to order of ITAT in assessee’s own case for A.Y. 2002-03 dated 28.1.2011 in ITA No.6745/M/08 and submitted that TPO himself accepted RPM for purchase of finished goods in the distribution segment of the assessee and no adjustment was made by considering that operating margin of the assessee in the said segment being commensurate with the operating margin of the comparable companies. He submitted that TPO also accepted RPM for distribution segment in A.Y. 2004-05, A.Y. 2005-06, AY. 2006-07 as well as AY 2007-08 and to substantiate his submissions, ld A.R. referred to pages 135 to 140 of paper book which is TPO’s order for A.Y. 2004-05, page 171 of PB which is order of TPO for A.Y. 2005-06, page-201 for A.Y 2006-07 and page 228 for A.Y. 2007-08 in respect of orders of TPO. He submitted that order of ld CIT(A) may be confirmed.
17. We have carefully considered the submissions of the representatives of the parties, orders of the authorities below as well as TPO’s order in assessee’s own case for the preceding assessment year, viz; A.Y. 2002-03 as well as succeeding assessment years to the assessment year under consideration, referred hereinabove and also the ITAT order dated 28.1.2011 (supra).
18. The only question for our consideration is as to whether to determine ALP in respect of business activity relating to distribution segment of the assessee with the AE is to be considered by RPM or TNMM. We observe that TPO has applied TNMM and has suggested adjustment of Rs.4,90,07,000 by showing desired profits margin of comparable companies at 0.36% on sales as the operating margin of the assessee shown is (-) 19.84%. Accordingly, TPO computed the ALP in the purchase of finished goods at Rs.2,70,81,000 as against actual value of Rs.7,60,88,729 shown by the assessee. We observe that TPO stated that the assessee has adopted RPM for determining the ALP for the import of finished goods. He has stated that the assessee has determined gross profit margin by taking difference between costs of purchase of value of sales. The assessee has stated that the gross profit margin in the distribution activity was 40.80% vis-à-vis comparable companies identified by the assessee, earned margin of 14.85%. However, TPO suggested that as per Rule 10B(2) of Income tax Rules, for the purpose of determining ALP, the comparable transaction considered by the assessee must be similar to the international transaction in terms of similarity in the characteristics of the product and the functions performed, assets employed and risks assumed in the controlled transaction and the uncontrolled transaction must also be similar. Accordingly, TPO did not agree with the comparable companies considered by the assessee. He also stated that RPM could be an appropriate method only when there is no value addition undertaken by the distributor. The TPO considered the selling and distribution expenses in marketing and stated that there is a value addition by the assessee and thus TNMM is the most appropriate method. The TPO did not accept the adjustment given by the assessee and, accordingly, made this addition.
19. During the course of hearing, ld D.R. also supported the method considered by TPO and referred to para 2.29 of OECD Price Guidelines 2010 as stated hereinabove. On the other hand, ld A.R. justified the RPM method adopted by it and also referred to order of TPO in the preceding assessment years as well as succeeding assessment years to the assessment year under consideration to substantiate that RPM is the most appropriate method to determine ALP. He submitted that the assessee made adjustment for marketing and selling expenses to the profits to make it comparable to the comparable companies’ profits. We agree with ld CIT(A) that there is no order of priority of methods to determine ALP. RPM is one of the standard method and OECD guidelines also states that in case of distribution and marketing activities when the goods are purchased from AEs which are sold to unrelated parties, RPM is the most appropriate method. In the case before us, there is no dispute to the fact that the assessee buys products from its AEs and sells to unrelated parties without any further processing. Further, the assessee has also produced certificates from its AEs that margin earned by AEs on supplies to the assessee is 2% to 4% or even less. The department has not disputed the above certificates. Therefore, the TPO’s contention that AEs have earned higher profit is not based on facts. On the other hand, we agree with ld CIT(A) that the margin of profit earned by AEs themselves is also reasonable and, therefore, it could not be said that there is shift of profits by the assessee to its AEs at overseas. Considering the facts of the case and also the order of TPO that RPM method has been accepted in the preceding as well as succeeding assessment years to the assessment year under consideration in respect of distribution segment activity of the assessee, we do not find any infirmity with the order of ld CIT(A) in deleting the addition of Rs.4,90,07,000 made by the AO. Ground No.2 is accordingly rejected by upholding the order of ld CIT(A).
20. Ground No.3 is as under:
“Whether on the facts and in the circumstances of the case and in law, the ld CIT(A) erred in holding that the assessee is in receipt of services and benefit from its Associative Enterprises in lieu of the marketing fee payments amounting to Rs.1,14,28,409.”
21. The assessee has paid to its overseas AEs a sum of Rs.1,14,28,409 as cost contribution wherein certain common marketing services were rendered by group entities. In this regard, it is relevant to state that the Consumer Product Division of L’Oreal Group created a centralized International Marketing Management Division known as ‘DMI’ for each of the three brands, namely, L’Oreal Paris, Garnier and Maybelline. Under the marketing service arrangement each affiliate is to bear their appropriate share of the international marketing costs incurred. As per the agreement, the allocation of marketing expenses by DMI, there is mark up of 5% of internal costs. Thus, the assessee contributed Rs.1,14,28,409 as marketing services fees. TPO in the course of Transfer Pricing Proceedings, asked the assessee to provide necessary evidence to show the receipt of services. TPO has stated that no documentary evidence in this regard has been submitted by the assessee. He has stated that in the absence of any direct evidence to indicate the benefit to the assessee, it is concluded that the assessee has not benefited at all from the cost sharing arrangement and has considered the cost sharing arrangement at ALP for the same at Nil. Therefore, AO while making the assessment order added the said amount of Rs.1,14,28,409 to the income of the assessee. Being aggrieved, the assessee filed appeal before ld CIT(A).
22. Ld CIT(A) after considering the submissions of the assessee has stated in paras 7.31 to 7.35 that the assessee has submitted documents to prove the receipt of services and benefits from DMI in lieu of the marketing fee payments. Ld CIT(A) has also discussed in para 7.35 the correspondence between the assessee and DMI to come to the conclusion that the assessee has received marketing services against which the said amount of Rs.1,14,28,409 has been shared by the assessee. Therefore, ld CIT(A) has deleted the disallowance made by the Assessing Officer. Hence, the department is in appeal before us.
23. During the course of hearing, ld D.R. submitted that ld CIT(A) has considered additional documents which were produced before him without seeking Remand Report from the Assessing Officer. He submitted that TPO has categorically stated that the assessee could not furnish evidence to justify that the assessee has received any benefit from the cost sharing arrangement and, therefore, in ALP study determined the same at Nil.
24. Ld A.R. admitted that fresh documents were submitted by the assessee before ld CIT(A) which were considered while allowing the claim of the assessee and deleting the disallowance made by the AO. He submitted that he has no objection if the matter is restored to the file of TPO to examine the same in the light of benefits if any derived by the assessee against the said payments to DMI.
25. In view of above submissions of representatives of the parties, we consider it prudent to set aside the orders of authorities below and restore the matter to the file of the AO with a direction that he will get it examined from TPO as to whether the assessee has received any benefit under cost sharing arrangement for which assessee made the said payment of Rs. Rs.1,14,28,409. In case assessee is able to produce requisite documents to the satisfaction of the TPO that the assessee received benefit under cost sharing arrangement, he will decide the claim of the assessee accordingly. Hence, ground No.3 is allowed for statistical purposes.
26. In the result, appeal filed by the department is partly allowed for statistical purposes.
Pronounced in the open court on 25th April, 2012