Court : Mumbai Bench of the Income-tax Appellate Tribunal
Citation : ACIT Vs. Dufon Laboratories [2010-T11-26-ITAT-MUM-T9
Brief:- The taxpayer, a manufacturer and exporter of chemicals had more than 97.5 percent of its sales to its associated enterprise (“AE”). It benchmarked the sales to AEs under the Comparable Uncontrolled Price (“CUP”) method based on the average price charged by the AEs to the customers. The Revenue observed that the non-AEs who purchased the chemicals paid a higher price and adopted the price charged to the non-AEs as the CUP.
The taxpayer stated that the AEs operated in the insulation industry and that the non-AEs were in the aerospace sector, which also resulted in the difference in pricing. It also contended that the AE came into existence for the reason that its ultimate customers required long term warranties on the product and were more comfortable dealing with an American firm than directly with the taxpayer. It was also pointed out that the ALP determined by the Revenue turned out to be higher than even the price ultimately charged to the buyers by the AEs. It also stated that the sale to non-AEs were in small quantities and non-recurrent, which cannot be compared directly with the sales to the AEs. However, the Revenue rejected taxpayer’s contentions after considering various aspects concerning the comparability of sales to non-AEs including differences in turnover, quantity, customer profiles and geography. On appeal, the Tribunal accepted the contentions of the taxpayer and ruled that there was no case for the Revenue in making the adjustments and accordingly, the sales to the AEs were held to be at arm’s length.
Facts:- The assessee was engaged in the business of processing and exporting chemicals. Its international transactions were primarily that of sales to its Associated Enterprise (“AE”), namely M/s. Chemical Link LLC, USA. The assessee also had sales transactions with non-AEs, although the majority of the sales transactions (i.e., 97.5% of total sales) were with its AE. The assessee determined the ALP of its international transactions with the AE using the Comparable Uncontrolled Price (“CUP”) Method.
During the assessment proceedings, the Assessing Officer (“AO”) sought justification from the assessee for the variation in selling price of products sold to AE vis-à-vis non-AEs.
The assessee explained the difference as being on account of the quantity discount and on account of the difference in the end-user of the products, i.e., the difference in the sector / industry in which the user operates. The assessee had provided a 20% discount on account of the former, and a 1% discount for the latter (industry discount). In response, the AO observed the following:
• The sale price of a product was not dependent on its end use, and no evidence to support this contention had been furnished by the assessee.
• The assessee furnished no evidence of there being any agreement between the assessee and the AE for discount on quantity / bulk purchases.
The AO therefore concluded that the assessee had not followed the CUP method properly, and had failed to furnish comparable prices. Furthermore, the assessee’s contention regarding the 20% quantity discount was not tenable according to the AO. However, the AO allowed a 5% industry discount, stating that it was a ‘general practice in the industry’.
In addition to the transfer pricing adjustment, the AO disallowed the deduction claimed by the assessee on net interest income and dividend income under section 80HHC of the Act.
Aggrieved by the order of the AO, the assessee filed an appeal before the Commissioner of Income Tax (Appeals) [“CIT(A)”].
Appeal proceedings before the CIT(A)
The assessee firstly explained to the CIT(A) that the AE had been set up primarily for two reasons. The first being that the customers felt comfortable dealing with an American organisation, and the second being because of the warranty to be given on the products which had a sensitive and important application.
Furthermore, the variation in selling price of products sold to the AE vis-à-vis non-AEs was explained by the assessee using the below outlined contentions (See Note- 1 Below) , which were acknowledged by the CIT(A) stating that the application of the CUP Method requires a high degree of comparability :
• Quantity differences : Volume differences are a material factor in determining prices. The rate of small / uneconomical quantities would be high so as to recover fixed costs of dispatch such as clearing and forwarding, and documentation expenses.
• Geographical differences : 97.5% of the sales of the assessee were to Europe and the USA, which are large markets, because of the bulk of the consumption carried out here. These markets also had greater level of competition. On the other hand, sales to non-AEs in South East Asia, were faced with lesser competition as this market was relatively smaller and did not attract big players.
• Customer profile : The assessee dealt with big multi-national customers who are considered to be eminent and very reputed in this line of business, and therefore commanded a price for the product, which left the assessee with no scope of getting a price of its choice.
• Survival of the Assessee : The assessee was dependent on the AE for capturing and maximising its profits in the big and flourishing markets of the USA and Europe, which, in the current year, accounted for 97.5% of its business. On the other hand, business with non-AEs took place once in a while and comprised small orders which summed up to only 2.5% of sales. Therefore, higher prices paid by non-AEs have little relevance to the business profile of the assessee.
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• Paradox in ALP computation : The assessee pointed out a paradox in the AO’s ALP computation, whereby the AO had worked out a sale price for the assessee to its AE, which worked out to be more than the actual price paid by all its customers to the AE.
• Losses suffered by AE : The AE had no other business interests other than with the assessee. It had also suffered losses not only in the current year, but also in the last year. Therefore, it had no intention of posting higher profits outside India.
The CIT(A) appreciated that the assessee was not a multinational but small manufacturer and exporter, which had established an AE under the commercial compulsion of offering a long-term warranty to its customers. The CIT(A) reiterated that the basic intent of a separate code on transfer pricing was an anti-tax avoidance measure in order to avoid cross border shifting of profits from India to offshore jurisdictions by multinational companies. In this context, the CIT(A) referred to the concept of risk based scrutiny / audit, and stated that if the same were to be applied to the assessee, then the CIT(A)’s observations would be as follows:
• AE is in USA where the tax rates were higher.
• Internal Revenue Service of USA is known to follow a strict transfer pricing regime.
• Assessee enjoys a benefit under section 80HHC.
• AE has suffered losses.
Considering all these factors, the CIT(A) held that there could not be any saving or avoidance of tax by the assessee by shifting profits outside India. The CIT(A) therefore, regarded this to be a low risk case. Furthermore, placing reliance on the decision of the Bangalore Tribunal in the case of Phillips Software v. ACIT [2008-TII-09-ITAT-Bang-TP], the CIT(A) held that while the motive of tax avoidance need not be shown at the time of initiating transfer pricing provisions, the same was required to be shown at the assessment / audit. It was also stated that the AO had to demonstrate that the assessee manipulated prices to shift profits outside India.
In support of this, the CIT(A) observed that the assessee had furnished a per unit comparison of its prices to the AE, and prices of the AE to its customers. If overheads are reduced from the difference of the two prices above, then the AE is left with losses. Further, the assessee has earned a net profit of 42.49% which by no standard is low or unreasonable.
Based on all the above information, the CIT(A) held that the transactions were at arms’ length and that no adjustment was required. The CIT(A) thereby deleted the transfer pricing adjustment.
In respect of interest income disallowed for deduction under section 80HHC, the assessee argued that due to business reasons, the assessee has to invest in fixed deposits (“FD”) in order to avail overdraft (“OD”) facility and the FDs are placed because of the business necessity to avail the OD facility. Similarly, in respect of the disallowance for the deduction of dividend income under section 80HHC, the assessee argued that shares of the Cooperative Bank were purchased to comply with the legal requirements of the Cooperative Law. Unless the shares are taken, bank facilities are not disbursed.
On this issue, the CIT(A) held that interest income is business income as there is a direct nexus between interest received and export activity and it is therefore part of operational income. Similar view was taken by CIT(A) on the issue of disallowance of dividends.
Aggrieved by the order of the CIT(A), the Revenue appealed to the Tribunal.
Appeal Proceedings Before the Tribunal
The Revenue supported the order of the AO, and placed reliance on an earlier year’s order of the Tribunal whereby the matter was set aside for lack of evidence. The Revenue contended that since all facts were available this year, the matter could be decided.
As for the assessee, it placed before the Tribunal the same contentions / observations as it had before the CIT(A).
The Tribunal held that the following factors had been rightly considered by the CIT(A) :
• Quantity differences: Volume sold will have a bearing on prices and is a significant factor in fixing prices.
• Geographical differences : Geographical situations in several ways influence the transfer price (Ranbaxy Laboratories v. ACIT  299 ITR (AT) 175 (Delhi)) .
• Customer profile : Transactions with high profile customers would be different from sales to small players in South East Asia.
• Survival of the Assessee : The assessee has to depend on the AE for capturing and maximising its profits in the big and flourishing market of USA and Europe.
• Losses suffered by AE : Reduction of overheads from the difference between the per unit selling price of the AE and the per unit purchase price of the AE, leaves the AE with hardly any profit.
Upholding the order of the CIT(A), the Tribunal opined that the transactions of the assessee with its AE were at arms’ length and that no adjustment was required.
The Tribunal also upheld the CIT(A) order in respect of the treatment of interest earned on fixed deposit and dividend income as business income and allowed deduction under section 80HHC of the Act.
On the issue of comparability, this ruling certainly comes as welcome guidance to the taxpayers as well as to the assessing authorities, as it clearly lays down some of the important factors that would typically influence the determination of prices by most corporates. Although this ruling does not provide guidance on how these factors can be accounted for, but perhaps, adjustments made on account of these factors will find better acceptance with the authorities provided there is a sound basis of computation supported by adequate documentation.
Further, when undertaking an audit and evaluating the intent of tax avoidance, this ruling puts forth the relevance of evaluating risk after considering the business and commercial realities of a taxpayer. This, in spirit, finds similarity to the risk based scrutiny / assessment proposed by the soon to be implemented Direct Tax Code.
As for interest income from FDs placed, and dividend income from shares bought because of business necessity, this ruling establishes that they can be considered as business income eligible for deduction under section 80HHC.
1. Case Laws relied upon by the assessee – Aztec Software and Technology v. ACIT  294 ITR 32 (Bangalore), Ranbaxy Laboratories v. ACIT  299 ITR (AT) 175 (Delhi), Mentor Graphics (P) Ltd. v. DCIT  112 TTJ 408 (Delhi).