Toyota Boshoku Automotive India Pvt. Ltd Vs ACIT (ITAT Bangalore)
Held that assessee leverages on the use of technology from the AE and does not contribute any unique intangibles to the transaction. PSM cannot be applied. TNM Method is Most Appropriate Method.
Facts- The appellant is engaged in the business of manufacturing automobile component such as seats, door strings, and interiors for the automobile industry. During the course of scrutiny proceedings, it has been observed that the company had entered into several international transactions with its associated enterprises. The case was referred to the transfer pricing officer as per sec. 92CA and made an adjustment of Rs.7,52,74,460/-.
Being aggrieved, the appellant preferred the present appeal.
Conclusion- The coordinate bench in assessee’s own case has held that the assessee leverages on the use of technology from the AE and does not contribute any unique intangibles to the transaction. It may be true that the Assessee aggregated payment of royalty with the transaction of manufacturing as it was closely linked and adopted TNMM but that does not mean that the transactions are so interrelated that they cannot be evaluated separately for applying PSM. Further, the Assessee does not make any unique contribution to the transaction, hence PSM in this case cannot be applied.
Held that TNM Method is the Most Appropriate Method and the AO is directed to apply the said method in determining the ALP, after affording an opportunity of being heard to the assessee.
FULL TEXT OF THE ORDER OF ITAT BANGALORE
This appeal filed by the assessee is directed against the asst. order passed by the National e-Assessment Centre, Delhi dated 22/4/2021 for the asst. year 2016-17 with the following grounds of appeal:-
“General
1. That on facts and circumstances of the case and in law, the order passed by the Learned AO, pursuant to the directions of the Hon’ble Dispute Resolution Panel – 2, Bangalore (‘Panel’ or ‘DRP’), and the order of the Learned Deputy Commissioner of Income-tax, Transfer Pricing- Circle (2)(2)(2), Bengaluru (‘Learned TPO’) to the extent prejudicial to the Appellant, is bad in law and facts and liable to be quashed.
Transfer pricing (‘TP’) related
2. That, on the facts and in the circumstances of the case, the Learned Transfer Pricing Officer (‘TPO’)/ Hon’ble DRP, erred in making a TP adjustment to the arm’s length price of the Appellant’s international transaction of payment of royalty amounting to INR 75,274,460.
3. That, on the facts and circumstances of the case, the Learned TPO/ Hon’ble DRP erred in rejecting the TP documentation maintained by the Appellant under section 92D of the Act read with Rule ioD of the Income- tax Rules, 1962 (‘the Rules’).
4. That, on the facts and circumstances of the case, the Learned TPO/ Hon’ble DRP erred in rejecting the aggregation approach followed by the Appellant to benchmark the international transactions including payment of royalty.
5. That, on the facts and circumstances of the case, the Learned TPO/ Hon’ble DRP has erred in questioning the commercial rationale of payment of running royalty to Toyota Boshoku Corporation (‘TBC’) by alleging that the transaction is hypothetical.
6. That, on the facts and circumstances of the case, the Learned TPO / Hon’ble DRP has been inconsistent in the view to the extent of holding that on one hand there is no requirement for making any royalty payment whereas on the other hand, it was held that it is because of the technology transferred that the Appellant is being able to earn non-routine profits.
That, on the facts and circumstances of the case, the Learned TPO / Hon’ble DRP has erred in rejecting the Transactional Net Margin Method (‘TNMM’) used by the Appellant and applying the Profit Split method (‘PSM’) as the most appropriate method (‘MAM’) to benchmark the international transaction of payment of royalty.
Without prejudice, while applying PSM, the Learned TPO / Hon’ble DRP erred in:
a) comparing two totally different ratios/ profit level indicators for computation of TP adjustment wherein the ratio of royalty income by sales of comparable companies is compared with the ratio of operating profit earned by the Appellant before royalty to its operating revenue to determine additional profit earned by the Appellant;
b) considering royalty income of comparable companies instead of royalty expenses to compute the royalty / sales ratio;
c) applying arbitrary methodology of profit allocation between the AE and the Appellant in a 2:3 ratio.
9. Without prejudice , the Learned TPO/ Hon’hle DRP while undertaking the comparability analysis for applying PSM erred in,
a) considering loss incurred on account of foreign exchange fluctuations as operating in nature while computing the ratio of operating profit earned (before royalty) by the Appellant to its operating revenue;
b) rejecting functionally similar comparable companies selected by the Appellant, without providing any reason for rejection of such comparable companies;
c) randomly selecting certain companies which are functionally dissimilar i.e., Minda Industries Limited, JBM Auto Limited, ZF Steering Gear (India) Limited;
d) selecting companies which have incurred R&D expenses whereas the selection criteria set by the TPO himself suggests that companies which have incurred R&D expenses should not be selected as comparables; and
e) not selecting certain companies proposed by the Appellant i.e., Rasandik Engineering Industries India Limited and Sandbar Technologies Limited which have not incurred any R&D expenses.
10. That, on the facts and circumstances of the case, the Learned TPO / Hon’ble DRP has erred in applying an inconsistent approach in AY 2016-17 as the Learned TPO had himself accepted similar approach of economic analysis, carried out by the Appellant in AY 2011-12 as well as AY 2012-13 and concluded that all the international transactions of the Appellant, including the payment of royalty was at arm’s length.
ii. That, on the facts and circumstances of the case, the Learned AO has erred in passing the assessment order contrary to the directions issued by the Hon’ble DRP. (Tax effect: INR 26.050-985)
Corporate tax related
12. That, on the facts and circumstances of the case, the Learned AO/ Hon’ble DRP erred in considering the reimbursements of INR 53,809,953 made to TBC by the Appellant as Fees for Technical Services (‘FIS’) and consequently disallowing the same under section 40(a)(i) of the Act for alleged failure to withhold taxes under section 195 of the Act.
13. That, on the facts and in the circumstances of the case, the Learned AO/ Hon’ble DRP erred in not appreciating that amount paid to TBC was not towards rendition of any service but represented reimbursement of the salary cost incurred by the Appellant on which tax was deducted at source under section 192 of the Act.
14. That on the facts and the circumstances of the case, the Learned AO/ Hon’ble DRP erred in not appreciating the fact that the seconded employees are the employees of the Appellant and not TBC.
15. That on the facts and circumstances of the case, the Learned AO/ Hon’ble DRP erred in not appreciating that the remittances made are in the nature of cost-to-cost reimbursements, without any profit element and that such reimbursements cannot be considered as income chargeable to tax in the hands of the recipients for the purpose of the provisions of section 195 of the Act.
(Tax effect: INR 18,622,549)
16. That the Learned AO/ Hon’ble DRP erred in law and on facts in holding expenses (aggregating to INR 90,58,664) incurred on account of plant layout charges to facilitate material movement, re-arrangement of production lines and for optimum utilization of space to be of capital in nature in the hands of the Appellant, even in the absence of any enduring benefit or increase in production capacity.
17. That the Learned AO/ Hon’ble DRP have erred in stating that the expenses spent on plant layout charges are for setting up or re-aligning the production process and hence are considered as capital in nature.
18. Without prejudice to the above, the Learned AO/ Hon’ble DRP erred in not allowing the consequential additional depreciation under section 32(iia) of the Act for the expenses treated as capital expenditure for AY 2016-17.
19. Without prejudice to the above, the Learned AO/ Hon’ble DRP erred in not allowing the consequential depreciation for the expenses treated as capital expenditure for the prior years. (Tax effect: INR 3,135,016)”
2. The brief facts of the case are that the assessee is company is engaged in the business of manufacture of automobile component such as seats, door strings, and interiors for the automobile industry It filed its return of income on 29/11/2016 declaring the total income as Nil and current year carry forwarded loss amounting to Rs.1,37,85,727/- . The case was selected for scrutiny and statutory notices were issued to the assessee. The assessee furnished the details time to time in ITBL portal. During the course of scrutiny proceedings, it has been observed that the company had entered into several international transactions with its associated enterprises. The case was referred to the transfer pricing officer as per sec.92CA of the Act and the TPO after detailed study of the documents furnished by the assessee he observed that the company has entered into the following international transactions with its AEs as under:-
2.1 The TPO passed order on 30th Oct, 2019 by making adjustment u/s 92CA of the Act of Rs.7,52,74,460/-. By observing as under:-
2.1 The TPO passed order on 30th Oct, 2019 by making adjustment u/s 92CA of the Act of Rs.7,52,74,460/-. By observing as under:-
5. TP study of the taxpayer
1. In its TP Study, the taxpayer has aggregated all international transactions and has used TNMM as the most appropriate method to benchmark the international transactions. The TPO found that the sale and purchase transactions with AEs are minimal. Major transactions are payment of management fees and royalty. The taxpayer ha.’-‘ka turnover of Rs. 464 Crores and it has used an entity level margin as profit level indicator to benchmark international transaction of small value.
1. 1 Entity level margins of such a huge company cannot accurately predict the arm’s length price of stray and independent transactions of much smaller value. The TPO rejected the TP Study vide notice dated 27.09.2019 and concluded that Profit Split Method (PSM) is the most appropriate method. The TPO gave an opportunity to the taxpayer to make an analysis under PSM methods such as excess profit method, profit differential method (also called residual profit split method).
2. The taxpayer furnished a reply dated 14.10.2019 stating that as the taxpayer is a licensed manufacturer, the manufacturing activity is dependant on the technical know-how from TBC, the transactions are closely interlinked, royalty relates to turnover and forms an essential part of sales and due to the peculiar circumstance of operations involving various types of interdependent transactions, the taxpayer has aggregated the transactions and used TNMM as the MAM which should be allowed.
5.4 Why TNMM cannot be used as an appropriate method here?
5.4.1 There are numerous approximations in usage of TNMM. Aggregation of transactions and analysis can still be justified if there are numerous high-value international transactions, and all the transactions are so inter-linked that they can be called a ‘bundle of transactions’. For instance, if a company is in ‘start-up stage’ and all technologies have been transferred by AE; so also, a major portion of purchases or sales are from the AE, then we can infer that intangibles received from AE under technology transfer agreement and regular sale-purchase transactions are part of an entity-level interaction between the company and its AE. Start-up technologies provided by AE are a bundle of technologies that include both generic tech (those that are easily available from a university or technology consultant) and proprietary tech (those that have been indigenously developed by the licensor of tech). Entire bundle is part of the setting up of the business.
5.4.2 However, the useful economic life of start-up tech is 4-5 years, and the
present taxpayer has been in operation for much more than that. Then why is it paying a running royalty on sales? Because it consistently gets new technology from its licensor (the AE). We do not know whether these new technologies are generic or proprietary, whether these new technological updates are unique or easily available in the market. There is no evidence that such tech actually increases the profitability of the company beyond the profits it would routinely get. TNMM cannot give us that benchmark — of relative enhancement of profits from the ‘technological updates’. On the contrary, TNMM can become a method to justify profit shifting in such scenarios.
How TNMM can be misused to justify profit shifting?
5.5 Consider an automobile company that purchased technologies and machinery for a new vehicle gear system back in 2003. It has no international transaction. It makes better profits than market average. Market average (what we call mean OP/OR) is the average of companies performing better than average and worse than average. Now, this company performs better than market average. It gets healthy profits and pays healthy taxes to Indian treasury. One fine day, in 2012, it decides to reduce its tax burden in India. So, it starts an AE in Cayman Island and pays royalty to the AE. By doing this, it reduces its profits in India to the market average. As a cover, it prepares documentation on how the AE gave the taxpayer the knowhow of a new technique to weld gear machines. There is no way of benchmarking such unpatented knowhow (even for patents, a survey shows that 98% of patents cannot be commercially harnessed). The company pays less tax in India and can justify the profit shifting by saying that it is within tolerance limit of TNMM mean margin.
In this situation, TNMM actually defeats the very purpose of transfer pricing as an anti-abuse provision. There is no justification for application of TNMM, because the so-called tech supplied by the AE to this hypothetical company is not ‘start-up tech’. It is technological update/upgradation. There is no benchmark of such technology intangible. As such, intangibles can be benchmarked only using analytical approaches. TNMM is very crude, and it definitely does not give any indication of the arm’s length nature of royalty transactions.
The taxpayer’s case
5.6 The taxpayer’s case is.not very different from that of the hypothetical situation described above; The, taxpayer started operations in 2003 and still pays a running royalty of 5% in F.Y,,,2012-13, The useful fife of start-up-lech is over. The technological up gradations and, updates it gets from its AE are intangibles, and their value cannot be determinedirom an entity level analysis of taxpayer.
Why CUT cannot be used as an appropriate method here?
5.7 CUT stands for Comparable Uncontrolled Transactions. This method can be categorized under ‘other method’ in Rule 10AB of the IT Rules. Under this method, the TP analyst finds comparable transaction and finds mean of the royalty rate in those transactions. For finding comparable transactions, there are three basic factors to check:
1.Whether the technology in comparable transaction is similar to the technology of tested transaction?
2.Are the two technologies (tested transaction and comparable transaction) of similar uniqueness?
3.Do both technologies have similar utility for enhancing profits?
It is usually difficult to find similar transactions where above data is available. If technologies are in similar fields, then we can refer to a technical consultant to make a technology audit and find out if the technologies have similar uniqueness and similar degree of utility, leading to higher profitability. CUT fails severely if such analysis is not done. Technology transfer is transfer of intangibles. Without doing a valuation of intangibles involved in the transaction, how do you compare them? It is like comparing an apple to a black box. There may be an apple inside the black box, or a potato, or even a chicken leg piece. The taxpayer manufactures car seats and other car interiors. It receives technologies from AE for enhancement of such products.
6. Profit Split Method as MAM
1. 1. The TPO concludes that PSM is the most appropriate method for
benchmarking royalty transactions. Internationally, PSM has been considered the most appropriate method for benchmarking of royalty transactions. The logic for same is also very strong. A licensee will commit to pay a percentage of its sales as royalty in third party situation only if it knows that it can make much more profits. The profitability from the intangibles shared by licensor have to be split between the licensor and licensee. Profit Split is the logic on which all third-party negotiations of royalty rate take place internationally.
6.2 After going through the data available on public databases, and analysis of the facts of the case, the TPO concludes that residual profit split steps can be applied to get the profit split. The TPO refers to the judgement of ITAT, Delhi bench in the case of Global One India P Ltd. (ITA No. 5571/De1/2011 and ITA No. 5896/De1/2012) for the steps involved. There is sufficient literature on the steps involved. However, in this case, the ITAT had also observed that (refer Para 20.5 of ITAT order) residual PSM involves: a) determination of routine return, and b) allocation of residuary profits.
6.3 The TPO did a search for comparables involved in ‘manufacture of car seats, other interiors’. The TPO does analysis in two steps, TNMM step and PSM step. In TNMM step, the PLI is the EBITR, meaning earnings before interest, taxes, and royalty and R&D. This margin for the comparables is found and the average is found. This is the market profitability of companies with basic technologies. The technologies transferred by the AE to taxpayer have helped the taxpayer get better profitability. Same is calculated by the difference between EBITR/Revenue ratio of taxpayer and market (ALP margin of companies with basic technologies). This is to be split between taxpayer and AE in an appropriate ratio based on FAR analysis of both.
6.4 Determination of routine return: The entire exercise of finding comparables is to find the routine return of the taxpayer. This is the first step. The method of finding routine returns is very similar to TNMM: just that the mean OP/OR of comparables is taken as routine profitability. For this, the TPO has to select companies that do not have R&D expenses in P&L. Every manufacturing company generates intangibles/technologies on a daily basis. Such technology is part of the basic and generic technology. But some companies have a separate R & D unit and allocate expenses to the R & D unit. The developments in the R & D unit are significant intangibles, .and lead to additional profitability. Owing to this, companies having R & D expenses in P & L Account cannot be taken as comparable. For ‘routine returns’ we need to take companies that do not have a separate R & D centre and that do not allocate separate expenses to R & D.
6.5 The final companies used to get routine returns (profitability from routine functions without application of intangibles supplied by AE) are as under:
