[Serdia Pharmaceuticals (India) Pvt. Ltd. Vs. ACIT (ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08) (Mumbai)]
Mumbai Tribunal Ruling- CUP method is the ‘most appropriate method’ to determine the arm’s length price in the cases of generic drug manufacturers so long as comparables are available and while innovators of drugs are allowed monopolistic pricing during the period when patents are in force so as to recoup the R & D costs, once the patent period expires, the higher pricing of the drug vis-à-vis prices of generic drugs manufactured by competitors cannot be justified on the ground of heavy R&D costs.
Facts: Serdia Pharmaceuticals India Private Limited (the assessee) was a company incorporated in India of which 74% of its share capital was held by a Netherlands based company Servier International BV (Servier BV) and the remaining 26% of its share capital was held by a Mauritius based company Serdia (Mauritius) Limited. Servier BV, in turn, was a subsidiary of Les Laboratoires Servier France (Servier France). Servier France had a subsidiary in Egypt in the name of Servier Egypt Industries Ltd Egypt (Servier Egypt). Therefore, Servier France and Servier Egypt were the associated enterprises (AEs) of the assessee under the Indian transfer pricing regulations.
The assessee was engaged in the business of producing drugs mainly in the field of anti-hypertension and metabolism. It produced and marketed drugs in finished dosage forms (FDF). The assessee imported active pharmaceutical ingredient (API) from Servier France and Servier Egypt for manufacturing and marketing FDF.
The FDF is to facilitate consumption by end user. It may be in form of tablet, liquid or gel made of excipients (medicinally inactive constituents). The excipients are vehicles in which one or more API is suspended in. An API may be a patented or generic. A patented API can be produced by the patent holder, and this monopoly allows the pharmaceutical company, which developed the drug, to sell it in a monopoly market and thus, allows the company to recoup the cost of developing that particular drug by selling the drug in monopolistic conditions. Once patent on an API expires or is not valid in a particular geographical location, any pharmaceutical company can manufacture and sell that API. The API then becomes generic in nature, and the expiration, or inapplicability, of the patent, ends the monopoly of the patent holder.
The issue in dispute in this case was the arm’s length price (ALP) of three APIs, i.e. Trimetazidine, Indapamide for assessment year 2002-03 and Gliclazide for assessment year 2003-04 and 2004-05, that assessee imported from its AEs. On a reference made by the Assessing Officer (AO) to the Transfer Pricing Officer (TPO) to determine ALP of transaction that the assessee entered into with its AEs, the TPO noted that the assessee had determined the ALP by adopting Transactional Net Margin Method (TNMM), with operating margin as a percentage of net sales at 8.76%, as the most appropriate method (MAM). The comparable companies, as selected by the assessee, showed operating margins ranging between (-) 13.29% to 19.07%, and the arithmetic mean of margin of comparable companies was found to be 6.67%. As the operating margin of the assessee was more than the average margin of comparable companies, the assessee claimed that its international transactions with its AEs were at ALP. The assessee had purchased, from its AEs, Indapamide at Rs. 1, 89,456 per kg and Trimetazidine at Rs. 52,546 per kg. The assessee claimed that there were no internal Comparable Uncontrolled Prices (CUPs) of uncontrolled transactions which were available.
On the basis of information furnished by the assessee regarding its competitors, the TPO collected information on the prices at which these APIs were purchased by other producers of the competing FDFs. The TPO noted that while Indapamide was imported by the assessee’s competitor from Italy at the price of Rs. 40,375 per kg whereas the assessee had imported the same from its AE at a price of Rs. 1,89,456 per kg. The TPO further noted that while the assessee had imported Trimetazidine from its AE at the price of Rs. 52,546 per kg whereas the same drug was sold by other vendors at much lower rates of Rs. 8,150 per kg (Nivedita Chemicals Pvt Ltd), Rs. 8,625 per kg (Sharon Pharmachem Limited), Rs. 10,558 per kg (Orion) and Rs. 11,000 per kg (Trichem).
In respect of the FDF made of Indapamide, the assessee contended that it was a global market leader and its products were patented in Europe and USA and APIs used by the assessee were better than that used by its competitors. While in respect of Trimetazidine, the assessee contended that it was market leader as compared to its peers and made submissions to demonstrate that the quality of Trimetazidine manufactured in India was not comparable with the quality of Trimetazidine imported by the assessee from its AE, as Trimetazidine imported from its AE had higher purity levels and longer shelf life compared to that manufactured by the competitors in India. Further, such API was launched after clinical trials as against the API manufactured in India. The assessee received technical assistance in marketing its products when it bought API from its AEs. And hence the higher price paid by it was justified.
The TPO was of the view that given the fact that the APIs purchased by the assessee from its AEs abroad were not unique items in the sense that other pharmaceutical companies were also purchasing the same APIs, though from different vendors, and having regard to the nature of goods, CUP method was the MAM to determine the ALP. As regards TNMM applied by the assessee, the TPO was of the considered view that TNMM applied by the assessee is used, only a method of last resort, when it is not possible to apply any of the other methods as this method is not reliable because profits are affected by so many other aspects besides the product prices . On the basis of this reasoning, the TPO rejected the TNMM applied by the assessee and proceeded to compute the ALP on the basis of CUP method.
The TPO adopted rate of Rs. 40,375 per kg in case of Indapamide as against the rate of Rs. 1,89,456 which was paid by the assessee to its AE which was 4.5 times the ALP adopted by the TPO. As regards Trimetazidine, the TPO noted that the highest CUP, as per information gathered by the assessee – which was duly confronted to the assessee, was Rs. 11,000 i.e. of Trimetazidine supplied by Nivedita Chemicals Pvt Ltd. Since the assessee had challenged the purity standards of the Trimetazidine manufactured by Nivedita Chemicals Pvt Ltd., the TPO made two adjustments Rs. 4,850 per kg for differences in quality norms, based on the differences in prices in British Pharmacopoeia quality standards vis-à-vis Japanese Pharmacopoeia quality standards and a further Rs. 5,000 per kg for any variations in purity standards. The adjusted CUP was thus computed at Rs. 20,850 (i.e. Rs. 11,000 + Rs. 4,850 + Rs. 5,000), as against price of Rs. 52,546 per kg paid by the assessee to its AE for imports of Trimetazidine. In AY 2003 -04 and AY 2004-05 same adjustments were made to these two APIs and also adjustments were made in respect of imports of one more API namely Glicazide.
On appeal, the order of TPO was upheld by Commissioner of Income Tax (Appeals) [the CIT (A)] and hence, the assessee filed an appeal in Income Tax Appellate Tribunal (Tribunal).
Observations and decision of the Tribunal:
• Selection of the MAM is not an unfettered choice on the part of taxpayer and the selection has to be exercised on the touchstone of principles, governing selection of MAM, set out in Section 92 C (1) read with Rule 10C (1) of Income Tax Act, 1961 (Act). Thus it is clear that the selection of method for determining the ALP is not on the unfettered discretion of the taxpayer.
• In a situation in which the TPO finds that the selection of MAM is not appropriate to the all the relevant factors, he has the powers, as indeed the corresponding duty, to select the MAM and compute the ALP by applying that method. It is not at all necessary, as has been contended by the assessee, that unless the TPO can demonstrate that the ALP computed by the assessee is not computed in the manner as prescribed in the regulations, he cannot reject the method chosen by the taxpayer.
• Once the assessee places on record reasons for selecting a particular method of determining the ALP, that reasoning can be declined though for cogent reasons by the TPO, and that aspect of the matter can be challenged before the appellate authorities. Thus, the TPO was justified in determining the ALP on the basis of, what he found to be, the MAM on the facts of the case.
• The Tribunal relying on ACIT v. MSS India Pvt. Ltd. (32 SOT 132)(Pune) and the OECD Transfer Pricing Guidelines 2010 held that CUP and traditional transaction methods are preferred over the transaction profit methods. .
• The price movements and demand sensitivity to the price indicate that the APIs imported by the assessee are not unique items as claimed by the assessee, and that such business models, being adopted by pharmaceutical companies, leave ample scope for them to manipulate API prices so as to regulate profitability of their controlled entities in the end use jurisdiction.
• The APIs were generic drugs and not patent protected when they were purchased from AEs; hence attributing high price to cost and process of developing a new drug cannot be accepted as patent protection is to enable the innovator of a drug to recover the high initial costs by allowing him a monopolistic market in the initial stages of marketing the drug. Therefore, he must compete with the generic drug manufacturers, in post patent period, on selling prices.
• In GlaxoSmithKline Inc. v. Her Majesty the Queen (2010 FCA 201), the Federal Court of Appeal (Canada), while agreeing that the CUP method should apply in determining the appropriate price of API purchased, reversed the Tax Court’s decision on the basis that the Tax Court used incorrect com parables in as much as an inquiry should be made into those circumstances that an arm’s length purchaser, standing in the shoes of the appellant, would consider relevant in deciding whether it should pay the price paid by Glaxo to its AE for its ranitidine API.
• In India, re-characterization provisions in respect of payments made in excess of ALP as dividend, royalty or other income to AEs as done in Glaxo case have not yet been legislated, but that does not mean that judicial precedents from the countries where re-characterization of payment in excess of ALP payment is permissible, cease to be relevant in India. These decisions, though they go a step further than the present legal position in India, continue to be as relevant and as useful as they would have been in the absence of such re-characterization provisions in the respective countries. The rationale and logic of these decisions continue to remain unaffected by these provisions.
• The grounds on which the Glaxo decisions of the Tax Court of Canada was overturned by the Federal Court of Appeal have nothing to do with claimed superiority of the product, but on the basis of compulsions of the license agreement, because of which the assessee was said under an obligation to purchase the API at a higher price as in present case the contention of assessee for paying higher price was due to product superiority and not on the basis of license agreement under which assessee had to pay higher price.
• API, whether made by original patent holder of the drug or generic drug manufacturers, is not only known by the same name, it is the same – though maybe with some variations of quality.
• The Act prescribes a mechanism for computation of ALP. Merely because another arm of the Government considers this price at an ALP, even though for the purposes of customs duty, the assessee can not be relieved of the burden of establishing that it is at arm’s length, for the purposes of transfer pricing requirements, in terms of the provisions of the Act.
• In instant case, CUP method is the MAM for determining ALP considering the facts of this case, and the selling price of related APIs in Indian market constitutes good com parables for applying the said method.
• The internal CUP subsequently provided by the assessee are rejected as they are sale instances outside India by AEs to unrelated parties and thus, are in respect of different geographical markets and without necessary supporting documentation.
• Thus, the Tribunal has upheld the CUP as the MAM for bench marking import of APIs from the AEs.
This case again re-emphasizes the need and the importance to demonstrate to revenue authorities the correct business model, so as to bring out the economic rationale behind the conduct of business.
Though, this decision brings out the superiority of the CUP method , but if transfer pricing is viewed one dimension ally, only from the perspective of determining price for transfer of goods/services, without its interlink with business; then many unresolved issues may lie. In this case, for example, the question whether Glaxo’s case is completely applicable to the facts of the case, may be indeterminable, further, does the residue super normal profits lying with the Indian entity after applying the CUP method, rightfully belong to it?, or is it that the assessee did not correctly bring into play the intangibles belonging to its AEs in its business model, and hence is burdened with such super normal profit as compared to com parables.
The case brings out other nuances which will probably evolve over time, like the importance of customs valuation while applying CUP, the level of weightage to be given to the business model, i.e., circumstances of business vis-à-vis price of product, as it was given in Glaxo.