Court – Delhi Tribunal
Citation: Abhishek Auto Industries Vs. DCIT (2010- TII-54-ITAT-DEL-TP)
Brief :Payment of royalty and know how fee under an agreement can not be ignored by the Revenue while doing the Transfer Pricing analysis, the transfer pricing adjustment can be made only to the international transactions and not transactions at the enterprise level which include domestic transactions, and internal comparability is most efficient when it involves the transactions of the tested party itself.
Facts: Abhishek Auto Industries (assessee) was engaged in manufacturing of car seat belts in technical collaboration with Takata of Japan (Takata), which was an Associated Enterprise (AE) of the assessee by virtue of holding 30 % share in share capital of the assessee. The assessee imported complete knock down Kits (CKD) from Takata and then carried out a manufacturing process by assembly on these CKD Kits, by adding certain indigenous raw materials and made the car seat belts. This manufacturing process by assembly was carried out with the technical know-how received from Takata. These seat belts were then supplied to the car manufacturers such as Maruti, Honda and Tata etc. The assessee had capitalized the technical fee paid to Takata.
During the relevant previous year, the assessee undertook international transactions with Takata, viz, purchase of raw materials, machines, payment of royalty, technical know-how and interest on loan. The assessee filed Accountant’s Report in Form 3CEB disclosing these transactions undertaken with Takata, however no methods prescribed under section 92C of the Income tax Act, 1961 (Act) were mentioned in Form 3CEB. As per the assessee as the raw material components and machines supplied by Takata were not available with any other supplier in open market, the ascertainment of the arm’s length price (ALP) of these products was difficult. The assessee entered into technical collaboration agreement with Takata and obtained the Government approvals thereof with regard to payment of royalty and technical fee. Hence, as per the assessee since the technical fee and royalty were paid by the assessee as per the agreement only, the question of determining arm’s length price did not arise.
The Assessing Officer (AO) referred the case to Transfer Pricing Officer (TPO) for determination of ALP under sec. 92CA (1) of the Act. Before the TPO the assessee submitted comparative analysis of gross profit margins of various types of seat belts manufactured from the materials supplied by other suppliers, which are being supplied by the assessee to third parties vis-à-vis seat belts manufactured from the materials supplied by Takata. The assessee claimed that it is earning a higher rate of gross profit on the seat belts manufactured from the materials under transfer pricing purview as compared to the seat belts manufactured from the materials supplied by the other suppliers.
The assessee filed statutory audit report pleading that since it earned considerable profits by selling the seat belts procured from outside India as compared to the selling of seat belts manufactured in India, so the price paid for the material imported from the foreign collaborator, report may be accepted by the tax authorities.
The TPO did not draw any adverse inference relating to purchase of machinery and payment of interest. However, as regards the other transactions, i.e. purchase of raw material, payment of royalty and technical fee, undertaken with Takata, the TPO made transfer pricing adjustments. The TPO rejected assessee’s working and by adopting Transactional Net Margin Method (TNNM) the average net profit margin of comparables was worked out to be at 9.21% as against the assessee’s operating margin on overall basis of 4.56%. He held that a formal agreement between the assessee and Takata cannot be the basis for determining the ALP of the transaction and relying on US Case Laws determined the value of international transaction of payment of royalty and technical know-how fees to be NIL citing reasons as follows-
• No transfer of technology or know how has taken place.
• The price of know-how and royalty is bundled in the price charged for supply of material.
• Expenses have been incurred on expatriates, which the assessee was under no obligation to incur.
On appeal, the Commissioner of Income Tax (Appeals) [CIT (A)] upheld TPO’s order and also enhanced the transfer adjustment considering the average net margins earned by the comparable companies at 10.74%.
Observations and decision of the Tribunal:
• It is a settled proposition of the law that legally binding agreements between parties cannot be disregarded without assigning any cogent reasons thereto. In this case, it has not been imputed that agreements were non genuine or sham, rather they are duly approved by Reserve Bank of India and other regulatory agencies.
It is also a settled proposition that commercial transactions are in the domain of the businessman and tax department cannot intervene in realm of intricacies of commercial expediencies involved in these arrangement.
In this case if the assessee had not entered into joint venture agreement with Takata, it would not have been able to make any sales whatsoever using their technology and raw material and the machines supplied by them. The very existence of this business in AE segment depended upon the joint venture agreement which has been duly approved by the Government of India in accordance with law.
Hence, the TPO and the CIT (Appeals) were not correct in disregarding this agreement without assigning any cogent reasons except challenging the commercial need for such arrangement which is in the domain of the businessman and not of the revenue authorities.
• The machinery were imported by the assessee to manufacture the assembly line for manufacturing of seat belts for which the technical know-how fee and foreign technicians were also deputed by the AE. Whenever international transactions of such nature are undertaken, it is a combination of technical know-how, royalty, technical assistance through the deputation of ex-pat employees on the rolls of the person obtaining the technical know-how. There is merit in assessee’s submissions that merely by importing machinery, it cannot be said that the assessee would become competent to make use of such machinery. Technical know-how and technical assistance was needed for the use of machinery under the normal circumstances.
• It has not been disputed that provisions of chapter X and section 92C deal with international transactions only and not with transactions which have no international cross border element at all. Hence, net operating margin shouldn’t have been applied on total net sales but on sales to domestic parties using raw materials and know-how supplied by the AE.
• Using internal com parables helps the case of assessee. The best comparability can be of the transactions of the tested party itself. In this case the international transactions have demonstratively boosted the profits of the assessee. The segment which did not have the benefit of foreign technology and foreign raw material had an operating profit to sales margin at 2.88% whereas the segment, which had this benefit, had a margin of 10.49% (computed excluding technical know-how fee as it was never claimed as revenue expense). It is obvious that the transactions are at arm’s length and no adjustments are called for.
• Accordingly, the transfer pricing adjustments made by the TPO have been deleted with regard to the purchase of raw material and payment of royalty and technical fees.
Comments:- This is an important ruling by the Tribunal re- emphasizing that the provisions of Chapter X and Section 92C deal with international transactions only and not with transactions which have no international cross border element at all. Therefore, the basis of making the adjustments on the enterprise level is not correct.
The Tribunal has applied internal TNMM for bench marking the international transactions by comparing the segment which did not have the benefit of technology and raw materials supplied by the AE with the segment, which had these benefits from the AE.
There has not been any particular method prescribed under the Indian transfer pricing regulations to benchmark the payment of royalty or technology fee. By applying the analogy that profit is the function of income and expense and therefore, once the operating margin of the tested party is at arm’s length by comparing the average margin earned by the com parables companies, all international transactions with the AE, which form part of the Profit & Loss Account of the tested party are deemed to be at arm’s length; it seems that this philosophy has been applied by the Tribunal for determining whether the payment of royalty or technology fee are at arm’s length.