Transfer pricing –Comparable cannot be selected if risk assumed and capital employed in international transactions are unmatched

IN THE ITAT PUNE BENCH ‘B’

Hoganas India (P.) Ltd.

versus

Deputy Commissioner of Income-tax

IT Appeal No. 1463 (Pune) of 2010
[ASSESSMENT YEAR 2006-07]

JANUARY 11, 2013

ORDER

R. S. Padvekar, Judicial Member

This appeal is filed by the assessee challenging the assessment order dated 7.10.2010 passed under section 143(3) of the Income-tax Act, 1961 read with directions under section 144C(5) of the Act for assessment year 2006-07. The assessee has taken the following grounds (revised) in the appeal:-

1.1 The ld. Assessing Officer erred in assessing the total income of the appellant company at Rs. 11,69,71,550/- as against the returned income of Rs. 11,42,29,221/- as filed by the company.

1.2 The ld. Assessing Officer erred in making an addition of Rs.28,54,085/- to the international transaction of receipt of sales commission by the appellant company of Rs. 14,41,555/- for arriving at the arm’s length price of this international transaction.

2. The Hon’ble Dispute Resolution Panel, Pune and/or the ld. Transfer Pricing Officer/the ld. Assessing Officer erred in not appreciating that the transaction of receipt of sales commission and import of traded goods by the appellant company were closely linked transactions and that for the purpose of benchmarking the above transactions were to be aggregated under the segment “Distribution Activity” in accordance with the provisions of rule 10A(d).

3. Without prejudice to ground No.2, the Hon’ble Dispute Resolution Panel, Pune and/or the ld. Transfer Pricing Officer/the ld. Assessing Officer erred in not appreciating that US $ 30 per MT was the arm’s length price of the aforesaid international transaction.

4. The Hon’ble Dispute Resolution Panel, Pune and/or the ld. Transfer Pricing Officer/the ld. Assessing Officer erred in not appreciating that the functions performed and risks assumed by the appellant company when acting as an agent of Hoganas AB Sweden were insignificant vis-à-vis functions performed and risks assumed in the marketing activity carried on by the appellant company in its manufacturing segment.

5. The Hon’ble Dispute Resolution Panel, Pune and/or the ld. Transfer Pricing Officer/the ld. Assessing Officer erred in working out the arm’s length percentage of the commission received from the appellant company’s AE @ 4.44% instead of @ 0.95% being the correct percentage and considering the fact that the sales commission received by the appellant company worked out to 1.49% of the actual sales price, no upward adjustment/addition was warranted on the facts of the case.

6. The Hon’ble Dispute Resolution Panel, Pune and/or the ld. Transfer Pricing Officer/the ld. Assessing Officer erred in not appreciating that inadvertently the internal rate of return attributable to the marketing functions of the appellant company for the manufacturing segment was worked out @ 4.44% by multiplying the percentage of PBIT of manufacturing segment of the company with the numerator of Selling and Administration Overheads (instead of only Selling Overheads as the correct numerator) and dividing by denominator being aggregate of Selling and Administrative Overheads and Factory Overheads.

7. The Hon’ble Dispute Resolution Panel, Pune and/or the ld. Transfer Pricing Officer/the ld. Assessing Officer erred in not appreciating that on the facts of the case and in law, the benefit of option available to the appellant under the proviso to section 92C(2) of the Act and as per CBDT’s Circular No.12 of 2001 dated August 23,2001 of adopting arm’s length price, a price which varies by not more than 5% from the arm’s length ought to be granted and that the upward addition had to be made in respect of the balance amount, if any.”

2. The only issue in controversy is in respect of adjustment made by the Transfer Pricing Officer (TPO) and confirmed by the Dispute Resolution Panel, Pune (DRP) in respect of commission received by the assessee-company from its parent company and the said adjustment is made by the TPO under section 92 CA(3) of the Income-tax Act, 1961.

3. The assessee is in the manufacturing, distribution and marketing of iron and ferrous powders in India. The assessee filed the return of income declaring a total income of Rs.11,42,91,720/- for the assessment year 2006-07. As the assessee has intimated the international transactions with AE i.e. associated enterprises, a reference was made by the Assessing Officer under section 92CA(1) of the Act to the TPO for determination of Arm’s Length Price (ALP) of the international transactions reported by the assessee in its audit report. The assessee has adopted TNMM method for determining the ALP. Apart from international transactions relating to purchase of iron powder for manufacturing, purchase of trading materials, export of iron powders, purchase of consumables and spares, the assessee also undertook international transactions relating to provision of market services to its parent company, for which it has received commission. The issue in controversy before us is in respect of the commission received by the assessee, to which adjustment has been made by the TPO leading to an addition of Rs.28,24,085/-. Hence we restrict our order to the said addition only as that is disputd in this appeal.

4. The assessee was paid commission of Rs.14,41,555/- by Hoganas AB Sweden. The sales achieved by Hoganas AB Sweden stood at Rs. 9,66,22,606/- and the commission received by the assessee is at Rs. 14,41,555/- which works to 1.49% of the corresponding sales achieved by Hoganas AB Sweden in India. The TPO has noted that the commission received by the assessee was not on the standard rate. The assessee received commission of $ 30 per MT of the product sold of its AE in India, irrespective of the sale price of the product or the type of the product. The TPO observed that the assessee undertakes similar marketing functions, assumes similar risk and employs similar assets for its own marketing functions for the products manufactured by it and as in respect of earning of sales commission. The TPO observed that for the purpose of benchmarking transaction relating to receipt of sales commission, there is an internal comparable available which is the profit attributable to the marketing functions of the assessee for the products manufactured by it i.e. the internal rate of return attributable to the marketing functions of the assessee is comparable to the functions undertaken for earning the sales commission. As noted by the TPO, the sales commission received by the assessee by conducting internal rate of return attributable to the marketing functions of the company worked out to 4.44% and therefore the TPO asked the assessee why the said rate should not be adopted in place of 1.49% worked out against the sales of the Hoganas AB Sweden. The assessee resisted the action of the TPO by submitting that the net profit earned by the assessee is not only the result of the functions performed under the factory overheads and the SADA expenses, but also result of the functions performed under the head “raw material cost” and accordingly while attributing the net profit of SADA expenses, such profit should also be attributed towards the cost of raw materials. The assessee also filed the working showing that the internal rate of return was to the extent of 1.46% as against 1.49% that was in respect of the commission received from Hoganas AB Sweden. The TPO did not agree with the working made by the assessee. It appears that the assessee filed the working of the attribution of the net profit for each expense head, which is reproduced at page 13 of the TPO’s order. The assessee also filed net profit working attributable to SADA expenses, which was not accepted by the TPO. The TPO made the working of the net profit attributable to SADA expenses as under:-

“Net profit attributable to SADA Expenses:

5. As per the working made by the Assessing Officer, the net profit attributable to SADA expenses was at 4.44%. The TPO, therefore, proceeded to make adjustment taking the difference between 4.44% and 1.49% which was worked out at Rs.28,24,085/-. The operative portion of the reasons given by the TPO is as under:-

“(xiv) The difference in the working given by the assessee in its submission, and the working given above is only for the reason that inappropriate base was taken while arriving at the profitability attributable to the marketing functions by the assessee. This means that if the profitability ratio in case of marketing functions has to be arrived at by taking total cost then the same basis has to be adopted for arriving at the profitability ratio from the manufacturing functions as has been demonstrated in the working given above. It is noteworthy that, for the purposes of this analysis, the entire profit generated by the assessee out of the all functions it has undertaken, has been categorized/divided into marketing functions and manufacturing functions and therefore it is imperative to take same base while arriving at the profit attributable to marketing or the manufacturing function. In the working given by the assessee for arriving at the profitability attributable to marketing function in the denominator total cost has been taken, and then on, assessee has gone on to compute percentage of profit attributable to marketing functions by multiplying percentage of marketing expenses as percentage of total cost with the total profit of the assessee company which defies any mathematical logic and rationale.

(xv) Accordingly, it is arrived at that the contentions of the assessee are not acceptable in view of facts and circumstances of the case and are accordingly rejected. It is further arrived at that for the purposes of benchmarking, the profits attributable to marketing functions of the assessee for its own manufactured products is valid internal comparable available and accordingly the proposed adjustment is made to this international transaction to arrive at the arm’s length price of this international transaction.”

6. The Assessing Officer also observed that the assessee has neither asked nor contended that benefit of (+) (-) 5% should be granted as per section 92C(2) of the Act. The matter was travelled upto DRP, as the assessee filed objections to the draft order. The assessee filed copy of the commission agreement with Hoganas AB Sweden. The assessee contended that the basis of payment of the sales commission was at $ 30 per MT of the product sold by Hoganas AB Sweden directly to the customers situated in Territory-1 i.e. India and Territory-2 i.e. Egypt, Iran, Pakistan and Saudi Arabia. It was also pointed out that the sales commission received was not linked to the sales made by Hoganas AB Sweden in the above territories. The assessee also produced all the credit and debit entries. The assessee objected to the observation of the TPO that the functions undertaken, assets employed and risk assumed would NOT be different in respect of trading activity and earning of the sales commission and hence he did not accept the benchmarking made by the assessee-company by aggregating the transaction of trading of imports from AE and in respect of sales commission from AE.

7. The assessee filed the working to demonstrate its net profit with SADA before the DRP. The assessee contended that as per the terms of the agreement between the assessee-company and Hoganas AB Sweden, the commission received was in the nature of an overriding commission paid by AE. The order procurement was directly by AE and the assessee had not to incur any specific cost for earning the commission income. The assessee also justified the adoption of TNMM method as the most appropriate method by submitting that for working the ALP in respect of closely linked transaction of purchase of traded goods from Hoganas AB Sweden and Hoganas Belgium and receipt of commission from Hoganas AB Sweden and the receipt of commission was closely linked with the other transactions. The assessee contended that $ 30 per MT of the iron powder was based on the commission paid to the external agent. That existed before Hoganas AB Sweden decided to implement the agreement with its subsidiaries. The assessee also contended that the above payment of commission was in line with the ALP considering the functions assumed and minimum risk borne by the assessee. The assessee also contended that the functions performed and risk assumed by the assessee-company while acting as an agent of Hoganas AB Sweden could not be compared with the marketing functions carried on by it in its own manufacturing segment. The assessee filed comparative figures and working. The assessee also contended that for the purpose of benchmarking transaction relating to receipt of sales commission, the internal rate of return attributable to marketing functions of the assessee’s manufacturing segment should not be used. As per the working made by the assessee, the commission received by the assessee-company excluding the manufacturing segment works out at 0.95%. The assessee also pleaded for giving benefit of ±5%. The DRP was not impressed with the contentions of the assessee justifying that comparable percentage of the commission received is much higher than the commission pertaining to the marketing activity of the assessee and confirmed the order of the TPO.

8. We have heard the rival submissions of the parties and perused the record. The short controversy in this appeal is in respect of the commission received by the assessee from its parent company i.e. Hoganas AB Sweden. As per the agreement with Hoganas AB Sweden, the sales directly made by the parent company in India and other Asia region, the assessee has to receive commission @ $ 30 per MT. The assessee-company worked out the profit level indicator as operating profit or operating revenue of the aforesaid distribution activity at 15.37% and according to the assessee the arithmetic mean of the profit level indicator of the comparable trading companies was at 1.96% only. While filing the working before the TPO as well as the DRP, the assessee aggregated the sales of the manufactured goods and traded goods and accordingly worked out the percentage of SADA. The core issue before us is whether commission @ $ 30 per MT received by the assessee from its AE, its parent company is at ALP. The principles for determining the ALP are well settled by different judicial pronouncements. What is to be considered while adopting the comparable are the functions performed, capital utilized and risks assumed. It is pertinent to note here that the DRP as well as TPO has not questioned the nature of the functions to be performed by the parent company. The assessee’s claim is that there is a minimal risk and no cost is involved for acquiring the business by the parent company, for which assessee is paid commission. The sale price of the product is not considered but weight is considered. The assessee received commission of Rs.14,41,555/- which worked out to 1.49% to the sales achieved by the parent company i.e. Hoganas AB Sweden. In our opinion, the benchmarking adopted by the TPO as well as the DRP treating the assessee itself as a comparable is not correct. Admittedly the assessee is involved in the manufacturing activity also and marketing its own products i.e. iron powder. Apart from that, the assessee is importing iron product and marketing the same that is a trading activity. Nothing has been brought out on record by the DRP as well as the TPO that the assessee has to incur cost for the sales achieved by the parent company as in the case of its own marketing. The ld. counsel for the assessee also submitted that no risk is involved. Hence, how the assessee can be treated as internal comparable as the benchmarking. In our opinion, the approach of the TPO as well as the DRP is not correct. It is seen that the risk involved and asset employed by the assessee-company compared to its own marketing with that of the marketing of the parent company, of which commission is paid, is unmatched. Moreover, minimum risk is involved as the assessee is not directly involved in any of the sale transactions by the parent company. It appears that the commission is paid by the parent company to its subsidiaries in the Asia region to compensate loss of profit when direct sales are made. In our opinion, the benchmarking done by the TPO as well as the DRP is not correct, as the parameters of the risk and the assets involved are not matching. We, therefore, delete the addition made by the TPO on the directions of the DRP and allow the appeal filed by the assessee.

9. In the result, assessee’s appeal is allowed.