Case Law Details

Case Name : Cherokee India Pvt. Ltd. Vs. ITO (ITAT Mumbai)
Appeal Number : ITA. No. 825/Mum/2010
Date of Judgement/Order : 22/07/2011
Related Assessment Year : 2005- 2006

Cherokee India Pvt. Ltd. Vs. ITO

ITAT Mumbai

ITA. No. 825/Mum/2010

Assessment year: 2005- 2006



1. Assessment made by the Assessing Officer under section 143 (3) of the Act read with section 92C(4) of the I.T. Act for the assessment year 2005- 2006, having been confirmed by the learned CIT(A), assessee is in appeal before us. Though several grounds were urged before us, all the grounds are directed against the correctness of the transfer pricing adjustment made by the TPO as against the profit/losses declared by the assessee under Transactional Net Margin Method (hereinafter referred to as “TNMM”).
2. Facts of the case are as follows :- Assessee-company was set up in Santacruz Electronics Export Processing Zone (SEEPZ). This was incorporated on 25-1-1984 as a wholly owned subsidiary (99.95%) of Cherokee International, USA. The prime goal of the company was to act as a subsidiary to its parent company (hereinafter referred to as “Associated Enterprise” or “AE”). The object of the company was to manufacture various magnetic components like transformers, inductors, printed circuit boards etc., and to export the same to AE.

 2.1. In the year under consideration assessee exported finished goods worth Rs.15,91,07,755/-. The assessee however incurred loss of Rs. 13.2 lakhs during the year. Operating loss of the assessee as a percentage of sales works out to 0.93%.

2.2. The case of the assessee was that 95% of the raw materials were received from AE free of cost i.e., without payment of custom duty as provided in the EXIM policy. Balance is sourced, by the assessee, locally or through imports. Title to the goods vests with AE throughout the manufacturing process. It was also contended that the production schedule is given by the AE and assessee does not own any manufacturing intangibles nor do they conduct any independent research and development activities. Under the circumstances, it was contended, on the exports made to the AE a mark-up of 6% is charged to the expenditure/ standard cost incurred by the assessee. The ‘standard cost’ is based on an estimate of the cost likely to be incurred during the year. In the process, it takes into account the future volumes and other factors to a reasonable extent. Since the products are priced based on estimate of time involved in conversion of raw material into finished goods and estimated cost, any variation due to inefficiencies or capacity utilisation will lead to under-absorption of overheads and such under-absorption will lead to some overheads which will be saddled on the entity without being transferred on to the selling price of finished goods. Under the circumstances, as against the estimated profit of Rs. 62 lakhs (based on the earlier year’s figures) the assessee-company incurred a loss of around Rs. 13 lakhs. It was contended that there were justifiable factors for incurring the loss which is more to do with economics rather than with an object to avoid tax.

2.3. Since it is a transfer pricing case, in view of the provisions of section 92CA of the Act, the case of the assessee was referred to TPO (The Transfer Pricing Officer) for computation of ALP (Arms Length Price) in relation to the international transactions. The Transfer Pricing Officer in turn, issued a questionnaire to the assessee-company and requested to submit detailed explanations to support the arms length price computed in this case.

2.4 Assessee submitted that 95% of the raw materials were supplied by AE on free of cost basis and the assessee-company does not have to pay for the raw materials and components received from AE nor is it required to take any other risks and merely has to incur the basic running expenditure to manufacture the end-product to enable it to export the same to AE. As per the arrangement stated to have been entered into with the AE, the assessee charged a mark-up of 6% on the ‘standard cost’. In other words, assessee is rewarded for the value addition made to the raw materials procured from the AE. Assessee being a captive manufacturer of transformers etc., it does not bear any risk of business related to marketing inventory or of capital in which event the method followed by the assessee i.e., mark­up of 6% on the standard cost, is reasonable. In other words, TNMM is the most appropriate method and the assessee furnished certain com-parables.

2.5. The TPO observed that if the assessee does not have to bear any risk of business there was no need to incur loss. Under the circumstances, he observed that the claim of assessee that it followed cost-plus method, is not evidenced by the financial results. Transfer Pricing Officer had noticed that though the assessee-company has claimed that it was entitled for a mark-up of 6% on costs attributable to the assessee, as per the agreements entered with AE, assessee­ company did not furnish a copy of the agreement. The TPO directed the assessee-company to produce copy of the agreement and also to define the “standard cost” i.e., cost on which mark-up was agreed to be charged. Assessee, however, failed to produce the agreement.

 2.6. Having regard to the circumstances of the case, the TPO observed that even as per the method adopted by the assessee i.e., TNMM, the mark-up should be on the total cost incurred by the assessee whereas the assessee claimed to have incurred net loss which means that it is not able to recover even the cost attributable to manufacturing of the transformers etc., which are supplied to the AE.

2.7. Assessee objected to the view of the TPO by stating that as per Rule lOB assessee has to prove that the transaction is at ALP and, in support thereof, data of comparables has to be supplied to the Officer. It was also contended that transfer pricing requirements are framed not to assessee profits but to ascertain as to whether the transactions are at arms length. Once the transaction is proved to be at arms length, it is immaterial as to whether the company is making profit or loss. It was also contended that cost-plus method has certain limitations and thus it is not applicable to the case of the assessee. The limitations are (a) For CPM, it is required to work-out the direct and indirect cost of manufacturing; Though direct cost can be ascertained on actual basis, determination of indirect costs would have involved allocation of costs and for that purpose exclusion of cost relating to selling, general and administrative expenses are required. (b) For valid comparison similar exercise was required to be conducted on the com-parables as well. Given the information available on the databases, it posed limitations on constructing similar cost base for com-parables (c) Due to paucity of information, it was not feasible to determine the consistency in the methods for computing costs between the company and the uncontrolled comparable companies.

2.8. The TPO observed that even if TNMM is considered as most appropriate method to benchmark the transactions with the AE, the issue herein is not mainly with regard to mark-up of 6% on costs but centres around the question of nature of mark-up i.e., whether the assessee has actually shown to have charged the mark-up of 6% on costs. Having regard to the circumstances i.e., (a) assessee is making net loss despite charging mark-up on the costs (b) claimed to have charged 6% on cost, as per the agreement, but actual working thereof is not reflected in the accounts (c) there is absence of details regarding the standard cost (d) agreement is not placed on record, the TPO concluded that the assessee should be entitled to charge a mark­up as per TNMM on the total cost so incurred. In the instant case, the cost of exports were shown at Rs.15,91,07,755/- and with a mark-up of 6% on costs the arms length value of the sales of finished goods is taken to be Rs. 16,21,17,599/-. Accordingly, TPO suggested for an adjustment of Rs.30,09,844/-.

3. Assessing Officer, accordingly, completed the assessment which was challenged by the assessee before the learned CIT(A). It was contended that the method followed by the assessee- company as well as the percentage of mark-up is in accordance with the procedure prescribed in law and hence, the transfer pricing adjustment made by the Assessing Officer deserves to be set aside. Explaining further, it was stated that the external com-parables were extracted from the “PROWESS” database. Comparison of the data shows that the price charged by the assessee is within the margin i.e., the assessee was selling its goods on ALP. It was also contended that the TPO has disregarded various com-parables without giving any reasons. Submissions made before the TPO were reiterated before the CIT(A).
4. Learned CIT(A) observed that the assessee is a contract manufacturer and hence cost-plus method is the most appropriate method for testing the arms length price. He further observed that by charging the mark-up on estimated cost the assessee has depressed the cost base. The basis for such estimation is also not known. In the opinion of the learned CIT(A), if there was a difference between the estimated cost and the actual cost, then it is incumbent upon the assessee-company to make up by billing the balance in the subsequent months. The method followed by the assessee was rejected on the main ground that contract manufacturer normally bills at total actual cost whereas, in the present case it has been done on estimated cost. He further noticed that the assessee being a wholly owned subsidiary of Cherokee International, LLC, USA and was to function as a fully integrated Indian subsidiary, cost-plus method would have been proper since the assessee should not have taken any risk and it should have been compensated by its parent on actual cost. He also highlighted the fact that assessee failed to produce any documents/ agreements with its principal regarding contractual terms of sharing cost. Doubting the correctness of the method followed by the assessee, he observed in para 4.3 as under:

“One of the ways through which transfer pricing is done in such transaction is that the supplier (appellant) to which the cost-plus method is applied does not receive a charge from the principal for costs related to it. This is done in order to reduce the suppliers (appellants) cost base on which mark-up is calculated. In the present case, by adopting the estimated cost the base has been reduced by Rs. 1,32,04,176/- (Rs.5,01,64, 176 – Rs.3,69,60,000) thus making it liable for adjustments. The TPO on the facts of the case, characterization of transaction and functions performed as correctly applied the mark-up of 6% on actual cost.”

4.1. He also observed that once parent company is holding 99.95% holding it has to compensate its subsidiary on actual cost even if the local company is inefficient and thus, cost-plus method has to be adopted. At any rate, assessee-company having not taken the actual cost into consideration and charged mark-up of 6% on estimated cost, this itself would have lead to adjustments under TNMM also. Learned CIT(A) thus, supported the Order of the TPO/Assessing Officer by observing that even under TNMM adjustment made by the TPO is in accordance with law. In this regard, he observed that when a tax payer intends to dispute Transfer Pricing Method adopted by the tax authorities, the burden of proof is upon the assessee to prove that the method followed by the assessee is reasonable. No doubt the transfer pricing regulations do not question the intent and purpose of parties of setting the contract price by the tax payer but it applies, regardless of the intention, to the extent the contract price deviates from the arms length price. He accordingly upheld the Order of the Assessing Officer.

5. Further aggrieved, assessee is in appeal before us. Learned Counsel submitted that in the instant case TNMM is the most appropriated method. Adverting our attention to the details of key financials in respect of comparable companies with turnover less than Rs. 50 crores (page 59 of the paper book), it was submitted that the assessee followed a well established method of cost-plus 6% mark-up thereon and the said price, with reference to the comparable cases, can be said to be at arms length. The TPO as well as the Assessing Officer accepted TNMM as the correct method but the learned CIT(A) sought to apply cost-plus method which is not justified. He further contended that the Assessing Officer has not given any com-parables to arrive at standard cost and has not followed the parameters prescribed under Rule 10B of the I.T. Rules in which event, method followed by the assessee-company should not have been disturbed. In this regard, he relied upon the decision of the ITAT, Mumbai Bench in the case of C.A. Computer Associates Pvt. Ltd. vs. DCIT 37 SOT 306. He also adverted our attention to the written submissions filed before the CIT(A) (page 1 at para 3.2) to submit that assessee followed systematic method to arrive at standard cost and added a mark-up of 6% thereon which should not have been doubted merely because the net result was a loss in the year under consideration. He strongly submitted that method followed by the assessee is based upon acceptable data and the price charged by the assessee is at arms length in which event Assessing Officer cannot reject the method followed by the assessee to estimate arms length price arbitrarily. Written submissions were filed reiterating the points argued before us.

6. On the other hand, learned DR submitted that the decision of the ITAT, Mumbai Bench (supra), is not applicable to the facts of the instant case. In that case, the issue was as to whether bad debts can be taken into consideration to determine ALP of any international transaction. Having regard to the parameters prescribed in Rule 1OB the Bench observed that bad debts written off cannot be a factor to determine ALP. However, in the case of Cherokee India Pvt. Ltd. the assessee has not discharged his obligation of proving the correctness of the method followed by it. Adverting our attention to Rules 1OB, 1OC and 1OD of the I.T. Rules learned D.R. submitted that every person, who enters into an international transaction, has to maintain certain documents. In the instant case, the assessee being a contract manufacturer, the mode of sharing of costs and agreement there-for can be verified only if the agreement to that extent is placed on record, as no prudent businessman would have suffered loss. In the instant case, 5% of the raw materials were purchased by the assessee apart from investing in plant and machinery etc., and for such risks undertaken the assessee would not allow itself to be at the mercy of AE and would have certainly entered into a written agreement. Since assessee failed to produce the document and having admitted that it had marked-up it’s profit on the estimated cost only, the tax authorities were justified in accepting the mark-up on the total cost rather than on estimated cost-either under cost-plus method or under TNMM. Learned Counsel relied upon the decision of ITAT, Delhi Bench in the case of Mentor Graphics 1O9 ITD 1O1 to submit that “transfer pricing” is not an exact science and evaluation of transactions is some times based on approximation after taking into account all facts and circumstances of the case. In the instant case, the assessee did not perform its obligation of proving the correctness of its claim with regard to the agreement entered into with AE and also on account of failure to charge the mark-up on the actual cost. Therefore, the tax authorities were justified in ignoring the basis adopted by the assessee. Learned DR thus strongly relied upon th Orders passed by the tax authorities.

8. We have carefully considered the rival submissions and perused the record. In our considered opinion, the initial burden is upon the assessee to prove the correctness of the method followed. In the instant case this burden was not discharged properly. As could be seen from Rules 1OB to 1OD of the I.T. Rules read with provisions of section 92C of the Act, the ALP in relation to an international transaction has to be determined by one of the prescribed methods, which is a most appropriate method in the circumstances of the case i.e., having regard to the nature of transaction, class of transaction, class of associated persons, functions performed for such performance and such other relevant factors as the Board may prescribe. Though the assessee has to prove that the method followed by it is the most appropriate method, it is not an unfettered choice on the tax payer and this is subject to following certain procedures. Apart from the reliability of the data of the uncontrolled transactions, it is mandatory to every person who has entered into an international transaction to keep and maintain such information and documents as may be prescribed and the Assessing Officer may require such person to furnish any such information or documentation within a particular period of time.
9. In the instant case, correctness of the method followed by the assessee hinges upon the nature of agreement entered into with AE. Though, the assessee claimed that it has applied a mark-up of 6% on the costs, as per TNMM, whether such mark-up can be based on an estimated cost is required to be proved by referring to the agreement whereas the assessee could not furnish the agreement and did not place sufficient proof to support his logic of arriving at “standard cost”. Since assessee is a contract manufacturer and 5% of the raw materials are purchased on its own to manufacture the end-product, there is some element of risk involved, having invested on the plant and machinery, infrastructure etc., to carry on the activity of manufacture. While considering the reasonableness of the reward all these factors have to be cumulatively taken note of. As rightly pointed out by the tax authorities, in the case of a contract manufacturer it is unthinkable for a manufacturer to agree, in writing, to carry on the business so as to end up in losses. Assessee having not taken actual cost into consideration, TPO/Assessing Officer, as well as the learned CIT(A), have correctly noticed that either under TNMM or under cost-plus method the cost of goods supplied should be taken into consideration. It also deserves to be noticed that the mark-up of 6% has not been disputed by the tax authorities.
10. Learned Counsel, appearing on behalf of the assessee, submitted before us that in order to disregard the method followed by the assessee, the burden is upon the TPO to prove that the uncontrolled transactions are not comparable and in this regard he relied upon the decision of ITAT, Mumbai Bench in the case of C.A. Computer Associates Pvt. Ltd. (supra). In our opinion, the decision rendered in the aforecited case is confined to the facts therein; Since parameters prescribed in Rule 10B, vis-à-vis bad debts written off, were not taken into consideration the Tribunal correctly observed that the TPO was not justified in arriving at the arms length price by taking into account the bad debts written off. In the instant case, however, there is no dispute with regard to the method followed by the assessee except for the fact that the assessee has not proved satisfactorily as to why estimated ‘standard-cost’ has to be taken into consideration particularly when the transaction is with the principal who is holding 99.95% control over the assessee-company.
11. As could be noticed from paras 4.1 to 4.6 of the CIT(A)’s order, the main factor for disregarding the method followed by the assessee was due to non-furnishing of the so-called agreement with the AE. Since, we are in agreement with the detailed reasons given by the TPO/ Assessing Officer as well as the CIT(A), we hold that the initial burden is upon the assessee to prove the reasonableness of the method followed by the assessee-company and in the absence of proving the same by producing any document/agreement with its principal highlighting the contractual terms of sharing cost, the learned CIT(A) was correct in holding that the special provisions of the Act have to be construed strictly and the method adopted by the tax authorities for making transfer pricing adjustments is reasonable in the circumstances of the case. We, therefore, affirm the Order of the learned CIT(A) and dismiss the appeal filed by the assessee.

Order pronounced in the open Court on this the 22nd day of July, 2011.

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