Marubeni India Pvt. Ltd. Vs ACIT (I.T.A. No. 919/Del/2009)- ITAT Delhi
Delhi Tribunal Ruling –-Interest income is to be excluded from operating revenue for computing the net profit from operating activity unless such interest income has nexus with the international transaction. Under the captive service and cost plus model, if an expense has a direct link with the international transaction, the same should form part of total cost i.e. operating costs. The onus is on the taxpayer to maintain robust documentation for availing necessary economic and risk adjustments. The option of +/- 5 % is available only to the taxpayer when he is computing the ALP and not when the AO/TPO is computing the ALP
Marubeni India (P) Ltd (the assessee) was a 100 % subsidiary of Marubeni Corporation, Japan (MCJ/AE). The assessee’s operations primarily consisted of representation service. The assessee liaised between various business divisions of MCJ and their suppliers and customers in India. For such agency/handling business, the assessee was paid commission by its AE. The assessee also traded in a broad range of industrial, agricultural land and consumer goods, commodities and natural resources. The assessee also provided project related activities either as a sub¬contractor or supplier to third parties. The assessee used to enter into a contract with MCJ/other each year for studying the market and economic situation in India. Under the R & D agreement, the assessee provided information to MCJ on a periodic basis. For this service, the assessee was paid a fixed fee every quarter/year based on the decision at the time of entering into the agreement.
For Assessment year (AY) 2002-03, the assessee had reported seven international transactions with its AEs while for AY 2003 -04, the assessee had reported six international transactions with its AEs. On a reference made to the Transfer Pricing Officer (TPO), he had accepted all the transactions and method used by the assessee except the transaction in respect of agency and market research.
The assessee had used Transactional Net Margin Method (TNMM) as the most appropriate method to benchmark the international transaction in respect of agency and market research. The assessee had chosen operating profit margin on operating cost (OP/OC) as the profit level indicator. The TPO was not satisfied with respect to computation of arm’s length price (ALP) of the said international transaction. The TPO observed that the assessee erred in including interest income as a part of operating income while computing ALP. Similarly, he observed that the assessee failed to exclude certain expenses in operating expenses.
On appeal to the Commissioner of Income Tax (Appeals) [CIT (A)], the assessee had received partial relief. On aggrieved by the order of the CIT(A), both the assessee as well as tax department had preferred appeals before the Income Tax Appellate Tribunal (Tribunal).
Observations and decision of the Tribunal:
• The assessee pointed out that interest income earned on the deposits made out of surplus fund was held to be a business income in assessee’s own case for the AY 2000-0 1 by the Hon’ble Supreme Court of India and therefore, such interest income would form part of operating income for the purpose of computing operating margin of the assessee.
• The basic object of the Chapter X of the Income-tax Act, 1961 (the Act) is to determine and arrive at the ALP by comparing the operating profits of the controlled transaction with the uncontrolled transaction and while doing so, the TPO has to consider all the components which are part of the operating income and from which one has to reduce the cost incurred in earning operating income.
• According to the CIT (A), it is a universal practice under Transfer Pricing Regulation (TPR) that interest income is to be excluded from the operating revenue for computing the net profit from the operating activity. The CIT(A) recorded a finding that earning of interest income has never been the primary operating income generating activity, in fact, interest income is prima facie earned as a result of finance activity by investing the surplus funds and it is not the result of an operating activity. However, the situation would be different if the earning of interest itself is the main activity for which ALP is to be determined.
• The assessee provided agency and marketing research service to its AE. This activity is all together different then earning interest income. If interest is included as a part of the operating revenue, then it would mean to compute the return on investment which is an inappropriate profit level indicator for a service provider. Thus, for computing operating margin on cost, neither the interest income nor interest expenses are relevant. The essential element for consideration is the cost incurred for the operating activity which has to be taken into account.
• In AY 2002-03, assessee has closed down certain branches and paid compensation for the same. The assessee has claimed that since these costs are not regular operating expenditure these ought to have been excluded from the operating cost. If the business in certain branches was closed as per the independent decision of the assessee, then it may not be a relevant factor which can influence the international transaction. But if the business was closed due to the influence of AE, then this issue would be a relevant issue for the purpose of ALP.
• The assessee is captive company of MCJ, which compensates the assessee at cost plus 10%, that means MCJ runs the whole risk. In this case, the compensation received by closure of certain unit may not be a regular in nature. But by closing down certain branches, the assessee has reduced the cost of AE. It means that closure has a direct link with the international transaction. Hence, such expenses cannot be excluded while computation of ALP.
• As regards the non-inclusion of disputed telephone expenditure is concerned, since the same is in the nature of abnormal item and the TPO has not brought sufficient material on record which can exhibit that this amount was directly inter-linked with the international transaction, the CIT (A) has rightly excluded this amount from calculation of operating cost.
• As far as business promotion expenses are concerned, since 25% of the same were treated as personal in nature, it may not have any bearing on international transaction. Hence, CIT (A) has rightly excluded business promotion expenses which has element of personal nature from the operating cost.
• The assessee claimed that the comparable companies’ data has to be adjusted to account for the functional and risk level difference. The asses see has to maintain relevant documentation as required by the law to demonstrate such adjustments; however, in the absence of exact details, exhibiting the risk borne by the comparable vis-à-vis the risk in running the business taken by the assessee, claim made by assessee has been rejected.
• The assessee had also sought for an adjustment on account of general recessionary conditions of the market. However, the Tribunal has observed that the comparison made by the TPO has taken into consideration the general factor available to the assessee vis-à-vis to the comparable in the market. Therefore, no separate adjustment deserves to be made because of the general conditions of the market at that relevant point of time.
• The benefit of +/- 5 % as per proviso to Section 92C of the Act cannot be considered to be a standard universal deduction allowed in each and every case which the assessee exceeds the permissible limit and falls outside the arm’s length. The proviso provides a relief to the taxpayer at the time of determining the ALP. Therefore, this option is available to the assessee only when assessee is computing the ALP and not when the A O/TPO is computing the ALP.
This judgement has brought out various nuances regarding what should constitute operating income and operating expenses while computing the ALP. The Tribunal has rightly observed that the interest income is to be considered as operating when it emanates in the course of the international transaction with the AE.
The decision of Tribunal has put the onus on taxpayers, who are captive service providers, for maintaining robust documentation to decide whether a particular expenditure incurred out of the business decision has nexus with the international transaction with its AE, and whether such decision has been taken under the influence of AE and has any impact on profits/losses arising out of the international transaction with its AE. Further, under the cost plus model, due consideration is to be given to the total cost base in order to evaluate whether only operating expenses have been taken into account for determining the operating margin earned by the taxpayer.
It has also been held that in order to avail risk and economic adjustments, it is extremely important for the taxpayer to demonstrate the functions performed, risks assumed and asset used by the taxpayer vis-à-vis the com parables by maintaining the appropriate documentation.
The Tribunal has observed that +/- 5 % benefit is to be given only when assessee makes the computation of ALP and not when AO/TPO computes ALP. With due respect to the Tribunal, we believe that since the proviso to Section 92C is beneficial to the taxpayer, the same cannot be interpreted so narrowly.