Transfer Pricing – TPO should provide reasons for rejecting the Most Appropriate Method [MAM] used by the assessee before adopting a different MAM

Indian Additives Limited Vs The ACIT (ITAT Chennai)- Fact that a particular MAM used by the taxpayer cannot be rejected without providing any cogent reasons. Further, the Tribunal has mentioned that if there exist significant amount of purchases from Associates enterprises , the same cannot be included while computing the gross margins under the Resale Price Method [RPM]. The Tribunal have also re-emphasised the importance of comparing the FAR analysis of the tested party and that of the comparable companies while applying the TNM method.

ITAT Chennai

I.T.A. No. 703/Mds/2009

Assessment Year : 2004- 05

Indian Additives Limited Vs The Assistant Commissioner of Income Tax

I.T.A. No. 951 /Mds/2009

Assessment Year : 2004- 05

The Assistant Commissioner of Income Tax Vs Indian Additives Limited

O R D E R

PER ABRAHAM P. GEORGE, ACCOUNTANT MEMBER :

These are appeals filed by the assessee and Revenue respectively, for assessment year 2004-05, both directed against an order dated 27.3.2009 of Commissioner of Income Tax (Appeals)-XI, Chennai.

2. Assessee in its appeal has raised only one issue which is against the direction of the CIT(Appeals) that 75% of the royalty expenditure alone should be allowed as revenue expenditure and the balance has to be considered as capital expenditure. Revenue in its appeal has also raised a related issue that the CIT(Appeals) erred in allowing 75% of running royalty claimed, as revenue expenditure. Only other issue arising in Revenue’s appeal is regarding deletion of addition of Rs.  1,22,19,429/- made on account of revision of arms length price.

3. We will first take up the issue regarding royalty. Assessee had claimed a sum of Rs.  2,75,24,000/- as revenue outgo on amounts paid to one M/s Chevron Oronite Company LLC, USA (COCL). As per the assessee, this was running royalty. The A.O., however, was of the opinion that this was a capital expenditure, since assessee had acquired a right to use technology and technical know how from M/s COCL. However, the A.O. allowed depreciation thereof.

4. In assessee’s appeal before the CIT(Appeals), argument of the assessee was that it was a revenue expenditure and such payments made to M/s COCL were separate and distinct from lump sum payments of royalties given to M/s COCL. Ld. CIT(Appeals) after considering submission of the assessee, held that 75% of the payments could be considered as revenue expenditure and only 25% could be disallowed as capital expenditure. For this, he placed reliance on the order of his predecessor for assessment year 1999- 2000 in assessee’s own case.

5. Now before us, as already mentioned, both parties are aggrieved. Assessee is aggrieved that 25% of the payment was considered as capital expenditure, whereas, Revenue is aggrieved that 75% of the payment was allowed as revenue expenditure by the CIT(Appeals). Learned A.R. submitted that this Tribunal in assessee’s own case, allowed the claim of the assessee as revenue expenditure for assessment year 1999-2000 to 2002-03. Copy of the order of this Tribunal in I.T.A. Nos. 2138/Mds/2998 & 700 to 702/Mds/2009 and in I.T.A. Nos. 2238/Mds/2008 & 971 to 973/Mds/2009 dated 1 3^th November, 2009 was filed.

6. Learned D.R. fairly admitted that this issue stood decided in favour of assessee.

7. We have perused the orders and heard the rival contentions. We find that the same issue regarding royalty payment mad to M/s COCL was considered by this Tribunal in the orders referred supra. It was held by this Tribunal at para 2.17 of its order dated 13^th November, 2009, as under:-

“2.17 In the facts and circumstances of the case, when the royalty payments shall be computed at a particular percentage of sales priced, and if there was no sales, no royalty would be payable. Merely because goods were produced in India by the assessee acquiring the technical process from the foreign collaborator, it cannot be said that the royalty payment is referable to the production house / manufacturing of the products. The technical know-how for the manufacturing process was acquired by the assessee against a lump sum payment of royalty and subsequent to that, if there is no sale of the product manufactured by the assessee, then there would be no royalty payable. Thus, the running royalty payable has no nexus or direct connection with the manufacture of the product. The liability to pay the royalty arises only when there is a sale. Therefore, we are of the view that the running royalty cannot be said to be a capital expenditure. We do not find any rationale in bifurcation of the running royalty and treating one part as capital and the other part as revenue by the learned Commissioner of Income Tax (Appeals) without any basis. The decision relied upon by the learned Commissioner of Income Tax (Appeals) is on the facts that the assessee could continue to use the technology even after the expiry of the period of payment of royalty. Therefore, when the lump sum royalty was separately agreed and paid, then the running royalty, in the facts and circumstances, would only be a revenue expenditure paid for the use of the licence, trade mark and technical information for a particular period. Accordingly, this issue is decided in favour of the assessee and against the Revenue.”

8. Respectfully following the order of this Tribunal for the earlier assessment years, claim of the assessee has to be allowed for the impugned assessment year as well. Hence, appeal of the assessee for assessment year 2004-05 stands allowed, whereas, the related ground of the Revenue stands dismissed.

9. Coming to the only other issue, which is raised by the Revenue regarding adjustment towards arms length price, short facts apropos are that assessee had entered into certain transactions with related parties which, inter alia, included purchase of raw materials, purchase of finished goods, sale of finished goods, liaison activities, royalty and technical services charges. Such related parties being situated in Singapore, France and USA, Assessing Officer made a reference under Section 92CA of Income-tax Act, 1961 (hereinafter called “the Act”) to the Transfer Pricing Officer (TPO). It is to be noted that assessee had filed Form No.3CEB certified by its statutory auditors as prescribed under Rule 10E of Income-tax Rules, 1962, for the international transactions entered into by it, during the relevant previous year. Assessee is a joint venture of M/s COCL, USA and Chennai Petroleum Corporation Limited, both holding equal number of shares numbering 11,83,401 of which face value was Rs.  100/- each. Assessee was manufacturing additives and supplying it to fuel and lubricant companies. Such additives were blended with lubricants by its buyers and then sold. Assessee is licensed to manufacture and supply Oronite fuel and lubricant products. Since 50% of the share holding of the assessee rested with COCL, USA, the other subsidiary companies of COCL in Singapore and France also became associated enterprises. During the relevant previous year, assessee purchased raw materials and finished goods from COCL, Singapore and finished goods alone from COCL, France. It had also effected sale of finished goods to COCL, Singapore. In addition, it was having certain transactions with COCL, Singapore for liaison activities, and also transactions relating to royalty and technical service with COCL, USA. Purchase of raw materials from COCL, Singapore, was of the value of Rs. 13,55,90,154, which was in addition to purchase of finished goods Rs. 4,66,66,369/- from the same associated enterprise. Purchase of finished goods from COCL, France came to Rs. 63,48,769/-. These together, totalled to Rs. 18,86,05,292/-. As per the assessee, the purchase of raw materials from COCL, Singapore of Rs. 13,55,90,154/- consisted of two specific items on which comparables existed and arms length price was computed and given in Form No. 3CEB filed. It had worked out arms length price vis-à-vis the above purchase of Rs.  13,55,90,154/- at Rs.  18,16,05,784/- based on comparable third party transactions listed in Annexure – 2(B) of the said Form. The comparison of price of these two raw materials, were with purchase effected by M/s Herdilla Schenectady and M/s Lubrizol India Pvt. Ltd. Thus, in so far as these two raw materials were concerned, assessee had adopted a comparable uncontrolled price (CUP) method for fixing the arms length value. Since such value was higher than the prices paid by the assessee to its associated enterprises, no adjustment whatsoever was made. Vis-à-vis purchase of finished goods from COCL Singapore and France, assessee adopted resale price method by working out the internal gross profit margin as given by it at Annexure-2(D) of Form 3CEB. Though the assessee had transactions of sale of finished goods, laision, royalty and technical services with associated enterprises, only the above transactions of purchase of raw materials and finished goods were considered by the TPO, under the Transactional Net Margin (TNM) method he adopted for computing the arms length price. In other words, as far as other transactions were concerned, the TPO accepted the arms length price worked out by the assessee for comparison. During the course of proceedings, before the TPO, assessee gave submissions justifying the method followed by it in valuing the international transactions. The TPO was of the opinion that the prices charged in respect of international transactions relating to purchase of raw materials and finished goods were not in accordance with sub-section (1) and (2) of Section 92C of the Act. According to the TPO, assessee had purchased 15 items of raw materials from associated enterprises, but, only two items were considered while adopting CUP method of comparison. Assessee had submitted before the TPO that no comparable details were available regarding 13 items out of 15 items supplied by the associated enterprises since these were proprietory in nature. TPO being not satisfied with the methodology adopted by the assessee, made a search in the Internet and identified one company named M/s Interflon India Pvt. Ltd. (IIP) as a comparable entity. The financial accounts of the said company were furnished to the assessee and it was required to compute arms length price in relation to its international transaction based on Transactional Net Margin method. Assessee, however, was of the opinion that M/s IIP was doing business in small quantities and it had very small turnover when compared to assessee. Further, as per the assessee, M/s IIP was supplying only from the old stock and none of assessee’s customers had purchased any item from M/s IIP. TPO addressed a letter to M/s IIP for the details of its ownership and for ascertaining possibility of any transaction with its associated enterprises, whereupon M/s IIP replied that it was an independent company held by Indian promoters and had no related parties transactions at all. Nevertheless, it was also confirmed by M/s IIP that in the relevant previous year, it had only small customers and only one major customer was M/s Bennet Colman & Co. Ltd., Mumbai. The TPO rejected the contention of the assessee that its turnover could not be compared with that of M/s IIP, for, according to him, this was not a criteria to be adopted for selecting a comparable concern. Thereafter he made the following comparison between financial results of assessee and M/s IIP:-

 

INDIAN ADDITIVES LTD.(ASSESSEE)	March 2004	INTER FLON (INDIA) PVT. Ltd.	2004
Rs.       Crore           (Non! Annualised)	12 mths
Income
Sales	1203600000	Sales	1400227
other income	5600000	other income	220629
TOTAL INCOME	1209200000	TOTAL INCOME	1620856
Expenditure		Expenditure
Raw materials, stores, etc.	779300000	Cost of materials	412349
Wages & Salaries	62500000	Employee cost	186846
Energy (power & fuel)	41500000	Packing cost	55231
Indirect taxes (excise, etc.)	176000000
Advertising               & Marketing expenses	0
distribution expenses	0
others	97000000	ether exp	608844
depreciation	54000000	depreciation	85265
Stocks	– 19300000	Stock	162126
TOTAL EXPENDITURE	1191000000	TOTAL EXPENDITURE	1510661
OPERATING PROFIT	18200000	OPERATING PROFIT	110195
OP/SALES	1.512130276	OP/SALES	7. 869795397

Thereafter, he proceeded to do a Functional, Risk and Asset Analysis (FAR) of the two companies and came to a conclusion that both the entities were performing similar functions, undertaking similar risks and having similar assets. A.O., thereafter applied the profit margin of 7.87% of M/s IIP, on the purchase cost of raw materials and finished goods totalling to Rs.  18,86,05,292 after aggregating it with profit margin of 1.51% of the assessee-company, and arrived at an arms length purchase price of Rs.  17,63,85,863/-. Computation made by the TPO is reproduced here under:-

Computation of Arm’s Length Price:

Purchase price of Raw materials & Finished goods (A)	:	18,86,05,292
Profit margin of Assessee company (B) @ 1.51%	:	28,47,940
Sale price relatable to AE Purchases (A+B) (C)	:	191453232
Arms length profit margin @ 7.87% (D)	:	15067369
Arm’s Length Purchase price (C-D) (E)	:	176385863
Difference in Price (A-E) (F)	:	12219429

He, therefore, directed the A.O. to adjust the total income of the assessee upwardly by a sum of Rs. 1,22,19,429/-.

10. In its appeal before the CIT(Appeals), argument of the assessee was that raw materials purchased for Rs.  Rs. 13,55,90,154/- from COCL, Singapore, had two com-parables and based on such comparable, the arms length price was determined adopting CUP method. As per the assessee, such arm’s length price was much higher than what was paid by the assessee and hence, there was no question of any adjustment whatsoever. Further, as per the assessee, TPO had made adjustment on purchase prices of two raw materials on which com-parables were existing, on a reasoning that there were no com-parables for other raw materials purchased, which were proprietary in nature. In so far as purchase of finished goods was concerned, explanation of the assessee was that these were all proprietary goods manufactured by COCL, Singapore and France and never produced by any other company nor available in open market. Therefore, according to assessee, it had adopted resale price for finding the arm’s length price. Assessee pointed out before ld. CIT(Appeals) that resale of such finished goods were effected only to third parties and hence, reducing gross profit from such resale prices was a good and correct method for fixing arm’s length price. Vis-à-vis comparison made by the TPO with M/s IIP, assessee pointed out that the said M/s IIP was 100% Indian company, whereas, assessee was an equal collaboration between a public sector undertaking and foreign company. Assessee also brought to the attention of ld. CIT(Appeals) that M/s IIP was only doing purchase of material and selling it after repackaging. As per the assessee, sales effected by M/s IIP were only to very small customers. Assessee pointed out to ld. CIT(Appeals) that M/s IIP was supplying additives and lubricants to food industries, whereas, additives and lubricants supplied by the assessee were for automobile industries. Hence, according to it, both the companies were engaged in totally different type of business. In a nutshell, its argument was that M/s IIP was neither comparable in terms of industry serviced, products dealt with and size of business operations. Reliance was placed on the decision of Honourable Delhi High Court in the case of Sony India Ltd. (288 ITR 52) and that of Special Bench of this Tribunal in the case of Aztec Software and Technology Services [294 ITR (AT) 32].

11. Ld. CIT(Appeals) after going through the submission of the assessee, came to a conclusion that M/s IIP was doing business in food industry, whereas, assessee was in automobile industry and hence, these two companies could not be compared at all. According to him, the size of operations also had great bearing and M/s IIP was having only insignificant turnover when compared to that of the assessee. Ld. CIT(Appeals) also noted that for subsequent assessment year 2005-06, the TPO had held that no adjustment was necessary in the international transaction entered into by the assessee. For these reasons, he deleted the addition made by the A.O. based on the order of the TPO.

12. Now before us, learned D.R., strongly assailing the order of ld. CIT(Appeals), submitted that M/s IIP was doing a comparable business and supplying additives. According to him, assessee had not given any good comparable case for the raw materials purchased from its associated enterprises abroad, claiming that 13 out of 15 items purchased were of proprietary nature. According to learned D.R., Assessing Officer had found the case of M/s IIP to be similar and made a FAR analysis and properly came to a conclusion that transaction net margin method was appropriate for valuing the international transactions of the assessee.

13. Per contra, learned A.R. submitted that the TPO had applied the profit margin worked out from the financials of M/s IIP, on cost of raw materials and finished goods purchased. As per the learned A.R., application of TNM method was uncalled for when the assessee had given the specific com-parables and adopted CUP method. According to him, without rejecting the com-parables given by the assessee, the TPO had arbitrarily adopted TNM method that too based on the financials of a small company not at all comparable with that of the assessee. Relying on the comparison table of financials, given at para 7.4 of TPO’s order, learned A.R. submitted that if the other income of Rs.  2,20,629/- was excluded from the profits of M/s IIP, it would result in negative margin. According to him, not only was the turnover of M/s IIP negligibly small, but it was also catering to different industrial field. Learned A.R. argued that TPO had adopted the TNM method without making proper analysis and without rejecting the CUP and Resale price method adopted by the assessee. According to him, CIT(Appeals) was justified in deleting the addition made.

14. We have perused the orders and heard the rival contentions. TPO had relied on financials of M/s IIP which he considered to be a comparable company and worked out the profit margin which came to 7.87% and applied it on purchase price paid by the assessee for raw materials and finished goods purchased by it from its associated enterprises after aggregating the profit margin thereto. In the first place, what we find is that the TPO had applied Transaction Net Margin method on the purchase prices of raw materials and finished goods as under:-

Purchase price of  raw materials from M/s C0CL, Singapore	:	135590154
Purchase price of finished goods from M/s C0CL, Singapore	:	46666369
Purchase price of finished goods from M/s C0CL, France	:	6348769
T0TAL (A)	:	188605292
Profit margin of assessee-company (1.51%) (B)	:	2847940
Price attributable to AE as per assessee (A+B)	:	191453232
Profit    margin  of    7.87%   (taken   from   the financials of M/s IIP) if applied to A+B	:	15067369
Arm’s Length Price (A+B) – Profit margin 15067369/-	:	176385863
difference in price (A -176385863)	:	12219429

We find one major error committed by the TPO in above work out. Against the purchase of raw materials for 135590154/- as appearing in Form No.3CEB submitted by the assessee relating to its international transactions, it had specifically stated that these were two items, namely, Dodecyl Phenol and Zinc Di Thio Phosphates from the AEs. Assessee had also computed arm’s length value of such purchase by adopting CUP method and for such CUP method, it had given specific com-parables of two unrelated parties, namely, Herdillia Schenectady and Lubrizol India Pvt. Ltd. vide Annexure-2(B) of the said Form, duly certified by its auditors. The TPO did not give any reason why he rejected the CUP method adopted by the assessee when assessee could show that such CUP method was based on prices charged or paid in a comparable uncontrolled transaction. On the other hand, we find that the TPO had rejected the method adopted by the assessee on a finding that out of 15 raw materials imported, assessee could not give comparison in 13 items, but, only for the above two items. If that was so, then the adjustment that should have been carried out was on such 13 items of raw materials on which no com-parables were given by the assessee and not for the two items of raw materials where the assessee could give specific com-parables adopting CUP method. Even for those 13 items, assessee has specifically mentioned that these were not available in the market and no comparable were there at all. Thus, we do not find any proper reason why the TPO could reject the method adopted by the assessee and apply the TNM method based on the financial of M/s IIP. Again, if we look at financial of M/s IIP reproduced by us at para 9 above, its sales were of Rs. 14 lakhs and odd against the sales in excess of Rs.  120 Crores of the assessee. The said M/s IIP had not paid any excise duty and indirect taxes, but, had incurred only packing cost in addition to cost of materials. As against this, assessee had paid indirect taxes of about Rs. 60 lakhs. Obviously, M/s IIP was not engaged in any major manufacturing activity nor it had a comparable turnover. There were substantial differences in the financial data of the two companies which considerably eroded the degree of comparability between the two. Thus, the TPO not only adopted the TNM method without rejecting the CUP method followed by the assessee, but also made addition based on the financial results of an un comparable entity.

15. Now, coming to the other items which were purchased namely finished goods, assessee had adopted resale price method for fixing the ALP. The purchases of finished goods were from M/s COCL, Singapore and COCL, France and for arriving at arm’s length price, assessee adopted the resale price method by deducting a gross profit margin of 12.746% from the resale price of such finished goods to unrelated parties. The working of gross profit has been given in Annexure-2(D) of Form 3CEB submitted by the assessee. Gross profit margin of 12.746% has been worked out by the assessee from its own financials by averaging the results for financial years 2002-03 and 2003-04. In other words, it has averaged the gross profit of two years and deducted such average gross profit rate from the resale price, to arrive at arm’s length price. Now, if we look at resale price method given in clause (b) of sub-rule (1) of Rule 10B, the price at which the goods are sold to unrelated parties has to be adjusted by the amount of normal gross profit margin and such normal gross profit margin has to come out of comparable of uncontrolled transactions, whether that of assessee or of another similarly placed entity. Can we say that assessee has worked out the gross profit margin based on any comparable uncontrolled transaction? Assessee had made a working based on its own gross profit rate including that of the transactions related to the AEs and we cannot understand how an adjustment made on such gross profit rate, averaged for two years could result in any variation. It is only a reverse working of its own results. The primary principle behind determining the arm’s length price is that the comparison should come from uncontrolled transactions. When the comparison does not come from uncontrolled transactions, then such comparison cannot give any rationale results. No doubt, in so far as purchase of raw materials from associated enterprises are concerned, though the TPO committed a mistake in applying TNM method basing himself on the working results of an un comparable entity, as already held by us, we find that no consideration whatsoever has been given by any of the authorities below regarding the correctness or appropriateness of the resale price method adopted by the assessee in computing the Arm’s Length Price relatable to purchase of finished goods. The most important step when resale price method is adopted for determining the arm’s length price of purchases from associated enterprises is the reduction of gross profit margin from the resale price. Such gross profit margin can be determined in any of the two methods. First is the gross profit margin of the assessee itself. But when gross profit margin of the assessee itself is considered, then such gross profit margin has to be worked out excluding the purchases from the associated enterprises and sales thereof. Otherwise, as already pointed out by us, it will be meaningless. However, here more than 70% of assessee’s sales were out of purchases sourced from associated enterprises, and hence working out the gross profit margin internally, after excluding such transactions, would be inappropriate due to negligible quantities of balance purchases and sales. Hence, in such cases, the gross profit margin should be taken from comparable uncontrolled transactions entered into by similarly placed concerns. Thus, the assessee has committed two fundamental mistakes in working out the arm’s length price based on resale price method. It went by its internal gross profit rate averaged over two years, that too without excluding the purchases and sales from the associated enterprises. Neither the A.O. nor the TPO went into this aspect but simply applied TNM method, that too based on a single comparable, which as already mentioned by us was not comparable at all, on account of volume and nature of activity. Therefore, in our opinion, the determination of arm’s length price and adjustments required, if any, on total income of the assessee, requires a re look by the A.O., in so far as it relates to purchase of finished goods from M/s COCL, Singapore and COCL, France are concerned. We, therefore, set aside this issue and remit it back to the A.O. for proceeding in accordance with law. However, so far as the purchase of raw materials are concerned, determination of arm’s length price by the assessee cannot be faulted, since it had proceeded based on comparable uncontrolled transactions of two concerns, based on the CUP method, which was rejected by the TPO and A.O. for wrong reasons. Further, not only the TPO had unilaterally adopted TNM method, but made comparisons with the working results of a concern which was not comparable at all. Hence, ld. CIT(Appeals) was justified in setting aside the adjustment on arm’s length price for purchases of raw materials. We find no reason to interfere on this aspect. Thus, in so far as the adjustments made on purchase of raw materials from associated enterprises is concerned, we sustain the deletion of addition made by ld. CIT(Appeals). But, in so far as determination of arm’s length price on purchase of finished goods are concerned, we are of the opinion that the matter requires re-visit by the Assessing Officer for the reasons mentioned above. In the result, we set aside the issue relating to the determination of arm’s length price of purchase of finished goods, back to the file of the A.O., whereas, in so far as determination of arm’s length price of the purchase of raw materials is concerned, we uphold the order of ld. CIT(Appeals). The A.O. shall, while determining the arm’s length price of the purchase of finished goods, proceed in accordance with law.

16. Appeal filed by the Revenue is partly allowed for statistical purposes

17. To summarise the results, appeal of the assessee is allowed, whereas, that of Revenue is partly allowed for statistical purposes.

The order was pronounced in the Court on 1 7^th June, 2011.