* IN THE HIGH COURT OF DELHI AT NEW DELHI
RESERVED ON: 08.07.2013
% PRONOUNCED ON: 16.12.2013
+ ITA 306/2012
LI AND FUNG INDIA PVT. LTD. ..... Appellant
Through: Mr. Porus Kaka, Sr. Advocate with
Mr. Neeraj Jain, Mr. Manish Kanth and
Mr. Ramit Katyal, Advocates.
Versus
COMMISSIONER OF INCOME TAX ..... Respondent
Through: Mr. N.P. Sahni, Sr. Standing Counsel
and Mr. Ruchesh Sinha, Advocate.
CORAM:
HON'BLE MR. JUSTICE S. RAVINDRA BHAT
HON'BLE MR. JUSTICE R.V. EASWAR
MR. JUSTICE S.RAVINDRA BHAT
1. The present appeal under Section 260A of the Income Tax Act, 1961
(hereafter ,,the IT Act) impugns the order dated 30.09.2011 of the Income
Tax Appellate Tribunal, Delhi Branch ,,D, New Delhi (hereafter ,,the
Tribunal) in ITA No. 5156/Del/2010, for the assessment year 2006-07.
The present appeal concerns the alleged apportioning of consideration
between the Appellant (i.e. the assessee, M/s Li Fung (India) Pvt. Ltd,
hereinafter ,,LFIL) and its Associated Enterprise (hereinafter ,,AE) in
order to arrive at the arms length price for the transactions between the
two entities, using the Transactional Net Margin Method (TNMM). The
following questions of law arise from the appeal:
ITA 306/2012 Page 1
a. Whether the assessment of the Revenue of arms length price
applying the TNMM method was contrary to the transfer pricing
provisions under the IT Act and Rules?
b. Whether the Transfer Pricing Officers (TPOs) apportionment by
considering the cost plus mark up of 5% on FOB value of goods
between third party enterprises, sourced through the appellant is in
compliance with the law?
2. The facts that give rise to these questions of law are as follows. LFIL is a
wholly owned subsidiary of Li & Fung (South Asia) Ltd., a company
incorporated in Mauritius as a captive offshore sourcing provider. Li &
Fung (Trading)(the AE),is a group company incorporated in Hong Kong,
which enters into contracts with customers viz. retail chains overseas, for
rendering sourcing support services for the supply of high volume, time
sensitive consumer goods. The appellant entered into an agreement dated
4.12.1997 with the AE, whereby the contract for rendering sourcing
services is outsourced or subcontracted to LFIL, for which it is
remunerated at cost plus a mark up of 5% for services rendered to the AE,
and ultimately, the AEs customers.
3. LFIL previously received buying support services fees amounting to Rs.
47, 69, 83, 904 from the AE, which ought to be considered as an
international transaction of rendering buying support services to AE under
the Transfer Pricing provisions under Sections 92 to 92F of the IT Act. To
justify that the transaction was at arms length, LFIL applied the
Transactional Net Margin Method (TNMM) as the most appropriate,
considering Operating Profit Margin divided by Total cost as the Profit
level indicator. Since the operating profit margin at 5.17% exceeded the
weighted average operating margin of 26 other comparable companies at
ITA 306/2012 Page 2
4.07%, LFIL contended that such a transaction of rendering of sourcing
services was at arms length on an application of the TNMM method.
4. During the course of the Transfer Pricing assessment, LFIL contended that
it was a low risk captive sourcing service provider performing limited
functions with minimal risk as an offshore provider and substantial
functions relating to buying services was performed by the AE, which also
assumed various enterprise risks. Thus, the compensation paid to the
appellant at cost plus 5% as remuneration was to be considered at arms
length while applying the TNMM. Alternatively, the AE entered into
contracts with unrelated third parties for rendering buying services @ 4%
to 5% of the FOB value of exports. LFIL had in turn received service fee
of Rs.47.69 crores which is equivalent to nearly 4% of the FOB value of
the export (by the vendors) from the AE, which constituted 80% of the
consideration received by the AE, which, in LFILs opinion ought to have
been considered at arms length.
5. The Transfer Pricing Officer by an order dated 28.10.09 under Section
92CA(3) of the IT Act did not dispute the selection of the comparable
companies for application of TNMM by LFIL. However, he held that the
cost plus compensation @ 5% of cost of incurred by LFIL was not at arms
length and applied a mark up of 5% on the FOB value of export of Rs.
1202.96 crores made by the Indian manufacturer to overseas third party
customers.
6. The reasons given by the TPO were that:
a) LFIL was performing all the critical functions, assumed significant risks
and used both tangible and unique intangibles developed by it over a period
of time;
ITA 306/2012 Page 3
b) there was no evidence that the AE had either technical capacity or
manpower to assist LFIL and that in the absence of any credible evidence,
the involvement of the AE could not be accepted;
c) LFIL had developed several unique intangibles which had given an
advantage to the AE in the form of low cost of the product, quality of the
product and enhanced the profitability of the AE, though the cost for
development and use of intangibles was not taken for computation of
routine mark up of 5% considered by LFIL;
d) LFIL had crucially developed supply chain management which provided
the link between the suppliers and customer to achieve strategic and pricing
advantage;
e) LFIL owned human capital intangible, developed at their own cost with
all related risks in creation and maintenance of such intangible;
f) the AE recognised that India offers both cost and operational advantage
such as lower salaries for the employees, low cost material and low cost
manufacture. LFIL had neither quantified this locational saving nor had the
AE attributed any part of the additional profit on account of locational
saving to LFIL.
7. The TPO did not, as stated earlier, dispute the analysis undertaken by
LFIL, but for the above reasons applied the 5% mark up to FOB value of
exports made by Indian manufacturer to overseas third party customers,
amounting to Rs 1202.96 crores and accordingly computed an addition of
Rs 57, 65, 61, 186/- to the appellants income on account of the alleged
difference in calculation of the arms length price of the above
transactions. Thus, the Assessing officer in the draft assessment order
passed under section 144C(1) of the Act made an addition, inter alia, on
account of transfer pricing adjustment of Rs. 57,65,61,186 on the basis of
the order passed by the TPO. The reasoning of the TPO is as follows:
ITA 306/2012 Page 4
"5.2.5 The compensation model of the assessee does not include the
profit attributable to the assessee on account of location saving:
Globalization and continuous search for lower cost has resulted in
transfer of manufacturing and procurement activities from high cost
economy like European Union, Japan, UK and United States, to
lower cost economies like India to stay competitive and to increase
profits. In this case, the AE has recognized that India offers both cost
and operational advantage such as tower salaries for the employees,
low cost material and low cost manufacture. Accordingly, it has
established a trading company in India for procurement of goods.
Location savings generally emerge when companies transfer their
operation site from high cost economy to economies with low cost.
That is, they take advantage of price differences in the factors for
production or procurement across the countries. In many cases, the
location saving arise from differences of low labour cost, low raw
material and finished goods cost, low logistic cost and lower quality
control cost. The net location saving represent saving from moving to
low cost economy. In this case, the assessee is operating in low cost
economy has generated location saving due to huge difference in cost
of procurement between high cost economy and low cost economy
like India. From a trading pricing prospective the common question
in this case is: "who is entitled to additional profits in form of
locational saving?" or "which country should tax the profits?" In
this case, the assessee has established its sourcing subsidiary in
India in order to earn or to have the advantage of the locational
saving. However, the assessee has neither quantified locational
saving nor has attributed any part of the additional profit on account
of locational saving to the assessee, in India. It is pertinent to
mention here that the assessee is the most critical part of global
supply chain of the AE. It is responsible for identifying and
qualifying the contracted manufacturer, for working with them and
other designers to manufacture garments in the technical
specifications, for selection of fabrics, for control over the
manufacturer, for identifying appropriate sourcing of fabrics and
accessories, for quality insurance, for transportation logistics and
for coordinating logistics. The compensation model for the assessee
which is based on reimbursement of the cost with the percentage
mark up has not included locational saving attributable to the
assessee. These facts prove that cost plus compensation @ 5% of
ITA 306/2012 Page 5
cost of the assessee is not at arms length because it does not include
profit attributable to the assessee on account of locational saving.
5.3 Whether the assessed commission should be expressed as a
percentage of the FOB price of goods sourced through the assessee?
In this case the AB has allowed commission of 5% of cost
incurred by the assessee for its sourcing activities in India and has
not computed commission on FOB price of goods sourced through
the buying office. I have examined the compensation model along
with the facts of the case and reached a conclusion that in this case
commission should be expressed as a percentage of FOB price of
goods sourced through the assessee for the following reasons:
(a) It is evident from the FAR analysis as discussed in Para 5.2.2
of this order that the assessee has played a major role in identifying
suppliers, raw material, design, production control, manufacturing
control, quality control, packing and export of merchandise and has
been in constant touch with the buyer. It has assumed significant
risks and has used both its tangibles and unique intangibles which
resulted in enhancement and profitability of sourced goods as
discussed in Para 5.2.4 and 5.2.5 of this order. These facts clearly
prove that value addition activities of the assessee can only be
expressed as a percentage of FOB of goods sourced through the
assessee.
(b) The assessee is operating in a low cost country like India and
its operating cost is so low that it is a very poor proxy of the value it
adds to the sourced goods.
(c) The assessee has developed unique intangibles like supply
chain management intangibles and Human Asset Intangible which
has resulted in huge commercial and strategic advantage to the AE
and these intangibles have enhanced the profit potential of the AE.
However, these intangibles did not form part of the operating cost.
Accordingly, the value addition made by the assessee using
intangible, to the FOB value the goods sourced through it remained
unremunerated and operating cost plus mark up model does not
capture the compensation for value addition made through these
ITA 306/2012 Page 6
intangibles. Accordingly commission should be computed on FOB
value of goods.
(d) The assessee has generated huge locational saving for the AE
as discussion in Para 5.2.5 of this order. However, compensation
model based on operating expense of the assessee does not include
locational saving attributable to the assessee which could only be
capture if commission is calculated on FOB value of goods sourced
through the assessee.
In view of the above findings, it is held that the correct compensation
model at arms length price, in this case, would be commission of
FOB cost of goods sourced from India.
6. The risk profile of the assessee has been discussed in detail in
Para 5.2.1 of this order. It has been discussed in detail in this order
that the assessee functions like an independent entrepreneur. Hence,
it takes matching risks. For sake of convenience, risks relevant in the
business of the assessee and risks disclosed in T.P. studies are
analyzed in the following table:
SI. No. Risk matrix relevant to The risk matrix as disclosed in
business of the assessee transfer pricing report under
Rule 10D
1. Market Risk Disclosed in transfer pricing
report
2. Service liability Disclosed in transfer pricing
report
3. Capacity utilization risk Disclosed in transfer pricing
report
ITA 306/2012 Page 7
4. Foreign exchange risk Disclosed in transfer pricing
report
5. Credit & collection risk Disclosed in transfer pricing
report
6. Scheduling risk Not disclosed in transfer
pricing report but actually
borne by assessee.
7. Government & institutional Not disclosed in transfer
risk pricing report but actually
borne by assessee.
8. Operational risk Not disclosed in transfer
pricing report but actually
borne by assessee.
9. Asset redundancy risk Not disclosed in transfer
pricing report but actually
borne by assessee.
10. Infrastructure failure risk Not disclosed in transfer pricing
report but actually borne by
assessee.
11. Human capital intangible Disclosed in transfer pricing
related risk (manpower risk) report.
12. Security risk Not disclosed in transfer pricing
report but actually borne by
ITA 306/2012 Page 8
assessee.
13. Environmental risk Not disclosed in transfer pricing
report but actually borne by
assessee.
It is evident from the risk analysis, as mentioned in the table
above that the assessee is a risk bearing entity and it cannot be said
that assessee- is a risk-free entity. It is an independent entrepreneur.
Hence, there is no case for risk adjustment in the assessees case.
Without prejudice to the above finding that the assessee is a risk
bearing entity and does not require any adjustment on account of
risk, the claim of the assessee is not admissible on the following
grounds:
(a) The assessee has not conducted risk analysis either in case of tested
party and comparables and has not demonstrated its risk matrix of
comparables as different from tested party.
(b) No computation of risk adjustment is filed.
(c) The onus to support risk adjustment is on the assessee, who has not
discharged that onus.
********** ************
8.1 The assessee has adopted TNMM with a PLI of OP/OC. It may be
pointed out that it is not the intention of this order to change the method
adopted by the assessee. The method adopted by the assessee is accepted.
The only change being made is on the cost base being applied while
applying the PLI, chosen by the assessee. It has already been pointed that
the costs do not include cost of sales made through the assessee. This being
the case, the mark-up of 5% should obviously be calculated on the full FOB
value of exports in on Rs.1202.96 Crores. Following the discussion in the
preceding paras, the operating income shall be calculated as a mark-up the
FOB value of exports that have been facilitated by the assessee.
ITA 306/2012 Page 9
9. Calculation of arms length price
The assessee has credited total receipt of Rs.476,983,904 on the
basis of operating cost of the assessee plus a markup of 5% and at the net
level the net operating margin of Rs.24,914,814 comes to 5.22%. This is in
consonance with the assessees claim it is operating on cost plus 5%
markup basis. Following the discussion in the preceding paras, the receipt
as claimed by the assessee, shall be substituted by the FOB value of exports
being Rs.1202.96 crores. The markup of 5% that shall be applied to this and
the same shall be credited to the Profit & Loss Account. After taking into
account this gross income, the net operating income is computed at
Rs.601,480,000. Thus, the arms length price is calculated as below:
Net Operating income (as calculated above) Rs.601,480,000
Operating income shown by assessee Rs.24,918,814
Difference Rs.576,561,186
Accordingly, the value of the international transaction of the assessee shall
be adjusted upward by Rs.576,561,186 to bring it to arms length. Since the
difference computed as a percentage of the Arms Length Price is more than
5% no benefits under the proviso to Section 92C(2) is available to the
assessee.
10. The transfer pricing approach may be summarized as below.
(i) The assessee has used TNMM as the method and OP/TC was claimed
to be the PLI.
(ii) It was noticed that the cost of goods sold through the assessee has
not been included in the cost base while computing the margin.
(iii) A show cause is this regard was issued to the assessee. The same is
reproduced at Para 5.1.
ITA 306/2012 Page 10
(iv) The assessee markup has been calculated on the FOB value of
exports made through the assessee. The rationale for this has
been given at para 5.3.
(v) An adjustment of Rs.576,561,186 was made to the value of
international transaction.
(vi) The assessee was afforded reasonable opportunity of being heard
(including personal hearing) as mentioned on page 1 of this
order."
8. The Dispute Resolution Panel (DRP) by order dated 30.09.2010 passed
under Section 144C (5) of the Act reduced the said mark up of 5% of FOB
value of exports to 3%. The Assessing Officer accordingly in the final
assessment order dated 8.10.2010 passed under section 143(3)/144C(3) of
the IT Act computed LFILs income at Rs 36, 67, 95, 634/- as against the
returned income of Rs 3,08,26,448 after making the addition on account of
transfer pricing adjustment. The material part of DRPs reasoning is as
follows:
"After going through the functions of the assessee, we find that it
has assumed the role of a full risk bearing trader. Therefore, the
plea of the assessee that the cost of goods should not be part of the
cost base cannot be allowed. The assessees plea that the Honble
ITAT and the Delhi High Court, have held that it is eligible for
deduction u/s 80-O of the Income Tax Act has no application in the
instant case as the decisions were not rendered in the context of
setting the arms length price of the assessees international
transactions.
International transactions have to be judged at a different
level as opposed to transactions covered by the domestic law. The
OECD also recognizes the fact that related parties may fashion their
transactions in such a manner that may call for looking at the
substance of transactions over the form they are given. The relevant
portions of the OECD guidelines issued on 22.07.2010 are as
below:-
ITA 306/2012 Page 11
"1.67 Associated enterprises are able to make a such greater
variety of contracts and arrangements than can independent
enterprises because the normal conflict of interest which would exist
between independent parties is often absent. Associated enterprises
may and frequently do conclude arrangements of a specific nature
that are not or are very rarely encountered between independent
parties. This may be done for various economic, legal, or fiscal
reasons dependent on the circumstances in the particular case.
Moreover, contracts within an MNE could be quite easily altered,
suspended, extended, or terminated according to the overall
strategies of the MNE as a whole, and such alterations may even be
made retroactively. In such instances, tax administrations would
have to determine what the underlying reality is behind a
contractual arrangement in applying the arms length principle.
1.68 In addition, tax administrations may find it useful to refer to
alternatively structured transactions between independent
enterprises to determine whether the controlled transaction as
structured satisfied the arms length principle. Whether evidence
from a particular alternative can be considered will depend on the
facts and circumstances of the particular case, including the number
and accuracy of the adjustments necessary to account for
differences between the controlled transaction and the alternative
and the quality of any other evidence that may be available."
Therefore, the assessees claims that it does not bear the risks of a
normal trader have to be tested in this light. Accordingly, we are
inclined to accept the TPOs conclusion that the FOB value of goods
should form part of the cost base for calculating the remuneration
that should accrue to the assessee. That leads to the next question as
to what should be the correct markup that should be applied. The
TPO has applied the markup of 5% because the assessee is
operating on a cost plus 5% model. However, when we are
increasing the cost base manifold, the application of a markup of
5% will be excessive.
We accordingly hold that given the facts and circumstances of the
case a markup of 3% will be reasonable. This will adequately cover
the valuable intangibles that have been developed and used by the
assessee as also the location saving that the assessee is passing on
to its AE.
Directions under Section 144C(5) of the IT Act
ITA 306/2012 Page 12
In view of the discussion on each of the grounds of objections above,
the Assessing Officer is directed to complete the assessment as per
the draft order forwarded by him to the assessee subject to
modification as discussed in Para 3 above. The Assessing Officer
may incorporate the reasons given by the Panel at appropriate
places in respect of the various objections while passing the final
order. He is also directed to append a copy of these directions to the
assessment order.
The objections of the assessee are disposed of as above."
9. LFIL preferred an appeal to the Tribunal against the assessment order,
which by the impugned order dated 30.09.2011, even while accepting that
the TNM Method was the appropriate method for calculation, rejected the
LFILs contention that under Rule 10B (1)(e) of the Income Tax Rules
("the Rules") made no provision for considering the cost incurred by third
parties or an unrelated enterprise to compute net profit margin. The
Tribunal by its impugned order held that the appellant was performing all
critical functions with the help of tangible and unique intangibles as well
as supply chain developed, which helped the AE to enhance its business
and resulted in location saving to the consumer, compensation for the
services rendered by LFIL to the AE, equivalent to the cost plus 5% mark-
up, was not at arms length. Since LFIL was providing crucial sourcing
services and the AE was remunerated by third parties based on such
services, the Tribunal relied upon the mark up on FOB value of goods
sourced through LFIL as the appropriate method to work out arms length
compensation. The tribunal accepted the TPOs reasoning for applying the
5% of the FOB value of exports to third parties by Indian manufacturers.
The relevant part of the reasoning in the impugned order is reproduced
below:
"The TPO did not consider the cost plus compensation @ 5%
at arms length by holding that assessee is performing all critical
ITA 306/2012 Page 13
functions, assuming significant risks and used both tangibles and
unique intangibles developed by it over a period of time. The
associated enterprise is not having technical capacity and
manpower to assist the assessee in this regard. The assessee has
developed several unique intangibles which has been given
advantage in the form of low cost of product, quality of the
product and enhanced the profitability of AE. These intangibles
have developed profit potential of AE. The assessee has developed
the supply chain management which gives customer a strategic
and pricing advantage. The assessee has also developed its own
human capital intangible at its own cost. The cost for the same is
born by assessee. The AE has recognized that India offers both
cost and operational advantage on account of lower salaries for
the employees, low cost material and low cost manufacture.
The associated enterprise is charging from the purchasers on
the basis of FOB value of exports up to 5%. The total exports effected
by the assessee during the year were Rs.1202.96 crores. Assessee
has been paid in respect of the international transaction effected in
the form of exports on the basis of cost plus 5%. The Learned ARs
plea that no adjustment has been made in the earlier years. For this,
he has submitted assessment order for AY 2002-03 to 2005-06
wherein the transaction net marginal method with operating profit
over total cost (OP/TC) as a profit level indicator has been
accepted. This TNMM method has been accepted in these years.
Reliance is also placed on the decision of Hon'ble Supreme Court in
the case of Radhasoami Satsang Vs. CIT, cited supra and CIT vs. New
Poly Pack (P) Ltd., 245 ITR 492, other case laws. In this regard, we
hold that the principle of res judicata is not applicable in the income-
tax proceedings. Each assessment year is a separate unit and what is
decided in one year shall not ipso facto apply in the subsequent years.
We have gone through the orders passed in the earlier years which
has been placed in the paper book at pages 293 to 305 and for all
these assessment years starting from 2002-03 to 2004-05, we find
that while accepting profit level indicator nothing has been
said about the basis on which the compensation has been
received by the associated enterprise on the goods exported from
India through assessee. As we have already stated earlier, the
associated enterprise was receiving the compensation as a
percentage of the FOB value of the goods exported through the
assessee and as per the guidelines of the OECD which recognizes
that the related party may fasten their transaction in such a manner
ITA 306/2012 Page 14
that may call for looking at the substance of transactions over the
form they are given. In this case, the associated enterprise was
receiving the compensation on the basis of FOB value while the
Indian associate (assessee) was compensated only by cost plus 5%
mark up. When the associated enterprise are receiving the
compensation at FOB value and the assessee which is providing
critical functions with the help of tangible and unique intangibles
developed over the years and with the help of supply chain
management which are important to achieve the strategic and pricing
advantage. All these help the associated enterprise to enhance and
retain the business and also contributes towards the locational
savings on account of low cost salary, low cost material and low
cost manufacture in India. Therefore, in our considered view, the
cost plus 5% mark up is definitely not on the arms length while
working out the compensation for the services rendered by the
assessee to the associated enterprise. In such a situation, mark up
on the FOB value of the goods sourced through the assessee
shall be the most appropriate method to work out the correct
compensation at arms length price. Therefore, the rules of
consistency cannot be applied forever when such facts have not been
considered/discussed at all in the earlier years.
It is also pleaded that the assessee has received 80-O
deduction in the earlier years in respect of providing these
professional and technical services. In this regard, we hold that
every assessment year is a separate assessment year for income-
tax purposes and the principle of res judicata is not applicable.
Further during this year, the assessee has not claimed or entitled for
80-O deduction. Therefore, it cannot be a plea to justify the
transaction at the arms length.
Assessee claims that there is no provision in the Rule
10B(1)(e) to include the cost incurred by third parties or unrelated
enterprise to compute the net profit margin of the assessee. For this
proposition, we do not agree in view of the fact that assessee is
providing all critical functions and the majority of work related
to these exports is performed by assessee itself. Associate
enterprise had no capacity to execute the work. The associated
enterprise is charging from the third party on the basis of FOB value
of the exports made possible by assessee. Assessee is providing
sourcing services through its tangible and intangible capacity to these
third party clients in the form of low cost product resulting into
profitability and pricing advantage. The assessees reliance on
ITA 306/2012 Page 15
DCIT vs. Cheil Communication India Pvt. Ltd., cited supra, is not
of much help as in that case, the facts were different. In that case,
the assessee was providing to their party/media agency for and on
behalf of the principal. In that case, the advertising space has been
let out to the third party vendor in the name of ultimate customer and the
beneficiary of advertisement. The assessee in that case was simply
acting as intermediary between ultimate customer and the third party
vendor in order to placement of advertisement. In assessees case,
the associated enterprise has been receiving the mark up as 5%
of the FOB value of exports effected by assessee by applying its
tangible and intangible capacity. The critical and all crucial work is
done by assessee. The AE is paying back to the assessee only on the
basis of cost plus 5% mark up. Such an arrangement cannot be said at
arms length. In our considered view, such method will go against the
basic normal business sense, as inefficient and high cost services
provided by assessee shall fetch more revenue to the assessee. Such
an arrangement on the face of it cannot be said to be at arms length.
The AE is getting remuneration on FOB value of export for which
critical and main functions are performed by assessee. We also
uphold that the assessee has developed a technical capacity and owns
manpower which had developed human intangibles to perform all
the critical functions. These tangible and unique intangible have
been developed over the years. In view of these facts, we hold that
to arrive at arms length of these transactions, the mark up must be
on the basis of FOB (free on board) value of the exports. Since the
AE is receiving 5% of FOB value then the total receipt by AE
must be Rs.60.148 crores. Thus, the attribution between assessee
and AE must be from this amount.
AO made addition of Rs.33.60 crores. If it is added to the
actual receipts of assessee then it is much more than the total
amount received by associated enterprise regard to these exports.
Thus, the way in which this adjustment has been made gives
abnormal / absurd results which cannot be sustained. The
assessee was performing critical functions with the help of
tangible and unique intangibles developed over the period of
time and with the help of supply chain management which the
assessee had developed, the majority of compensation based on
the FOB value of the exports materialized through the assessee
must come to the assessee. So the correct compensation at the arms
length price based on the FOB cost of the goods sourced from
ITA 306/2012 Page 16
India needs to be decided. The total export during the year was
Rs.1202.96 crores. AE received in total of Rs.60.148 crores.
The assessees claim that no agreement was entered by the
assessee with the ventures to whom the goods are sourced shall not
justify the cost plus mark up. The associate enterprise entered into
the agreements for sourcing the goods and the compensation is
based on the FOB value of the goods sourced from the India and
the assessee performing all crucial and critical function to fulfill the
conditions to execute the agreements. Therefore, we find no merits in
this plea. The other claim of the assessee that location savings
attributable to the end purchaser is also not justified as the
assessee has developed many unique intangibles and also human
capital intangibles which gives the locational advantage to procure
low cost goods which helps the associated enterprise to
obtain/retain the business and also benefits the end purchaser. These
tangibles and unique intangibles developed over the period of time
and the developed supply chains of the management owned by
assessee benefits the ultimate purchaser and also provide locational
savings to the all including the associated enterprise. As we have
already said that the amount of adjustment computed by the TPO
cannot exceed the amount which could have been received by the
associated enterprise. There is nothing on the record from where we
could gather that the compensation @ 5% on FOB value received by
AE is depressed or on lower side. In view of these facts, we are of
the view that the amount of adjustment so computed should not
exceed the amount received by the associated enterprise. In our
considered view, the AO as well as the DRP has proceeded on a
wrong footing which have given absurd results of adjustments. In
view of the fact that majority and crucial services rendered by
assessee, the distribution of compensation received by AE @ 5% of
the FOB value of the exports between the assessee and the
associated enterprise should be in the ratio of 80 : 20. The assessee
must get 80% of the total receipt by AE from the ultimate purchasers.
AO is directed to compute the arms length price in the above
manner."
10. LFILs counsel argued that the addition of Rs. 33, 59, 69, 186/- made on
account of difference in the arms length price of international transactions
of buying/sourcing services is not sustainable for the reason that the TPO
ITA 306/2012 Page 17
applied the TNMM method contrary to the Transfer Pricing Regulations.
Section 92 of the Act stipulates that any income arising from an
international transaction shall be computed having regard to the arms
length price. Further, Section 92F(ii) defines arms length price as a price
which is applied or proposed to be applied in a transaction between
persons other than associated enterprises in uncontrolled conditions. For
the purpose of determining the arms length price in relation to an
international transaction, various methods are prescribed under section
92C(2) of the Act and Rule 10B of the Rules provide the manner in which
such methods should be applied by the assessee, assessing officer, Transfer
Pricing Officer, etc.
11. Mr. Porus Kaka, learned senior counsel, while stating that the TNMM was
chosen by LFIL as the appropriate method to calculate the arms length,
provided the court with an interpretation of the provision. He argued that
for applying TNMM, it would be noted that the net profit margin realized
from the international transactions by the appellant is to be computed only
with reference to the cost incurred by LFIL itself. The provision does not
consider or impute cost incurred by the third parties or unrelated
enterprises, to compute net profit margin of the appellant enterprise.
12. The learned counsel stated that the TPO, in the impugned order, enhanced
the cost base of the appellant enterprise artificially by considering the cost
of manufacture and export of finished goods by third party vendors which
is clearly inconsistent with the manner of application of TNMM as
provided in Rule 10B(1)(e). He argued that the TPOs enhancement of
LFILs cost base, by artificially considering the cost of manufacture and
export of finished goods, clearly amounts to imputing notional
adjustment/income in LFILs hands on the basis of a fixed percentage of
the FOB value of export made by unrelated party vendors. Thus, the value
ITA 306/2012 Page 18
of exports by third party vendors or customers does not provide any
benchmark for determining arms length price.
13. The learned counsel for LFIL submitted that, while applying the TNMM
method, payment made by an assessee to third party vendors for and on
behalf of the principal (which was reimbursed by the AE), cannot to be
included in the total cost for determining the profit margin and the mark up
is to be applied to the cost incurred by the appellant company. The value of
export by third party vendors to third party customers does not provide any
substantial basis for determining the arms length price
14. Counsel further submitted that the mark up upon the entire FOB value of
the AE would artificially enhance the LFILs cost base for applying the
OP/TC margin. He urged that LFILs compensation model should be based
on functions performed by it and the operating costs thereby incurred and
not on the cost of goods sourced from third party vendors in India. Thus,
allocating a margin of the value of goods sourced by third party customers
from exporters/vendors in India is inappropriate and unjustified.
15. Learned senior counsel further argued that in terms of the Transfer Pricing
documentation, LFIL had established the international transactions of
rendering buying services to be at arms length price having regard to the
operating profit margin earned by comparable companies having similar
functional profile. The computation of LFILs operating profit margin
(OP/TC%) by enhancing the cost base i.e. by increasing the cost of sale
facilitated by the assessee would lead to an arbitrary adjustment to the
income of the appellant which was never intended by the legislation.
16. The learned counsel further contended that LFIL is performing such
functions which undertake a limited risk, and do not involve the direct
manufacture of goods. This is evident from the fact that LFIL has made no
investment in the plant, inventory, working capital, inter alia nor does it
ITA 306/2012 Page 19
bear any enterprise risk for manufacture and export of the goods. Thus,
LFILs functional and risk profile is entirely different and has nothing to
do with manufacture and export of consumer goods by unrelated third
parties. Counsel argued that LFIL was merely involved in rendering
buying or sourcing support services with regard to such goods and
received a handsome remuneration on a cost plus mark-up of 5% which
adequately highlights the functions performed, assets utilized and risks
borne by the appellant on application of TNMM.
17. It was next urged that the said method of assessment undertaken for
determining the arms length price of international transactions applying
TNMM was accepted in the Transfer Pricing assessment consistently year
after year. The TPO, in the previous years, did not dispute the functional
analysis taken by LFIL and the factors determining LFILs operations, the
functions performed, assets utilized and risk assumed, often having
similarities with every years assessment. Counsel cited Radhasaomi
Satsang v. CIT, 193 ITR 321, to argue that where a fundamental aspect
permeating through the different assessment years is accepted one way or
the other, a different view in the matter is not warranted, unless there was
any material change in facts. Similarly, he also cited this Courts decision
in the case of CIT v. Neo Polypack (P) Ltd245, ITR 492to rely on the rule
of consistency despite the non applicability of the res judicata in tax
proceedings. Thus, in conclusion it was argued that the application of
TNMM by the TPO by enhancing the cost base by considering FOB value
of export by unrelated party vendors was inconsistent with the Transfer
Pricing regulations and thus liable to be deleted.
18. The learned counsel also pleaded that the concept of locational savings are
attributed to the end purchaser only. The TPO by holding that the arms
length prices of international transactions of running, buying/sourcing
ITA 306/2012 Page 20
services by LFIL ought to be 5% of the FOB value of exports, clearly
misunderstood the business model and international transactions
undertaken by the appellant. The TPO failed to consider the fact that the
transaction of export of finished goods is being undertaken by third party
vendors or exporters to the overseas customers, whereas neither LFIL nor
its AE are parties to such contracts. By providing sourcing support
services, none of them have gained any advantage on account of locational
saving associated with the export of goods between exporters and overseas
customers. Thus, it is submitted that the adjustment made by the TPO on
ground of locational saving, is not sustainable and liable to be deleted.
19. The learned counsel also urged that the amount of adjustment computed by
the TPO in the order passed cannot exceed the net margin i.e. gross
revenue received from the end customers less amount paid to LFIL, i.e. the
amount retained by the AE in respect of the transactions. LFIL rendering
sourcing services has facilitated exports by the vendors/suppliers of nearly
(USD 273.4 million @ Rs.44/$) Rs. 1,202.96 crores in the relevant
previous year. The AE entered into the contract with the unrelated party
customers for rendering buying services at 4% to 5% of FOB value of
exports. The appellant has in turn received services fee (at cost +5%) of
Rs. 47.69 crores which is nearly 4% of the FOB value of the export from
the AE. However, the TPO/AO in the impugned order has computed the
arms length price of the appellant by considering a mark-up of 3% on the
FOB value of exports that have been facilitated by the appellant computed
an adjustment of Rs 33, 59, 69, 186/-.
20. The counsel argued that the adjustment made by the TPO/AO would result
in LFILF, which is only a subsidiary, ended up receiving higher amount
than what has been received by the AE from third party customers in lieu
of facilitating the export of finished goods. This can be noted from the fact
ITA 306/2012 Page 21
that such adjustment proposed by the TPO/AO has resulted in the AE
retaining only 1% of the FOB value of export on the entire export of Rs
1202.96 crores, with nearly 80% of the remaining consideration on FOB
value of export must be borne by LFIL. The counsel for the appellant
argued that since substantial functions relating to the buying services,
undertaking enterprise risks, utilization of substantial assets as well as
bearing L/C charges were borne primarily by the AE. Thus, the TPO/AO
has erroneously held that LFIL has developed several unique intangibles
and developed a supply chain management, human capital at its own risk
without appreciating that the appellant was only a captive offshore service
provider not undertaking any independent enterprise risk. For this line of
argument, counsel relied on the judgment of the Supreme Court, reported
as DIT v. M/s Morgan Stanley & Co., 2007 (7) SCC 1.
Revenues contentions
21. The learned counsel for the Revenue primarily relied upon the various
orders of the AO, TPO and ITAT (Delhi Bench). His submission was that
LFIL was involved in performing all of the crucial functions of the
transaction. Moreover, all significant risks were borne by it, and unique
intangibles developed by it over a period of time were crucial to the
conduct of the transactions. These intangibles included supply chain
management and human capital, which were owned and maintained by
LFIL, at its cost, but were not reflected adequately in the assessment/price
paid for these services by the AE on account of the relationship between
the parties. These intangible provided several advantages exclusively to
the AE in the form of low cost, quality of the product, strategic and pricing
advantage as well as enhanced profitability. Learned counsel submits that
LFIL offered cost and operational advantages including lower salaries, low
cost material and low manufacturing costs, while the AE, on the other
ITA 306/2012 Page 22
hand, had neither quantified locational saving nor had it attributed any part
of its additional profit on account of locational saving to the assessee in
India. The assessee, according to counsel, did not show if the AE had any
technical capacity or manpower and therefore, LFILs claim of its
involvement in execution of sourcing services could not be accepted.
22. The counsel for the Revenue urged that since the AE was receiving 5% of
the FOB value from the purchasers and assessee in performing crucial and
critical functions with the use of tangible and unique intangibles developed
over a period of time, it is only proper that LFIL must receive the majority
of the receipts with regard to the execution of work. Thus, he contends that
the markup should be based on the FOB value and on that basis it was
argued that the orders of lower authorities were to be sustained.
23. It was lastly argued that OECD also visualizes that AEs can structure their
transactions in such manner as may require close scrutiny. The TPOs task
is therefore to often look behind the facts as they seem and arrive at the
substance of the transaction to compute the value of the transaction. The
application of the cost plus (TNMM) method by basing the return on the
FOB value therefore afforded a realistic picture. If this were not the case,
learned counsel submitted that income generated by LFILs services, but
credited to the AE, would fall outside the tax net, contrary to the purpose
of the transfer pricing provisions. Moreover, it was argued that if such
services were directly provided by LFIL, without the AE acting as an
intermediary, the payment for its services would far exceed the payment it
is received from the AE, which is a crucial indicator that the transaction, as
it currently stands, is not at arms length and requires interference. Thus, it
was argued by learned counsel that determination of ALP and real income
was sound and did not call for interference.
ITA 306/2012 Page 23
Discussion regarding the relevant provisions of the IT Act and Rules
24. Companies with dispersed production facilities or those trading through
different units (usually in different countries), employ transfer pricing, a
mechanism that involves over or undercharging for goods or services sold
between branches or constituent units at a price (usually) determined by
the holding company. The main objective of transfer pricing is to take
advantage of differential taxation between countries, by structuring
transactions such that the legal incidence for tax occurs in a jurisdiction
with lower tax rates. Accordingly, the endeavor of various states, or more
precisely, their tax administrators, through various transfer pricing
enactments and judicial rules, is to ensure that such devices or mechanisms
are not used to locate profits and income in such a manner as to shift to
low tax regimes, with the tax payers ultimate objective of reduced tax
burden, when in reality the incidence of tax in the host jurisdiction should
actually be higher. Transfer pricing laws thus seek to address the tension
between these competing objectives. Crucially, in India, in balancing these
objectives, the precise limits of the methods and mechanics of calculating
the arms length price are provided for by the IT Act and the IT Rules
made thereunder, so as to ensure certainty in these calculations rather than
roving enquiries.
25. Specifically, the object behind introduction of Chapter X of the IT Act was
to prevent assessees from avoiding payment of tax by transferring income
yielding assets to non-residents whilst at the same time retaining the power
to benefit from such transactions i.e. the income so generated. Under the
original 1961 IT Act, a similar provision was found under Section 92. By
Finance Act, 2001 w.e.f. 1.4.2002, Section 92 was substituted by Sections
92 to 92F, provisions in Chapter X of the Act. The Central Board of Direct
Taxes ("the CBDT") by its Circular No. 14/2001 dated 12.12.2001 [2001
ITA 306/2012 Page 24
252 ITR (ST.) 65] spelt out the scope and effect of these provisions The
rationale for substituting the existing Section 92 of the IT Act was
explained in the following extract of the said Circular:
"55.2Under the existing section 92 of the Income Tax Act, which
was the only section dealing specifically with cross border
transactions, an adjustment could be made to the profits of a
resident arising from a business carried on between the resident and
a non-resident, if it appeared to the Assessing Officer that owing to
the close connection between them, the course of business was so
arranged so s to produce less than expected profits to the resident.
Rule 11 prescribed under the section provided a method of
estimation of reasonable profits in such cases. However, this
provision was of a general nature and limited in scope. It did not
allow adjustment of income in the case of non- residents. It referred
to a ?close connection? which was undefined and vague. It provided
for adjustment of profits rather than adjustment of prices, and the
rule prescribed for estimating profits was not scientific. It also did
not apply to individual transactions such as payment of royalty, etc.,
which are not part of a regular business carried on between a
resident and a non-resident. There were also no detailed rules
prescribing the documentation required to be maintained.
55.3 With a view to provide a detailed statutory framework which
can lead to computation of reasonable, fair and equitable profits
and tax in India, in the case of such multi-national enterprises, the
Act has substituted section 92 with a new section, and has
introduced new Sections 92A to 92F in the Income Tax Act, relating
to computation of income from an international transaction having
regard to the arms length price, meaning of associated enterprise,
meaning of international transaction, computation of arm?s length
price, maintenance of information and documents by persons
entering into international transactions, furnishing of a report from
an accountant by persons entering into international transactions
and definitions of certain expressions occurring in the said
sections."
26. Chapter X opens with Section 92 which provides that the income arising
from "international transactions" shall be calculated having regard to the
ITA 306/2012 Page 25
ALP. The explanation to Section 92 clarifies that allowance for any
expense or interest arising from an international transaction shall also be
determined having regard to the ALP. Section 92A defines as to which the
enterprises would, for the purposes of the provisions of Chapter X, come
within the purview of an AE. Section 92A (1) generally defines an AE as
one, which is, directly or indirectly, managed and controlled by another.
The one appropriate mode, amongst the several, through which control can
be exercised by one enterprise on the other is provided in sub-section (2)
of Section 92A. In the eventuality of an enterprise fulfilling any of the
attributes provided in sub-clause (a) to clause (m), the two enterprises
under Section 92A(2) is deemed to be AE. Section 92B defines as to what
would be construed as an "international transaction". In order to
appreciate the full width, amplitude of an "international transaction" the
meaning of which is provided in section 92B one would have to in addition
read the definition of "transaction" given in Section 92F(v).
27. Section 92C is the provision enabling determination of ALP. Section 92C
(1) states that ALP in relation to an "international transaction could be
determined by any of the methods provided in the said sub-section which is
"most appropriate" having regard to the nature of transactions or class of
transaction or class of associated persons or functions performed by such
persons or such other relevant factors which may be prescribed by the
Board. The methods provided being (a) comparable uncontrolled price
method; (b) resale price method; (c) cost plus method; (d) profit split
method; (e) transactional net margin method and; (f) such other method as
may be prescribed by the Board. In determining the most appropriate
method, regard is to be had to Rules 10A and 10B of the IT Rules, 1962.
Section92C(3) casts the obligation of computing the ALP on the assessee,
at the first instance. The AO then would proceed to determine the ALP in
ITA 306/2012 Page 26
relation to an "international transaction" in accordance with Section 92C
(1) and (2) only if he is of the opinion that any of the circumstances as
indicated in Section 92Cs (3)(a) to sub-clause (d) of sub-Section (3) of
Section 92C prevails. These circumstances are that the price charged or
paid for international transaction has not been determined as prescribed
under sub- section (1) and (2) of section 92C or, the assessee has not kept
information and documents of its international transactions in the form
prescribed under Section 92D (1) and the Rules made in that regard or, the
information or data used by the assessee in computing the ALP is not
reliable or correct or, that the assessee, failed to furnish, within the
specified time the information sought pursuant to a notice issued under
Section 92D (3). The first proviso to Section 92 (3) mandates that before
the AO proceeds to determine the ALP on the basis of the material or
information or document available with him he shall give an opportunity
by serving upon the assessee a show cause notice fixing thereby a date and
time for the said purpose. Under Section 92C (4) the Assessing Officer is
empowered to compute the total income of the assessee only after the ALP
has been determined by the Assessing Officer in terms of the provision of
sub-section (3) of Section 92C.
28. Under Section 92CA (inserted w.e.f. 1.6.2002), the AO is empowered to
refer the computation of ALP, in relation to, an "international transaction"
under Section 92C to the TPO, if he considers it "necessary" or
"expedient" to do so with the prior approval of the Commissioner. It is
only after a reference is made under Section 92CA (1) that the TPO gets a
mandate to approach upon the assessee by issuing him a notice calling
upon him to produce or cause to be produced on a date to be specified
therein, any evidence on which the assessee may rely in support of the
computation made by him of the ALP. Section 92CA (3) provides that the
ITA 306/2012 Page 27
TPO, by an order in writing, will determine the ALP in relation to an
"international transaction" in accordance with Section 92C (3) after
hearing such evidence as the assessee may produce including any
information or documents referred to in Section 92D (3), after considering
such evidence as the TPO may require on any specified points, and after
taking into account all relevant material which the TPO has gathered. The
TPO has to send a copy of the order, by which a determination of ALP is
made both to the Assessing Officer and the assessee. Section 92CA (3A)
provides the time frame within which the TPO has to pass an order under
Section 92CA (3).
29. Prior to the Finance Act, 2007, Section 92CA (4) read as follows: "On
receipt of the order under sub-section (3), the Assessing Officer shall
proceed to compute the total income of the assessee under sub-section (4)
of section 92C having regard to the arms length price determined under
sub-section (3) by the Transfer Pricing Officer."
30. It would be useful to recollect that the IT Act draws heavily from the
Organization for Economic Co-operation and Development Model Tax
Conventions interpretation under Article 9. In terms ofArticle 9, when
conditions are made or imposed between two AEs in their commercial or
financial relations which differ from those which would have been made
between independent enterprises, then any profits which would, but for
those conditions, have so accrued, may be included in the profits to bring
them to a level that would prevail when independent enterprises would
enter into comparable transactions under comparable conditions. Section
92F(ii) specifically defines Arms Length Price as a price which is applied
or proposed to be applied in a transaction between persons other than
associated enterprises in uncontrolled conditions.
ITA 306/2012 Page 28
31. To compute arms length price of an assessee, several methods are
prescribed under Section 92C of IT Act. As per this provision, the arms
length price in relation to an international transaction shall be determined
by the ,,most appropriate method out of the prescribed methods i.e.
a) comparable uncontrolled price method; b) resale price method; c)
cost plus method; d) transactional net margin method; e) profit split
method and f) any method as prescribed by the Revenue. In case
where more than one price can be determined by the most
appropriate method, the arms length price calculated is the
arithmetic mean of such two or more prices. Thus, the provision
does not entail any preference of methods and adopts the ,,best
method rule.
32. Rules 10B and 10C of the IT Rules prescribe different measures on
application of the methods prescribed for calculation of the arms length
price. In terms of Rule 10B (1)(e), while applying the TNMM, the normal
margin of profit that is expected in the same line of trade forms the basis of
turnover of either purchases or sales, whichever is considered more
reliable. It examines the net profit margin relative to an appropriate base
that a tax payer realizes from a controlled transaction and compares the
profitability of either of the controlled parties with the profitability of the
uncontrolled comparables. The net profit envisioned has to be computed
with reference to the cost incurred or sales effected or assets employed or
required to be employed by the enterprise or having regard to any other
relevant base indicating that determination of the net profit is not a matter
which can be carried out on an ad hoc basis.
33. Accordingly, Rule 10B(1)(e) prescribes, in detail, the steps to be
undertaken while applying the TNNM method: first, one must compute the
ITA 306/2012 Page 29
net profit margin of the assessee with the reference to the sales, costs,
assets or any other relevant base. The net profit margin from an external
(or internal) comparable (as discussed below) is then calculated, which is
subsequently adjusted for factors materially affecting profit. This profit
margin is then worked out after such adjustments is treated as the actual
margin of profit, and added to the cost/other relevant base to arrive at the
ALP.
34. The OECD Guidelines, which are instructive in such cases, clarify that any
attempt to use TNMM should begin by comparing the net margin which
the tested party makes from a controlled transaction with the net margin it
makes from an uncontrolled one (an "internal comparable"). If this proves
impossible, possibly if there are no transactions with uncontrolled parties,
then the net margin which would have been made by an independent
enterprise in a comparable transaction (an "external comparable") serves
as a guide to determine the ALP. Here, the strict criterion is of an
independent enterprise, carrying out a comparable transaction, with the
caveat that this will be only a guide. Indeed, the emphasis is very clearly
on finding a comparable transaction. In addition, a functional analysis of
both the associated enterprise and the independent enterprise is required to
determine if the transactions are comparable. It might of course be possible
to adjust results for minor functional differences, provided that there is
sufficient comparability to begin with, The standard of comparability for
application of TNMM is no less than that for the application of any other
transfer pricing method.
35. The ITS 2009 Transfer Pricing Guidelines accepted by the OECD state,
inter alia, that when an associated enterprise acts only as an agent or
intermediary in the provision of the service, it is important in applying the
cost plus method that, in the ultimate analysis, the return or mark-up is
ITA 306/2012 Page 30
appropriate for the performance of the agency function rather than for the
performance of services themselves. Rule 3.41 of the Transfer Pricing
Guidelines 2009 state that in applying the TNMM, various considerations
should influence the choice of margin used. These include the reliability of
the value of assets employed in the calculations is measured and the
factors affecting whether specific costs should be passed through, marked
up or excluded entirely from the calculation. Under Rule 2.134, while
applying a cost based transactional net margin method, fully loaded costs
are often used, including all the direct and indirect costs attributable to the
activity or transaction, together with an appropriate allocation in respect of
the overheads of the business. It should not be based on the classification
of costs as internal or external, but rather on comparability (including
functional) analysis, and in particular on a determination of the value
added by the tested party in relation to those costs. Rule 7.36 of the
Guidelines, further state that when an associated enterprise is acting only
as an agent or intermediary in the provision of services, it is important in
applying the cost plus method that the return or mark-up is appropriate for
the performance of an agency function rather than performance of the
services themselves. In such a case it may not be appropriate to determine
arms length pricing as a mark-up on the cost of the services should be
lower than would be appropriate for the performance of services
themselves.
36. The appellant, during the relevant assessment year, entered into
international transactions of buying services for sourcing of garments,
handicrafts, leather products etc. in India for its affiliate, the AE, and was
paid service charges of 5% of cost plus mark up incurred for providing
these services. The assessee had worked out the arms length of
ITA 306/2012 Page 31
international transaction by applying TNMM by company operating profit
margin of 26 companies and assessees OP/OC taken at 5.17%.
37. The tax authorities i.e. the TPO, and the AO (as well as the DRP) and the
Tribunal accepted the application of TNMM by LFIL as "the most
appropriate" one. Nevertheless, they did not consider the cost plus
compensation at 5% at arms length. The reasoning for not doing so was
that LFIL was performing all critical functions, assuming significant risks
and used both tangibles and intangibles developed by it over a period of
time. Reliance was placed upon the technical capacity, manpower, low
cost of product, quality of product in India available to the assessee and the
enhanced profit potential the AE. The tribunal held that the cost plus 5%
mark up is definitely not on the arms length while working out the
compensation for the services rendered by LFIL to the associated
enterprise and mark up on the FOB value of the goods sourced through the
assessee shall be the most appropriate method for calculation of arms
length price.
38. In scrutinizing Transfer Pricing documents, the TPO undertakes an
exercise known as "FAR" (functions performed, assets owned and risks
assumed by the associated enterprises involved). This analysis plays a
critical role in determining the arms length price of an international
transaction entered into between AEs. The FAR analysis defines roles,
responsibilities and risks assumed by the parties involved providing
steadfast pointers into the underlying economic substance of the
transactions. The OECD Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations too recognize the importance of FAR
in the transfer pricing context, with the arms length compensation
between AEs reflecting the functions that each enterprise performs (taking
into account the assets used and the risks assumed by either party).In this
ITA 306/2012 Page 32
case, what prevailed with the TPO and all other authorities was the
circumstance that LFI, i.e. the assessee, according to them, performed all
the critical functions, assumed significant risks and used both tangibles and
unique intangibles developed by it over a period of time. These intangibles
included supply chain management which is important to achieve the
strategic and pricing advantage, as well as human intangibles in the form
of technical capacity and owned manpower to perform the critical
functions. It was further held that the assessee had performed all critical
functions, assumed significant risks and also developed significant supply
chain intangibles in India and Li & Fung HK, the AE did not have either
any technical expertise or manpower to carry out the sourcing activities in
Hong Kong.
39. The TPOs determination enhanced LFILs cost base for applying the
operating profit over total cost margin. LFILs compensation model is
based on functions performed by it and the operating costs incurred by it
and not on the cost of goods sourced from third party vendors in India.
Allotting a margin of the value of goods sourced by third party customers
from Indian exporters/vendors to compute the appellants profit is
unjustified. This Court is of opinion that to apply the TNMM, the
assessees net profit margin realized from international transactions had to
be calculated only with reference to cost incurred by it, and not by any
other entity, either third party vendors or the AE. Textually, and within the
bounds of the text must the AO/TPO operate, Rule 10B(1)(e) does not
enable consideration or imputation of cost incurred by third parties or
unrelated enterprises to compute the assessees net profit margin for
application of the TNMM. Rule 10B(1)(e) recognizes that "the net profit
margin realized by the enterprise from an international transaction
entered into with an associated enterprise is computed in relation to costs
ITA 306/2012 Page 33
incurred or sales effected or assets employed or to be employed by the
enterprise ..." (emphasis supplied). It thus contemplates a determination of
ALP with reference to the relevant factors (cost, assets, sales etc.) of the
enterprise in question, i.e. the assessee, as opposed to the AE or any third
party. The textual mandate, thus, is unambiguously clear.
40. The TPOs reasoning to enhance the assessees cost base by considering
the cost of manufacture and export of finished goods, i.e., ready-made
garments by the third party venders (which cost is certainly not the cost
incurred by the assessee), is nowhere supported by the TNMM under Rule
10B(1)(e) of the Rules. Having determined that (TNMM) to be the most
appropriate method, the only rules and norms prescribed in that regard
could have been applied to determine whether the exercise indicated by the
assessee yielded an ALP. The approach of the TPO and the tax authorities
in essence imputes notional adjustment/income in the assessees hands on
the basis of a fixed percentage of the free on board value of export made
by unrelated party venders.
41. LFIL, in the Transfer Pricing documentation, established the international
transactions of rendering buying services to be at the arm's length price
having regard to the operating profit margin of comparable companies
having similar functional profile. LFILs computation of the operating
profit margin (OP/TC per cent) by enhancing the cost base, i.e., by
increasing the cost of the sales facilitated by LFIL leads to an arbitrary
adjustment of its income, as such an alteration resides plainly outside the
Rules and the provisions of the Act.
42. Moreover, there is considerable merit in the submission that the (finding of
the) lower authorities, including the Tribunal, misdirected themselves in
holding that LFIL assumed substantial risk. Whilst this Court would
neither state that LFIL performed functions with a limited risk component,
ITA 306/2012 Page 34
as it does not engage itself in manufacturing of garments (which is LFILs
stance), apart from broad assumptions made by the Revenue, no material
on record testifies to that fact such that it can be the basis for an ALP
adjustment. Indeed, LFIL has neither made investment in the plant,
inventory, working capital, etc., nor does it claim to have any expertise in
the manufacture of garments. More importantly, and given no material to
the contrary, LFIL does not bear the enterprise risk for manufacture and
export of garments. LFILs functional and risk profile thus is entirely
different and has nothing to do with the manufacture and export of
garments by unrelated third party vendors. Simply put, LFIL renders
support services in relation to the exports, which are manufactured
independently. Thus, attributing the costs of such third party manufacture,
when LFIL does not engage in that activity, and more importantly, when
those costs are clearly not LFILs costs, but those of third parties, is clearly
impermissible. A contrary conclusion would amount to treating it (the
appellant) as the vendor/ exporters partner in their manufacturing business
a completely unwarranted inference.
43. Indeed, having done the work, LFIL has developed experience and
expertise which the Tribunal has held to be human capital and supply
chain intangibles. But such description does not in any way reveal how
the appellant bears any risk - either enterprise or economic. LFILs
remuneration on a cost plus mark-up of 5 per cent represents the functions
performed, assets utilized and risks assumed by it.
Further, the TPOs determination that LFIL bore significant risks is not
borne out from the records. In transactions in which LFIL was a party, it
did not bear any financial risk. To the contrary, its costs towards
establishment, transportation, salaries, etc. were fully reimbursed, and it
was insulated from any economic or financial downside to any particular
ITA 306/2012 Page 35
transaction. In other words, its remuneration was based entirely on the
costs borne by it. In essence, it is a low risk contract service provider
exclusively rendering sourcing support to the AE. It does not bear any
significant operational risks for its functions, rendered to the third party
vendor/customers. Rather, it is the AE that undertakes substantial functions
and in fact assumes enterprise risks, such as market risk, credit risk etc. It
also bears the letter of credit associated charges and other expenses.
44. Another important aspect which cannot be overlooked is that the the
transfer pricing documentation maintained in terms of section 92D of the
Act read with rule 10B of the Income-tax Rules, determined the arm's
length price of the "international transaction" of the provision of buying
services applying the TNMM, by comparing operating profit margin of
LFIL with that of the comparable companies, as under:
Weighted average OP/OC per cent. of 4.07 per cent.
26 comparable companies
OP/OC per cent. of LFIL 5.17 er cent.
This exercise has not been discarded. In other words, the TPO and the
appellate fora were aware that in accordance with the rules, a comparison
of the profit margin of LFIL with that of other similarly functioning
companies was shown, and is, at the first instance, relevant to determine
the ALP. The profit margin, as well as the cost plus model adopted by
LFIL, was not shown to be distorted or of such magnitude as to persuade
the tax authorities into discarding the exercise altogether. Having not
contradicted this comparison, the Revenue proceeded to its own
determination and calculations. This, however, is improper, given that
the assessment carried out by the assessee must first be rejected, for any
ITA 306/2012 Page 36
further alterations to take place. Indeed, it cannot be that the Revenue
admits to the correctness of LFILs assessment but nonetheless proceeds
to adopt a different method.
45. Indeed, once the TNMM was deemed most appropriate method, the
distortions, if any, had to be addressed within its framework. Here, the
unrelated transactions which were compared by LFIL have not been
adversely commented upon, and neither has the choice of the TNMM.
The TPO, therefore, ignored the relevant and crucial material, and
straightaway proceeded to broaden the base for arriving at the profit
margin, for attributed income of the assessee. Not only is this a clear
infraction of the terms of the Act and Rules; the TPO went ahead to
introduce what is clearly alien to the provisions of law and travelled
outside the Rules.
46. The assessee had argued that no such adjustment was made in the earlier
assessment years, for which assessment orders of previous four years
were submitted, wherein the TNMM with operating profit over total cost
(OP/TC) as a profit level indicator was accepted previously. Reliance
was placed on decisions of the Supreme Court in Radhasoami Satsang
(supra) and CIT v. New Poly Pack (supra) to support the aforementioned
argument. Although previous tax assessments do not bar subsequent
claims as res judicata, each assessment must be justified on its own
terms, and as detailed above, the assessment by the TPO/AO, and the
subsequent acceptance of these methods by the appellate authorities, is
inconsistent with the IT Rules and the IT Act.
47. At this point, it is useful to note that the TPO is required to scrutinize the
various methods that may be employed to evaluate their appropriateness,
the correctness of the data, consideration of surrounding factors, etc. The
selection of the most appropriate method will depend upon the facts of
ITA 306/2012 Page 37
the case and factors mentioned in rules contained in Rule 10C. It would
be useful here to refer to two circulars issued by the CBDT, which
prescribe the ground rules defining the powers and jurisdiction of the tax
authorities and administrators:
Circular No. 12 dated 23rd August, 2001 reads as follows:
"The aforesaid provisions have been enacted with a view to provide
a statutory framework which can lead to computation of reasonable,
fair and equitable profit and tax in India so that the profits
chargeable to tax in India do not get diverted elsewhere by altering
the prices charged and paid in intra-group transactions leading to
erosion of our tax revenues.
................. .......................
(iii) it should be made clear to the concerned Assessing officer s that
where an international transaction has been put to a scrutiny, the
Assessing officer can have recourse to Sub-section (3) of section
92C only under the circumstances enumerated in Clauses (a) to (d)
of that sub-section and in the event of material information or
documents in his possession on the basis of which an opinion can be
formed that any such circumstance exists. In all other cases, the
value of the international transaction should be accepted without
further scrutiny."
The following portions of Circular No. 14 are relevant:
"The relevant portions of Circular No. 12 may be usefully referred
to as under the new provision is intended to ensure that profits
taxable in India are not understated (or losses are not over stated)
by declaring lower receipts or higher outgoings than those which
would have been declared by persons entering into similar
transactions with unrelated parties in the same or similar
circumstances.
The basic intention underlying the new transfer pricing regulations
is to prevent shifting out of profits by manipulating prices charged
or paid in international transactions, thereby eroding the country's
tax base. The new section 92 is, therefore, no intended to be applied
ITA 306/2012 Page 38
in cases where the adoption of the Arm's length Price, determined
under the regulations would result in a decrease in the overall tax
incidence in India in respect of the parties involved in the
international transaction.
Under the new provisions the primary onus is on the taxpayer to
determine an Arms length Price in accordance with the rules, and to
substantiate the same with the prescribed documentation. Where
such onus is discharged by the assessee and the data used for
determining the Arms length price is reliable and correct there can
be no intervention by the Assessing officer. This made clear by sub
section (3) of Section 92C of the Income-tax Act which provides that
the Assessing officer may intervene only if he is, on the basis of
material or information or document in his possession, of the
opinion that the price charged in international transaction has not
been determined in accordance with sub section (1) and (2) or
information and documents relating to the international transaction
have not been kept and are maintained by the assessee in
accordance with the provisions contained in sub section (1) of
section 92D of the Income-tax Act and the rules made there under;
or the information or data used in computation of the Arms length
price is not reliable correct; or the assessee has failed to furnish,
within the specified time, any information or document which he was
required to furnish by a notice issued under sub section (3) of
section 92D. If any one of such circumstances exists, the Assessing
officer may reject the price adopted by the assessee and determine
the Arms length Price in accordance with the same rules."
48. The TPO after taking into account all relevant facts and data available to
him has to determine arms length price and pass a speaking order after
obtaining the approval of the Department of Income Tax (Transfer
Pricing). The order should contain details of data used, reasons for arriving
at a certain price and applicability of methods, subject to judicial scrutiny.
The order of the TPO, in the instant case, has not provided any substantive
reasons for disregarding the TNM method as applied by LFIL. Further, the
TPOs arbitrary exercise of adjusting the cost plus mark up of 5% on the
FOB value of exports finds no mention in the IT Act nor the Rules. Such
ITA 306/2012 Page 39
an exercise of discretion by the TPO, disregarding the LFILs lawful tax
planning measures with its group companies, is not in compliance with the
IT Act and Rules of Income Tax.
49. This court summarizes its conclusions as follows:
(a) The broad basing of the profit determining denominator as the
entire FOB value of the contracts entered into by the AE to
determine the LFILs ALP, as an "adjustment", is contrary to
provisions of the Act and Rules;
(b) The impugned order has not shown how, and to what extent,
LIFIL bears "significant" risks, or that the AE enjoys such
locational advantages, as to warrant rejection of the Transfer
pricing exercise undertaken by LFIL;
(c) Tax authorities should base their conclusions on specific facts,
and not on vague generalities, such as "significant risk",
"functional risk", "enterprise risk" etc. without any material on
record to establish such findings. If such findings are warranted,
they should be supported by demonstrable reason, based on
objective facts and the relative evaluation of their weight and
significance.
(d) Where all elements of a proper TNMM are detailed and
disclosed in the assessees reports, care should be taken by the
tax administrators and authorities to analyze them in detail and
then proceed to record reasons why some or all of them are
unacceptable.
(e) The impugned order, upholding the determination of 3% margin
over the FOB value of the AEs contract, is in error of law.
50. In light of the above circumstances, this Court is of the opinion that the
TPOs addition of the cost plus 5% markup on the FOB value of exports
ITA 306/2012 Page 40
among third parties to LFILs calculation of arms length price using the
TNMM is without foundation and liable to be deleted. The appeal is
allowed and the order dated 25/11/11 of the ITAT Tribunal, Delhi Branch
is liable to be and is accordingly set aside. The questions of law framed are
answered in favour of the assessee, and against the revenue. The appeal is
allowed in the above terms.
S. RAVINDRA BHAT
(JUDGE)
R.V. EASWAR
(JUDGE)
DECEMBER 16, 2013
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