Latest Expert Exchange Queries
sitemapHome | Registration | Job Portal for CA's | Expert Exchange | Currency Converter | Post Matrimonial Ads | Post Property Ads
 
 
News shortcuts: From the Courts | News Headlines | VAT (Value Added Tax) | Service Tax | Sales Tax | Placements & Empanelment | Various Acts & Rules | Latest Circulars | New Forms | Forex | Auditing | Direct Tax | Customs and Excise | ICAI | Corporate Law | Markets | Students | General | Indirect Tax | Mergers and Acquisitions | Continuing Prof. Edu. | Budget Extravaganza | Transfer Pricing
 
 
 
 
Popular Search: VAT Audit :: form 3cd :: ACCOUNTING STANDARD :: cpt :: TDS :: due date for vat payment :: articles on VAT and GST in India :: TAX RATES - GOODS TAXABLE @ 4% :: ICAI offer Get Windows 7,Office 2010 in Rs.799 Taxes :: empanelment :: Central Excise rule to resale the machines to a new company :: ACCOUNTING STANDARDS :: ARTICLES ON INPUT TAX CREDIT IN VAT :: list of goods taxed at 4% :: VAT RATES
 
 
From the Courts »
 Ravneet Takhar Vs. Commissioner Of Income Tax Ix And Ors.
 Jaiprakash Associates Ltd. Vs. Commissioner Of Income Tax
 Formula One World Championship Limited Vs. Commissioner Of Income Tax, International Taxation-3 And Anr.
 Commissioner Of Income Tax International Taxation-3 Delhi Vs. Formula One World Championship Ltd. And Anr.
 Reliance Communications Ltd vs. DDIT (ITAT Mumbai)
  Sushila Devi vs. CIT (Delhi High Court)
 Ashok Prapann Sharma vs. CIT (Supreme Court)a
  Vatsala Shenoy vs. JCIT (Supreme Court)
  Vatsala Shenoy vs. JCIT (Supreme Court)
 M.K.Overseas Pvt. Ltd. Vs. Pr.Commissioner Of Income Tax-06
 Arshia Ahmed Qureshi Vs. Pr. Commissioner Of Income Tax-21

LI AND FUNG INDIA PVT. LTD. Vs. COMMISSIONER OF INCOME TAX
January, 04th 2014
*              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




ITA 306/2012                                                                 Page 41

 
 
Home | About Us | Terms and Conditions | Contact Us
Copyright 2016 CAinINDIA All Right Reserved.
Designed and Developed by Binarysoft Technologies Pvt. Ltd.
Publishing Management System PMS News Management System Publishing Management System Development Online News Management System for media company custom Publishing management system development Survey management system Market Res

Transfer Pricing | International Taxation | Business Consulting | Corporate Compliance and Consulting | Assurance and Risk Advisory | Indirect Taxes | Direct Taxes | Transaction Advisory | Regular Compliance and Reporting | Tax Assessments | International Taxation Advisory | Capital Structuring | Withholding tax advisory | Expatriate Tax Reporting | Litigation | Badges | Club Badges | Seals | Military Insignias | Emblems | Family Crest | Software Development India | Software Development Company | SEO Company | Web Application Development | MLM Software | MLM Solutions