IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCHES : "I" NEW DELHI
BEFORE SHRI A.D.JAIN, JM AND
SHRI J.SUDHAKAR REDDY, A.M.
ITA nos. 5571/Del/2011
Assessment Year : 2007-08
AND
ITA No.5896/Del/2012
Assessment Year 2008-09
Global One India P.Ltd. vs. ACIT, Circle 12(1)
DSO 601-603, 607-608 New Delhi
6th floor, DLF South Court, Saket
New Delhi
AABCG 2558 B
(Appellant) (Respondent)
Appellant by:- Shri Rahul Kumar Mitra, C.A.
Respondent by:- Shri Peeyush Jain, CIT, D.R.(T.P.)
ORDER
PER J.SUDHAKAR REDDY, AM
Both these appeals are filed by the assessee and are directed against
separate orders of the ACIT Circle 12(1), New Delhi for the Assessment Year
2007-08 dt. 31.10.2011 and order of the Dy.CIT, Circle 12(1), New Delhi dt.
22.10.2012 for the Assessment Year 2008-09, both passed u/s 143 r.w.s. 144C
of the Act. As the issues arising in both these appeals are common, for the
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
sake of convenience, they are heard together and are disposed of by way of
this common order.
2. Facts in brief:- The assessee is a company incorporated in India and is a
Subsidiary of EGN BV, Netherlands. The assessee company is engaged in
providing internet and related network services to the group's customers in
India. The services offered by Globe One India include internet direct
connections, installation/configuration of routers, etc., and fully managed
support solutions developed around the basic network services. The parent
company, EGN BV, is confirmed and registered under the laws of the
Netherlands. The assessee company filed a transfer pricing report along with its
return of income on 30.10.2007, declaring `nil' income. Later, the assessee
filed a revised return of income on 31.3.2009, declaring income of
Rs.19,29,436/-. A reference was made u/s 92CA(1) to the TPO-I(2) for
determination of arm's length price of the international transactions undertaken
by the assessee. The TPO, in his order, rejected the profit split method
adopted by the assessee company as the most appropriate method and adopted
the TNMM method and determined an upward adjustment of Rs.9,46,20,328/- to
be made to the arm's length price for the Assessment Year 2007-08 and a Rs.
13,47,02,724/- upward adjustment for the Assessment Year 2008-09. The
assessee approached the DRP, without success. Aggrieved the assessee is
before us.
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2.1. The other issues that arise for our consideration in these appeals
are disallowance u/s 40A(ia) and levy of interest u/s 234B of the Act.
2.2. The assessee, as part of the Equant BV group, provides seamless
net work connectivity to its customers across locations/countries. For service
of particular customers, the net work connectivity, which is owned and deployed
by the other operating entities of the Equant group, have to be used. The
assessee has submitted the following as the background of its business.
"Background of business and bench marking methodology of the appellant:
The business activities relating to in providing internet and related network
services by the appellant are explained in brief below:
As an example, customer A is having office in Gurgaeon and Delhi and these two
offices would send and receive email communication with its overseas offices
through the circuit connectivity as provided by the local incensed service
provider.
a) Incoming email from Overseas offices of Customer A to the offices at
Gurgaon and New Delhi:-
(i) Email moves from Customer Head office at international
destination to Equant AE's node. From Equant AE's node the email
travels through international link provided by Flag Telecom.
(ii) Flag Telecom terminates the email at a landing station in India i.e.
at Mumbai.
(iii) From other Telecom License service provider net work
arrangement (i.e. Bharti/Reliance) at Gurgaon/Delhi, again local
license telecom service provider's pick up the email and terminate
at Customer a Gurgaon and Delhi site.
(b) Outgoing email from Customer A offices at Gurgaeon and New
Delhi to other overseas offices:-
(i) Local licensed telecom service providers like Bharti, Reliance, etc. picks up the
email from Customer A offices at Gurgaon and Delhi and terminates the same at
licensed Telecom License service provider network arrangement at
Gurgaon/Delhi.
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(ii) From Telecom license service provider network arrangement at Gurgaon the
email would be picked up by local telecom service provider i.e. VSNL, etc. for
termination at Mumbai landing station.
(iii)From Mumbai landing station, the Flag Telecom arranges to pick email of
Customer A for onward deliverance to the Overseas offices of Customer A
through Equant Overseas AE's net work.
Globally the Equant group is a recognized leader in telecom services and
provides global, integrated and customized communication infrastructure
solutions that enable the key business process of its customers;
The group operates the world's largest seamless data net work in more than 220
countries and territories. Over the years, Equant has successfully integrated
several different net works into one and has consolidated entities such that
today, Equant conducts business in most countries vis a single, multi functional
entity that provides a full range of solutions and services;
Customers contracts of the group are for provision of integrated services on
Equant's group's net work which is spread across the globe;
Equant operates as a globally organized company with critical customer facing
and revenue generating activities being undertaken by the group's various
operating entities across the globe (including GOIPL in India). Accordingly, each
of the operating entities (including GOIPL) that own or operate elements of the
network, contribute to the global network;
In many cases the Equant group deals directly with the one location of its
customer to complete the sales contract and invoice the customer centrally for
all services in all countries. Generally, only one Equant group entity records the
revenues generated from the multinational customer;
Underlying costs of providing services are generated across the span of the
Equant group, which creates a mismatch between where the revenue is
recorded and where the expenses are incurred to provide the services;
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In some cases, the customers' decision makers are spread between different
countries, and require the services to be billed between more than one location,
but not necessarily all the locations where the services are provided this
again results in a mismatch between where the revenues are recorded and
where the services are provided;
Each of the entities in the Equant group is reliant upon the other functions to
generate global profits or losses for Equant group, the services and investments
made by each of these entities is of a non routine nature;
The Key Industry Success Factors for the business of the Equant group are :
Price/competition;
Network capability;
Global footprint/span and;
Performance reliability;
Service quality;
Value added services/solutions offered.
The various operating entities of the Equant group own/ deploy the necessary
leg of the network footprint in their respective country/jurisdiction;
Each of the entities that owns or operates elements of the network contributes
to the global Equant network. Accordingly, all Equant operational entities share
the benefits and risks of the increased demand for Equant solutions and services
together with the benefits and risks undertaken in investing, expanding and
maintaining a global tele communications net work;
In line with the group's global operation model, for provision of services, the
appellant utilizes the global network footprint for connecting the customers
outside the Indian territory. As GOIPL uses the global network for providing
internet services to the group's customers it is evident that Equant is truly a
global seamless organization.
The operations of the Equant are thus highly inter related involving unique
services and related intangibles. Given the globally integrated nature of the
telecommunication services that are provided to customers and the high value
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Global One India P.Ltd., New Delhi
customer facing activities of each operating entity, including GOIPL, for transfer
pricing purposes, it was concluded that the transactions of GOIPL with its group
companies are highly inter related and involve unique services and related
intangibles."
This functional profile is not disputed by the Revenue before us.
3. The assessee adopted the "Profit Split Method" (PSM) as the "Most
Appropriate Method" (MAM) for determining the "Arm's Length Price"(ALP) of
the international transactions, based on residual profit analysis referred to in
the T.P. regulations.
3.1. The steps adopted by the assessee are as follows:
Step-I: Determination of the consolidated global operating profits/loss of the Eq
group from the global tele communication operations.
Step-II: Allocating basic arm's length return to each of the operating entity for
undertaking the routine support services. The return in question is calculated by
bench marking the same with comparables which are routine support service
providers in India.
Step-III: Residual profits/loss is determined by deducting the routine arm's
length return of all the group entities from the consolidated profits of the group.
Step-IV: The residual profits/losses is allocated among the operating entities in
proportion to the relative contribution made by each such entity to the combined
global profits/loss. Relative contribution has to be determined based on the
contribution of each entity to the key value drivers which are sales and
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A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
marketing operations/net work operations and field operations identified by the
business with equal weight based on the detailed functional analysis.
3.2. The submissions of the assessee are that the operations of the group are
highly integrated, interconnected and intrinsically linked wherein one group
entity records the revenues generated, whereas another group entity incurs the
expenditure for providing the services and that multiple entities are involved in
the transaction, and that in such a factual situation, only PSM is the M.A.M.
3.3. The T.P.O. issued a show cause notice proposing adoption of
Transactional Net Margin method (TNMM) as the Most Appropriate Method
(M.A.M.) for bench marking the international transactions, in place of Profit Split
Method (PSM) adopted by the assessee. The assessee filed a detailed reply.
The T.P.O. rejected the contentions of the assessee that P.S.M. is the M.A.M.
He held that TNMM is the M.A.M.
3.4. The findings/objections of the TPO are summarized below.
(1) PSM has not been applied correctly as even in PSM you are supposed to
show by bench marking against external comparables that your
international transactions are at arm's length. You have not done so.
(2) Only external comparables are used for bench marking what you claim to
be routine services.
(3) In T.P. report it has been claimed that among the unique
intangibles/value added services undertaken by you are sales and
marketing activities. Your audited financials show that you have spent
only Rs.3,128,853/- on advertisement and sale promotion out of total
expense of Rs.620,423,787. Hence it does not appear that you are
carrying out any significant sales/marketing activity of much significance.
Personnel expenses are also only Rs.64,107,400.
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(4) The largest head of expenses of Rs.292,432,061 is recurring head
installation charge under the account head `circuit expenses'. Therefore,
your main activity is providing internet and related network services.
(5) Description of field operation does not constrictive any unique intangibles
and value added services. This is a very routine exercise which any
service provider will undertake.
The TPO further held that:
i. It is possible to determine the cost incurred by the Indian entity
separately, and hence, it should be bench marked on a standalone
basis and not by using PSM.
ii. Earlier year's TP orders cannot be relied upon as there is no res
judicata in tax proceedings;
iii. Acceptance of PSM in other jurisdictions is of no consequence since
applicability of PSM is to be judged with reference to Indian TP
regulations and not the TP regulations in other countries.
iv. PSM cannot be applied in the absence of reliable external market
data for bench marking international transactions;
v. The assessee has not put forth any evidence of any intangible
created by it based on which it can justify the application of PSM;
vi. The assessee has not been able to prove that its operations are
integrated to disprove the applicability of TNNM;
vii. The key value drivers identified by the assessee are routine in
nature and do not lead to creation of any unique intangible and
marketing expenses are very low even though they constitute a
key driver cost;
viii. The assessee has not been able to demonstrate any unusual
reasons for the losses earned by it during the relevant FY
ix. Assessee's arrangement with the AE as borne out in the agreement
does not justify the use of PSM on account of the following
reasons:
(a) As per the agreement, assessee's AE is the administrator who
decides how much payment is to be made by each AE including
the assessee;
(b) Administrator's decision shall be binding in the event of disputes
between the AEs;
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(c) The Administrator alone shall have the right to access the
records of the AEs and not vice versa;
x. The assessee has applied PSM in the TP study for the first time;
xi. The assessee is relying on PSM merely to camouflage its losses at
the net level;
xii. Even though the circuit expenses are a key driver, the assessee
has not maintained any record/evidence of such expenses as is
clear from assessee's notes to account to the audited financial
statements;
xiii. Assessee is not providing any unique intangible if it is outsourcing
the last mile connectivity to unrelated parties and with unrelated
parties participating in the value chain there is no place for any
seamless operations between the assessee and its AEs.
3.5. The DRP upheld the conclusion drawn by the TPO that TNMM is the most
appropriate method. The Assessing Officer passed an order u/s 143(3) r.w.s.
144(C) of the Act carrying out the adjustments determined by the TPO in his
order u/s 92CA(3) on 12.10.2010 and made an adjustment of Rs.9,46,20,328/-.
The Assessing Officer also made certain disallowances u/s 40A(i) of the Act.
3.6. The Ld.Counsel Mr.Rahul Kumar Mitra disputed the objections raised by
the TPO and submitted as follows.
"The 'key value drivers' i.e. Sales & Marketing operations, Network operations
and Field operations, have been identified. based on a detailed functional
analysis and are nothing but those 'functions' performed with the concomitant
'assets' and 'risks' that are crucial for success in the industry in which the
appellant operates.
Further, again based on a detailed functional analysis, each of the value drivers
is determined to be equally important for the global operations of the Group, and
hence, each driver has been given equal weight. Accordingly, the residual group
profit/loss is divided equally among each of the value drivers.
Further, while applying RPSM, especially in a scenario wherein the functions
performed or services rendered are unique in nature and comparables are not
available easily for determining the manner in which profit has to be split,
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Global One India P.Ltd., New Delhi
reliance has to be placed on some other indicia such as costs for determining
how the residual profit must be allocated. This approach is supported by OECD
Guidelines, UN's Practical Manual on Transfer Pricing for Developing Countries
('UN TP Manual') as well as US Treasury Regulations. For your Honours'
reference, enclosed herewith as Appendices to this annexure are:
a) the relevant extracts of Chapter II (Part III: Transactional profit methods)
on TP Methods of OECD Guidelines
b) the relevant extracts of Chapter VI (Section 6.3.13: Profit Split Method) on
TP Methods of UN TP Manual
c) The relevant extracts of US Treasury Regulations Para 4.182-6 (c)(3)(i)(b)
Moreover, each of the above costs that are relied upon to measure the
contributions to key 'value drivers' are from financials and are fully based
on the actual costs/ expenses borne by the various entities. They represent third
party costs determined based on full-fledged negotiations in the open market.
The Ld TPO has also raised an objection to application of the residual PSM on
the ground that the marketing expenditure incurred by the appellant is merely
Rs 31,28,853 out of a total expense of Rs 62,04,23,787 where as the personnel
expenses are merely Rs 6,41,07,400.
To the extent GOIPL has low marketing cost its contribution to the sales and
marketing driver is also low, which has in effect resulted in a lower attribution of
losses to GOIPL considering that there are losses at the group level in this FY.
The Ld TPO has argued that since appellant's largest head of expense of Rs
292,432,061 is 'recurring head installation charge' under the head circuit
expenses, it is clear that appellant's main activity is providing internet and
related services.
Even the appellant agrees that its main activity is provision of internet and
related services. However, the important point is that owing to the integrated
nature of appellant's operations, it is PSM and not TNNM that is the most
appropriate method for benchmarking appellant's international transactions
connected with the provision of internet and related services.
The circuit expenses are incurred by the appellant as part of its activities/ role of
providing the network/ connectivity for the India leg of the global network. The
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A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
fact that circuit expenses incurred by the appellant during the year are
significant can in no way lead to a conclusion that PSM is not the most
appropriate method in the instant case.
The Ld TPO has also stated in the Notice that the description of the 'Field
operations' in the TP study is not reflective of any unique intangibles or value
added services but reflects services that are routine in nature.
In this regard, it is submitted that Field Operations constitute one of the key
drivers of the business. The Field Operations and Integration Services ("FOIS")
teams are the interface/ Equant's presence at customer sites around the globe,
and are responsible for delivering quality services to customers in all countries of
operation. Because the field operation personnel are in direct contact with the
customers on regular basis, through the quality they bring in their work or
service delivery they also contribute in a significant manner to the business
operations of the Group and also help the group in identifying new business
opportunities. Thus, the field operation is also a significant value driver of the
Group's business.
The appellant is the joint entrepreneur in the business and not a low risk captive
unit.
· Even if the costs incurred by an entrepreneur can be identified, the return
attributable to it cannot be ascertained by applying TNNM and comparing it with
other independent comparables/ entrepreneurs.
· Appellant's operations are highly integrated, it is also not possible to
directly identify the revenue that is attributable to appellant's efforts in India.
· Appellant's business is integrated other parameters for applicability of
PSM also have to be considered - not possible to identify revenue streams
attributable to any specific operating entity which is why the total group revenue
necessarily has to be apportioned between the different operating entities based
on key value drivers as is done under PSM.
· Mere determination of the costs cannot imply that TNNM can be applied in the
instant case. This does not any-how enable an identification of appellant's
corresponding share in the Group revenue and/ or profit/ loss.
· In FY 2004-05 (i.e. AY 2005-06) and FY 2005-06 (i.e. AY 2006-07) the
appellant's case was picked up for detailed TP scrutiny. In both the years, the TP
basis of the appellant was examined in detail and TPOs had sought voluminous
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information/ explanation on the manner in which PSM was applied for
determining the arm's length price. After analysing and evaluating the detailed
submissions put forward by the appellant, the Ld TPO's predecessors reached an
informed conclusion as to the appropriateness of PSM for benchmarking
appellant's international transactions.
· The principle of res-judicata is very much applicable to tax matters as well so
long as there is no material change in the facts and circumstances surrounding
the case in the different years in question.
· To rebut the applicability of res-judicata, the Ld TPO has relied upon the
Tribunal Ruling in the case of Carraro India Ltd vs. DCIT (2008 - TIOL - 519-
ITAT - Del). However, the said decision does not anywhere state that the
principle of res-judicata is not applicable to tax matters but rather highlights that
during each year 'facts and circumstances' are to be examined before applying
the said principle.
· Further, the applicability of the principle of res-judicata is supported by several
decisions of the Apex Court. The Hon'ble Supreme Court has clearly laid down
that where a fundamental aspect permeating through the different assessment
years has been found as a fact one way or the other, and the parties have
allowed the position to be sustained by not challenging the order, it is not
allowed to change the position in any subsequent year.
· There is no justification for taking a different view on a fundamental issue i.e.
choice of the TP method when there are similar facts.
· Given that there has been no change in the nature and terms of the
international transactions entered into by the appellant over the years,
there is no justification for taking a different view on a fundamental issue
i.e. choice of the TP method when there are similar facts and hence, in
line with the earlier years, PSM should be accepted as the most
appropriate method even for the current FY.
· TP Regulations in different jurisdictions are similar in substance - today
the TP principles accepted and applied internationally are largely similar
being mostly based on the OECD Guidelines published and reviewed by
OECD from time to time. Indian Courts/ Tribunal have in many cases
referred to overseas TP legislations/ jurisprudence to seek guidance on
various TP issues.
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· The underlying basis for applicability of PSM is same/similar as per the
OECD Guidelines, US regulations and the Indian TP regulations applicable
in case of integrated transactions involving unique intangibles.
· To the extent the global policy of the Group based on PSM has been
accepted in other countries as well even though such acceptance is based
on their TP regulations, it raises a strong presumption of the conformity
of the Equant Group policy (based on PSM) with the arm's length principle
enshrined in the Indian TP regulations.
· Non-acceptance of PSM would imply that India is the only exception:
Globally, wherever the Revenue authorities have audited/ tested the inter-
company transaction pricing/ TP policy/method for the Equant group, PSM
has been accepted and no adverse inference has been drawn either in
relation to the application of the method or the transfer prices. appellant
understands that Revenue Audits have been completed in countries
including France, Belgium, Italy, Thailand, etc. Hence, should your
Honours' accept Ld TPO's approach to benchmarking appellant's
international transactions using TNNM, the taxi TP treatment of the
appellant in India shall be the only exception to what is otherwise a
universal acceptance of the global TP policy of the Equant Group.
· The key value drivers are not the outcome of the appellant's subjective
evaluation but the result of an objective industry and functional analysis
undertaken by the appellant which clearly bears out the main industry
characteristics. Here the appellant would like to reiterate the submission
made before the Ld TPO to highlight the fact that it has indeed relied
upon the external market data in the application of PSM.
· The key `value drivers' i.e. Sales & Marketing operations, Network
operations and Field operations, have been identified based on a detailed
functional analysis and are nothing but those 'functions' performed with
the concomitant 'assets' and 'risks' that are crucial for success in the
industry in which the appellant operates.
· Further, again based on a detailed functional analysis, each of the value
drivers is determined to be equally important for the global operations of
the Group, and hence, each driver has been given equal weight.
Accordingly, the residual group profit/loss is divided equally among each
of the value drivers.
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· Further, while applying RPSM, especially in a scenario wherein the
functions performed or services rendered are unique in nature and com
parables are not available easily for determining the manner in which
profit has to be split, reliance has to be placed on some other indicia such
as costs for determining how the residual profit must be allocated. In the
instant case actual costs incurred by the various operating entities is
considered as key value driver cost. This approach is supported by OECD
Guidelines as well as US regulations. Moreover, each of the above costs
that are relied upon to measure the contributions to key 'value drivers' are
from financials and are fully based on the actual costs/ expenses borne by
the various entities. They represent third party costs determined based on
full-fledged negotiations in the open market.
· Here, the appellant would like to draw reference to detailed description
of the Group Overview and the integrated nature of appellant's operations
as discussed in the submission filed in the DRP application. Further, on
the contribution of key value drivers, in the detailed submission filed
before the Ld TPO it was also clearly explained how each value driver
contributes to the business/ creation of a unique intangibles i.e. the
network, field operations, sales and marketing, etc. Further, as submitted
before the Ld TPO, the total key driver cost constitutes as much as one-
fourth (approx) of the total expenses for the appellant which is not an
insignificant amount contrary to what has been contended by the Ld TPO.
Hence, the assertions made by the Ld TPO that key value drivers
identified by the appellant are completely routine and do not lead to
creation of any unique intangibles completely baseless.
· The appellant had furnished before the TPO detailed reasons/
explanation for losses being made by the Equant Group at the global
level. Hence, the observation of the Ld TPO on absence of any credible
reasons for losses is completely incorrect. Commercial reasons for losses
include: -
(a) Prevalent market trends in the global telecommunications industry, the
Equant group operates in a very dynamic, highly competitive, and
fragmented market that is in a constant stage of change and is
experiencing continuous erosion of prices for telecommunications
connectivity.
(b) In the last decade the telecommunications market has gone through
significant changes at an incredibly rapid pace. Bankruptcy filings and
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consolidation trends during the recent few years highlight the transition in
the industry.
(c) In the recent years, the telecommunications market has moved away
from the need to utilize specific data networks, as the Internet is
becoming cheaper and more secure for sending data. Further, the current
state Internet Services Provider ('ISP') industry also finds customers not
demonstrating loyalty to any particular service provider as internet
services are increasingly viewed as a commodity product.
(d) Consequently, margins available in providing basic network and data
transmission services have fallen dramatically and a reliance solely on
such data transmission activity is no longer a viable business option for
telecom service providers. The network capacity market has become very
price competitive, and it is becoming difficult to generate profits from the
sale of "plain vanilla" network usage.
(e) The trends/ movements in the telecommunications industry clearly reflect
that the pricing for pure network operating services has become a
commodity, leading to severe constraints on margins from Equant's
customers and competitors. Because of this change, Equant is facing an
enormous challenge, with the focus moving away from the simple, yet
incredibly risky investment for the provision of network capacity, as the
value in network transport has decreased and will continue to do so, to
become a total telecommunications solutions based company.
He further submitted that,
(i) The inter-company agreement does not give any discretionary power to
the Administrator to determine the intra-group payments. Rather the
payments are to be made in accordance with the arm's length principle
(and in consonance with the OECD Guidelines).
(ii) Similarly, in relation to disputes, it is provided as per para 6.6 of the
agreement that in the event an AE and the Administrator are not able to
reach any agreement even after making reasonable efforts for the same,
the disputes between the AE and the administrator would be referred to
an arbitrator whose decision shall be binding on the parties. Moreover,
the Arbitrator would also be appointed jointly by the administrator and
the disputing party.
(iii) The last point of the TPO on the power to have access to records is
merely a procedural aspect in the administration of the agreement and
not imply absence of any power/ say of the AEs in the administration of
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agreement/ allocation mechanism. Further, the appellant does access to
the methodology/basis followed by the Administrator for carrying out the
RPSM. Also, the RPSM workings are also shared by administrator with the
appellant and the same were also filed with the Ld TPO during the audit
proceedings and the workings are shared the appellant.
Hence, he argued that the observations made by the Ld TPO are incorrect.
On facts he submitted that :
· Both the statements of the TPO in this regard are factually incorrect since
neither has the PSM been applied in the TP study for the first time nor is
it a device to camouflage the losses of the appellant.
· PSM based model is followed by the Equant Group globally for the setting
of Transfer Prices. This model is clearly borne out from the inter-
company agreement which was put in place long before the FY 2006-07
i.e. the agreement was effective from January I, 2004. The TP
documentation is merely a written manifestation of this model and drawn
up for compliance under the TP regulations. Further, the TP model based
on PSM has also been accepted by the Ld. TPO's predecessors in the prior
years.
· At the outset, it needs to be stressed that the circuit expenses pertaining
to provision of last mile connectivity is not a key driver cost. The Equant's
Group's Core asset is the global network that connects overseas entities
to the 'Point of Supply' and in which all the group entities have invested
heavily and which also is the unique intangible employed by the Group.
· In the entire process of international communication the most important
role is that of transmitting and receiving the signals from one country to
another which is the role performed by the global network which is
developed and maintained by the Equant Group. As recognized by the
Ld.TPO in the TP Order itself, last mile connectivity is merely a small part
of the entire networking process and its outsourcing does not negate the
importance of global network as an intangible.
· Merely because the appellant outsources the last mile connectivity to
third party internet service providers does not detract from the
importance of the global network in which the Equant Group (including
GOIPL) has heavily invested and it is the cost pertaining to the global
network constitutes the key driver. Here it is reiterated that each Equant
operating entity (including GOIPL) assumes the significant risks associated
16
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
with making an investment in the global network and also assume the
overall responsibility vis-a-vis the customers for ensuring effective / error
free services.
4. The Ld.D.R. Mr.Peeyush Jain, on the other hand, opposed the
contentions of the assessee and referred to the assessment order for the A.Y.
2009-10 where the A.O. has left a Note. He submits that PSM is not the Most
Appropriate Method(MAM). He referred to page 260 of the assessee's paper
book, wherein in the executive summary of T.P. study for the F.Y. 2006-07, it is
specifically stated at para 1.4.2 by the auditors, that their recommendations
on the issue of M.A.M. are based on facts as on 31.3.2007 and that the
methodology and the MAM may have to be reviewed in case of change in the
facts and circumstances of the case, to drive home the point that, it is not
mandatory to follow PSM as the MAM adopted in the Previous Years, in this year
also, even if the same is accepted by the T.P.O. He argued that it is well
settled that the burden of proof is on the assessee to prove that its international
transactions with its Associated Enterprise are at arm's length. He referred to
the order of the TPO and submitted that the application of PSM by the assessee
is not as per Rule 10B(1)(d). He referred to page 180 of the paper book and
pointed out, to the details given therein, of the A.E. and all the international
transactions, entered into by the assessee and pointed out that they are of
(i) purchase of equipment, (ii) telecom charges, and (iii) reimbursement of
expenses in two cases. He submitted that purchase of equipment is not service
17
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
and hence PSM cannot be applied. He questioned whether PSM can be the
most appropriate method for purchase of equipment. It is only in the case of
Telecom charges, which is received by the assessee from Equant Ireland that
PSM may possibly be applied and in that case the profits of both the enterprise
have to be considered. He vehemently contended that the intra transfer pricing
policy of the Group, cannot be compared and cannot be considered as a bench
mark. He relied on the TPO's order, and the show cause notice given by the
T.P.O. and submitted that this is a case where the key drivers are not applied
correctly. He questioned as to what are the unique intangibles. He submitted
that losses are being brought forward in this case and referred to page 3 of the
TPO's order and relied on the findings therein and contended that losses
cannot be apportioned to the assessee. He submitted that the basis of allocation
is not reasonable and that the assessee has not justified the same. On the TPO
accepting PSM in the earlier years, he submitted that it might probably be a
mistake and there is no res judicata in tax proceedings. He pointed that the law
allows the TPO's to change and arrive at the correct Most Appropriate Method,
when he is convinced that a change is required. He questioned that if the case
of the assessee is that there was a mark up, then the assessee having a loss,
cannot be explained. On a query from the Bench as to whether errors in
applying the method should be corrected or the method itself should be
rejected, he submitted that if the errors are such that go to the root of the
method to be applied, in such cases the TPO has to change to the most
18
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
appropriate method. He contended that the assessee has plug in client, and
has no unique intangibles. He relied on each and every finding of the T.P.O.
which are brought out in the earlier part of this order and submitted that the
T.P.O's order, as confirmed by the DRP's order, has to be upheld.
4.1. In reply the Ld.Counsel for the assessee Mr.Rahul Mitra submitted
that, the very categorization of the assessee is wrongly understood by the
Ld.D.R. and that the assessee is not a service provider and that he is an
entrepreneur. He contended that if PSM is not correctly applied, then the
remedy is to correct the same and not reject the method itself. He pointed out
that the allocation was on a scientific basis and that, if the TPO found fault with
it, he could have suggested a different method of allocation which he felt
appropriate, rather than reject the method. He contended that net working is an
intangible and the assessee is an independent entrepreneur and transactions are
inter related, hence PSM is applicable.
4.2. Joining the , the Ld.D.R. Mr.Peeyush Jain submitted that the entire
group has 100 entities and when the assessee has transactions only with two
entities, how could the entire group profits be apportioned? He submitted that
only such entities as are involved in the international transactions should be
considered. He vehemently contended that PSM was not applied by the
assessee as per the requirement of Rule 10(A)(A), as residual profits allocation
are not bench marked.
19
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
4.3. The Ld.Counsel for the assessee admitted that PSM has not been
applied as per the requirements of the Income Tax Act read with Rules to the
extent that residual profits allocation was not bench marked. But he submitted
that nowhere in the world, bench marking of residual profits for allocation is
required. He relied on various commentaries in support of the same. He
referred to the decision of the Chennai Bench of the Tribunal in the case of
Asendas (India) Pvt.Ltd. vs. DCIT in ITA no.1736/Madras/2011, order dated
02nd January,2013, and submitted that the Tribunal has adopted a valuation
methodology not given in the rules, as a matter of exception. He relied on
interpretation of statutes and submitted that the Tribunal is entitled to put life
and force into the language of the Section so as to iron out the creases. He
relied on a number of decisions of the Hon'ble Supreme Court and High Courts
for the proposition that the Tribunal can read down the law in certain
circumstances and argued that this is one such circumstance.
Alternately, he relied on Rule 10(A)(B), which was introduced w.e.f. 1.4.2012
giving the assessee a choice to adopt any other recognized method and
submitted that this rule is retroactive, as it is procedural in nature. Hence, he
submits that the method adopted by the assessee is a recognized method and
has to be accepted as MAM under Rule 10(A)(B).
4.4. The Ld.D.R. replied stating that the sixth method is prospective and is
applicable w.e.f. 1.4.2012 and no arm's length can be determined without bench
20
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
marking with comparables. He submitted that the Tribunal cannot read down
enactments and has to simply enforce the law as enacted by the Parliament.
5. On the corporate tax issues the assessee filed two additional grounds
which are as follows.
"Ground no.10: That the LdAO has erred on facts and in law in charging interest
u/s 234C of the Act on the assessed income of IR 272,043,590/-.
10.1. Without appreciating that interest u/s 234C is leviable on the tax on
returned income i.e. tax on the total income declared in the return of income
and not on the assessed income as per the provisions of S.234C of the Act.
10.2. As there is no mention of the levy of interest u/s 234C of the Act in the
assessment order and thereby ignoring the judicial precedents wherein it has
been held that interest u/s 234C could be levied only when there is specific
mention in the assessment order that interest u/s 234C is leviable.
11. Without prejudice to ground numbers 1 to 5 and without accepting the
additions made by the Ld.AO in any manner whatsoever, the Ld.AO has erred in
not allowing deduction u/s 80-IA(4) of the Act from the gross total income (as
assessed)."
6. Ld.Counsel submitted that these are legal grounds which do not
require any investigation into the facts of the case and under these
circumstances he argued that the same may be admitted.
6.1. The Ld.D.R. submitted that the assessee has not claimed a
deduction u/s 80-I either in the original return of income, or in the revised
21
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
return of income and hence submitted that the additional grounds may be
rejected.
7. After hearing rival contentions, we find that both the grounds
raised are legal grounds and that no fresh investigation into facts is required.
When all facts are on record, in our view, these grounds have to be admitted,
being legal grounds, by following the judgement of Hon'ble Supreme Court in
the case of National Thermal Power Co.Ltd. vs. CIT(1998) reported in 229 ITR
383 (SC). In the result we admit the additional grounds.
8. Ground no.5 to 9 are grounds connected with corporate tax
issues.
9. The Ld.Counsel for the assessee submitted that the A.O. disallowed
payments made for lease lines, as the assessee has not deducted tax at source
u/s 40(A)(i)(a). The A.O. disallowed the same by holding that lease lines were,
technically speaking, equipment and payment for taking these lines on lease,
is covered u/s 194-I and that the assessee himself has described the payment
has been made towards lease lines. The Ld.Counsel relied on the decision of
the Delhi high court in the case of Asia Satellite Tele Communication Co. 332 ITR
340(Del)C and submitted that the issue is covered in his favour. He relied on
the decision of the Mumbai Tribunal in the case of "Vodafone S.R.Ltd." 135 TTJ
182 and submitted that such payments are not for the use of equipment and,
therefore, not liable to TDS u/s 194-I.
22
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
9.1. On the additional ground of deduction u/s 80 IA(iv), he submitted
that any disallowances made by the A.O. would go to increase the income and
consequently the assessee would be eligible for deduction u/s 80 IA on such
increased profits. He relied on the order in the case of "Gem Plus Jewellery
India Pvt.Ltd." (2011) reported in 330 ITR 175 (Bom) in support of his
contentions. For levy of interest u/s 234C, he recorded that such interest is
levied only on returned income and not on assessed income.
9.2. In reply, the Ld.D.R., though not leaving his ground, submitted
that he relies on the order of the A.O. and the reasoning thereof for
disallowance made u/s 40A(i)(a) of the Act.
9.3. On the additional grounds the Ld.D.R. submitted that the A.O.
may be directed to examine the same, if the Tribunal chose to admit these
grounds.
10. Rival contentions heard. On a careful consideration of the facts
and circumstances of the case and on a perusal of the papers on record and
orders of the authorities below, case laws cited, we hold as follows.
11. We first take up corporate tax issues which is ground no.5 for the
A.Y. 2007-08. The assessee is a licensed internet provider. During the year it
procured, domestic half circuit facility to its customers from Telecom Service
Providers like BSNL, MTNL, and international half circuit facility from Flag,
Atlantic, at France. These are standard facilities provided for transmission of
data by those organisations. The issue is whether tax should be deducted at
23
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
source u/s 194 I from payments made for use of such standard facilities. The
Hon'ble Delhi High Court, in the case of Asia Satellite vs. CIT, reported in 332
ITR 340 and the Hon'ble Madras High Court, in the case of Skycell
Communications Ltd. vs. DCIT, reported in 351 ITR 53 (Madras) have
adjudicated the issue in favour of the assessee. Respectfully following the same,
we hold that payments made towards use of standard facility, when the lessee
is not having any domain or control or possessory rights over such facility,
cannot be categorized as use of assets for the purpose of the Act.
11.1. Respectfully following the order of the Jurisdictional High Court on this
issue, we allow this ground of appeal of the assessee. In the result ground no.5
for the A.Y. 2007-08 is allowed.
12. Ground no.6 for A.Y. 2007-08 is on the issue of the Assessing Officer not
granting the benefit of carry forward of business losses and unabsorbed
depreciation, to the assessee. After hearing both the parties, as this is a
factual matter and as the same is not adjudicated by the lower authorities, and
as this is a legal claim, we set aside the same to the file of the A.O. for fresh
adjudication in accordance with law. In the result this ground is allowed for
statistical purposes.
13. Ground no.7 for the A.Y. 2007-08 and ground no.6 for the A.Y.
2008-09 are general in nature. Ground no.8 for the A.Y. 2007-08 and ground
no.7 for the A.Y. 2008-09 are against the levy of interest u/s 234'B'. Levy of
interest is mandatory and consequential. Hence, these grounds are dismissed.
24
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
14. Ground no.9 for the A.Y. 2007-08 and ground no.9 for the A.Y.
2008-09 are on the initiation of penalty u/s 271(1)(c ) of the Act. The same is
dismissed as premature.
15. Ground no.8 for the A.Y. 2008-09 is against the A.O. not allowing
credit of TDS and charge of interest. As this is a factual matter, the same is set
aside to the file of the A.O. for verification and disposal in accordance with law.
This leaves us with ground no. 1 to 4 in both the AYs, which is against the
transfer pricing adjustments, as well as the additional grounds admitted by us.
16. The additional ground is regarding claim of deduction u/s 80I. Having
admitted this ground by applying the decision of the Hon'ble Supreme Court in
the case of NTPC Ltd., we deem it appropriate to remit the matter to the file of
the Assessing Officer for fresh adjudication in accordance with law. Similarly,
the additional grounds raised on levy on interest u/s 234, we also set aside this
additional ground to the file of the AO for fresh adjudication in accordance with
law.
16.1. In the result, these grounds are allowed for statistical purposes.
17. We now take up the issue of transfer pricing adjustment, which are
ground nos. 1 to 4.
17.1. A perusal of the function of the assessee company demonstrates that
the transactions of the company are highly integrated and interrelated. It
involves more than one enterprise to complete a transaction. This is a case
where a transaction passes through a number of A.Es and for a transaction to
25
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
fructify, each entity makes a contribution. The various parties which make a
contribution to the transaction, share the revenues that arise as a consequence
to such contribution. The different entities are also associated enterprises. The
fact is that the EQUANT Group relies on the functions of each of the entities of
the group to generate revenues and each of the operating entities of the
EQUANT Group deploys the necessary assets and function required at each
step for network foot print. Each entity owns assets and also employs man
power, with the help of which they operate different locations of the network
and thus contribute to the Global EQUANT network.
17.2. Thus, keeping in view the above, we come to a conclusion that
the nature of the assessee's operations is integrated, interconnected and
interdependent. On these facts, we have to decide as to what is the "MAM"
under the facts and circumstances.
17.3. Before us there are two methods for consideration, i.e. PSM and TNMM.
The Special Bench of the Tribunal, in the case of Aztech Software and
Technologies Services Ltd. vs. ACIT, reported in 107 ITD, at page , states as
follows:
"Profit Split Method (PSM)
Rule 10B (1) (d) prescribes PSM as follows:
(i) The combined net profit of the associated enterprises arising
from the international transaction in which they are engaged, is
determined;
(ii) The relative contribution made by each of the associated
enterprises to the earning of such combines net profit, is then
evaluated on the basis of the functions performed, assets
26
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
employed or to be employed and risks assumed by each
enterprise and on the basis of reliable external market data
which indicates how such contribution would be evaluated by
unrelated enterprises performing comparable functions in the
similar circumstances;
(iii) the combined net profit is then split amongst the enterprises in
proportion to their relative contributions, as evaluated under
sub clause(ii);
(iv) the profit thus apportioned to the assessee is taken into
account to arrive at an arm's length price in relation to the
international transaction;
181. This method may be applicable in case where transactions
involved transfer of unique, intangible or any multiple
interrelated international transactions, which cannot be
evaluated separately for determining the ALP of any one
transaction.
182. The profit split method first identifies the profit to be split for
the associated enterprise from the controlled transactions in
which the associated enterprises are engaged. It then splits
those profits between the associated enterprises on an
economically valid basis that approximates the divisions of
profits that would have been anticipated and reflected in an
agreement transactions or a residual profit intended to
represent the profit that cannot readily be assigned to one of
the parties, such as the profit arising from high value,
sometimes unique, intangibles.
183. The contribution of each enterprise is based upon a functional
analysis and valued to the extent possible by any available
reliable external market data. The functional analysis is an
analysis of the functions performed (taking into account assets
used and risks assumed) by each enterprise. The external
market criteria may include, for example, profit split
percentages or returns observed among independent
enterprises with comparable functions."
27
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
17.4. The OECD transfer pricing guideline for multinational enterprises and tax
administration in Chapter 2 on transfer pricing methods, at page 93, para C.1
states as follows:
"C.1 In general
2.108 The transactional profit split method seeks to eliminate the effect
on profits of special conditions made or imposed in a controlled
transaction (or in controlled transactions that are appropriate to
aggregate under the principles of paragraphs 3.9-3.12) by
determining the division of profits that independent enterprises
would have expected to realize from engaging in the transaction or
transactions. The transactional profit split method first identifies
the profits to be split for the associated enterprises from the
controlled transactions in which the associated enterprises are
engaged (the "combined profits"). References to "profits" should
be taken as applying equally to losses. See paragraphs 2.124-2.131
for a discussion of how to measure the profits to be split. It then
splits those combined profits between the associated enterprises
on an economically valid basis that approximates the division of
profits that would have been anticipated and reflected in an
agreement made at arm's length. See paragraphs 2.132-2.145 for
a discussion of how to split the combined profits."
17.5. On residual analysis analyses, it is stated as follows:
"C.3.2.2 Residual analyses
2.121 A residual analysis divides the combined profits from the controlled
transactions under examination in two stages. In the first stage, each
participant is allocated an arm's length remuneration for its non-unique
contributions in relation to the controlled transactions in which it is
engaged. Ordinarily this initial remuneration would be determined by
applying one of the traditional transaction methods or a transactional net
margin method, by reference to the remuneration of comparable
transactions between independent enterprises. Thus, it would generally
not account for the return that would be generated by any unique and
valuable contribution by the participants. In the second stage, any
residual profit (or loss) remaining after the first stage division would be
allocated among the parties based on an analysis of the facts and
28
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
circumstances, following the guidance as described at paragraphs 2.132-
2.145 for splitting the combined profits.
2.122 An alternative approach to how to apply a residual analysis could seek to
replicate the outcome of bargaining between independent enterprises in
the free market. In this context, in the first stage, the initial remuneration
provided to each participant would correspond to the lowest price an
independent seller reasonably would accept in the circumstances and the
highest price that the buyer would be reasonably willing to pay. Any
discrepancy between these two figures could result in the residual profit
over which independent enterprises would bargain. In the second stage,
the residual analysis therefore could divide this pool of profit based on an
analysis of any factors relevant to the associated enterprises that would
indicate how independent enterprises might have split the difference
between the seller's minimum price and the buyer's maximum price.
2.123 In some cases an analysis could be performed, perhaps as part of a
residual profit split or as a method of splitting profits in its own right, by
taking into account the discounted cash flow to the parties to the
controlled transactions over the anticipated life of the business. One of
the situation in which this may be an effective method could be where a
start-up is involved, cash flow projections were carried out as part of
assessing the viability of the project, and capital investment and sales
could be estimated with a reasonable degree of certainty. However, the
reliability of such an approach will depend on the use of an appropriate
discount rate, which should be based on market benchmarks. In this
regard, it should be noted that industry wide risk premiums used to
calculate the discount do not distinguish between particular companies let
alone segments of business, and estimates of the relative timing of
receipts can be problematic. Such an approach, therefore, would require
considerable caution and should be supplemented where possible by
information derived from other methods."
17.6. The United Nations Practical Manual on Transfer Pricing for
Developing Countries Chapter VI Transfer Pricing Methods, states as
follows:
"6.3.13.1. The Profit Split Method is typically applied when both sides of the
controlled transaction contributes significant intangible property. The profit is to
be divided such as is expected in a joint venture relationship.
29
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
6.3.13.2. The Profit Split Method seeks to eliminate the effect on profits of
special conditions made or imposed in a controlled transaction(or in controlled
transactions that it is appropriate to aggregate) by determining the division of
profits that independent enterprises would have expected to realize from
engaging in the transaction or transactions. Figure 5 illustrate this.
6.3.13.3 The Profit Split Method starts by identifying the profits to be
divided between the associated enterprises from the controlled transactions.
Subsequently, these profits are divided between the associated enterprises
based on the relative value of each enterprise's contribution, which should
reflect the functions performed, risks incurred and assets used by each
enterprise in the controlled transactions. External market date (e.g. profit split
percentages among independent enterprises performing comparable functions)
should be used to value each enterprise's contribution, if possible, so that the
division of combined profits between the associated enterprises is in accordance
with that between independent enterprises performing functions comparable to
the functions performed by the associated enterprises. The Profit Split Method is
applicable to transfer pricing issues involving tangible property, intangible
property, intangible property, trading activities or financial services.
17.7. Residual analysis is stated as follows:
6.314.7 The Residual Profit Split Method is used more in practice than the
contribution approach for two reasons. Firstly, the residual approach breaks up a
complicated transfer pricing problem into two manageable steps. The first step
determines a basic return for routine functions based on comparables. The
second step analysis returns to often unique intangible assets based not on
comparables but on relative value which is, in many cases, a practical solution.
Secondly, potential conflict with the tax authorities is reduced by using the tow
step residual approach since it reduces the amount of profit that is to be split in
the potentially more controversial second step.
6.3.17.3. In step 1 of the residual analysis, a basic return for the
manufacturing function is determined for Company A and Company B. Specially
a benchmarking analysis is performed to search for comparable independent
manufactures which do not own valuable intangible property. The residual profit,
which is the combined profits of company A and company B after deducting the
basis (arm's length ) return for the manufacturing function, is then divided
between Company A and Company B. This allocation is based on relative R & D
expense which are assumed to be a reliable key to measure the relative value of
each company's intangible property. Subsequently, the net profits of Company A
and Company B are calculated in order to work back to a transfer price."
30
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
17.8. In "Practical Guide to U.S.Transfer Pricing by Robert T Cole, Chapter 10,
PSM authored by arlow N.Higinbotham, pg nos.10-52, it is stated as follows:
"Thus, to summarize, RPSM provides a test of arm's length transfer
pricing between value- added stages of an integrated enterprise that is
consistent with the separate enterprise standard under conditions of resource
mobility and competitive capital and product markets. By valuing functional
activities and capital in terms of the competitive norms of the market place,
RPSM attributes extra- normal profit or loss in proportion to the relative
investment cost (or other valuation) of the non-routine intangible assets to
which such extraordinary profits pertains. This approach is consistent with the
IRS statutory objective u/s 482 of requiring consideration for intangible property
transferred in a controlled transaction to be commensurate with the income
attributable to the intangible. It is also consistent with the result that would
obtain at arm's length under a hypothetical joint venture agreement between the
different parties contributing their respective investments of functional and
entrepreneurial capital."
17.9. Residual Profit Split Method is stated as follows:
10.04 Residual Profit Split Method
As illustrated in Figure 10-2, RPSM proceeds in two steps:
Step 1: Functional capital is provided a return derived from data for
functional comparables, i.e. independent companies performing similar routine
manufacturing or distribution functions; and
Step 2:The remaining "residual" operating profit or loss is allocated based on
residual, "entrepreneurial" capital so as to equalize the rate of return on such
capital, adjusted for market differences in the cost of capital.
In actual practice, implementation of the RPSM concept outlined above involves
the determination of a number of interrelated valuations of functional and
entrepreneurial activities in different countries and economic circumstances. The
existing IRS regulations provide relatively little specific guidance concerning
these valuations, and thus leave open the question of how best to determine the
"relative value of each controlled taxpayer's contribution to the success of the
relevant business activity in a manner that reflects the functions performed, risks
assumed, and resources employed by each participant in the relevant business
activity, consistent with the comparability provisions of 1.482- 1(d) (3)."
31
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
18. We now consider TNMM. In Aztek Software and Technology Services
(supra) the TNMM is stated as follows.
"Transactional Net Margin Method (TNMM) :
Rule 10(B)(1)(e) describes TNMM as under:
(i) The net profit margin realized by the enterprise from an international
transaction entered into with an associated enterprise is computed in
relation to costs incurred or sales effected or assets employed or to be
employed by the enterprise or having regard to any other relevant
base;
(ii) The net profit margin realized by the enterprise or by an unrelated
enterprise from a comparable uncontrolled transaction or a number of
such transactions is computed having regard to the same base;
(iii) The net profit margin referred to in sub clause (ii) arising in comparable
uncontrolled transactions is adjusted to take into account the
differences, if any, between the international transaction and the
comparable uncontrolled transactions, or between the enterprises
entering into such transactions, which could materially affect the
amount of net profit margin in the open market;
(iv)The net profit margin realized by the enterprise and referred to in sub
clause (i) is established to be the same as the net profit margin
referred to in sub clause (iii);
(v) The net profit margin thus established is then taken into account to arrive
at an arm's length price in relation to the international transaction.
The TNMM requires establishing comparability at a broad functional level. It
requires comparison between net margins derived from the operation of the
uncontrolled parties and net margin derived by an AE on similar operation.
Under this method, the net profit margin realized by an AE from an international
transaction is computed in relation to a particular factor such as costs incurred,
sales, assets utilized etc. The net profit margin realized by an AE is compared
with net profit margin of the uncontrolled transactions to arrive at the ALP. The
TNMM is similar to RPM and CPM to the extent that it involves comparison of
margin earned in a controlled situation with margins earned from comparable
uncontrolled situation. The only difference is that, in the RPM and CPM
methods, comparison is of margins of gross profits and whereas in TNMM the
comparison is on margins of net profit.
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TNMM requires comparison between net margins derived from the operations of
the uncontrolled parties and net margins derived by an AE from similar
operations. Net margin is indicated by the rate of return on sales or cost or
operating assets, and this forms the basis for TNMM. A functional analysis of the
tested party or the independent actions are comparable and the adjustments
that are required to be made to obtain reliable results. The tested party would
have to consider other factors, like cost of assets of comparable companies, etc.
while applying the return on assets measure. Ordinarily, the tested party, has to
be the party provided services because it is on the basis of rate of return on
sales or cost or operating assets that transactional margin is computed. These
parameters generally available in the case of party providing service
18.1. The , in its review of comparability and methods, dt. 22nd July,201, 0 in
Part III B Transactional Net Margin Method, B I, page 33, paras 2.58 to 2.59,
held as under.
"B. Transactional net margin method
B.1. In general
2.58 The transactional net margin method examines the net profit relative to
an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a
controlled transaction (or transactions that are appropriate to aggregate under
the principles of paragraphs 3.9 3.12). Thus, a transactional net margin
method operates in a manner similar to the cost plus and resale price methods.
This similarity means that in order to be applied reliably, the transactional net
margin method must be applied in a manner consistent with the manner in
which the resale price or cost plus method is applied. This means in particular
that the net profit indicator of the tax payer from the controlled transaction ( or
transactions that are appropriate to aggregate under the principles of
paragraphs 3.9-3.12) should ideally be established by reference to the net profit
indicator that the same tax payer earns in comparable uncontrolled
transactions, i.e. by reference to "internal comparables" (see paragraphs 3.27-
3.35). A functional analysis of the controlled and uncontrolled transactions is
required to determine whether the transactions are comparable and what
adjustments may be necessary to obtain reliable results. Further, the other
requirements for comparability, and in particular those of paragraphs 2.69-2.75,
must be applied.
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2.59. A transactional net margin method is unlikely to be reliable if each party
to a transaction makes valuable, unique contributions, see paragraph 2.4. In
such a case, a transactional profit split method will generally be the most
appropriate method, see paragraph 2.109. However, a one-sided method
(traditional transaction method or transactional net margin method) may be
applicable in cases where one of the parties makes all the unique contributions
involved in the controlled transaction, while the other party does not make any
unique contribution. In such a case, the tested party should be the less complex
one. See paragraphs 3.18-3.19 for a discussion of the notion of tested party."
18.2. In the working draft of a chapter of the practical Manual in Transfer
Pricing for Developing Countries, in Chapter 5 Transfer Net Margin Method is
discussed at para 2.1.
"Transactional Net Margin method
2.1. Definition and choice of tested party
The transactional net margin method (`TNMM') is a profit based method that can
be used to apply the arm's length principle. The TNMM can be applied on either
the related party manufacturer or the related party distributor as the tested
party for transfer pricing purposes.
The TNMM examines the net profit margin relative to an appropriate base (e.g.
costs, sales, assets) that a tax payer realizes from a controlled transaction (or
transactions that are appropriate to be aggregated). The profit margin
indicators are discussed in paragraph 2.3 below.
The TNMM compares the net profit margin (relative to an appropriate base) that
the tested party earns in the controlled transactions to the same net profit
margins earned by the tested party in comparable uncontrolled transactions or
alternatively, by independent comparable companies. As such, the TNMM is a
more indirect method than the cost plus/resale price method that compares
gross margins. It is also a much more indirect method than the CUP method that
compares prices, because it uses net profit margins to determine (arm's length)
prices. One should bear in mind that many factors may affect net profit
margins, but may have nothing to do with transfer pricing.
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The TNMM is used to analyse transfer pricing issues involving tangible property,
intangible property or services. When the TNMM is applied on controlled
transactions involving tangible property, the tested party in the analysis can
either be the related party manufacturer or the related party distributor. The
choice of the tested party depends on the availability of comparable data. This
usually implies that the TNMM is applied to the least complex of the related
parties involved in the controlled transaction, because generally more
comparable data will then be in existence and fewer adjustments will be required
to account for differences in functions and risks between the controlled and
uncontrolled transactions. In addition, the tested party should not own valuable
intangible property. This, by the way, is also the reason why it is recommended
to select the least complex entity for the application of the cost plus method or
resale price method."
18.3. The Transfer Pricing , in the case at hand, has applied the TNMM
method. While doing so, at para 3.7, he considered the objection of the
assessee to the use of TNMM as the MAM.
He observed as follows:
"that the assessee's business does not has any integration with the other group
entities has already brought in sufficient details in the earlier part of this order.
The assessee runs its business independently in India. For the deployment of
their party entities for the proliferation of its network services, there is nothing
on record to show that the assessee is getting any help or leverage from the
other group entities. The assessee is negotiating with the Indian regularators all
by itself. The assessee is operating in India as a standalone entity for setting up
the operational requirements in India. Therefore, there is no case to say that
TNMM does not qualify to be the MAM for its reason."
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18.4. In our view, the TPO has erred on facts. The revenues in the case
of the assessee are generated in a transaction where there is contribution from
multiple entities. It is true that the assessee runs its business independently in
India. This leads to a conclusion that the assessee is an independent
entrepreneur . But when a transaction is integrated and interrelated and when
costs are incurred by multiple entities and the revenues are to be apportioned to
multiple entities, then the factual conclusions of the T.P.O have to be vacated.
18.5. Transaction Net Margin method compares the profit margin of tax
payer arising from a non arm's length transaction, or a group of such similar
transactions, with the profit margin realized by the assessee with its A.E. on a
similar transaction whereas the PSM allocates operating profits or losses from
controlled transactions, on the principle of relative contributions made by each
party in creating the combined revenues.
18.6. The objection of the assessee is that the TNMM does not take into
account commercial/business reasons for losses. The TPO rejected this
argument. He held that the assessee has not been able to identify, the reasons
that has lead to incurrance of loss. He concluded as follows:
"the administrator can examine the records of the operating entity but not vice
versa in any dispute the decision of the administrator shall be binding. No
independent entity would have agreed to such terms, nor would it have agreed
to be tied down by the financial performance of another entity/entities over
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which/whom it has little or no control. The assessee's arrangement with the
A.E. and the use of PSM to justify its financial result does not answer the arm's
length principle."
18.7. In our view the argument of the assessee, that in cases where
there are commercial losses, TNMM cannot be applied, cannot be accepted as a
general rule. To this extent, we agree with the conclusions of the T.P.O.
T.N.M.M. can be applied even in cases where there are commercial or other
losses. At best, suitable adjustments may be asked for. On the role of the
administrator we will be discussing the same separately.
18.8. The next objection of the assessee is that TNMM cannot be used
for bench marking returns earned by the number of complex
entities/entrepreneur, where each make valuable unique contributions. The TPO
has not specifically dealt with this objection of the assessee. We find much
force in this contention of the assessee and agree with the same. We are
supported by OECD Guidelines, on this issue. At para 2.59 of the OECD
Guidelines it is stated as follows:
A transactional net margin method is unlikely to be reliable if each party to a
transaction makes valuable, unique contributions, see paragraph 2.4. In such a
case, a transactional profit split method will generally be the most appropriate
method,( see paragraph 2.109)." In such a case, a transactional profit split
method will generally be the Most Appropriate Method.
18.9 Even otherwise, we find that the TPO has, while adopting the TNMM
method, considered four comparables, i.e., (i) City Online Services Ltd., (ii)
HCL Infinet Ltd., (iii) Sify Ltd., and (iv) Southern Online Bio Technologies Ltd.
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18.10. In all these cases, the operating profit at the entity level has
been taken for the purpose of bench marking with the entity level profits of the
assessee and adjustments were made. TNMM does not contemplate bench
marking at the entity level. The rules contemplate bench marking at the
transaction level. For this proposition we draw strength from the following case
laws:
(i) UCB India (P) Ltd. vs. ACIT, 30 SOT 95 (Mum);
(ii) A.C.I.A. vs. Tes Diam, 37 SOT 341.
Thus we are unable to uphold the order of the T.P.O on this ground also.
Hence, for all these reasons, T.N.M.M. is held as not the M.A.M., in the facts
and circumstances of the case.
19. In the case at hand, we are of the considered opinion that the "Profit
Split Method" (PSM) is the "M.A.M" for the reason that the assessee generates
revenue out of operations that are highly integrated. When one transaction,
(example transmitting data from a destination in one country, to a destination
in a different country in a secured manner) requires deployment of assets and
functions of different entities, located in different Geographical locations, to
ultimately deliver services and when such combined efforts generate revenues,
the MAM for determining arm's length price is "Profit Split Method (PSM)."
19.1. In our considered opinion, the Transfer Pricing Officer is wrong in
rejecting PSM on the ground that it is not possible to determine the cost
incurred by the Indian entity separately. The cost incurred by the assessee is
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available on record. The entity maintains books and the same are subject to
audit. What is to be seen is the contribution of the entities' resources to a
transaction, or to a series of similar transactions. In our view, this finding is
not correct. Hence, this ground of the T.P.O. taken for rejecting application of
"PSM" as the "MAM" is not sustainable.
The Transfer Pricing Officer, had after a detail enquiry in the earlier
assessment years, accepted "PSM" as the "MAM". This being so, in our view,
rejection of this method on the ground that resjudicata does not apply to
income tax proceedings is not correct. Recently, the Hon'ble Supreme Court, in
the case of CIT vs. Excel Industries Ltd. has held that "the revenue cannot be
allowed to Flip-flop on the issue. Consistency should be a rule rather than an
exception". There are a number of other decisions on this issue. Suffice it to
say that, the T.P.O., in this case, has not brought out any valid reasons to
depart from the earlier view of his Predecessor.
19.2. The TPO's opinion, that acceptance of "PSM" in other jurisdictions as of
no consequence, to our mind, is also incorrect. No doubt, the arm's length
price has to be determined with reference to the Indian Transfer Pricing
regulations only. At the same time, guidance can be taken from OECD
commentaries, UN guidelines and other such literature.. The Hon'ble Supreme
Court, on a number of occasions, did refer to Commentaries of OECD, UN etc.,
while arriving at conclusions. One such case is, Azadi Bachao Andolan, 184 CTR
SC 450. Even the Indian transfer Pricing Regulation recognize this aspect, as
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evident from the introduction of Rule 10 AB, which allows the use of any other
method which is generally accepted, for determining ALP.
20. On the T.P.O's objection that reliable external market data is not
available, we find that the assessee has given comparables, while determining
ALP, of the basic routine rate of return. At this first stage, the requirement of
identifying comparables and bench marking the same with the basic rate of
return adopted by the assessee is met. The TPO should have examined the
comparables taken by the assessee while allocating the basic rate of return to
each of the operating entity, for undertaking the services and if he was not
satisfied with these comparables or was of the opinion that the "ALP" should be
different, he should have given adequate reasons and not have adopted fresh
comparables. On the objection of the T.P.O. that the assessee has not put forth
any evidence that it has unique intangibles, we hold that "PSM" can be adopted
as "MAM" under the domestic TP Regulations even in cases involving multiple
interrelated international transactions, which cannot be evaluated separately for
determining ALP of any one transaction. When the transaction involves
contributions of multiple entities and are integrated and interrelated and they
cannot be separately evaluated for the purpose of determining ALP of any one
transaction, the "PSMP" is the "MAM". Hence, in our view, use of unique
intangibles is not a must for adopting "PSM". In any event, we have considered
the facts of this case and we have, elsewhere in this order, given a finding
that the assessee does possess unique intangibles in the field of data transfer
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Global One India P.Ltd., New Delhi
and communications, and comparing the operations with a simple E Mail and as
a plug in operator is not factually correct. If the assessee is held to be a simple
Email operator, then it is to be explained as to why reputed global enteprises
would pay them for data transmission, when E Mail is free. The assessee does
offer unique services as compared to an ordinary Email service and it is these
unique services which are its intangibles.
20.1. We also hold that the factum of the assessee having a loss is no
ground to reject "PSM" as the "MAM". The decision as to what is the "MAM"
does not depend on the factor as to whether an assessee has a loss or has a
profit. On the objection of the T.P.O. rejecting the allocation done by the
Administrator, we find that the arrangement with the AE under the agreement
demonstrates that the administrator does not have absolute discretionary
power to determine inter group payment. The agreement provides that
disputes, if not reasonably resolved, can be referred for arbitration. Thus, the
conclusion drawn by the T.P.O. is erroneous. In our view, this cannot be a
ground for rejection of PSM. The conclusion of the T.P.O. that the PSM is
adopted only to camouflage the loss at the net level, is merely an allegation
which, in our view, is not substantiated or demonstrated by the T.P.O. and
hence is devoid of merit.
20.2. When determining as to which is the MAM, the TPO is required to
primarily examine the functional profile of the assessee and the nature of the
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international transaction and having undertaken such an exercise, we are of
the view the "PSM" is the "MAM".
20.3. The contention of the Ld. Departmental Representative that the
assessee is an E Mail service provider and that the assessee is a plug in
entity, is not supported by any documentation. This submission, in our view, is
not factually correct. If the assessee did not have any unique intangibles, then
no client would have engaged them for transmission of any data, as the usual
internet facility and e-mail facility are available free of cost. But for these unique
intangibles, nobody would utilize the services of the assessee company and its
associate enterprises. The claim of the assessee that it has certain technologies
which maintain the secrecy and confidentiality of a communication and also
ensures safe, secure and timely delivery, is having significant substance. On
these facts, we come to the conclusion that the assessee does have unique
intangibles in the field of data transfer and communications.
20.4. The TPO's primary objection is that "PSM" method has not been correctly
applied. It is the view of the T.P.O. that Bench Marking with the help of
comparables is not done while allocating residuary profits. We would deal with
this issue in the later part of this order. In our view, the TPO ought not to
reject the method itself when he feels that it is not correctly applied. The proper
course available to him is to apply this method in the manner in which he feels
it should have been applied.
20.5. The assessee in this case has adopted `residuary profit split method'.
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As explained in various commentaries, residual PSM involves:
i) Determination of routine return
ii) Allocation of residuary profits.
At the stage of determination of routine profits, as already stated, bench
marking has to be done by the assessee, with reliable external market data from
uncontrolled transactions.
20.6. Coming to the allocation of residuary profits, in our view, though the
Rules do suggest that benchmarking should be done with external uncontrolled
transactions, we find that this is an impossibility in this case, as it is not
possible to get a comparable. On a perusal of the various commentaries, we
are of the view that such allocation can be done, based on how much each
independent enterprise might have contributed. Relative contribution has to be
determined, based on key value drivers. Bench marking at this stage is not
practicable as comparables having similar, multiple, interrelated and integrated
transactions, would be difficult to find. Thus, in our view, in such a situation, a
harmonious interpretation of the provisions is required to make the rule
workable, so as to achieve the desired result of determination of the "ALP". The
secondary stage of allocation of Residuary Profits is to be done on the basis of
contribution of each entity, as stated in the commentaries and Guidelines
referred above, as these are generally accepted .
20.7. The argument of the Ld. Counsel of the assessee that the provisions
have to be read down cannot be accepted, as law has to be interpreted as
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provided in the statute. Nevertheless, to make the provisions workable, a
harmonious interpretation is the requirement, as held by the Supreme Court in
CIT vs. J.H.Gotla, reported in 156 ITR 985. Such harmonious interpretation, in
our view, does not tantamount to misreading the provisions, or to the reading
down of a provision. Both the OECD Transfer Pricing Guidelines as well as the
UN Draft Method of Transfer Pricing for Developing Countries, suggest that an
allocation of residual profits under PSM should be done, based on contributions
by each entity.
20.8. We have already extracted the OECD Transfer Pricing Guidelines at
para 17.4. At para 2.121, it is stated as follows: "In the second stage, any
residual profit (or loss) remaining after the first stage division would be allocated
among the parties based on an analysis of the facts and circumstances, following
the guidance as described at paragraphs 2.32 to 2.145 for splitting the combined
profits.
The paragraphs read as follows.
"C.3.4. How to split the combined profits
C.3.4.1. In general
2.132 : The relevance of comparable uncontrolled transactions or internal
data and the criteria used to achieve an ;arm's length division of the profits
depend on the facts and circumstances of the case. It is therefore not desirable
to establish a prescriptive list of criteria or allocation keys. See paragraphs
2.115-2.117 for general guidance on the consistency of the determination of the
splitting factors. In addition, the criteria or allocation keys used to split the profit
should:
· Be reasonably independent of transfer pricing policy formulation, i.e. they
should be based on objective data (e.g. sales to independent parties), not on
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data relating to the remuneration of controlled transactions (e.g. sales to
associated enterprises), and
· Be supported by comparables data, internal data, or both.
C.3.4.2 Reliance on data from comparable uncontrolled transactions
2.133 One possible approach is to split the combined profits based on the
division of profits that actually results from comparable uncontrolled
transactions. Examples of possible sources of information on uncontrolled
transactions that might usefully assist the determination of criteria to split the
profits, depending on the facts and circumstances of the case, include joint-
venture arrangements between independent parties under which profits are
shared, such as development projects in the oil and gas industry; pharmaceutical
collaborations, co-marketing or co-promotion agreements; arrangements
between independent music record labels and music artists; uncontrolled
arrangements in the financial services sector; etc.
C.3.4.3 Allocation keys
2.134 In practice, the division of the combined profits under a transactional
profit split method is generally achieved using one or more
allocation keys. Depending on the facts and circumstances of the case, the
allocation key can be a figure (e.g. a 30%-70% split based on evidence of a
similar split achieved between independent parties in comparable transactions),
or a variable (e.g. relative value of participant's marketing expenditure or other
possible keys as discussed below). Where more than one allocation key is used,
it will also be necessary to weight the allocation keys used to determine the
relative contribution that each allocation key represents to the earning of the
combined profits.
2.135 In practice, allocation keys based on assets/capital (operating assets, fixed
assets, intangible assets, capital employed) or costs (relative
spending and/or investment in key areas such as research and development,
engineering, marketing) are often used. Other allocation keys based for instance
on incremental sales, headcounts (number of individuals involved in the key
functions that generate value to the transaction), time spent by a certain group
of employees if there is a strong correlation between the time spent and the
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creation of the combined profits, number of servers, data storage, floor area of
retail points, etc. may be appropriate depending on the facts and circumstances
of the transactions.
Asset-based allocation keys
2.136 Asset-based or capital-based allocation keys can be used where there is a
strong correlation between tangible or intangible assets or capital employed and
creation of value in the context of the controlled transaction. See paragraph
2.145 for a brief discussion of splitting the combined profits by reference to
capital employed. In order for an allocation key to be meaningful, it should be
applied consistently to all the parties to the transaction. See paragraph 2.98 for
a discussion of comparability issues in relation to asset valuation in the context
of the transactional net margin method, which is also valid in the context of the
transactional profit split method.
2.137 One particular circumstance where the transactional profit split method
may be found to be the most appropriate method is the case where each party
to the transaction contributes valuable, unique intangibles. Intangible assets
pose difficult issues in relation both to their identification and to their valuation.
Identification of intangibles can be difficult because not all valuable intangible
assets are legally protected and registered and not all valuable intangible assets
are recorded in the accounts. An essential part of a transactional profit split
analysis is to identify what intangible assets are contributed by each associated
enterprise to the controlled transaction and their relative value. Guidance on
intangible property is found at Chapter VI of these Guidelines. See also the
examples in the Annex to Chapter VI "Examples to illustrate the Transfer Pricing
Guidelines on intangible property and highly uncertain valuation".
Cost-based allocation keys
2.138 An allocation key based on expenses may be appropriate where it
is possible to identify a strong correlation between relative expenses incurred
and relative value added. For example, marketing expenses may be an
appropriate key for distributors-marketers if advertising generates
material marketing intangibles, e.g. in consumer goods where the value of
marketing intangibles is affected by advertising. Research and development
expenses may be suitable for manufacturers if they relate to the development of
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significant trade intangibles such as patents. However, if, for instance, each
party contributes different valuable intangibles, then it is not appropriate to use
a cost-based allocation key unless cost is a reliable measure of the relative value
of those intangibles. Remuneration is frequently used in situations where people
functions are the primary factor in generating the combined profits.
2.139 Cost-based allocation keys have the advantage of simplicity. It is however
not always the case that a strong correlation exists between relative expenses
and relative value, as discussed in paragraph 6.27. One possible issue with cost-
based allocation keys is that they can be very sensitive to accounting
classification of costs. It is therefore necessary to clearly identify in advance
what costs will be taken into account in the determination of the allocation key
and to determine the allocation key consistently among the parties.
Timing issues
2.140 Another important issue is the determination of the relevant period of time
from which the elements of determination of the allocation key (e.g. assets,
costs, or others) should be taken into account. A difficulty arises because there
can be a time lag between the time when expenses are incurred and the time
when value is created, and it is sometimes difficult to decide which period's
expenses should be used. For example, in the case of a cost-based allocation
key, using the expenditure on a single-year basis may be suitable for some
cases, while in some other cases it may be more suitable to use accumulated
expenditure (net of depreciation or amortization, where appropriate in the
circumstances) incurred in the previous as well as the current years. Depending
on the facts and circumstances of the case, this determination may have a
significant effect on the allocation of profits amongst the parties. As noted at
paragraphs 2.116-2.117 above, the selection of the allocation key should be
appropriate to the particular circumstances of the case and provide a reliable
approximation of the division of profits that would have been agreed between
independent parties.
C.3.4.4 Reliance on data from the taxpayer's own operations
("internal data")
2.141 Where comparable uncontrolled transactions of sufficient reliability are
lacking to support the division of the combined profits, consideration should be
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given to internal data, which may provide a reliable means of establishing or
testing the arm's length nature of the division of profits. The types of such
internal data that are relevant will depend on the facts and circumstances of the
case and should satisfy the conditions outlined in this Section and in particular at
paragraphs 2.116-2.117 and 2.132. They will frequently be extracted from the
taxpayers' cost accounting or financial accounting.
2.142 For instance, where an asset-based allocation key is used, it may be
based on data extracted from the balance sheets of the parties to the
transaction. It will often be the case that not all the assets of the taxpayers
relate to the transaction at hand and that accordingly some analytical work is
needed for the taxpayer to draw a "transactional" balance sheet that will be
used for the application of the transactional profit split method. Similarly, where
cost-based allocation keys are used that are based on data extracted from the
taxpayers' profit and loss accounts, it may be necessary to draw transactional
accounts that identify those expenses that are related to the controlled
transaction at hand and those that should be excluded from the determination of
the allocation key. The type of expenditure that is taken into account (e.g.
salaries, depreciation, etc.) as well as the criteria used to determine whether a
given expense is related to the transaction at hand or is rather related to other
transactions of the taxpayer (e.g. to other lines of products not subject to this
profit split determination) should be applied
consistently to all the parties to the transaction. See also paragraph 2.98 for a
discussion of valuation of assets in the context of the transactional net margin
method where the net profit is weighted to assets, which is also relevant to the
valuation of assets in the context of a transactional profit split where an asset-
based allocation key is used.
2.143 Internal data may also be helpful where the allocation key is based on a
cost accounting system, e.g. headcounts involved in some aspects of the
transaction, time spent by a certain group of employees on certain tasks,
number of servers, data storage, floor area of retail points, etc.
2.144 Internal data are essential to assess the values of the respective
contributions of the parties to the controlled transaction. The determination of
such values should rely on a functional analysis that takes into account all the
economically significant functions, assets and risks contributed by the parties to
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the controlled transaction. In those cases where the profit is split on the basis of
an evaluation of the relative importance of the functions, assets and risks to the
value added to the controlled transaction, such evaluation should be supported
by reliable objective data in order to limit arbitrariness. Particular attention
should be given to the identification of the relevant contributions of valuable
intangibles and the assumption of significant risks and the importance, relevance
and measurement of the factors which gave rise to these valuable intangibles
and significant risks.
2.145 One possible approach not discussed above is to split the combined profits
so that each of the associated enterprises participating in the controlled
transactions earns the same rate of return on the capital it employs in that
transaction. This method assumes that each participant's capital investment in
the transaction is subject to a similar level of risk, so that one might expect the
participants to earn similar rates of return if they were operating in the open
market. However, this assumption may not be realistic. For example, it would
not account for conditions in ;capital markets and could ignore other relevant
aspects that would be revealed by a functional analysis and that should be taken
into account in a transactional profit split."
Para 6.3.14 Step 2: Allocation of Residual Profit (i.e. profit remaining after step
1) between the associated enterprises based on the facts and circumstances. If
the residual profit is attributable to intangible property then the allocation of this
profit should be based on the relative value of each enterprise's contributions of
intangible property.
20.9. In the UN Transfer Pricing Manual, Chapter VI, at para 6.3.17.4,
it is stated as follows.
"The PSM involves the determination of the factors that bring about the
combined profit, setting a relative weight to each factor and calculating the
allocation of profits between the associated enterprises. The contribution
analysis is difficult to apply, because external market data that reflect how
independent enterprises would allocate the profits in similar circumstances is
usually not available. The first step of the residual analysis often involves the
use of the TNMM to calculate a return and is not, in itself, more complicated
than the typical application of TNMM. The second step is, however, an
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additional step and often raises difficult additional issues relating to the valuation
of intangibles.
20.10. In the text for transfer pricing regulations of US Treasury, it is
given as follows.
"Allocate residual profit. The allocation of income to the controlled taxpayers'
routine contributions will not reflect profits attributable to the controlled group's
valuable intangible property where similar property is not owned by the
uncontrolled taxpayers from which the market returns are derived. Thus, in
cases where such intangibles are present there normally will be an unallocated
residual profit after the allocation of income described in paragraph(c)(3)(i)(A) of
this section. Under this second step, the residual profit generally should be
divided among the controlled taxpayers based upon the relative value of their
contributions of intangible property to the relevant business activity that was not
accounted for as a routine contribution. The relative value of the intangible
property contributed by each taxpayer may be measured by external market
benchmarks that reflect the fair market value of such intangible property.
Alternatively, the relative value of intangible contributions may be estimated by
the capitalized cost of developing the intangibles and all related improvements
and updates, less an appropriate amount of amortization based on the useful life
of each intangible. Finally, if the intangible development expenditures of the
parties are relatively constant over time and the useful life of the intangible
property of all parties is approximately the same, the amount of actual
expenditures in recent years may be used to estimate the relative value of
intangible contributions. If the intangible property contributed by one of the
controlled taxpayers is also used in other business activities(such as transactions
with other controlled taxpayers), an appropriate allocation of the value of the
intangibles must be made among all the business activities in which it is used."
20.11. A perusal of the above demonstrates that there is a general
consensus on the principles of allocation of residual surplus. Hence, we are
inclined to accept the following submissions of the assessee.
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"1. It is an admitted fact that as per rule 10B(1)(d) of the IT Rules, India
prescribes that an assessee can adopt -
a. either a contribution PSM, namely where the entire systems profits
are split amongst the various AEs, who are parties to the transactions in
question; or
b. a residual PSM, namely where each of the AEs, who are parties to
the transactions in question, are first assigned routine/ basic returns for
the routine functions performed by them; and thereafter, the residual
profits are split amongst the AEs, however, in a manner that whether or
not an assessee adopts a contribution PSM or a residual PSM, the profits,
would need to be split amongst the various AEs, who are parties to the
transactions in question, on the basis of reliable external market data,
which indicates how unrelated parties would have split such profits in
similar circumstances.
2. In other words, as per rule 10B(l)(d) of the IT Rules, a contribution or
residual PSM would need to be supplemented by a comparable PSM.
3. The terminologies, namely "contribution PSM", "residual PSM" and
"comparable PSM", have not been used in the IT Act or Rules, however,
they can be found in the TP guidelines of OECD [paragraphs 2.108 to
2.1491 and UN [paragraphs 6.3.13.1 to 6.3.181, by referring to the
similarity of the manner of application of the said methods, as contained
in the OECD and UN TP guidelines; and also in the IT Rules.
4. Having said that, PSM prescribed by the IT Rules of India is quite
unique, as compared to both OECD and UN TP guidelines, namely that
both OECD and UN provide flexibility to the taxpayer to adopt any of the
following sub-methods under the overall PSM, namely contribution PSM,
residual PSM or comparable PSM, whereas, the Indian IT Rules
mandatorily require a taxpayer to adopt a comparable PSM to supplement
either a contribution or residual PSM.
5. Such prescription to mandatorily use comparable PSM to split
entrepreneurial profits, by the Indian TP regulations, actually would make
the PSM virtually redundant in most cases, since, it is not possible to
obtain reliable market data on third party behavior in the matter of
splitting profits, except for in some rare cases of joint venture
arrangements. However, in cases of transactions involving either
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contribution or exploitation of intangibles by all the parties to the
transaction or where such transactions are extremely interrelated, of the
types as in the case of the appellant, where knowledge of third party
behavior is impossible to possess, but where the case otherwise deserves
the treatment of PSM, then the prescription to mandatorily use a
comparable PSM would render the whole machinery of PSM under the
Indian TP regulations a nullity & impossible to be implemented.
6. This is exactly what the UN has provided in its TP guidelines
relating to comparable PSM, namely that such method is seldom used,
since reliable external market date on third party behavior in the matter of
splitting profits are often not available [paragraph 6.3.15 of UN TP
guidelines].
7. Describing the comparable PSM, the OECD held in its guidelines that
external data for comparable PSM can be available in cases of joint
venture agreements between independent parties under which profits are
shared, such as development projects in the oil and gas industry;
pharmaceutical collaborations; co-marketing or co-promotion agreements;
arrangements between independent music record labels and music artists;
uncontrolled arrangements in the financial services sector; etc [paragraph
2.133 of the OECD TP guidelines].
8. Thus, typically, comparable PSM can be applied in industries, where
joint venture arrangements exist. However, for industries, like the one of
telecommunication connectivity services carried on by the Equant or Global
One Group, where the key intangible used by the Group is the proprietary
network, without which the services cannot be rendered; and thus
existence of joint venture arrangements between third parties is not
conceivable, the application of comparable PSM would be an impossibility.
9. The OECD further acknowledges that where comparable
uncontrolled transactions of sufficient reliability are lacking to support the
division of the combined profits, consideration should be given to internal
data, which may provide a reliable means of establishing or testing the
arm's length nature of the division of profits, meaning that resort to either
contribution or residual PSM may be made, without the same having to
pass through the compulsory rigors of comparable PSM
[paragraph 2.141 of the OECD TP guidelines].
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10. Further, many of the global TP specialists have commented on the
lack of reliable third party data, which often renders comparable PSM
impossible to apply for splitting profits amongst related parties, except for
in the limited cases of joint venture arrangements and determination of
royalty, where again, the split of profits between the licensor and the
licensee can be discernible on the face of accounts. Extracts from a few of
the said articles/ books are reproduced below for ease of reference -
a. J.P. Warner and H.B. McCawley, Transfer Pricing: The Code and the
Regulations, note 70, at A-144; and T. Horst. Profit Split Methods 0,60 Tax
Notes (1993), at 335 - "The comparable profit split method is rarely
applied, as information on comparable reference transactions will
not normally be available."
b. Transfer Pricing and Corporate Taxation: Problems, Practical
Implications - Chapter 3.5 - page 31 - Authored by Elizabeth A. King - " ....
Practitioners rarely use comparable profit split method, because pairs of
sufficiently comparable companies can rarely be found."
c. Practical Guide to U.S. Transfer Pricing, Robert T. Cole, Chapter 10,
Profit Split Method authored by Harlow N. Higinbotham; Page number 10-
52: - "Numerous commentators have cited difficulties in identifying and
documenting information on comparable independent transactions as
potentially insurmountable obstacle to the practical realization of CPSM.
This pessimistic viewpoint overlooks a relatively voluminous body of
evidence and experience in the intellectual property area where such
calculations are routinely, if somewhat roughly, applied in valuing license
transactions".
d. Transfer Pricing Rules and Compliance Handbook - Page number 33
- 0.2 Comparable Profit Split Method - Authored by Marc M. Levey, C.
Wrappe Steven and Steven C. Wrappe - " .... The use of comparable profit
split method will be limited because it will typically be difficult to find
comparable companies engaged in transactions that are similar to those of
both the buyer and the seller, and data delineating how the independent
parties shared the combined profits from a comparable transaction rarely
exists. Finding a comparable transaction is made more difficult because
the regulations provide that the comparability degree of similarity not only
of the function, risk, but also of contractual terms."
11. In view of the above discussions emanating from the OECD and UN
TP guidelines; and also commentaries of several transfer pricing experts, it
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is evident that comparable PSM is rarely used internationally in view of
lack of reliable external data with respect to third party behavior to split
profits; and OECD and UN clearly give taxpayers an option to adopt
anyone of the three sub- methods under the overall PSM, namely
contribution PSM, residual P'SM and comparable PSM, without requiring
the contribution and residual PSMs to mandatorily pass through the sanity
of comparable PSM, being a mandate given under the Indian TP
regulations, in the form of rule10OB(I)(d) of the IT Rules. Thus, such
compulsory mandate would render the entire mechanism PSM unworkable
in India, even in the most deserving of cases.
12. It is a golden and accepted rule of jurisprudence that an
interpretation, which makes a statute or rule unworkable or impossible to
be complied with, should be avoided; and recourse need to have to the
interpretation, which would make the statute or rule workable and also
subserve the purpose for which it has been enacted. In this connection,
reference is invited to the ruling of the Hon'ble Supreme Court in the case
of Superintendent of Taxes vs. Onkarmal Nathumal Trust [AIR 1975 SC
2065], where it has been held that "The law in its most positive and
peremptory injunctions, is understood to disclaim, as it does in its general
aphorisms, all intention of compelling performance of that which is
impossible" ... where the law creates a duty or charge, and the party is
disabled to perform it, without any default in him, and has no remedy
over, there the law will in general excuse him; and though impossibility of
performance is in general no excuse for not performing an obligation
which a party has expressly undertaken by contract, yet when the
obligation is one implied by law, impossibility of performance is a good
excuse.
13. The requirement contained in rule 10B(1)(d) of the IT Rules of
mandatory adoption of comparable PSM in all cases of PSM is a lacuna,
which renders the entire scheme or mechanism of PSM virtually
redundant, otiose and impossible to comply with even in the most
deserving of cases, namely where there can be no doubt that the AEs, who
are parties to the transactions in question, contribute and exploit non-
routine or unique intangibles, or the transactions are so interrelated that
they cannot be evaluated separately for the purposes of determining the
ALP thereof.
14. Now, it is submitted that such lacuna is curable even by maintaining,
and without disturbing the overall spirit and concept of PSM, as enshrined
in rule 10B(1)(d) of IT Rules, and as also understood in the OECD and UN
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TP guidelines, through interpreting rule 10B(1)(d) in a manner that the
same provides an option and not compulsory mandate to apply a
comparable PSM in a case where reliable external data to gauge third
party behavior is impossible to be obtained.
15. In this connection, reference is invited to the ruling of the Hon'ble SC
rendered in the case of M.Pentiah and others vs. Muddala Veeramallappa
and others (1961 AIR 1107), where the Hon'ble Court quoted with
approval, the famous words on interpretation of statutes said by Lord
Denning in the case of Seaford Court Estates Ltd. Vs. Asher(1), namely :
"When a defect appears a Judge cannot simply fold his hands and blame
the draftsman. He must set to work on the constructive task of finding the
intention of Parliament.............. and then he must supplement the written
word so as to give "force and life" to the intention of the legislature.
..........A judge should ask himself the question how, if the makers of the
Act had themselves come across this ruck in the texture of it, they would
have straightened it out? He must then do as they would have done. A
Judge must not alter the material of which the Act is woven, but he can
and should iron out the creases."
16. In other words, in case the Hon'ble Tribunal perceives that the
requirement contained in rule 10B(1)(d) of the IT Rules of mandatory
adoption of comparable PSM in all cases of PSM actually renders the entire
scheme or mechanism of PSM virtually redundant, otiose and impossible
to comply with, even in the most deserving of cases, namely where there
can be no doubt that the AEs, who are parties to the transactions in
question, contribute and exploit non routine or unique intangibles, or the
transactions are so inter related that they cannot be evaluated separately
for the purpose of determining the ALP thereof, however where reliable
external data to gauge third party behavior is impossible to be obtained,
then the requirement for adoption of comparable PSM should be dispensed
with, and the assessee should be given an option to adopt a residual or
contribution PSM, when such sub-methods of PSM are otherwise accepted
globally, both under the OECD and UN TP guidelines, and also in rule
10B(1)(d) itself.
17. It is submitted that applying such an interpretation would not
tantamount to altering the overall mechanism of PSM under the Indian TP
regulations, but would merely supplement life and force into rule 10B(1)(d)
of the IT Rules, in order to make the mechanism of PSM actually workable
in India, and not rendered otiose on the ground of impossibility of
performance."
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20.12. In view of the above discussion, we are of the considered opinion
that the TPO, should determine the ALP by adopting residual PSM as the MAM
and by allocating residual profits based on the relative value of each enterprise's
contribution, as suggested in various commentaries.
20.13. In any event, the legislature has introduced Rule 10AB by the IT(Sixth
Amendment) Rules, 2012 w.e.f. 1.4.2012 under the sub head "Other method of
determination of ALP". This is extracted for ready reference.
"Rule 10AB: For the purposes of clause (f) of sub section(1) of section 92C, the
other method for determination of the arm's length price in relation to an
international transaction shall be any method which takes into account the price
which has been charged or paid, or would have been charged or paid, for the
same or similar uncontrolled transaction, with or between non-associated
enterprises, under similar circumstances, considering all the relevant facts."
While introducing the Amendment the CBDT Circular is referred to below.
"The Central Board of Direct Taxes, vide Notification No.18/2012
(F.No.142/5/2012-TLP) dt. 25th May,2012 introduced the sixth method in TP,
referred to as the "Other Method," with effect from 1st April,2012, i.e. on and
from the Assessment Year 2012-13, through inserting rule 10AB, read with
clause (f) of rule 10B(1) of the IT Rules. The said "Other Method" is like an
omnibus or residual one, in the sense that it refers to any method, which takes
into account the price charged or paid or which would have been charged or
paid, for similar uncontrolled transactions, with or between non-AEs, would
have been charged or paid, for similar uncontrolled transactions, with or
between non AEs, under similar circumstances, considering all the relevant facts.
Thus, the said "Other Method" would ideally operate where none of the methods
specified under the IT Act and Rules would apply, with reference to the
descriptions/definitions provided in rule 10B(1) of the IT Rules, yet there is a
compelling need to arrive at the ALP of any transaction between AEs, as per the
requirements of the TP regulations, couched in Chapter X of the IT Act."
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Though the note does not indicate much as to the purpose, it can be seen that
the purpose and objective of introduction of this rule is to determine the "arm's
length price", whenever the methods suggested result in practical difficulties by
adopting generally accepted methods which are not specifically listed. It is a
procedural provision aimed at arriving at the "ALP". Thus, in our , it is
retroactive. "ALP", ideally, should be the same, in the previous years, as in the
subsequent years when the facts and circumstances are the same, irrespective
of the method adopted for arriving at the same. One cannot be heard saying
that the "ALP" arrived by one methord cannot be acceptable for the earlier year
as that method was not notified by the CBDT. In our view, "Arms Length Price"
should be the same, with minor variations. When a new method is allowed, with
the objective of enabling determination of the proper ALP, in our
comprehension, such a provision operates retroactively, and can be used to
determine the ALP in the earlier assessment years also. When the aim and
object of introducing a Rule allowing the assessee to adopt any other method
for determining the ALP, by introducing S.10AB, is to remove unintended
practical difficulties and only to enable proper determination of the ALP, the
Rule, in our view, has to be considered as retroactive and, thus, retrospective.
20.14. The Ld.Counsel for the assessee has relied on the
decision of the Hon'ble Madras High Court in the case of Acendas India
P.Ltd. vs. DCIT in ITA 1736/Mds/2011 and the decision of the Bangalore
Bench of the Tribunal in the case of Tally Solutions P.Ltd. vs. DCIT in ITA
1235/Bng/2010, for the proposition that suitable adjustments and methodology
prescribed for evaluation of an international transaction are permissible and
that the prescribed methods may not be rigidly followed, as was
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done in those cases.. He has also relied on the decision of Hon'ble Supreme
Court in the case of Allied Motors P.Ltd. vs. CIT, 224 ITR 677(SC).
20.15. These decisions support the contentions of the assessee. Thus,
we hold that Rule 10AB can be applied for the impugned AYs also, for
determining the ALP .
21. In view of the above discussion, this issue is remitted to the file of the AO
for fresh adjudication in line with the observations made by this Bench on this
issue. In the result, this ground of transfer pricing adjustment for both the AYs
is set aside to the file of the Assessing Officer.
22. In the result, the appeals for both the Assessment Years are allowed in
part.
Order pronounced in the Open Court on 15th April,2014.
Sd/- Sd/-
(A.D. JAIN) (J.SUDHAKAR REDDY)
JUDICIAL MEMBER ACCOUNTANT MEMBER
Dated: the 15th April, 2014
*manga
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Copy of the Order forwarded to:
1. Appellant; 2.Respondent; 3.CIT; 4.CIT(A); 5.DR; 6.Guard File
By Order
Asst. Registrar
59
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