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From the Courts »
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 ITO vs. Vikram A. Pradhan (ITAT Mumbai)

Sumitomo Corporation India Pvt. Ltd. Through Mr. Mitsutaka Yasuda Vs. Commissioner Of Income Tax
July, 28th 2016
         IN THE HIGH COURT OF DELHI AT NEW DELHI
%                                           Judgment delivered on: 22 .07.2016

+       ITA 381/2013

SUMITOMO CORPORATION INDIA PVT. LTD.
THROUGH MASAHIRO MARUYAMA                                    ..... Appellant
                     versus
COMMISSIONER OF INCOME TAX                                    ..... Respondent

                                     WITH
+       ITA 738/2015

SUMITOMO CORPORATION INDIA PVT. LTD.
THROUGH MR. MITSUTAKA YASUDA                                 ..... Appellant
                    versus

COMMISSIONER OF INCOME TAX                                   ..... Respondent

                                     WITH

+       ITA 382/2013

SUMITOMO CORPORATION INDIA PVT. LTD.
THROUGH MASAHIRO MARUYAMA                                    ..... Appellant

                                   versus

COMMISSIONER OF INCOME TAX                                   ..... Respondent

                                     AND

+       ITA 702/2014

SUMITOMO CORPORATION INDIA PVT. LTD.
THROUGH MR. MITSUTAKA YASUDA                                 ..... Appellant
                    versus

COMMISSIONER OF INCOME TAX                                   ..... Respondent



ITA 381/2013 & Connected Matters                                    Page 1 of 32
Advocates who appeared in these cases:
For the Appellants   : Mr. C.S. Aggarwal, Senior Advocate With Mr.
                       Prakash Kumar and Mr. Himanshu Sinha,
                       Advocates.
For the Respondents  : Mr. Ashok K Manchanda, Senior Standing
                       counsel.

CORAM:
JUSTICE S.MURALIDHAR
JUSTICE VIBHU BAKHRU

                                   JUDGMENT
VIBHU BAKHRU, J

1.      The Assessee has preferred these appeals under Section 260A of the

Income Tax Act, 1961 (hereafter ,,the Act) impugning the orders passed by

the Income Tax Appellate Tribunal (hereafter 'the Tribunal) in respect of

Assessment Years (hereafter ,,AYs) 2007-08, 2008-09, 2009-10 and 2010-

11.


2.      The controversy in these appeals relates to the Transfer Pricing

Adjustments directed by the Tribunal in respect of the commission earned

by the Assessee with respect to certain international transactions with its

Associated Enterprises (hereafter 'AEs') which are referred to as "indenting

transactions". The Tribunal has directed that the Arms Length Price

(hereafter ,,ALP) in respect of such transactions be determined on the basis

of the average rate of commission earned by the Assessee in respect of



ITA 381/2013 & Connected Matters                                Page 2 of 32
transactions with unrelated parties ('Non-AEs'). The Assessee claims that

the said direction is patently erroneous as the indenting transactions with

Non-AEs are not comparable with indenting transactions with its AEs; the

volume of the indenting transactions with Non-AEs is only a small fraction

of such transactions and the concerned products are also different. It is also

the case of the Assessee that the Tribunal has not followed any particular

method in directing the determination of ALP and as such, the same is

wholly arbitrary. The Assessee urges that it is incumbent on the Tribunal to

first determine the most appropriate method for determining the ALP and,

thereafter, compute the ALP in conformity with the discipline of that

method.


3.      The controversies involved in these appeals as well as the material

facts are similar. The questions of law framed in these appeals are also

identical and read as under:


                  "(1) Whether the Income tax Appellate Tribunal was
                 right in applying and computing arms length price with
                 associated enterprise on indenting transactions by
                 applying average rate of commission with non-associated
                 enterprise in spite of difference in the turnover and the
                 purported segments and no such correction/computation
                 on this account was made by the Transfer Pricing
                 Officer?




ITA 381/2013 & Connected Matters                                   Page 3 of 32
                 (2) Whether the Income Tax Appellate Tribunal has
                 disregarded the assessees claim that they had followed
                 Transactional Net Margin Method? (This question will
                 include the submission of the appellant that the Transfer
                 Pricing Officers order does not adopt any specified
                 method)"

4.      For the purposes of addressing the above questions, only the facts

obtaining in ITA No. 381 relevant to AY 2007-08 (ITA No.381/2013) are

referred herein.


5.      The Assessee was incorporated in 1997 and has its offices in Delhi,

Mumbai and Chennai. The Assessee is a subsidiary of Sumitomo

Corporation Japan (hereafter the ,,SCJ) which is one of the largest general

trading companies (Sogo Shosha) of Japan. SCJ is the flagship company of

the Sumitomo group which is a large conglomerate of companies. The

Assessee has seven operating divisions and deals in various products.


6.      The Assessee filed its return of income for AY 2007-08 on

25.10.2007 declaring a total income of Rs.15,35,40,749/-.


7.       The Assessee reported the following international transactions for

FY 2006-07:-




ITA 381/2013 & Connected Matters                                   Page 4 of 32
     S. No. Type of International transaction                Total value of
                                                           transaction (Rs.)

     1.         Purchase of goods                                102,825,122

     2.         Sale of goods                                      1,294,774

     3.         Rendering of support services                    304,525,711

     4.         Interest Earned                                       722,621

     5.         Services received                                 10,335,041

     6.         Reimbursement of expenses (payment)                   628,502

     7.         Reimbursement of Expenses (receipts)              14,036,868




8.        The Assessee claimed that the transactions of purchase and sale of

goods with its AEs were on principal to principal basis. And, the income

from rendering support services was in relation to transactions (referred to

as indenting transactions) where the Assessee only rendered assistance by

following up with the customers and the sale/purchase of goods was done

directly by the AE. The Assessing Officer (hereafter ,,the AO) made a

reference to the Transfer Pricing Officer (hereafter ,,TPO).

The Transfer Pricing (TP) approach of the Assessee

9.        In terms of Section 92E of the Act read with Rule 10E of the Income

Tax Rules, 1962 (hereafter 'the Rules'), the Assessee furnished the transfer



ITA 381/2013 & Connected Matters                                 Page 5 of 32
pricing report in respect of its international transactions with AEs. The

Assessee considered Transactional Net Margin Method (hereafter 'TNMM')

as the most appropriate method and selected the ratio of gross profit to

operating costs - Berry Ratio - as the Profit Level Indicator (hereafter 'PLI').

The Assessee computed its gross profit on trading transactions (sales on

principal to principal basis) by reducing the cost of sales from the aggregate

value of sales made to AE as well as Non-AEs. The gross profit on trading

segment so computed was then added to commission earned to compute the

total gross profits. This amount was taken as the numerator and was

divided by operating expenses to compute the Berry Ratio (the PLI selected

by the Assessee) at 1.79%

10.     The Assessee claimed that its transaction with the AEs were on arms

length basis and supported this claim by the data relating to a set of 23

comparable companies. The weighted average arithmetic mean (adjusted

using data for financial years 2004-05, 2005-06 and 2006-07) of the PLI of

these comparable companies was computed at 1.18%.

Proceedings before the TPO/AO

11.     The TPO noticed that the Assessee's transactions could be classified

into two types - "Indent sales" and "Proper sales". In respect of "Indent



ITA 381/2013 & Connected Matters                                   Page 6 of 32
sales", the Assessee merely indents for the goods which are supplied

directly by the supplier to the purchaser; the Assessee only receives

commission on the value of the invoice or the quantity of goods supplied.

In case of "Proper sales", the Assessee purchases the goods and sells the

same. The purchases made are against confirmed orders and thus, the

transactions of purchase and sale are back to back. The Assessee acquires

the title to goods only for a brief moment; this is described as a "flash title".

Such sale transactions are on a profit margin.


12.     The TPO examined the transfer pricing report submitted by the

Assessee and noticed that the PLI used by the Assessee did not take into

account the cost of sales. The TPO held that the use of such ratio (Berry

ratio) as the PLI was not permissible under Rule 10B(1)(e) of the Rules

which contained provisions for computation of ALP by TNMM.

According to the TPO, the TNMM could be applied only by determining

the net profit margin in relation to the costs incurred, sales affected or

assets employed. He reasoned that since the denominator used by the

Assessee for computing the Berry ratio excluded the cost of goods, the PLI

so worked out was not in accordance with Rule10B(1)(e) of the Rules. The

TPO further proceeded to hold that the Assessee had itself indicated that




ITA 381/2013 & Connected Matters                                    Page 7 of 32
functions performed and risks undertaken in respect of the international

transactions of "Proper sales" and "Indent sales" were similar and,

accordingly, held that the indenting transactions with AE ought to be

compared with the trading transactions entered into by the Assessee with

Non-AEs.


13.     He held that the commission earned by the Assessee ought to be

expressed as a percentage of FOB price of goods sourced through the

Assessee because the Assessee had played a major role in identifying

suppliers, support in after sales services, business promotion, etc.        He

further held that the Assessee had assumed significant risks and the

commission/service income model did not account for the fair

compensation for the value addition made by the Assessee.


14.     The TPO rejected the use of Berry Ratio as the PLI for several

reasons. First of all, he held that the Assessee had developed unique

intangibles like supply chain intangibles and human assets intangibles,

which according to him had resulted in huge commercial and strategic

advantage to the AE and had enhanced the profit potential of the AE. The

Berry Ratio could not be used in cases where the Assessee was using

valuable and unique intangibles. Secondly, he held that Berry Ratio was



ITA 381/2013 & Connected Matters                             Page 8 of 32
very sensitive to cost base and it was difficult to accurately compute the

cost base of comparable companies on the basis of the available data as

different companies had accounted for their costs differently.


15.     The TPO finally concluded that the gross margin earned by the

Assessee in its trading segment with Non AEs - computed at 4.45% - ought

to be taken as the rate of commission on the FOB price of the goods

sourced through the Assessee in respect of indenting transactions with the

AEs. He, accordingly, computed the arms length commission income from

indenting transaction with AEs at Rs.85,68,44,783/- (being 4.45% of

Rs.19,25,49,38,946) and accordingly directed enhancement of Assessee's

income by an amount of Rs.55,26,16,748/- after reducing the commission

of Rs.30,42,28,035/- as declared by the Assessee.





16.     Pursuant to the order dated 28th October, 2010 passed by the TPO,

the AO issued a draft assessment order on 23 rd December, 2010. The

Assessee filed objections against the draft assessment order before the

Dispute Resolution Panel (hereafter 'DRP') which were not accepted and

the DRP issued its directions on 27th September, 2011. The AO passed the

final assessment order on 25th October, 2011 pursuant to the DRPs

directions.



ITA 381/2013 & Connected Matters                                 Page 9 of 32
Proceedings before the Tribunal


17.     Aggrieved by the final assessment order, the Assessee preferred an

appeal before the Tribunal urging several grounds. The Assessee, inter

alia, contended that the functions performed and the risks undertaken in

respect of principal to principal transactions with Non-AEs were not similar

to the indent based transactions with AEs and that the TPO had erred in

proceeding on the basis that the said transactions were comparable. The

Assessee claimed that in respect of indent transactions, the credit risks and

foreign exchange fluctuation risks were negligent and the Assessee's

function was merely to follow up on behalf of the customers and not to deal

with them.


18.     The Assessee further claimed that the TPO had "erred in comparing

indent based transactions of AEs with principal based transactions of Non-

AEs and not with indent transaction of Non-AE after allowing appropriate

adjustments" and, therefore, the addition was misconceived, misplaced and

unsustainable.




ITA 381/2013 & Connected Matters                                 Page 10 of 32
19.     The Assessee contended that the TPO/DRP had erred in disregarding

the transfer pricing approach adopted by the Assessee for determining the

ALP of its international transactions. It was urged that the Assessee's use of

TNMM with Berry Ratio as the PLI had been discarded without any valid

justification.


20.     The Tribunal referred to the tabular statement wherein the TPO had

computed the gross profit margin from trading transactions with AEs at

4.80%; gross profit margin on trading transactions with Non-AEs at 4.45%;

and commission earned at 1.61%. The Tribunal also referred to the order

of the TPO wherein he had referred to the Assessee's letter dated 19 th

October, 2010 in which the Assessee had bifurcated the commission earned

between commission from AEs and Non-AEs; the commission from Non-

AEs was declared as 2.26% on value of goods while the commission from

AE transactions was computed at 1.58%.


21.     The Tribunal accepted the Assessee's contention that the nature of

indenting transactions were different from trading transactions. The trading

transactions involved certain risks and finances whereas in respect of

indenting transactions, the Assessee did not incur any financial obligation

or carry any significant risks. The Tribunal found that the indent business



ITA 381/2013 & Connected Matters                                 Page 11 of 32
of the Assessee was nothing but trade facilitation, both in form as well as in

substance. It further noted that there was no material on record to regard the

indent transactions as trading transaction. The Tribunal further proceeded to

note and accept the Assessee's contention that it would be appropriate to

compare commission/service income earned by the Assessee in respect of

transactions with AEs with the similar transactions with Non-AEs.

However, the Tribunal rejected the Assessee's claim for an appropriate

adjustment on account of difference in volumes as well as the associated

risks. The Tribunal held that in the facts and circumstances of the case, no

adjustment as to the extent of volume was necessary as the Assessee had

entered into separate contracts for each transaction and it was not the

Assessee's case that each of such separate transaction with an AE was

greater in volume as compared to a similar transaction in the Non-AE

segment. The Tribunal then proceeded to direct that the commission

computed at the rate of 2.26% (i.e. the rate of commission in respect of

transactions with Non-AEs) be taken as the bench mark for determining

the ALP for commission earned in the AE segment.


22.     The Assessee has impugned the above decision before us in ITA

381/2013.




ITA 381/2013 & Connected Matters                                 Page 12 of 32
Submissions


23.     Mr C.S. Aggarwal, learned Senior Advocate, appearing for the

Assessee contended that the fundamental issue in these appeals related to

the determination of the most appropriate method to be adopted for

determining the ALP. He submitted that the Assessee in its TP studies

found TNMM to be the most appropriate method for determination of the

ALP and this method was also accepted in the preceding years. However,

the TPO had rejected the same and made the ALP adjustment without

reference to any particular method. He contended that the Tribunal also fell

in error in making an adjustment without reference to any particular

method.


24.     Mr Aggarwal submitted that even if the TPO or the Tribunal found

that Berry ratio was not an acceptable PLI, the said authorities could have

substituted the same with an appropriate PLI but could not have rejected the

TNMM as that was accepted as the most appropriate method in the

preceding years, that is, 2003-04 to 2006-07. He contended that there was

no material difference in the business model of the Assessee and, thus,

there was no reason for the TPO to depart from the method adopted in the

preceding years.



ITA 381/2013 & Connected Matters                                Page 13 of 32
25.     Next, Mr Aggarwal contended that the Tribunal had erred in

accepting the Assessee's submission that the commission from Non-AEs be

compared with the commission from AEs for two reasons. First of all, this

was a submission in the alternative; and secondly, this proposition was

coupled with a claim to make an economic adjustment on account of

volume and the difference in products. He further submitted that the

products in respect of which commission was earned in the Non-AE

segment were different from the special products in the AEs segment. He

handed over a tabular statement in support of his contention. This statement

indicated the products in respect of which indenting transactions were

entered into in the Non-AE and the AE segments. He pointed out that in

respect of products classified under the automotive, chemicals (plastic),

construction, machinery, minerals and energy, power, steel pipes, etc.

divisions, there were no indenting transactions in the Non-AE segment and,

therefore, there would be no comparable standards on the basis of which an

ALP adjustment could be made.


26.     Mr Manchanda, learned Senior Standing Counsel countered the

submissions made by Mr Aggarwal. He earnestly contended that the

Tribunal had applied the Comparable Uncontrolled Price (CUP) Method




ITA 381/2013 & Connected Matters                                Page 14 of 32
and had used an internal comparable transaction, which was from the same

company and the same industry, for determining the ALP. He submitted

that this was the most reliable method for computing the ALP and the

Assessee could not be heard to dispute the same. He earnestly contended

that the above method was proposed by the Assessee with certain economic

adjustments which, the Tribunal found were not justified. He submitted that

the Assessee had canvassed an adjustment on account of volume of

transactions between AE and Non-AEs segment and in support of its claim

had produced the brokerage rates for transactions in the security markets.

The Tribunal had rejected the same as it found that each transaction was a

separate transaction in terms of a separate contract and, therefore, any

discount on volumes was not warranted.


27.     With respect to the contention that the products dealt in the AE

segment were different from those in the Non-AEs segment, Mr

Manchanda, contended that there were only two product categories,

namely, telecom and transport where there were no comparables in the

Non-AEs segment. He urged that the commission earned by the Assessee

in respect of these two segments was at the rate in excess of 5% which was

above the average rate of commission of 2.26% in the Non-AE segment. He




ITA 381/2013 & Connected Matters                               Page 15 of 32
argued that if the said two product categories were excluded, the ALP

adjustment would increase. He further submitted that in order for the

Assessee to make good his claim that a comparison between AE segment

and Non-AEs segment was to be made product wise, the Assessee was

required to produce every contract/agreement and invoice in the two

segments which the Assessee had failed to do.


28.     Mr Manchanda further sought to contend that the Assessee had also

earned service fee for services which had been excluded while calculating

the commission earned in the Non-AE segment. He contended that if such

fees was included in the commission earned in the Non-AE segment, the

profit margin calculated in respect of such segment would increase

substantially from 2.26% and would result in a higher ALP adjustment.


Reasoning and Conclusion


29.     Before proceeding to address the issues, it would be relevant to refer

to Section 92C of the Act. The relevant extracts of which are set out

below:-


        "92C. (1) The arm's length price in relation to an international
        transaction or specified domestic transaction shall be
        determined by any of the following methods, being the most



ITA 381/2013 & Connected Matters                                  Page 16 of 32
        appropriate method, having regard to the nature of transaction
        or class of transaction or class of associated persons or
        functions performed by such persons or such other relevant
        factors as the Board may prescribe, namely :--

            (a) comparable uncontrolled price method;

            (b) resale price method;

            (c) cost plus method;
            (d) profit split method;

            (e) transactional net margin method;
            (f) such other method as may be prescribed by the Board.

         (2) The most appropriate method referred to in sub-section (1)
        shall be applied, for determination of arm's length price, in the
        manner as may be prescribed :
        Provided that where more than one price is determined by the
        most appropriate method, the arm's length price shall be taken
        to be the arithmetical mean of such prices:
        Provided further that if the variation between the arm's length
        price so determined and price at which the international
        transaction or specified domestic transaction has actually been
        undertaken does not exceed such percentage not exceeding
        three per cent of the latter, as may be notified by the Central
        Government in the Official Gazette in this behalf, the price at
        which the international transaction or specified domestic
        transaction has actually been undertaken shall be deemed to be
        the arm's length price:

        Provided also that where more than one price is determined by
        the most appropriate method, the arm's length price in relation
        to an international transaction or specified domestic transaction
        undertaken on or after the 1st day of April, 2014, shall be
        computed in such manner as may be prescribed and
        accordingly the first and second proviso shall not apply.



ITA 381/2013 & Connected Matters                                   Page 17 of 32
        Explanation.--For the removal of doubts, it is hereby clarified
        that the provisions of the second proviso shall also be
        applicable to all assessment or reassessment proceedings
        pending before an Assessing Officer as on the 1st day of
        October, 2009."



30.     It is apparent from the above that ALP has to be computed by the

most appropriate method as is referred to in Section 92C(1). Sub-rule (1)

of Rule 10C of the Rules postulates that the most appropriate method would

be one which is best suited to the facts and circumstances of each particular

international transaction and which provides the most reliable measure of

an ALP in relation to that transaction. It is, thus, necessary that before an

exercise is undertaken for making an ALP adjustment, the Assessee/TPO

must identify the most appropriate method for computation of ALP. Sub-

rule (2) of Section 10C of the Rules that postulates that the following

factors shall be taken into account for selecting the most appropriate

method:-

         "(2) In selecting the most appropriate method as specified in
         sub-rule (1), the following factors shall be taken into account,
         namely:--

              (a) the nature and class of the international transaction
                  [or the specified domestic transaction];

              (b)     the class or classes of associated enterprises entering
                     into the transaction and the functions performed by



ITA 381/2013 & Connected Matters                                       Page 18 of 32
                     them taking into account assets employed or to be
                     employed and risks assumed by such enterprises;
              (c) the availability, coverage and reliability of data
                  necessary for application of the method;

              (d) the degree of comparability existing between the
                  international transaction [or the specified domestic
                  transaction] and the uncontrolled transaction and
                  between the enterprises entering into such
                  transactions;
              (e) the extent to which reliable and accurate adjustments
                  can be made to account for differences, if any,
                  between the international transaction [or the specified
                  domestic     transaction]    and    the    comparable
                  uncontrolled transaction or between the enterprises
                  entering into such transactions;

              (f) the nature, extent and reliability of assumptions
                  required to be made in application of a method."



31.     The Assessee had, for reasons indicated in its transfer pricing report,

adopted TNMM as the most appropriate method with Berry ratio as the

PLI. Although, the TPO found fault in the use of Berry ratio - according to

him, the same was not permissible under Rule 10B(1)(e) of the Rules - he

did not proceed to select the most appropriate method for computation of

ALP.       This, in our view, would be essential as the reliability of the

determination of the ALP is in turn dependent on the effectiveness of the

method in relation to the controlled transaction being tested. In the present




ITA 381/2013 & Connected Matters                                   Page 19 of 32
case, the dispute essentially relates to the commission earned by the

Assessee in respect of transaction with its AEs.


32.     We are inclined to accept Mr Aggarwal's contention that although the

TPO had discarded the method adopted by the Assessee, it had not

followed any particular method in making the ALP adjustment. It appears

that the TPO has adopted a hybrid method. He imputed the character of

trading transactions to the indenting transactions entered into by the

Assessee with its AEs. Having done so, he compared the profit margin

realized by the AE from such transactions with profit margin realized by

the AE from a comparable uncontrolled transaction. The said approach was

rejected by the Tribunal - and, in our view, rightly so - as it was not

permissible for TPO to re-characterize the tested transaction.


33.     We find no infirmity with the Tribunal's finding that indenting

transactions reported by the Assessee were plainly in the nature of

facilitating trade where the Assessee was required to do nothing more than

to follow up the customers for facilitation of the transaction. The Assessee

was not required to raise any invoice for sale and purchase and its financial

commitment and risk were inconsiderable.




ITA 381/2013 & Connected Matters                                 Page 20 of 32
34.     However, we find that the Tribunal erred in proceeding to determine

the ALP on the basis of the rate of commission reported by the Assessee in

respect of indenting transactions with Non-AEs, without further

examination as to the similarity between the two transactions. The Tribunal

effectively used the CUP Method for imputing the ALP of Assessee's

indenting transaction with AEs. This may well be the most appropriate

method to be used for determining the ALP. However, if the Tribunal

thought that this was the case, it was necessary for the Tribunal to conduct

a further in-depth inquiry as to the relevant uncontrolled transactions. It is

well settled that in applying the CUP Method, a very high degree of

similarity between the controlled and uncontrolled transactions is required.

It is the Assessee's case that volume of such transactions in the Non-AEs

segment was insignificant as compared to the transactions in the AE

segment against such transactions were only in a few product categories. If

the average rate of commission on such transactions was to be applied to

the FOB value of the goods involved in the indenting transactions with

AEs, the Tribunal would have to satisfy itself that there is no significant

variation in the rate of commission between different products. This would

confirm that the dissimilarity between the product categories did not have a




ITA 381/2013 & Connected Matters                                 Page 21 of 32
vital bearing on the rate of commission. The Tribunal did not conduct any

such enquiry and it is material to note that the TPO also did not conduct

any such exercise. In our view, this methodology was used by the Tribunal

at a stage at which - given the extent of the examination required - it may

not be feasible.


35.     One of the principal issues before the Tribunal concerned the

applicability of TNMM with Berry ratio as the PLI, as the most appropriate

method. Mr Aggarwal had sought to contend before us that the TPO had

rejected the PLI of Berry ratio but had not rejected the TNMM as the most

appropriate method and, therefore, it was incumbent upon him to replace

the PLI with whichever ratio he considered appropriate as had been done in

the preceding years. He contended that on principles of consistency, he was

required to follow the TNMM method.          There is much merit in the

contention that a method once considered appropriate should be

consistently applied unless for good reasons, the TPO decides otherwise.

However, this is a salutary guiding principle and would not fetter the TPO

from independently examining the transfer pricing approach reported by the

Assessee. The purpose of imputing ALP to international transactions is to

ensure that the real income of the Assessee in respect of international




ITA 381/2013 & Connected Matters                               Page 22 of 32
transactions (and with effect from 1st April, 2013 certain domestic

transactions) are charged to tax under the Act. It is thus, implicit that the

exercise to determine such income be undertaken for each assessment year.


36.     The special provisions for assessing income from international

transactions having regard to ALP is of a recent vintage and was introduced

by the Finance Act, 2001. The provisions under Chapter X of the Act have

undergone significant changes over a period of time. The principles for

computation of ALP are also evolving and as such, we are not persuaded to

accept that the TPO was required to simply follow the transfer pricing

methodology adopted in the preceding years. It is also well settled that

principles of res judicata do not apply in assessment proceedings as

assessment for each year is a separate proceeding and inquiry into the ALP

in respect of international transactions under Section 92 of the Act is in aid

of assessing the income chargeable to tax for the year under consideration.


37.     We may now also consider Mr Aggarwal's contention that Berry

ratio had been accepted as the appropriate PLI in respect of Sogo Shosha

establishments and, therefore, the same should also be accepted in the case

of the Assessee. The term ,,Sogo Shosha' is used in respect of large general

trading companies that include within their fold a large network of



ITA 381/2013 & Connected Matters                                 Page 23 of 32
subsidiary and affiliated companies, thus, enabling the said companies to

leverage their network for their business. It is reported that these companies

account for a substantial portion of the Japan's overall trade across the

world. However, it is not necessary that the trading arrangement between

Sogo Shosha enterprises and their affiliates/ subsidiaries in India be

identical or similar. It is also not possible to assume - without it being

established as a fact - that all international transactions entered into by

Indian enterprises with their related Sogo Shosha enterprises would be on

identical footing. Thus, it is not apposite to determine the ALP without

examining the nature of international transaction in each case.


38.     Insofar as the use of Berry ratio as a PLI is concerned, the TPO had

rejected the same for three reasons. First of all, he held that the same is not

permissible under Rule 10B(1)(e) of the Rules; secondly, he held that the

Assessee had acquired substantial intangibles in the form of supply chain

intangibles and human resources intangibles and Berry ratio was not an

apposite PLI in cases where an Assessee used substantial intangibles for its

business. Thirdly, the TPO held that the rate of commission on indenting

transaction was determined in reference to the value of goods and not on

the basis of any cost incurred by the Assessee.




ITA 381/2013 & Connected Matters                                  Page 24 of 32
39.     In our view, the decision of the TPO that Rule 10B(1)(e) of the Rules

does not permit use of Berry ratio is not sustainable. The TPO had reasoned

that under Rule 10B(1)(e) of the Rules, only the total costs incurred, sales

effected or assets employed could be used as denominator of the ratio

chosen as the PLI. This is plainly erroneous. Rule 10B(1)(e)(i) of the Rules

reads as under:-


           "10(e) transactional net margin method, by which,--

           (i) the net profit margin realised by the enterprise from an
           international    transaction or     a  specified    domestic
           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;"





40.     It is clear from the plain language of the above quoted clauses that

the net profit margin realised could be computed having regard to "any

other relevant base". Berry ratio is a ratio of operating profits to operating

expenses. In cases where operating expenses is considered as a relevant

base, there would be no difficulty in using Berry ratio as the PLI in terms of

Rule 10B(1)(e)(i) of the Rules.




ITA 381/2013 & Connected Matters                                 Page 25 of 32
41.     Insofar as the other two reasons are concerned, it is necessary to

understand the substratal rationale of using Berry ratio as the PLI. The said

ratio was used by the Internal Revenue Service (IRS) in the USA in the

case of E.I. Du Pont DE Nemours & Co. v. United States: 608 F.2d 445

(1979) to sustain their stand that substantial part of the profits of a

subsidiary in Switzerland were rightly allocated to Du Pont. Charles H.

Berry, an economist (since deceased) provided necessary evidence in

support of IRS's stand by using the ratio of Operating Profits to Selling,

General and Administration Expenses to show that more than fair share of

profits had been transferred to Du Pont's Swiss subsidiary. This ratio came

to be known by the name of the economist who had used it in the

aforementioned case. The aforesaid case concerned the allocation of profits

between Du Pont De Nemours, an American Company engaged in

manufacture of chemicals, and its wholly owned subsidiary established in

Switzerland (Du Pont International S.A. referred to as 'DISA'). The said

subsidiary was established in 1959. At the material time, Section 482 of the

Internal Revenue Code empowered the Secretary of the Treasury (or his

delegate) to "distribute, apportion, or allocate gross income, deductions,

credits, or allowances between or among such organizations, trades, or




ITA 381/2013 & Connected Matters                                 Page 26 of 32
businesses, if he determines that such distribution, apportionment, or

allocation is necessary in order to prevent evasion of taxes or clearly to

reflect the income of any of such organizations, trades, or businesses."


42.     The Treasury Regulations as in force during the relevant period

contemplated determination of ALP for sale by one controlled entity to

another by four methods (in order of preference); comparable uncontrolled

price method; the resale price method; cost plus method; and any other

appropriate method. Du Pont sold its chemical products to DISA and also

arranged for resale of such chemicals to the legitimate consumers. The said

transactions resulted in DISA reporting a profit margin of 35%. Du Pont

submitted the set of 21 comparable entities which it claimed performed

functions similar to DISA. IRS, on the other hand, introduced evidence to

show that six of the companies identified by Du Pont as similar to DISA

had reported average selling cost which were much higher than DISA. The

Court agreed with the evidence produced by IRS's expert that what a

business spends to provide services would be a reasonable indication of the

magnitude of those services.




ITA 381/2013 & Connected Matters                                 Page 27 of 32
43.     Berry ratio was used in the above context to show that the average

ratio in the case of 21 distributors was 129.3% and in the case of DISA, it

was 281.5% for the year 1959 and 397.1% in the year 1960. It is relevant

to note that in that case also the Commissioner of Revenue did not

reallocate the profits between DISA and Du Pont on the basis of Berry ratio

but on the basis of applying the resale price method. Berry ratio was only

introduced as an expert evidence by IRS to defend the challenge to such

reallocation. In other words, the said ratio was only used to show that DISA

had made extraordinarily high profits and IRS had rightly exercised its

jurisdiction to reallocate such profits of DISA to Du Pont. The Du Pont's

challenge to the said ratio as being inappropriate measure was rejected by

the Court in the following words:-


         "Whatever the general limits of any particular gauge of
         industry profitability, plaintiff cannot escape the basic thrust
         of defendant's proof. Defendant has shown that DISA made
         extraordinarily high profits which the Commissioner
         reallocated to an economically reasonable level."

44.     Subsequently, in 1990, Berry ratio was included as an acceptable PLI

in certain circumstances under the Treasury Regulations in USA. OECD

Guidelines issued in July 2010 also accepted that Berry ratio to be apposite

in certain circumstances.          More recently, Japan has also accepted use of



ITA 381/2013 & Connected Matters                                    Page 28 of 32
Berry ratio for purposes of transfer pricing in certain circumstances in its

tax legislation reforms introduced in March 2013.


45.     Traditionally, the denominator of the ratio only comprised of selling,

general and administration expenses. However, the Treasury Legislation of

USA also included depreciation as a part of the Operating Expenses used as

a denominator in the berry ratio. As is apparent, Berry ratio has limited

applicability; it can be used effectively only in cases where the value of

goods have no role to play in the profits earned by an Assessee and the

profits earned are directly linked with the operating expenditure incurred by

the Assessee. In other words, the operating expenditure incurred by the

Assessee effectively captures all functions performed and risks undertaken

by the Assessee. Thus, in cases where an Assessee uses intangibles as a

part of its business, Berry ratio would not be an apposite PLI as the value of

such tangibles would not be captured in the operating cost and, therefore, it

would not be appropriate to compute the ALP based on net profit margin

having regard to the operating cost as a relevant base. Similarly, Berry

ratio would not be an appropriate PLI for determining ALP in cases of

Assessees who have substantial fixed assets since the value added by such

assets would not be captured in Berry ratio.



ITA 381/2013 & Connected Matters                                  Page 29 of 32
46.     It can be seen from the above that the Berry ratio can be used only in

very limited circumstances and the limitations that we have listed above are

by no means exhaustive. There is also a view expressed that use of Berry

ratio as a PLI results in indicating less than fair ALPs in tax jurisdiction

where the Assessees have a lower bargaining power. In the aforesaid

context, in our view, the TPO had correctly reasoned that Berry ratio could

not be used as a PLI in cases of Assessees which were using intangibles.

However, we find that there was no cogent material for the TPO to hold

that the Assessee had developed supply chain and human resources

intangibles. In any event, there was no material to conclude that costs of

such intangibles were not captured in the operating expenses.


47.     In our prima facie view, the third reason stated by the TPO, that is,

the rate of commission paid to the Assessee is based on the value of the

goods, would be a valid reason to reject the use of Berry ratio because

Berry ratio can only be applied where the value of the goods are not

directly linked to the quantum of profits and the profits are mainly

dependent on expenses incurred. The fundamental premise being that the

operating expenses adequately represent all functions performed and risks

undertaken. For this reason Berry ratio is effectively applied only in cases



ITA 381/2013 & Connected Matters                                  Page 30 of 32
of stripped down distributors; that is, distributors that have no financial

exposure and risk in respect of the goods distributed by them.


48.     In the present case, the Assessee asserts that its business comprises

of two segments, trading segment and indenting segment and the functional

risk and the reward in the two segments are different. In the trading

segment, the Assessee earns a higher profit margins (calculated on the

value of the goods traded) while in the indenting segment its profit margins

are lower. Plainly, the use Berry ratio would give unreliable results if the

product mix of the comparables is different from the product mix of the

Assessee. This would make the task of finding a set of comparables fairly

difficult.


49.     In view of the above, the first question of law is answered in the

negative and the second question of law is answered in the affirmative; that

is, the questions are answered in favour of the Assessee and against the

Revenue. The impugned orders are accordingly set aside and the matters

are remanded back to the Tribunal to decide it afresh. It will be open for the

Tribunal to further remand the matter to the TPO/AO for a fresh




ITA 381/2013 & Connected Matters                                 Page 31 of 32
examination of the issues relating to Transfer Pricing in accordance with

law. The parties are left to bear their own costs.




                                                     VIBHU BAKHRU, J




                                                     S.MURALIDHAR, J
JULY 22, 2016
MK/RK




ITA 381/2013 & Connected Matters                             Page 32 of 32

 
 
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