Friday, December 24, 2010

Delhi ITAT: Pass through costs should not be considered while computing net cost plus margin

In its recent ruling Delhi Bench of Income tax Appellate Tribunal (‘Delhi ITAT’) made a very important observation, in case of DCIT vs. Cheil Communications India Pvt. Ltd. (I.T.A. No. 712/Del/2010) ,that while doing the transfer pricing analysis the margin earned by the taxpayer on the functions performed is required to be considered and not the margin earned on the cost of services. This observation recognizes the concept of “pass through cost” and suggest that while computing the Net Cost plus Margin or say Cost plus Margin, “pass through cost” should not be considered in the denominator or cost base.

Cheil Communications India Pvt. Ltd. (‘the taxpayer’) is a subsidiary of Korean Parent Company (‘KPC’). The taxpayer is an advertising agency and is engaged in undertaking advertising services for its customers in respect of their Products and Brands, the capacity agent. As part of its business operations of preparation of advertisements and provision of related consultancy services, the taxpayer also facilitates placement of such advertisement in the print, electronic etc. media, as the case may be. For this purpose it makes payment to third parties like advertisement agencies, printing presses etc. for renting of advertisement space etc on behalf of its customers and recovers the same from the respective customers. Such third party payments per se, do not represent any value-added functions undertaken by the appellant.

The issue in this case is regarding Profit Level Indicator (‘PLI’), i.e. while determining denominator for the purpose of computation of net cost plus mark-up for transfer pricing analysis, whether Gross Cost needs to be considered or Cost net of “pass through costs” needs to be considered ( “Operating Profit/ Total Cost” vs. “Operating Profit/ Value Added Expenditure”). The taxpayer contented that it should be “Operating Profit/ Value Added Expenditure” and the tax authorities was of the view that it should be “Operating Profit/ Total Cost”.

[Total Cost = Value Added Expenditure + Pass Through Cost]
[Total Receipts = Agency Commission + Pass Through Cost]
[Operating Profit = Total Receipts – Total Cost = Agency Commission – Value Added Expenditure]

In light of the OECD guidelines and facts of the case, Delhi ITAT observed that a mark-up is to be applied to the cost incurred by the taxpayer in performing agency function and not to the cost of rendering advertising space on behalf of its associated enterprises i.e. “Operating Profit/ Value Added Expenditure”.

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Happy Reading
Gaurav Garg
JGarg Economic Advisors
New Delhi, India

+91 9899994934
gaurav@jgarg.com

www.jgarg.com

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