Delhi ITAT: Determination of arm's length price is necessary for 5% benefit given in Circular 12/2001

Important and interesting judgment from Delhi Bench of Income Tax Appellate Tribunal (‘Delhi ITAT’) in case of UE Trade Corporation (India) Pvt. Ltd. v. Asst. CIT [ITA No.4460(Del)/2009]. In the case under review, Delhi ITAT opinioned that wherein the taxpayer has not determined the arm’s length price for an international transaction entered during the financial year with an associated enterprise then benefit of 5% given in circular 12/2001 is not available to the taxpayer. Further, Delhi ITAT also observed that the benefit of 5% available in the Income-tax Act (‘Act’), proviso to section 92C(2), is only available from the mean of prices and not from a single price. The case relates to assessment year 2003-04.

Facts

UE Trade Corporation (India) Pvt. Ltd. (‘the taxpayer’), was involved in import of pulses from its associated enterprise out side India. In order to justify the import price, the taxpayer considered Comparable Uncontrolled Price (‘CUP’) method as the most appropriate method. For the purpose of CUP, the taxpayer relied upon the price quotation available on “Agriwatch”. The case was selected for the scrutiny by the Assessing Officer (‘AO’), the AO also referred the case to the Transfer Pricing Office (‘TPO’) for determination of arm’s length price of inter company transactions. However, the TPO failed to give his report to the AO and accordingly AO himself determined the arm’s length price of international transactions. The AO also relied upon “Agriwatch” and suggested an addition in 6 import transactions.

In appeal before the Commissioner of Income Tax (Appeals) (‘CIT(A)’), the taxpayer got relief in 4 import transactions as the price determined by the AO was with in 5% from the price determined by the taxpayer. Both, the taxpayer and the AO went in appeal to Delhi ITAT. The issues relating to transfer pricing raised before Delhi ITAT and its observations are given below:

Benefit of 5% variation as per proviso to section 92C(2) of the Act

The proviso, which is applicable to the proceedings of this year, contemplates an option to the taxpayer to choose a price which may vary from the arithmetical mean by an amount not exceeding five per cent of such arithmetical mean. This proviso is applicable where more than one price is determined and thereafter the mean of such prices is taken to be arm’s length price. Delhi Tribunal also observed that position does not change even after the substitution of the older proviso by Finance (No.2) Act, 2009 by new two provisos.

Benefit of 5% variation as per circular 12/2001 issued by the Board

The Board circular states that where arm’s length price determined by the tax-payer is five per cent less or five per cent more than the price determined by the AO, the price declared by the taxpayer may be accepted. In the first limb of this paragraph, the Board has used the words “arm’s length price determined by the tax payer”, which means that on the basis of pricing study, the taxpayer has determined a price. In the second limb, the words used are “price declared by the tax payer” i.e., the taxpayer has determined the arm’s length price and thereafter declared such price for the purpose of transfer pricing adjustment. Delhi Tribunal observed that wherein the taxpayer has not determined the arm’s length price but the AO (or say TPO) determines an arm’s length price in such a case benefit of 5% is not available.

Aggregation of international transactions

When each transaction is separate transaction and not interconnected transactions, computation of arm’s length price needs to be done on transaction wise basis.

Though Delhi ITAT opinioned on some other issues also, however we feel either they have loose the gravity because of the amendment in the Act or they were not relating to transfer pricing.

Conclusion

To our understanding the most important take away would be determination of arm’s length price even if one may not have exact comparables for the transaction, we think that’s why it is said “Transfer Pricing is an Art and not a Science”

Best Regards

Gaurav Garg

Transfer Pricing Consultant

www.jgarg.com

+91 9899994934

gaurav@jgarg.com

Mumbai ITAT: Continuing debit balance is not an international transaction

Mumbai Bench of Income-tax Appellate Tribunal (Mumbai – ITAT, in short) has pronounced a very important judgment, dated January 5, 2011, relating to overdue of trade receivables from associated enterprises in case of Nimbus Communications Ltd. vs. Asst. Commissioner of Income-tax (ITA No.: 6597/Mum/09). Though the judgment is not generic, however it put emphasis on evaluation of transactions between associated enterprises in light of conduct between third parties. Further, one of the important observation in the judgment is that the interest rates for the purpose of borrowing of money (in current case LIBOR) should not be used as comparable rates for overdue of trade receivables.

Facts of the Case

The taxpayer, Nimbus Communications Ltd, is engaged in the business of marketing of airtime available on television programs, cricket and other sports events, and is also in the business of producing television serials.

During year under consideration, the taxpayer had international transactions with one of its associated enterprise, i.e. World Sports Nimbus Pte Ltd Singapore, and the said associated enterprise had some overdue payments, to be made to the taxpayer. The taxpayer did not charge any interest on these overdue payments. The taxpayer does not charge any interest on the debit balances with the independent parties nor does it paid any interest to any international creditors.

The Assessing Officer referred these transactions, for ascertainment of arm’s length price, to the Transfer Pricing Officer (TPO) and the TPO passed the order stating that charging of interest on outstanding balances, after a period of time of normally 30 days, would be the expected normal arm’s length price, thus, interest at 2.19%LIBOR on balances outstanding beyond 30 days was recognized as the income.

Aggrieved taxpayer carried the matter before Commissioner of Income-tax (Appeals), but without any success. Not satisfied with the judgment of Commissioner of Income-tax (Appeals), the taxpayer pleaded before Mumbai ITAT.

Observation of Mumbai ITAT

   

Mumbai ITAT observed in the captioned case that;

• A continuing debit balance is not an international transaction per se, but is a result of international transaction. Unlike loan or borrowing it is not an independent transaction to be viewed on standalone basis
• There is nothing on record to show that not realizing the debts from the Associated Enterprises has any impact on profit, income, losses or assets of the taxpayer. Hence it doesn't amount to international transaction under the provision of the Income-tax Act.
•  The factum of payment has to be considered vis-a-vis terms of payment set out in transactional arrangement and not in isolation with the commercial terms. Moreover, the LIBOR rate as considered by the revenue authorities is relevant only in case of lending and borrowing of funds and not in case of commercial overdues as in the instant case.
• In any event, even when ALP is made in respect excessive credit period allowed under the CUP method, the comparable has to be dues recoverable from a debtor and not from the borrower.
• It is also to be seen whether the taxpayer charges such interest from independent parties or other enterprises have charged such interest in similar business transactions with independent parties. No such exercise has been carried out in this case nor it has been shown that realizing debts in time from the Associated Enterprises would have any impact on profits, income, losses or assets of the taxpayer.
• The appeal of the taxpayer is allowed by Mumbai ITAT.

Conclusion

We understand that in the captioned case the important fact which went in favor of the taxpayer was that as per normal business practice no interest was charged on overdue payments by the taxpayer or independent third parties, however the outcome may have been different if charging of an interest on overdue payments was a normal business practice.                      

For any further discussion on the case or for transfer pricing services please feel free to call us or email us....             

Best Regards

Gaurav Garg 

Transfer Pricing Consultant

(M) +91 9899994934

(E) gaurav@jgarg.com

JGarg Economic Advisors

www.jgarg.com

Mumbai ITAT: Hidden comparable data considered as CUP, Decision of Canadian tax court in case of Glaxo Smithkline hounds pharma companies in India

Mumbai Bench of Income Tax Appellate Tribunal (Mumbai ITAT, in short) in its recent ruling dated December 31, 2010 in case of Serdia Pharmaceuticals (India) Limited vs. Asst. Commissioner of Income-tax (ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08) has ruled on several issues relating to transfer pricing including the rejection of Transactional Net Margin method considered by the taxpayer over Comparable Uncontrolled Price method proposed by the transfer pricing officer. The judgment is quite big, however synopsis of the judgment is given below:

Facts of the Case

The taxpayer, i.e. Serdia Pharmaceuticals India Private Limited (Serdia or the taxpayer, in short), is a company incorporated in India and 74% of its share capital is held by Servier International BV, a company incorporated in the Netherlands, and the remaining 26% of its share capital is held by a Mauritius based company by the name of Serdia (Mauritius) Limited. Servier BV, in turn, is a subsidiary of Les Laboratoires Servier France (Servier France, in short), a well-known pharmaceutical company which is said to have its presence in more than 140 countries worldwide, including in Egypt by way of a subsidiary in the name of Servier Egypt Industries Ltd Egypt (Servier Egypt, in short).

The taxpayer is engaged in secondary manufacturing process in the sense it does import the active pharmaceutical ingredients (API, in short), puts them in a delivery mechanism by combining them with excipients, and thus produce the FDF, i.e. finished dosage form, for consumption by the end user. The FDF is produced and marketed by Serdia, while the API is imported from its Associated Enterprises (AEs, in short).

For the purpose of computation of arm’s length price and compliance of Indian transfer pricing regulations, the transfer pricing report was carried out by one of the Big4 Accounting firm and Transactional Net Margin Method (TNMM, in short), was used as the most appropriate method. As the operating margin of the taxpayer was more than the mean operating margin of comparable companies, the transactions with the AEs were considered to be at arm’s length.

During the course of related assessment proceedings, the Assessing Officer made references to the Transfer Pricing Officer (TPO, in short) for determination of arm’s- length price for the transactions that the taxpayer entered into with its AEs.

During the course of the transfer pricing assessment, the TPO collected information on the prices at which these APIs are purchased by other producers of the competing FDFs. And it was observed by the TPO that the prices at which other producers are purchasing these APIs is much lower than the price paid by the taxpayer to its AEs for purchase of same APIs. After doing certain adjustment for difference in quality, the TPO considered the prices at which other producers are purchasing as Comparable Uncontrolled Price (CUP, in short) and suggested an equal to the difference in prices.

The taxpayer filed an appeal before the Commissioner of Income-tax (Appeal), however no relief was given by the Commissioner of Income-tax (Appeal) to the taxpayer.  Aggrieved by the stand so taken by the Commissioner (Appeals), the taxpayer filed an appeal before Mumbai ITAT.

Issues addressed by Mumbai ITAT

Mumbai ITAT addressed on couple of more issues than given below, however we are of the view that the issues given below are more important from the perspective of knowledge sharing:

Issue No.1: Whether it is open to the transfer pricing officer to reject the most appropriate method adopted by the taxpayer, wherein, the results arrived at by determination of arm’s length price computed by the taxpayer is not contrary to the transfer pricing regulations in India?

Mumbai ITAT: It is within the powers of the transfer pricing officer to go into the question as to whether the method of determining the arm’s length price adopted by the taxpayer is indeed most appropriate method of determining the arm’s length price on the facts of taxpayer’s case, and, on being satisfied that it is not the most appropriate method of determining the arm’s length price, the TPO is also justified in determining the arm’s length price on the basis of, what he found to be, the most appropriate method on the facts of the case.

Issue No.2: Since Indian transfer pricing regulations does not provide for any order of preference in selection of the most appropriate method, no such order of preference – direct or implied, can be exercised.

Mumbai ITAT: While there is no particular order or priority of methods which the taxpayer must follow, and no method can invariability be considered to be more reliable than others, on a conceptual note, transactional profit methods (i.e., Transactional Net Margin Method and Profit Split Method) are treated as methods of last resort which are pressed into service only when the standard methods, which are also termed as ‘traditional methods’ (i.e., Comparable Uncontrolled Price Method, Resale Price Method and Cost Plus Method) cannot be reasonably applied”. The traditional transaction method have an inherent edge over the traditional profit methods in most of the situations, and, therefore, wherever both the methods can be applied in an equally reliable manner, traditional transaction methods are to be preferred over traditional profit methods.

Issue No.3: Applicability of CUP method, as the most appropriate method, for import of APIs/ generic drug from AEs.

ITAT: As long as appropriate comparables can be found, CUP method will indeed be the most appropriate method in respect of purchases of generic drug, even when such a generic drug is manufactured by its original patent holder. The high quality standards employed in manufacturing process do confer a certain degree of comfort in the sense that the API has minimal impurities and has been manufactured in a responsible manner, but this degree of comfort does not affect its comparability with the same API manufactured by generic drug companies.

Issue No.4: When import price is approved by one wing of the Government (for e.g. Custom Authorities), can such prices being treated as excessive or unreasonable having regard to legitimate business?

ITAT: the Income-tax Act provides a specific mechanism for computation arm’s length price, and it is only when determination of arm’s length price is made in accordance with the scheme of the Act that the onus of the taxpayer is discharged. Merely because another arm of the Government considers this price at an arm’s length price, even though for the purposes of customs duty, the taxpayer can not be relieved of the burden of establishing that it is an arm’s length, for the purposes of transfer pricing requirements, in terms of the provisions of the Income tax Act.

Conclusion

As Mumbai ITAT has upheld the order of the Commissioner of Income-tax (Appeal), it is expected that the taxpayer would go to Hon’ble High Court. For the taxpayer and transfer pricing professionals in India this case is very important as:

·         The data which is considered as CUP by the TPO was not available with the taxpayer at the time of filing of return. Further, such data is regarded as hidden comparable as same such kind of price information is not available in public domain and accordingly some tax authorities restrict its usage. This case allows the usage of hidden comparables. Further, I am not sure why the taxpayer has not taken appealed again the usage of the same.

·         This case highlights the importance of traditional methods over transactional profit methods, thus it may not be the cake walk for the tax authorities or the taxpayer to simply apply TNMM and close the case.

·         In this case useful reference was made to decision pronounced by the tax court of foreign jurisdiction, thus it is important for the transfer pricing professionals in India to not only track the judgments of Indian Appellate Authorities and Courts but also to keep eye on development happening in foreign land.    [Glaxo Smithkiline Inc Vs Her Majesty the Queen (2008 TCC 324 ) – Tax Court of Canada].

·         The decision of Mumbai ITAT, in light of Glaxo Smithkiline Inc Vs Her Majesty the Queen (2008 TCC 324 ) – Tax Court of Canada, may have far reaching consequence on multinational pharmaceutical companies operating in India.

·         As this case will move to Hon’ble High Court, it would be interesting to watch a battle - CUP vs. TNMM.

Trust the above will find you useful.

Your’s

Gaurav Garg

Transfer Pricing Consultant

(M): +91 9899994934

(E): gaurav@jgarg.com

JGarg Economic Advisors

New Delhi, India