Mumbai Bench of Income Tax Appellate Tribunal ('ITAT Mumbai') pronounced a very important judgment in case of Dresser Rand India Pvt. Ltd vs. Add. CIT on September 7, 2011, where in it observed that there is no need for carrying our benefit test analysis while computing arm's length price of receipt of management services under cost contribution arrangement from associated enterprises.
BackGround
The taxpayer, a subsidiary of Dresser Rand US (“DR US”), is engaged in the business of manufacturing various types of process gas compressors, including horsepower reciprocating compressors and its accessories, and also of providing field services in connection with the same.
Two types of international transactions which were under review before the Hon’ble ITAT in the captioned cases are as follows;
- Payment for management charges under cost contribution arrangement (“CCA”), by DR India to DR US, equal to INR 105.5 million
- Allowing discount equal to 10% on field services provided to foreign associated enterprises (AEs), equal to INR 1.07 million
The transfer pricing officer (‘TPO’) computed “nil” value for management services received by DR India and also ruled that no discount should have been allowed to the AEs. DR India filed an appeal before the Dispute Resolution Panel (‘DRP’), however the latter also upheld the view of the TPO.
The case went to ITAT Mumbai and verdict came in favour of DR India. Please find summary of the views and submission of parties to the case and observation of ITAT Mumbai on the same.
Cost Contribution Arrangement – Payment for Management Charges
Benefit Test Analysis
The TPO argued that DR India has not received any benefit from the subject CCA. As per the TPO;
- It was incorrect on the part of DR India that DR India does not have an audit department and so needed to avail audit services from DR US, given the fact that DR India have two managers and executives in the field of accounts and also has paid INR 2.186 million towards audit fees to external consultants.
- DR India is a cash rich company and accordingly it is in no need of treasury services from DR US.
- DR India has several management, marketing and production experts on its payroll and thus in no need for guidance from global leadership.
- Similar expenditure was not there in the earlier years.
- By availing these services, the overall profitability and growth rate should have gone up but it indeed came down
DR India argued and submitted the documents to support that it has received management services from DR US. Further, it has used Transactional Net Margin Method (‘TNMM’) to justify the arm’s length nature of transaction.
On the benefit test analysis, ITAT Mumbai observed;
- It is only elementary that how the taxpayer conducted his business is entirely his prerogative and it is not for the tax authorities to decide what is necessary for the taxpayer and what is not.
- The TPO has gone much beyond his powers by questioning commercial wisdom of DR India’s decision to take benefit of expertise of DR US
- When evaluating the arm’s length price of the services, it is wholly irrelevant as to whether the taxpayer benefits from it or not. The real question to be determined in such cases is whether the price of these services is, what an independent enterprise would have paid for the same.
- It is also irrelevant that whether the AE rendered the same services to the taxpayer in the preceding years without any consideration or not
Arm’s Length Price - Allocation Keys
The TPO argued that the allocation keys used under CCA is not correct i.e. instead of using sales and number of staff as the keys, the cost should be shared in the ratio of actual use of services and the cost should be charged as per Indian employee cost.
However, ITAT Mumbai ruled in favour of the taxpayer by observing the following points;
- There is no objective way in which use of services can be measured and as is the commercial practice even in market factors driven situation, the costs are shared in accordance with some objective criterion, including sales revenue and number of employees
- The question of charging as per domestic employee costs cannot be the basis of allocating the costs because such an allocation will deal with some hypothetical pricing whereas the allocations are to be done for the actual costs incurred.
- As it is an allocation of costs on the basis of actual costs and the fact of expenditure is not even in dispute, the dispute is confined to the basis on which cost allocations must take place. And since we find the basis for allocation of costs as reasonable, no interference is really called for.
Discount on Field Services to AEs
The TPO noted that the field services were rendered to the domestic customers as also to the AEs abroad, but the taxpayer grants a discount of 10% to the AEs. He noted the taxpayer’s contention that this discount of 10% is given to the AEs as a part of the global policy, and on reciprocal basis. However, the TPO held that since the taxpayer has allowed discount to the AEs, to that extent, the price of services rendered is not an arm’s length price.
However, ITAT Mumbai ruled in favour of the taxpayer by observing the following points;
- DR India has followed TNMM as the most appropriate method for the purpose of computation of arm’s length price and the TPO has any argument against TNMM. The question of applying CUP method, even if that be so, can only arise if TNMM is rejected.
- Even under CUP method, it is not necessary that all sales must take at the same price. There can always be variation of prices for the same product or services on valid grounds, such as quantum of business, risk factors, marketing efforts needed etc. Whenthe taxpayer is dealing with an AE, at least there are no commercial risks, no marketing costs and there could be several other factors as well justifying a normal discount as the taxpayer could indeed go to many important customers.
- There is nothing on record to even suggest that such a discount is not an arm’s length discount, or that discounts have not been allowed under any other situations.
Analysis of Judgement
Payment of Management Charges
For the last couple of years, the TPOs/ tax authorities emphasized on benefit test analysis for management charges paid by the Indian subsidiaries to their AEs and in many cases, like the present case, the tax payers failed to satisfy the tax authorities on benefit test. Accordingly, the tax payers face transfer pricing additions. Now, this judgment would certainly bring a relief to the taxpayers.
But technically speaking the observation of ITAT Mumbai that “it is wholly irrelevant as to whether the taxpayer benefits from it or not” is not very sound. To put it in another words, ITAT Mumbai wants to say that if your size of shoe is 9 inches you may still buy a shoe of 7 inches or say 12 inches. All my readers would agree that generally pricing of a commercial transaction is a process which is dependent upon two parameters i.e.
- What is the cost of the supplier, and
- Utility to the consumer
As per economic principle, the transaction generally happens at a point or a price where the above two intersect each other or may be at a point where difference between them is insignificant.
I am of the feel that this observation of ITAT Mumbai is based on the assumption that to take management services is in fact DR India’s decision, (refer para 8 of the order)
“The Transfer Pricing Officer was not only going much beyond his powers in questioning commercial wisdom of assessee’s decision to take benefit of expertise of Dresser Rand US, but also beyond the powers of the Assessing Officer. We do not approve this approach of the revenue authorities.”
As a student of transfer pricing, I have learned that it may not be correct to go with the above assumption while evaluating a case between two AEs. Because, the very start of the transfer pricing analysis is based on the assumption that the “relationship between two enterprises can have influence on commercial decisions and price of transactions”.
I am eagerly waiting to see whether the Tax Authorities would appeal before Hon’ble High Court against the observation of ITAT Mumbai and if yes then how well prepared they would be, to tackle the findings of the ITAT Mumbai.
Discount on Field Services to AEs
It’s a good observation by ITAT Mumbai and I am in line with the same. But I would like to suggestmy readers that they should try to collate documents to support “%” of discount i.e. why discount should be 10% and why not 5%.
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Gaurav Garg
JGarg Economic Advisors
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