Mumbai ITAT: RPM preferred over TNMM to compute ALP in case of distributor of finished goods

In its recent judgment dated April 25, 2012, Mumbai Bench of Income Tax Appellate Tribunal (‘Mumbai ITAT’) in case of ITO vs. L’oreal India P. Ltd. [ITA No.5423/Mum/2009] upheld resale price method (‘RPM’) as the most appropriate method for computing arm’s length price ('ALP') of the transaction wherein the taxpayer in India was involved in purchase and resale of the finished goods.

 Facts of the case:

The taxpayer is a 100% subsidiary company of L’Oreal SA France and is engaged in the business of manufacturing and distribution of cosmetics and beauty products. During the year under review the taxpayer imported finished goods from its associated enterprises (‘AEs’) and resells it to independent parties. For the purpose of computation of the ALP, the taxpayer considered RPM as the most appropriate method.

During the course of transfer pricing audit, the transfer pricing officer (‘TPO’) rejected RPM as the most appropriate method and considered transactional net margin method (‘TNMM’) as the most appropriate method on the following grounds:

• The appellant is consistently incurring losses in India and hence the pricing policy is not at arm’s length.
• Gross margin in case of comparable cases cannot be relied upon because of product differences of comparable companies.
• The degree of similarity in the functions performed, assets employed and risks assumed between the taxpayer and the comparable companies identified by the appellant is not sufficient for the application of RPM but is sufficient for application of TNMM.
• Adjustment of the margin/profits of the appellant is not permissible under rule 10B.
• The taxpayer has incurred huge expenses on selling and distribution and hence there is a substantial value addition to the goods sold.


 Accordingly, the TPO suggested an addition equal to INR 4.90 cr.


Observation of CIT(A):
Against the above order of the assessing officer/ transfer pricing officer, the taxpayer appealed before Commissioner of Income-tax Appeals (‘CIT(A)’). The CIT(A) ordered in favor of the taxpayer on the basis of following:


• As per OECD guidelines RPM is easiest method to determine ALP where the reseller does not add substantially to the value of the product.
• RPM is based on the similarity of functions performed by the taxpayer and not similarity of product distributed.
• The contention of the TPO that the comparable companies selected by the appellant for the distribution segment should not be allowed on the ground of product differentiation cannot be accepted because the TPO has itself selected comparable companies for manufacturing segment from the category of FMCG products that are used for personal consumption.
• The losses incurred by the taxpayer are on account of business strategy of the taxpayer and can also be attributed to the initial years of the distribution segment. 
The TPO has erred in relating the losses to the transfer pricing policy of the taxpayer.
• The profit margin earned by the AE need to be considered for an all-round approach in transfer pricing.  The fact that the taxpayer was incurring losses and its AEs were earning low profits establishes that there is no motive on the part of the taxpayer to transfer profits to its AEs.

            

Observation of Mumbai ITAT:

Against the order of CIT(A), the AO appealed before the Mumbai ITAT  and ITAT uphold the order of CIT(A) and considered RPM as the appropriate method for computing ALP for import of finished goods from AEs.

Our Comments:               

This case is quite important from the perspective of creating robust documentation wherein the taxpayer is into losses. In this case though RPM is accepted as the most appropriate method for the purpose of computation of ALP, but something which needs appreciation is the justification of losses in India. The taxpayer was able to do so by sharing the profit margin earned by the AEs and also by co-relating the losses with business strategy. 

Happy Reading

CA Gaurav Garg

CA Vineeta Goyal

JGarg Economic Advisors Pvt. Ltd.

New Delhi, India

www.jgarg.com

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