Delhi HC: Continuous losses is not the criteria to disallow the payment for brand fees/ royalty under transfer pricing provisions

On March 29, 2012 Hon’ble High Court of Delhi pronounced a land mark judgment in case of ELK Appliances Ltd., wherein it observed that tax officer is not authorised to disallow the payment made for brand fee or royalty while determining an arm’s length price of the same.

Facts of the Case

This case relates to financial year 2001-02 and 2002-03. EKL Appliances Ltd. (‘taxpayer’), Group Company of Electrolux group, was engaged in the business of manufacturing of refrigerators, washing machines, compressor and spares thereof and also trading all these items and microwaive ovens, dish washers, cooking ranges, air conditioners and spares thereof. In respect of the assessment years 2002-03 and 2003-04, it filed returns of income declaring losses amounting to Rs. 148,23,80,117/- and  Rs. 1,14,59,660/- respectively. The Assessing Officer noticed that there were international transactions entered into by the taxpayer during the relevant previous years and accordingly invoked the provisions of Section 92CA(3) of the Act and referred the question of determination of the Arms Length Price (“ALP) to the Transfer Pricing Officer (“TPO”).

The TPO noticed that the taxpayer has been incurring huge losses year after year except for the financial year 1999-2000 and considering the perpetual losses, “the payment of royalty to the Associate Enterprise did not appear justified, as the technical knowhow/ brand fee agreements with A.E. had not benefited the taxpayer company in achieving profits from its operations”. The TPO further noted that the taxpayer itself stopped the payment from 01.10.1998 till 01.01.2002 and thus “the justification for payment of brand fee during the year under reference becomes questionable”.

He conceded that there was an increase in the turnover but observed that it has not resulted in any profit to the taxpayer. According to him, despite the payment of the brand fee for several years, the taxpayer has not been able to make a turnaround. He further held that the fact that the A.E. had charged similar brand fee from another company in New Zealand did not prove that the price paid by the taxpayer for obtaining the use of the brand name and the technical knowhow represented the ALP. He was of the view that the taxpayer had to demonstrate the actual benefit derived by it by using the brand name which it had failed to do. The continuous losses according to the TPO showed that the taxpayer did not benefit in any way from the brand fee payment. For these reasons, the TPO held that the brand fee payment made by the taxpayer to the A.E. was unjustified and the ALP of the transactions should be taken as nil.

Observations of Hon’ble High Court of Delhi

The Hon’ble High Court of Delhi ruled in favour of the taxpayer and observed,

•  It is not necessary for the taxpayer to show that any legitimate expenditure incurred by him was   also incurred out of necessity.
• In applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of business, reasonableness of the expenditure has to be judged from the point of view of the businessman and not of the Revenue.
• The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allow-ability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the taxpayer has suffered continuous losses.

Relying upon OECD guidelines, the Hon’ble High Court of Delhi also observed;

•    It is also not necessary for the taxpayer to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred “wholly and exclusively” for the purpose of business and nothing more.
•  The TPO is expected to examine the international transaction as he actually finds the same and then make suitable adjustment.

 Conclusion

This judgement should bring a good relief for other taxpayers also, as in number of cases the Revenue has disallowed payment of royalty or brand fee because of low profitability or no profitability. As the judgment suggests that profitability should not be the criteria to allow or disallow the payment, it is recommended that the taxpayer should try to benchmark transactions like payment of royalty/ brand fee or say management charges using comparable uncontrolled price method or cost plus method. Transactional Net Margin Method, considering payer of expenses as the tested party should be avoided.   

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Delhi ITAT: Royalty rates approved by RBI, accepted as CUP

In ruling dated December 16, 2011, Income-tax Appellate Tribunal of Delhi (‘Delhi ITAT’) ruled in favor of the taxpayer, Sona Okegawa Precision Forgings Ltd., wherein arm’s length price of the royalty payment to associated enterprise was computed as Nil by the transfer pricing officer.

Sona Okegawa Precision Forgings Ltd. (‘the taxpayer’) is a joint venture between Sona Holding and Mitsubishi Materials Corporation, Japan (‘the associated enterprise’). The taxpayer was formed in 1995 and began commercial production in November 1998. The taxpayer is engaged in the manufacturing of precision forged (net shaped) bevel gears, differential case assemblies and synchroniser rings for automotive and other applications.

During the financial year 2005-06, the taxpayer had several transactions including payment of royalty with its associated enterprise. In order to validate the arm’s length nature of payment of royalty, the taxpayer relied upon the technical collaboration agreement approved by the Government of India for payment of royalty @ 1% and 3% of net sale price of the manufactured goods sold or used by the taxpayer as Comparable Uncontrolled Price (‘CUP’). As a corroborative method, the taxpayer also relied upon the transactional net margin method.

The case was selected for the transfer pricing audit, wherein the transfer pricing officer rejected the CUP analysis carried out by the taxpayer and observed that:

• The taxpayer is a contract manufacturer and as per guidelines issued by OECD, there is no justification for payment of royalty in such a case.
• Secondly, the taxpayer has itself created provision for technical know-how separately as seen from the schedules of the audit report.

 The taxpayer, filed an appeal before Dispute Resolution Panel and the same was turned down.

The taxpayer, appealed with Delhi ITAT and Hon’ble Delhi ITAT observed;

• On issue relating to royalty - The taxpayer has placed on record a copy of the letter dated 30.04.1993 written by the Reserve Bank of India, Exchange Control Department, to the taxpayer, in which payment of royalty @ 3% on domestic sales was allowed to be paid for a period of five years. There are similar other correspondences which have been placed on record. The taxpayer has also placed on record a press note issued by the Government of India, Ministry of Commerce and Industries, Department of Industrial Policy & Promotion, issued in 2003, under which royalty payment @ 8% on export sales and 5% on domestic sales have been referred to be reasonable for the purpose of processing approval of payments. On the other hand, the officer failed to bring any material on record that payment of royalty @ 3% was not at arm’s length. Therefore, the payment stands justified under the CUP method.
•  On issue relating to contract manufacturer – Bulk of sales are to uncontrolled parties. Thus, the taxpayer is not a captive manufacturer supplying all manufactured goods to its associated enterprise. In fact, the technology has been used for manufacturing and supplying goods to independent parties.

My Comment’s

I am bit skeptical about usage of rates allowed by the Reserve Bank of India as CUP for the purpose of transfer pricing analysis under light of this ruling. I am of the feel that this ruling is more because of the fact that the transfer pricing officer not did his homework well and not submitted any CUP data to say transaction between the taxpayer and its associated enterprises was not at arm’s length. Further, Hon’ble High Court of Punjab and Haryana in case of M/s Coca-Cola India Inc. vs. ACIT (C.W.P. No.16681 of 2005)

“The contention that according to the permission granted by the Reserve Bank of India under the FERA, the assessee cannot charge more than particular price, can also not control the provisions of the Act, which provides for taxing the income as per the said provision or computation of income, having regard to arm’s length price in any international transaction, as defined.”

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Chennai ITAT: Uncontrolled price on date of sales contract should be considered as CUP

In case of Liberty Agri Products (P) Ltd (IT APPEAL NO. 1610 (MDS.) OF 2010), the Income-tax Appellate Tribunal of Chennai (‘Chennai ITAT’) has observed that uncontrolled price on the date of sales contract should be considered as comparable uncontrolled price (‘CUP’) instead of uncontrolled price on the date of shipment received on the port.

Liberty Agri Products (P) Ltd. (‘Taxpayer’) is a part of M/s Kuok Group. During FY 2005-06, the taxpayer entered into transactions with its group company in Singapore, wherein the taxpayer purchased edible oil worth USD 23,530,749.06 and applied CUP as the most appropriate method. For the purpose of CUP, the taxpayer relied upon internal CUP (i.e. sales made by the associated enterprise in comparable transactions to third parties in India) and also on notification issued by the Custom Authorities in respect of tariff value on import of edible oils on the date of signing of sales contract. As corroborative evidence the taxpayer also documented the rates of oil published by Solvent Extractors Association of India in relation to degummed soya bean oil could also be well relied on.

During the transfer pricing scrutiny, the transfer pricing officer rejected the CUP data of the taxpayer and instead took Customs average rage at Kandla Port. As there was difference of more than 5% per metric ton, the transfer pricing officer suggested an addition of Rs. 26. 13 million.  

The taxpayer appealed before the Chennai ITAT, after an unsuccessful attempt before lower authorities.

Chennai ITAT agreed to the contentions of the taxpayer that instead of comparing the price with the Customs tariff rate on the date of entry into the port, the transfer pricing officer should have compared the price declared by the taxpayer with the Customs tariff rate at Kandla Port as it is stood on the day of contract of sale entered into between the taxpayer and its associated enterprise. Further, Chennai ITAT also observed that in these types of bulk purchases and sales, it is always better to compare the price of individual consignments rather than on a compromise of average price. 

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ITAT Hyderabad: Corporate Guarantee is not an International Transaction

Important observation made by Hon'ble Income Tax Appellate Tribunal of Hyderabad in case of Four Soft Ltd. dated September 9, 2011, for your reference;

• For computing the net margin of the taxpayer for the purposes of transfer pricing, only the cost related to the transaction with the Associated Enterprises has to be considered and accordingly segmented financials is to be considered for the purpose of arriving at the net margin on the international transaction. 
• Exchange fluctuation gains arise out of several factors, for instance, realisation of export proceeds at higher rate, import dues payable at lower rate. Since the gain or loss on account of exchange rate fluctuation arises in the normal course of business transaction, the same should be considered while computing the net margin for the international transactions with the associated enterprises of the taxpayer.
• TP legislation provides for computation of income from international transaction as per Section 92B of the Act. The corporate guarantee provided by the taxpayer company does not fall within the definition of international transaction. The TP legislation does not stipulate any guidelines in respect to guarantee transactions. In the absence of any charging provision, the lower authorities are not correct in bringing aforesaid transaction in the TP study. In considered view of Hon'ble ITAT, the corporate guarantee is very much incidental to the business of the taxpayer and hence, the same cannot be compared to a bank guarantee transaction of the Bank or financial institution.

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ITAT Mumbai: No need for benefit test analysis while computing ALP for receipt of management services

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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Delhi ITAT: For the purpose of transfer pricing analysis different STP units of a taxpayer should not be analysed on a standalone basis

In its recent judgment dated June 17, 2011 in case of ACIT vs. Birla Soft Ltd. [IT Appeal No. 4001 (Delhi) 2009] Hon’ble Delhi Bench of the Income-tax Appellate Tribunal (‘Delhi ITAT’) observed that it would be wrong to consider different STP units of the taxpayer on a standalone basis, for the purpose of transfer pricing analysis, wherein the services provided by the units are same/similar and to same Associated Enterprises (‘AEs’). Further, Delhi ITAT also observed that current year data of an uncontrolled transaction is to be used for the purpose of comparability, while examining the international transactions with AEs.

Facts

Birla Soft Ltd. (‘Taxpayer’) is the wholly owned subsidiary of Birla Soft Enterprises, which is further  owned by  Birla Soft Inc. US. It is engaged in the business of software development and related services. The software related business was being carried out from Software Technology Park (‘STP’). For the purpose of computation of arm’s length price, the taxpayer selected transactional net margin method (‘TNMM’) as the most appropriate method and justified the net margin earned on an operating cost (‘NCP’) on a company wide basis vis-à-vis margin earned by 24 comparable companies.

During the course of assessment, the assessing officer referred the case to the transfer pricing officer (‘TPO’) for computation of arm’s length price. The TPO;

·         rejected the company wide approach of the taxpayer and in-turn compared the profitability of each STP units on a standalone basis with the mean margin of comparable companies.

·         Out of 24 comparable companies selected by the taxpayer, the TPO rejected 9 companies.

·         Further, instead of multiple/ prior years data used by the taxpayer of comparable companies, the TPO only used current year data.

As out of 3, 2 STP Units were having lower NCP than the mean NCP of comparable companies, the TPO suggested transfer pricing addition.

The case travelled to Commissioner of Income-tax (Appeals) (‘CIT(A)’) and it disapproved the STP units on a standalone approach of the TPO. [The judgment is silent on stand of CIT(A) on comparable companies and usage of multiple/ prior years data].

Against the order of CIT(A), the Tax Department/ TPO filed an appeal before Delhi ITAT. The couple of transfer pricing issues which were raised before Hon’ble Delhi ITAT in this case were;

·         Whether the multiple year data used by the tax payer precedes the current year data used by the tax authorities?

·         Should each STP unit be considered as the standalone unit for computing ALP or the result of all the STP units has to be considered in totality?

Observation of Delhi ITAT – STP Units on a standalone basis

Hon’ble Delhi ITAT observed that there is no significant functional difference in the software development and maintenance services to related and unrelated parties. The services rendered by the STP Unit were rendered to the same AEs of, namely, Birla Soft Inc. US and Birla Soft UK on continuing basis. The terms and conditions for rendering such services by each of the STP Unit was governed by one single agreement entered into between Birla Soft India and Birla Soft Inc. US. The learned TPO assumed that functions, assets and risks (‘FAR’) undertaken by each of the STP Unit are distinct from each other and is comparable with the functions, assets and risks undertaken by existing comparables. In other words, learned TPO totally ignored the unity of the business, administrative control and unity of funds etc. The independent FAR analysis of each unit with existing comparables is practically not possible because there is a common management, interlacing of the funds etc.

Based on the above findings, Delhi ITAT held that the different STP Unites should not be benchmarked on a standalone basis.

Observation of Delhi ITAT – Usage of Multiple / Prior years data

Hon’ble Delhi ITAT observed that the usage of word ‘shall’ in the Rule 10B(4) makes it mandatory to first use the current year data and the proviso appended to the main section carves out an exception that the data relating to maximum two years prior to the current year may be considered, if the circumstances reveal an influence on the determination of transfer prices in the current year.

Rule 10B(4) of the Income-tax Rules

“(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into :

Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.”

In this case, as the taxpayer was not able to demonstrate the influence of multiple/ prior year’s data on the determination of transfer prices in the current year, the view of the TPO was upheld.

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Chennai ITAT: Domestic PLR is not a comparable interest rate for loan given in foreign currency

Judgment dated May 20, 2011 of Hon'ble Income-tax Appellate Tribunal (‘ITAT’) in case of Siva Industries & Holdings Ltd. vs. Assistant Commissioner of Income-tax [IT Appeal No.2148 (MDS) of 2010] provides bit of guidance on justification of arm’s length rate of interest (‘ALP’) for a loan given by an Indian Company to its Foreign Subsidiary.

Facts of the Case

The tax payer, Siva Industries, has granted a loan to its subsidiary company in Mauritius for the purpose of making investment and had charged 6% interest p.a. the tax payer took average of 12 month’s US $ denominated LIBOR rate for the said period for the purpose of computing the ALP.

The tax authorities contended that the said rate cannot be taken for computing ALP since the loan was given from India and hence Prime Lending Rate (PLR) in India at that time should be considered and accordingly determined 11.75% p.a as the rate for computing the ALP and made the addition consequently.

Observation of the ITAT

The ITAT observed that as the loan provided to subsidiary company in Mauritius was out of its own funds and in foreign currency, the transaction would have to be looked upon by applying commercial principles in regard to international transaction. If that was so, then the domestic PLR would have no applicability. Further, the Hon’ble ITAT has also observed that as the rate charged by the taxpayer is more than mean LIBOR for a year, the LIBOR charged by the taxpayer from its subsidiary company in Mauritius is at arm’s length.

Our Comments

We feel though this judgment would provide relief to the taxpayers but it should give worry to the tax authorities. From a technical perspective it is correct to say that domestic PLR should not be considered comparable interest rate for the foreign currency loan however it may not be correct to say that LIBOR can be considered as comparable interest rate.

We understand that LIBOR is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. 

(Source: http://www.investopedia.com/terms/l/libor.asp)

We feel the correct approach would be to consider LIBOR as a base rate and then adjustment should be carried out based on the credit worthiness of the borrower and other commercial factors like time period, security, purpose etc.

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