AAR: Income not chargeable to tax are also covered under TP provisions

Recent ruling by Advance Ruling Authority (‘AAR’), dated August 14, 2012, in case of Castleton Investment Limited [A.A.R. No.999 of 2010] came as a surprise to many stake holders on applicability of transfer pricing.

Though the ruling was on other issues as well but this write-up is limited to the issue pertaining to applicability of transfer pricing provision in India.

The Applicant, M/s Castleton Investment Limited of Mauritius (‘CIL’), raised a question that if the transfer of shares by the applicant to its associated enterprise is not taxable, whether the provisions of section 92 to section 92F of the Act relating to transfer pricing would be applicable? In response to the same AAR observed that the applicability of section 92 does not depend on the chargeability under the Act. The only saving grace is that the judgement is only applicable in on that applicant and on that transaction for which it is sought.

Facts of the Case

Glaxo Smithlkine Pharmaceuticals Limited (GSKPL) is a company incorporated in India. The applicant had acquired 600,000 shares in it in the year 1993. It also acquired 1,680,170 shares in Burroughs Wellcome (India) Limited (‘BWL’) in the year 1996. GSKPL and BWL merged.  In the year 2004, the applicant received in lieu of the shares held by it in BWL, shares in GSKPL. These shares were held as investment in the books of CIL. As a part of reorganization, CIL propose to transfer shares held in GSKPL to its associated enterprise, Glaxo Smithlkine (Pte) Limited.

On transfer of shares, AAR observed that any capital gain arising from such transfer would not be taxable in India.

Question

Whether the provisions of section 92 to section 92F of the Act relating to transfer pricing would be applicable?

Observation of AAR

It is not material that the gain or income is taxable in the country or not, section 92 to 92F would apply if the transaction is one coming within those provisions. In case, where there is no liability what would be the purpose of undertaking a transfer pricing exercise is not a question that would affect the operation or rigour of a statutory provision on its plain word. There is nothing to show in transfer pricing provisions that the expression ‘income’ has to be given a restricted meaning and the applicability of section 92 does not depend on the chargeability under the Act. 

Comment

This ruling of AAR will only going to create confusion in the minds of taxpayer and consultant. It is quite strange to observe that AAR has disregarded its earlier ruling in the case of Praxair Pacific and Vanenburg Group BV. A view that transfer pricing provisions are applicable even on those transactions wherein income is not taxable in India, is like a shaft without arrowhead. 

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CA Gaurav Garg

JGarg Economic Advisors

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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. 

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CA Gaurav Garg

CA Vineeta Goyal

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Delhi ITAT: Information regarding secret data used by the tax department should be shared with the taxpayer

In the case of Adobe Systems India Pvt. Ltd. vs. JCIT (ITA No.5693, Del, 2011), Delhi Bench of the Income Tax Appellate Tribunal observed that in case tax authorities uses some information or data, in respect of which information is not available in public domain (secret data), for the purpose of computation of the arm's length price in such case such information/ data should be supplied to the taxpayer for his objection or examination. The absence of such opportunity violates the fundamental principle of natural justice. 

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Abhishek Agarwal

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Mumbai ITAT: Taxpayer should charge interest on loan given to non resident AEs

In its recent judgment in the case of M/s Tata Autocomp Systems Ltd. vs. ACIT Mumbai bench of Income Tax Appellate Tribunal (‘Mumbai ITAT’) observed that the lending or borrowing money between two associated enterprises comes within the ambit of international transaction and taxpayer should charge interest from its non resident associated enterprise.

Facts of the case:

The taxpayer is a company, involved in the manufacturing of indoor plastic, rendering engineering services, supply chain management services and administrative support for joint venture companies. In order to have better supply chain management and relationship with the customer in Europe, the taxpayer established a manufacturing company TACO Kunstsofftechnik GMBH (‘TKT’) in Germany. During the year under review, in order to assist TKT during start-up phase and because of commercial expediency, the taxpayer granted the interest free loan to TKT.

The case was referred to the transfer pricing officer (‘TPO’). The TPO rejected the interest free pricing of the transaction and re-computed the arm’s length price by considering lending rate equal to 10.25 % based on loans received by the taxpayer from Indian banks. The taxpayer took an alternative stand before the TPO, without prejudice to the its stand of interest free loan, that even if interest isto be charged on the interest free loan provided by the Assessee to TKT, the same should berestricted to 4.15% which is the rate specified in the benchmarking exercise conducted by theassessee for ascertaining the arm's length interest rate.

The taxpayer filed an appeal before the Dispute Resolution Panel (‘DRP’) against the order of the TPO. On review of the appeal, The DRP upheld the order of TPO but arrived at 12% rate ofinterest and directed the AO to recalculate the adjustment adopting rate of interest at 12% perannum instead of the calculation at 10.25% in the TPO's order.

Against the directions issued by the DRP, the taxpayer filed an appeal with the ITAT. The observation of the same are given below

Observations of Mumbai ITAT:

• Interest free loan extended to the associated concerns as at arm's length lending or borrowing money between two associated enterprises comes within the ambit of international transaction and whether the same is at arm’s length price has to be considered.
• The fact that the loan has the RBI's approval does not put a seal of approval on the true character of the transaction from the perspective of transfer pricing regulation as the substance of the transaction has to be judged as to whether the transaction is at arm’s length or not.
• Relying upon the judgment in the cases of DCIT v. M/s Tech Mahindra Ltd.(Mumbai Tribunal) and M/s Siva Industries & Holdings Ltd. v. ACIT ( (Chennai Tribunal), the tribunal ruled that the claim of the taxpayer to adopt EURIBOR rate as stated before the TPO is reasonable and deserves to be accepted. And also observed that the rate of interest to be used for benchmarking shall be the rate of interest in respect of the currency in which the underlying transaction has taken place in consideration of economic and commercial factors around the specific currency denominated interest rate.

Our Comments:

Judgement is in line with the well recognised arm’s length principle and also reinforces the pricing principle that for foreign currency loan one should not consider Indian currency loan rate. 

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CA Gaurav Garg

CA Parul Mittal

JGarg Economic Advisors Pvt. Ltd.

New Delhi, India

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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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CA Gaurav Garg

JGarg Economic Advisors Pvt. Ltd.

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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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Gaurav Garg

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New Delhi, India

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