Transfer Pricing: TNMM under Rule 10B(1)(e) contemplates ALP
determination with reference to the relevant factors (cost, assets,
sales etc.) of the assessee and not those of the AE or third party.
Assessee’s study report cannot be discarded without showing how it is
wrong. Finding that assessee is a risk bearing entity should be based on
tangible material
The assessee, a wholly owned subsidiary in India of Li & Fung
(South Asia) Ltd., Mauritius, was set up as a captive offshore sourcing
provider. It entered into an agreement with Li & Fung (Trading),
Hong Kong, an associated enterprise, for rendering “sourcing support
services” for the supply of high volume & time sensitive consumer
goods. The assessee was entitled to receive cost plus a mark up of 5%
for the services rendered to the AE. The assessee claimed that it was a
low risk captive sourcing service provider performing limited functions
with minimal risk. It adopted the TNMM and computed the PLI at operating
profit margin/total cost. Since the operating profit margin at 5.17%
exceeded the weighted average operating margin of 26 other comparable
companies, the assessee claimed that its remuneration was at arms’
length. The TPO did not dispute the TNMM or the comparables but held
that the assessee ought to have received 5% on the FOB value of the
goods sourced through the assessee (i.e. the exports made by the Indian
manufacturers to overseas third party customers). He also held that the
assessee was a risk bearing entity and an independent entrepreneur and
it could not be said that the assessee is a risk-free entity. The DRP
upheld the TPO’s order though it reduced the mark up to 3% of FOB value
of exports. On appeal by the assessee, the Tribunal (143 TTJ 201) upheld the stand of the TPO. On further appeal by the assessee HELD by the High Court reversing the Tribunal:
(i) The assessee’s compensation model is based on functions performed
by it and the operating costs incurred by it and not on the cost of
goods sourced from third party vendors in India. Allotting a margin of
the value of goods sourced by third party customers from Indian
exporters/vendors to compute the assessee’s profit is unjustified. To
apply the TNMM, the assessee’s net profit margin realized from
international transactions had to be calculated only with reference to
cost incurred by it, and not by any other entity, either third party
vendors or the AE. Rule 10B(1)(e) does not enable consideration or
imputation of cost incurred by third parties or unrelated enterprises to
compute the assessee’s net profit margin for application of the TNMM.
Rule 10B(1)(e) contemplates a determination of ALP with reference to the
relevant factors (cost, assets, sales etc.) of the enterprise in
question, i.e. the assessee, as opposed to the AE or any third party.
The approach of the TPO in essence imputes notional adjustment/income in
the assessee’s hands on the basis of a fixed percentage of the FOB
value of export made by unrelated party venders;
(ii) The finding that the assessee assumed substantial risk is not
based on any material. The assessee made no investment in the plant,
inventory, working capital, etc., nor did it bear the enterprise risk
for manufacture and export of garments. It merely rendered support
services in relation to the exports which were manufactured
independently. Thus, attributing the costs of such third party
manufacture when the assessee did not engage in that activity and when
those costs were clearly not the assessee’s costs, but those of third
parties, is clearly impermissible. A contrary conclusion would amount to
treating the assessee as the vendor/ exporters’ partner in their
manufacturing business – a completely unwarranted inference;
(iii) Tax authorities should base their conclusions that the assessee
bears “significant” risks on specific facts, and not on vague
generalities, such as “significant risk”, “functional risk”, “enterprise
risk” etc. without any material on record to establish such findings.
If such findings are warranted, they should be supported by demonstrable
reason, based on objective facts and the relative evaluation of their
weight and significance;
(iv) Also, as the TPO did not discard the exercise conducted by the
assessee of comparing its operating profit margin with that of the
comparable companies, and it was not shown that the profit margin and
cost plus model adopted by the assessee was distorted, he could not have
proceeded to his own determination and calculations. The TPO must first
reject the assessment carried out by the assessee before making further
alterations. Where all elements of a proper TNMM are detailed and
disclosed in the assessee’s study reports, care should be taken by the
tax administrators and authorities to analyze them in detail and then
proceed to record reasons why some or all of them are unacceptable.
Source: ITAT Online
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