Vodafone Transfer Pricing Verdict: High Court Mocks Dept’s ‘Unique’ Interpreta​tion Of Law

Vodafone India Services Pvt. Ltd vs. UOI (Bombay High Court)​

The assessee, an Indian company, issued equity shares at the premium of Rs.8591 per share aggregating Rs.246.38 crores to its holding company. Though the transaction was reported as an “international transaction” in Form 3 CEB, the assessee claimed that the transfer pricing provisions did not apply as there was no income arising to it. The AO referred the issue to the TPO without dealing with the preliminary objection. The TPO held that he could not go into the issue whether income had arisen or not because his jurisdiction was limited to determine the ALP. He held that the assessee ought to have charged the NAV of the share (Rs. 53,775) and that the difference between the NAV and the issue price was a deemed loan from the assessee to the holding company for which the assessee ought to have received 13.5% interest. He accordingly computed the adjustment for the shares premium at Rs. 1308 crore and the interest thereon at Rs. 88 crore. The AO passed a draft assessment order u/s 144C(1) in which he held that he was bound u/s 92-CA(4) with the TPO’s determination and could not consider the contention whether the transfer pricing provisions applied. The assessee filed a Writ Petition challenging the jurisdiction of the TPO/AO to make the adjustment. The High Court directed the DRP to decide the assessee’s objection regarding chargeability of alleged shortfall in share premium as a preliminary issue. Upon the DRP’s decision, the assessee filed another Writ Petition. HELD by the High Court allowing the Petition:

(1) A plain reading of Section 92(1) of the Act very clearly brings out that income arising from a International Transaction is a condition precedent for application of Chapter X of the Act.

(2) The word income for the purpose of the Act has a well understood meaning as defined in s. 2(24) of the Act. The amounts received on issue of share capital including the premium is undoubtedly on capital account. Share premium have been made taxable by a legal fiction u/s 56(2)(viib) of the Act and the same is enumerated as Income in s. 2(24)(xvi) of the Act. However, what is bought into the ambit of income is the premium received from a resident in excess of the fair market value of the shares. In this case what is being sought to be taxed is capital not received from a non-resident i.e. premium allegedly not received on application of ALP. Therefore, absent express legislation, no amount received, accrued or arising on capital account transaction can be subjected to tax as Income (Cadell Weaving Mill Co. vs. CIT 249 ITR 265 approved in CIT vs. D.P. Sandu Bros 273 ITR 1 followed);

(3) In case of taxing statutes, in the absence of the provision by itself being susceptible to two or more meanings, it is not permissible to forgo the strict rules of interpretation while construing it. It was not open to the DRP to seek aid of the supposed intent of the Legislature to give a wider meaning to the word ‘Income';

(4) The other basis in the impugned order, namely that as a consequence of under valuation of shares, there is an impact on potential income and that if the ALP were received, the Petitioner would be able to invest the same and earn income, proceeds on a mere surmise/assumption. This cannot be the basis of taxation. In any case, the entire exercise of charging to tax the amounts allegedly not received as share premium fails, as no tax is being charged on the amount received as share premium.

(5) Chapter X is invoked to ensure that the transaction is charged to tax only on working out the income after arriving at the ALP of the transaction. This is only to ensure that there is no manipulation of prices/consideration between AEs. The entire consideration received would not be a subject-matter of taxation;

(6) The department’s method of interpretation indeed is a unique way of reading a provision i.e. to omit words in the Section. This manner of reading a provision by ignoring/rejecting certain words without any finding that in the absence of so rejecting, the provision would become unworkable, is certainly not a permitted mode of interpretation. It would lead to burial of the settled legal position that a provision should be read as a whole, without rejecting and/or adding words thereto. This rejecting of words in a statute to achieve a predetermined objective is not permissible. This would amount to redrafting the legislation which is beyond/outside the jurisdiction of Courts.

(7) In tax jurisprudence, it is well settled that following four factors are essential ingredients to a taxing statute:- (a) subject of tax; (b) person liable to pay the tax; (c) rate at which tax is to be paid, and (d) measure or value on which the rate is to be applied. Thus, there is difference between a charge to tax and the measure of tax (a) & (d) above;

(8) The contention that in view of Chapter X of the Act, the notional income is to be brought to tax and real income will have no place is not acceptable because the entire exercise of determining the ALP is only to arrive at the real income earned i.e. the correct price of the transaction, shorn of the price arrived at between the parties on account of their relationship viz. AEs. In this case, the revenue seems to be confusing the measure to a charge and calling the measure a notional income. We find that there is absence of any charge in the Act to subject issue of shares at a premium to tax.

(9) W.e.f. 1 April 2013, the definition of income u/s 2(24)(xvi) includes within its scope the provisions of s. 56(2) (vii-b) of the Act. This indicates the intent of the Parliament to tax issue of shares to a resident, when the issue price is above its fair market value. In the instant case, the Revenue’s case is that the issue price of equity share is below the fair market value of the shares issued to a non-resident. Thus Parliament has consciously not brought to tax amounts received from a non-resident for issue of shares, as it would discourage capital inflow from abroad.

(10) Consequently, the issue of shares at a premium by the Petitioner to its non resident holding company does not give rise to any income from an admitted International Transaction. Thus, no occasion to apply Chapter X of the Act can arise in such a case.

https://drive.google.com/file/d/0B9NaQTAkeZWsMGpDenlac3U3S2c/view?usp=sharing

 

Transfer Pricing: High Court Clarifies Important Aspects Of The Law - TNMM

Li And Fung India Pvt. Ltd vs. CIT (Delhi High Court)

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

 

No penalty u/s. 271 (1) (c) for bona fide transfer pricing adjustments

DCIT vs. Vertex Customer Services (ITAT Delhi)


Expl. 7 to s. 271 (1) (c) provides that in the case of an assessee who has entered into an international transaction, any amount added or disallowed in computing the total income u/s 92C (4) shall for purposes of s. 271 (1) (c) be deemed to represent income in respect of which particulars have been concealed or inaccurate particulars furnished unless the assessee shows that the s. 92C computation was made in good faith and with due diligence.

The assessee, a call centre, adopted the Transactional Net Margin Method (“TNNM”) and showed an operating profit to operating cost at 10.12% on the basis of comparables. The assessee, however, showed a loss of Rs. 4.27 crs from the international transaction after making adjustment for (i) cost relating to first year operation, (ii) cost relating to excess capacity and (iii) provision for doubtful debts towards sums due from the parent company. The adjustments were made on the ground that these were extraordinary costs and required to be excluded in computing the arms’ length price under Rule 10B (e) (iii) which provides that the net profit margin arising in comparable uncontrolled transactions can be adjusted for differences between the international transaction and the comparable transaction or between the enterprises entering into such transactions which could materially affect the amount of net profit margin in the open market. The TPO rejected the third adjustment on the ground that it being an ordinary item of expenditure did not qualify for adjustment. On merits, the assessee accepted the addition though it challenged the levy of penalty. The CIT (A) allowed the appeal on the ground that the treatment of the provision for doubtful debts as an extraordinary item and not as operational cost was justified. On appeal by the Revenue, HELD dismissing the appeal:

(i) The question whether the provision for bad debt in respect of sum owed by the parent company is a matter falling in the ordinary course of trade or whether it is an extraordinary item warranting exclusion from operational cost is a debatable point on which there can be two opinions. The fact that the assessee accepted the addition and did not challenge the same will not change this aspect;

(ii) In accordance with the law in Hindustan Steel 83 ITR 26 (SC) and Nath Bros 288 ITR 670 (Del), penalty u/s 271 (1) (c) cannot be imposed where there is merely a difference of opinion. Penalty also cannot be imposed unless the party obliged either acted deliberately in defiance of law or was guilty of conduct contumacious or dishonest, or acted in conscious disregard of its obligation;

iii) On facts, there was also a full disclosure of the relevant facts by the assessee. The conduct of the assessee was not mala fide or contumacious. The computation claiming exclusion of the provision for doubtful debts in arriving at comparable profit margins cannot be said to have been done not in good faith or without due diligence. Accordingly penalty under Expl. 7 to s. 271 (1)(c) could not be levied.

Case Law:



1. This appeal by the revenue is directed against the orders of the CIT(A) dated 30.1.2008 and pertains to assessment year 2003-04.

2. The issue raised is that the ld. CIT(A) has erred in deleting the penalty amounting to Rs. 90,07,004/- imposed by the Assessing Officer under section 271(1)(c).

3. In this case the Assessing Officer noted in assessment order that the assessee company has entered into international transactions with its associated enterprises. Since the amount of international transaction was in excess of Rs. 5 crores, a reference was made to the Transfer Pricing Officer (TPO) to determine the arm's length price in terms of section 92CA(3) of the IT Act, 1961. The TPO observed that the assessee company was in the business of running a call centre. From the financial services provided, it was noted that there was substantial loss to the assessee during the year amounting to Rs. 4,27 crores. It was explained to the TPO that this was due to certain costs related to excess capacity and the certain cost related to the year being first year of operations and also there was provision for doubtful debt amounting to Rs. 22857529/-.

3.1 Among the reasons so provided, the TPO did not accept the provision of doubtful debts. He held that even after providing adequate latitude to the assessee regarding the first year of the company, excess capacity and start up expenses, there is no case for excluding the provisions for doubtful debts from the computation of operating costs. Pursuant to this TPO's report the Assessing Officer made the impugned addition of Rs. 25229708/- in the income of the assessee and penalty proceedings were also initiated.

3.2 In the penalty proceedings the assessee explained that it had made full disclosure in the facts of the case and in the returned filed and the provision of doubtful debts has been added back in the computation of income. Hence, there was no concealment or furnishing of inaccurate particulars. However these were not accepted and penalty under section 271(1)(c) was leveled by holding that assessee has not fully and truly disclosed the real operating cost and the comparable profit margin on the same as required under section 92(C) and this resulted in suppression of income as well as higher claim of loss.

4. Upon assessee's appeal the ld. CIT(A) noted that assessee had made adjustment in the operational profit due excess capacities cost, start up cost and provision of doubtful debt. He further noted that the TPO while accepting the two adjustments of start up cost and unutilized capacity was not in favour of excluding the provision of doubtful debt from the computation of operation of cost. The ld. CIT(A) referred to the provision of Explanation VII of section 271(1)(c) and several case laws. The ld. CIT(A) observed that the facts relating to provision of doubtful debts were disclosed to the revenue authorities and there was enough reason for the assessee to treat the provision of doubtful debt as extraordinary item and for exclusion of the same from the operational cost. The ld. CIT(A) observed that ingredients of Explanation-VII section 271(1)(c) were not satisfied. Further, the CIT(A) noted that Assessing Officer has not brought on record any evidence to show that the assessee had not computed the transaction price in good faith and with due diligence. Ultimately, the ld. CIT(A) concluded that the assessee had disclosed the full facts of the case to the TPO as well as to the Assessing Officer. It was only on account of difference of opinion between the assessee and the TPO that provision for doubtful debt was considered as an ordinary operative expense forming part of the operating cost and resulting in TP adjustment. Hence, the CIT(A) held it was not a fit case for levy of penalty.

5. Against this order the revenue is in appeal before us.

6. The ld. DR contended that only question to be addressed in this case is whether the provision of doubtful debt on the facts of the case was an extraordinary item to be excluded from the operating cost. She claimed there was nothing extraordinary about the provision of doubtful debt and hence, there was no reason why the same was to be excluded. She claimed this was very much coming within the ambit of levy of penalty under section 271(1)(c) Explanation-7 and the penalty had been rightly imposed.

6.1 The counsel for the assessee on the other hand submitted that there was no case of concealment or furnishing of inaccurate particulars. The assessee has duly taken services of reputed consultants and on their considered advise the arms length price was determined. The assessee's actions were all in good faith and with due diligence. In the consultants opinion the provision for doubtful debt was an extraordinary item. The difference between the Assessing Officer and the assessee and its consultants was merely a difference of opinion and this cannot be taken to show any malafide act on the part of the assessee.

6.2 We have carefully considered the submission. Before proceeding further we can gainfully refer to the Explanation-7 to provision of section 271(1)(c) which reads as under:-
"Where in the case of an assessee who has entered into an international transaction defined in section 92B, any amount is added or disallowed in computing the total income under sub-section(4) of section 92C, then, the amount so added or disallowed shall, for the purposes of clause (c) of this sub-section, be deemed to represent the income in respect of which particulars have been concealed or inaccurate particulars have been furnished, unless the assessee proves to the satisfaction of the Assessing Officer or the Commissioner (Appeals) [or the Commissioner] that the price charged or paid in such transaction was computed in accordance with the provisions contained in section 92C and in the manner prescribed under that section, in good faith and with due diligence."

6.3 A reading from the makes it clear that any adjustment in the transfer pricing is done by the revenue, then it will be deemed to represent income in respect of which particulars have been concealed or inaccurate particulars have been furnished unless the assessee proves to the satisfaction of the Assessing Officer or the Commissioner (Appeals) that the price charged or paid in such transactions was computed in accordance with provisions contained in section 92(C) and in the manner prescribed under that section, in good faith and is due diligence.

6.4 Now let us examine what action the assessee has taken to compute the arms length price in this case. The assessee has taken the services of reputed consultants KPMG for the transfer pricing review. For the purpose of determining the arms length price the assessee had applied the transactional net margin method as the most appropriate method. The TPO has not disturbed the method applied by the assessee. The assessee has identified comparable cases that are comparable to the assessee's call centre activities. The operating profit to operate cost has been calculated by the assessee at the average of 10.12%. This aspect also not being disturbed by the TPO or Assessing Officer. The assessee had incurred substantial loss amounting to Rs. 4.27 crores. Reason for the same was explained to be relating to (i) cost relating to first year operation; (ii) cost relating to excess capacity and (iii) provision for doubtful debts.

6.5 The first two adjustments were not questioned by the TPO, it was only with regard to the exclusion of bad debts, that it was claimed in the penalty order that Rule 10B(e)(iii) does not envisage making of any adjustments in the profit margin of the assessee. The said rule provides that for the purpose of sub-section (2) of section 92 (C) the arms length price in relation to international transaction can also be determined by transactional net margin method by which -

i) the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

ii) the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transactions action and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

iv) the net profit realized by the enterprise and referred to in sub-clause (i) is established to be same as the net profit margin referred to in sub-clause(iii);

v) the net profit margin thus established is then taken into account to arise at an arm's length price in relation to international transaction.

6.6 Now in the light of above, we shall examine whether the exclusion of provision of doubtful debt in this case from the operating cost can be said to be an act not done in good faith and with due diligence.

6.7 The ld. CIT(A) in his appellate order has noted that necessary facts relating to the provisions of doubtful debts were disclosed to the revenue authorities in various forms. The facts relating the said provision were that 7C Limited UK, owed a sum of GBP 307,810 to the assessee in respect of services rendered for providing call centre. However, on November, 30, 2002, 7C Holdings Ltd. and 7 C Limited UK went into winding up, after being in debt to the assessee 7C Limited UK had also incurred an amount of GBP 529,000 with respect to the formation of the assessee (which had to be cross charged to the assessee). As part of the negotiations, the Administrator decided to cancel both the debts. Accordingly, the receivable of Rs. 22,857,524 was shown as a provision for bad and doubtful debt. Now under these circumstances, this provision for doubtful debit was not considered as a part of operation and cost. The CIT(A) has observed that treatment of this extraordinary item as not forming part of operational cost is clearly justifiable.

7. Upon careful consideration, we are of the opinion that if the sums are owed by the parent company become bad the same cannot be conclusively said to be a matter falling in ordinary course of trade. The fact that the assessee has accepted the addition and not challenged the same will not change this aspect, in our considered opinion it is certainly a debatable point. A point on which admittedly there can be two opinions. As per the Accounting Standard-5 issued by the Institute of Chartered Accountant of India, extraordinary items are incomes or expenses that arise form events or transactions that are clearly distinct, from the ordinary activities of the enterprise and therefore, are not accepted to recur frequently or regularly. Hence, in the light of the aforesaid discussion whether the provision for doubtful debt on the facts of the case, can be said to be an extraordinary item warranting exclusion from operational cost is a debatable point.

8. It is further noted that as against the sum owed to the assessee, the parent company had incurred larger amount in the formation of the assessee company which was to be cross charged to the assessee. This sum was also cancelled alongwith the debt. If this sum was not cancelled against sums owed by the parent company, the assessee's cost would have been further loaded by a larger amount by the cross charge for formation expenses. In these circumstances, coupled with the fact that there was a full disclosure by the assessee of all the relevant facts, we hold that the assessee's computation cannot be said to have been done, not in good faith and not with due diligence. Hence, no levy of penalty under section 271(1)(c) is called for. In this regard, we place reliance upon the decision of the Hon'ble A'pex Court rendered by a large Bench comprising of three of their Lordships in the case of Hindustan Steel vs. State of Orissa in 83 ITR 26, wherein it was held that "An order imposing penalty for failure to carry out a statutory obligation is the result of a quasi-criminal proceedings, and penalty will not ordinarily be imposed unless the party obliged either acted deliberately in defiance of law or was guilty of conduct contumacious or dishonest, or acted in conscious disregard of its obligation. Penalty will not also be imposed merely because it is lawful to do so. Whether penalty should be imposed for failure to perform a statutory obligation is a matter of discretion of the authority to be exercised judicially and on a consideration of all the relevant circumstances. Even if a minimum penalty is prescribed, the authority competent to impose the penalty will be justified in refusing to impose penalty, when there is a technical or venial breach of the provisions of the Act, or where the breach flows from a bona fide belief that the offender is not liable to act in the manner prescribed by the statute." We further place reliance upon the decision of the Hon'ble High Court of Delhi delivered in the case of CIT Vs. Nath Bros. Exim International Ltd. in [2007] 288 ITR 670 (Delhi), where it was held that "where there was no need of enquiry by Assessing Officer there was only the need of application of law. And on legal position the Assessing Officer was not satisfied and did not agree with the assessee, but that itself could not be a ground to invoke the penalty provision of the statute"

9. Hence in the background of the aforesaid discussion and precedents, in our considered opinion on the facts and circumstances of the case the assessee cannot be held liable for penalty under section 271(1)(c) of the IT Act as his conduct is not malafide or contumacious. Accordingly, we do not find any infirmity or illegality in the order of the ld. CIT(A). Hence we confirm the same.

10. In the result, the appeal filed by the revenue is dismissed.
Order pronounced in the open court on 21.9.2009.

Honeywell Ruling by Pune Tribunal

"Current year" financial data of comparables and only the expenses having nexus with operating profits to be considered for FAR Analysis. Though per OECD guidelines, it is permissible to take profit of similar transaction not only of period under consideration, but also for next or previous year or take average of such profit - This however is not permitted under Indian TP Regulations.


HONEYWELL AUTOMATION INDIA LTD
PAN NO : AAACT3904F
Vs
Dy COMMISSIONER OF INCOME TAX
CIRCLE 7, PUNE

FACTS
The taxpayer is engaged in the business of providing integrated automation and software solutions that increase productivity in industry, provide comfort in work environments, ensure safety & security of home and business premises. The company was incorporated as a joint venture between Tata Group and the Honeywell Group in 1988 and currently enjoys a good position in Indian automation and control industry. Subsequent to the year ended March 31, 2004, Tata Group sold its entire equity stake to the Honeywell Group resulting in the Honeywell Group acquiring a controlling stake in the company.

During the year under consideration, the taxpayer, as per its audit report disclosed six international transactions with its associated enterprises. Out of six, in case of five transactions, arm’s length principles have been accepted to be satisfied and accordingly no adjustments made under the transfer pricing regulations. The detail of such transactions is available at page 2 of the order of Transfer Pricing Officer (TPO).

The taxpayer in its audit report justified and supported prices paid to its associated enterprises (AE) for the raw material etc. used in System Integration Division under TNM Method. The Transfer Pricing Officer (TPO), to whom the case was referred, however, found, from the study of report, that taxpayer had bifurcated system integration division for computing operating profit in two sub-business segments namely IS-Infra and Balance Systems. Each of these segments was separately benchmarked by taking external comparables to prove arm’s length price. The TPO did not agree that suitable comparables were taken into consideration. He also rejected bifurcation into two sub-segments (profits) since sub-segments, according to the TPO, were part of business of rendering system integration activities and accordingly TNM Method could be applied to aggregated transactions for computing arm’s length profit. TPO carried fresh analysis after finding uncontrolled comparables and worked out mean margin of the operating profit of such comparables at 0.42% as against negative figure [ (-)0.84%] disclosed by the taxpayer as per its accounts. The TPO vide show cause notice dated November 9, 2006 asked the taxpayer why arm’s length profit be not computed by applying above ratio.

The taxpayer vide its replies dated 13.06.2006, 28.07.2006, 03.08.2006 and 15.11.2006 raised objections against above computation.

The taxpayer submitted that if profit margin of the companies mentioned by the taxpayer for the financial year ended March 31, 2004 was taken into account, it will be minus 0.82%. It was accordingly contended that there was no case for making adjustment under the transfer pricing.

The Transfer Pricing Officer (TPO), on due consideration of taxpayer’s objections, did not find any substance in them. He observed that system integration segment was the identified business unit and, therefore, operating profit of the said unit has to be taken into account for benchmarking. Similar results of comparables were taken into account for analysis after considering functions carried by them. It was not possible to bifurcate and take profit of sub-segments since what was comparable in each case, was systems integration activity for applying Transactional Net Margin Method. The TPO accordingly rejected the objections of the taxpayer.
After rejecting contentions of the taxpayer, the TPO made adjustment of Rs 282 lakhs as per the following calculations:

“The profit of the system integration segment is being computed as follows:
Gross Sales: 22050 lakhs
Operating Profit: -186 lakhs
Arm’s length operating profit margin: 0.42%
Arm’s length operating profit = 22050 lakhs * 0.42% = 93 lakhs
Profit to be added to total income – 189 lakhs – 93 lakhs = 282 lakhs.

On receipt of order of the TPO, the Assessing Officer (A.O) made assessment in conformity with the said order.

The addition made under the head “Transfer Pricing adjustments” was challenged by the taxpayer in appeal before the CIT (Appeals) and the main contention of the taxpayer that the A.O committed an error in the selection of the comparables was reiterated. The CIT (A) did not find any force in the contentions raised by the taxpayer. The Transfer Pricing adjustments were accordingly upheld. The taxpayer being aggrieved has brought the issue in appeal before the Income-tax Appellate Tribunal (ITAT).

The ITAT observed, “In this complicated field of transfer pricing, the taxpayer has raised only a limited issue relating to exclusion of Wellwin Industry Ltd. as a comparable. All other objections raised before revenue authorities have been given up. Neither the selection of most appropriate method (TNMM), nor any parameters of selection have been challenged by the counsel for the taxpayer. As regards the question of not considering profit / losses of Wellwin Industry Ltd., for the period ending March 31, 2004, it is an admitted position that results of that enterprise for the relevant period are not available. The party after September, 2003 maintained accounts for 18 months and closed its account only on March 31, 2005. The company did not maintain separate accounts for the period March 31, 2004. The taxpayer did try to work out the alleged losses of the concern for the period ending March 31, 2004 on some basis by taking average of profits but was unable to show to the revenue authorities that figures so arrived at were correct and reliable for comparison.”

In the OECD guidelines, it is permissible to take profit of similar transaction or enterprises not only of the period under consideration, but also for next or previous year or take the average of such profit. This, however, is not permitted under the Indian Regulations on Transfer Pricing.

For the relevant financial year in which the international transaction took place, is to be considered for comparability analysis. Under the proviso, data for period not being more than two years prior to financial year in which international transaction was entered, may also be considered, if such data reveals facts which could have an influence on the determination of transfer prices. Under the proviso, there is no scope to consider data for a subsequent assessment year. The assessee has not been able to reveal any facts to bring the case within the above proviso. Admittedly, Wellwin Industry Ltd. in the period prior to the financial year under consideration had shown profit and same was taken into consideration for determining arm’s length price for the assessment year 2003-04. However, its accounts for the period ended 31.3.2004 are not available and, therefore, could not be taken for working mean margin of profit.

On these facts, ITAT did not find any error in the approach of revenue authorities in excluding Wellwin Industry Ltd. for a comparative analysis.

As regards the alternative contention of the taxpayer, Tribunal held that for finding operative profit margin of the taxpayer or other similar enterprises, under TNM Method, all receipts and disbursements shown in accounts for the relevant period are required to be scrutinised. Only items of receipt or expenditure having nexus with the operating profit/loss of the enterprises are to be taken into consideration. An item of receipt or expenditure, which has no direct connection with operating profit, is to be ignored. Further, relevant receipts and expenditure for the year ending 31.3.2004 are relevant and not future profit or loss of the subsequent year. It appears that to settle accounts with Tata Group, which withdrew from the enterprise after 31.3.2004, future losses were also provided in the accounts. Otherwise such provision of future losses, prima facie, had no connection with operating profit of the financial year.

The objection that such a claim was not made before the TPO or other revenue authority, cannot debar the taxpayer from raising this claim before the Income-tax Appellate Tribunal. Evidence of claim is available in the primary record considered by the revenue authorities. The matter can be considered and decided on the basis of material available on record and would cause no surprise to the opposite party.
In the case of National Thermal Power Co. Ltd. vs. CIT, the Supreme Court examined the question of powers of Appellate Tribunal relating to question raised for the first time before the Tribunal. The Supreme Court observed:

“There is no reason to restrict the power of the Tribunal under section 254 only to decide the grounds which arise from the order of the Commissioner of Income-tax (Appeals). Both the assessee as well as the Department has a right to file an appeal/cross-objections before the Tribunal. The Tribunal should not be prevented from considering questions of law arising in assessment proceedings, although not raised earlier. The view that the Tribunal is confined only to issues arising out of the appeal before the Commissioner (Appeals) is too narrow a view to take of the powers of the Tribunal.

Undoubtedly, the Tribunal has the discretion to allow or not to allow a new ground to be raised. But where the Tribunal is only required to consider the question of law arising from facts which are on record in the assessment proceedings, there is no reason why such a question should now be allowed to be raised when it is necessary to consider that question in order to correctly assess the tax liability of an assessee.”

Tribunal therefore, permitted the assessee to raise alternative ground of appeal on question of deduction of provision for future loss debited in the profit and loss account. The Tribunal opined that consideration of above debit entry is fundamental to computation of correct profit margin of the enterprise. As the question was not raised by the taxpayer before the revenue authorities and was neither examined by the taxpayer nor by TPO, ITAT set aside impugned orders and directed that above question be examined in accordance with law and profit margin of the taxpayer be determined as warranted by facts and circumstances of the case.

All relevant details be examined to finally decide the issue. In the interest of justice, the question of claim of deduction of provision of future loss is remitted to the file of the Assessing Officer / T.P.O. The same be examined and allowed in accordance with law. The alternative ground of appeal raised by the taxpayer is accepted, to the extent mentioned above.

Transfer Pricing Case Law--Essar Shipping

IN THE ITAT MUMBAI BENCH ‘L’

Essar Shipping Ltd.

v.

Deputy Commissioner of Income-tax, Range 5(1), Mumbai

K.C. SINGHAL, VICE PRESIDENT

AND R.S. SYAL, ACCOUNTANT MEMBER

IT APPEAL NOS. 4624 AND 4565 (MUM.) OF 2006

[ASSESSMENT YEAR 2002-03]

NOVEMBER 21, 2008

Section 92C of the Income-tax Act, 1961 - Transfer pricing - Computation of arm’s length price - Assessment year 2002-03 - Whether transfer pricing provisions are always applicable when transactions are entered into with associated enterprises and one holds larger voting power in other - Held, yes - Whether transfer pricing provisions provide for allowing deduction towards pro tanto addition to income on account of determination of arm’s length price in case of receipt of dividend from associated enterprises - Held, no - Whether, therefore, where there is a receipt of dividend by one enterprise from other associated enterprise, which is chargeable to tax in India, then application of transfer pricing provisions could not be ruled out to that extent on plea that it would amount to double taxation - Held, yes

Section 92C of the Income-tax Act, 1961, read with rule 10B, of the Income-tax Rules, 1962 - Transfer pricing - Computation of arm’s length price - Assessment year 2002-03 - Assessee had taken on hire one ship from its associate enterprise, namely, EIL which was engaged in operation of ships - Assessing Officer referred matter to Additional Commissioner, Transfer Pricing, under section 92CA(1) for computing arm’s length price of bare boat hire charges - Assessee had worked out amount of hire charges at arm’s length price at US$ 94,550 per month on basis of Comparable Uncontrolled Price Method (CUP Method) - Additional Commissioner, however, rejected said method - Thereafter, assessee submitted an alternate working before Additional Commissioner on basis of cost plus method - Additional Commissioner accepted assessee’s working as per cost plus method, except for reducing claim of dividend on ground that no dividend was, in fact, received by assessee - He, accordingly, reduced dividend of US$ 274 per day from payments made to EIL and, thus, determined amount payable to EIL at Rs. 2,26,02,767 - Assessing Officer upheld order of Additional Commissioner and held that inclusion of dividend by assessee of US$ 274 per day was erroneous - On appeal, Commissioner (Appeals) upheld order of Assessing Officer - Whether as per cost plus method sum of direct and indirect cost along with gross profit mark-up, etc., is taken as arm’s length price in relation to supply of property of provision of services by enterprise - Held, yes - Whether, therefore, what is relevant is to include gross profit mark up and not to reduce anything from cost - Held, yes - Whether therefore, Commissioner (Appeals) was not justified in reducing US$ 274 per day from lease rental by taking it as provision for dividend instead of normal gross profit mark-up for purposes of determination of arm’s length price under section 92C - Held, yes

Facts

The assessee-company had taken on hire one ship from its associated enterprise, namely, EIL, which was engaged in the operation of ships. The Assessing Officer referred the matter to the Additional Commissioner Transfer Pricing under section 92CA(1) for computing the arm’s length price of bare boat hire charges. The assessee contended that it had paid charter hire charges at US$ 94,550 per month to EIL. It also stated that it had entered into an agreement with EIL for taking the above ship for a period of one year and as per Clarkson report, the average one year time charter rates for a similar size of vessel was US$ 12,582 per day. By considering the age of the ship taken on hire, the amount of hire charges at the arm’s length price was worked at US$ 94,550 per month on the Comparable Uncontrolled Price Method (CUP method). The Additional Commissioner, however, rejected said method. Therefore, the assessee submitted an alternate working before the Additional Commissioner, on cost plus method. The Additional Commissioner, had accepted the assessee’s working as per cost plus method, except for reducing claim of the dividend on the ground that no dividend was, in fact, received by the assessee.

He, accordingly, reduced dividend of US$ 274 per day from payments made to EIL and, thus, determined the amount payable to EIL at Rs. 2,26,02,767. The Assessing Officer made an addition for the differential amount of Rs. 22,24,314 to the income of the assessee.

On an appeal, the Commissioner (Appeals) confirmed the action of the Assessing Officer.

On second appeal :

Held

Section 92C deals with the computation of the arm’s length price. Certain methods have been prescribed for determining such price in the international transactions and it has been mentioned in sub-section (2) of section 92C that the most appropriate method shall be applied for the determination of the arm’s length price. [Para 11]

The assessee had justified the charter hire payment by relying on CUP method. That method, as explained in clause (a) of rule 10B, deals with the determination of the arm’s length price on the basis of comparable uncontrolled transaction. The emphasis under that method is to rely on such comparable cases for the price shown, which are not related to the assessee. In simple words, it is just like showing some comparable case justifying the price paid for the services received. Such comparable uncontrolled transaction can also take the shape of any reliable date justifying the market price of similar services. In the instant case, the assessee had relied on the Clarkson Report as the comparable uncontrolled transaction. That report refers to the modern ships which are not more than ten years old and the average one year time charter rate for such vessel has been given at US$ 12,582 per day for the year-in-question. The assessee had computed the charter hire payment made to EIL at the rate of around 25 per cent of the rate as prescribed in Clarkson Report on the ground that the ships hired by it were 22 years old. There was absolutely no material worth the name by which one could justify the reduction at 75 per cent due to age factor of the ship. In principle one was agreeable with the assessee that the adjustment in the price was permissible as per sub-rule (a)(ii) of rule 10B(1). But keeping into consideration such a vast age gap of the two ships one was not inclined to hold that the ad hoc deduction of 75 per cent would bring the case within the adjustable range. [Para 12]

One was also not convinced with the submission of the assessee that the same rate of hire charges had been paid in the preceding year, which had been accepted in the assessment made under section 143(3) and resultantly the same rate should not be brought within the shadow of doubt in the instant year. The provisions for the computation of income from the international transaction having regard to the arm’s length price had been introduced for the first time in the assessment year 2002-03 and the same year was involved in the instant case. Such provisions were not applicable to the preceding year when the same amount of hire charges had been accepted by the revenue. Hence, there was no question of relying on the assessment order for the preceding year to justify the charter hire payment made in the relevant year in the light of the provisions which had seen the light of the day for the first time in the current year. [Para 13]

It was also contended by the assessee that the provision of transfer pricing should not be applied on the ground that the entire amount of dividend receivable from EIL was taxable in its hands and if the amount of lease rental as payable was reduced, that would amount to double taxation on the same income to that extent. In the instant case no dividend was paid/proposed by EIL in respect of the current year as well as for the succeeding year. It implied that the income earned by EIL had remained in its coffers and was not disbursed to the assessee by way of dividend. When the dividend itself was not received, there could not be any point of double taxation of the amount to that extent. Further, there was also no merit in the contention of the assessee that the possibility of EIL paying dividend in the next year out of the accumulated profit could not be ruled out. [Para 14]

One was not agreeable with the proposition that if the assessee-company had received dividend from the associated enterprise, then to that extent, no addition on account of transfer pricing provisions was possible. Firstly, only the transactions with the associated enterprise are brought within the purview of transfer pricing provisions. The definition of the associated enterprise as per section 92A makes it explicitly clear that one enterprise is considered as an associated enterprise of the other if one holds a larger interest in the other by way of management or control or capital, etc. Sub-section (2) of the said section further lists certain cases in which two enterprises shall be deemed to be associated enterprises. One of such deeming clause is that one holds directly or indirectly shares carrying not less than twenty six per cent of the voting power in each of such enterprises Therefore, the transfer pricing provisions are always applicable when the transactions are entered into with the associated enterprises and one holds larger voting power in the other. There is no provision in this section, which provides for allowing deduction towards the pro tanto addition to the income on account of determination of arm’s length price in case of receipt of dividend from the associated enterprises. [Para 15]

Therefore, if there is a receipt of dividend by one enterprise from the other associated enterprise, which is chargeable to tax in India, then the application of the transfer pricing provisions could not be ruled out to that extent on the plea that it would amount to double taxation. The intention of the Legislature becomes further clear on reading of the second proviso to section 92C(3), which also applies to section 92CA by virtue of sub-section (4) providing for not allowing deduction under section 10A, 10AA or 10B under Chapter VI-A in respect of the amount of income by which the total income of the assessee is enhanced after computation of income under this sub-section. [Para 16]

Therefore, the working of the assessee at the arm’s length price as per CUP Method did not merit acceptance. Now the question arose as to how such price should be determined. The assessee had submitted an alternate working before the Additional Commissioner, Transfer Pricing on the cost plus method and the Additional Commissioner, had accepted the assessee’s working as per cost plus method, except for reducing the claim of the dividend on the ground that no dividend was, in fact, received by the assessee. In such a situation, it became apparent that the cost plus method with which the Additional Commissioner, had proceeded could not be substituted with any other method at the instant stage. The Commissioner (Appeals) had approved of the action of the Assessing Officer by which the inclusion of dividend by the assessee of US$ 274 per day had been held to be erroneous. The assessee was in appeal against that exclusion and the revenue was not aggrieved on that issue. Resultantly, one was confined only to considering whether the Commissioner (Appeals) was justified in excluding US$ 274 per day from the hire charges. The cost plus method as per clause (c) of rule 10B(1) provides for taking the direct and indirect cost of production incurred by the enterprises in respect of property transferred or services provided to an associate enterprise and also in determining the amount of a normal gross profit mark up to such cost. The sum of direct and indirect cost along with the gross profit mark-up, etc., is taken as arm’s length price in relation to the supply of property or provision of services by the enterprise. What is relevant for further inclusion in the cost plus method apart from the direct and indirect costs is to add up the amount of normal gross profit. When the interest on loan and depreciation were considered together, constituting the direct and the indirect costs the amount came to US$ 2767 as lease rental per day. That amount was to be increased further by the amount of a normal gross profit mark-up. The authorities had excluded the dividend portion at 10 per cent from that claimed by the assessee in the calculation made available to the Additional Commissioner, Transfer Pricing on a misnomer. What is relevant is to include the gross profit mark-up and not reduce anything from the cost. The 10 per cent gross profit rate was reasonable one for the inclusion in the direct and indirect costs for determining the arm’s length price on cost plus method. Even if one goes by such a reasonable gross profit mark-up of 10 per cent on such cost the figure would result in US$ 274. Therefore, the Commissioner (Appeals) was not justified in reducing US$ 274 per day from the lease rental by taking it as a provision for dividend instead of the normal gross profit mark-up for the purposes of determination of the arm’s length price under section 92C. Therefore, the appeal of the assessee on that issue deserved to be allowed. [Para 17]

Hearing procedure to be followed by the Transfer Pricing Officer

Moser Baer India Ltd vs. ACIT (Delhi High Court)

Where the assessees challenged by writ petitions the orders passed by the Transfer Pricing Officer (“TPO”) determining the Arm’s Length Price (“ALP”) in relation to “International transactions” on the grounds that the said orders were passed without granting an oral hearing and without considering the documents and information filed by the assessees and without disclosing the information and documents obtained by the TPO which were used by him in the determination of the ALP, HELD, allowing the challenge:

(1) S. 92CA (3) imposes an obligation on the TPO to accord an oral hearing to the assessee. Even otherwise, an order entailing civil and penal consequences cannot be passed without a hearing.

(2) The fact that the assessee did not demand an oral hearing makes no difference. It is the constitutional obligation of the State to adopt a procedure which is both fair and just while dealing with its citizens. The fact that a citizen is unaware of his legal right cannot be used as a plank to seek legal sustenance for its actions which are otherwise invalid. It is duty of the State, in its role as a litigating party, to inform the citizen of his right i.e., to seek an oral hearing.

(3) The argument of the department that the failure to grant an oral hearing is a defect which could be cured by providing such an opportunity in the appellate forum is not acceptable.

(4) As a matter of procedure, the show-cause notice issued by the TPO just prior to the determination of ALP should refer to the documents or material available with the AO in relation to the international transaction in issue. The show cause notice should also give an option to the assessee:-

(a) To inspect the material available with the AO as give the leeway to file further material or evidence if he so desires, and

(b) to seek a personal hearing in the matter.

(5) An order is passed in breach of the principles of natural justice is a nullity in the eye of law and consequently a writ petition is maintainable notwithstanding the availability of alternate remedy.