1. These two appeals are by assessee against the orders of the CIT (A)-32 Mumbai, dated 30.01.2009. Since common issues are involved in both the appeals, these were decided together. Assessee placed on record a paper book running to pages 1 to 197 and also case law which were considered.
2. Briefly stated, assessee was incorporated as Household Remedies (P) Ltd on 9.10.1987. It had entered into a technical license agreement with M/s Sumitomo Chemical Co. Ltd (SCCL) dated 19.4.2000 for grant of license for non exclusive, non transferrable, non assignable license to use technology in India solely and exclusively for the allowed purpose i.e. for commercial production of Pynamine Forte and other products that may be mutually agreed upon between the parties from time to time in writing. AO accepts that assessee is in to manufacturing of household insecticides and pesticides in crop protection field. As part of the license the technology and intellectual property and production of chrysanthemic chloride and d-Allethrin were granted to assessee. In the year 2000-01 the SCCL Japan acquired 90% of the equity share capital of the company and the name was changed. The Company is primarily engaged in the manufacture of insecticides and pesticides. As per the agreement the company has to sell its products only to the parties approved by the said SCCL. It also purchases the requirement of intermediates from the said company only. In the impugned two years assessee has purchased intermediates and sold the products to the entities that are expressly approved by the said SCCL. One of the company to whom most of the products were sold as M/s Sumitomo Chemical India (P.) Ltd (SCI) i.e. 100% subsidiary of SCCL. In the transfer pricing report assessee submitted that the arrangement with SCCL and SCI is in the nature of contract manufacturing. The transactions were referred to TPO for determining Arm length Price. While accepting the price paid/received as arm's length price for purchase of insecticides and pesticides, intermediates from SCCL and sale of insecticides and pesticides to another associate concern SCI, the TPO however, examined the payment of royalty at 5% to SCCL as per the technology license agreement. He was of the opinion that since the purchase and sales are only from/to associate concerns and also on the reason that sales are not to be made to anybody else and there is no commercial exploitation of technical knowhow, he considered that functions being performed by assessee as nothing but contract manufacturing. Since it is a contract manufacturing agreement, there is no justification for payment of royalty for use of technical knowhow etc. Accordingly he determined the arms length price at NIL and disallowed an amount of Rs.89,44,388/- paid by assessee to M/s SCCL as royalty in assessment year 2003-04 and the an amount of Rs.67,70,358/- in assessment year 2004-05. AO made similar disallowance in the assessment order passed 'having regard to' the TPO's order.
3. It was submitted before the CIT (A) that assessee was not a contract manufacturer and an independent manufacturer and obtained technical knowhow for manufacturing of insecticides and pesticides and the royalty being paid from financial year 2000-01 onwards and this agreement was also approved by the RBI vide their letter dated 25.9.2000 (Page 26 of the paper book) for a period of seven years on the ex-factory price. It was further submitted that assessee has not paid royalty on entire sales price, but only on the value addition made to the intermediates purchased from the principal company, therefore, no royalty was paid on purchase cost of the raw material and only on the value addition. In support assessee placed the certificate from the Chartered Accountant to demonstrate about the royalty working (page 194 of the paper book) and also furnished details of sales made to outside parties i.e. third parties so as to counter the observations of the TPO that assessee has sold only to the group concerns. The learned CIT (A), while affirming that assessee was contract manufacturer however, allowed royalty payment on the sales made to outside parties and partly allowed the claim.
4. Assessee is aggrieved on this and the grounds were raised which are similar in both the years. For the sake of record, the grounds raised in assessment year 2003-04 are extracted as under:
"1. (a) The learned Commissioner of Income Tax (Appeals) has erred in disallowing Rs.61,25,3201- out of total royalty payment of Rs.89,44,388/-, being royalty payment in connection with sales made to the associated enterprise by the appellants . Your appellants submit that the same is allowable and ought to have been allowed. Without prejudice to the above, it is submitted that the learned Commissioner of Income Tax (Appeals) failed to appreciate that the royalty paid by the appellants is only 5% of net ex-factory price of sale, and that as per section 92C(2), a standard deduction of 5% has to be granted from arm's length price determined by the TPO/AO. Your appellants submit that since the royalty of 5% paid comes within that range, no adjustment needs to be made. Without prejudice to the above, your appellants submit that AO/TPO has not adopted any particular method for determining arm's length price of royalty as per provisions of Section 92C the Income tax Act, 1961. Hence your appellants submit that no adjustment needs to be made.
(b) Your appellants submit that the learned Commissioner of Income Tax (Appeals) erred in passing the appellate order on the erroneous presumption that your appellant was a 'Contract Manufacturer', even though evidences to the contrary were submitted before him and the lower authorities.
(c) Without prejudice to the above, your appellants submit that the addition made by the Transfer Pricing Officer and Assessing Officer is excessive and ought to be reduced substantially".
5. The learned Counsel explained the facts of the case and referred to the various papers placed in the paper book to submit that assessee is not a contract manufacturer. While admitting that there was a mistake committed by assessee in the Transfer Pricing study stating that the agreement is in the nature of contract manufacturing, it was submitted that this statement in TP Study cannot be taken adversely to assessee's actual business profile. It was submitted that assessee had large amount of assets and is manufacturing insecticides and pesticides and is selling in the Indian market. Then he referred to the statement in page 63 to submit that assessee had Rs.22.91 crores of sales to outside parties, whereas the sales to SCI is Rs.51.35 crores in assessment year 2003-04. Likewise assessee also sold to third parties at Rs.24.00 crores whereas the sales to SCI was Rs.62.33 crores in assessment year 2004-05. He further submitted that the royalty was not paid on entire sale price but only on the value addition made by assessee while manufacturing insecticides and pesticides from the intermediates imported from SCCL. It was further submitted that the CIT (A) allowed royalty at 5% in sales made to third parties, whereas assessee has paid royalty at the same price to SCCL whereas the sales were made to its 100% subsidiary in India at the arm's length price. It was his submission that the price charged to SCI and to outside parties was the same and this was accepted by the TPO as arm's length price. Even purchases of the intermediates were also accepted as that of arms length price. Therefore, since assessee has obtained technical knowhow from SCCL, 5% royalty on the entire value addition made should have been allowed by the CIT (A) rather than restricting to sales made to third parties. He further submitted that assessee is not a contract manufacturer and referred to the percentage of raw material imported, indigenous material and packing material so as to submit that assessee is not a contract manufacturer.
6. The learned Counsel relied on various case law to submit that the agreement is on principal to principal basis and not a contract manufacturing arrangement.
7. It was further argued that the TPO cannot question the business purpose of transaction when assessee paid 5% royalty and restrict the same to Nil stating that assessee is a contract manufacturer. It was the submission that apart from the fact that assessee is an independent manufacturer and not a contract manufacturer, the TPO cannot disallow the entire amount under section 37(1) and relied on the principles laid down by the Hon'ble Delhi High Court in the case of CIT v. EKL Appliances Ltd.[2012] 206 Taxman 97 (Mag.)/20 taxmann.com 509 and also the ITAT decision in the case of Ericson India (P.) Ltd v. Dy. CIT in ITA No. 5141/Del/2011. It was also further contention that since royalty was paid at 5%, AO cannot disallow the entire amount as it was within the safe harbor range of (+)/(-) 5% and relied on the cases of ITAT Bangalore in the case of Philips Software Centre (P.) Ltd. v. Asstt. CIT [2008] 26 SOT 226 & ITAT Pune Bench decision in the case of Starnet Networks (India) (P.) Ltd. v. Dy. CIT [ITA No.1350/PN/2010] to submit that no disallowance can be made.
8. With reference to the issue of additional ground in AY 2003-04 the learned Counsel referred to the reasoning for reopening the assessment being a proposed addition under section 2(22)(e) on the loans and advances given by the SCI which was examined and no addition was made, vide Para 6 of the assessment order. Since no addition on the reason for reopening was made the learned Counsel submitted that the reopening of assessment and completing the assessment on a different aspect (disallowance of royalty) in assessment year 2003-04 was not proper and relied on the principles laid down by the Hon'ble Bombay High Court in the case of CIT v. Jet Airways (I) Ltd. [2011] 331 ITR 236/[2010] 195 Taxman 117 and Ranbaxy Laboratories Ltd. v. CIT [2011] 12 taxmann.com 74/200 Taxman 242 (Delhi HC).
9. The learned CIT (DR), however, submitted that assessee is a contract manufacturer. It was his submission that assessee purchases entire intermediates from the related party and sold to private parties mainly to the related party. He submitted that there are three types of manufacturing processes i.e. full fledged manufacturing, contract manufacturing and toll manufacturing. What assessee's Counsel was distinguishing is between the full fledged manufacturing and toll manufacturing and not contract manufacturing. He referred to page 186 of the paper book i.e. Schedule-I to the TP Report to submit that the Chartered Accountant has certified that the manufacturing of goods carried on by assessee is wholly dependent on the use of technical knowhow of which associate enterprise is the owner and goods manufactured by assessee are sold to the persons, prices and other conditions as influenced by the associate enterprise. Referring to the schedule-I and also the functional analysis submitted by assessee in the TP report, it was his submission that assessee is a contract manufacturer. Further he also referred to the percentage of raw material used in manufacturing to submit that assessee is controlled by the principle company in manufacturing activity. Therefore, it cannot be considered as an independent manufacturer and in a contract manufacturing there is no requirement of royalty payment. It was his submission that AO has rightly considered that there is no need to pay any royalty. In support of his contention that assessee is a contract manufacturer he relied on the observations of the ITAT in the case of Sona Voka Precision Ltd to submit that in that case only fraction of the goods manufactured are sold to the AE, whereas bulk of the sales are sold to the uncontrolled parties. In that case it was held that assessee cannot be said to be a contract manufacturer for AE whereas in this case two-thirds of the goods manufactured are sold to AE. Therefore, assessee has to be considered as contract manufacturer. It was further submitted that the case law relied upon by assessee was not applicable as they are pertaining to the definition of 'work contract' under section 194C and does not apply to the arrangement of contract manufacturing. He also distinguished the decision of the Hon'ble Delhi High Court in the case of EKL Appliances (Supra) to submit that in that case assessee could not demonstrate the benefit or advantage obtained by the technical knowhow received and there was no justification for the royalty which was disallowed, whereas in this case the facts are different. It was his submission that the CIT (A) has correctly allowed the royalty payment on sales made to outside parties and disallowed the royalty payment on sales made to AE.
10. In reply it was submitted that assessee is an independent manufacturer and referred to the indigenous material utilized in the local manufacturing which is varying from 8 to 21% in these two years. It is also the contention that when the sales are made to outside parties, at what percentage the sales are made to the outside parties become irrelevant as the TPO accepted the price obtained from AE as arms length price, which in fact was the same price for which the goods are sold to third parties. The condition that every sale has to be to the party approved by the principal is inevitable as assessee is manufacturing critical chemicals which can not be sold to unauthorized persons, unless one verifies the facilities they have for utilizing the products sold as raw material. Since these insecticides and pesticides are very critical and cannot be made available to all persons proper restrictions are placed on the supply of manufactured goods by the license holder so as to protect from the risks involved in selling the products to outsiders. The observation relied upon by the TPO that even sales are controlled was in the context of approved sales to the authorized persons only but there is no control of the pricing or marketing or any other aspect of it. He referred to the manufacturing activity and to the fact that assessee is purchasing intermediates and utilizing it in its own machineries for production of specified chemical/ insecticides and pesticides and packing them in different packs. It was also submitted that assessee's sales are independent of principal except that the parties are to be approved by the principal. It was submitted that assessee is having proper license to manufacture products on its own and it cannot be considered as contract manufacturing as there is no arrangement either for contract manufacturing or paying charges for it. Even if the third party obtains license, similar conditions are being placed and royalty has to be made for technology transfer which was approved by the RBI at 5% on value addition made by assessee in the manufacturing process.
11. We have considered the rival contentions. As seen from the record assessee entered into an agreement for obtaining license to manufacture specified insecticides and pesticides and agreed to pay 5% royalty on the value addition and RBI has approved the royalty at 5% for a period of seven years. Till assessment year 2003-04 there was no dispute with reference to the payment of royalty and even in the original assessment completed the royalty was allowed as eligible expenditure in the order under section 143(3). In assessment year 2004-05 this issue for the first time was examined by the TPO on the basis of the TP report of assessee wherein assessee submitted that the arrangement is in the nature of contract manufacturers in the FAR analysis. Since this was admitted by assessee, the TPO without examining the nature of agreement or the manufacturing activity of assessee or any other incidental factor came to a conclusion that since assessee admitted to be a contract manufacturer, there is no need to pay any royalty. In his order the TPO also mentions that assessee was not making any sales to outside parties, the fact of which is not correct. On the basis of his observations, he arrived at the royalty arms length price at Nil.
12. The Hon'ble Delhi High Court in the case of EKL Appliances Ltd. (supra) has examined a similar issue whether the TPO has power to restrict it to nil when he was supposed to have determined the arms length price of the international transaction. The Hon'ble High Court after examining the facts of the case held as under:
"19. There is no reason why the OECD guidelines should not be taken as a valid input in the present case in judging the action of the TPO. In fact, the CIT (Appeals) has referred to and applied them and his decision has beer: affirmed by the Tribunal. These guidelines, in a different form, have been recognized in the tax jurisprudence of our country earlier. It has been held by our courts that it is not for the revenue authorities to dictate to the assessee as to how he should conduct his business and it is not for them to tell the assessee as to what expenditure the assessee can incur. We may refer to a few of these authorities to elucidate the point. In Eastern Investment Ltd. v. CIT , (1951) 20 ITR 1, it was held by the Supreme Court that "there are usually many ways in which a given thing can be brought about in business circles but it is not for the Court to decide which of them should have been employed when the Court is deciding a question under Section 12(2) of the Income Tax Act". It was further held in this case that" it is not necessary to show that the expenditure was a profitable one or that in fact any profit was earned". In CIT v. Walchand & Co. etc., (1967) 65 ITR 381, it was held by the Supreme Court that 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. It was further observed that the rule that expenditure can only be justified if there is corresponding increase in the profits was erroneous. It has been classically observed by Lord Thankerton in Hughes v. Bank of New Zealand , (1938) 6 ITR 636 that "expenditure in the course of the trade which is un-remunerative is none the less a proper deduction if wholly and exclusively made for the purposes of trade. It does not require the presence of a receipt on the credit side to justify the deduction of an expense". The question whether an expenditure can be allowed as a deduction only if it has resulted in any income or profits came to be considered by the Supreme Court again in CIT v. Rajendra Prasad Moody , (1978) 115 ITR 519, and it was observed as under:-
"We fail to appreciate how expenditure which is otherwise a proper expenditure can cease to be such merely because there is no receipt of income. Whatever is a proper outgoing by way of expenditure must be debited irrespective of "whether there is receipt of income or not. That is the plain requirement of proper accounting and the interpretation of Section 57(iii) cannot be different. The deduction of the expenditure cannot, in the circumstances, be held to be conditional upon the making or earning of the income."
It is noteworthy that the above observations were made in the context of Section 57(iii) of the Act where the language is somewhat narrower than the language employed in Section 37(1) of the Act. This fact is recognized in the judgment itself. The fact that the language employed in Section 37(1) of the Act is broader than Section 57(iii) of the Act makes the position stronger.
20. In the case of Sassoon J. David & Co. Pvt. Ltd. v. CIT , (1979) 118 ITR 261 (SC), the Supreme Court referred to the legislative history and noted that when the Income Tax Bill of 1961 was introduced, Section 37(1) required that the expenditure should have been incurred "wholly, necessarily and exclusively" for the purposes of business in order to merit deduction. Pursuant to public protest, the word "necessarily" was omitted from the section.
21. The position emerging from the above decisions is that it is not necessary for the assessee to show that any legitimate expenditure incurred by him was also incurred out of necessity. It is also not necessary for the assessee 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. It is this principle that inter alia finds expression in the OECD guidelines, in the paragraphs which we have quoted above.
22. Even Rule 10B(1)(a) does not authorize disallowance of any expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same or that in the view of the Revenue the expenditure was un-remunerative or that in view of the continued losses suffered by the assessee in his business, he could have fared better had he not incurred such expenditure. These are irrelevant considerations for the purpose of Rule l0B. Whether or not to enter into the transaction is for the assessee to decide. The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allowability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the assessee has suffered continuous losses. The financial health of assessee can never be a criterion to judge allowability of an expense; there is certainly no authority for that. What the TPO has done in the present case is to hold that the assessee ought not to have entered into the agreement to pay royalty/ brand fee, because it has been suffering losses continuously. So long as the expenditure or payment has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning. As provided In the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and suitable adjustment but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorized".
13. The principles laid down by the Hon'ble Delhi High Court in the above said case equally applies to the facts of the case. Even though the learned CIT (DR) tried to distinguish on the reason that the facts are different the ratio decidendi in the above said case is about the powers of the TPO to determine the ALP at nil value. As in the above said case what the TPO has done in the present case is also to hold that assessee need not pay any royalty on the presumption that assessee is a contract manufacturer. The TPO has to examine whether the price paid or amount paid was at arms length or not under the provisions of Transfer Pricing and its rules. The rule does not authorize the TPO to disallow any expenditure on the ground that it was not necessary or prudent for assessee to have incurred the same. On that principle alone, we cannot approve the order of the TPO as it not only considered the facts wrongly but also exceeded the jurisdiction available to the TPO in examining the arms length price on a transaction.
14. Apart from the legal position stated above, even on merits the disallowance of entire royalty payment on sales to AE was not warranted. Assessee admitted that it wrongly claimed in the TP report that the arrangement is in the nature of contract manufacturing. However, as seen from the agreement entered by the erstwhile Home Remedies Ltd with SCCL it is for obtaining license for manufacturing specified products. Since the technology is specific to the manufacturing specific items, the condition is that the intermediates are to be imported from the SCCL. However, after importing the intermediates assessee is also using the indigenous material in manufacturing the specified insecticides and pesticides. It is also acquiring packing material required for packing insecticides and pesticides produced in 5 ltrs and 20 ltrs containers. Since these insecticides and pesticides are for specified for usage (mosquito repellents etc.,) these products are mainly sold to AE and also to other third parties who require the insecticides and pesticides so manufactured. Assessee is also paying excise duty and other taxes. The principal company is not paying any amount to the assessee company towards manufacturing if it were to be considered as contract manufacturing. Even though admittedly assessee mentioned in the TP report that the arrangement is in the nature of contract manufacturing, the facts indicates otherwise. The royalty was paid as per the agreement on the value-added price to the SCCL for providing the license and technical knowhow. This payment is independent of whether assessee is full fledged manufacturer or a contract manufacturer or a toll manufacturer and the nature of manufacturing activity cannot have any bearing on the payment of royalty. As submitted, the royalty is not paid on the entire sales price but only on the value added price which was worked out separately. We are also surprised that the CIT (A) restricted the royalty on the sales to AE only when the sales to AE was at arms length price as that of sales to third parties. There is no logic in allowing the sales made to the third parties and not on sales made to AE. As already stated the said agreement was approved by the RBI for payment of royalty at 5% for a period of 7 years. There was also no such disallowance in earlier years. Since we do not find any reason to restrict the royalty to Nil, we are not in a position to approve the order of the CIT (A) on this issue. Without going into the nitty-gritty of determining whether assessee is a contract manufacturer or a full-fledged manufacturer, since royalty is paid for allowing assessee in utilizing the technical knowhow and the license for manufacturing activity, we are of the opinion that the payment of royalty is wholly and exclusively for the purpose of business. In view of this, we allow assessee's ground and direct AO to allow the royalty as claimed.
15. Assessee also raised one of the argument as ground that the TP adjustment so made will be within the safe harbor limit of +/-5%. This argument can not be accepted as the International Transaction is the payment of royalty alone. The TPO determined ALP at NIL which works out to 100% variation. This is more than the safe harbor limit prescribed. Therefore this argument cannot be accepted. However, we have held that the payment of Royalty is wholly and necessarily for the purpose of business.
16. The rate of Royalty at 5% was allowed by CIT(A) on part of sales. Revenue has not come in appeal or objected to the said rate. Therefore, we hold that 5% royalty rate is at arm length price. For all the reasons stated above, we hold that assessee's payment of royalty cannot be disallowed invoking the TP provisions. We direct AO to allow the same. Grounds in both assessment years are thus allowed.
17. In assessment year 2003-04, assessee has raised one more additional ground on the jurisdiction of AO for reopening the assessment. This issue was not raised before the CIT (A) and for the first time raised before the ITAT. Since it a legal issue, after considering the rival contentions, the additional ground was admitted.
18. As briefly stated above, AO reopened the assessment under section 147 on the reason that there were advances received from the associate concern whose 100% shares are also held by the SCCL and has 90% shareholding in assessee company. Even though there is no direct shareholding by the AE company (SCI) in assessee's company, AO was of the view that the provisions of section 2(22)(e) are applicable on the loans and advances given by the SCI to assessee. For that reason only assessment was reopened. However, in the course of the assessment proceedings assessee submitted that the amount received was nothing but trade advance and do not attract deemed dividend provisions under section 2(22)(e). AO accepted the submissions and no adverse inference was drawn on this issue. However, based on the TP report for assessment year 2004-05, AO similarly disallowed the royalty amount even though on record there seems to be no reference to the TPO as prescribed under the provisions. Since the issue of disallowance of royalty was not an issue for reopening the assessment and the issue on which the assessment was reopened was dropped in the course of the assessment proceedings, AO has exceeded the jurisdiction provided under section 147 as held by the Hon'ble Bombay High Court in the case of Jet Airways (I) Ltd. , (supra). AO gets power to assess such other income, only if the income referred to in the reasons for reopening has been assessed. As the AO did not bring any income to tax on the issue of deemed dividend, we hold that reopening of the assessment itself was bad in law. Therefore, in AY 2003-04 it has to be held that the re-assessment per se was bad in law.
19. In the result, both the appeals by assessee in ITA Nos. 2057 & 2058/Mum/2009 are allowed.