R.S. SYAL, AM:-This appeal by the Revenue is directed against the order passed by the CIT(A) on 30.6.2010 in relation to the assessment year 2004-05.
2. The only issue raised in this appeal is against the deletion of addition on account of transfer pricing adjustment in respect of two international transactions.
3. Briefly stated, the facts of the case are that the assessee, an Indian company, is held 44.15% by Bausch & Lomb Indian Holdings Inc., USA, which, in turn, is indirectly held 100% of Luxottica SPA, Italy. The assessee is primarily engaged in the business of manufacturing, importing and selling of sunglasses and prescription frames in India besides exporting some finished frames to Luxottica Group. The assessee reported six international transactions in Form No. 3CEB classified into three categories, namely, Class I, Class II and Class III. The Transactional Net Margin Method (TNMM) was applied in respect of transactions falling in Class I and Class II and the Comparable Uncontrolled Price (CUP) method in respect of transaction falling in Class III. On a reference made by the Assessing Officer (AO) to the Transfer Pricing Officer (TPO) for determining the arm’s length price (ALP) of the international transactions, the latter took up transactions falling under Class I, on which the assessee adopted Profit level indicator (PLI) of Operating Profit/Total Cost (OP/TC) and computed the same at 17.87%, as against average net profit margin of comparables at 6.23%. That is how, it was shown that these international transactions were at ALP. The TPO did not accept application of the TNMM as the most appropriate method by observing that there were transactions both of purchase and sale, namely, Import of raw material, components and semi finished goods, Import of capital goods and Export of semi finished goods. In his opinion, the operating profit margin from the international transaction per sewas not identifiable. He opined that aggregation of all the international transactions by the assessee was not appropriate inasmuch as controlled transactions could be aggregated with controlled transactions alone and uncontrolled transactions with uncontrolled transactions. He held that there was no provision under which aggregation of controlled transactions with uncontrolled transactions was permissible. He, therefore, treated CUP as the most appropriate method for international transactions under Class I. He proceeded to determine the ALP of one of the international transactions under Class I, namely, ‘Import of raw materials, components and semi finished goods’ with transacted value of Rs. 2,54,95,801/-, without questioning the ALP of the other three international transactions under this Class. Going with the first international transaction of 'Import of raw materials, components and semi finished goods’, the TPO noticed that an order dated 26.8.2004 was passed by the Assistant Commissioner of Customs, wherein such imports of raw material, components and semi finished goods were examined in detail. It was noticed from such order that the assessee submitted before the Assistant Commissioner of Customs that the raw material imported by it from its AE was, in turn, purchased by the AE from other parties and : ‘the imports were made at substantially higher prices than the price at which the AE has purchased the raw material.’ It was, thus, observed that the raw material imported by the assessee from its AE was not manufactured by such AE, but, procured from a supplier in the same geographical location i.e., Italy itself and then sold to the assessee at a higher price. He inferred from this that the comparable uncontrolled price of the imports made by the assessee was available. On being called upon to explain its stand on the application of CUP and treating the transaction of purchase by the AE as a comparable transaction, the assessee put forth that the third party supplier prices did not constitute a valid CUP because there were several differences in the third party supplier prices vis-à-vis the prices charged from it. These differences were explained, being, a time gap between the third party supplying goods to the assessee’s AE and, in turn, the assessee importing them from its AE. In this regard, it was submitted that the raw materials were purchased by its AE from third parties during the period December, 2001 to May, 2002 and imports were made by the assessee during the period April, 2003 to March, 2004. The other distinguishing feature pointed out by the assessee was that its AE was making bulk purchases, thereby availing huge volume discounts. Still another distinguishing feature was put across that the details of third party raw material purchase prices, submitted before the Customs Authorities, were on a sample basis. In the light of the above distinguishing features, it was argued before the TPO that there was no internal CUP available to benchmark the international transaction of Import of raw material/components from group companies. The TPO did not accept the assessee’s contentions. He noticed from the submissions made before the Customs Authorities that the comparable uncontrolled price of various items purchased was ascertainable. A chart has been drawn in the TPO’s order showing average margin of 11.75% charged by the AE from the assessee. As the AE was not doing any trading of the raw material and merely procuring the same for distribution to groups concerns, the TPO held this margin of 11.75% as the basis for determining the ALP of the international transaction. By reducing such profit margin at 11.75% from the transacted value of import of raw material, the TPO determined comparable uncontrolled price at Rs. 2,28,15,034/- against the purchase price shown by the assessee at Rs. 2,54,95,801/-, thereby recommending transfer pricing adjustment of Rs. 26,80,767/-. The assessee assailed the assessment order containing this addition before the ld. CIT(A), who deleted the addition by accepting the assessee’s contention that the percentage variation computed by the TPO was not on account of margin charged by the AE on sale to the assessee, but, towards the weighted average pricing methodology followed by the AE and the same being further supported by a certificate received from Luxottica SPA, Italy, confirming that no mark-up was charged on raw material and components purchased by the assessee. Ergo, he held that the TPO’s conclusion that the AE earned average margin of 11.75% on sale of raw material and components etc. to the assessee was not justified, which resulted into erasing the addition . The Revenue is aggrieved against the deletion of addition.
4. We have heard the rival submissions and perused the relevant material on record. It is noticed that the assessee has drawn up its accounts on entity level without there being any separate accounts for Class I, Class II and Class III international transactions. It is only for the purpose of determining the ALP of these international transactions that the assessee split up common expenses/incomes into these three classes. In doing so, the assessee benchmarked all the international transactions under Class I as per the TNMM by showing that its PLI of 17.87% was better than 6.23% of comparables. The TPO has disputed only ‘Import of raw materials, components and finished goods’ from the international transactions under Class I and determined its ALP by applying the CUP method.
5. The first issue is ascertaining the most appropriate method on import of raw materials etc. There is hardly any need to emphasize that the CUP is the most appropriate method for determining the ALP of purchase or sale of goods or services because it seeks to compare the exact price charged or paid rather than the profit rate. Operating profit under TNMM is affected by several factors, some of which may significantly impact the determination of ALP while others may not. Thus, if some direct comparable uncontrolled instance of purchase or sale of similar goods or services is available, then, CUP serves as the most appropriate method for determining the ALP of such an international transaction. Adverting to the facts of the instant case, we find that the dispute is only qua the determination of ALP of the international transaction of ‘Import of raw materials, components and semi finished goods’ under Class I transactions. It is obvious that if some comparable uncontrolled instances can be found, then, there can be no other method more appropriate than the CUP method for determining the ALP of such import of goods etc. As the ld. CIT(A) has also upheld the application of CUP as the most appropriate method, which aspect has not been challenged by the assessee, we hold that the TPO was right in applying the CUP method for determining the ALP of the international transaction of import of raw materials, components and semi finished goods.
6. Now, turning to the application of the CUP method, we find that the ld. CIT(A) has deleted the addition by simply accepting the assessee’s contention that the percentage variation computed by the TPO was not on account of margin charged by the AE on sale to the assessee, but, due to weighted average price methodology followed by the AE. This is in complete contrast to what the assessee argued before the Customs Authorities, namely, that: ‘the imports were made at substantially higher prices than the price at which the AE has purchased the raw material’. The ld. CIT(A) was swayed by the assessee’s submission without reconciling the conflicting stands of the assessee taken before the Customs Authorities on one hand and that taken before him about the weighted average price methodology indicating no margin charged by the AE on the sale to the assessee on the other hand. We cannot countenance the view point of the ld. CIT(A) in deleting the addition on this count.
7. At the same time, we find that the TPO has taken assistance from the order of the Customs Authorities, during which proceedings the assessee contended that the imports were made at substantially higher prices than the price at which the AE had purchased the raw material. The TPO sought details from the assessee which divulged that the AE charged average margin of 11.75% on the goods supplied to the assessee. It is with this application of average profit rate of 11.75% that the TPO has computed transfer pricing adjustment of Rs. 26,80,767/-. In order to evaluate the action of the TPO, it would be befitting to take note of the mandate of rule 10B(1)(a) which prescribes the method for computation of the ALP under the CUP method as under : -
“(a) comparable uncontrolled price method, by which,-
(i) the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified ;
(ii) such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market ;
(iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm’s length price in respect of the property transferred or services provided in the international transaction ;”
8. Sub-clause (i) of 10B(1)(a) provides for identifying the price charged or paid for property transferred in acomparable uncontrolled transaction. Under sub-clause (ii), the price identified under sub-clause (i) is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions. Such adjusted price arrived at under sub-clause (ii) becomes ALP of the international transaction of property transferred as per sub-clause (iii). When we espouse the facts of the instant case, it is found that the TPO has proceeded to determine the ALP under CUP method by considering the transaction between the asessee’s AE in Italy and third party also in Italy. Such a geographical difference, where in both the buyer and seller are foreign parties, cannot constitute a 'comparable’ uncontrolled transaction, more so, when the assessee itself has been treated as a tested party. An external comparable uncontrolled transaction will exist when similar goods are purchased by some another Indian party from a non-AE. Similarly, some internal comparable uncontrolled transaction will exist when the assessee purchases similar goods from a non-AE. The essence of the matter is that a pre-transaction of purchase by the foreign AE from another unrelated foreign party cannot constitute an internal CUP for determining the ALP of the same goods purchased by an Indian assessee from its AE.
9. Further, what the TPO has done is to apply the alleged profit rate of 11.75% charged by the AE from the assessee for computing the ALP. The CUP method contemplates comparing the adjusted comparable uncontrolled price with the price charged or paid in an international transaction. The TPO has not compared any price charged in a comparable uncontrolled transaction with the price paid by the assessee. It is axiomatic that the CUP method requires comparison of the price charged in a comparable uncontrolled transaction and then making transfer pricing adjustment for the difference, if required. It does not say that the international transaction must be on cost to cost basis and no profit element can be charged. In our considered opinion, profit margin, if any charged by the AE from the assessee cannot be considered for determining the ALP of a comparable uncontrolled transaction. Even if the AE charges a reasonable mark-up on its cheap comparable purchase price, the price so charged will be ALP so long such price charged is less than what other comparable companies charge in uncontrolled transactions. Having set aside the view point of the ld. CIT(A) in deleting the addition and approving in principle, the adoption of the CUP method and the further fact that the TPO has not applied the CUP method in the manner as discussed above, we are of the considered opinion that it would be in the fitness of things if the matter is restored to the file of AO/TPO for determining the ALP of this international transaction under the CUP method as per law. We order accordingly. Needless to say, the assessee will be allowed a reasonable opportunity of being heard in such fresh proceedings.
10. Now, we take up the solitary international transaction of ‘Import of finished goods’ with value of Rs. 5,30,25,583 under Class II. The assessee benchmarked this international transaction under the TNMM by showing its profit margin at 5.61% as against 2.37% of comparables. The TPO did not approve application of TNMM for benchmarking this international transaction on the ground that it was a transaction of import of finished goods from its AE, which were sold as such without any value addition by the assessee in the capacity of a distributor. He again went through the order dated 26.8.2004 passed by the Customs Authorities, during the course of which it was argued by the assessee that the price to the assessee was higher than the price to the unrelated parties. The assessee had also contended before the Customs Authorities that it sold the imported sunglasses, etc. to the dealers/retailers at almost 50% of the MRP, whereas the dealers/retailers were selling at 40% mark up. From this submission made before the Customs Authorities, the TPO inferred that the transaction of import of finished goods from AE was not at ALP as the assessee itself admitted that the price charged by its AE was higher than what the AE was charging from other unrelated Indian enterprises. Considering these and host of other factors, which were noted while not approving TNMM for Class I transactions, the TPO held that the TNMM could not be accepted as the most appropriate method. He changed the most appropriate method to the Resale Price Method (RPM) for determining the ALP of this international transaction of 'Import of finished goods’. In determining the ALP under the RPM, the TPO noticed that the assessee contended before the Customs Authorities that the gross margin of down the line distributors was 100% on cost or 50% if computed on sales. He, therefore, adopted normal gross profit margin under Rule 10B(1)(b)(ii) at 50% and computed the ALP of the import of finished goods at Rs. 4.24 crore, thereby proposing transfer pricing adjustment of Rs. 105,57,553/- as under:-
| Total sales of traded goods made during the year |
: |
Rs.13,02,21,637/- |
GP on sales as computed by the assessee |
: |
37.57% |
Value of the import of finished goods |
: |
Rs.5,30,25,583/- |
Re-sale price computed on the same GP margin |
: |
Rs.8,49,36,061/- |
Arm’s Length GP on sale |
: |
50% |
Arm’s length Price of the international transaction @ 50% of resale price |
: |
Rs.4,24,68,030/- |
11. The AO made this addition. When challenged, the ld. CIT(A) deleted the same by accepting the assessee’s contention that the so-called ALP margin (i.e. 50% on sales earned by down the line distributors) was not the actual gross margin of the distributors as they also paid VAT/sales tax at around 12.5% on sale to end customer, thereby bringing their gross margin of 37.50%, which was in close vicinity to the assessee’s gross profit margin of 37.57%. The Revenue is aggrieved against deletion of this addition.
12. We have heard the rival submissions and perused the relevant material. The first issue is determination of the most appropriate method, being either the TNMM or RPM. The international transaction under consideration is 'Import of finished goods’ which have been sold by the assessee in India as such, without any value addition. The TPO applied the RPM, which has not been disturbed by the ld. CIT(A) and further there is no challenge to it by the assessee. In our considered opinion, the RPM is quite a useful method where the goods purchased by the Indian AE are sold without doing any value enahncement. We, therefore, approve the application of RPM as the most appropriate method.
13. Now coming to the merits, we find that the ld. CIT(A) chose to delete the addition by simply accepting the assessee’s contention that the VAT/sales tax was around 12.5% on sale to end customer and thus the actual adjusted gross margin of distributors should be considered as down to 37.5%. When we talk of profit margin, the same covers all the costs. Vat/sales tax is an indirect tax and unlike income-tax is a charge against income and not appropriation of income. Its inclusion firstly in the sale price and then claim of deduction, neutralizes both the sides. The net result is that its simultaneous receipt and payment do not impact the ultimate profit margin so as to warrant a separate adjustment on account of its payment alone. The ld. CIT(A) failed to take note of this important aspect and went on to consider only the payment part in isolation of the receipt part of VAT/sales tax. He further failed to consider the assessee’s contention before the Customs Authorities that: ‘they have submitted the details of these imports and that this shows that the price to the Indian company is higher than the price to the unrelated parties.’ As such, we are constrained to disapprove the view taken by the ld. CIT(A) in deleting the addition on this slippery reasoning.
14. Now, let us examine whether the determination of the ALP by the TPO under RPM is justified. In this regard, we find that rule 10B(1)(b), dealing with the mechanism for determination of the ALP under this method, reads as under :-
“(b) resale price method, by which,-
(i) the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified ;
(ii) such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions ;
(iii) the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services ;
(iv) the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market ;
(v) the adjusted price arrived at under sub-clause (iv) is taken to be an arm’s length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise;”
15. A perusal of the above mandate transpires that sub-clause (i) of Rule 10B(1)(b) provides that the price at which the goods purchased by the enterprise from its AE is resold is identified. Such resale price under subclause
(ii) is reduced by the amount of normal gross profit margin from the purchase and resale of the same goods in a comparable uncontrolled transaction. The price so arrived at is revised under sub-clause (iii) by the expenses incurred by the assessee and the price so arrived at is adjusted to take into account the functional and other differences between the international transaction and the comparable uncontrolled transaction. The adjusted price so arrived under sub-clause (iv) is taken as ALP in respect of purchase of goods from the AE. We find that sub-clause (ii) talks of reducing the resale price of the enterprise by the amount of a normal gross profit margin arising from the purchase and resale of similar goods in a comparable uncontrolled transaction. The term ‘uncontrolled transaction’ has been defined in Rule 10A(a) to mean: ‘a transaction between enterprises other than associated enterprises whether resident or nonresident.’ When we substitute the definition of the term ‘uncontrolled transaction’ in Rule 10B(1)(b)(ii), the relevant part would read that the resale price of the enterprise is reduced by the amount of normal gross profit margin accruing in a comparable transaction between enterprises other than the associated enterprises. The crux of the matter is that ALP of an international transaction of purchase of goods is always determined on the basis of the gross profit margin on the resale price charged in a comparable transaction between enterprises other than the associated enterprises. It cannot be anything else. Only when some gross profit margin in comparable transaction between two independent enterprises is available, sub-clause (ii) of Rule 10B(1)(b) works. In other words, the existence of a comparable uncontrolled transaction giving gross profit margin accruing from purchase and resale of similar goods is an essential condition for determining the ALP under RPM. Adverting to the facts of the instant case, we find from the calculation of the ALP under RPM as extracted above that the TPO has taken arm’s length margin of GP on sales at 50%, which has been considered for determining the ALP of this international transaction at Rs. 4.24 crore leading to transfer pricing adjustment of Rs. 1.05 crore. This 50% arm’s length gross profit margin on sales has been taken by the TPO on the basis of what the assessee stated before the Customs Authorities in a generalized manner. The TPO has not brought on record any comparable uncontrolledcase and thus has not eventually determined gross profit margin from purchase and resale of similar goods in a comparable uncontrolled transaction. In the absence of availability of any comparable uncontrolled transaction, we cannot approve the action of the AO in making such an addition, as the same has not been done in the manner prescribed under the rule. As we have upheld the application of RPM as the most appropriate method and found the view point of the ld. CIT(A) in deleting addition to be untenable, we consider it expedient to set aside the impugned order and remit the matter to the file of TPO/AO for a fresh determination of the ALP of this transaction under the RPM in the manner discussed hereinabove.
16. To sum up, we set aside the impugned order deleting the additions made by the AO on account of transfer pricing adjustment in Class I and II international transactions and send the matter back to the TPO/AO for determining afresh the ALP of Class I international transaction under the CUP method and of Class II international transaction under the RPM as per law.
17. In the result, the appeal is allowed for statistical purposes.