M/S AO SMITH INDIA WATER PRODUCTS PRIVATE LIMITED,BANGALORE vs. DEPUTY COMMISSIONER OF INCOME TAX, CIRCLE-1(1)(1), BANGALORE

IN THE INCOME TAX APPELLATE TRIBUNAL BANGALORE BENCHES “B”, BANGALORE Before Shri Chandra Poojari, Accountant Member & Shri Prakash Chand Yadav, Judicial Member IT(TP)A No.890/Bang/2022 : Asst.Year 2018-2019 M/s.AO Smith India Water The Deputy Commissioner of Products Private Limited Income-tax, Circle 1(1)(1) vs. No.300, Phase 2, KIADB Bangalore. Industrial Area, Harohalli Kanakapura Taluk, Ramnagara Bangalore – 562 159. PAN: AAFCA8954R. (Appellant) (Respondent) Appellant by: Sri.T.Suryanarayana, Advocate Respondent by: Sri.Subramanian.S, JCIT-DR Date of Date of Hearing : 22.07.2024 Pronouncement: 25.07.2024 O R D E R Per Prakash Chand Yadav, JM : The present appeal of the assessee is directed against the order of the Assessing Officer dated 26th July, 2022, passed u/s.143(3) r.w.s. 144C(13) of the Income-tax Act, 1961. The relevant assessment year is 2018-2019.

2 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. of income on 26th November, 2018 declaring `Nil’ income. The same was processed u/s.143(1) of the Income-tax Act, 1961 (the Act). Thereafter, the case of the assessee was selected for scrutiny. The learned Assessing Officer (AO) observing that the assessee has entered into international transactions with its Associate Enterprises (AEs) referred the matter to the Transfer Pricing Officer (TPO) for computing the Arm’s Length Price vis-à-vis transactions of the assessee with its AE. The learned TPO after examining TP report conducted certain adjustments and has sent his order to the AO. Accordingly, draft assessment order was passed. Against this draft assessment order, the assessee filed its objection before the DRP. The learned DRP partly accepted the objections of the assessee and granted some relief. Thereafter, the AO passed the final assessment order.

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“3. The financial results of M/s.A.O. Smith India Water Heating Pvt. Ltd. for the financial year 2008-09, is as under:- Particulars Amount (Rs.) Operating Revenue 20,85,54,881 (Sales) Operating Cost 30,36,45,788 Operating Profit (-)9,50,90,907 OP/Sales% (-)45.59%

The assessee-company has international transactions as per 3CB referred at para 4.The TPO issued show cause notice for examination of documents, and dealt on the international transactions and found the assessee has applied Cost Plus Method in respect of purchase of water heaters and components and INMM method. On receipt of commission. However the TPO rejected the TP Study and conducted the survey and applied the filter and finally made adjustment of Rs.10,54,56,085 in respect of international transactions of purchase of water heaters and sales commission and passed order under Section 92CA of the Act Dt.8.1.2013.Subsequently, the Assessing Officer passed Draft assessment order with other disallowances under Section 40(a)(ia) of the Act of Rs.6,15,293 as the TDS was not paid within said financial year and disallowance of warranty provision of Rs.41,69,288 and determined the total income of Rs.18,14,640 under Section 143(3) r.w. 144C of the Act Dt.8.2.2013. Against the Draft assessment order, the assessee filed objections before the DRP and whereas the Hon'ble DRP has confirmed the addition of disallowance of provision for warranty and granted relief in respect of disallowance of professional fees under Section 40(a)(ia) of the Act to be deleted and directed the Assessing Officer to delete the addition. After DRP directions Assessing Officer passed final 3

4 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. assessment order under Section 143(3) r.w. 144C determining the total income at Rs.17,521,347 Dt.31.12.2017.Aggrieved by the final assessment order, the assessee has filed an appeal with the Tribunal. At the time of hearing as we have discussed, at page No.2 the learned Authorised Representative has not pressed the grounds of appeal and made endorsement and they are treated as dismissed. Whereas in respect of Ground No.3(1), the learned Authorised Representative submitted that the disputed issue is covered in favour of the assessee by the order in assessee's own case in IT(P)A Nos.176 & 332/Bang/2015 for Assessment Year 2010-11 and placed copy of the order. But in respect of disallowance of provision of warranty, the learned Authorised Representative submitted details and made arguments and also envisaged submissions on levy of interest under Section 234B and 234C of the Act and prayed for allowing the appeal. Contra, the learned Departmental Representative supported the orders of the lower authorities. 4. We have heard the rival contentions and perused the material on record. On the first disputed issue in respect of purchase of water heaters and components, TP Adjustment as submitted by the learned Authorised Representative issue is covered and dealt by Tribunal in assesses own case in IT(TP)A Nos.176 & 332/Bang/2015 for Asst. Year 2010-11 Dt.8.2.2018, at paras 14 to 20 as under : “14. Now the assessee is before us with the submission that it is an accepted principle that the computation of ALP based on a direct method like RPM, which tests the results at gross level unlike the TNMM which tests the results at net level, extinguishes the requirement of making adjustment in relation to the difference in operating expenses, which could be different from enterprise to enterprise. It was further contended to as provided in Rule 10B, under RPM price of international transaction needs to be computed on the basis of gross profit margin earned in uncontrolled transactions, while under TNMM price of international transaction is computed on the basis of net profit margin of uncontrolled transactions. As per Rule 10C(1), the most appropriate method for determining the ALP depends upon the facts and circumstances of each case. Similarly, the operating expenses incurred by the assessee is different from the operating expenses incurred by comparable companies. The learned counsel for the assessee has highlighted that it incurs certain expenses which does not affect sale/purchase price of the goods sold. Therefore, in a situation where incurrence of item expenses affects only the net profit of the entity without corresponding effect of gross profit or price of transactions, the TNMM will not provide the most reliable arms length results. The selection of TNMM would require making reliable 4

5 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. adjustment to arrive at the operating profit i.e., adjustment for expenditure incurred in the current year, the benefit of which will be received in the future year. In the absence of reliable adjustment, the selection of TNMM will not result in arriving at the ALP of the international transaction. In transactions method like RPM or Cost Plus method, the effect of these factors may be eliminated as natural consequences of insisting upon greater product of function similarity. Depending upon the facts and circumstances of the case and particular on the effect of functional differences on the cost structure and the revenue of the potential comparables, the net profit indicators can be less sensitive than the gross margin to the difference in the extent of complexity of function and difference in the level of risk. 15. It was further contended that comparability should not be interpreted in isolation because of the conditions and circumstances of the controlled transactions should be taken into consideration while comparing the net margin. Under the facts and circumstances of the assessee, the net margin comparability is more volatile than the gross margin comparable. In the light of these facts, it was contended that if the cost structure is such that costs are effecting in net profit directly without affecting the price or gross margin, then there can be no two opinions that RPM should be preferred over the TNMM method. In support of these contentions, he placed reliance upon the following judgments:- (1) Horiba India Pvt. Ltd., v. DCIT, 81 taxmann.com 209 (2) Bose Corporation Pvi. Ltd, v. ACIT, Circe 3(1), New Delhi, 77 taxmann.com 194 (3) ITOv. L'Oreal India Pvt. Ltd., (2015) 24 taxmann.com 192 (Bom) (4) Matte Toys India Pvt. Ltd, v. DCIT in ITA No. 2476/Mum/2008. The ld. DR placed reliance upon the order of the AO and the DRP. 16. Having heard the rival submissions and from a careful perusal of the record, we find that undisputedly the assessee is a trading company and carries out distribution it imports water filters from AO Smith and marketing of products of AOS group in India. China and sells them in India. AO Smith India is, according to the TP document, a distributor of AOS Water Heaters in India. The Tribunal has examined the most appropriate method in the case of distributor to determine the ALP for the international transactions. In the case of Horiba India Pvt. Ltd. (supra), the Tribunal has held that in the case of a distributor where the goods are purchased from the AE and resold to other independent entities without any value addition, then the resale price method should be reckoned as most appropriate method. One of the main reason given by the TPO as well as the DRP is that the assessee is full fledged/full risk distributor and 5

6 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. performing host of functions, therefore RPM should not be taken as the most appropriate method, because all these functions require huge cost which may not represent the gross profit margin. This contention of the revenue was rejected by the Tribunal and it was held that in comparable controlled transaction scenario, a normal distributor will undertake all kinds of functions which are related to sales of the product. The things like market research, sales & marketing, warehousing, controlled quality and also risks like market risk, credit risk, etc. are undertaken by any distributor for the sale of the products. The Tribunal further held that what is important to see is whether there is any value addition or not on the cost purchased for resale. If there is no value addition to the finished goods purchased from the AE are sold in the market as it is, then gross profit margin earned on such transactions become a determining factor to analyse the gross compensation after the cost of sales. Accordingly the Tribunal held that the RPM is the most appropriate method. 17. Similarly, in the case of Bose Corporation Pvt. Ltd. v ACIT (supra), the assessee company was engaged in the business of distribution of sound and audio assistant for individual customers and public places. It was a wholly owned subsidiary of Bose Corporation, USA. During the relevant year, assessee purchased furnished goods from its AE and resold the same in India to unconnected parties. The assessee adopted resale price method (RPM) as most appropriate method (MAM) for determining the ALP of the said international transactions. The profit level indication (PLI) adopted by the assessee was gross profit/sale and the assessee has made itself tested party for the purpose of international transactions. The TPO rejected the transfer pricing study of the assessee and opined that transactional net margin method was to be applied for determining ALP of international transactions under question. While determining the issue is the most appropriate method in case of distributor, the Tribunal has held that the resale price method (RPM) is the, most appropriate method and directed the TPO to calculate margin of the comparables by using RMP. The relevant observation of the Tribunal is extracted hereunder for the sake of reference: 8.1 At this juncture, we note the mandate of Rule 10C which defines the Most appropriate method". Sub-rule (1) of Rule 10C states that: "For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm's length in relation to the international transaction."Sub-rule (2) of Rule10C lists certain factors which should be taken into account in selecting the most appropriate method as specified in sub-rule (1). 6

7 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. These factors, inter alia, include ©, the availability coverage and reliability of data necessary application of the method'; and (d) the degree of comparability. existing between the international transaction and the uncontrolled transaction…… 8.2 An overview of the factors prescribed for choosing the most appropriate method indicates that firstly, the data necessary for application of the given method should be available and secondly, the uncontrolled transactions should be functionally similar, if not identical. A company, in order to be ranked as comparable under the RPM, should preferably be engaged in doing similar activity as that of the assessee or at least of the same genus of the activity, with a different product. The Ld. TPO himself has categorized the comparables chosen by the assessee as traders akin to computer industry or engaged in trading of instruments. As the basic requirements under rule 10(c)(1) are fulfilled by these comparables and that the Ld. TPO has not brought on record any evidence to prove material difference between the assessee and the comparables so selected, we direct the Ld. TPO to calculate the margin of the comparables by using RPM." 18. In the case of CIT Vs. L'Oreal India Pvt. Ltd., similar dispute was raised before the Hon'ble High Court of Bombay. In that case, assessee had business in 2 segments* viz., manufacturing and distribution. In respect of business of distribution, the TPO suggested transfer pricing adjustment by applying the TNMM and rejected the resale price method (RPM) adopted by the assessee because the TPO found that assessee was incurring loss consistently and hence the price police was not at arm's length. The Hon'ble High Court, having examined all aspects have finally concluded that RPM is the most appropriate method. The relevant observation of the Hon'ble High Court is extracted hereunder for the sake of reference: "7. After having perused the relevant part of the order passed by the Commissioner and the Tribunal on this question, we are in agreement with Mr. Pardiwalla that the Tribunal did not commit any error of law apparent on the face of the record nor can the findings can be said to be perverse. The Tribunal has found that the TPO has passed an order earlier accepting this method. The Tribunal has noted in para 19 of the order under challenge that this method is one of the standard method and the OECD (Organization of Economic Commercial Development) guidelines also state in case of distribution or marketing activities when the goods are purchased from associated entities and there are sales effected to unrelated parties without any further processing, then, this method can be adopted. The findings of fact are based on the materials which have been produced before the Commissioner as also the Tribunal, 7

8 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. Further, it was highlighted before the Commissioner as also the Tribunal that the RPM has been accepted by the TPO in the preceding as well as succeeding assessment years. That is in respect of distribution segment activity of the Assessee. In such circumstances, and when no distinguishing features were noted by the Tribunal, it did not commit any error in allowing the Assessee's Appeal. Such findings do not raise any substantial question of law. The Appeal is devoid of merits and is, therefore, dismissed. There would be no orders as to costs." Copy of the order of the Tribunal in the case of L'Oreal India Pvt. Ltd., is also placed on record to demonstrate as to under what circumstances the RPM was considered to be most appropriate method. Similarly, in the case of Mettal Toys India Pvt. Ltd, V. DCIT (supra), the Tribunal again reaffirmed its view that in the case of distributor, the RPM is the most appropriate method by holding that ultimate aim of the transfer pricing is to examine whether price of the margin arising from the international transactions with a related party is at ALP or not. The determination of the approximate ALP is a key factor for which most appropriate method is to be followed. Therefore, if at any stage of the proceedings, it is found that by adopting one of the prescribed method other than choosing earlier the most appropriate ALP can be determined, the assessing authorities as well as the appellate authorities should take into consideration such a plea raised before them provided it is demonstrated as to how a change in the method will produce better or more appropriate ALP on the facts of the case. The Tribunal accordingly rejected the contention of the Revenue and directed the TPO to adopt RPM instead of TNMM for computing the ALP. 20. Turning to the facts of the case, we find that undisputedly, assessee is a distributor of AO Smith China which is involved in the manufacture of water heaters and sells the water heater imported from AO Smith China in India without making any value addition to the product. In a similar type of case, it has been repeatedly held by the Tribunal and the Hon'ble High Court of Bombay that in case of distributor, whether the product is being sold to the uncontrolled entities without making any value addition RPM is the most appropriate method and should be preferred over TNMM. Accordingly, we set aside the order of the AO, passed consequent to direction of the DRP in this regard and direct the AO/TPO to adopt the RPM as the most appropriate method.” We applying the ratio of decision of the co-ordinate bench and are of the substantive opinion that the assessee is a subsidiary distributor and the product is being sold to the uncontrolled entities without making any value addition therefore RPM is the most appropriate method and should be preferred over TNMM and Accordingly set 8

9 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. aside the order of the Assessing Officer passed in pursuant to the directions of the DRP and direct the Assessing Officer/TPO to adopt RPM as Most Appropriate Method and allow the ground of appeal of the assessee.”

“11. We have heard the rival submission and perused the material on record. Admittedly, there is no arrangement between the assessee and its AE for brand building as per the agreement dated 24.08.2015. It was consistently held by various judicial precedents that burden is on the Revenue to demonstrate that there was an agreement to enter into an international transaction for incurring the AMP expenses in order for an adjustment to be determined. The recent Bangalore Bench of the Tribunal in the case of Nike India Pvt. I.td.. Vs. DCIT (supra) after referring to the judicial pronouncements on the subject had clearly held that for a TP adjustment to be made under AMP expenses, there should exist an arrangement between the assessee and its AE for brand building. It was also held by the Tribunal that the burden is on the Revenue to establish that the Indian entity had to incur the AMP expenses by terms of agreement and no inference can be made on the same. We have perused the agreement and the various expenses incurred by the assessee under the head "advertisement and sales promotion". These expenses incurred are towards sales promotion activities undertaken by the assessee towards distribution of apple products and not for brand promotion. The expenses warranty which are in the nature of post sales expenditure can by no stretch of imagination 9

10 IT(TP)A No.890/Bang/2022(AY 2018-19) M/s.AO Smith India Water Products Pvt.Ltd. be construed as AMP expenses. much less for the purpose of brand building. 12. Moreover, pursuant to the DRP's direction, the margin of the distribution segment was accepted as being on arm's length. Therefore, the distribution segment which included sales promotion and warranty expenses when it is accepted to be at arm's length, there can be no separate adjustment in respect of these said expenses. In this context. we rely on the Bangalore Bench order of the case of Epson Pvt. Ltd. Vs. DCIT (supra). Therefore, in light of the aforesaid reasoning and the judicial pronouncements cited supra, the adjustment determined under the AMP expenses is deleted.”

Order pronounced in the open court on 25th July, 2024.

Sd/- Sd/- (Chandra Poojari) (Prakash Chand Yadav) Accountant Member Judicial Member Bangalore; Dated: 25th July, 2024 Devadas G*

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Copy to: 1. The Appellant. 2. The Respondent. 3. The CIT(A) Concerned. 4. The DCIT concerned. Asst.Registrar 5. The Sr. DR, ITAT, Bangalore. ITAT, Bangalore 6. Guard File.