ROXTEC INDIA PVT. LTD.,NEW DELHI vs. ACIT, NEW DELHI

INCOME TAX APPELLATE TRIBUNAL DELHI BENCH “I-2”: NEW DELHI BEFORE SHRI BHAVNESH SAINI, JUDICIAL MEMBER AND SHRI PRASHANT MAHARISHI, ACCOUNTANT MEMBER ITA No. 240/Del/2017 (Assessment Year: 2012-13) Roxtec India Pvt. Ltd, Vs. ACIT, 308, Hemkunt Chambers, Central Circle-21(2), 89, Nehru Place, New Delhi New Delhi PAN: AADCR1329K (Appellant) (Respondent)

Assessee by : Shri Nikhil Surana, CA Shri Lokesh Jain, CA Revenue by: Ms. Nidhi Sharma, Sr. DR Date of Hearing 21/08/2020 Date of pronouncement 20/10/2020

O R D E R PER PRASHANT MAHARISHI, A. M. 1. This appeal is filed by the assessee against the order of the ld AO dated 27.10.2016 for the Assessment Year 2012-13 passed u/s 143 (3) read with Section 144C read with Section 92CA (3) of The Income Tax Act, 1961 on 27/10/2016 wherein the returned income of the assessee of loss of ₹ 39,796,549 as per return of income filed on 30 November 2012 is assessed at a loss of ₹ 30,329,704/– wherein a transfer pricing adjustment of ₹ 9,404,349/- has been made. 2. The assessee has raised the following grounds of appeal:- “1. The ld AO as well Hon’ble DRP has grossly erred both on facts and in law in confirming the action of the ld Transfer Pricing Officer in re- computing the arm length price in respect of ‘Import of Material’ and ‘Export of finished goods’ by applying Transactional Net Margin Method and rejecting resale Price Method as the most appropriate method, thereby making a TP adjustment of Rs. 9,404,349/-.

Margin Method Should be adopted. He thereafter selected five comparables computed the operating margin wherein operating profit/operating ratio of the comparables was computed at (-) 3.57 percentage. Thereafter the AO stated that assessee has earned total revenue of ₹ 222,265,148/– and has incurred total operating cost of ₹ 251,806,217/– and therefore the arm’s-length profit computing margin of (-) 3.57 percentage assessee should have incurred a loss of ₹ 7,934,866 against which the assessee has incurred loss of ₹ 29,541,069/- and therefore there is a difference of Rs. 2,16,06,203. The above difference he applied to the international transactions of the assessee of ₹ 109,601,558 and proportionately adopted 43.53 percentage of the difference of Rs 2 16,06,203 which comes to proportionate adjustment of ₹ 9,404,349/- . Accordingly the order was passed u/s 92CA (3) of the act on 23rd of January 2016. The draft order was passed by the learned assessing officer on 21st of March 2016. Assessee filed objection before the learned Dispute Resolution Panel – 2, New Delhi. The learned DRP issued directions on 23 September 2016 wherein the method adopted by the learned transfer pricing officer was upheld and consequently the adjustment proposed by the TPO was also upheld. Consequently the final assessment order u/s 143 (3) was passed on 27/10/2016 determining assessed loss of assessee at ₹ 30,329,704. The assessee is aggrieved with that order and is in appeal before us. 5. The learned authorised representative submitted that benchmarking analysis made by the assessee is correct by adopting the resale price method as the most appropriate method. It was stated that the quantum of employee benefit expenses cannot be compared with the revenue as there has been a substantial shortfall in the revenue in the current year on account of slowdown in the telecom sector. He therefore submitted that substantial fall of the revenue from 44.00 Crores to 22 crores. It was further stated that human capital cannot be reduced in the short period of time. Considering the fact that the core function of the assessee is sales and marketing such deduction was neither advisable nor feasible. He also submitted that the comparative payroll charged is designation Page | 3

and role of each employee for four years has been provided and on review of the same it can be clearly observed that all the employees have been undertaking general sales and marketing activities. He further submitted that expenses in the nature of rent, travelling and conventions expenses are the normal business expenditure which cannot show that assessee is carrying out substantial value addition on production. With respect to the advertisement and sales marketing promotion expenditure incurred by the assessee of ₹ 27.16 lakhs Under the head advertisement and sales promotion, it was stated that these are majorly on account of free samples distributed to the customers and no efforts have been made by the learned transfer pricing officer to show the exact nature of these expenses and it has been relied on the nomenclature used by the assessee. It was further stated that incurring of the said expenses clearly shows that assessee is only engaged in distribution function. He otherwise stated that the amount of expenditure of ₹ 27.16 lakhs are reasonable and nowhere conclusive of the fact that assessee is carrying out substantial value addition. He further stated that there is a wrong observation about the import of the goods which have been clearly classified as import of materials in the nature of semi finished and finished goods. He further referred to the risk profile of the assessee and stated that the lower authorities have incorrectly read the risk profile. It was stated that the product research and development functions risk only rest with the associated enterprise and not with the assessee and further the manufacturing functions risk is also with the associated enterprise. With respect to the product liability risk and the warranty risk it was submitted that risk rests with the associated enterprise and not with the assessee except limited warranty to obtain the product from the customers and sending it to its associated enterprise. 6. With respect to the appropriateness of using the Resale Price Method as the most appropriate method by the assessee , he advocated that there is no finding in support of the conclusion that assessee is carrying out substantial value addition and therefore the Resale Price Method is the most appropriate method. Page | 4

He submitted that the assessee import sealing moulds and wedges from the associated enterprise and assembles them in ready to use packs to send them to customers in India remains uncontroverted. He further referred to page number 40 of the paper book wherein the operating model has been discussed in detail. He therefore submitted that assessee is carrying out minimum value addition because there is only an expenditure of ₹ 10.81 lakhs with respect to the wages and the quantum and nature of the plant and machinery also does not suggest that substantial value addition has been carried out by the assessee. He otherwise submitted that the Transactional Net Margin Method is not the most appropriate method and submitted that TNMM is applied when cost plus method or resale price method does not give reliable data. He otherwise submitted that in case of the assessee it has earned negative margin on account of substantial drop in the revenue as it is unable to absorb it is fixed and semi fixed cost , therefore substantial losses been incurred. He further stated that there has been no change in the gross margin earned by the assessee which is submitted at page number 101 of the paper book. Therefore negative margin earned by the assessee must not be attributed to the value addition of the assessee and therefore the Transactional Net Margin Method does not truly reflect margins earned form the business of the assessee. He therefore submitted that Resale Price Method as the most appropriate method adopted by the assessee for the purpose of import of material of semi finished and finished goods. He therefore submitted that the learned DRP/TPO erred in adopting Transactional Net Margin Method on combined bases with respect to the import of material and export of finished goods. 7. The learned departmental representative vehemently supported the order of the learned assessing officer/TPO and direction of the learned dispute resolution panel. He also referred to the various observation in those orders and substantiated same with various figures in the annual accounts. He also referred to the functional profile of the assessee.

specification and quality norms driven by the parent company. Assessee also does sourcing and purchase of materials for the production or assembly process. Vendor selection, its qualification, inbound logistics etc. are all the responsibilities of the assessee. The assessee is also responsible for the quality of material that is purchased by the company from the local vendors. The associated enterprise is only responsible for the material supplied by it to the assessee. The assessee also markets the above products and generates a lead from the customers. The assessee also assumes the market risk and warranty risk to the extent of product supplied by the vendors. It is an altogether different thing that the assessee is given a back-to-back warranty of the goods supplied by the associated enterprises. However it is apparent that assessee is also responsible for warranty to its customers. The transfer pricing study report shows that in case defect is on account of the assembly activity performed in India then the warranty risk would be with the assessee. 10. Now coming to the financials of the assessee for the year it is apparent that looking at note number 17 wherein revenue from operations are shown, the revenue for last year i.e. 31 /3/ 2011 was ₹ 25,14,45,769 whereas the revenue for this year is ₹ 234,303,011/–. Therefore there is no material change in the total revenue (sales). Further the assessee is also incurring advertisement and sales promotion expenditure. Last year it incurred for that expenditure Rs 42.90 lakhs whereas for this year it is 27.16 lakhs. It has also incurred electricity and water expenditure of ₹ 11.47 lakhs. It salary wages bonus expenditure for the year is 5,13,00,000 whereas in the last year it was 4.69 crores. Even in the financial statement at note number 29 assessee is stated to be engaged in production of goods. We have also carefully considered the chart of the employee expenditure submitted by the assessee at page number 87 – 88 of the paper book. However, from the above chart it is apparent that assessee does not have anybody who is doing vendor selection, vendor control, assembly activity et cetera. Therefore the chart of the employee submitted by the assessee does not match with the functions stated by the assessee in the TP Study . It is Page | 7

apparent that in Resale Price Method if there is no substantial addition, should be used as the most appropriate method. However at page number 86 of the paper book assessee shows that it earns the gross profit of 35%, at page number 90 of the paper book assessee submits that its gross profit ratio is 36.09% at page number 8 1 assessee shown operating margin on cost and 17.75%, at page number 79 shown its gross margin on revenue at 41.61%. Such a kind of margin earned by distributor is unheard of, these figure itself shows that assessee is making substantial value addition to the product purchased by it. Further at page number 30 the summary of transactions analyzed clearly shows that assessee is importing semi finished goods and finished goods from its associated enterprise. Therefore it is evident that such goods cannot be resold looking at the margins that assessee has earned, requires only minor modifications. Assessee shows in its transfer pricing study report itself that it is assembling the product after obtaining certain raw material from its associated enterprise and certain raw materials from its developed vendors. Resale price method applies when property purchase by the enterprise from an associated enterprises resold. In this case the it is not the resale of the same material but it is further improved, through its own vendors and then sold to the customers which are identified by the assessee. On looking at page no 83 -85 of the paper book where the list of plant and machinery used by the assessee is given, it shows that assessee has various dies, Moulds , tools and other machines of RS 2.66 crors. The learned dispute resolution panel while dealing with the objection of the assessee about the Most Appropriate Method (objection number 1A) has dealt with as Under:- “Findings :- The objection of the A was given an anxious consideration by us. Before delving deep into the subject matter once consideration, it is considered to be in the fitness of things to refer in brief to the circumstances in which resale price method (RPM and the Transactional Net Margin Method (TNMM) are applicable. Page | 8

Regarding the RPM the authorities on the subject are unanimous in their view that RPM as a direct method which compares the gross margin i.e. gross profit of sales, on transactions between related and unrelated parties for the determination of the arm’s-length price (ALP). The RPM method requires high level of functional comparability and is mainly applicable where the controlled party are distributors. Practically the application of RPM is found by working backwards from the transactions taking place at the next stage in supply chain, and as determined by subtracting an appropriate gross markup from the sale price to an unrelated third-party, with the appropriate gross margin being determined by examining the conditions Under which the goods or services are sold and comparing the said transactions to other, third-party transactions. 1, The RPM begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. Therefore, the use of RPM is ideal for distribution activity, whereby the tested party purchase the products or obtained the services from its associated enterprises and resells the products/services to an independent enterprise. 2. RPM is the most appropriate in a situation where the sellers add relatively little value to the goods and not alter the goods physically before the resale. Packaging, repacking, labeling or minor assembly does not ordinarily constitute physical alteration. 3. RPM is used in cases where reseller does not apply intangible assets to add value. The greater the value-added to the goods by the functions performed by the seller, the more difficult it will be to determine an appropriate resale margin. This is especially true in a situation where the seller contributes to the creation or maintenance of an intangible property, such as marketing intangible, in its activities.

The sum and substance of the above narration is that that RPM evaluates the process of functions performed rather than the product. To put it plainly, this method requires detailed comparisons of functions performed, risk borne and contractual terms of controlled and uncontrolled transactions. When the functions of the A at hand are viewed against the above background facts the applicability of RPM becomes a suspect. In this context the transfer pricing orders para number 5.1.1 to 5.1.3 passed by the transfer pricing officer becomes relevant. For the sake of facility the reasons subscribedby the TPO for rejecting RPM in the case of the A are reproduced below:- “5.1.1 further, it is saying that you have incurred substantial personnel expenses of ₹ 54,888,092/–, out of with salaries and wages are 5,13,04,008/- /–). If you were performing only trading function, these expenses were not justified in relation to total turnover of ₹ 222,242,360 –. Further you have incurred several expenses Under the head operating and other expenses which are related to production like rent, travelling and conveyance, which should have been taken into account in factoring the value addition made by you in respect of sales termed as deemed manufacturing. It is also seen that you are also undertaking other functions like advertising, sales promotion and having a distribution network. Incurring of these costs are also indicate that you’re not acting as a mere trader but banking on significant other functions also. Further, it is also not in doubt these imports have been made in the nature of raw material as the international transactions clearly classify them as raw materials. 5.1,2 since, the functions performed by you cannot be taken into account without considering the cost incurred by you as mentioned above, the choice of resale price method is not a right choice. Transactional net margin method (TNMM) which takes into Page | 10

account all these cost is the right method to be selected for benchmarking the transactions of raw material which have been imported as raw material and are being processed/packaged before sale. Regarding the choice of indicator, operating profit/operating revenue (OP/OR) is the best indicator as it takes into account the profit after incurring of various cost like other indirect cost, operating expenses and depreciation. Operating revenue has been chosen as the denominator is the sales are to 3rd parties while purchases are from aAE. 5.1.3 the assessee has stated that RPM is the most appropriate method as it is not carrying out any value addition activities. From the above discussion on manufacturing activity of the assessee, it is abundantly clear that the assessee has undertaken substantial manufacturing activities and not disclosed in the true manner.” From the above it was clear that A was not performing the function of a simple trader or distributor. It was also engaged in activities relating to manufacturing of frames through local vendors as per the design provided by its associated enterprise. The panel is fortified in its above view also by the description given in the TP study report titled as functional analysis (page 13 – 23) of the functions and entailing expenditures of various types incurred by the A on sale of goods in local market, export of goods to associated enterprise, exploring Indian customer base, strategic management functions, corporate service functions, product research and development functions, manufacturing function (page 17 of TP study provided by the A), sourcing and purchasing materials for the production or assembly process, vendor selection, inbound Logistics, quality assurance, storage and outbound logistics to deliver goods to the and customers for which the A took market risk, inventory risk, credit and collection risk, limited product liability risk, limited warranty risk and foreign exchange risk. For the sake of clarity the relevant extracts of the Page | 11

functional analysis casting reflections on the claim of the A that it was a trader/distributor are reproduced below:- “Roxtec India based on its estimated sales, order the products from AE Roxtec India purchase and sealing modules and wedges from AE and procures frames form local vendors who use the design as provided by Roxtec India. The product is then assembled into customised the ready to use packs and sold thereof to the customer. During the year, the company exported certain products to AE. These products are the frames manufacture by the local vendors using the technology and design provided by Roxtec India. The production of such frames are outsourced by Roxteck India to vendors in India. The vendor’s are identified and selected by Roxtec India in collaboration with the AE. The vendor is provided with the designs for the purpose of sample production. Such sample production is approved by the AE. Subsequently, the purchase order is placed by Roxtec India on vendor for the manufacture of frames. The consideration payable to the vendors for the manufacturing activities is determined by Roxtec India taking consensus of inputs received from AE. Roxtec India assembles the manufactured frames along with the incidental fittings, rubber components and spares (collectively referred to as kits) The kits of frames are invoiced and shipped to AE. The invoices raised enterprise amounting to cost plus markup of 10%, wherein the cost component shall include cost of frames (received from third- party vendors), cost of assembling, cost of carying inventory, proportionate cost of overheads and related expenses (a proportionate cost of warehouse).” From a plain reading of the above it is clear as the sky that the A was engaged in other inextricably linked allied activities of direct and Page | 12

proximate which were required to be performed relating to the semi finished goods imported by it from its associated enterprise to make them marketable. Thus by no stretch of imagination could the A be labelled as a distributor. Moreover the activities incidental to the semi finished goods imported by the A from its AE, as is apparent from the above description of facts, had to undergo several process post purchases which entailed in various kinds of expenditure of different varieties which RPM was not capable of factoring in. In the above conspectus, TNMM is held by us to be the most appropriate method as TNMM compares net margins of profits earned in uncontrolled transactions by independent entities against those achieved in related party transactions. In comparison the profits or margins using the TNMM, typically some form of ratio most commonly used expresses net profit as a percentage of cost (full cost or operating cost), a particular balance sheet category ( eg assets, capital employed, etc ) or sales/services receipts. In the aforesaid premises, we have no hesitation in holding that A was rightly held as a manufacturer by the TPO which culminated in the rejection of the RPM. Accordingly ground number two is dismissed.”

assessee had suffered loss in those transaction with its associates. In the present case before us the issue is whether the assessee is a distributor or a manufacturer and whether resale price method is applicable to the international transactions entered into by the assessee. It is not the case that assessee has resold the same goods with only minor modifications to justify the adoption of RPM as the most appropriate method. In the present case the assessee has assembled the goods partly purchased from its associated enterprise and partly developed by its own vendor. Therefore, the decision relied upon by the learned authorised representative does not help the case of the assessee. 12. In view of the above facts we do not find any infirmity in the order of the learned assessing officer/transfer pricing officer as well as the direction of the learned dispute resolution panel in rejecting the resale price method adopted by the assessee and adopting transactional net margin method as the most appropriate method. Therefore solitary ground of appeal is dismissed. 13. In the result appeal of the assessee is dismissed. Order pronounced in the open court on 20/10/2020. -Sd/- -Sd/- (BHAVNESH SAINI) (PRASHANT MAHARISHI) JUDICIAL MEMBER ACCOUNTANT MEMBER Dated: 20/10/2020 A K Keot Copy forwarded to 1. Applicant 2. Respondent 3. CIT 4. CIT (A) 5. DR:ITAT ASSISTANT REGISTRAR ITAT, New Delhi