MARATHON ELECTRIC INDIA PVT. LTD.,FARIDABAD vs. DCIT, FARIDABAD

O R D E R PER PRASHANT MAHARISHI, A. M. 1. This appeal is filed by the assessee against the order of the ld CIT (A), Faridabad dated 12.06.2015 for AY 2010-11 wherein, the appeal filed by the assessee against the assessment order passed u/s 143(3) of the Act on 11.04.2014 by the ld Dy Commissioner of Income Tax, Circle-1, Faridabad was partly allowed. 2. The assessee has raised the following grounds of appeal:- “1. That on the facts and in the circumstances of the case and in law, the order passed by the Learned Commissioner of Income Tax (Appeals) [“Ld. CIT (A)”] under section 250 of the Indian Income Tax Act (“the Act”) is bad in law.

2. That on the facts and circumstances of the case and in law, the Ld. CIT (A) erred in determining the arm's length price of the international transaction of reimbursement of expenses paid to the AE to be Nil, thereby making an addition to the total income of Rs. 5,870,089. In doing so, the Ld. CIT (A) grossly erred in: 2.1 not appreciating the characterization of the entities involved in the transaction; 2.2 disregarding the fact that the conduct of the appellant conforms to the allocation of risk i.e. the entity bearing product liability risk is undertaking decisions in relation to the same; Page | 1 2.3 questioning the commercial/business wisdom of the Appellant for undertaking the said transaction and ignoring the vast jurisprudence on the matter; and 2.4 not appreciating the fact that no benefit has been passed on to the AE since it is recovering the same amount that has been paid to an independent third party.

3. The Learned Assessment Officer (“Ld. AO”) grossly erred in initiating penalty proceedings u/s 271 (1 )(c) of the Act mechanically without recording any satisfaction for its limitation.

4. That the Ld. AO grossly erred in levying an interest u/s 234B, 234C and 234D of the Act to the taxable income of the Appellant.”

3. Ground No. 1 is general in nature, Ground No. 3 is against the initiation of penalty proceedings u/s 271(1)(c) of the Income Tax Act is premature and ground No. 4 is against levy of interest u/s 234 B, 234C and 234D which is consequential l in nature, therefore, ground Nos. 1, 3 and 4 are dismissed.

4. The only remaining ground is ground No. 2, which is against the confirmation of the order of the ld AO/ TPO in determining the Arm’s length price of the international transaction of reimbursement of expenses paid to the associated enterprises determined by the ld TPO at Rs. Nil. Thereby an adjustment of Rs. 5870089/- was made to ALP of International Transaction and consequent addition to total Income. 5. Brief facts of the case shows that the assessee is a company who filed its return of income on 13.10.2010 declaring income of Rs. 41976399/-. The assessee has entered into an international transaction and therefore, the ld AO referred to the Ld Transfer Pricing Officer for determination of Arm’s Length Price of the international transaction. The assessee has entered into several international transactions, such as purchase of raw material, export of motors, import of capital goods, provision of services and reimbursement of expenses paid and received. 6. Only dispute is with respect to the reimbursement of expenses paid by the assessee to its associated enterprises having the value of transaction of Rs. 5870089/-. 7. The assessee is engaged in manufacturing and sale of fractional Horse Power electric motors, which find wide application in domestic use products like air conditioners, coolers, washing machines etc and electric fans. It has one manufacturing unit set up as an Export Oriented Unit (EOU) and second was in the domestic Tariff Area (DTA) Unit.

12. The assessee preferred an appeal before the ld CIT (A). He confirmed the above adjustment. The reasons was that he concurred with the views of the ld AO/ TPO that no unrelated party would make payment for testing of motors when there is remote possibility that fault would be found and further when the goods are covered by warranty. He also noted that in assessee’s own case for AY 2008-09 the ld DRP-1, New Delhi as per their direction dated 27.08.2012 have upheld the action of the ld AO making the identical adjustment. Thus, this addition was upheld. Therefore, assessee is in appeal before us on this ground as per Ground no [2] of this appeal.

“5. Ground no. 9 to 13 of the appeal are related to the Transfer Pricing Adjustment. The learned counsel for the assessee referred to paper-books filed in two volumes from pages 1 to 715 and submitted that international transaction is in respect of 'firewall charges' reimbursement to AE. He submitted that when finished goods are shipped to the AE in US from Indian Ports, there is a time lag before the products reach the destined port. At times, motors capture moisture during the transit period and this can adversely impact their functioning. The moisture in the motor may cause sparking at the time of usage and can cause harm to the user. On the request of the assessee, the AE engages a third party that tests all the motors to ensure the desired quality standards of the US market. The learned counsel for the assessee further submitted that in order to determine whether all motors meet the desired quality standards, each motor needs to be tested individually. He submitted that such testing charges incurred are paid by assessee to the AE which the AE pays to the third party on cost-to-cost basis without any mark-up. He submitted that the third party, i.e., Commercial Warehouse & Cartage Inc. ("CWC") USA undertakes functions of unpacking, testing and repacking of motors. He submitted that payment of firewall charges was made by the assessee to its AE was an integral part of the manufacturing function, the same was aggregated and benchmarked using the TNMM as the most appropriate method. The learned counsel submitted that the learned TPO rejected the arguments put-forth by the assessee stating the following reasons: a) An unrelated party would not make such a payment; b) If the AE wishes to test all the motors for its satisfaction, then it amounts to duplicative service and no separate payment is required to be made by the assessee. c) No unrelated party would make payment for testing of motors in which no fault is detected; d) No independent party would pay such testing charges when goods are covered by warranty; 5.1 The learned TPO in view his observations, benchmarked the transaction applying CUP method and valued at nil. 5.2 The learned counsel for the assessee submitted that the learned TPO/DRP has ignored the following points which are primary reasons for which the assessee is incurring such expenses: "(i) Impact on the brand reputation: It is important to understand that the main reason behind incurring such expenses is to ensure that none of the motors are defective when sold to the customer in the overseas market. It is pertinent to note that the product liability risk, in a value chain, is that of a manufacturer. Since in the instant case. MEIPL is the manufacturing entity, any defect in the product Page | 5 will have a detrimental effect on the brand reputation of MEIPL. In case any defect is identified in the goods which are being sold in the US market, the reputation of MEIPL would be impacted and not that of the distributor as the distributor is earning a gross margin by just rendering distribution services. Adverse brand reputation would lead to drastic reduction in sales in subsequent years and hence the profitability of the Assessee. (ii) Penal charges: It is important to understand that US being the most developed country in the world has the most stringent laws against the damages caused by the use of faulty/ defective items. A company could even face trial for providing faulty products. In the instant case, if the motors supplied by MEIPL to the customer is used in a building and due to a short circuit in the motor (because of the moisture) it catches fire, then this could lead to huge product liability claims been initiated against the manufacturer i.e. MEIPL and not the distributor. The Assessee could also face trial for the same apart from huge damages claim which will impact the overall reputation/ functioning of the Assessee. (iii) Cost to cost charges: An important point which must be considered while evaluating arm's length nature of this transaction is that, on request of MEIPL, the AE appoints the third party that performs unpacking, testing and repacking of motors. The cost of such activities is borne by the AE which then recovers exactly the same from MEIPL i.e. without charging any mark-up. In other words, this is a cost to cost reimbursement and hence the AE has not benefitted anything from this arrangement. These motors ought to have been tested in US only and could not have happened in India (as testing is performed to check moisture in motors during transit). If testing was possible in India, MEIPL would have directly appointed the third party. In this case, since the AE is familiar with the US market, has appointed this third party for the purpose of testing. Back to back invoices have already been submitted by the Assessee to the Ld. TPO / Ld. DRP (on sample basis for AY 2007-08) (For back-to-back invoices please refer pg 611-693 of PBII). (iv) Cost not related to AE: It is hereby stated that the AE is a distributor of goods which are manufactured by the Assessee. It has also been stated before the lower authorities that the AE retains only 10% of revenue and the balance is remitted back to the Assessee. Hence, the profit is that of the Assessee with limited returns to the AE - a gross margin of 10%. Under these circumstances it that the AE would not bear such expense of testing when it is earning only minimal returns. Should the AE start to bear these expenses it's margins would take a hit. In any third party set-up such costs can never be passed onto the distributor."

5.3 Further, the learned counsel also submitted that why such testing was required and how it was different from warranty and other expenses, which are as follows: "11. The Ld. TPO has compared this expense with warranty' expenses. It is true that Assessee provides warranty, but this expense is separate and distinct to firewall charges. Any motor that does not contain moisture may also have functional problems (i.e. other problem relating to functionality of the motor) because of which MEIPL could bear the warranty charges. But it is the responsibility of the Assessee to provide the motors in working conditions. It is also important to point out that if products are sold without testing, it can lead to extra claims on warranty - which not only is economically non- viable but also impacts reputation of the company's brand.

13. The Ld. TPO has mentioned that 'no third party ' would incur such expenses in which no fault is detected. While saying this, the Ld. TPO has not given any reference to any third party not incurring such expense. It is apparent, that fault or no fault in the motors can only be determined once all the motors are tested. Hence this argument is also flawed. Further, the Assessee believes that it is the responsibility of the manufacturer to provide goods in working conditions to its distributor. Hence all third-party manufacturers are likely to incur such expenses." 5.4 The learned counsel for the assessee also argued that this was a genuine business expenditure, incurred wholly and solely for the purpose of the business of the assessee and cannot be disallowed by the learned TPO. He submitted that the AE is merely acting as a distributor who is never liable for the goods manufactured. On the issue of application of the CUP method by the learned TPO, the learned counsel for the assessee submitted as under: "16. The learned TPO has further rejected the aggregation approach and benchmarked the transaction using CUP method. In this regard, the Assessee submits that subject transaction is interlinked with the primary transaction and the reason for the same is already mentioned in the TP study. However, without prejudice to the above, even if the approach of the Ld. TPO is to be selected, the Assessee furnished third party invoices which Page | 7 represented CUP for the subject transaction. However, the Ld. TPO ignored the same and determined the value to be 'Nil' without identifying a single comparable. In relation to the same, the Assessee wishes to rely on the following judicial rulings, wherein it has been held that it is imperative to have a Comparable uncontrolled transaction.

5.7 We have heard the rival submissions of the parties and perused the relevant material on record. We find that the Hon'ble Delhi High Court in the case of EKL Appliances (supra) has held that the TPO is expected to examine the international transaction as he actually finds the same and then make suitable adjustment but a wholesale disallowance of the expenditure by the learned TPO is not authorized. The relevant finding of the High Court is reproduced as under: "22. Even Rule 10B(1)(a) does not authorise disallowance of any expenditure on the ground that it was not necessary or prudent for the Respondent to have incurred the same or that in the view of the Revenue the expenditure was unremunerative or that in view of the continued losses suffered by the Respondent in his business, he could have fared better had he not incurred such expenditure. These are irrelevant considerations for the purpose of Rule 10B. 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 then make suitable adjustment but a wholesale ITA No. 5257/Del./2011 & 1060/Del./2014 disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorised." 5.8 In the instant case, the assessee has incurred expenditure and not making payment of mark-up is not adverse to the entity in Indian Jurisdiction. The assessee has claimed the expenditure paid by the AE on its behalf. The contention of the TPO is that the assessee was not required to incur the said expenses. But it was under jurisdiction of the Assessing Officer whether particular expenditure was incurred wholly and exclusively for the purpose of business and not in the domain of the TPO to hold that in view of the warranty etc., the assessee was not required to incur expenditure on firewall charges. The contention of the assessee seems plausible that motors were required to checked for content of moisture acquired in transport from India to the USA, i.e., the Page | 10