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Income Tax Appellate Tribunal, DELHI ‘I-1’ BENCH,
Before: SHRI N.K. BILLAIYA, & SHRI KULDIP SINGH
PER N.K. BILLAIYA, ACCOUNTANT MEMBER,
This appeal is taken up for adjudication pursuant to the order of the Tribunal dated 10.06.2019 in MA No. 21/DEL/2019. The relevant findings of the Tribunal read as under:
“6. We have carefully considered the contents of the miscellaneous application and the submissions made by the Ld. Counsel. We find force in the contention of the counsel. It is true that the assessee had relied upon the decision of the coordinate bench in the case of Mitsubishi corporation India Private Limited in ITA No.5042/Del/2011. We further find that the assessee has relied upon the decision of the Hon’ble Delhi High Court in the case of Sumitomo Corporation Tax Appeal No.381 of 2013. It is also true that in earlier years the revenue has accepted the bench marking of the international transaction by taking TNMM as MAM.
The ratio laid down by Hon’ble Supreme Court in the case of Honda Siel Power (supra) squarely applies on the facts of the case in hand.
8. It would be apt to refer to the conclusions of the Hon’ble Delhi High Court full bench in the case of Lachman Dass Bhatia Hingwala (supra) :-
(A) The decision rendered in Honda Siel Power Products Ltd. [2007] 295 ITR 466 by the apex court is an authority for the proposition that the Income Tax Appellate Tribunal under certain circumstances can recall its own order and there is no absolute prohibition.
(B) In view of the law laid down in Honda Siel Products Ltd. [2—7] 295 ITR 466 by the apex court, the decisions rendered by this court in K. L. Bhatia [1990] 182 ITR 361 (Delhi), Deeksha J. N. Sahni [2002] ITR 16 (Delhi) and Smt. Baljeet Jolly [2001] 250 ITR 114 (Delhi) which lay down the principle that the Tribunal under no circumstances can recall its order in entirety do not lay down the correct statement of law.
(c) Any other decision or authority which has been rendered by pressing reliance on K. L . Bhatia [1990] 182 ITR 361 (Delhi) and the said line of decisions are also to be treated as not laying down the correct proposition of law that the Tribunal has no power to recall an order passed by it in exercise of power under section 254 (2) of the Act.
(D) The Tribunal, while exercising the power of rectification under section 254 (2) of the Act, can recall its order in entirety if it is satisfied that prejudice has resulted to the party which is attributable to the Tribunal’s mistake, error or omission and which error is a manifest error and it has nothing to do with the doctrine or concept of inherent power of review.
(E) When the justification of an order passed by the Tribunal recalling its own order is assailed in a writ petition, it is required to be tested on the anvil of law laid down by the apex court in Honda Siel Power Products Ltd. [2007] 295 ITR 466 SC and Saurashtra Kutch Stock Exchange Ltd. [2008] 305 ITR 227
In the light of the above mentioned discussion and drawing support from the jurisdiction High Court decisions referred here in above. We are of the considered view that by not considering the previous assessment history of the assessee overlooking the decision of the coordinate bench in the case of Mitsubishi (supra) and the decision of Hon’ble Delhi High Court in the case of Sumitomo Corporation (supra) an error has crept in the order of the Tribunal.
10. We accordingly recall the order of the Tribunal for the limited purpose of adjudicating upon the applicability of the most appropriate method on the impugned international transaction.”
Briefly stated, the facts of the case are that appellant company is a closely held company, and is engaged in the automotive component sector. The appellant company is 100% subsidiary of Mitsubishi Electric Corporation, Japan. During the year under consideration, the appellant company entered into international transaction of import of automotive components for trading amounting to Rs. 1,57,29,67,076/- with its Associated Enterprises [AEs].
In the Transfer Pricing documentation, the appellant determined the arm’s length price of the international transaction of import of finished goods applying Transactional Net Margin Method [TNMM]. For the purpose of bench marking, the appellant considered it to be the tested party and Operating Profit/Operating Revenue [OP/OR%] as the Profit Level Indicator [PLI].
For the purpose of application of TNMM, the appellant considered the following six comparable companies with an average operating profit margin of 4.91%:
Sl. Company Name Weighted No. Average 1. George Oakes Ltd 4.04 2. India Motor Parts & Accessories Ltd 7.95 3. Jullundur Motor Agency [Delhi] Ltd 4.56 4. Speed-A-Way Pvt Ltd 5.90 5. Sri Aruna Auto Service Ltd 1.83 6. PAE Ltd 5.16 Arithmetic 4.91 Mean
Since the operating profit margin earned by the appellant company from its trading segment was at 3.71%, therefore, it was within the arm’s length range +/-5% of the mean operating profit margin of the comparable companies at 4.91%. Therefore, the appellant treated the international transaction to be at arm’s length.
During the proceedings before the TPO, the TPO observed that most of the purchases made by the appellant were directly supplied to Maruti and there is no much value addition to the product in terms of brand building or expenditure of advertisement, marketing or promotion. The TPO was of the opinion that the trading segment should be bench marked as per Resale Price Method [RPM], which is the Most Appropriate Method [MAM] when there is direct purchase and sale without any addition to the value of the goods. The assessee was asked to show cause as to why RPM should not be taken as MAM than TNMM.
7. After doing FAR analysis, the TPO was of the opinion that the assessee does not undertake any economically significant functions or undertakes any value addition while supplying the products purchased from its AEs to the OEM, Maruti. The TPO further observed that products imported by the appellant are only against firm orders.
Therefore, the assessee does not bear any inventory risk. There is no liability to promote the product, no inventory to maintain and only when the assessee gets confirmed order from customers it procures the same from its AEs and delivers to OEMs. There is no market risk and the assessee is a minimal risk distributor and hence RPM is the MAM.
Having decided that RPM is the MAM, the TPO proceeded by rejecting two of the six comparables taken by the assessee and computed gross basis analysis of the remaining four comparables as under:
Sl. Company Name Weighted No. Average 1. George Oakes Ltd 9.61 2. India Motor Parts & Accessories Ltd 14.43 3. Jullundur Motor Agency [Delhi] Ltd 11.98 4. Speed-A-Way Pvt Ltd 13.48 Average 12.37
9. Gross basis results of the assessee was determined as under:
Particulars Amount [Rs.] Sales 1,992,645,735
Less Opening Stock [A] 99,873,727 Purchase [B] 1,710,995,301 Closing Stock [C] 136,045,036 Excise Duty [D] 204,452,998 Cost of goods sold 1,879,276,990 [A+B]-C+D] Gross Profit 113,368,745 Gross Profit ratio 5.69
Based on the above, the TPO found that the gross profit margin earned by the assessee is not at arm’s length and accordingly made the following adjustment:
Sales of the assessee[A] 1,992,645,735 GPM of the assessee [B] 5.69% Arm’s Length [C] 12.37% Difference [D] = [C-B] 6.68% Amount of GP less reported [D-A] 133,108,735
Accordingly, adjustment of Rs. 133,108,735/- was made on the income of the assessee.
Aggrieved, the assessee raised objections before the DRP but without any success.
Before us, the ld. AR vehemently contended that the TPO has grossly erred in taking RPM as the MAM. It is the say of the ld. AR that the assessee operates a limited risk distributor and does not bear any significant market, quality or inventory risk. The ld. AR contended that the assessee is incurring no inventory risk and very little market risk. The ld. AR contended that inventory turnover ratio of the comparable companies selected by the assessee and accepted by the TPO is 11.43% whereas that of the appellant is 16.89%. It was contended that the time lag of receipt of goods and sale of goods to third party customers is minimal. It is the say of the ld. AR that unlike a normal risk taking distributor who is compensated on gross margin basis, the assessee is not engaged in performing significant selling and distribution function, addition/identification of new customers, inventory management etc. Therefore, the assessee is not entitled to profits arising from favourable prices movement, new customer additions or better inventory management etc.
The ld. AR vehemently stated that recharacterisation is inconsistent with the functional profile of the assessee because being a limited risk distributor, the assessee is compensated on a gross margin basis. It may incur losses at net level due to factors such as market conditions, efficiency/inefficiency of operations and inventory management etc. Therefore, such a compensation model would not be consistent with its functional characterisation of a limited risk distributor.
The ld. AR further pointed out that the TPO has ignored the fact that significant functional and risk differences between the appellant and the full fledged distribution companies considered for the purpose of comparability and such differences cannot be eliminated by RPM.
Therefore, TNMM should be taken as the MAM.
Per contra, the ld. DR strongly supported the findings of the TPO.
Further, the ld. DR read the relevant observations of the TPO in taking RPM as the MAM. It is the say of the ld. DR that there is no error or infirmity in the observations of the TPO and RPM should be accepted as MAM.
We have given thoughtful consideration to the orders of the authorities below. There is no dispute that the assessee is incurring no inventory risk and very little market risk. The appellant places orders on its associated enterprises for purchase of goods against confirmed orders received from unrelated domestic customers and the appellant does not perform any critical function such as advertisement, marketing, management of inventory etc. There is also no quarrel that the customers of the appellant could have purchased directly from the AE, Japan. However, Indian customers wanted to procure these goods locally from the appellant rather than buying the same from their group companies. Since the information relating to prices of such products is already available with the Indian customer, it is difficult for the appellant to charge significantly different prices.
In our considered opinion, a normal risk taking distributor undertakes necessary decisions and performs functions related to market strategy, pricing operation and inventory management and at the same time, bears risk relating to fluctuations in market, inefficient inventory and operations management. In such a scenario, a normal risk taking distributor may earn high profits and incur losses whereas a limited risk distribution, like the appellant, has a limited function and risk profile because the key decisions relating to marketing strategy, pricing, inventory management etc., are taken by the principal. The limited risk distributor merely executes the strategy and receives guaranteed returns and cannot incur losses.
In our understanding of the law, actual transactions, as entered into between the parties, is to be considered. Meaning thereby, that the authorities have no right to rewrite the transaction unless it is held that the same is sham or bogus or entered into by the parties in bad faith to avoid and evade tax. Our view is fortified by the OECD Guidellines. Para 1.64 of the same states as under:
“1.64. A tax administration's examination of a controlled transaction ordinarily should be based on the transaction actually undertaken by the associated enterprises as it has been structured by them, using the methods applied by the taxpayer insofar as these are consistent with the methods described in Chapters II. In other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured”.
A similar view was taken by the Hon'ble High Court of Delhi in the case of CIT Vs. EKL Appliances and 1070/2011 wherein the Hon'ble High Court has held as under:
“17. The significance of the aforesaid guidelines lies in the fact that they recognise that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the associated enterprises. It is of further significance that the guidelines discourage re-structuring of legitimate business transactions. The reason for characterisation of such re-structuring as an arbitrary exercise, as given in the guidelines, is that it has the potential to create double taxation if the other tax administration does not share the same view as to how the transaction should be structured.”
We find that the TPO has ignored the fact that there are significant functional and risk differences between the appellant and full-fledged distribution companies, considered for the purpose of comparability.
The TPO has simply ignored the intensity of functions, which, when measured by ratio of operating expenses to sales of the comparable companies, is higher than that of the appellant, and, therefore, gross margins earned by such external comparable distributors would always be higher than the gross margins earned by the assessee.
In our considered view, the distributors with higher intensity of function would earn higher margin as compared to distributors with lower intensity of functions. However, such variations are eliminated while computing the net margin.
The guidelines issued by the United Nations also fortify our view that RPM is heavily influenced by the intensity of functions. The relevant extract of the guidelines reads as under:
“6.2.9.5. As the gross profit margin remunerates a sales company for performing marketing and selling functions, the Resale Price Method especially depends on comparability regarding functions performed, risks assumed and assets used. The Resale Price Method thus focuses on functional comparability. A similar level of compensation is expected for performing similar functions across different activities. If there are material differences that affect the gross margins earned in the controlled and the uncontrolled transactions, adjustments should be made to account for such differences. In general comparability adjustments should be performed on the gross profit margins of the uncontrolled transactions. The operating expenses in connection with the functions performed and risks incurred should be taken into account in this respect, as differences in functions performed are frequently reflected in different operating expenses.
Al. 4.3.4 .. Moreover, the RPM focuses on the gross profit margins, which are heavily influenced by the scope and intensity of the functions performed.”The OECD guidelines also states that differences in level of operating expenses may lead to variations in gross profit margins, however, the TNMM is tolerant to such differences. Para 2.62 of the guidelines states as under:
“2.62 One strength of the transactional net margin method is that net profit indicators (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP method. Net profit indicators also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, this may lead to a wide range of gross profit margins but stiff br6adly similar levels of net operating profit indicators.”
In the case in hand, the operating expenses to sales ratio is only 2% as against 5.23% to 8.16% in case of comparable companies considered by the TPO which can be understood from the following chart:
India Motor George Speed-A- Parts & Jullundur Particulars Oakes Way Pvt. Accessories Motor Agency Ltd Ltd. Ltd. (Delhi) Ltd. GPM (%) 9.61 14.43 13.48 12.18 NPM (%) 5.15 9.48 6.72 5.97 Operating expenses to 7.86 5.23 5.48 8.16 sales ratio (%)
The reason for significant difference in the operating expenses to sales ratio is due to the significant difference in the intensity of functions. There is no quarrel that the appellant is not performing the functions, such as, advertisement, marketing, finding new customers, inventory management etc. Accordingly, the cost of such functions is also borne by the associated enterprise and not borne by the appellant whereas the comparable companies, being independent distributors, are also performing all these functions. Consequently, the intensity of functions of the appellant is much lower than that of the comparable companies as is evident from the operating expenses sales ratio.
This high level of difference in the intensity of functions makes the comparability at the gross level unreliable. As mentioned elsewhere, since the appellant is performing limited functions and is assuming limited risks, it is compensated on the basis of guaranteed net margin. This fact tilts the TNMM as MAM in favour of the assessee.
The co-ordinate bench Bangalore in the case of Abott Medical Optics Pvt. Ltd Vs. DCIT has held that in cases where there is significant difference in the intensity of functions performed by the tested party and the comparables companies, RPM cannot be applied as the MAM. The relevant finding of the coordinate bench reads as under:
“ However, while applying the resale price method, the activity of trading and connected activity carried out by the assessee as well as comparables must be similar. In the case on hand there is no dispute that the assessee has incurred huge expenditure on account of selling and distribution as well as promotion amounting to more than Rs.75 lakhs. It is also not in dispute that this expenditure of selling and distribution and sales promotion has been incurred in respect of the trading of the goods imported from the AE as the asses has already closed its manufacturing operations prior to the F.Y. relevant to the A.Y. under consideration. The TPO has rejected the resale price method on the ground that the business model of the assessee is not comparable with that of the comparable companies who are not incurring such expenditure on selling and distribution and sales promotion. We find that there is a substance in the reasons assigned by the TPO while rejecting the resale price method and particularly in view of the fact that the assessee has incurred huge expenditure on account of sale and distribution as well as sales promotion. The assessee has carried out the IT(T.P) A No.1116/Bang/2011 trading activity only in the goods imported from the AE and such expenditure incurred by the assessee it is not found in the comparable cases would be relevant factor”.
Accordingly, the companies with high level of intensity of functions cannot be regarded as appropriate comparables for bench marking transactions applying RPM. Whereas TNMM, which is a net margin based method, takes into consideration the differences in functional profile and level of intensity of functions of the tested party vis v is comparable companies.
Considering the facts of the case in totality, TNMM is MAM and has been rightly applied by the assessee in bench marking its international transactions and since the OEM over sales of the appellant is at 3.71%, it is within the safe harbour range of +/- 5 of the average of the comparable companies which is at 4.91%. Therefore, we direct the TPO to delete the adjustment of Rs. 13,31,08,735/-.
Ground No. 2 with all its sub-grounds is allowed.
In the result, the appeal of the assessee in is allowed.
The order is pronounced in the open court on 30.10.2019.