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Income Tax Appellate Tribunal, DELHI BENCHES : I-1 : NEW DELHI
Before: SHRI R.S. SYAL & SHRI KULDIP SINGH
ORDER PER R.S. SYAL, AM: These two cross appeals – one by the assessee and the other by the Revenue – arise out of the order passed by the CIT(A) on 27.10.2009 in relation to the assessment year 2005-06.
The only issue raised in these appeals is against reduction/sustenance of addition on account of transfer pricing adjustment.
Briefly stated, the facts of the case are that the assessee, an Indian company, is a subsidiary of Akon Inc., USA. The assessee is engaged in the business of manufacturing and export of microwave components, mainly used in Defense. Three international transactions were reported including two interlinked transactions of `Purchase of raw materials’ worth Rs.2,82,65,027/- and `Sales of finished goods’ amounting to Rs.3,46,10,993/-. There is no dispute on the third transaction of Purchase of finished goods amounting to Rs.2.41 crore. The Assessing Officer (AO) referred the matter of determination of the arm’s length price (ALP) of the international transactions to the Transfer Pricing Officer (TPO). The assessee benchmarked both the disputed transactions by applying Cost Plus Method (CPM) to justify that these were at ALP.
However, no documentation was filed determining the ALP of such transactions on comparability standards. The TPO did not dispute the application of CPM as the most appropriate method. As the assessee maintained accounts on entity level, including trading segment, the TPO bifurcated such accounts into `Manufacturing’ and `Trading' segments, as under:-
Heads of account Manufacturing Trading Total as per audited financials. Gross Sales Sales 34610993 27152888 61763881 Stock adjustment 6029300 0 6029300 Total Revenue 40640293 27152888 67793181 Purchases 28265027 24123089 52388116 Consumables 638442 0 638442 Clearing expenses, freight and 408154 50000 458154 cartage Custom Duty 0 1309732 1309732 Salaries 5085321 0 5085321 Electricity 546663 0 546663 Generator expenses 1680966 0 1680966 Factory maintenance 17393 0 17393 Factory equipment repair 181573 0 181573 Depreciation 3046933 0 3046933 Total direct and indirect costs 3,98,70,474 25482821 65353293 Profit 769821 1670067 2439888 Cost Plus Margin 1.93% 6,55% 3,73%
That is how, the assessee’s Cost plus margin in the `Manufacturing’ segment, consisting of both the interlinked disputed international transactions of `Purchase of raw material’ and `Sale of finished goods’, was worked out at 1.93%. As the assessee had not done any transfer pricing analysis for these transactions, the TPO embarked on the same by proposing four companies as comparable. The assessee objected to their adoption as comparable. The TPO got convinced with the assessee’s submissions in respect of three companies, but, retained Astra Microwave Component Ltd. (AMCL) as comparable. The TPO computed Adjusted cost plus margin of AMCL, as under:-
Comparables for Akon for A.Y. 2005-06 With and without working capital adjustment Income Astra Microwave Net Sales 68 Stock Adjustment 2.87 Total Income (Q1) 70.87
Expenses Raw Material 24.5 Power & Fuel 0.35
Employee Expenses 6.82 Factory Repairs 1.19 Indirect Operating Exp 0.12 Rent 0.32 Lease Rent 0.15 Depreciation 5.47 Total Expenses (TC) 38.92 Unadjusted Profit 31.95 Unadjusted Cost Plus Margin (%) 82.09 Average Inventory 13.76 Average Sundry Debtors 19.55 Total Current Asset 33.31 Average Sundry Creditors 5.35 Net Working Capital (NWC) 27.96 NWC/Operating Income % 39.45% NWC of Akon -2.95% Standard WC as per Akon 02.006 Change in WC as per Akon 29.966 Interest cost @ 11% 3.29626 Adjusted Profit 28.65 Adjusted Total Cost 42.22 Adjusted Cost Plus Margin 67.87%
By applying such adjusted cost plus margin of 67.87% of AMCL to the total direct and indirect costs incurred by the assessee, including cost of goods sold, the TPO worked out the transfer pricing adjustment of Rs.2,62,90,268/-, as under:-
‘Total Cost = Rs.3,98,70,472 Profit at the rate of 67.87% = Rs.2,70,60,089 Profit earned by the assessee = Rs.7,69,821 Difference = Rs.2,62,90,268’ 5
A draft order was passed making addition on account of transfer pricing adjustment to the above extent. The assessee challenged the action of the AO/TPO before the ld. CIT(A), who observed that the assessee company was receiving Kits as raw material from its AE and after assembling and partial testing, the same were re-exported to such AE. In view of these facts, it was held that the raw material cost was not liable to be considered either as the assessee’s direct and indirect costs or as a part of revenue for working out the gross profit margin. In this way, the ld. CIT(A) computed the assessee’s gross margin on ‘Cost of value addition’ at 9.65%, as under:-
Particulars 2004-05 (in Rs.) Gross Sales Invoiced to Akon Inc. USA 3,46,10,993 Less: Purchase Cost of Raw Kits (Contra entry) 2,82,65,027 Increase/Decrease in Stock (Closing Stock – Opening 60,29,300 Stock) Sales Consideration attributable to actual value addition 1,23,75,266 made by appellant on the raw kits Less: Direct Overhead Cost a) Purchases (As discussed in Para 10 above) Nil b) Direct and Indirect Wages 50,85,318 c) Consumables 6,38,442 d) Electricity Cost 5,46,663 e) Generator Running Cost 16,80,966 f) Depreciation cost on Depreciable Assets 30,46,933 6 g) Factory Maintenance 17,393 h) Factory Equipment Repair 1,81,573 i) Clearing Expenses 4,08,154
Total Direct Cost of Value Additon 1,16,05,442 Less: Trading Expenses (as discussed in Para 11.3 above) 3,50,000 Net Direct Cost 1,12,55,442
Gross margin on Value Addition 11,19,824
Gross Margin on ‘Cost of Value Addition’ 9.56%
The assessee’s contention about AMCL being not functionally comparable was jettisoned by the ld. CIT(A), who worked out the adjusted cost plus margin of AMCL in the similar way as that of the assessee by excluding cost of raw material both from the costs and revenue base, at 51.63%, as under :-
Income Rs. In Cr.
Net Sales 65.24 Stock Adjustment 2.87 Total Income 68.11
Expenses Raw Materials 24.5 Power and Fuel 0.35 Employee Expenses 6.82 Factory repairs 1.19 Indirect Operating Expenses 1.24 Rent 0.32
Lease Rent 0.15 Depreciation 5.47 Total Expenses (TC) 40.04
Additional Expenses for which income considered on account of function Travelling and conveyance 0.67 Advertisement 0.17 Export Promotion Expenses 0.53 Entertainment & Business Promotion 0.21 Total Expenses (TC) 41.62 Unadjusted Profit 26.49 Unadjusted cost plus margin % 63.64% Average Inventory 13.76 Average Sundry Debtors 19.55 Total current assets 33.31 Average Sundry Creditors 5.35 Average Sundry Creditors 5.35 Net Working Capital (NWC) 27.96 NWC/Operating Income % 41.05 NWC of Akon -2.95 Standard WC as per Akon -2.006 Change in WC required 29966 Interest cost @ 11% 3.29626 Adjusted Profit 23.19 Adjusted Total Cost 44.92 Adjusted Cost Plus Margin % 51.63
In this way, the ld. CIT (A) worked out the amount of transfer pricing adjustment at Rs.46,91,361/-, as under:-
1 Total cost of International Transaction (refer Para Rs.1,12,55,442 10 above) 2. Cost Plus Margin earned by the comparable 51.63% company (refer Para 14 above) 3. Profit the appellant should have made (1 x 2) Rs. 58,11,185
4. Profit actually made by the appellant (refer Para Rs. 11,19,824 11 above) 5. Adjustment Rs. 46,91,361
The assessee is aggrieved against the sustenance of addition to the tune of Rs.46.91 lac, whereas the Revenue has assailed the reduction in the amount of addition by Rs.2.12 crore.
We have heard the rival submissions and perused the relevant material on record. The Revenue is aggrieved against the reduction in the addition by the ld. CIT(A) for excluding the cost of raw material from the direct costs, which we are taking up first for consideration.
We have noticed above that the assessee applied CPM to claim that its international transaction was at ALP. However, no benchmarking was done as no comparable was given nor any determination of ALP was done. The assessee applied CPM as the most appropriate method in such a fractured manner, which has not been disputed by the TPO as well. The only controversy is if the cost of purchase of material should be excluded from the cost base. In order to appreciate the rival contentions, it would be apposite to consider the prescription of CPM given u/s 10B(1)(c) as under:-
(i) the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined ; (ii) the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined ; (iii) the normal gross profit mark-up referred to in sub- clause (ii) is adjusted to take into account the functional and other differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market ; (iv) the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii) ; (v) the sum so arrived at is taken to be an arm’s length price in relation to the supply of the property or provision of services by the enterprise ;
Sub-clause (i) of Rule 10B(1)(c) provides for determining the `direct and indirect cost’ of productions incurred by the enterprise in respect of property transferred. Sub-clause (ii) requires determining the `normal gross profit margin’ to such costs arising in a comparable uncontrolled transaction. As per sub-clause (iii), the normal gross profit 10 margin as computed under sub-clause (ii) is adjusted due to differences, if any, between the international transaction and comparable uncontrolled transactions. Under sub-clause (iv), the direct and indirect costs incurred by the enterprise under sub-clause (i) are increased with the adjusted gross profit margin as determined under sub-clause (iii).
The amount so determined under sub-clause (iv) is taken as ALP in relation to the property or services under sub-clause (v).
It is apparent that sub-clause (i) talks of `direct and indirect costs’ of production incurred by the assessee in respect of property transferred.
The moot question is as to whether the cost of raw material should be included in the direct costs base of the assessee under this sub-clause.
Ordinarily, when some raw material is purchased which is subjected to certain processes and, then, finished good emerges, the cost of raw material is included in the direct cost base and, so is the amount of sale price for determining the gross margin of the assessee for comparing it with comparables. However, it is a trite law that pass through costs cannot be considered for determining profit margin. Pass through costs are such costs which are reimbursed as such without any profit. Such costs may be in the form of some services availed or some material supplied by the other enterprise for the purposes of use in the rendering of services or manufacturing of goods by the assessee and such cost of services or material cost is reimbursed as it is without any profit margin.
One situation may be in which a party supplies specific material to be used in the ultimate goods to be manufactured for him. In such a situation, material supplied may not be charged at all and it may be transferred to the other enterprise by way of a transfer note and included directly in its own cost of goods. Another situation may be in which cost of material may be charged and then recovered as such. There is no qualitative difference between such two situations. In both, there is a tacit understanding that the specific material supplied is going to be used in the goods to be manufactured for and on behalf of the supplier of material alone and remuneration to the other is only for services rendered in the manufacture of ultimate goods and not on the cost of such specific material supplied. Under such circumstances, the cost of material cannot be considered as the cost component of the person who 12 has to manufacture the ultimate goods because it is not the cost incurred by him on which some profit is going to be earned. However, if a particular cost is not recoverable as such, and some profit element is involved, then, it sheds the character of pass through costs, which is required to be included in the cost base.
Adverting to the facts of the instant case, we find it as an undisputed position that the assessee received kits as raw material from its AE and, after assembling and partial testing, re-exported the same to the AE. This is evidenced from the documents available on record. We can understand the sequence of transactions with the help of Invoices/Purchase orders placed at pages 206, 211 and 205 of the paper book. Firstly, the AE placed Purchase order for a fixed number of kits on the assessee with a specific Purchase order No. of 301412 on page 206 of the paper book which is dated 4.7.2004. Simultaneously, the AE exports equal number of raw kits for which it has placed purchase order, a copy of which is on page 211 of the paper book. This export invoice by the AE is also dated 7.4.2004 on which, again, there is a reference to the purchase order No.30.4.2002. It is mentioned on the face of export invoice itself under the head ‘Comments’: “These materials are shipped to our subsidiary for assembly and partial test, it will re-export to the USA under Akon P.O. # 301412.” After doing the needful in India, the assessee re-exports such kits to its foreign AE. A copy of invoice raised by the assessee dated 7.5.2004 exporting such kits with the same Purchase order no. 301412 is available on page 205 of the paper book.
Similar is the position qua all other invoices raised by the foreign AE at the time of export of kits to the assessee and invoices raised by the assessee at the time of re-export of such tested kits back to the AE.
Though for the purposes of accounting, purchase price of kits received from AE for re-export is recorded in the books of account with equal amount of credit to the AE, but, no separate amount is paid as such price as per the export invoice of AE is ultimately adjusted against the price charged by the assessee at the time of re-export, which also includes cost of kits received from the AE for re-export. This transaction shows that import of raw kits by the assessee is made with prior obligation of re- exporting the same kits to the AE after doing the needful at its end. 14 Thus, it is evident that the duty of the assessee is confined only to rendering services on the raw kits to be ultimately used by the AE. The assessee gets remunerated only in respect of the services rendered by it on the kits, such as, testing, etc., and there is no profit element in the overall sale price on the price of specific kits used as raw material at the time of resale. This is evidenced from the fact that the ld. CIT(A) reduced cost of purchases and stock adjustment from the figure of gross sales revenue for determining the sale consideration attributable to actual value addition made by the assessee on raw kits. It is this revenue which has been considered for determining the gross profit margin of the assessee at 9.65%. The position would have been different if the assessee had imported kits as raw material with open choice to sell the same in any manner he liked. In that situation, there would have been no obligation on the part of the assessee to return the same kits to the supplier. That could have justified the inclusion of cost of raw material in the direct costs. Au contraire, here is a case in which there is a prior binding obligation for returning the same raw kits in its finished form to its AE. This demonstrates that the purchase price of raw kits is merely a 15 pass through cost which cannot be considered for determining the gross margin of the assessee. Albeit such purchase price is technically recorded by the assessee in its books of account, but, the same, being a pass through cost, is liable to be excluded for the purpose of calculating the gross profit margin. In like manner, the margin has also to be computed only after excluding the cost of purchase of raw kits from the gross sales revenue as has been rightly done by the ld. CIT(A), who determined total costs at Rs.1.12 crore, being a figure under sub-clause (i) of Rule 10B(1)(c) and sale consideration attributable to the actual value addition made by the assessee on the raw kits amounting to Rs.1.23 crore, thereby deducing gross margin on value addition at Rs.11,19,824/- giving percentage of gross profit to total direct and indirect costs at 9.65%. It is palpable that the cost price of raw kits to the assessee stands reduced from both the direct costs and also revenue.
It is noticed that the TPO initially proposed four companies as comparable out of which three were excluded and only one, namely, AMCL, was retained. The TPO computed gross profit margin of AMCL at 67.87% by considering the value of raw goods in purchase and sales as well. The ld. CIT(A), following the uniform method as adopted for the assessee, determined adjusted cost plus margin of AMCL at 51.63%.
The ld. AR contended that AMCL was wrongly considered as comparable and hence the same should be excluded.
In this regard, it is noticed that the assessee submitted before the TPO that AMCL: “has a wide range of product manufacturing and its turnover is ten times in comparison to Akon with huge asset base.” The TPO rejected this contention by observing that the assessee did not specifically object to the consideration of this company as comparable on the ground of functional similarity. The assessee reiterated its submission before the ld. CIT(A) as well, who noted on page 30 of the impugned order that the assessee did not compare his results with any comparable company and, hence, there was no justification for it to contend that AMCL is a “full-fledged design manufacturing and marketing company.” He, however, upheld the comparability on the ground that both the assessee and AMCL were engaged in dealing in microwave super components and sub-systems which has application in defense, space and civil communication systems. We have noticed the functionality of the assessee in receiving raw kits from its AE, doing some value addition to the same and returning the same to its AE to be used in the final output. This shows that the assessee is a captive unit as against AMCL, a full-fledged manufacturing and marketing company, similar to that of the assessee’s AE. Even though the assessee is making substantial value addition, but, is not a complete manufacturer in itself of the final product. Under such circumstances, we fail to appreciate as to how AMCL can be considered as functionally comparable with the assessee. The same is, therefore, directed to be excluded from consideration.
Having eliminated AMCL which was the only company chosen by the TPO as comparable, there remains no other company which can be considered as comparable. Section 92(1) specifically provides that:
“Any income arising from an international transaction shall be computed having regard to the ALP.” Section 92C deals with the computation of arm’s length price. Sub-section (1) of section 92C provides that ALP of an international transaction shall be determined by any of the methods prescribed in this section, being the most appropriate method having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such person or such other relevant factor as the Board may prescribe. The methods so prescribed include Cost Plus Method, Transaction Net Margin Method. On a conjoint reading of sections 92(1) and 92C(1), it becomes perceptible that income from an international transaction is required to be computed having regard to its ALP as per the method prescribed. Such a determination cannot be dispensed with.
For determining ALP under any method, it is sine qua non that there must be either some direct comparable instances available or any other close comparable, whose price/profit could be adjusted so as to bring it at par with the international transaction. If a solitary functionally comparable instance is available, but its figures as required under the chosen most appropriate method, cannot be directly found out from its annual accounts without allocation or truncation, etc., then the method so chosen has to be ignored. In such a situation, the next most suitable method is required to be used for transfer pricing analysis, whose relevant figures are available.
Having regard to the above statutory provisions mandating the determination of ALP of an international transaction, which has gone haywire in the extant case for the lack of any comparable uncontrolled transaction, we set aside the impugned order and remit the matter to the file of AO/TPO for a fresh determination of the ALP of this transaction as per law. In such fresh proceedings, the AO/TPO should first try to determine the ALP under the CPM as was initially chosen as the most appropriate method. If due to one reason or the other, the requisite figures of the functionally comparable instance(s) are not available, the TPO will be free to choose the second best method for determining the ALP of these related international transactions of Purchase of raw material and Sale of finished goods. Needless to say, the assessee will be allowed a reasonable opportunity of hearing in such fresh proceedings.
In the result, both the appeals are allowed for statistical purposes.
The order pronounced in the open court on 15.02.2017.