M/S ABOTT MEDICAL OPTICS PRIVATE LIMITED,BANGALORE vs. DCIT, BANGALORE

Per Shri Vijay Pal Rao, J.M. : This appeal by the assessee is directed against the assessment order dt.20.9.2011 passed under Section 143(3) r.w.s. 144C of the Income Tax Act, 1961 (in short 'the Act') in pursuant to the directions of Dispute

“ 1. That the order of the learned Deputy Commissioner of Income Tax, Circle 11(1), Bangalore ('Assessing Officer' or 'AO') to the extent prejudicial to the Appellant, is bad in law and liable to be quashed.

2. That the learned AO and the learned Dispute Resolution Panel (,Panel') erred in upholding the rejection of Transfer Pricing (TP) documentation by the learned Assistant Director of Income tax (Transfer Pricing) - IV, Bangalore (,Transfer Pricing Officer' or 'TPO').

3. That the learned AO and the learned Panel erred both in facts and law in malting an adjustment of Rs.70,951,686 to the transfer price of the Appellant by, holding that the international transactions do not satisfy the arm's length principle envisaged under the Income Tax Act, 1961 (the 'Act') and in doing so grossly erred in: 3.1. Upholding application of Transactional Net Margin Method ("TNMM") as the most appropriate method with selection of Operating Profit to Sales ratio as the Profit Level Indicator as against Resale Price Method ('RPM') with Gross Profit to Sales ratio as the relevant Profit Level Indicator adopted by the Appellant in the TP Documentation in respect of its distribution activity. 3.2. Upholding the rejection of comparability analysis of the Appellant in the TP documentation and confirming the comparability analysis as adopted by the learned TPO in the TP Order. 3.3. Disregarding com parables introduced by the Assessee. 3.4. Disregarding application of multiple year/ prior year data as used by the Appellant in the TP documentation and holding that current year (i.e. Financial Year 2006-07) data for comparable companies should be used.

4. Without prejudice to application of TNMM as the most appropriate method, the learned AO and the learned Panel erred in not providing appropriate adjustment towards the significant expenses incurred by the Appellant towards marketing, advertisement and sales promotion activities due to initial year of its distribution operation.

5. The learned AO and the learned Panel erred in not providing the benefit of lower range of +/-5% in determination of arm's length price.

6. That the learned Assessing Officer erred in consequently levying and computing

3 IT(T.P) A No.1116/Bang/2011 interest under Section 234B and Section 234D of the Act. That the Appellant craves leave to add to and/or alter, amend, rescind, modify the grounds herein above or produce further documents before or at the time of hearing of this Appeal.”

Financial Results of Advanced Medical Optics for the F Y 2006-07.

Description Amount (Rs.) Operating Revenue 50,82,61,938 Operating Cost 55,37,24,288 Operating Loss 8.94% on sales Operating Loss 8.21% on cost

International Transactions (as mentioned in the 92CE report) a. Purchase of traded goods Rs.20,97,79,716 b. Purchase of Capital Goods Rs.29,21,305 c. Sale of Capital Goods Rs.92,52,000 d. Reimbursement of expenses Rs.6,89,520

4 IT(T.P) A No.1116/Bang/2011 To benchmark its international transactions the assessee adopted Resale Price Method (RPM) as Most Appropriate Method (‘MAM’) and selected 8 comparable companies The TPO rejected the Transfer Pricing study of the assessee on various grounds. The TPO applied Transactional Net Margin Method (‘TNMM’) as MAM for determining the Arm’s Length Price (‘ALP’). Accordingly, the TPO has made a search and selected 6 comparables as under :

Sl.No. Company Name Sales OP OP/Sales 1 Advanced Micronic 29.12 2.77 9.50% Devices Ltd. (Seg.)

Accordingly, the TPO proposed an adjustment under Section 92CA of Rs.7,77,36,983. The assessee challenged the action of the TPO before the DRP and the DRP rejected two companies and retained the four companies in the list of comparables.

5 IT(T.P) A No.1116/Bang/2011 trading activity without any value addition in the goods imported from AE and sold to third party therefore, RPM is the MAM for the international transactions by the assessee is purely trading in nature. In support of his contention, he has relied upon the following decisions : i. OSI Systems Pvt. Ltd. Vs. DCIT dt.12.8.2015 in ITA No.683/Hyd/2014. ii. Loreal India PVt. Ltd. Vs. ITO dt.25.4.2012 in IT(TP)A No.5423/Mum/2009. iii. Danisco India Pvt. Ltd. Vs. ACIT dt.29.4.2014 in IT(TP)A No.5291/Del/2010.

Thus the learned Authorised Representative has submitted that when there is no value addition in the goods imported from the AE and sold to the third party then, the RPM adopted by the assessee for bench marking its international transactions has been accepted by the Tribunal in a series of decisions. He has further submitted that for the Assessment Year 2006-07, the A.O./TPO accepted the resale method and no addition was made.

Therefore during the F.Y. relevant to the A.Y. under consideration there was no manufacturing activity and the assessee has already sold the said facility however the assessee has incurred huge selling and distribution expenses as well as sales promotion expenses which indicates that the assessee has added value to the goods of the AE and further the business model of the assessee is not comparable with the comparable companies for the purpose of computing ALP under RPM. He has further pointed out that the assessee has made an adjustment of Rs.15,82,71,804 (credit to value of purchases of traded goods) which is not supported by the adequate documentation and has not reflected in the transaction as per the Note 20 on Schedule 13. The learned D.R. has referred to the Auditor’s Report at 7287 and submitted that had this adjustment not been made, the loss for the year would have been much more than the loss shown in the books of accounts, Further the 7 IT(T.P) A No.1116/Bang/2011 inventory value would have been higher by Rs.4,25,19,854. The learned Departmental Representative then referred to the reasoning of the TPO in rejecting the resale price method in the case of the assessee and submitted that the price charged for the medical products includes the premium for marketing which cannot be compared with the resale price of the comparables. The learned Departmental Representative then referred to the finding of the DRP and submitted that the functions performed with effect to the resale price method should also be similar or it should be possible to make adjustment for such differences. While making a comparison, the presence of such functions and risk in the case of comparable and availability of data is required for computation of gross margin. He has relied upon the orders of the authorities below.

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 9 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. As regards the resale price method accepted by the TPO for the Assessment Year 2006-07, we are of the view that res judicata is not applicable in the matter of taxation and further when there is no such similar expenditure on account of selling and distribution expenses and sales promotion expenses in the said year then the rule of consistency cannot be applied. Accordingly, we do not find any error or illegality in the orders of the authorities below in adopting the TNMM as MAM instead of RPM.

“ 19. One of the things which is clearly discernable from the facts of this case is that so far as the year before us is concerned, which was incidentally first full year of assessee’s operations, the import content of the raw materials was as high at 98.55 per cent. This is materially different from the import content of the raw material in the cases of the comparables selected by the Revenue authorities. The import content of raw material in these cases ranged from 26 per cent to 56.83 per cent (Hindustan Motors—31 per cent; Honda Siel—48.2 per cent; Hyundai Motors—25.29 per cent; General Motors—56.83 per cent and Maruti Udyog—26 per cent). This variation is particularly important since the business model of a car maker having 98.5 per cent import content in raw material normally cannot be the same as of a car maker having import content of 26 per cent to 56.84 per cent. While the latter shows substantial indigenous inputs in the raw material, the former is virtually an assembly

11 IT(T.P) A No.1116/Bang/2011 job of the imported knocked down kits. These business models are so fundamentally different that, in our understanding, no comparisons are possible unless the impact of the import contents are eliminated, or unless it is the case, as was the case before the Tribunal in Sony India (P) Ltd. (supra), that the decision to have such a huge import content was a conscious decision taking into consideration all commercial considerations including the obvious benefits of a better quality which is bound to reflect or translate into higher seller product. No doubt, a higher import content of raw material by itself does not warrant an adjustment in operating margins, as was held in Sony India (P) Ltd.’s case (supra), but what is to be really seen is whether this high import content was necessitated by the extraordinary circumstances beyond assessee’s control. As was observed by a Co-ordinate Bench of this Tribunal in the case of E-Gain Communication (P) Ltd. (supra) "the differences which are likely to materially affect the price, cost charged or paid in, or the profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustment to eliminate the differences having material effect". We do not agree with the AO that every time the assessee pays the higher import duty, it must be passed on to the customers or it must be adjusted for in negotiating the purchasing price. All these things could be relevant only when higher import content is a part of the business model which the assessee has consciously chosen but then if it is a business model to import the SKD kits of the cars, assemble it and sell it in the market, that is certainly not the business models of the comparables that the TPO has adopted in this case. The adjustments then are required to be made for functional differences. The other way of looking at the present situation is to accept that business model of the assessee company and the comparable companies are the same and it is on account of initial stages of business that the unusually high costs are incurred. The adjustments are thus required either way. It is, therefore, permissible in principle to make adjustments in the costs and profits in fit cases. We also do not agree with the authorities below that the onus is on the assessee to get all such details of the comparable concerns so as to make this comparison possible. The assessee cannot be expected to get the details and particulars which are not in public domain. In such a situation, i.e. when information available in public domain is not sufficient to make these comparisons possible, it is inevitable that some approximations are to be made and reasonable assumptions are to be made. The argument before us was that it was first year of assessee’s operations and complete facilities ensuring a reasonable indigenous raw material content was not in place. The assessee’s claim is that it was in these circumstances that the assessee had to sell the cars with such high import contents, and essentially high costs, while the normal selling price of the car was computed in the light of the costs as would apply when the complete facilities of regular production are in place. None of these arguments were before any of the authorities below. What was argued before the AO was mere fact of higher costs on account of higher import duty but then this argument proceeded on the fallacy that an operating profit margin for higher import duty is permissible merely because the higher costs are incurred for the inputs. That argument has been rejected by a Co-ordinate Bench and we are in respectful agreement with the views of our esteemed colleagues. This additional argument was 12 IT(T.P) A No.1116/Bang/2011 not available before the authorities below and it will indeed be unfair for us to adjudicate on this factual aspect without allowing the TPO to examine all the related relevant facts. We, therefore, deem it fit and proper to remit this matter to the file of the TPO for fresh adjudication in the light of our above observations and particularly dealing with the contention that the present year being first full year of operations, the assessee was forced to have higher import content in raw material as the manufacturing facilities, and vendor development, was not complete, as also dealing with the contention that the business model in this year of operation was fundamentally different from the business model of the comparable concerns. The TPO will also consider whether the import content of the raw material have substantially come down in the succeeding years and will take into account the conclusions that can be drawn from such a decline or consistency, as the case may be, of the import content in the raw material. In case the TPO comes to the conclusion that adjustments in operating profits margin on account of peculiarities of business model resulting in higher import duties, the TPO will consider the manner in which impact of the same can be reasonably neutralized in a practical manner. One of the suggestions that the assessee has advanced before us is to take into account impact of the non-cenvatable import duty additionally borne by the assessee. The TPO has to consider the same, and other options which can be put into service to neutralize the impact of such higher costs. While so deciding the matter afresh, the TPO shall also give a due and fair opportunity of hearing to the assessee, shall deal with the contentions of the assessee in a fair and objective manner by way of a speaking order, and in accordance with the law and judicial precedents as may be available at that time. As we remit the matter to the file of the TPO, we are alive to the fact that it is difficult to miss, even on a cursory glance, that many of the arguments and facts in support of arguments are indeed taken up before us for the first time, and, to that extent, the authorities below never had an opportunity to examine these aspects of the matter. Take, for example, the submissions regarding capacity underutilization. It was never taken up before the TPO in the first place. Similarly, the issues regarding product cycles and impact of these product cycles on operating profit margins was never before the AO. The relevance of multiple year data hinges on acceptance of this theory about relevance of product cycle. The crisil report which has been repeatedly referred before us was apparently not available to the TPO. In these circumstances and bearing in mind the fact the year before us was only second year of implementation of transfer pricing regime and it was a new area of taxation laws in which law had not developed, we think that it will meet the ends of justice that the assessee has liberty to raise all these arguments before the TPO so that the TPO can examine all the relevant contentions and decide the same by way of a speaking order in accordance with the law. As we are remitting these issues to the file of the TPO, and as these issues are somewhat academic at this stage which will be relevant only when the assessee’s plea regarding adjustment on account of higher import duties being warranted by peculiarities of operations in this year, we refrain from making any observations on the merits of the case. With the above observations, we hereby remit the matter to the file of the TPO so far as question of determination of ALP under the TNMM method is concerned.”

13 IT(T.P) A No.1116/Bang/2011 We do agree with the view taken by the Pune Bench of ITAT that if the abnormal expenditure towards the advertisement, marketing and sales promotion is only on account of the beginning of the activity of distribution-ship then an appropriate adjustment has to be allowed while determining the ALP under TNMM. We may clarify that the Assessing Officer has to verify by comparing this expenditure during the year with the subsequent years to find out that the significant expenditure towards the marketing, advertisement and sales promotion is only during the initial year and not in the later year. Accordingly, we set aside this issue to the record of the A.O./TPO for re-examination and adjudication in the above terms.

13.1 Needless to say the benefit of second proviso to Section 92C of the Act also be considered.

14 IT(T.P) A No.1116/Bang/2011 14. Ground No.6 is regarding levy of interest under Sections 234B & 234D of the Act which is consequential in nature.