M/S. MC DONALD'S INDIA (P) LTD.,NEW DELHI vs. DCIT, NEW DELHI

This appeal filed by the assessee is directed against the order dated 29- 12-2009 of ld. CIT(A)-XX New Delhi for Assessment Year 2003-04 confirming the additions made by the Learned Assessing officer [ in short ‘AO’ ] in order passed u/s 143(3) of the act dated 27/03/2006 pursuant to the order dated 08/02/2006 of Transfer Pricing officer ( In short ‘TPO’) u/s 92CA(3) of THE Income tax Act 1961 ( hereinafter referred in short ‘ The Act’).

The grounds of appeal raised by the assessee are as under:-

The assesse carried matter before CIT(A) who held that because of the difference in geographical regions the CUP method adopted is not appropriate, the consultancy services rendered by the assesse are the back bone and basis on which royalty and franchisee fee received and thus aggregation of transaction has rightly been made by TPO and further as the MacDonald corporation has right to make good the default of payment of royalty by franchise by assesse and therefore franchise fee as claimed cannot be a pass through cost. Assesse being aggrieved by the order of ld. CIT(A) on confirmation of ALP determined by TPO has filed this appeal before us.

For this the ld AR of the appellant submitted that a. Ld. TPO and CIT (A) has not appreciated the basic fact that Royalty is payable to MDC by Restaurants for the use of McDonald Brand (owned by MDC) @ 5% of sales & since MIPL is not running any restaurants itself, the question of any payment for Royalty by MIPL does not arise. This basic fact by itself makes it clear that MIPL merely receives Royalty fees for onward transmission to MDC. b. In fact, vide para no. 10.8 of order of ld. TPO dated 8.2.2006, the learned TPO has excluded the receipts by way of initial franchisee fees from the working operating profit margins and cost base for applying mark-up. It is submitted that conceptually there is no difference between collection and remittance of initial franchisee fees on one hand and royalty fees on the other hand. Therefore, the TPO was not justified in holding that although initial franchisee fees had to be excluded, royalty fees had to be included. c. Further, this issue is covered by the order of Income Tax Appellate Tribunal, Bench-E dated 30.01.2009 in the appellant’s own case for A.Y. 2001-2002 which is placed in the paper book at page 457-468. Vide para 8 (PB 463) of the aforesaid order, the Hon’ble Tribunal held that “This shows that as per the Master License agreement and franchises agreement, the assessee has to pass on the entire royalty which it has to received from franchises and there is no income left to the assessee as per this Master License Agreement and franchises agreement”. Further, the Tribunal has held (PB 464) that “We have also noted that as per the Master License Agreement along with franchises agreement, the assessee is not earning anything on account of royalty and entire royalty is to be passed on to Mc Donald’s Corporation USA”. d. Assesse is a service provider and is charging 10% margin on all the operating cost and royalty and initial franchisee fees are pass through cost. For this he placed reliance on para 2.93 of the OECD guidelines. e. He further relied on decision of the coordinate bench of in case of Cheil Communications India Pvt. Ltd ITA No.712/del/2010. He further read para 40 of that decision to support his claim. f. He further submitted that the issue is now squarely covered by the decision of Hon’ble Delhi High Court in the case of Jonson Matthey India Pvt.Ltd vs. DCIT dated 13.10.2015. He drew our attention to para Nos. 36, 37, 38 and 39 of that decision. He further submitted that therefore the pass through cost in form of royalty shall be excluded from income as well as expenses. g. He further submitted that while applying a cost based remuneration model a markup is to be provided only on value added services and in this case royalty and franchisee fee are not value added services and only are pass through cost. Therefore he submitted that the adjustment to ALP confirmed by ld. CIT (A) while considering the royalty in working of PLI may be deleted.

Against this LD DR referred to page 265, 109,103 of PB to support the orders of LD TPO. He therefore submitted that royalty is not a pass through cost. He further referred to para no .8 of order of TPO to support that ld TPO has rightly not excluded royalty. He further submitted that there is a basis between collection of royalty and payment of royalty and pass through cost are generally same but here there is a difference too therefore it has some profit or loss element, hence, he submitted that it is not a pass through cost.

We have carefully considered the rival contention and also perused the relevant documents cited before us. Brief facts have already been noted.

Now coming to the issue of whether the royalty is a pass through cost or not. Brief facts of the case is assesse is collecting the royalty and franchisee services fess from the JVs based on the sub licensing agreement and also remits it back to McDonald corporation based on the master license agreement. The amount of royalty that was to be collected by JVs is 5% of gross sales from operation of McDonald restaurants and same amount is required to be remitted by the assesse within five days of the end of each month. Ld TPO as well as the ld CIT(A) did not agree to the contention of the assesse for the only reason that there is discretion available to McDonald to compel assesse to make good in case there is a default of payment of royalty by franchisee. Though there is a clause in agreement it cannot be read in isolation or complete ignorance of risk involved in those clauses of agreement on practical business matrix of the assessee. It was submitted that there is no such default which has occurred either in previous years or in subsequent years.. Therefore there is no risk assumed by the assesse in collection and onward remittance of Royalty. This argument of the assessee has not been controverted by Ld DR. Further it is contention of the assessee that there is no value addition to the collection of royalty amount and reimbursement of the same to the MDC. During the year there is a collection of royalty fees of Rs.52637830/-and there is a payment of royalty fees of Rs.52086668/- during the year. The amount of Rs.551162/- it was submitted could not be remitted because of the reason of RBI restriction and absence of approval to remit this money outside India. Therefore the above facts show that assesse has remitted the money to the McDonald corporation without any value addition. The originally the assesse was established only for the ease of administrative convenience for obtaining regulatory approvals for remittance of royalty and franchisee fees only. It is not the case of the revenue that assessee has commercially exploited or anyway enjoying the benefit of royalty and franchise fees. Further assesse also cannot keep the some collected on behalf of McDonald corporation because it is required to remit such funds being 5% on gross sales within five days of the end of each month. This also shows that even the benefit of credit or retaining money is also not available with the assesse on account of royalty and franchisee fees.

The pass through cost is those, which are incidental to the main business activities of the multinational enterprises group. The assesse in case of pass through cost do not perform any significant function or assume any significant risk. The cost is reimbursed to the AE for whom the activities are performed and therefore they are not considered as part of operating cost in the tax payer’s computation of PLI. In fact it is required to be determined whether an independent enterprise in comparable circumstances would have either paid for the performed the service. In this case the assesse company was set up with that objective and is earning mark-up over the cost incurred separately. The pass through cost are required to be demonstrated in substance and with actual intent. The para No 2.93 of OECD transfer pricing guidelines is as under:- “2.93 In applying a cost based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with the an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at Arm’s length to treat a significant portion of taxpayer’s cost as pass-though costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit indicator). This depends on the extent to which an independent party in comparable circumstances would agree not to earn a mark-up of part of the costs it incurs. The response should not be based on the classification of costs as “internal” or “external” costs, but rather on a comparability (including functional) analysis. See paragraph 7.36.”

The LD TPO as well as the ld CIT (A) has not shown that an independent service provider in comparable circumstances would not have performed such function of collection of royalty and onward remittance of the same to MDC when it is reimbursed for other services on cost plus mark up and there could have been payment of further remuneration on this aspect also. In this case assesse has submitted that it is being remunerated separately on cost basis, does not provide any value addition to the collection and payment of royalty and franchise fees and has not performed any significant function as the royalty and initial franchisee fee is collected by JV and paid to assesse who in turn remits to the AE. It has also not assumed any significant risk based on past practices or any experience. No instances have been pointed out by ld TPO or ld CIT(A) to show that risk of nonpayment by franchisee devolving on the assesse is imminent and a real risk.

Assessee has further relied on the decision of The decision relied upon 2011] 11 taxmann.com 205 (Delhi) Deputy Commissioner of Income-tax v. Cheil Communications India (P.) Ltd.* where in it is held after considering OECD guidelines as under :- “40. The rival contentions of both the parties have been considered and orders of the authorities below have carefully been perused. The only question that falls for our consideration is with regard to the method of computing profit/TC margin whether on gross basis as done by the TPO or net basis as worked out by the assessee. In this case the assessee has applied TNM method to determine ALP, which has also been accepted by the Revenue authorities. The comparables cited by the assessee has also been accepted by the TPO as appropriate. It is also found by us that in the regular financial accounts maintained by the comparable companies, the comparables recognize revenue on a net basis. The assessee has also recognized revenues on a net basis in its financial account, which had been duly audited by the auditor. The assessee has computed the margin of operative profit on the total cost on the basis of net revenue by way of mark-up received from the associate concern. The payment made by the assessee to third party vendor/media agencies for and on behalf of the principal has not been included in the total cost for determining the profit margin, though, on the other hand, the TPO has included the payment reimbursed by the assessee's associate enterprise to the assessee on account of payment made to third party vendor/media agencies. It is not in dispute that the assessee is engaged in undertaking advertising services for its customers/AEs in the capacity of an agent. As part of its business operation, the assessee facilitates placement of advertisement for its AE in the print/electronic etc. media and for that purpose, the assessee is required to make payment to third parties for rendering of advertisement space on behalf of its customers or AEs. It is, thus, clear that the assessee's business is not sale of advertising slots to its customers or associate concern. For performing the functions for and on behalf of AEs, the assessee is remunerated by its AEs on the basis of a fixed commission/charges based on expenses or cost incurred by the assessee for release of a particular advertisement. It is also to be noted that advertising space (be it media, print or outdoor), has been let out by third party vendors in the name of ultimate customers and beneficiary of advertisement. We have gone through the invoices and purchase orders from third party vendors and find that they contain customers' name, and all the terms of advertisement are finalized after taking the approval from the customers. The assessee simply acts as an intermediary between the ultimate customer and the third party vendor in order to facilitate placement of the advertisement. The payment made by the assessee to vendors is recovered from the respective customers or AEs. In the event customer fails to pay any such amount to the advertisement agency the bad debt risk is borne by the third party vendor and not by the advertising agency i.e. the assessee. It is, thus, clear that the assessee has not assumed any risk on account of non-payment by its customers or AEs. At this stage a useful reference may be made to ITS 2009 Transfer Pricing Guidelines accepted by the OECD where it is laid down that when an AE is acting only as an agent or intermediary in the provision of service, it is important in applying the cost plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves, and, in such a case, it may not be appropriate to determine ALP as a mark-up on the cost of services but rather on the cost of agency function itself, or alternatively, depending on the type of comparable data being used the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. In this type of case, it will be appropriate to pass on the cost of rendering advertising space, to the credit recipient without a mark-up and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function. These guidelines are as under : "3.41 In applying the transactional net margin method, various considerations should influence the choice of margin used for example, these considerations would include how well the value of assets employed in the calculations is measured (e.g. to that extent there is intangible property the value of which is not captured on the books of the enterprise) and the factors affecting whether specific costs should be passed through, marked-up, or excluded entirely from the calculation."

In the proposed revision of Chapter I-III of the Transfer Pricing Guidelines issued on 9th Sept., 2009 - 9th Jan., 2010 by OECD, it has been provided in para 2.134 as under : "2.134 In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at arm's length to treat a significant portion of the taxpayer's costs as pass-through costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit margin indicator). This depends on the extent to which an independent party at arm's length would accept not to be remunerated on part of the expenses it incurs. The response should not be based on the classification of costs as 'internal' or 'external' costs, but rather on a comparability (including functional) analysis, and in particular on a determination of the value added by the tested party in relation to those costs."

Further, OECD in ITS 2009 Transfer Pricing Guidelines has laid down as under : "7.36 When an AE is acting only as an agent or intermediary in the provision of services, it is important in applying the cost plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves. In such a case, it may not be appropriate to determine arm's length pricing as a mark-up on the cost of the services but rather on the costs of the agency function itself or alternatively, depending on the type of comparable data being used, the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. For example, an AE may incur the costs of rendering advertising space on behalf of group members, costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a mark-up, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function."

In the light of these guidelines, it would be, therefore, clear that a mark-up is to be applied to the cost incurred by the assessee company in performing its agency function and not to the cost of rendering advertising space on behalf of its AEs. We further find that the method adopted by the assessee while submitting transfer pricing study based on net revenue has been accepted by the Department in earlier year and, therefore, there is no reason to depart from that stand already accepted by the Department in earlier year. In the light of the view we have taken above, we therefore, uphold the order of the learned CIT(A) on this issue and reject the ground raised

The exclusion of pass through costs from the denominator of total costs where the financial ratio of OP to TC is used is acknowledged in para 2.93 and 2.94 of the OECD Guidelines. Para 2.93 states that the extent to which it would be acceptable "at arm's length to treat a significant portion of the taxpayer's costs as pass-through costs to which no profit element is attributed (i.e. costs which are potentially excludable from the denominator of the net profit indicator)" would depend on the extent to which "an independent party in comparable circumstances would agree not to earn a mark-up on part of the costs it incurs." Para 2.94 of the OECD Guidelines further acknowledges that "comparability issues may arise in practice where limited information is available on the breakdown of the costs of the comparables." This Court has in CIT v. EKL Appliances Ltd. [2012] 345 ITR 241 (Delhi) has noted that the OECD Guidelines have been recognised in our tax jurisprudence. What is however, is significant is that in the absence of any reliable comparable data, and in the absence of proper reasons, it would not be justified for the Revenue to simply reject a financial ratio adopted by the Assessee for computing the net profit margin by excluding a pass through cost from the TC in the denominator. The expression "any other relevant base" occurring in Rule 10(1)(e)(i) of the Rules is wide enough to encompass a denominator that excludes pass through costs as long it is demonstrated to be at arm's length.

It is further importantly pointed out that the very purpose of transfer pricing is to benchmark transactions between related parties in order to discover the true price if such entities were unrelated. If MUL had bought the PGM directly from JMUK there would have been no application of transfer pricing since MUL and JMUK are unrelated entities. MUL would have purchased the PGM just like JMIPL did on negotiated prices. There is merit in the contention that the prices at which JMIPL purchased PGM from JMUK were already at arm's length and that it was for administrative convenience that MUL had outsourced this function to JMIPL. The submission of the Revenue that the accounting entries of JMUK do not treat the cost of PGM as a pass through cost fails to acknowledge that JMUK is in the business of selling PGM. It does not require to charge JMIPL for processing the raw material i.e. PGM as that is passed on to MUL's vendors and thereby to MUL. The fact that JMIPL is paid a fixed manufacturing charge per unit shows that costs associated with the possible fluctuations in the price of the raw material is passed on to the customers and does not affect the profits of JMIPL. The submission of the Revenue that the international transaction between JMUK and JMIPL with regard to sale of precious metals may not be at ALP because JMIPL was a wholly owned subsidiary of JMUK does not appear to be based on any definite information but on suspicion. No convincing reason is forthcoming in the orders of the TPO, the CIT(A) or the ITAT for rejecting the alternate plea of JMIPL as regards the PLI being OP/TC-RMC.”

Further coordinate bench while deciding the appeal in case of assessee for AY 2001-02 in dated 30.10.2009 has held that as per the Master License agreement and franchises agreement, the assessee has to pass on the entire royalty which it has to receive from franchises and there is no income left to the assessee as per this Master License Agreement and franchises agreement. Further, the coordinate bench has also held that as per the Master License Agreement along with franchises agreement, the assessee is not earning anything on account of royalty and entire royalty is to be passed on to Mc Donald’s Corporation USA. Coordinate bench has held so as under :- “8. We have heard the rival submissions and have gone through the material available on record and the judgments cited by Ld AR of the assessee. We find that in view of Master License Agreement dated 1.4.1996 and Service Agreement dated 1.4.1999, the assessee is running two types of businesses although both are connected with Me Donald's Corporation USA. As per this agreement dated 1.1.1996 I.e. Master License Agreement, the assessee can operate restaurant system under Me Donald's System and the assessee can run it of its own or through franchises. In both these situations, the assessee has to pay royalty to Me Donald's Corporation USA @ 5% of gross turnover. Regarding advertisement, clause (vi) of this Master License Agreement is relevant as per which, licensee has to spend during each calendar year for advertisement or promotion of restaurant business for the general public and amount which is not less than 5% of its gross sales. In view of this, we find that as per Master License Agreement dated 1.1.1996, the assessee has to pay 5% of gross turnover to Me Donald's Corporation USA as Royalty and at the same time, the assessee has to spend minimum 5% of gross turnover for advertisement. As per franchises agreement of the assessee with Connaught Piaza restaurant Pvt. Ltd. also, we find that the franchises has to incur minimum of 5% of gross sales towards advertisement and the franchise has to pay to the assessee royalty @ 5% of the gross sales. This shows that as per the Master License agreement and franchises agreement, the assessee has to pass on the entire royalty which it has to receive from franchises and there is no income left to the assessee as per this Master License Agreement and franchises agreement. Thereafter, the assessee has entered into a Marketing Support Agreement with the franchises on 1.10.1997. As per this Marketing Support Agreement, the assessee has to contribute some part of the advertisement expenditure which is required to be borne by the franchises. As per clause (d) of this Marketing Support agreement dated 1.10.1997, it is noted that if the business of the franchises is expanded and its sales are increased, it will result into an increase in profitability and consequently it will increase the return on the investments as well as result in an increase in the net wealth of the franchisee company. This shows the purpose for which the assessee has agreed to bear a part of the advertisement expenditure which was otherwise to be borne by the franchises. The purpose is to increase the return on investment i.e. dividend and increase in net worth of investment. We have also noted that as per the Master License Agreement along with franchises agreement, the assessee is not earning anything on account of royalty and entire royalty is to be passed on to Me Donald's Corporation USA and hence, the Assessing Officer could have examined the allowability of such advertisement expenditure borne by the assessee which was otherwise to be borne by the franchises. Because the so-called increase in return on investment of the assessee will be in the form of dividend income which is an exempt income and hence any expenditure incurred for earning an exempt income is not allowable u/s 14A of the income Tax Act, 1961. The Assessing Officer could have examined the allowability of such advertisement expenditure on this basis but this was dot done by him. Be that as it may. In the present appeal, we have to decide regarding applicability of section 92 with regard to advertisement expenditure partly borne by the assessee which was to be otherwise borne by the franchises, [n this regard, we are of the considered opinion that section 92 of the income Tax Act, 1961 is not applicable with regard to advertisement expenditure which has been borne by the assessee as a result of this agreement} with Indian franchises and the same has resulted into lesser profit/loss of the assessee and more profit to the franchises and it has no impact on the income of the Me Donald's Corporation USA because whether the advertisement expenditure is borne by the assessee or by the franchises, the benefit of Me Donald's Corporation USA will remain the same. The benefit of McDonald's' USA remains unchanged. Me Donald's Corporation USA will get the same amount of royalty whether advertisement expenditure is borne by the assessee or by its franchises and hence, it cannot be said that by agreeing to bear a part of the advertisement expenditure 'which was to be borne by the franchises, there is any arrangement between the assessee and a non resident to the effect that there is no profit to the assessee or lesser profit to the assessee.” Therefore it is apparent that the transaction of royalty is a pass through cost which does not result in to any profit and loss to the assessee.

In view of the above facts and circumstances we are of the view that while working out PLI of the assessee transaction of Royalty income of Rs. 52637830/- should not be considered as operating income and royalty reimbursed to the MDC of Rs. 52086668/- shall not be considered as operating expenses of the assessee. We therefore reverse the finding of CIT (A) that royalty receipt from franchisee , JV is the operating income of the assessee and payment of royalty to MDC shall be the operating expenses of the assessee while working PLI of the assessee In the Result ground No o. 5 of the appeal is allowed with above direction.

Ground No 6 of the appeal is against other transfer pricing issues. At the time of hearing it was submitted by Ld AR that assessee does not contest the transfer pricing issues as covered by the ground no 6 of the appeal. and hence ground no 6 of the appeal is dismissed. 22. Ground NO. 7 of the appeal is with respect to allowing appropriate adjustment of risk assumed vis-a viz-comparable company identified by ld TPO. 23. Before us it was contended that the appellant business does not involve any risk whereas the comparable companies identified by TPO carry lot of risk. The ld TPO did not make any adjustment in this regard and has held that assesse carried a risk on account of delay in payment of royalty fees and initial franchisee fees to the McDonald corporation in time and therefore there is a risk of cancellation of the agreement and in anyway the assesse carries the risk of foreign exchange fluctuation. 24. Before us the assesse contended that view of the TPO is incorrect. He submitted that cancellation of agreement is not risk on the assesse but the risk is on JVs who losses the business and on McDonald corporation who