MOSER BAER INDIA LTD vs. DCIT CIRCLE -5 (1),

PER A.T. VARKEY, JUDICIAL MEMBER :

“1. That the Commissioner of Income- Tax (Appeals) erred on facts and in law in sustaining the addition of Rs. 54,62,582/- to the appellant’s income on account of the alleged difference in the arm’s length price of the international transactions, upholding the findings in the order passed by the Transfer Pricing Officer (TPO)/other assessing officer.

4. That the Commissioner of Income-tax (Appeals) erred on facts and in law in not holding that the international transactions entered into with the associated enterprise were at arm’s length and no adjustment to the price thereof was called for being made. 5. That the Commissioner of Income-tax (Appeals) erred on facts and in law in disregarding the adjustment made to the prices of international transaction of export to Glyphics Media inc. (GMI) on account of geographical difference, for determining the arm’s length applying Comparable Uncontrolled Price (CUP) method holding that such adjustment were not correctly made.

6. That the Commissioner of Income-tax (Appeals) erred on facts and in law in holding that the benchmarking analysis in the instant case to be conducted by taking the wholesale export prices charged by the appellant from GMI as given and then comparing these prices with arm’s length computed from the uncontrolled transactions after making the necessary adjustments.

7. That the Commissioner of Income-tax (Appeals) erred on facts and in law in holding that the correct way of making the adjustment on account of selling expenses incurred by GMI was to reduce the average selling distribution expenses incurred by the appellant from the prices charged from unrelated parties.

11. That the Commissioner of Income-tax (Appeals) erred on facts and in law in not appreciating that in order to make a comparison of like with like and for application of CUP method, adjustment was ought to be made on account of the geographical differences in the international transactions and comparable uncontrolled transactions.

13. That the Commissioner of Income-tax (Appeals) erred on facts and in law in not appreciating that the adjustment on account of geographical difference was made on the basis of instance of purchase of similar product by an unrelated party in Europe and USA during the relevant previous year.

14. That the Commissioner of Income-tax (Appeals) erred on facts and in law in upholding the adjustment on account of selling and distribution expenses incurred by the appellant at Rs. 0.27 per CD allegedly being selling and distribution expenses incurred in distributing the products in non US locations.

15. That the Commissioner of Income-tax (Appeals) erred on facts and in law in holding that the appellant failed to come up with documentation to show that it treats that US and European market differently.

16. That the Commissioner of Income-tax (Appeals) erred on facts and in law in holding that appellant did not produce adequate documentation for claiming adjustment on account of purchasing power priority considering the various variables, such as, interest rate, exchange rate, price level, etc.

18. That the Commissioner of Income-tax (Appeals) erred on facts and in law in not appreciating that the instances of purchase of CDs in Europe and in USA by Imation during the relevant previous year was also placed on record in

19. That the Commissioner of Income-tax (Appeals) erred on facts and in law in holding that the reference to Big Mac Index by the appellant is also misplaced. The prices of a burger in US could be lower for a number of reasons.

21. That the Commissioner of Income-tax (Appeals) erred on facts and in law in holding that the reference to lower prices of home electronics and household appliances in US is also misplaced as these belong to different product categories.

23. That the Commissioner of Income-tax (Appeals) erred on facts and in law in holding that, it the arm’s length prices falls outside the tolerance band, Transfer Pricing adjustment would have to be mad for the difference between the arm’s length price determined by the assessing officer based on the arithmetical mean of the prices and the price shown by the assessee.

6 analysis, each international transaction is to be compared with the arm’s length price determined and the TPO was correct in following such a methodology. The appellant craves leave to add, after, amend or vary from the above grounds of appeal s before or at the time of hearing.”

3. All the grounds relate to adjustment of Rs.54,62,582/- to the international transaction of the assessee with its AE Glyphics Media Inc. USA (hereinafter referred to as “GMI”)

“MBI exports similar products to unrelated parties as well as GMI. Since internal comparables were available, the international transaction relating to sale of finished goods could be justifies as being at arm’s length, applying CUP method. For the purposes of comparing the price charged from GMI and independent uncontrolled parties in Europe, the following methodology was adopted: i) Entire sales to AE (GMI) during 2001-2002 were sorted on the basis of packing and memory size. ii) Comparable sales to all independent uncontrolled parties in Europe were also sorted on the basis of packing and memory size, and iii) Average sale price to the AE (GMI) was adjusted on the following account: a) Adjustment for expenses of the intermediary: GMI is a wholesale distributor of MBI. GMI exclusively deals in products manufactured of MBI and incurs expenditure for sale of such products in USA. The wholesale price charged from GMI, therefore, is to be suitably adjusted for comparison with the retail price charged from other

8 independent enterprises. Alternatively, GMI incurs expenditure in selling/ distributing MBI products in USA, which expenditure are incurred by MBI for selling such products to unrelated parties in other markets, viz, Europe. Considering this fact, the wholesale price charged from GMI was increased by the proportionate selling expenses incurred by GMI so as to make the data comparable. The mark- up is determined on the basis of actual operating expenses incurred by GMI during the relevant period. b) Adjustment for geographical difference:

The market in US is different from European market. The European market is dominated more by brand name and aesthetics for which the customer is willing to pay extra. On the other hand, sales to USA are standard and not customer specific. The costing of products exported to Eupore is, therefore, significantly higher due to packing and printing. Also, US Market is more competitive and price- conscious. USA demands best price being a strong economy with huge demand potential.

We compared the price that an independent party (Emtec) was prepared to pay to GMI in USA and to MBI in the European market for the same product. The USA prices were 10-20% lower than the European prices. Accordingly, on a conservative basis, 10% of export price has been loaded on the wholesale price charged by MBI from GMI. iv) The adjusted price of sale to GMI was compared with the average sale price of comparable uncontrolled enterprises. v) The result of such comparison is charted (Table-2) as follows; Table2 Sr. Name of Average Add Add 10% Adjusted Average Difference No. Packing wholesale Specific mark up average retail in average price to cost due to wholesale price price AE (in US factor difference price to [Arm’s [Col. 7- $) (in US in US and GMI (in Length Col. 6] (in $) Europe US$) price] (in US$)

9 markets US$) (in US$) 1 2 3 4 5 6 7 8 1 CDR Cake 0.18 0.02 0.02 0.22 0.18 -0.04 Box – Rotterdam 2 CDR Cake 0.18 0.02 0.02 0.22 0.19 -0.03 Box- Direct 3 CDR Cake 0.18 0.02 0.02 0.22 0.18 -0.04 Box- Total 4 Jewel 0.26 0.02 0.03 0.31 0.30 -0.01 case- Rotterdam 5 Jewel case- 0.33 0.02 0.04 0.39 0.32 -0.07 Direct 6 Slim case- 0.27 0.02 0.03 0.32 0.31 -0.02 Total 7 Slim case- 0.28 0.02 0.03 0.33 0.29 -0.04 Rotterdam 8 Slim case- 0.27 0.02 0.03 0.32 0.31 -0.01 Direct 9 Slim case- 0.27 0.02 0.03 0.33 0.29 -0.03 Total 10 Floppies 0.12 0.02 0.01 0.16 0.10 -0.06

It was noticed that the price charged to GMI was higher than as compared to the average sale price charged to comparable uncontrolled enterprises. Sale to GMI is, therefore, being considered at arm’s length under CUP method.” 4.3.2 On the basis of the economic analysis carried out in the TP report, the appellant came to the conclusion that international transaction of sale of finished goods to GMI was at arm’s length. GMI had incurred losses from the transactions relating to sale of products of MBIL and there could not be any allegation to transfer of profits by virtue of the international transactions.”

Glyphics Media Transactions Comparable uncontrolled transactions Type of Average Less Add selling Add: 10% Adjusted Average packing wholesale Differential & Mark-up average Rate (Rs.) price freight Distribution due to retail (Rs.) (Rs.) expenses difference price incurred by in US & (Rs.) GMI (Rs. ) European Markets (Rs.) 1 2 3 4 5 6 7 CDR 8.53 0.05 1.11 0.96 10.65 8.54 Cake Box CRD 13.03 0.17 1.11 1.397 15.37 13.21 Slim Case CDR 12.96 0.28 1.11 1.38 15.18 14.4 Jewel case

“i) The methodology adopted in the benchmarking analysis is not correct as average value of each category of transaction was done with the Arm’s Length Price, which is again an average figure. Averaging is not to be done for the transactions in each of the three categories and rather each of the transactions is to be judged separately vis-à-vis ALP. It may be possible that out of several Sales transactions to GMI, Prices are below the Arm’s Length price in some instances that would require transfer pricing adjustments. ii) The TPO had no objection to the adjustment made on account of freight differential, though he had reservations about the other two adjustments. iii) The adjustment for selling & distribution was made by adding a figures of Rs. 1.11/- per CD, to the average wholesale price charged from the GMI, to all the three categories of packaging. The value of Rs. 1.11/- was arrived at by dividing the total expenses of GMI for the period 01.04.2001 to 31.03.2002 of US$ 11,84,410, by the total number of CDs sold to GMI and then by multiplying the same with the appropriate foreign exchange rate to arrive at average selling & distribution (S&D) expenses per CD. iv) According to the TPO, the correct way of doing this adjustment would be to reduce average selling & distribution expenses incurred by MBIL from the prices charged by it from unrelated parties. This was accepted, by the A.R.s during the hearing on 15.3.2004. However, the TPO was of the view that certain adjustments are to be done before coming up with the correct arm’s length price. v) The appellant had furnished details of selling & distribution expenses incurred by MBIL amounting to Rs. 76,22,56,882/- to the TPO vide its letter dated 11.03.2004. it was contended that these expenses were primarily incurred

12 for sales promotion activities in Europe, Japan and East Asian markets only and not in USA. An analysis of the expenses revealed that the total expenses of Rs. 76.22 crs. Included expenses on account of royalty of Rs. 39,57,72,326/-, insurance of Rs. 2,86,47,543/- and commission on sales of Rs. 3,70.644/-. Royalty was paid to Philips for acquiring patent rights, which was for the entire sales, both domestic and exports, to US as well as to Europe and other countries. The TPO argued that royalty not being selling & distribution expenses should be excluded. According to the TPO, the same was the case for insurance. Commission on sales being on domestic sales, the same was also to the excluded. Since packing, freight and forwarding charges of Rs. 25,20,03,838/- were being separately considered for working out the freight differential and the same not being selling & distribution expense, had also to be excluded to bring at par the price of export to GMI and those of sales to the UREs. After excluding these expenses, the TPO calculated the balance of Rs. 8,45,62,531/- to be the actual selling & distribution expenses that is to be considered for making the necessary adjustment. The same was calculated as under: TOTAL Rs. 76,22,56,882/- Less : Royalty Rs. 39,57,72,326/- Insurance Rs. 2,86,47,543/- Commission on sales Rs. 3,70,644/- Packing, freights & forwarding Rs. 25,29,03,838/- BALANCE Rs. 8,45,62,531/- vi) The appellant had contended that the balance of RS. 8,45,62,531/- were entirely for promoting export sales other than those to GMI. These expensed included salary and allowances, staff welfare expenses, rent, printing & stationery, postage telegram, telephone, advertisement and publicity, sales promotion & execution expenses and miscellaneous expenses. It was also explained by the appellant that these are salaries form marketing Division of MBIL only. However the TPO was of the view that a part of these expenses pertained to domestic sales. According, the TPO computed the relevant sales & distribution expenses pertaining to the export sales to Non-US destination excluding the GMI exports at Rs. 0.27/- per CD as under:-

13 Total sales made during the year: Rs. 680 crores Less: Export sales made to GMI: Rs. 5 crores Balance: Rs. 675 crores Domestic turnover @ 5% to 7% of the total turnover : Rs. 50 crores. Export turnover to Non- US Destination : Rs. 625 crores. Ratio between Export turnover to Non- Us destination and total turnover : 625/675=93% Apportionment of selling & distribution expenses to Non- US destinations: Rs. 8,45,62,531/- x 0.93= Rs. 7,86,43,165/-.

Total Number of CDs and Floppies exported to UREs in Non- US destinations = 29,00,26,730 (while working out the corresponding adjustment in GMI’s wholesale price, the appellant had used this number)

Selling & distribution expenses per CD for export sales to Non- US destination = Rs. 0.27/-.

The value of Rs. 0.27/- was accordingly used by the TPO as selling & distribution expenses per CD for export sales to Non- US destination that needs to be subtracted from the export prices charged to UREs in accordance with Rule 10B(3) of the IT Rules. vii) The appellant had claimed that European customers were willing to pay more than US customers (para 5.10 of the T.P. Report). To substantiate this, an example was given of the prices an independent party (Emtec) was prepared to pay to GMI in USA and to MBIL in Europe for the same product. The TPO was ot prepared to accept this difference on the basis of one or two isolated transactions as no other examples were furnished either in the TP Report or during the 92CA proceedings. On the contrary, the TPO found instances from the details of export sales filed with letter dated 11.02.2004 that higher prices were charged from the same US customer viz LG Electronics lnc for 10.11-0 (Jewel case CD box) sales in three destinations as evident from the details below: viii) Vide letter dated 11.03.2004, the appellant clarified that US prices were higher in LG’s case due to difference in memory size in the items supplied, as CDs supplied to USA had higher memory size of 700MB (80 minutes) as against 650MB (74 Minutes) supplied to Germany and Poland. The TPO however, was not convinced about the explanation as price difference on account of memory difference was not corroborated from the details filed by the appellant. The same was also stated to have been confirmed through local enquiries by the TPO. Further, the TPO highlighted two specific instances by way of two invoices raised on Emtec of Australia for sale of CDs of 74 minute (i.e. 650 MB: invoice No. RTD/EXP/264/01-02 Dt. 10.8.2001) and of 80 minutes (i.e. 700MB; invoice No. RTD/EXP/140/01-02 dt. 20.06.2001) where the price difference worked out to 3.5% only. In the LG Electronics’ case, the difference was of 9.59%. hence, according to the TPO, the same was obviously not due t difference in memory size. When this fact was brought to notice of the appellant during the TP proceedings on 11.3.2004, no answer could be provided. ix) The TPO further observed that the details of exports submitted by the appellant pertained to exports to all destinations including Europe, Morrocco, Colombia, Venezula, Turkey, Australia, Panama, Japan, Mexico, Syria, UAE and Casablanca and not restricted to Europe alone. It was not the appellant’s case that there was a price differential between these countries and the USA. Examination of details furnished by the appellant also revealed no price pattern on the basis of destination to a particular country. Accordingly, it was concluded by the TPO that since the uncontrolled transactions included exports to all these counties besides Europe, there was absolutely no justification for making adjustment for geographical market differences. Hence, adjustment on account of geographical differential was not accepted by the TPO while computing Arm’s length price.” the average of various transactions prices for each of three categories of CD packing viz. Jewel Box Slim case and Cake box and adjustments were made to these average prices for freight differential and selling and distribution expenses in the manner stated hereunder :-

Jewel Case Packing Average price charged from UREs for export Rs. 14.4 Adjustment as per Rule 10B for freight differential Add: Freight Differential Rs. 0.28 Rs. 14.68 Less: Selling and Distribution expenses as worked out Rs. 0.27 above Arm’s Length Price Rs. 14.41 95% thereon Rs. 13.69 Slim case packing Average price charged from UREs for export Rs. 13.21 Adjustment as per Rule 10B for freight differential Add: Freight Differential Rs. 0.17 Rs. 13.38 Less: Selling and Distribution expenses as worked out Rs. 0.27 above Arm’s Length price Rs. 13.11 95% thereof Rs. 12.45 Cake Box Packing Average price charged from UREs for export Rs. 8.54 Adjustment as per Rule 10B for freight differential Add: Freight differential Rs. 0.05 Rs. 8.59 Less: Selling and Distribution expenses as worked out Rs. 0.27 above Arm’s Length price Rs. 8.32 95% thereof Rs. 7.90 transactions by the assessee were compared with the ALPs worked out above. As a result the position was arrived as below:

Sr. Description Price per ALP 95% of ALP of the Remarks No. CD the ALP Invoice amount 1 5.2.13 Slim case: Rs. Rs. Rs. 420000 @ The book price in invoice from 12.92 13.11 12.45 13.11 = Rs. the invoice is more India for 420000 55,06,200/- than 95%of the CDRs for Rs. ALP. Hence no TP 54269376 @ Rs. adjustment called 12.92 for as per proviso to section 92C(2) of the Act. 2 5.2.12- S3 Slim Rs. Rs. Rs. 7200@ 13.11= The book price in case invoice from 10.63 13.11 12.45 Rs, 94,392/- the invoice is less India for 7200 than 95% of the CDRs for Rs. ALP. Hence TP 76,555@ Rs. adjustment is called 10.63 for an amount of Rs. 17,837/- on account of difference between the ALP value of the transaction and the invoice value. 3 B 100-0-0 Cake Rs. 7.88 Rs. 8.32 Rs. 7.90 6570000 @ Rs. The book price in Box Invoice from 8.32 = Rs. the invoice is less India for 5,46,62,400/- than 95% of the 6570000 CDRs ALP. Hence TP for Rs. 51794784 adjustment is called @ 7.88 for an amount of Rs. 28,67,616/- on account of difference between the ALP value of the transaction and the invoice value.

17 4 10.4-11- S2 Rs. Rs. Rs. 980000 @ Rs. The book price in Jewel Box 12.23 14.41 13.69 14.41 = Rs. the invoice is less invoice from 1,41,21,800/- than 95% of the Rotterdam for ALP. Hence TP 980000 CDRs for adjustment is called Rs. 11985321.6 for an amount of @ Rs. 12.33 Rs. 21,36,479/- on account of difference between the ALP Value of the transaction and the invoice value. 5 10-4-11-S2 Jewel Rs. Rs. Rs.13.69 196000 @ The book price in Box invoice from 12.68 14.41 14.41 = Rs. the invoice is less Rotterdam 28,24,360/- than 95% of the 196000 CDRs for ALP. Hence TP Rs. 2485844,48 adjustment is called @ Rs. 12.68 for an amount of Rs. 3,38,516/- on account of difference between the ALP Value of the transaction and the invoice value. 6 S.2-13-S1 Slim Rs. Rs.13.11 Rs. 35800 @ Rs. The book price in Box Invoice from 13.02 12.45 13.11 = Rs. the invoice is less Rotterdam for 4,69,338/- than 95% of the 35800 CDRs for ALP. Hence TP Rs. 465995.712 adjustment is called @ Rs. 13.02 for as per proviso to section 92C(2) of the Act. 7 S.2-13-S.1 Slim Rs.13.02 Rs.13.11 12.45 186400 @ Rs. The book price in Box invoice from 13.11 = Rs. the invoice is less Rotterdam 2443704/- than 95% of the 186400 CDRs for ALP. Hence TP Rs. 2410224 @ adjustment is called Rs. 13.02 for as per proviso to section 92C(2) of the Act. 8 S.2-13-S.1 Slim Rs. Rs.13.11 Rs. 10800 @ 13.11 The book price in case invoice from 12.16 12.45 = Rs. 14115880 the invoice is less Rotterdam than 95% of the 18 1080000 CDRs ALP. Hence TP for Rs. adjustment is called 1313746.112 @ for an amount of Rs. 12.16 Rs. 1,02,134/- on account of difference between the ALP Value of the transaction and the invoice value.

per the tabulation given above, proposed a total addition of Rs.

54,62,582/- as per the details given below:

S. No. of Transaction value (Rs.) Arm’s Length Difference (to be above Price (Rs.) added to Table No. assessee’s 4 income (Rs.) 2 76,555 94.392 17,837 3 5,17,94,784 5,46,62,400 28,67,616 4 1,19,85,321 1,41,21,800 21,36,479 5 24,85,844 28,24,360 3,38,516 8 13,13,746 14,15,880 1,02,134 Total 6,76,56,250 7,31,18,832 54,62,582

12. On appeal the CIT(A) confirmed the adjustment made by the AO in his order dated 27.12.2007 and hence this appeal.

a) Adjustment on account of selling and distribution expenses; b) Adjustment on account of geographical differences; c) Incorrect comparison of prices by TPO; d) Without prejudice, the adjustment at best should be restricted to the amounts of profits retained by the associated enterprise; e) Without prejudice, benefit of +(-)5% as per the proviso to section 92C(2) of the Income Tax Act, 1961 to be provided while computing the arm’s length price:

a) Adjustment on account of selling and distribution expenses

“The appellant has while making the benchmarking for comparison of prices of export to USA and to the unrelated parties in European countries, considered the actual expenditure incurred by GMI in distribution of such products in USA. Such expenses, it would be appreciated would have been incurred by the appellant had it not been operating in USA through the associated enterprise, namely GMI. The appellant on the other hand has its own base in Europe to undertake selling and distribution function and it has not engaged a sole selling agent/wholesale distributor in that country.

The aforesaid adjustment was made considering the fact that much higher expenses are required to be incurred by GMI in promoting sale of CDS manufactured by the appellant in USA and the fact that the appellant does not have any presence in USA

The TPOI while computing arm’s length price applying CUP method instead of adjusting the sale of GMI by the selling and other expenditure incurred by it, and comparing the sale so adjusted with the sale price to unrelated parties in European countries, on the country made adjustment on account of marketing and selling expenses incurred for promoting the sale of products in European countries and reducing the same from the price charged from unrelated parties in Europe. The adjustment so made by the assessing officer does not recognize the business realities that much higher expenses/cost is required to be incurred for selling the products in USA, where the appellant does not have a substantial market presence as compared to the expenditure required to be incurred by appellant in Europe. The TPO while making the 20 adjustment has not taken into account the most significant factor influencing the prices of export to GMI. Hence the TPO has erroneously computed the selling and distribution expenses @ Rs. 0.27 per CD instead of Rs. 1.11 per CD as computed by the appellant.

It is respectfully submitted, that for the purpose of determining the arm’s length price applying the CUP method, comparison of international transactions with GMI have to be made with that of unrelated parties in a similar situation, i.e., the two parties are to be placed in similar situation to make comparison of like with like possible. Reliance n this regard is placed on the following case laws:

Egain Communication (P) Ltd. vs DCIT 118 ITD 243 (Kol) Schefenacker Motherson Ltd. vs. ITO 123 TTJ 509 (Del) Honeywell Automation Pvt. Ltd. vs. DCIT 108 TTJ 924 (Del) Mentor Graphics (Noida) (P) Ltd. vs. DCIT 109 ITD 101 (Del) DCIT vs. Sony India (P) Ltd. 114 ITD 488 (Del) Skoda Auto India (P) Ltd. vs. ACIT 122 TTJ 699 (Pune)

It is to be appreciated that the comparison of prices charged from GMI without making the aforesaid adjustments with that of prices charged from third party, would result in fallacious comparison as the two parties would not be placed in the similar situation.

Rule 10B(3) of the Rules provides that an appropriate adjustment is required to be made to account for the differences between the controlled and uncontrolled transactions.

Reliance in this regard is also placed on the recent decision of the Delhi high Cour tin the case of Sony Ericsson Mobile Communications India (P) Ltd. vs. CIT (TA 16/2014) where in the Hon’ble Delhi High Court that reasonable accurate adjustments should be made to eliminate the material differences on the price or margins of the comparables. Reliance in this regard is also placed on the decision of the Hon’ble High Court in the case of Rampgreen Solutions (P) Ltd. vs. CI (ITA No. 102/2015 wherein

21 the Hon’ble High Court held that comparables selected for the benchmarking analysis should be functionally similar and subject to similar business environment and risks. The comparison of prices as sought to be made by the TPO, without eliminating/making adjustments for quantifiable differences in the two transactions is not in accordance with the transfer pricing regulations. The adjustment on account of difference in market, it is submitted, is be taken into consideration to determine the arm’s length price that would have been charged from GMI in identical situation as that of unrelated party comparable.

It would be appreciated, therefore that the comparison sought to be made by the TPO ignoring the adjustment to the international transactions on account of geographical and other differences as aforesaid so as to apply CUP method is not in accordance with the provisions of section 92C read with rule 10C of the Rules. It is further submitted that GMI while representing the appellant in USA as sole distributor or sole selling agent, incurs significant selling and distribution expenses.” b) Adjustment on account of geographical differences

It is respectfully submitted that the prices of export of product or commodity vary from country to country for the reasons that (i) the prices being offered by the competitors in the market; (ii) the duties and taxes on imports into the country and the resultant delivered cost to the customer; (iii) domestic capacity and domestic prices of local manufacturers; (iv) the standard of living and paying capacity prevailing in different countries; and (v) the prices for each country is determined considering the landed price in the hands of the customer. The net FOB price would always vary from country to country and in many cases within the same country on account of the difference in freight because of the distance, whether it is seaport of land locked country/city, to and fro container traffic and other factors. It is never possible that FOB value of sales make to two different destination would be same. It is further submitted that there are several factors influencing the pricing of any currency e.g. capital/current account inflows, trade deficit/surplus, monetary policy etc. For that reason, pricing of the product or commodity would vary from country to country based on the money supply situation and purchasing power parity, etc. Reference is also invited to the Big Mac Index usually referred to by the economists as an accepted indicator of the purchasing power parity/price in the 22 various countries, The Big Mac Index reveals that the currencies of various countries are generally over/under priced relative to their purchasing power. Therefore, the result of comparison between exports to different countries would also be effected by the distortions in the pricing of currencies. Therefore, it is submitted that prices of export of finished goods in one country cannot be benchmarked with reference to prices prevailing in another country by applying CUP method, on account of, inter alia, (i) variation on account of the strength of the currency, (ii) geographical differences from country to country owing to economic scenario/purchasing power, level of competition, etc. (iii) market condition, etc. The Mumbai Bench of Tribunal in the case of Intervet India (P) Ltd. vs. Asstt. CIT [2010] 130 TTJ 301 39 SOT 93, held that market conditions of Thailand and Vietnam are totally different and appropriate adjustments are required to be made to account for the effect of differences in geographical locations. Reliance in this regard is also placed on the following decisions wherein it has been held that appropriate adjustments need to made to account for the effect of differences in geographical locations • Gharda Chemicals Ltd vs DCIT (ITA No 2242/MUM/06) • CIT Vs Dufon Laboratories (ITA No 1399/Mum/09) • Dishman Pharmaceuticals and Chemicals Ltd Vs DCIT (ITA No. 154 & 587/Ahd/2007; ITA No.2180 & 3213/Ahd/2007) As per OECD guidelines, while applying any of the prescribed transfer pricing method, adjustments must be made on account of differences between controlled and uncontrolled situation that would significantly affect the prices charged or received by an independent enterprise. OECD guidelines provide that in making these comparisons, material differences between the compared transactions or enterprises should be taken into account. In order to establish the degree of actual comparability and then to make appropriate adjustments to establish arm’s length conditions, it is necessary to compare attributes of the transactions or enterprises that would affect conditions in arm’s length dealings. Attributes that may be important include the characteristics of the property or services transferred, the functions performed by the parties (taking into

23 account assets used and risks assumed), the contractual terms, the economic circumstances of the parties, and the business strategies pursued by the parties. Sub-rule (2) of Rule 10B of the Rules refers to comparability of transactions. Following the lead of OECD guidelines, the following factors are prescribed in this regard: • Characteristics of the property or services; • Functions performed, assets employed and risks assumed; • Contractual terms of the transactions; • Market conditions – geographic allocation and size of the markets; • Cost of labor and capital; • Economic development; and • Level of competition. Further, for the purpose of applying CUP method, minor differences in contractual terms or economic conditions can materially affect the amount charged in an uncontrolled transaction. CUP method becomes less reliable substitute for arm’s length dealings if not all significant characteristics of the uncontrolled transactions are comparable. Therefore, it would be appreciated that, if appropriate adjustment is not made for the significant differences between the controlled transaction and uncontrolled transaction, CUP method will not produce a reliable measure of an arm’s length result. In the case of the appellant the international transaction of export of CDs to GMI, the associated enterprise in USA, and export to unrelated parties in European countries has taken place in different market conditions. Geographical differences play a major role in determining the price of CDs sold to third parties in Europe and the price of CDs sold to GMI in USA. The same requires appropriate adjustment on account of geographical difference for the reasons submitted herein below: i) The US market is a low price market where consumers are not ready to pay more price for the commodities as compared to the consumers in Europe.

24 The fact that USA is characterized as a low price economy in comparison to European countries would be borne from the Big Mac Index of the various countries, which is enclosed at page 150 of the paper book. It would be appreciated that a Mc Donald burger which is sold for USD 3.00 in USA is sold for USD 3.61 in UK. Thus, due to this purchasing power parity, and also price conscious customers, products in the US market have to be sold at a lower price as compared to the markets in the European countries. Having regard to the price conscious US market the prices of sale of CDs are generally kept lower than what is charged from customers in Europe. ii) The appellant is a recent entrant in US market for export of CDs from India. The appellant does not have any presence or brand recognition in that country and is developing market through GMI and for that reason the appellant is constrained to price the products competitively while exporting to USA. iii) Marketing of CDs in USA is a different ball game altogether. Such products are sold in USA through various shopping malls/super markets which follow just in time (JIT) approach, i.e., the retailer would rent out a shelf space to the distributor who is required to supply/place on the shelf his products in specified quantity for sale to the customer. The distributor has to maintain requisite inventory and is to replenish the requisite quantity of CDs as soon as the shelf stock is reduced to a minimum level. It would be appreciated that in this case retailer, i.e, the super market/shop mall does not maintain any inventory and expect delivery of the product in the desired quantity and packing on a very short notice. It would be appreciated that the cost of operations, therefore, for the distributor in USA is much higher.

Further, the distributor in USA is dealing only in CDs exported by the appellant from India and is, therefore, incurring significantly higher selling expenses on distribution/resale of products in that country. The distributors in European countries, it would be appreciated, are generally dealing in several products/commodities and, therefore, the per unit cost of their operation is much lower than the cost of the distributors in USA.

A part of the higher cost of operations in USA for the distributor, which would otherwise have been incurred by the appellant (if

The appellant for the aforesaid reasons, while applying the CUP method to determine the arm’s length price, made adjustments, inter alia, on account of difference in price realization for sale of CDs in USA and Europe owing to geographical difference due to factors such as, difference in purchasing power parity, pricing, customers in USA being more price conscious, higher cost of distribution etc. The appellant based on instances of prices paid by an unrelated customer for similar products in USA and in Europe, on a conservative basis made an upward adjustment of 10% (the variation in prices ranged from 9% to 25% of the price) in the prices of sale of products to USA.

The TPO in his order has erroneously observed that the export price of 10.4-I-1-0 (Jewel-case CD box) to LG Electronics Inc. in USA was Rs. 13.59 per CD while sale prices of the same product in Poland and Germany, was Rs. 12.4 per CD. On that basis the TPO did not accept the contention of the appellant that the prices in Europe market were higher in comparison to USA on account of the aforesaid factors.

It is respectfully submitted that LG Electronics Inc. is a company based in Seoul, Korea and deals in their products in Europe i.e., Germany, Poland and also Latin America. L.G. Electronics, it is submitted, does not have any presence in USA nor does it sell its products in that country. The sale consignments meant for distribution in Latin America, viz Panama by LG, as a prudent practice are shipped to a transit destination, Miami port in USA and from there it is carried by road for sale in Latin America. (Refer email correspondence at page 151-152 of the paper book)

The sale price of consignment of export to LG in USA (referred by the assessing officer), therefore, does not represent the price of sale of CDs in USA as such consignment is meant for sale in Latin America and Miami port in USA is only a transit destination for the shipment. To that extent, the example referred and relied upon by the assessing officer is not of comparable uncontrolled transaction.

It has also been submitted before the transfer pricing officer that price of sale of CDs to LG in the consignment shipped to Miami,

It would be appreciated, that the prices of the aforesaid sale of CDs to LG Electronics in USA and Poland and Germany were different owing to the aforesaid reasons and the contention of the appellant that the prices charged for sale of CDs in Europe are higher than in USA for the reasons stated above, which is also corroborated by evidences placed on record, is valid.” c) Incorrect comparison of prices by TPO

“The TPO while determining the transfer price has compared the prices in respect of individual transactions of export to the associated enterprises and the average prices of export to unrelated parties

The Indian transfer pricing regulations provide for the evaluation of combined transactions. The Indian transfer pricing regulations provide for the evaluation of combined transactions. The term transaction has been defined in clause (v) of section 92F of the Act to include the arrangement, understanding or action in concert whether or not such arrangement, understanding or action is format or in writing. Further, Rule 10A(d) defines transactions to include a number of closely linked transactions.

The OECD guidelines also provides that there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis. Examples may include pricing of a range of closely linked products (e.g. in a product line) when it is impractical to determine pricing for each individual product or transaction.

It would be appreciated that prices of export of CDs to the associate enterprises as well as to unrelated parties would vary significantly during the year on account of the various factors, viz. timing of export, size of the consignment, market conditions and demand and supply forces etc. TPO while computing arm’s length price in respect of international transactions of export to GMI, has taken average of all transactions of export to unrelated parties during the relevant previous year.

27 By taking the average price as aforesaid, variation in prices of the transactions during the year have been normalized. On the other hand, comparison of such average price of exports to unrelated parties with prices of individual transactions of exports to GMI does not result in comparison of like with like. It is further submitted that each consignment of export of CDs are inter linked in as much as such transactions are entered into having regard to the international set off on account of variation in prices of the various international transactions entered into during the yer.

For the purpose of meaningful comparison, it would therefore be appreciated that export of CDs during the year to the associated enterprise is to be construed as one transaction and the comparison ought to be made of the average price of export of GMI with the average of all the prices in uncontrolled comparable transactions during the relevant previous year.

The comparison sought to be made by the TPO between prices of individual transaction and the average price of uncontrolled comparable transactions is, therefore, not appropriate and not in accordance with the provisions of the law.” d) Without prejudice, the adjustment at best should be restricted to the amounts of profits retained by the associated enterprise “It is respectfully submitted that as per audited accounts, GMI earned gross profit of USD 3,19,231 on total sales of USD 75,54,668, the cost of goods sold being USD 72,35,437. However, GMI had incurred loss of USD 8,65,179 after taking into account the operating expenses incurred for distributing the appellant’s products. Thus, appellant could not be expected to have made more profits than the combined profit made the appellant and its AE i.e. GMI, if it were to make sales directly to the third party customers.

Further, your Honour’s attention is incited to the recent decision fo the Hon’ble Tribunal in the case of Globe Vantedge (P) Ltd. vs. DCIT (ITA No. 2763 & 2764/D/2009) wherein it is held that adjustment on account of arm’s length price of international transactions cannot exceed the maximum arm’s length price i.e. the amount received by the associated enterprise from the customer and the actual value of international transactions. The Ho’ble 28 Jurisdictional High Court vide order dated 14.3.2013 (in ITA nos 1828/2010, 1829/2010 & 1254/2011) had dismissed the revenue’s appeal against the said order of the Tribunal. The Special Leave Petition (SLP) of the revenue against the said order has also been dismissed by the Supreme Court vide order dated 2.1.2014 (CC No. 22166 of 2013)” e) Without prejudice, benefit of +(-)5% as per the proviso to section 92C(2) of the Income Tax Act, 1961 to be provided while computing the arm’s length price: “It is respectfully submitted that, the TPO while computing the adjustment to the arm’s length price applied CUP method by taking the difference between average of prices of export to unrelated parties and uncontrolled prices for each export to GMI.”

It has been contended that the TPO has made adjustment on account of marketing and selling expenses incurred for promoting the sale of products in European countries and reduced the same from the price charged from unrelated parties in Europe. It has been contended that the above approach does expenses/cost is required to be incurred for selling the products in USA, where the assessee does not have a substantial market presence as compared to the expenditure required to be incurred by the assessee in Europe. The CIT(A) had considered the above objection and has held as under:

“9.4.4 The TPO during the TP proceedings had asked the appellant to filed details relating to the retail prices charged by GMI in the US market but the same was not furnished by the appellant. In adjudicating the issue relating to comparability of the prices charged in the international transactions with the retails prices charged in the European market would have been easier had this information been made available to the TPO. The issues relating to the computation of the adjustment factors would have been facilitated by this information. However, the burden of proof was not discharged by the appellant. Therefore, judicial notice of this fact should be taken while working out the adjustment factors. 9.4.5 The appellant had added Rs. 1.11 per CD to the average whole sale prices charged from GMI on account of selling and distribution expenses incurred by GMI in selling the appellant’s product in USA. The TPO did not accept this adjustment and on the contrary made this adjustment to the average retail price by way of deducting Rs. 0.27 per CD from the price charged from the unrelated parties in non- US destinations. In coming up with the adjustment of Rs. 0.27 per CD, the TPO analyzed various minor heads of expenses under the broad head of “selling & distribution expenses”, which has been discussed in detail at Para no. 5.3 (v) & (vi) of this order. During the course of appellate proceedings, the appellant has raised objections to the adjustment made by the TPO on the ground that the TPO had not appreciated the business realities of the requirement for the subsidiary to 30 incur higher expenses pleaded that to account for these selling and distribution expenses incurred by GMI, adjustments should have been made to the wholesale price charged by the appellant from GMI by a sum of Rs. 1.11 per CD. 9.4.6 It has already been held at Para 9.1 of this order that the correct way of making adjustment is to start from the export prices charged by the appellant from the unrelated parties in non- US destination s. therefore., the expenses incurred by GMI to develop a market for the appellant’s product do not have any relevance for the purpose of making adjustment on account of selling and distribution expense. What is relevant for the purpose of this adjustment is the selling and distribution expenses incurred by the appellant for distributing its product in non- US locations. The TPO in his order has computed Rs. 0.27 per CD as the amount of adjustment that is required to be made on account of selling and distribution expenses. The appellant has not pointed out any defect in the analysis done by the TPO. Even if it is accepted, as alleged by the appellant that it did no t concur with the methodology adopted by the TPO for this adjustment, the fact remains that the TPO had computed this adjustment factor objectively. Under these circumstances, I am inclined to agree with the analysis done by the TPO in coming up with Rs. 0.27 per CD as the adjustment factor for selling and distribution expenses. The TPO has analyzed each of the minor heads of expenses under the broad head of “selling and distribution expenses” and recorded his findings as to which of these expenses are to be excluded for working out the adjustment factor. Therefore, I am of the considered view that this computation requires no interference and the same is to be accepted for the computation of arm’s length price.”

17. Having considered the rival submissions and order of CIT(A), we find no reasons to deviate from the above conclusion. Rule 10B(3) clearly provides that reasonably accurate adjustments are to be made to eliminate the material uncontrolled transaction. The argument of the counsel on the premise that adjustment does not recognize the business realities that much higher expenses/cost is required to be incurred for selling the products in USA has already been considered by the CIT(A) who has held in this regard that the correct way of making adjustment is to start from the export prices charged by the assessee from the unrelated parties in non- US destination s. therefore., the expenses incurred by GMI to develop a market for the assessee’s product do not have any relevance for the purpose of making adjustment on account of selling and distribution expense. What is relevant for the purpose of this adjustment is the selling and distribution expenses incurred by the assessee for distributing its product in non- US locations.

The TPO in his order has computed Rs. 0.27 per CD as the amount of adjustment that is required to be made on account of selling and distribution expenses. In this case the TPO has computed Rs. 0.27 per CD as the amount of adjustment that is required to be made on account of selling and distribution analysis done by the TPO and, accepted by CIT(A). This methodology also is in accordance with the judgment of Hon’ble Delhi High Court in the case of Rampgreen Solutions (P) Ltd. vs. CIT wherein the Hon’ble High Court held that comparables selected for the benchmarking analysis should be functionally similar and subject to similar business environment and risks. In view of the above the contention raised by the counsel is held to be not maintainable and therefore rejected.

“9.5.2 I have carefully considered the submissions made by the appellant and appraised the evidence on record. There is no doubt that geographical market is one of the major economic circumstances that must be examined before coming to a conclusion regarding comparability between two sets of transactions. In fact economic circumstances include the following other factors apart from the geographical location that need to be considered for comparing two sets of transactions.: • Geographic location

33 • Size of the market • Competition and size and importance of competitors • Availability of substitute goods and services. • Levels of supply and demand • Consumer purchasing power • Government regulations • Costs of production (costs of local labor and raw materials) It two countries represent two different markets, adjustments have to be made by taking into account all the relevant factors. However, before considering any adjustment, it is to be kept in mind as discussed is to defend its use through appropriate party who claims an adjustment is to defend its use through appropriate documentation. I am of the considered view that in the present case, the appellant while claiming 10% loading on account of geographical market difference has not brought on record sufficient evidence to substantiate this claim. The reasons for coming to this conclusion are summarized below: i) Separate countries do not necessarily mean separate geographical markets. It is possible that a taxpayer approaches a group of several countries as a single homogenous market where it delivers similar products, performs similar functions, use similar functions, uses similar assets, assumes similar risks, establishes similar contractual terms and develops a single business strategy. It was incumbent on the part of the appellant to come up with documentation to show that it treats the US & the European market differently. But the same was not done at any stage of the proceedings. ii) The argument of purchasing power parity cannot be loosely used as it has connections with number of other economic variables. The purchasing power parity thereon asserts that the exchange rate between two currencies must be proportional to the price level of traded goods in the two countries. Purchasing power parity is also intimately tied the interest rate parity. The interest rate parity thereon originates from the link between interest rates and inflation rates. Thus, the interest rates, exchange rates, price level and foreign

34 exchange rates form an integrated system. Violations of purchasing power parity lead to arbitrage opportunities and give rise to a gray market. Therefore, for claiming any adjustment factor. No such documentation was done by the appellant and the adjustment factor of 10% was used without any firm basis. iii) The reference to Big Mac Index by the appellant is also misplace. The price of a burger in US could be lower for a number of reasons such as raw material cost, demand conditions, food habits etc. for the European market, a burger could be a novelty, have a different set of elasticity of demand and hence carrying a premium price. The same analogy could not be taken for CDs without getting into the factors responsible for prices in two different countries. In any case, there is no product similarity between a burger and a CD for meaning comparison.

The reliance on prices paid by Imation is also misplaced as it pertains to the subsequent year and do not reflect contemporaneous market situations. v) Adjustment relating to higher cost of performing distribution function in US compared to Europe has already been taken care of through selling and distribution expenses incurred by the appellant. Similarly, reference to higher labour cost is US is also misplaced as it refer to selling & distribution cost only. vi) One reason for claiming this adjustment for geographical difference is also on account of higher cost on printing & packaging for selling in Europe. Since the TPO has already allowed for adjustment on account of freight differential which include packing, freight and forwarding, there is no need to make adjustment for this factor under this head again. vii) There reference to lower prices of home electronics and household appliances in US is also misplaced as these belong to different product categories.

35 viii) The issue relating to price difference on account of memory size is also not relevant to compute an adjustment factor for geographical differences. ix) The TPO has pointed out that the Europen market in fact included all non- US destinations and there was no pricing pattern pointed out by the appellant on the basis of country – wise destinations. 9.5.3 It can be seen from the foregoing analysis that the computation of the adjustment factor at 10% is not transparent and properly documented. The appellant thus failed to discharge the onus cast on it for substantiating its claim of adjustment on account of geographical difference. Under these circumstances, I am of the considered view that the ad- hoc adjustment of 10% made by the appellant is not sustainable in the absence of supportive evidences. Therefore, it is held that the TPO was correct in not allowing any adjustment on account geographical market difference and it did not in any improve the reliability of the arm’s length prices computed.”

The question therefore which emerges is that are there sufficient claim of the assessee. The assessee has relied on big map index to contend that US is a lower price market as comparable Europe. It has also been contended that assessee is a recent presence or brand recognition. It has been stated that products are sold in USA through various shopping malls/super markets which follow just in time (JIT) approach i.e., the retailer would rent out a shelf space to the distributor who is required to supply/place on the shelf his products in specified quantity for sale to the customer. It has been stated that the distributor has to maintain requisite inventory and is to replenish the requisite quantity of CDs as soon as the shelf stock is reduced to a maintain level and the cost of operations for the distributor in USA is much higher. Also, it has been stated that, the distributor in USA is dealing only in CDs exported by the assessee from India and is therefore, incurring significantly higher selling expenses on distribution/resale of products in that country.

20. Having regard to the above we accept the claim of the assessee for adjustment. The CIT(A) or the TPO have not denied or disputed any of the above factual submission to the assessee. A rejection of a claim for general consideration for tenable is not a correct way to disregard the facts brought on record. The revenue ought to have appreciated the business and the nature of the market. The observation of the TPO that the export price of 10.4-I-I-0 (Jewel-case CD box) to LG Electronics Inc. in USA was Rs. 13.59 per CD while sale prices of the same product in Poland and German, was Rs. 12.4 per CD is also found to be misconceived and therefore for the reasons stated above we allow the adjustment as claimed by the assessee.

“77. As a concept and principle Chapter X does not artificially broaden, expand or deviate from the concept of "real income". "Real income", as held by the Supreme Court in Poona Electricity Supply Co. Ltd. v. CIT [1965] 57 ITR 521, means profits arrived at on commercial principles, subject to the provisions of the Act. Profits and gains should be true and correct profits and gains,

39 neither under nor over stated. Arm's length price seeks to correct distortion and shifting of profits to tax the actual income earned by a resident/domestic AE. The profit which would have accrued had arm's length conditions prevailed is brought to tax. Misreporting, if any, on account of non-arm's length conditions resulting in lower profits, is corrected.” 22. Having regard to the above and for the reasons stated above the adjustments made is deleted.