ADM AGRO INDUSTRIES KOTA & AKOLA P.LTD,GURUGRAM vs. ACIT, CIRCLE-1(1) , NEW DELHI

At the outset, Shri Ajay Vohra, learned Sr. Counsel, appearing for the assessee, on instructions, submitted that the assessee does not want to press ground No.1. Accordingly, this ground is dismissed as not pressed.

In ground Nos. 2 to 8, the issue raised by the assessee relates to adjustment proposed by the Transfer Pricing Officer (TPO) to the Arm’s Length Price (ALP) of the international transactions relating to merchanting trades.

Briefly, the facts are, the assessee is a resident corporate entity. As stated, the assessee is engaged in the following streams of activities :

In the year under consideration, the assessee undertook various international transactions with its Overseas Associated Enterprises (AEs) and in the audit report in Form 3CBE reported following transactions :

After verifying the 3CBE report as well as Transfer Pricing Study Report (TPSR) of the assessee, the TPO accepted the ALP of the trading segment. Whereas, in respect of merchanting trades, the TPO observed that the assessee has benchmarked such activities by applying Transactional Net Margin Method (TNMM) using Operating Profit(OP)/Value Added Cost(VAC) as the Profit Level Indicator (PLI).

Before us, learned Sr. counsel appearing for the assessee submitted, in so far as merchanting trade segment is concerned, the buyer and seller, both non-resident entities, are pre-identified and the assessee merely acts as a facilitator/service provider/arranger.

He submitted, the price for purchase and sale of goods under the merchanting activities are based on price information provided by leading global price brokers of international repute and leading commodity exchanges. He submitted, the limited economic value adding activities undertaken by the assessee consist primarily of coordination and processing of documentation. Therefore, the risk and functions involved in the merchanting trads are very less as compared to a regular trade transaction. He submitted, the assessee is not exposed to any risk of fulfilment of contract and risk on account of commodity price and inventory are transferred on back to back basis from the assessee to its AE. In this context, learned counsel drew our attention to the summary of purchase and sale transactions under merchanting trades along with their terms and price fixed, as placed in the paper book. He also drew our attention to copies of purchase and sale contracts, invoices and bill of lading for merchanting trades. He submitted, in the merchanting trades activities, the assessee earns fixed profit margin of 10 basis points on purchase price, which covers the administrative cost with a little mark-up.

Learned counsel submitted, since the assessee did minimal value addition in respect of the goods purchased and sold under the merchanting trades, such value addition could be considered akin to that done by business auxiliary service providers for application of TNMM. He submitted, unlike a routine trading activity where traders buy goods from vendors for re-sale purpose and stock the same in their custody and perform several functions and bear multiple risk, the assessee had not gone through that process, as the merchanting trades were conducted in high seas beyond the custom barriers of India, wherein, the transfer and title of goods passes from ADM Sarl to ADM Asia Pacific instantaneously on back to back basis. He submitted, the substantive difference in the functional and risk profile between the merchanting and physical trade business has been recognized in various judicial precedents. In this context, he drew our attention to a decision of Tribunal in the case of Kargil India Pvt. Ltd. vs. Addl. CIT (ITA No. 4095/Del/2010 dated 28.11.2013). He submitted, while commenting that the assessee has kept inventory with reference to merchanting activities as per the audited financial statement, the TPO has grossly misconceived the facts, as he has completely overlooked the fact that in addition to the merchanting activities, the assessee has a separate segment of physical trade and the inventory in the books of account are entirely on account of such physical trades.

He submitted, this can be further demonstrated from the fact that in merchanting trades, commodities traded are corn, sorghum, barley and wheat, whereas the inventory maintained by the assessee for physical trade pertain to yellow peas and oilseeds. He submitted, for merchanting trades, the assessee has neither kept any inventory nor has any fixed asset, as only few employees in India from accounting and finance department are involved primarily for preparing contracts, raising invoices and other accounting and administrative functions in relation to trades. Thus, he submitted, in such scenario, the assessee is merely undertaking auxiliary support function, which cannot be considered to have contributed in developing supply chain or creating human asset intangibles with reference to merchanting trades. He submitted, the buyer and seller in merchanting trades are related parties and predetermined and the assessee merely resells the goods to a pre-identified AE after purchasing from another AE and retaining a fixed margin of 10 basis points. He submitted, the assessee does not pay any role in price determination and price negotiation. He submitted, the assessee is not involved at the stage of deciding/determining the timing of these transactions. Thus, essentially, the assessee is involved in rendering minimal support functions.

He submitted, since, the assessee did minimal value addition in respect of merchanting trades, that can be considered akin to the functions done by the business auxiliary activity providers, therefore, value added cost considered in the denominator of PLI is total OC of the assessee in merchanting trades less the cost of goods sold. He submitted, since the value addition of the assessee in respect of merchanting trades is akin to a business auxiliary service provider, the assessee computed its return on value added cost incurred for merchanting trades and benchmarked the same against the weighted average of operating margins of comparables in business auxiliary service provider segment. He submitted, the operating cost base of the comparables, being service providers, is similar to the value added cost base of the assessee with respect to merchanting activities primarily comprising of employee cost and other related/allocable overheads, such as, rent, electricity, communication expense etc. Thus, he submitted, in the given circumstances, the PLI of the assessee has to be OP/VAC. In this context, he drew our attention to OECD guidelines on berry ratio. Further, in support, he relied upon the following decisions :

Therefore, he submitted, as per the ratio laid down in the aforesaid judicial precedents, OP/VAC as PLI is permissible under Rule 10(B)(1)(e). Thus, he submitted, the adjustment should be deleted.

Per contra, learned Departmental Representative submitted, the audited financials of the assessee do not make any distinction between the traded goods and merchanting goods. He submitted, as per the audited financials, the assessee has only one segment of trading activities. Drawing our attention to the Transfer Pricing Study Report, he submitted, as per the segmental reporting, the assessee is primarily engaged in the business of trading of agricultural products and there is no mention of merchanting activities in the segmental reporting. As regards assessee’s contention that in the merchanting trade segment, it is more like a risk free entity as it is only indulging in flash transfer of title and receiving 10 basis points on the purchase invoice value, learned Departmental Representative, inviting reference to RBI Circular No. RBI/2019-20/152 dated 23.01.2020 submitted that the circular clearly provides that the merchanting trader should be genuine trader of goods and not merely financial intermediaries who operate on behalf of somebody. Thus, he submitted, the basic premise of the assessee that it is not doing any major activity and mainly raising invoices with respect to merchanting trade is wrong and fallacious and deserves to be rejected. Drawing our attention to the TP study report of the assessee, learned Departmental Representative submitted, the TP study report makes it clear that the assessee enters into the purchase contracts with its AE and subsequent sale contract is also with another AE. He submitted, though, the assessee claims that sales and purchase contracts are entered simultaneously on the same day, but still the fact remains that the assessee first purchases the commodities from its AE and then sells it to another AE. In sum and substance, both the purchase and sale transactions were undertaken by the assessee. Therefore, it is absolutely wrong on the part of the assessee to claim that it has limited role in purchase and sale of commodities and no role in pricing mechanism.

Proceeding further, he submitted, as per material on record, the assessee enters into a trade transaction only when it can earn reasonable return covering its administrative cost. Meaning thereby, it is not the AEs but the assessee who determines when to enter into the trade. Further, he submitted, in the TP study report, there is no mention of retaining of fixed price margin of 10 basis points. Learned Departmental Representative submitted, assessee’s contention that it has not undertaken any risk or has undertaken limited risk, is unacceptable as the materials on record reveal that the assessee is involved in all the activities/functions which happens in any independent high seas purchase/sale transaction. He submitted, once the purchase contract is signed, the risk and the title of the goods immediately passes from seller to the assessee and the assessee company becomes the owner. Therefore, the assessee becomes responsible for all the risks associated with the goods. He submitted, even, the assessee is required to arrange insurance. He submitted, the insurance documents also make it clear that it has to be arranged and covered by the assessee. He submitted, as per the terms of the purchase contract, all the taxes, levies, duty etc. present or arising in future date on the cargo are on account of the assessee. Thus, he submitted, the aforesaid facts clearly reveal that the assessee is fully liable for all the risks and rewards of the transaction undertaken by it. He submitted, though, sales from merchanting trades contribute 98% of the total revenue earned by the assessee, however, the expenses allocated to merchanting trades constitutes 0.19% of the total expenses, which has absolutely no basis. He submitted, the PLI of berry ratio adopted by the assessee is not at all applicable as the assessee is a full-fledged trader of goods and the value of goods definitely has a role in the profits earned.

As regards judicial precedents cited by learned counsel for the assessee, learned Departmental Representative submitted, they are distinguishable on facts, hence, not applicable to assessee’s case.

In rejoinder, learned sr. counsel submitted, the audited financial statements of the assessee have been prepared in accordance with the Indian generally accepted accounting standards. He submitted, as per such standards, separate segmented results are not required to be prepared for merchanting trades and physical trades, as, both the activities fall under the broad spectrum of trading. He submitted, based on accounting treatment alone, it cannot be inferred that the functional and risk profile of the merchanting trades and other physical trades carried out by the assessee are same from transfer pricing standpoint.

He submitted, learned Departmental Representative has failed to appreciate the nature of functions performed and risk assumed in the physical trade activities and merchanting trades. He submitted, there is no allegation by RBI of any violation of the merchanting trades regulations/guidelines. He submitted, the assessee has held no inventory on account of merchanting trades, but only requires office space for employees involved in merchanting trades. He submitted that the majority of the fixed assets reported in the fixed assets schedule and financial statement, are plants and machinery, leasehold land etc., which were towards manufacturing plant of the assessee and have been shut down and consequently impaired during the financial year 2017-18.

We have patiently and carefully heard the parties, given a thoughtful consideration to the detailed submissions made, both orally and in writing, perused the materials on record and also applied our mind to the judicial precedents cited before us.

The crux of the dispute lies within a narrow compass, as to, what should be the PLI of the assessee qua the PLI of the comparables. Before we proceed to address this issue, it needs to be observed that in Form 3CEB, the assessee has reported revenue from two separate segments, firstly, merchanting trades segment and secondly, trading segment. In so far as the trading segment is concerned, the assessee, though, purchases (agricultural products) from its AEs, however, they are sold to un-related parties. Undisputedly, the purchases made by the assessee in the trading segment have been accepted by the TPO to be at Arm’s Length. In so far as merchanting trades segment is concerned, the assessee had applied TNMM as the most appropriate method to benchmark the transactions. Not only the TPO has accepted applicability of TNNM, but has also accepted the comparables selected by the assessee, who are basically business auxiliary service providers.

As discussed earlier, in merchanting trades, the assessee enters into a purchase contract with one of its overseas AE, viz, ADM Sarl.

From the aforesaid facts, it is clear that the functions performed and risk undertaken by the assessee is that of a business auxiliary service provider and not different from them. It is further established from the fact that the comparables selected by the assessee are business auxiliary service providers and the TPO has found them to be functionally similar to the assessee. That being the functionality of the assessee and the comparables, it needs to be examined whether PLI adopted by the assessee is acceptable. The TPO has rejected the PLI of OP/VAC on the ground that it is not in conformity with Rule 10(B)(1)(e). Of course, the DRP has endorsed the view of the TPO.

At this stage, it is necessary to look into the relevant statutory provisions relating to determination of ALP of international transactions with AEs. Section 92 of the Act provides for computation of income having regard to the ALP of international transactions with AE.

Thus, if we go by the provision of rule 10B(1)(e), the return on value added cost, otherwise known as berry ratio, is not completely excluded from its purview. It can be a relevant base for computing the margin. The berry ratio in simple terms means a ratio of gross profit to operating expenses. Therefore, where operating expense is considered as a relevant base, there would be no difficulty in using berry ratio as PLI in terms of Rule 10(B)(1)(e). In case of Sumitomo Corporation India Pvt. Ltd. (supra), Hon’ble jurisdictional High Court, while considering applicability of berry ratio, has observed that it can be used effectively only in cases where the value of goods have no role to play in the profit earned by a assessee and the profits earned are directly linked with the operating expenditure incurred by the assessee. The operating expenditure incurred by the assessee effectively captures the functions performed and risk undertaken by the assessee. Thus, in a case where assessee uses an intangible as a part of its business, berry ratio may not be an appropriate PLI, as the value of such intangible would not be captured in the operating cost. Similarly, berry ratio is not appropriate PLI for determining the ALP in cases where the assessee may be having substantial fixed assets since, the value added by such assets would not be captured in berry ratio. However, it can be applied where the operating expense adequately represent all functions performed and risks undertaken. Thus, the Hon’ble High Court held that berry ratio is effectively applied only in case of stripped down distributors who have no financial exposure and risk in respect of the goods distributed by them. Various other decisions cited by learned Sr. counsel lay down the ratio that Rule 10(B)(1)(e) does not completely rule out applicability of berry ratio.

Keeping in perspective the legal position enunciated in the judicial precedent cited before us, if we examine the facts of the present appeal, undisputedly, the only variation made by the TPO to the PLI of the assessee is to add the cost of goods to the denominator. However, it is a fact on record that the operating cost of the comparables are not inclusive of cost of goods, as they are business auxiliary service providers, hence, they do not have any cost of goods. Since, the assessee is found to be functionally comparable to the business auxiliary service providers, it is established that the assessee has undertaken limited functions and risk in the merchanting trades segment and earns a fixed profit margin. Therefore, in our view, the cost of goods cannot be included in the denominator of the PLI. Thus, for the assessee, return on value added cost will be the relevant base for computing the net profit margin to bring the profit margin of the comparables in alignment with that of the assessee.

Having held so, for the sake of completeness, we are of the view that various contentions of learned Departmental Representative need to be addressed. In course of hearing, learned Departmental Representative submitted that the accounts of the assessee as well as the TP study report disclose only one segment, i.e., trading segment. The merchanting trades segment is nowhere found either in TP study report or anywhere else. Thus, he has submitted that assessee’s contention that it has two segments, viz., trading segment and merchanting trades segment is not acceptable. Further, referring to RBI Circular, he has submitted that only genuine traders of goods are recognised as merchanting traders and not mere financial intermediaries. He has made various other allegations regarding disproportionate expenses relating to merchanting trade segment and physical trade segment etc.

On examination of facts on record, we find that the aforesaid submissions of learned Departmental Representative are extraneous to the issue at hand. Admittedly, in the TP study report, the assessee had furnished segmental information regarding both the merchanting trades segment and physical trade segment. The TPO has also accepted the segmental analysis of the assessee. In fact, he has accepted the transactions in trading segment to be at ALP. As discussed earlier, the only variation, he has made in merchanting trades segment, is in relation to PLI of the assessee. Thus, neither the TPO nor DRP have made any adverse comment regarding the merchanting trades segment.

In the result, appeal is partly allowed.