Income Tax Appellate Tribunal - Delhi
Global One India Pvt. Ltd., New Delhi vs Assessee
IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCHES : "I" NEW DELHI
BEFORE SHRI A.D.JAIN, JM AND
SHRI J.SUDHAKAR REDDY, A.M.
ITA nos. 5571/Del/2011
Assessment Year : 2007-08
AND
ITA No.5896/Del/2012
Assessment Year 2008-09
Global One India P.Ltd. vs. ACIT, Circle 12(1)
DSO 601-603, 607-608 New Delhi
6th floor, DLF South Court, Saket
New Delhi
AABCG 2558 B
(Appellant) (Respondent)
Appellant by:- Shri Rahul Kumar Mitra, C.A.
Respondent by:- Shri Peeyush Jain, CIT, D.R.(T.P.)
ORDER
PER J.SUDHAKAR REDDY, AM
Both these appeals are filed by the assessee and are directed against separate orders of the ACIT Circle 12(1), New Delhi for the Assessment Year 2007-08 dt. 31.10.2011 and order of the Dy.CIT, Circle 12(1), New Delhi dt. 22.10.2012 for the Assessment Year 2008-09, both passed u/s 143 r.w.s. 144C of the Act. As the issues arising in both these appeals are common, for the ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi sake of convenience, they are heard together and are disposed of by way of this common order.
2. Facts in brief:- The assessee is a company incorporated in India and is a Subsidiary of EGN BV, Netherlands. The assessee company is engaged in providing internet and related network services to the group's customers in India. The services offered by Globe One India include internet direct connections, installation/configuration of routers, etc., and fully managed support solutions developed around the basic network services. The parent company, EGN BV, is confirmed and registered under the laws of the Netherlands. The assessee company filed a transfer pricing report along with its return of income on 30.10.2007, declaring 'nil' income. Later, the assessee filed a revised return of income on 31.3.2009, declaring income of Rs.19,29,436/-. A reference was made u/s 92CA(1) to the TPO-I(2) for determination of arm's length price of the international transactions undertaken by the assessee. The TPO, in his order, rejected the profit split method adopted by the assessee company as the most appropriate method and adopted the TNMM method and determined an upward adjustment of Rs.9,46,20,328/- to be made to the arm's length price for the Assessment Year 2007-08 and a Rs. 13,47,02,724/- upward adjustment for the Assessment Year 2008-09. The assessee approached the DRP, without success. Aggrieved the assessee is before us.
2 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 2.1. The other issues that arise for our consideration in these appeals are disallowance u/s 40A(ia) and levy of interest u/s 234B of the Act. 2.2. The assessee, as part of the Equant BV group, provides seamless net work connectivity to its customers across locations/countries. For service of particular customers, the net work connectivity, which is owned and deployed by the other operating entities of the Equant group, have to be used. The assessee has submitted the following as the background of its business.
"Background of business and bench marking methodology of the appellant:
The business activities relating to in providing internet and related network services by the appellant are explained in brief below: As an example, customer A is having office in Gurgaeon and Delhi and these two offices would send and receive email communication with its overseas offices through the circuit connectivity as provided by the local incensed service provider.
a) Incoming email from Overseas offices of Customer A to the offices at Gurgaon and New Delhi:-
(i) Email moves from Customer Head office at international destination to Equant AE's node. From Equant AE's node the email travels through international link provided by Flag Telecom.
(ii) Flag Telecom terminates the email at a landing station in India i.e. at Mumbai.
(iii) From other Telecom License service provider net work arrangement (i.e. Bharti/Reliance) at Gurgaon/Delhi, again local license telecom service provider's pick up the email and terminate at Customer a Gurgaon and Delhi site.
(b) Outgoing email from Customer A offices at Gurgaeon and New Delhi to other overseas offices:-
(i) Local licensed telecom service providers like Bharti, Reliance, etc. picks up the email from Customer A offices at Gurgaon and Delhi and terminates the same at licensed Telecom License service provider network arrangement at Gurgaon/Delhi.3 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi
(ii) From Telecom license service provider network arrangement at Gurgaon the email would be picked up by local telecom service provider i.e. VSNL, etc. for termination at Mumbai landing station.
(iii)From Mumbai landing station, the Flag Telecom arranges to pick email of Customer A for onward deliverance to the Overseas offices of Customer A through Equant Overseas AE's net work.
Globally the Equant group is a recognized leader in telecom services and provides global, integrated and customized communication infrastructure solutions that enable the key business process of its customers; The group operates the world's largest seamless data net work in more than 220 countries and territories. Over the years, Equant has successfully integrated several different net works into one and has consolidated entities such that today, Equant conducts business in most countries vis a single, multi functional entity that provides a full range of solutions and services; Customers contracts of the group are for provision of integrated services on Equant's group's net work which is spread across the globe; Equant operates as a globally organized company with critical customer facing and revenue generating activities being undertaken by the group's various operating entities across the globe (including GOIPL in India). Accordingly, each of the operating entities (including GOIPL) that own or operate elements of the network, contribute to the global network;
In many cases the Equant group deals directly with the one location of its customer to complete the sales contract and invoice the customer centrally for all services in all countries. Generally, only one Equant group entity records the revenues generated from the multinational customer; Underlying costs of providing services are generated across the span of the Equant group, which creates a mismatch between where the revenue is recorded and where the expenses are incurred to provide the services; 4 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi In some cases, the customers' decision makers are spread between different countries, and require the services to be billed between more than one location, but not necessarily all the locations where the services are provided - this again results in a mismatch between where the revenues are recorded and where the services are provided;
Each of the entities in the Equant group is reliant upon the other functions to generate global profits or losses for Equant group, the services and investments made by each of these entities is of a non routine nature; The Key Industry Success Factors for the business of the Equant group are :
Price/competition;
Network capability;
Global footprint/span and;
Performance reliability;
Service quality;
Value added services/solutions offered.
The various operating entities of the Equant group own/ deploy the necessary leg of the network footprint in their respective country/jurisdiction;
Each of the entities that owns or operates elements of the network contributes to the global Equant network. Accordingly, all Equant operational entities share the benefits and risks of the increased demand for Equant solutions and services together with the benefits and risks undertaken in investing, expanding and maintaining a global tele communications net work;
In line with the group's global operation model, for provision of services, the appellant utilizes the global network footprint for connecting the customers outside the Indian territory. As GOIPL uses the global network for providing internet services to the group's customers it is evident that Equant is truly a global seamless organization.
The operations of the Equant are thus highly inter related involving unique services and related intangibles. Given the globally integrated nature of the telecommunication services that are provided to customers and the high value 5 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi customer facing activities of each operating entity, including GOIPL, for transfer pricing purposes, it was concluded that the transactions of GOIPL with its group companies are highly inter related and involve unique services and related intangibles."
This functional profile is not disputed by the Revenue before us.
3. The assessee adopted the "Profit Split Method" (PSM) as the "Most Appropriate Method" (MAM) for determining the "Arm's Length Price"(ALP) of the international transactions, based on residual profit analysis referred to in the T.P. regulations.
3.1. The steps adopted by the assessee are as follows:
Step-I: Determination of the consolidated global operating profits/loss of the Eq group from the global tele communication operations.
Step-II: Allocating basic arm's length return to each of the operating entity for undertaking the routine support services. The return in question is calculated by bench marking the same with comparables which are routine support service providers in India.
Step-III: Residual profits/loss is determined by deducting the routine arm's length return of all the group entities from the consolidated profits of the group.
Step-IV: The residual profits/losses is allocated among the operating entities in proportion to the relative contribution made by each such entity to the combined global profits/loss. Relative contribution has to be determined based on the contribution of each entity to the key value drivers which are sales and 6 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi marketing operations/net work operations and field operations identified by the business with equal weight based on the detailed functional analysis.
3.2. The submissions of the assessee are that the operations of the group are highly integrated, interconnected and intrinsically linked wherein one group entity records the revenues generated, whereas another group entity incurs the expenditure for providing the services and that multiple entities are involved in the transaction, and that in such a factual situation, only PSM is the M.A.M. 3.3. The T.P.O. issued a show cause notice proposing adoption of Transactional Net Margin method (TNMM) as the Most Appropriate Method (M.A.M.) for bench marking the international transactions, in place of Profit Split Method (PSM) adopted by the assessee. The assessee filed a detailed reply.
The T.P.O. rejected the contentions of the assessee that P.S.M. is the M.A.M. He held that TNMM is the M.A.M. 3.4. The findings/objections of the TPO are summarized below. (1) PSM has not been applied correctly as even in PSM you are supposed to show by bench marking against external comparables that your international transactions are at arm's length. You have not done so. (2) Only external comparables are used for bench marking what you claim to be routine services.
(3) In T.P. report it has been claimed that among the unique intangibles/value added services undertaken by you are sales and marketing activities. Your audited financials show that you have spent only Rs.3,128,853/- on advertisement and sale promotion out of total expense of Rs.620,423,787. Hence it does not appear that you are carrying out any significant sales/marketing activity of much significance. Personnel expenses are also only Rs.64,107,400.
7 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi (4) The largest head of expenses of Rs.292,432,061 is recurring head installation charge under the account head 'circuit expenses'. Therefore, your main activity is providing internet and related network services. (5) Description of field operation does not constrictive any unique intangibles and value added services. This is a very routine exercise which any service provider will undertake.
The TPO further held that:
i. It is possible to determine the cost incurred by the Indian entity separately, and hence, it should be bench marked on a standalone basis and not by using PSM.
ii. Earlier year's TP orders cannot be relied upon as there is no res judicata in tax proceedings;
iii. Acceptance of PSM in other jurisdictions is of no consequence since applicability of PSM is to be judged with reference to Indian TP regulations and not the TP regulations in other countries. iv. PSM cannot be applied in the absence of reliable external market data for bench marking international transactions;
v. The assessee has not put forth any evidence of any intangible created by it based on which it can justify the application of PSM; vi. The assessee has not been able to prove that its operations are integrated to disprove the applicability of TNNM;
vii. The key value drivers identified by the assessee are routine in nature and do not lead to creation of any unique intangible and marketing expenses are very low even though they constitute a key driver cost;
viii. The assessee has not been able to demonstrate any unusual reasons for the losses earned by it during the relevant FY ix. Assessee's arrangement with the AE as borne out in the agreement does not justify the use of PSM on account of the following reasons:
(a) As per the agreement, assessee's AE is the administrator who decides how much payment is to be made by each AE including the assessee;
(b) Administrator's decision shall be binding in the event of disputes between the AEs;8 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi
(c) The Administrator alone shall have the right to access the records of the AEs and not vice versa;
x. The assessee has applied PSM in the TP study for the first time; xi. The assessee is relying on PSM merely to camouflage its losses at the net level;
xii. Even though the circuit expenses are a key driver, the assessee has not maintained any record/evidence of such expenses as is clear from assessee's notes to account to the audited financial statements;
xiii. Assessee is not providing any unique intangible if it is outsourcing the last mile connectivity to unrelated parties and with unrelated parties participating in the value chain there is no place for any seamless operations between the assessee and its AEs. 3.5. The DRP upheld the conclusion drawn by the TPO that TNMM is the most appropriate method. The Assessing Officer passed an order u/s 143(3) r.w.s. 144(C) of the Act carrying out the adjustments determined by the TPO in his order u/s 92CA(3) on 12.10.2010 and made an adjustment of Rs.9,46,20,328/-. The Assessing Officer also made certain disallowances u/s 40A(i) of the Act. 3.6. The Ld.Counsel Mr.Rahul Kumar Mitra disputed the objections raised by the TPO and submitted as follows.
"The 'key value drivers' i.e. Sales & Marketing operations, Network operations and Field operations, have been identified. based on a detailed functional analysis and are nothing but those 'functions' performed with the concomitant 'assets' and 'risks' that are crucial for success in the industry in which the appellant operates.
Further, again based on a detailed functional analysis, each of the value drivers is determined to be equally important for the global operations of the Group, and hence, each driver has been given equal weight. Accordingly, the residual group profit/loss is divided equally among each of the value drivers. Further, while applying RPSM, especially in a scenario wherein the functions performed or services rendered are unique in nature and comparables are not available easily for determining the manner in which profit has to be split, 9 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi reliance has to be placed on some other indicia such as costs for determining how the residual profit must be allocated. This approach is supported by OECD Guidelines, UN's Practical Manual on Transfer Pricing for Developing Countries ('UN TP Manual') as well as US Treasury Regulations. For your Honours' reference, enclosed herewith as Appendices to this annexure are:
a) the relevant extracts of Chapter II (Part III: Transactional profit methods) on TP Methods of OECD Guidelines
b) the relevant extracts of Chapter VI (Section 6.3.13: Profit Split Method) on TP Methods of UN TP Manual
c) The relevant extracts of US Treasury Regulations Para 4.182-6 (c)(3)(i)(b) Moreover, each of the above costs that are relied upon to measure the contributions to key 'value drivers' are from financials and are fully based on the actual costs/ expenses borne by the various entities. They represent third party costs determined based on full-fledged negotiations in the open market.
The Ld TPO has also raised an objection to application of the residual PSM on the ground that the marketing expenditure incurred by the appellant is merely Rs 31,28,853 out of a total expense of Rs 62,04,23,787 where as the personnel expenses are merely Rs 6,41,07,400.
To the extent GOIPL has low marketing cost its contribution to the sales and marketing driver is also low, which has in effect resulted in a lower attribution of losses to GOIPL considering that there are losses at the group level in this FY. The Ld TPO has argued that since appellant's largest head of expense of Rs 292,432,061 is 'recurring head installation charge' under the head circuit expenses, it is clear that appellant's main activity is providing internet and related services.
Even the appellant agrees that its main activity is provision of internet and related services. However, the important point is that owing to the integrated nature of appellant's operations, it is PSM and not TNNM that is the most appropriate method for benchmarking appellant's international transactions connected with the provision of internet and related services. The circuit expenses are incurred by the appellant as part of its activities/ role of providing the network/ connectivity for the India leg of the global network. The 10 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi fact that circuit expenses incurred by the appellant during the year are significant can in no way lead to a conclusion that PSM is not the most appropriate method in the instant case.
The Ld TPO has also stated in the Notice that the description of the 'Field operations' in the TP study is not reflective of any unique intangibles or value added services but reflects services that are routine in nature. In this regard, it is submitted that Field Operations constitute one of the key drivers of the business. The Field Operations and Integration Services ("FOIS") teams are the interface/ Equant's presence at customer sites around the globe, and are responsible for delivering quality services to customers in all countries of operation. Because the field operation personnel are in direct contact with the customers on regular basis, through the quality they bring in their work or service delivery they also contribute in a significant manner to the business operations of the Group and also help the group in identifying new business opportunities. Thus, the field operation is also a significant value driver of the Group's business.
The appellant is the joint entrepreneur in the business and not a low risk captive unit.
• Even if the costs incurred by an entrepreneur can be identified, the return attributable to it cannot be ascertained by applying TNNM and comparing it with other independent comparables/ entrepreneurs.
• Appellant's operations are highly integrated, it is also not possible to directly identify the revenue that is attributable to appellant's efforts in India. • Appellant's business is integrated other parameters for applicability of PSM also have to be considered - not possible to identify revenue streams attributable to any specific operating entity which is why the total group revenue necessarily has to be apportioned between the different operating entities based on key value drivers as is done under PSM.
• Mere determination of the costs cannot imply that TNNM can be applied in the instant case. This does not any-how enable an identification of appellant's corresponding share in the Group revenue and/ or profit/ loss. • In FY 2004-05 (i.e. AY 2005-06) and FY 2005-06 (i.e. AY 2006-07) the appellant's case was picked up for detailed TP scrutiny. In both the years, the TP basis of the appellant was examined in detail and TPOs had sought voluminous 11 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi information/ explanation on the manner in which PSM was applied for determining the arm's length price. After analysing and evaluating the detailed submissions put forward by the appellant, the Ld TPO's predecessors reached an informed conclusion as to the appropriateness of PSM for benchmarking appellant's international transactions.
• The principle of res-judicata is very much applicable to tax matters as well so long as there is no material change in the facts and circumstances surrounding the case in the different years in question.
• To rebut the applicability of res-judicata, the Ld TPO has relied upon the Tribunal Ruling in the case of Carraro India Ltd vs. DCIT (2008 - TIOL - 519- ITAT - Del). However, the said decision does not anywhere state that the principle of res-judicata is not applicable to tax matters but rather highlights that during each year 'facts and circumstances' are to be examined before applying the said principle.
• Further, the applicability of the principle of res-judicata is supported by several decisions of the Apex Court. The Hon'ble Supreme Court has clearly laid down that where a fundamental aspect permeating through the different assessment years has been found as a fact one way or the other, and the parties have allowed the position to be sustained by not challenging the order, it is not allowed to change the position in any subsequent year. • There is no justification for taking a different view on a fundamental issue i.e. choice of the TP method when there are similar facts.
• Given that there has been no change in the nature and terms of the international transactions entered into by the appellant over the years, there is no justification for taking a different view on a fundamental issue i.e. choice of the TP method when there are similar facts and hence, in line with the earlier years, PSM should be accepted as the most appropriate method even for the current FY.
• TP Regulations in different jurisdictions are similar in substance - today the TP principles accepted and applied internationally are largely similar being mostly based on the OECD Guidelines published and reviewed by OECD from time to time. Indian Courts/ Tribunal have in many cases referred to overseas TP legislations/ jurisprudence to seek guidance on various TP issues.
12 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi • The underlying basis for applicability of PSM is same/similar as per the OECD Guidelines, US regulations and the Indian TP regulations applicable in case of integrated transactions involving unique intangibles. • To the extent the global policy of the Group based on PSM has been accepted in other countries as well even though such acceptance is based on their TP regulations, it raises a strong presumption of the conformity of the Equant Group policy (based on PSM) with the arm's length principle enshrined in the Indian TP regulations.
• Non-acceptance of PSM would imply that India is the only exception:
Globally, wherever the Revenue authorities have audited/ tested the inter- company transaction pricing/ TP policy/method for the Equant group, PSM has been accepted and no adverse inference has been drawn either in relation to the application of the method or the transfer prices. appellant understands that Revenue Audits have been completed in countries including France, Belgium, Italy, Thailand, etc. Hence, should your Honours' accept Ld TPO's approach to benchmarking appellant's international transactions using TNNM, the taxi TP treatment of the appellant in India shall be the only exception to what is otherwise a universal acceptance of the global TP policy of the Equant Group.
• The key value drivers are not the outcome of the appellant's subjective evaluation but the result of an objective industry and functional analysis undertaken by the appellant which clearly bears out the main industry characteristics. Here the appellant would like to reiterate the submission made before the Ld TPO to highlight the fact that it has indeed relied upon the external market data in the application of PSM. • The key 'value drivers' i.e. Sales & Marketing operations, Network operations and Field operations, have been identified based on a detailed functional analysis and are nothing but those 'functions' performed with the concomitant 'assets' and 'risks' that are crucial for success in the industry in which the appellant operates.
• Further, again based on a detailed functional analysis, each of the value drivers is determined to be equally important for the global operations of the Group, and hence, each driver has been given equal weight. Accordingly, the residual group profit/loss is divided equally among each of the value drivers.13 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi • Further, while applying RPSM, especially in a scenario wherein the functions performed or services rendered are unique in nature and com parables are not available easily for determining the manner in which profit has to be split, reliance has to be placed on some other indicia such as costs for determining how the residual profit must be allocated. In the instant case actual costs incurred by the various operating entities is considered as key value driver cost. This approach is supported by OECD Guidelines as well as US regulations. Moreover, each of the above costs that are relied upon to measure the contributions to key 'value drivers' are from financials and are fully based on the actual costs/ expenses borne by the various entities. They represent third party costs determined based on full-fledged negotiations in the open market.
• Here, the appellant would like to draw reference to detailed description of the Group Overview and the integrated nature of appellant's operations as discussed in the submission filed in the DRP application. Further, on the contribution of key value drivers, in the detailed submission filed before the Ld TPO it was also clearly explained how each value driver contributes to the business/ creation of a unique intangibles i.e. the network, field operations, sales and marketing, etc. Further, as submitted before the Ld TPO, the total key driver cost constitutes as much as one- fourth (approx) of the total expenses for the appellant which is not an insignificant amount contrary to what has been contended by the Ld TPO. Hence, the assertions made by the Ld TPO that key value drivers identified by the appellant are completely routine and do not lead to creation of any unique intangibles completely baseless. • The appellant had furnished before the TPO detailed reasons/ explanation for losses being made by the Equant Group at the global level. Hence, the observation of the Ld TPO on absence of any credible reasons for losses is completely incorrect. Commercial reasons for losses include: -
(a) Prevalent market trends in the global telecommunications industry, the Equant group operates in a very dynamic, highly competitive, and fragmented market that is in a constant stage of change and is experiencing continuous erosion of prices for telecommunications connectivity.
(b) In the last decade the telecommunications market has gone through significant changes at an incredibly rapid pace. Bankruptcy filings and 14 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi consolidation trends during the recent few years highlight the transition in the industry.
(c) In the recent years, the telecommunications market has moved away from the need to utilize specific data networks, as the Internet is becoming cheaper and more secure for sending data. Further, the current state Internet Services Provider ('ISP') industry also finds customers not demonstrating loyalty to any particular service provider as internet services are increasingly viewed as a commodity product.
(d) Consequently, margins available in providing basic network and data transmission services have fallen dramatically and a reliance solely on such data transmission activity is no longer a viable business option for telecom service providers. The network capacity market has become very price competitive, and it is becoming difficult to generate profits from the sale of "plain vanilla" network usage.
(e) The trends/ movements in the telecommunications industry clearly reflect that the pricing for pure network operating services has become a commodity, leading to severe constraints on margins from Equant's customers and competitors. Because of this change, Equant is facing an enormous challenge, with the focus moving away from the simple, yet incredibly risky investment for the provision of network capacity, as the value in network transport has decreased and will continue to do so, to become a total telecommunications solutions based company.
He further submitted that,
(i) The inter-company agreement does not give any discretionary power to the Administrator to determine the intra-group payments. Rather the payments are to be made in accordance with the arm's length principle (and in consonance with the OECD Guidelines).
(ii) Similarly, in relation to disputes, it is provided as per para 6.6 of the agreement that in the event an AE and the Administrator are not able to reach any agreement even after making reasonable efforts for the same, the disputes between the AE and the administrator would be referred to an arbitrator whose decision shall be binding on the parties. Moreover, the Arbitrator would also be appointed jointly by the administrator and the disputing party.
(iii) The last point of the TPO on the power to have access to records is merely a procedural aspect in the administration of the agreement and not imply absence of any power/ say of the AEs in the administration of 15 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi agreement/ allocation mechanism. Further, the appellant does access to the methodology/basis followed by the Administrator for carrying out the RPSM. Also, the RPSM workings are also shared by administrator with the appellant and the same were also filed with the Ld TPO during the audit proceedings and the workings are shared the appellant.
Hence, he argued that the observations made by the Ld TPO are incorrect. On facts he submitted that :
• Both the statements of the TPO in this regard are factually incorrect since neither has the PSM been applied in the TP study for the first time nor is it a device to camouflage the losses of the appellant.
• PSM based model is followed by the Equant Group globally for the setting of Transfer Prices. This model is clearly borne out from the inter- company agreement which was put in place long before the FY 2006-07 i.e. the agreement was effective from January I, 2004. The TP documentation is merely a written manifestation of this model and drawn up for compliance under the TP regulations. Further, the TP model based on PSM has also been accepted by the Ld. TPO's predecessors in the prior years.
• At the outset, it needs to be stressed that the circuit expenses pertaining to provision of last mile connectivity is not a key driver cost. The Equant's Group's Core asset is the global network that connects overseas entities to the 'Point of Supply' and in which all the group entities have invested heavily and which also is the unique intangible employed by the Group. • In the entire process of international communication the most important role is that of transmitting and receiving the signals from one country to another which is the role performed by the global network which is developed and maintained by the Equant Group. As recognized by the Ld.TPO in the TP Order itself, last mile connectivity is merely a small part of the entire networking process and its outsourcing does not negate the importance of global network as an intangible.
• Merely because the appellant outsources the last mile connectivity to third party internet service providers does not detract from the importance of the global network in which the Equant Group (including GOIPL) has heavily invested and it is the cost pertaining to the global network constitutes the key driver. Here it is reiterated that each Equant operating entity (including GOIPL) assumes the significant risks associated 16 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi with making an investment in the global network and also assume the overall responsibility vis-a-vis the customers for ensuring effective / error free services.
4. The Ld.D.R. Mr.Peeyush Jain, on the other hand, opposed the contentions of the assessee and referred to the assessment order for the A.Y. 2009-10 where the A.O. has left a Note. He submits that PSM is not the Most Appropriate Method(MAM). He referred to page 260 of the assessee's paper book, wherein in the executive summary of T.P. study for the F.Y. 2006-07, it is specifically stated at para 1.4.2 by the auditors, that their recommendations on the issue of M.A.M. are based on facts as on 31.3.2007 and that the methodology and the MAM may have to be reviewed in case of change in the facts and circumstances of the case, to drive home the point that, it is not mandatory to follow PSM as the MAM adopted in the Previous Years, in this year also, even if the same is accepted by the T.P.O. He argued that it is well settled that the burden of proof is on the assessee to prove that its international transactions with its Associated Enterprise are at arm's length. He referred to the order of the TPO and submitted that the application of PSM by the assessee is not as per Rule 10B(1)(d). He referred to page 180 of the paper book and pointed out, to the details given therein, of the A.E. and all the international transactions, entered into by the assessee and pointed out that they are of
(i) purchase of equipment, (ii) telecom charges, and (iii) reimbursement of expenses in two cases. He submitted that purchase of equipment is not service 17 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi and hence PSM cannot be applied. He questioned whether PSM can be the most appropriate method for purchase of equipment. It is only in the case of Telecom charges, which is received by the assessee from Equant Ireland that PSM may possibly be applied and in that case the profits of both the enterprise have to be considered. He vehemently contended that the intra transfer pricing policy of the Group, cannot be compared and cannot be considered as a bench mark. He relied on the TPO's order, and the show cause notice given by the T.P.O. and submitted that this is a case where the key drivers are not applied correctly. He questioned as to what are the unique intangibles. He submitted that losses are being brought forward in this case and referred to page 3 of the TPO's order and relied on the findings therein and contended that losses cannot be apportioned to the assessee. He submitted that the basis of allocation is not reasonable and that the assessee has not justified the same. On the TPO accepting PSM in the earlier years, he submitted that it might probably be a mistake and there is no res judicata in tax proceedings. He pointed that the law allows the TPO's to change and arrive at the correct Most Appropriate Method, when he is convinced that a change is required. He questioned that if the case of the assessee is that there was a mark up, then the assessee having a loss, cannot be explained. On a query from the Bench as to whether errors in applying the method should be corrected or the method itself should be rejected, he submitted that if the errors are such that go to the root of the method to be applied, in such cases the TPO has to change to the most 18 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi appropriate method. He contended that the assessee has plug in client, and has no unique intangibles. He relied on each and every finding of the T.P.O. which are brought out in the earlier part of this order and submitted that the T.P.O's order, as confirmed by the DRP's order, has to be upheld. 4.1. In reply the Ld.Counsel for the assessee Mr.Rahul Mitra submitted that, the very categorization of the assessee is wrongly understood by the Ld.D.R. and that the assessee is not a service provider and that he is an entrepreneur. He contended that if PSM is not correctly applied, then the remedy is to correct the same and not reject the method itself. He pointed out that the allocation was on a scientific basis and that, if the TPO found fault with it, he could have suggested a different method of allocation which he felt appropriate, rather than reject the method. He contended that net working is an intangible and the assessee is an independent entrepreneur and transactions are inter related, hence PSM is applicable.
4.2. Joining the , the Ld.D.R. Mr.Peeyush Jain submitted that the entire group has 100 entities and when the assessee has transactions only with two entities, how could the entire group profits be apportioned? He submitted that only such entities as are involved in the international transactions should be considered. He vehemently contended that PSM was not applied by the assessee as per the requirement of Rule 10(A)(A), as residual profits allocation are not bench marked.
19 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 4.3. The Ld.Counsel for the assessee admitted that PSM has not been applied as per the requirements of the Income Tax Act read with Rules to the extent that residual profits allocation was not bench marked. But he submitted that nowhere in the world, bench marking of residual profits for allocation is required. He relied on various commentaries in support of the same. He referred to the decision of the Chennai Bench of the Tribunal in the case of Asendas (India) Pvt.Ltd. vs. DCIT in ITA no.1736/Madras/2011, order dated 02nd January,2013, and submitted that the Tribunal has adopted a valuation methodology not given in the rules, as a matter of exception. He relied on interpretation of statutes and submitted that the Tribunal is entitled to put life and force into the language of the Section so as to iron out the creases. He relied on a number of decisions of the Hon'ble Supreme Court and High Courts for the proposition that the Tribunal can read down the law in certain circumstances and argued that this is one such circumstance. Alternately, he relied on Rule 10(A)(B), which was introduced w.e.f. 1.4.2012 giving the assessee a choice to adopt any other recognized method and submitted that this rule is retroactive, as it is procedural in nature. Hence, he submits that the method adopted by the assessee is a recognized method and has to be accepted as MAM under Rule 10(A)(B).
4.4. The Ld.D.R. replied stating that the sixth method is prospective and is applicable w.e.f. 1.4.2012 and no arm's length can be determined without bench 20 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi marking with comparables. He submitted that the Tribunal cannot read down enactments and has to simply enforce the law as enacted by the Parliament.
5. On the corporate tax issues the assessee filed two additional grounds which are as follows.
"Ground no.10: That the LdAO has erred on facts and in law in charging interest u/s 234C of the Act on the assessed income of IR 272,043,590/-.
10.1. Without appreciating that interest u/s 234C is leviable on the tax on returned income i.e. tax on the total income declared in the return of income and not on the assessed income as per the provisions of S.234C of the Act.
10.2. As there is no mention of the levy of interest u/s 234C of the Act in the assessment order and thereby ignoring the judicial precedents wherein it has been held that interest u/s 234C could be levied only when there is specific mention in the assessment order that interest u/s 234C is leviable.
11. Without prejudice to ground numbers 1 to 5 and without accepting the additions made by the Ld.AO in any manner whatsoever, the Ld.AO has erred in not allowing deduction u/s 80-IA(4) of the Act from the gross total income (as assessed)."
6. Ld.Counsel submitted that these are legal grounds which do not require any investigation into the facts of the case and under these circumstances he argued that the same may be admitted. 6.1. The Ld.D.R. submitted that the assessee has not claimed a deduction u/s 80-I either in the original return of income, or in the revised 21 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi return of income and hence submitted that the additional grounds may be rejected.
7. After hearing rival contentions, we find that both the grounds raised are legal grounds and that no fresh investigation into facts is required. When all facts are on record, in our view, these grounds have to be admitted, being legal grounds, by following the judgement of Hon'ble Supreme Court in the case of National Thermal Power Co.Ltd. vs. CIT(1998) reported in 229 ITR 383 (SC). In the result we admit the additional grounds.
8. Ground no.5 to 9 are grounds connected with corporate tax issues.
9. The Ld.Counsel for the assessee submitted that the A.O. disallowed payments made for lease lines, as the assessee has not deducted tax at source u/s 40(A)(i)(a). The A.O. disallowed the same by holding that lease lines were, technically speaking, equipment and payment for taking these lines on lease, is covered u/s 194-I and that the assessee himself has described the payment has been made towards lease lines. The Ld.Counsel relied on the decision of the Delhi high court in the case of Asia Satellite Tele Communication Co. 332 ITR 340(Del)C and submitted that the issue is covered in his favour. He relied on the decision of the Mumbai Tribunal in the case of "Vodafone S.R.Ltd." 135 TTJ 182 and submitted that such payments are not for the use of equipment and, therefore, not liable to TDS u/s 194-I. 22 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 9.1. On the additional ground of deduction u/s 80 IA(iv), he submitted that any disallowances made by the A.O. would go to increase the income and consequently the assessee would be eligible for deduction u/s 80 IA on such increased profits. He relied on the order in the case of "Gem Plus Jewellery India Pvt.Ltd." (2011) reported in 330 ITR 175 (Bom) in support of his contentions. For levy of interest u/s 234C, he recorded that such interest is levied only on returned income and not on assessed income. 9.2. In reply, the Ld.D.R., though not leaving his ground, submitted that he relies on the order of the A.O. and the reasoning thereof for disallowance made u/s 40A(i)(a) of the Act.
9.3. On the additional grounds the Ld.D.R. submitted that the A.O. may be directed to examine the same, if the Tribunal chose to admit these grounds.
10. Rival contentions heard. On a careful consideration of the facts and circumstances of the case and on a perusal of the papers on record and orders of the authorities below, case laws cited, we hold as follows.
11. We first take up corporate tax issues which is ground no.5 for the A.Y. 2007-08. The assessee is a licensed internet provider. During the year it procured, domestic half circuit facility to its customers from Telecom Service Providers like BSNL, MTNL, and international half circuit facility from Flag, Atlantic, at France. These are standard facilities provided for transmission of data by those organisations. The issue is whether tax should be deducted at 23 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi source u/s 194 I from payments made for use of such standard facilities. The Hon'ble Delhi High Court, in the case of Asia Satellite vs. CIT, reported in 332 ITR 340 and the Hon'ble Madras High Court, in the case of Skycell Communications Ltd. vs. DCIT, reported in 351 ITR 53 (Madras) have adjudicated the issue in favour of the assessee. Respectfully following the same, we hold that payments made towards use of standard facility, when the lessee is not having any domain or control or possessory rights over such facility, cannot be categorized as use of assets for the purpose of the Act. 11.1. Respectfully following the order of the Jurisdictional High Court on this issue, we allow this ground of appeal of the assessee. In the result ground no.5 for the A.Y. 2007-08 is allowed.
12. Ground no.6 for A.Y. 2007-08 is on the issue of the Assessing Officer not granting the benefit of carry forward of business losses and unabsorbed depreciation, to the assessee. After hearing both the parties, as this is a factual matter and as the same is not adjudicated by the lower authorities, and as this is a legal claim, we set aside the same to the file of the A.O. for fresh adjudication in accordance with law. In the result this ground is allowed for statistical purposes.
13. Ground no.7 for the A.Y. 2007-08 and ground no.6 for the A.Y. 2008-09 are general in nature. Ground no.8 for the A.Y. 2007-08 and ground no.7 for the A.Y. 2008-09 are against the levy of interest u/s 234'B'. Levy of interest is mandatory and consequential. Hence, these grounds are dismissed. 24 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi
14. Ground no.9 for the A.Y. 2007-08 and ground no.9 for the A.Y. 2008-09 are on the initiation of penalty u/s 271(1)(c ) of the Act. The same is dismissed as premature.
15. Ground no.8 for the A.Y. 2008-09 is against the A.O. not allowing credit of TDS and charge of interest. As this is a factual matter, the same is set aside to the file of the A.O. for verification and disposal in accordance with law. This leaves us with ground no. 1 to 4 in both the AYs, which is against the transfer pricing adjustments, as well as the additional grounds admitted by us.
16. The additional ground is regarding claim of deduction u/s 80I. Having admitted this ground by applying the decision of the Hon'ble Supreme Court in the case of NTPC Ltd., we deem it appropriate to remit the matter to the file of the Assessing Officer for fresh adjudication in accordance with law. Similarly, the additional grounds raised on levy on interest u/s 234, we also set aside this additional ground to the file of the AO for fresh adjudication in accordance with law.
16.1. In the result, these grounds are allowed for statistical purposes.
17. We now take up the issue of transfer pricing adjustment, which are ground nos. 1 to 4.
17.1. A perusal of the function of the assessee company demonstrates that the transactions of the company are highly integrated and interrelated. It involves more than one enterprise to complete a transaction. This is a case where a transaction passes through a number of A.Es and for a transaction to 25 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi fructify, each entity makes a contribution. The various parties which make a contribution to the transaction, share the revenues that arise as a consequence to such contribution. The different entities are also associated enterprises. The fact is that the EQUANT Group relies on the functions of each of the entities of the group to generate revenues and each of the operating entities of the EQUANT Group deploys the necessary assets and function required at each step for network foot print. Each entity owns assets and also employs man power, with the help of which they operate different locations of the network and thus contribute to the Global EQUANT network.
17.2. Thus, keeping in view the above, we come to a conclusion that the nature of the assessee's operations is integrated, interconnected and interdependent. On these facts, we have to decide as to what is the "MAM" under the facts and circumstances.
17.3. Before us there are two methods for consideration, i.e. PSM and TNMM. The Special Bench of the Tribunal, in the case of Aztech Software and Technologies Services Ltd. vs. ACIT, reported in 107 ITD, at page , states as follows:
"Profit Split Method (PSM) Rule 10B (1) (d) prescribes PSM as follows:
(i) The combined net profit of the associated enterprises arising from the international transaction in which they are engaged, is determined;
(ii) The relative contribution made by each of the associated enterprises to the earning of such combines net profit, is then evaluated on the basis of the functions performed, assets 26 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in the similar circumstances;
(iii) the combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub clause(ii);
(iv) the profit thus apportioned to the assessee is taken into account to arrive at an arm's length price in relation to the international transaction;
181. This method may be applicable in case where transactions involved transfer of unique, intangible or any multiple interrelated international transactions, which cannot be evaluated separately for determining the ALP of any one transaction.
182. The profit split method first identifies the profit to be split for the associated enterprise from the controlled transactions in which the associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis that approximates the divisions of profits that would have been anticipated and reflected in an agreement transactions or a residual profit intended to represent the profit that cannot readily be assigned to one of the parties, such as the profit arising from high value, sometimes unique, intangibles.
183. The contribution of each enterprise is based upon a functional analysis and valued to the extent possible by any available reliable external market data. The functional analysis is an analysis of the functions performed (taking into account assets used and risks assumed) by each enterprise. The external market criteria may include, for example, profit split percentages or returns observed among independent enterprises with comparable functions."
27 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 17.4. The OECD transfer pricing guideline for multinational enterprises and tax administration in Chapter 2 on transfer pricing methods, at page 93, para C.1 states as follows:
"C.1 In general 2.108 The transactional profit split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction (or in controlled transactions that are appropriate to aggregate under the principles of paragraphs 3.9-3.12) by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions. The transactional profit split method first identifies the profits to be split for the associated enterprises from the controlled transactions in which the associated enterprises are engaged (the "combined profits"). References to "profits" should be taken as applying equally to losses. See paragraphs 2.124-2.131 for a discussion of how to measure the profits to be split. It then splits those combined profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm's length. See paragraphs 2.132-2.145 for a discussion of how to split the combined profits."
17.5. On residual analysis analyses, it is stated as follows:
"C.3.2.2 Residual analyses 2.121 A residual analysis divides the combined profits from the controlled transactions under examination in two stages. In the first stage, each participant is allocated an arm's length remuneration for its non-unique contributions in relation to the controlled transactions in which it is engaged. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method, by reference to the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by any unique and valuable contribution by the participants. In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the facts and 28 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi circumstances, following the guidance as described at paragraphs 2.132- 2.145 for splitting the combined profits.
2.122 An alternative approach to how to apply a residual analysis could seek to replicate the outcome of bargaining between independent enterprises in the free market. In this context, in the first stage, the initial remuneration provided to each participant would correspond to the lowest price an independent seller reasonably would accept in the circumstances and the highest price that the buyer would be reasonably willing to pay. Any discrepancy between these two figures could result in the residual profit over which independent enterprises would bargain. In the second stage, the residual analysis therefore could divide this pool of profit based on an analysis of any factors relevant to the associated enterprises that would indicate how independent enterprises might have split the difference between the seller's minimum price and the buyer's maximum price.
2.123 In some cases an analysis could be performed, perhaps as part of a residual profit split or as a method of splitting profits in its own right, by taking into account the discounted cash flow to the parties to the controlled transactions over the anticipated life of the business. One of the situation in which this may be an effective method could be where a start-up is involved, cash flow projections were carried out as part of assessing the viability of the project, and capital investment and sales could be estimated with a reasonable degree of certainty. However, the reliability of such an approach will depend on the use of an appropriate discount rate, which should be based on market benchmarks. In this regard, it should be noted that industry wide risk premiums used to calculate the discount do not distinguish between particular companies let alone segments of business, and estimates of the relative timing of receipts can be problematic. Such an approach, therefore, would require considerable caution and should be supplemented where possible by information derived from other methods."
17.6. The United Nations - Practical Manual on Transfer Pricing for Developing Countries - Chapter VI - Transfer Pricing Methods, states as follows:
"6.3.13.1. The Profit Split Method is typically applied when both sides of the controlled transaction contributes significant intangible property. The profit is to be divided such as is expected in a joint venture relationship.29 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 6.3.13.2. The Profit Split Method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction(or in controlled transactions that it is appropriate to aggregate) by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions. Figure 5 illustrate this.
6.3.13.3 The Profit Split Method starts by identifying the profits to be divided between the associated enterprises from the controlled transactions. Subsequently, these profits are divided between the associated enterprises based on the relative value of each enterprise's contribution, which should reflect the functions performed, risks incurred and assets used by each enterprise in the controlled transactions. External market date (e.g. profit split percentages among independent enterprises performing comparable functions) should be used to value each enterprise's contribution, if possible, so that the division of combined profits between the associated enterprises is in accordance with that between independent enterprises performing functions comparable to the functions performed by the associated enterprises. The Profit Split Method is applicable to transfer pricing issues involving tangible property, intangible property, intangible property, trading activities or financial services.
17.7. Residual analysis is stated as follows:
6.314.7 The Residual Profit Split Method is used more in practice than the contribution approach for two reasons. Firstly, the residual approach breaks up a complicated transfer pricing problem into two manageable steps. The first step determines a basic return for routine functions based on comparables. The second step analysis returns to often unique intangible assets based not on comparables but on relative value which is, in many cases, a practical solution.
Secondly, potential conflict with the tax authorities is reduced by using the tow step residual approach since it reduces the amount of profit that is to be split in the potentially more controversial second step.
6.3.17.3. In step 1 of the residual analysis, a basic return for the manufacturing function is determined for Company A and Company B. Specially a benchmarking analysis is performed to search for comparable independent manufactures which do not own valuable intangible property. The residual profit, which is the combined profits of company A and company B after deducting the basis (arm's length ) return for the manufacturing function, is then divided between Company A and Company B. This allocation is based on relative R & D expense which are assumed to be a reliable key to measure the relative value of each company's intangible property. Subsequently, the net profits of Company A and Company B are calculated in order to work back to a transfer price." 30 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 17.8. In "Practical Guide to U.S.Transfer Pricing by Robert T Cole, Chapter 10, PSM authored by arlow N.Higinbotham, pg nos.10-52, it is stated as follows:
"Thus, to summarize, RPSM provides a test of arm's length transfer pricing between value- added stages of an integrated enterprise that is consistent with the separate enterprise standard under conditions of resource mobility and competitive capital and product markets. By valuing functional activities and capital in terms of the competitive norms of the market place, RPSM attributes extra- normal profit or loss in proportion to the relative investment cost (or other valuation) of the non-routine intangible assets to which such extraordinary profits pertains. This approach is consistent with the IRS statutory objective u/s 482 of requiring consideration for intangible property transferred in a controlled transaction to be commensurate with the income attributable to the intangible. It is also consistent with the result that would obtain at arm's length under a hypothetical joint venture agreement between the different parties contributing their respective investments of functional and entrepreneurial capital."
17.9. Residual Profit Split Method in the book U.S.Transfer Pricing by HARLOW N.HIGINBOTAM at Chapter 10, it is stated as follows:
10.04 Residual Profit Split Method As illustrated in Figure 10-2, RPSM proceeds in two steps:
Step 1: Functional capital is provided a return derived from data for functional comparables, i.e. independent companies performing similar routine manufacturing or distribution functions; and Step 2:The remaining "residual" operating profit or loss is allocated based on residual, "entrepreneurial" capital so as to equalize the rate of return on such capital, adjusted for market differences in the cost of capital.
In actual practice, implementation of the RPSM concept outlined above involves the determination of a number of interrelated valuations of functional and entrepreneurial activities in different countries and economic circumstances. The existing IRS regulations provide relatively little specific guidance concerning these valuations, and thus leave open the question of how best to determine the "relative value of each controlled taxpayer's contribution to the success of the relevant business activity in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of 1.482- 1(d) (3)."31 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi
18. We now consider TNMM. In Aztek Software and Technology Services (supra) the TNMM is stated as follows.
"Transactional Net Margin Method (TNMM) :
Rule 10(B)(1)(e) describes TNMM as under:
(i) The net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;
(ii) The net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;
(iii) The net profit margin referred to in sub clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;
(iv)The net profit margin realized by the enterprise and referred to in sub clause (i) is established to be the same as the net profit margin referred to in sub clause (iii);
(v) The net profit margin thus established is then taken into account to arrive at an arm's length price in relation to the international transaction.
The TNMM requires establishing comparability at a broad functional level. It requires comparison between net margins derived from the operation of the uncontrolled parties and net margin derived by an AE on similar operation. Under this method, the net profit margin realized by an AE from an international transaction is computed in relation to a particular factor such as costs incurred, sales, assets utilized etc. The net profit margin realized by an AE is compared with net profit margin of the uncontrolled transactions to arrive at the ALP. The TNMM is similar to RPM and CPM to the extent that it involves comparison of margin earned in a controlled situation with margins earned from comparable uncontrolled situation. The only difference is that, in the RPM and CPM methods, comparison is of margins of gross profits and whereas in TNMM the comparison is on margins of net profit.
32 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi TNMM requires comparison between net margins derived from the operations of the uncontrolled parties and net margins derived by an AE from similar operations. Net margin is indicated by the rate of return on sales or cost or operating assets, and this forms the basis for TNMM. A functional analysis of the tested party or the independent actions are comparable and the adjustments that are required to be made to obtain reliable results. The tested party would have to consider other factors, like cost of assets of comparable companies, etc. while applying the return on assets measure. Ordinarily, the tested party, has to be the party provided services because it is on the basis of rate of return on sales or cost or operating assets that transactional margin is computed. These parameters generally available in the case of party providing service 18.1. The , in its review of comparability and methods, dt. 22nd July,201, 0 in Part III B Transactional Net Margin Method, B I, page 33, paras 2.58 to 2.59, held as under.
"B. Transactional net margin method B.1. In general 2.58 The transactional net margin method examines the net profit relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a controlled transaction (or transactions that are appropriate to aggregate under the principles of paragraphs 3.9 - 3.12). Thus, a transactional net margin method operates in a manner similar to the cost plus and resale price methods. This similarity means that in order to be applied reliably, the transactional net margin method must be applied in a manner consistent with the manner in which the resale price or cost plus method is applied. This means in particular that the net profit indicator of the tax payer from the controlled transaction ( or transactions that are appropriate to aggregate under the principles of paragraphs 3.9-3.12) should ideally be established by reference to the net profit indicator that the same tax payer earns in comparable uncontrolled transactions, i.e. by reference to "internal comparables" (see paragraphs 3.27- 3.35). A functional analysis of the controlled and uncontrolled transactions is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results. Further, the other requirements for comparability, and in particular those of paragraphs 2.69-2.75, must be applied.33 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 2.59. A transactional net margin method is unlikely to be reliable if each party to a transaction makes valuable, unique contributions, see paragraph 2.4. In such a case, a transactional profit split method will generally be the most appropriate method, see paragraph 2.109. However, a one-sided method (traditional transaction method or transactional net margin method) may be applicable in cases where one of the parties makes all the unique contributions involved in the controlled transaction, while the other party does not make any unique contribution. In such a case, the tested party should be the less complex one. See paragraphs 3.18-3.19 for a discussion of the notion of tested party."
18.2. In the working draft of a chapter of the practical Manual in Transfer Pricing for Developing Countries, in Chapter 5 Transfer Net Margin Method is discussed at para 2.1.
"Transactional Net Margin method 2.1. Definition and choice of tested party The transactional net margin method ('TNMM') is a profit based method that can be used to apply the arm's length principle. The TNMM can be applied on either the related party manufacturer or the related party distributor as the tested party for transfer pricing purposes.
The TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a tax payer realizes from a controlled transaction (or transactions that are appropriate to be aggregated). The profit margin indicators are discussed in paragraph 2.3 below.
The TNMM compares the net profit margin (relative to an appropriate base) that the tested party earns in the controlled transactions to the same net profit margins earned by the tested party in comparable uncontrolled transactions or alternatively, by independent comparable companies. As such, the TNMM is a more indirect method than the cost plus/resale price method that compares gross margins. It is also a much more indirect method than the CUP method that compares prices, because it uses net profit margins to determine (arm's length) prices. One should bear in mind that many factors may affect net profit margins, but may have nothing to do with transfer pricing.34 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi The TNMM is used to analyse transfer pricing issues involving tangible property, intangible property or services. When the TNMM is applied on controlled transactions involving tangible property, the tested party in the analysis can either be the related party manufacturer or the related party distributor. The choice of the tested party depends on the availability of comparable data. This usually implies that the TNMM is applied to the least complex of the related parties involved in the controlled transaction, because generally more comparable data will then be in existence and fewer adjustments will be required to account for differences in functions and risks between the controlled and uncontrolled transactions. In addition, the tested party should not own valuable intangible property. This, by the way, is also the reason why it is recommended to select the least complex entity for the application of the cost plus method or resale price method."
18.3. The Transfer Pricing , in the case at hand, has applied the TNMM method. While doing so, at para 3.7, he considered the objection of the assessee to the use of TNMM as the MAM.
He observed as follows:
"that the assessee's business does not has any integration with the other group entities has already brought in sufficient details in the earlier part of this order.
The assessee runs its business independently in India. For the deployment of their party entities for the proliferation of its network services, there is nothing on record to show that the assessee is getting any help or leverage from the other group entities. The assessee is negotiating with the Indian regularators all by itself. The assessee is operating in India as a standalone entity for setting up the operational requirements in India. Therefore, there is no case to say that TNMM does not qualify to be the MAM for its reason."35 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 18.4. In our view, the TPO has erred on facts. The revenues in the case of the assessee are generated in a transaction where there is contribution from multiple entities. It is true that the assessee runs its business independently in India. This leads to a conclusion that the assessee is an independent entrepreneur . But when a transaction is integrated and interrelated and when costs are incurred by multiple entities and the revenues are to be apportioned to multiple entities, then the factual conclusions of the T.P.O have to be vacated. 18.5. Transaction Net Margin method compares the profit margin of tax payer arising from a non arm's length transaction, or a group of such similar transactions, with the profit margin realized by the assessee with its A.E. on a similar transaction whereas the PSM allocates operating profits or losses from controlled transactions, on the principle of relative contributions made by each party in creating the combined revenues.
18.6. The objection of the assessee is that the TNMM does not take into account commercial/business reasons for losses. The TPO rejected this argument. He held that the assessee has not been able to identify, the reasons that has lead to incurrance of loss. He concluded as follows:
"the administrator can examine the records of the operating entity but not vice versa in any dispute the decision of the administrator shall be binding. No independent entity would have agreed to such terms, nor would it have agreed to be tied down by the financial performance of another entity/entities over 36 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi which/whom it has little or no control. The assessee's arrangement with the A.E. and the use of PSM to justify its financial result does not answer the arm's length principle."
18.7. In our view the argument of the assessee, that in cases where there are commercial losses, TNMM cannot be applied, cannot be accepted as a general rule. To this extent, we agree with the conclusions of the T.P.O. T.N.M.M. can be applied even in cases where there are commercial or other losses. At best, suitable adjustments may be asked for. On the role of the administrator we will be discussing the same separately. 18.8. The next objection of the assessee is that TNMM cannot be used for bench marking returns earned by the number of complex entities/entrepreneur, where each make valuable unique contributions. The TPO has not specifically dealt with this objection of the assessee. We find much force in this contention of the assessee and agree with the same. We are supported by OECD Guidelines, on this issue. At para 2.59 of the OECD Guidelines it is stated as follows:
A transactional net margin method is unlikely to be reliable if each party to a transaction makes valuable, unique contributions, see paragraph 2.4. In such a case, a transactional profit split method will generally be the most appropriate method,( see paragraph 2.109)." In such a case, a transactional profit split method will generally be the Most Appropriate Method.
18.9 Even otherwise, we find that the TPO has, while adopting the TNMM method, considered four comparables, i.e., (i) City Online Services Ltd., (ii) HCL Infinet Ltd., (iii) Sify Ltd., and (iv) Southern Online Bio Technologies Ltd.37 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 18.10. In all these cases, the operating profit at the entity level has been taken for the purpose of bench marking with the entity level profits of the assessee and adjustments were made. TNMM does not contemplate bench marking at the entity level. The rules contemplate bench marking at the transaction level. For this proposition we draw strength from the following case laws:
(i) UCB India (P) Ltd. vs. ACIT, 30 SOT 95 (Mum);
(ii) A.C.I.A. vs. Tes Diam, 37 SOT 341.
Thus we are unable to uphold the order of the T.P.O on this ground also. Hence, for all these reasons, T.N.M.M. is held as not the M.A.M., in the facts and circumstances of the case.
19. In the case at hand, we are of the considered opinion that the "Profit Split Method" (PSM) is the "M.A.M" for the reason that the assessee generates revenue out of operations that are highly integrated. When one transaction, (example transmitting data from a destination in one country, to a destination in a different country in a secured manner) requires deployment of assets and functions of different entities, located in different Geographical locations, to ultimately deliver services and when such combined efforts generate revenues, the MAM for determining arm's length price is "Profit Split Method (PSM)." 19.1. In our considered opinion, the Transfer Pricing Officer is wrong in rejecting PSM on the ground that it is not possible to determine the cost incurred by the Indian entity separately. The cost incurred by the assessee is 38 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi available on record. The entity maintains books and the same are subject to audit. What is to be seen is the contribution of the entities' resources to a transaction, or to a series of similar transactions. In our view, this finding is not correct. Hence, this ground of the T.P.O. taken for rejecting application of "PSM" as the "MAM" is not sustainable.
The Transfer Pricing Officer, had after a detail enquiry in the earlier assessment years, accepted "PSM" as the "MAM". This being so, in our view, rejection of this method on the ground that resjudicata does not apply to income tax proceedings is not correct. Recently, the Hon'ble Supreme Court, in the case of CIT vs. Excel Industries Ltd. has held that "the revenue cannot be allowed to Flip-flop on the issue. Consistency should be a rule rather than an exception". There are a number of other decisions on this issue. Suffice it to say that, the T.P.O., in this case, has not brought out any valid reasons to depart from the earlier view of his Predecessor.
19.2. The TPO's opinion, that acceptance of "PSM" in other jurisdictions as of no consequence, to our mind, is also incorrect. No doubt, the arm's length price has to be determined with reference to the Indian Transfer Pricing regulations only. At the same time, guidance can be taken from OECD commentaries, UN guidelines and other such literature.. The Hon'ble Supreme Court, on a number of occasions, did refer to Commentaries of OECD, UN etc., while arriving at conclusions. One such case is, Azadi Bachao Andolan, 184 CTR SC 450. Even the Indian transfer Pricing Regulation recognize this aspect, as 39 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi evident from the introduction of Rule 10 AB, which allows the use of any other method which is generally accepted, for determining ALP.
20. On the T.P.O's objection that reliable external market data is not available, we find that the assessee has given comparables, while determining ALP, of the basic routine rate of return. At this first stage, the requirement of identifying comparables and bench marking the same with the basic rate of return adopted by the assessee is met. The TPO should have examined the comparables taken by the assessee while allocating the basic rate of return to each of the operating entity, for undertaking the services and if he was not satisfied with these comparables or was of the opinion that the "ALP" should be different, he should have given adequate reasons and not have adopted fresh comparables. On the objection of the T.P.O. that the assessee has not put forth any evidence that it has unique intangibles, we hold that "PSM" can be adopted as "MAM" under the domestic TP Regulations even in cases involving multiple interrelated international transactions, which cannot be evaluated separately for determining ALP of any one transaction. When the transaction involves contributions of multiple entities and are integrated and interrelated and they cannot be separately evaluated for the purpose of determining ALP of any one transaction, the "PSMP" is the "MAM". Hence, in our view, use of unique intangibles is not a must for adopting "PSM". In any event, we have considered the facts of this case and we have, elsewhere in this order, given a finding that the assessee does possess unique intangibles in the field of data transfer 40 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi and communications, and comparing the operations with a simple E Mail and as a plug in operator is not factually correct. If the assessee is held to be a simple Email operator, then it is to be explained as to why reputed global enteprises would pay them for data transmission, when E Mail is free. The assessee does offer unique services as compared to an ordinary Email service and it is these unique services which are its intangibles.
20.1. We also hold that the factum of the assessee having a loss is no ground to reject "PSM" as the "MAM". The decision as to what is the "MAM" does not depend on the factor as to whether an assessee has a loss or has a profit. On the objection of the T.P.O. rejecting the allocation done by the Administrator, we find that the arrangement with the AE under the agreement demonstrates that the administrator does not have absolute discretionary power to determine inter group payment. The agreement provides that disputes, if not reasonably resolved, can be referred for arbitration. Thus, the conclusion drawn by the T.P.O. is erroneous. In our view, this cannot be a ground for rejection of PSM. The conclusion of the T.P.O. that the PSM is adopted only to camouflage the loss at the net level, is merely an allegation which, in our view, is not substantiated or demonstrated by the T.P.O. and hence is devoid of merit.
20.2. When determining as to which is the MAM, the TPO is required to primarily examine the functional profile of the assessee and the nature of the 41 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi international transaction and having undertaken such an exercise, we are of the view the "PSM" is the "MAM".
20.3. The contention of the Ld. Departmental Representative that the assessee is an E Mail service provider and that the assessee is a plug in entity, is not supported by any documentation. This submission, in our view, is not factually correct. If the assessee did not have any unique intangibles, then no client would have engaged them for transmission of any data, as the usual internet facility and e-mail facility are available free of cost. But for these unique intangibles, nobody would utilize the services of the assessee company and its associate enterprises. The claim of the assessee that it has certain technologies which maintain the secrecy and confidentiality of a communication and also ensures safe, secure and timely delivery, is having significant substance. On these facts, we come to the conclusion that the assessee does have unique intangibles in the field of data transfer and communications. 20.4. The TPO's primary objection is that "PSM" method has not been correctly applied. It is the view of the T.P.O. that Bench Marking with the help of comparables is not done while allocating residuary profits. We would deal with this issue in the later part of this order. In our view, the TPO ought not to reject the method itself when he feels that it is not correctly applied. The proper course available to him is to apply this method in the manner in which he feels it should have been applied.
20.5. The assessee in this case has adopted 'residuary profit split method'. 42 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi As explained in various commentaries, residual PSM involves:
i) Determination of routine return
ii) Allocation of residuary profits.
At the stage of determination of routine profits, as already stated, bench
marking has to be done by the assessee, with reliable external market data from uncontrolled transactions.
20.6. Coming to the allocation of residuary profits, in our view, though the Rules do suggest that benchmarking should be done with external uncontrolled transactions, we find that this is an impossibility in this case, as it is not possible to get a comparable. On a perusal of the various commentaries, we are of the view that such allocation can be done, based on how much each independent enterprise might have contributed. Relative contribution has to be determined, based on key value drivers. Bench marking at this stage is not practicable as comparables having similar, multiple, interrelated and integrated transactions, would be difficult to find. Thus, in our view, in such a situation, a harmonious interpretation of the provisions is required to make the rule workable, so as to achieve the desired result of determination of the "ALP". The secondary stage of allocation of Residuary Profits is to be done on the basis of contribution of each entity, as stated in the commentaries and Guidelines referred above, as these are generally accepted .
20.7. The argument of the Ld. Counsel of the assessee that the provisions have to be read down cannot be accepted, as law has to be interpreted as 43 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi provided in the statute. Nevertheless, to make the provisions workable, a harmonious interpretation is the requirement, as held by the Supreme Court in CIT vs. J.H.Gotla, reported in 156 ITR 985. Such harmonious interpretation, in our view, does not tantamount to misreading the provisions, or to the reading down of a provision. Both the OECD Transfer Pricing Guidelines as well as the UN Draft Method of Transfer Pricing for Developing Countries, suggest that an allocation of residual profits under PSM should be done, based on contributions by each entity.
20.8. We have already extracted the OECD Transfer Pricing Guidelines at para 17.4. At para 2.121, it is stated as follows: "In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the facts and circumstances, following the guidance as described at paragraphs 2.32 to 2.145 for splitting the combined profits.
The paragraphs read as follows.
"C.3.4. How to split the combined profits C.3.4.1. In general 2.132 : The relevance of comparable uncontrolled transactions or internal data and the criteria used to achieve an ;arm's length division of the profits depend on the facts and circumstances of the case. It is therefore not desirable to establish a prescriptive list of criteria or allocation keys. See paragraphs 2.115-2.117 for general guidance on the consistency of the determination of the splitting factors. In addition, the criteria or allocation keys used to split the profit should:
• Be reasonably independent of transfer pricing policy formulation, i.e. they should be based on objective data (e.g. sales to independent parties), not on 44 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi data relating to the remuneration of controlled transactions (e.g. sales to associated enterprises), and • Be supported by comparables data, internal data, or both.
C.3.4.2 Reliance on data from comparable uncontrolled transactions 2.133 One possible approach is to split the combined profits based on the division of profits that actually results from comparable uncontrolled transactions. Examples of possible sources of information on uncontrolled transactions that might usefully assist the determination of criteria to split the profits, depending on the facts and circumstances of the case, include joint-
venture arrangements between independent parties under which profits are shared, such as development projects in the oil and gas industry; pharmaceutical collaborations, co-marketing or co-promotion agreements; arrangements between independent music record labels and music artists; uncontrolled arrangements in the financial services sector; etc. C.3.4.3 Allocation keys 2.134 In practice, the division of the combined profits under a transactional profit split method is generally achieved using one or more allocation keys. Depending on the facts and circumstances of the case, the allocation key can be a figure (e.g. a 30%-70% split based on evidence of a similar split achieved between independent parties in comparable transactions), or a variable (e.g. relative value of participant's marketing expenditure or other possible keys as discussed below). Where more than one allocation key is used, it will also be necessary to weight the allocation keys used to determine the relative contribution that each allocation key represents to the earning of the combined profits.
2.135 In practice, allocation keys based on assets/capital (operating assets, fixed assets, intangible assets, capital employed) or costs (relative spending and/or investment in key areas such as research and development, engineering, marketing) are often used. Other allocation keys based for instance on incremental sales, headcounts (number of individuals involved in the key functions that generate value to the transaction), time spent by a certain group of employees if there is a strong correlation between the time spent and the 45 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi creation of the combined profits, number of servers, data storage, floor area of retail points, etc. may be appropriate depending on the facts and circumstances of the transactions.
Asset-based allocation keys 2.136 Asset-based or capital-based allocation keys can be used where there is a strong correlation between tangible or intangible assets or capital employed and creation of value in the context of the controlled transaction. See paragraph 2.145 for a brief discussion of splitting the combined profits by reference to capital employed. In order for an allocation key to be meaningful, it should be applied consistently to all the parties to the transaction. See paragraph 2.98 for a discussion of comparability issues in relation to asset valuation in the context of the transactional net margin method, which is also valid in the context of the transactional profit split method.
2.137 One particular circumstance where the transactional profit split method may be found to be the most appropriate method is the case where each party to the transaction contributes valuable, unique intangibles. Intangible assets pose difficult issues in relation both to their identification and to their valuation. Identification of intangibles can be difficult because not all valuable intangible assets are legally protected and registered and not all valuable intangible assets are recorded in the accounts. An essential part of a transactional profit split analysis is to identify what intangible assets are contributed by each associated enterprise to the controlled transaction and their relative value. Guidance on intangible property is found at Chapter VI of these Guidelines. See also the examples in the Annex to Chapter VI "Examples to illustrate the Transfer Pricing Guidelines on intangible property and highly uncertain valuation". Cost-based allocation keys 2.138 An allocation key based on expenses may be appropriate where it is possible to identify a strong correlation between relative expenses incurred and relative value added. For example, marketing expenses may be an appropriate key for distributors-marketers if advertising generates material marketing intangibles, e.g. in consumer goods where the value of marketing intangibles is affected by advertising. Research and development expenses may be suitable for manufacturers if they relate to the development of 46 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi significant trade intangibles such as patents. However, if, for instance, each party contributes different valuable intangibles, then it is not appropriate to use a cost-based allocation key unless cost is a reliable measure of the relative value of those intangibles. Remuneration is frequently used in situations where people functions are the primary factor in generating the combined profits. 2.139 Cost-based allocation keys have the advantage of simplicity. It is however not always the case that a strong correlation exists between relative expenses and relative value, as discussed in paragraph 6.27. One possible issue with cost- based allocation keys is that they can be very sensitive to accounting classification of costs. It is therefore necessary to clearly identify in advance what costs will be taken into account in the determination of the allocation key and to determine the allocation key consistently among the parties. Timing issues 2.140 Another important issue is the determination of the relevant period of time from which the elements of determination of the allocation key (e.g. assets, costs, or others) should be taken into account. A difficulty arises because there can be a time lag between the time when expenses are incurred and the time when value is created, and it is sometimes difficult to decide which period's expenses should be used. For example, in the case of a cost-based allocation key, using the expenditure on a single-year basis may be suitable for some cases, while in some other cases it may be more suitable to use accumulated expenditure (net of depreciation or amortization, where appropriate in the circumstances) incurred in the previous as well as the current years. Depending on the facts and circumstances of the case, this determination may have a significant effect on the allocation of profits amongst the parties. As noted at paragraphs 2.116-2.117 above, the selection of the allocation key should be appropriate to the particular circumstances of the case and provide a reliable approximation of the division of profits that would have been agreed between independent parties.
C.3.4.4 Reliance on data from the taxpayer's own operations ("internal data") 2.141 Where comparable uncontrolled transactions of sufficient reliability are lacking to support the division of the combined profits, consideration should be 47 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi given to internal data, which may provide a reliable means of establishing or testing the arm's length nature of the division of profits. The types of such internal data that are relevant will depend on the facts and circumstances of the case and should satisfy the conditions outlined in this Section and in particular at paragraphs 2.116-2.117 and 2.132. They will frequently be extracted from the taxpayers' cost accounting or financial accounting. 2.142 For instance, where an asset-based allocation key is used, it may be based on data extracted from the balance sheets of the parties to the transaction. It will often be the case that not all the assets of the taxpayers relate to the transaction at hand and that accordingly some analytical work is needed for the taxpayer to draw a "transactional" balance sheet that will be used for the application of the transactional profit split method. Similarly, where cost-based allocation keys are used that are based on data extracted from the taxpayers' profit and loss accounts, it may be necessary to draw transactional accounts that identify those expenses that are related to the controlled transaction at hand and those that should be excluded from the determination of the allocation key. The type of expenditure that is taken into account (e.g. salaries, depreciation, etc.) as well as the criteria used to determine whether a given expense is related to the transaction at hand or is rather related to other transactions of the taxpayer (e.g. to other lines of products not subject to this profit split determination) should be applied consistently to all the parties to the transaction. See also paragraph 2.98 for a discussion of valuation of assets in the context of the transactional net margin method where the net profit is weighted to assets, which is also relevant to the valuation of assets in the context of a transactional profit split where an asset- based allocation key is used.
2.143 Internal data may also be helpful where the allocation key is based on a cost accounting system, e.g. headcounts involved in some aspects of the transaction, time spent by a certain group of employees on certain tasks, number of servers, data storage, floor area of retail points, etc. 2.144 Internal data are essential to assess the values of the respective contributions of the parties to the controlled transaction. The determination of such values should rely on a functional analysis that takes into account all the economically significant functions, assets and risks contributed by the parties to 48 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi the controlled transaction. In those cases where the profit is split on the basis of an evaluation of the relative importance of the functions, assets and risks to the value added to the controlled transaction, such evaluation should be supported by reliable objective data in order to limit arbitrariness. Particular attention should be given to the identification of the relevant contributions of valuable intangibles and the assumption of significant risks and the importance, relevance and measurement of the factors which gave rise to these valuable intangibles and significant risks.
2.145 One possible approach not discussed above is to split the combined profits so that each of the associated enterprises participating in the controlled transactions earns the same rate of return on the capital it employs in that transaction. This method assumes that each participant's capital investment in the transaction is subject to a similar level of risk, so that one might expect the participants to earn similar rates of return if they were operating in the open market. However, this assumption may not be realistic. For example, it would not account for conditions in ;capital markets and could ignore other relevant aspects that would be revealed by a functional analysis and that should be taken into account in a transactional profit split."
Para 6.3.14 - Step 2: Allocation of Residual Profit (i.e. profit remaining after step
1) between the associated enterprises based on the facts and circumstances. If the residual profit is attributable to intangible property then the allocation of this profit should be based on the relative value of each enterprise's contributions of intangible property.
20.9. In the UN Transfer Pricing Manual, Chapter VI, at para 6.3.17.4, it is stated as follows.
"The PSM involves the determination of the factors that bring about the combined profit, setting a relative weight to each factor and calculating the allocation of profits between the associated enterprises. The contribution analysis is difficult to apply, because external market data that reflect how independent enterprises would allocate the profits in similar circumstances is usually not available. The first step of the residual analysis often involves the use of the TNMM to calculate a return and is not, in itself, more complicated than the typical application of TNMM. The second step is, however, an 49 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi additional step and often raises difficult additional issues relating to the valuation of intangibles.
20.10. In the text for transfer pricing regulations of US Treasury, it is given as follows.
"Allocate residual profit. The allocation of income to the controlled taxpayers' routine contributions will not reflect profits attributable to the controlled group's valuable intangible property where similar property is not owned by the uncontrolled taxpayers from which the market returns are derived. Thus, in cases where such intangibles are present there normally will be an unallocated residual profit after the allocation of income described in paragraph(c)(3)(i)(A) of this section. Under this second step, the residual profit generally should be divided among the controlled taxpayers based upon the relative value of their contributions of intangible property to the relevant business activity that was not accounted for as a routine contribution. The relative value of the intangible property contributed by each taxpayer may be measured by external market benchmarks that reflect the fair market value of such intangible property. Alternatively, the relative value of intangible contributions may be estimated by the capitalized cost of developing the intangibles and all related improvements and updates, less an appropriate amount of amortization based on the useful life of each intangible. Finally, if the intangible development expenditures of the parties are relatively constant over time and the useful life of the intangible property of all parties is approximately the same, the amount of actual expenditures in recent years may be used to estimate the relative value of intangible contributions. If the intangible property contributed by one of the controlled taxpayers is also used in other business activities(such as transactions with other controlled taxpayers), an appropriate allocation of the value of the intangibles must be made among all the business activities in which it is used."
20.11. A perusal of the above demonstrates that there is a general consensus on the principles of allocation of residual surplus. Hence, we are inclined to accept the following submissions of the assessee. 50 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi "1. It is an admitted fact that as per rule 10B(1)(d) of the IT Rules, India prescribes that an assessee can adopt -
a. either a contribution PSM, namely where the entire systems profits are split amongst the various AEs, who are parties to the transactions in question; or b. a residual PSM, namely where each of the AEs, who are parties to the transactions in question, are first assigned routine/ basic returns for the routine functions performed by them; and thereafter, the residual profits are split amongst the AEs, however, in a manner that whether or not an assessee adopts a contribution PSM or a residual PSM, the profits, would need to be split amongst the various AEs, who are parties to the transactions in question, on the basis of reliable external market data, which indicates how unrelated parties would have split such profits in similar circumstances.
2. In other words, as per rule 10B(l)(d) of the IT Rules, a contribution or residual PSM would need to be supplemented by a comparable PSM.
3. The terminologies, namely "contribution PSM", "residual PSM" and "comparable PSM", have not been used in the IT Act or Rules, however, they can be found in the TP guidelines of OECD [paragraphs 2.108 to 2.1491 and UN [paragraphs 6.3.13.1 to 6.3.181, by referring to the similarity of the manner of application of the said methods, as contained in the OECD and UN TP guidelines; and also in the IT Rules.
4. Having said that, PSM prescribed by the IT Rules of India is quite unique, as compared to both OECD and UN TP guidelines, namely that both OECD and UN provide flexibility to the taxpayer to adopt any of the following sub-methods under the overall PSM, namely contribution PSM, residual PSM or comparable PSM, whereas, the Indian IT Rules mandatorily require a taxpayer to adopt a comparable PSM to supplement either a contribution or residual PSM.
5. Such prescription to mandatorily use comparable PSM to split entrepreneurial profits, by the Indian TP regulations, actually would make the PSM virtually redundant in most cases, since, it is not possible to obtain reliable market data on third party behavior in the matter of splitting profits, except for in some rare cases of joint venture arrangements. However, in cases of transactions involving either 51 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi contribution or exploitation of intangibles by all the parties to the transaction or where such transactions are extremely interrelated, of the types as in the case of the appellant, where knowledge of third party behavior is impossible to possess, but where the case otherwise deserves the treatment of PSM, then the prescription to mandatorily use a comparable PSM would render the whole machinery of PSM under the Indian TP regulations a nullity & impossible to be implemented.
6. This is exactly what the UN has provided in its TP guidelines relating to comparable PSM, namely that such method is seldom used, since reliable external market date on third party behavior in the matter of splitting profits are often not available [paragraph 6.3.15 of UN TP guidelines].
7. Describing the comparable PSM, the OECD held in its guidelines that external data for comparable PSM can be available in cases of joint venture agreements between independent parties under which profits are shared, such as development projects in the oil and gas industry; pharmaceutical collaborations; co-marketing or co-promotion agreements; arrangements between independent music record labels and music artists; uncontrolled arrangements in the financial services sector; etc [paragraph 2.133 of the OECD TP guidelines].
8. Thus, typically, comparable PSM can be applied in industries, where joint venture arrangements exist. However, for industries, like the one of telecommunication connectivity services carried on by the Equant or Global One Group, where the key intangible used by the Group is the proprietary network, without which the services cannot be rendered; and thus existence of joint venture arrangements between third parties is not conceivable, the application of comparable PSM would be an impossibility.
9. The OECD further acknowledges that where comparable uncontrolled transactions of sufficient reliability are lacking to support the division of the combined profits, consideration should be given to internal data, which may provide a reliable means of establishing or testing the arm's length nature of the division of profits, meaning that resort to either contribution or residual PSM may be made, without the same having to pass through the compulsory rigors of comparable PSM [paragraph 2.141 of the OECD TP guidelines].
52 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi
10. Further, many of the global TP specialists have commented on the lack of reliable third party data, which often renders comparable PSM impossible to apply for splitting profits amongst related parties, except for in the limited cases of joint venture arrangements and determination of royalty, where again, the split of profits between the licensor and the licensee can be discernible on the face of accounts. Extracts from a few of the said articles/ books are reproduced below for ease of reference - a. J.P. Warner and H.B. McCawley, Transfer Pricing: The Code and the Regulations, note 70, at A-144; and T. Horst. Profit Split Methods 0,60 Tax Notes (1993), at 335 - "The comparable profit split method is rarely applied, as information on comparable reference transactions will not normally be available."
b. Transfer Pricing and Corporate Taxation: Problems, Practical Implications - Chapter 3.5 - page 31 - Authored by Elizabeth A. King - " .... Practitioners rarely use comparable profit split method, because pairs of sufficiently comparable companies can rarely be found." c. Practical Guide to U.S. Transfer Pricing, Robert T. Cole, Chapter 10, Profit Split Method authored by Harlow N. Higinbotham; Page number 10- 52: - "Numerous commentators have cited difficulties in identifying and documenting information on comparable independent transactions as potentially insurmountable obstacle to the practical realization of CPSM. This pessimistic viewpoint overlooks a relatively voluminous body of evidence and experience in the intellectual property area where such calculations are routinely, if somewhat roughly, applied in valuing license transactions".
d. Transfer Pricing Rules and Compliance Handbook - Page number 33
- 0.2 Comparable Profit Split Method - Authored by Marc M. Levey, C. Wrappe Steven and Steven C. Wrappe - " .... The use of comparable profit split method will be limited because it will typically be difficult to find comparable companies engaged in transactions that are similar to those of both the buyer and the seller, and data delineating how the independent parties shared the combined profits from a comparable transaction rarely exists. Finding a comparable transaction is made more difficult because the regulations provide that the comparability degree of similarity not only of the function, risk, but also of contractual terms."
11. In view of the above discussions emanating from the OECD and UN TP guidelines; and also commentaries of several transfer pricing experts, it 53 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi is evident that comparable PSM is rarely used internationally in view of lack of reliable external data with respect to third party behavior to split profits; and OECD and UN clearly give taxpayers an option to adopt anyone of the three sub- methods under the overall PSM, namely contribution PSM, residual P'SM and comparable PSM, without requiring the contribution and residual PSMs to mandatorily pass through the sanity of comparable PSM, being a mandate given under the Indian TP regulations, in the form of rule10OB(I)(d) of the IT Rules. Thus, such compulsory mandate would render the entire mechanism PSM unworkable in India, even in the most deserving of cases.
12. It is a golden and accepted rule of jurisprudence that an interpretation, which makes a statute or rule unworkable or impossible to be complied with, should be avoided; and recourse need to have to the interpretation, which would make the statute or rule workable and also subserve the purpose for which it has been enacted. In this connection, reference is invited to the ruling of the Hon'ble Supreme Court in the case of Superintendent of Taxes vs. Onkarmal Nathumal Trust [AIR 1975 SC 2065], where it has been held that "The law in its most positive and peremptory injunctions, is understood to disclaim, as it does in its general aphorisms, all intention of compelling performance of that which is impossible" ... where the law creates a duty or charge, and the party is disabled to perform it, without any default in him, and has no remedy over, there the law will in general excuse him; and though impossibility of performance is in general no excuse for not performing an obligation which a party has expressly undertaken by contract, yet when the obligation is one implied by law, impossibility of performance is a good excuse.
13. The requirement contained in rule 10B(1)(d) of the IT Rules of mandatory adoption of comparable PSM in all cases of PSM is a lacuna, which renders the entire scheme or mechanism of PSM virtually redundant, otiose and impossible to comply with even in the most deserving of cases, namely where there can be no doubt that the AEs, who are parties to the transactions in question, contribute and exploit non- routine or unique intangibles, or the transactions are so interrelated that they cannot be evaluated separately for the purposes of determining the ALP thereof.
14. Now, it is submitted that such lacuna is curable even by maintaining, and without disturbing the overall spirit and concept of PSM, as enshrined in rule 10B(1)(d) of IT Rules, and as also understood in the OECD and UN 54 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi TP guidelines, through interpreting rule 10B(1)(d) in a manner that the same provides an option and not compulsory mandate to apply a comparable PSM in a case where reliable external data to gauge third party behavior is impossible to be obtained.
15. In this connection, reference is invited to the ruling of the Hon'ble SC rendered in the case of M.Pentiah and others vs. Muddala Veeramallappa and others (1961 AIR 1107), where the Hon'ble Court quoted with approval, the famous words on interpretation of statutes said by Lord Denning in the case of Seaford Court Estates Ltd. Vs. Asher(1), namely :
"When a defect appears a Judge cannot simply fold his hands and blame the draftsman. He must set to work on the constructive task of finding the intention of Parliament.............. and then he must supplement the written word so as to give "force and life" to the intention of the legislature. ..........A judge should ask himself the question how, if the makers of the Act had themselves come across this ruck in the texture of it, they would have straightened it out? He must then do as they would have done. A Judge must not alter the material of which the Act is woven, but he can and should iron out the creases."
16. In other words, in case the Hon'ble Tribunal perceives that the requirement contained in rule 10B(1)(d) of the IT Rules of mandatory adoption of comparable PSM in all cases of PSM actually renders the entire scheme or mechanism of PSM virtually redundant, otiose and impossible to comply with, even in the most deserving of cases, namely where there can be no doubt that the AEs, who are parties to the transactions in question, contribute and exploit non routine or unique intangibles, or the transactions are so inter related that they cannot be evaluated separately for the purpose of determining the ALP thereof, however where reliable external data to gauge third party behavior is impossible to be obtained, then the requirement for adoption of comparable PSM should be dispensed with, and the assessee should be given an option to adopt a residual or contribution PSM, when such sub-methods of PSM are otherwise accepted globally, both under the OECD and UN TP guidelines, and also in rule 10B(1)(d) itself.
17. It is submitted that applying such an interpretation would not tantamount to altering the overall mechanism of PSM under the Indian TP regulations, but would merely supplement life and force into rule 10B(1)(d) of the IT Rules, in order to make the mechanism of PSM actually workable in India, and not rendered otiose on the ground of impossibility of performance."
55 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi 20.12. In view of the above discussion, we are of the considered opinion that the TPO, should determine the ALP by adopting residual PSM as the MAM and by allocating residual profits based on the relative value of each enterprise's contribution, as suggested in various commentaries. 20.13. In any event, the legislature has introduced Rule 10AB by the IT(Sixth Amendment) Rules, 2012 w.e.f. 1.4.2012 under the sub head "Other method of determination of ALP". This is extracted for ready reference.
"Rule 10AB: For the purposes of clause (f) of sub section(1) of section 92C, the other method for determination of the arm's length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts."
While introducing the Amendment the CBDT Circular is referred to below.
"The Central Board of Direct Taxes, vide Notification No.18/2012 (F.No.142/5/2012-TLP) dt. 25th May,2012 introduced the sixth method in TP, referred to as the "Other Method," with effect from 1st April,2012, i.e. on and from the Assessment Year 2012-13, through inserting rule 10AB, read with clause (f) of rule 10B(1) of the IT Rules. The said "Other Method" is like an omnibus or residual one, in the sense that it refers to any method, which takes into account the price charged or paid or which would have been charged or paid, for similar uncontrolled transactions, with or between non-AEs, would have been charged or paid, for similar uncontrolled transactions, with or between non AEs, under similar circumstances, considering all the relevant facts. Thus, the said "Other Method" would ideally operate where none of the methods specified under the IT Act and Rules would apply, with reference to the descriptions/definitions provided in rule 10B(1) of the IT Rules, yet there is a compelling need to arrive at the ALP of any transaction between AEs, as per the requirements of the TP regulations, couched in Chapter X of the IT Act."56 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi Though the note does not indicate much as to the purpose, it can be seen that the purpose and objective of introduction of this rule is to determine the "arm's length price", whenever the methods suggested result in practical difficulties by adopting generally accepted methods which are not specifically listed. It is a procedural provision aimed at arriving at the "ALP". Thus, in our , it is retroactive. "ALP", ideally, should be the same, in the previous years, as in the subsequent years when the facts and circumstances are the same, irrespective of the method adopted for arriving at the same. One cannot be heard saying that the "ALP" arrived by one methord cannot be acceptable for the earlier year as that method was not notified by the CBDT. In our view, "Arms Length Price"
should be the same, with minor variations. When a new method is allowed, with the objective of enabling determination of the proper ALP, in our comprehension, such a provision operates retroactively, and can be used to determine the ALP in the earlier assessment years also. When the aim and object of introducing a Rule allowing the assessee to adopt any other method for determining the ALP, by introducing S.10AB, is to remove unintended practical difficulties and only to enable proper determination of the ALP, the Rule, in our view, has to be considered as retroactive and, thus, retrospective.
20.14. The Ld.Counsel for the assessee has relied on the decision of I.T.A.T. Chennai Bench in the case of Acendas India P.Ltd. vs. DCIT in ITA 1736/Mds/2011 and the decision of the Bangalore Bench of the Tribunal in the case of Tally Solutions P.Ltd. vs. DCIT in ITA 1235/Bng/2010, for the proposition that suitable adjustments and methodology prescribed for evaluation of an international transaction are permissible and that the prescribed methods may not be rigidly followed, as was 57 ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012 A.Ys. 2007-08 / 2008-09 Global One India P.Ltd., New Delhi done in those cases.. He has also relied on the decision of Hon'ble Supreme Court in the case of Allied Motors P.Ltd. vs. CIT, 224 ITR 677(SC).
20.15. These decisions support the contentions of the assessee. Thus, we hold that Rule 10AB can be applied for the impugned AYs also, for determining the ALP .
21. In view of the above discussion, this issue is remitted to the file of the AO for fresh adjudication in line with the observations made by this Bench on this issue. In the result, this ground of transfer pricing adjustment for both the AYs is set aside to the file of the Assessing Officer.
22. In the result, the appeals for both the Assessment Years are allowed in part.
Order pronounced in the Open Court on 15th April,2014.
Sd/- Sd/-
(A.D. JAIN) (J.SUDHAKAR REDDY)
JUDICIAL MEMBER ACCOUNTANT MEMBER
Dated: the 15th April, 2014
*manga
58
ITA Nos. 5571/Del/2011 & ITA 5896/Del/2012
A.Ys. 2007-08 / 2008-09
Global One India P.Ltd., New Delhi
Copy of the Order forwarded to:
1. Appellant; 2.Respondent; 3.CIT; 4.CIT(A); 5.DR; 6.Guard File By Order Asst. Registrar 59