Income Tax Appellate Tribunal - Mumbai
Serdia Pharmaceuticals (India) Pvt. ... vs Assessee
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08
Assessment year: 2002-03, 2003-04 and 2004-05
Page 1 of 71
IN THE INCOME TAX APPELLATE TRIBUNAL
MUMBAI L BENCH, MUMBAI
[Coram : N V Vasudevan JM and Pramod Kumar AM ]
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08
Assessment years: 2002-03, 2003-04 and 2004-05
Serdia Pharmaceuticals
(India) Private Limited ................................ Appellant
Vs.
Assistant Commissioner of Income Tax
Circle 7(2), Mumbai 400020 ........................... Respondent
Appearances
Mukesh Butani, Sriram Seshadri, and Nishtha Dhawan, for the appellant
Narendra Singh, for the respondent
O R D E R
Per Pramod Kumar:
1. In this bunch of appeals, the taxpayer has challenged correctness of Commissioner (Appeals)'s upholding following arm's length price (ALP) adjustments in the value of imports, of active pharmaceutical ingredients (APIs), by the taxpayer:
API Assessment year ALP adjustment Trimetazidine 2002-03 1,46,43,552 Indapamide 2002-03 48,89,856 Trimetazidine 2003-04 2,74,85,204 Indapamide 2003-04 47,06,566 Glicazide 2003-04 1,55,31,833 Trimetazidine 2004-05 3,60,21,884 Indapamide 2004-05 53,25,367 Glicazide 2004-05 2,12,49,394 Aggregate of impugned ALP adjustments 12,98,53,656
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 2 of 71
2. The taxpayer, i.e. Serdia Pharmaceuticals India Private Limited (Serdia, in short), is a company incorporated in India and 74% of its share capital is held by Servier International BV (Servier BV, in short), a company incorporated in the Netherlands, and the remaining 26% of its share capital is held by a Mauritius based company by the name of Serdia (Mauritius) Limited. Servier BV, in turn, is a subsidiary of Les Laboratoires Servier France (Servier France, in short), a well-known pharmaceutical company which is said to have its presence in more than 140 countries worldwide, including in Egypt by way of a subsidiary in the name of Servier Egypt Industries Ltd Egypt (Servier Egypt, in short).
3. Serdia is enagegd in the business of producing drugs mainly in the field of anti-hypertension and metabolism. It produces and markets drugs in finished dosage forms (FDFs), which is what a drug is called when it is ready for end use by the consumer, and in the process of producing these FDFs, the assessee imports active pharmaceutical ingredient (API) from Servier France and Servier Egypt.
4. Pharmaceutical products are manufactured in two basic stages, referred to as primary manufacturing and secondary manufacturing. Primary manufacturing is making the active pharmaceutical ingredient for a pharmaceutical product. Secondary manufacturing includes the process of putting the active ingredient into a delivery mechanism or packaging, such as a tablet, liquid, or gel. An active pharmaceutical ingredient (API) is thus key element and substance in a pharmaceutical drug, and it is this API which contains medicinal properties. A finished dosage form of a drug is traditionally composed of two things- the API, which is the drug itself; and an excipient, which is the substance of the tablet, or the liquid the API is suspended in, or other material that is pharmaceutically inactive or inert. The excipients are thus kind of a vehicle for an API, which are pharmaceutically inert, and represent all the ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 3 of 71 constituents of an FDF which lack medicinal properties. It is thus nothing more than unavoidable excess baggage with the API, but essential in the sense that it is a vehicle for the API. A drug, as FDF, may contain one or more APIs, and the drugs are chosen primarily for their active ingredients.
5. An API may be a patented or generic. A patented API can be produced by the patent holder, and this monopoly allows the pharmaceutical company, which developed the drug, to sell it in a monopoly market and thus allows the company to recoup the cost of developing that particular drug by selling the drug in monopolistic conditions. The patents, however, do not last for ever, and the patents have geographical limitations too. Once patent on an API expires or is not valid in a particular geographical location, any pharmaceutical company can manufacture and sell that API. The API then becomes generic in nature, and the expiration, or inapplicability, of the patent, ends the monopoly of the patent holder.
6. Serdia is engaged in secondary manufacturing process in the sense it does import the active pharmaceutical ingredients, puts them in a delivery mechanism by combining them with excipients, and thus produce the FDF, i.e. finished dosage form, for consumption by the end user. The FDF is produced and marketed by Serdia, while the API is imported from its AEs. So far as the dispute in the first year, i.e. assessment year 2002-03, is concerned, the FDFs produced by Serdia are Flavedon 20, Flavedon MR (in which Trimetazidine is used as API) and Natrilix and Natrilix SR (in which Indapamide is used as API). In the next two years, i.e. assessment years 2003-04 and 2004-05, the dispute extends to FDF Diamicron and Diamacron MR, which has Gliclazide as API.
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 4 of 71
7. The issue in dispute is the arm's length price of the above three APIs, i.e. Trimetazidine, Indapamide and Gliclazide, that Serdia is importing from its AEs - namely Servier France and Servier Egypt.
8. During the course of related assessment proceedings, the Assessing Officer made references to the Transfer Pricing Officer (TPO, in short) under section 92CA(2) for determination of arm's- length price for the transactions that Serdia entered into with its AEs. As far as assessment year 2002-03 is concerned, the TPO received the reference on 20 th January 2004. The TPO noted that the Serdia has determined the ALP by adopting TNMM, with operating margin as a percentage of net sales, as most appropriate method. The comparable companies, as selected by Serdia, showed operating margins ranging between (-) 13.29% to 19.07%, and the arithmetic mean of margin of comparable companies was found to be 6.67%. The claim of the assessee was that since its operating profit at 8.76% on net sales was higher than 6.67%, its international transactions are at arm's-length price. The TPO noted that the assessee had purchased, from its AEs, Indapamide at Rs 1,89,456 per kg and Trimetazidine at Rs 52,546 per kg. In the course of proceedings before the TPO, it was submitted by the taxpayer that the import price of APIs is, "determined based on the price proposed by the overseas entity and the assessee's judgment as regards its ability to manufacture and market the finished formulations in India using the imported raw material to generate revenues and reasonable profits", that the AEs do not sell these APIs to any independent enterprises in India and that the assessee is not aware of the prices at which these APIs are sold by the related AEs to independent enterprises abroad. The assessee, however, furnished details of prices at which these AEs had sent to other AEs in Spain, Poland, Morocco and Pakistan which showed prices ranging between € (Euros) 12,487 per kg to €16,007 per kg, so far as Indapamide is concerned, and prices ranging between €1,485 per kg to €2,693 per kg, so far as Trimetazidine is concerned. The TPO further noted that, as per ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 5 of 71 the information furnished by the assessee, following products compete with the assessee' s products :
Sl Brand name of Name of API Dosage Brand name of
No assessee's competitor's FDF
formulations
1. Flavedon 20/ Trimetazidine 20 mg/ Trivedon 20 - Cipla
Flavedon MR 35 mg Crytoguard -
Nicholas
Carvidon -
Microlabs
Cardimax - USV
Metagaurd - IPCA
2 Natrilix Indapamide 2.5 Lorvas - Torrent
Natrilix SR mg/
1.5 mg
9. On the basis of these inputs from the assessee, the TPO collected information on the prices at which these APIs are purchased by other producers of the competing FDFs. The TPO noted that while Indapamide was imported by assessee's competitor from Italy at the price of Rs 40,375 per kg , the assessee had imported by the same, from its AE, at the price of Rs 1,89,456 per kg. The TPO further noted that while the assessee had imported Trimetazidine from its Servier Egypt at the price of Rs 52,546 per kg, the same drug was sold by other vendors at much lower rates of Rs 8,150 per kg (Nivedita Chemicals Pvt Ltd), Rs 8,625 per kg (Sharon Pharmachem Limited), Rs 10,558 per kg (Orion) and Rs 11,000 per kg (Trichem).
10. As for the comparability of these prices of the API, while the assessee did not seem to have much to say so far as Indapamide is concerned, beyond pointing out that the assessee is market leader, with 68.9% market share, in respect of the FDF made of Indapamide , the assessee did seriously challenge the quality of Trimetazidine. The assessee also contended that both the products of the assessee are patented in Europe and USA, that these products are market leaders even ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 6 of 71 as the products are sold at higher prices and that all these factors put together show that the APIs used by the assessee are better than that used by its competitors. The assessee made elaborate submissions to demonstrate that the quality of Trimetazidine manufactured in India, is not at all comparable with the quality of Trimetazidine imported by the assessee from its AE Servier Egypt. It was contended that purity levels of Trimetazidine manufactured in India are much lower than purity level of Trimetazidine imported by the assessee, the shelf life of assessee's API is much longer, the effect of assessee's API last longer than the effect of the same API manufactured in India, that the efficacy of assessee's API is proven since it is launched after clinical trials as against Trimetazidine manufactured in India in respect of which no clinical trials are held and as such its safety and efficacy is yet to be established, and that the assessee also receives technical assistance in marketing its products when it buys API from its AE. For all these reasons, higher price paid by the assessee was sought to be justified. It was further mentioned that the assessee is market leader in Flavedon, i.e. FDF with Trimetazidine as API, and its market share is 35.44% as against 21.51 % market share held by Trivedon, marketed by Cipla.
11. The TPO was of the view that given the fact that the APIs purchased by the assessee from its AEs abroad are not a unique items in the sense other pharmaceutical companies are also purchasing the same APIs, though from different vendors, and having regard to the nature of goods, Comparable Uncontrolled Price (CUP) method is the most appropriate method to determine ALP on the facts of this case and that the CUP method "is most direct and reliable method to determine the ALP". As regards Transactional Net Margin Method (TNMM) applied by the assessee, the TPO was of the considered view that "TNMM applied by the assessee is only a method of last resort used when it is not possible to apply any of the other methods" as "this method is not reliable because profits are affected by so many other aspects besides the product prices".
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 7 of 71 On the basis of this reasoning, the TPO rejected the TNMM applied by the assessee and proceeded to compute the ALP on the basis of CUP method.
12. As regards CUP of Indapamide, the TPO noted the CUP of Rs 40,375 per kg and the fact that the assessee has not challenged the said quality of the API beyond in general and vague manner. Accordingly, rate of Rs 40,375 per kg was adopted as against the rate of Rs 1,89,456 which was paid by the assessee to Servier France. The price paid to the AE was thus more than 4.5 times the ALP of the Indapamide.
13. As regards CUP of Trimetazidine, the TPO noted that the highest CUP, as per information gathered by the assessee - which was duly confronted to the assessee, was Rs 11,000 i.e. of Trimetazidine supplied by Nivedita Chemicals Pvt Ltd. Since the assessee had challenged the purity standards of the Trimetazidine manufactured by Nivedita, the TPO made two adjustments - Rs 4,850 per kg for differences in quality norms, based on the differences in prices in British Pharmacopoeia quality standards vis-à-vis Japanese Pharmacopoeia quality standards, and a further Rs 5,000 per kg for any variations in purity standards. The adjusted CUP was thus computed at Rs 20,850 ( i.e. Rs 11,000 + Rs 4,850 + Rs 5,000), as against price of Rs 52,546 per kg paid by the assessee to its AE for imports of Trimetazidine. The price paid to the AE was thus more than 2.5 times the ALP, even after making all these adjustments, of the Indapamide.
14. The adjustments in respect of the above two APIs, i.e. Trimetazidine and Indapamide, were also made in the subsequent two years as well. There are variations in the figures but in principle, as learned representatives agree, the adjustments were of the same nature and for the same reasons. There is no variations in material facts, and, therefore, for the sake of brevity, we need not set out details for those two years. As learned representatives have agreed, whatever is decided ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 8 of 71 in the first year, i.e. assessment year 2002-03, will also follow in the two subsequent years before us, i.e. 2003-04 and 2004-05.
15. In the assessment year 2003-04 and 2004-05, however , the ALP adjustments were also made in respect of one more API, i.e. Glicazide, imported by the assessee. ALP adjustments were made in respect of imports of Glicazide as well.
16. Aggrieved, assessee carried the matter in appeal before the CIT(A) but without any success. In the appellate proceedings, learned CIT(A) called for Assessing Officer's remand report on submissions made by the assessee. As for the internal CUP inputs by way of sale instances by Servier France to unrelated parties in other countries, the Assessing Officer opposed the same, stated that these evidences were not even referred to in the transfer pricing study or before the auditors, urged the CIT(A) to treat the same as inadmissible 'additional evidences', and argued that an entirely new case is being made out at the appellate stage. On merits of these inputs, it was contended that, in any event, these internal CUP inputs are with respect of different markets where competition level and purchasing power levels are different, and in respect of which the assessee has not furnished sufficient details. As regards the submissions on variations in quality standards between the APIs imported by the assessee vis-à-vis APIs manufactured by the generic drug manufacturers, the Assessing Officer rejected the alleged variations and observed that even if comparable products are not exactly the same, the variations have been adequately adjusted for. The Assessing Officer also noted that, as evident from the correspondence exchanged by the assessee with Deputy Commissioner of Customs, GATT Valuation Cell, Mumbai, the assessee has himself accepted that 'increased market competition in India has resulted in overall reduction in prices of their selling price of formulation manufactured by them in India" and that " in order to the market share in India, their suppliers ( i.e. AEs supplying the ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 9 of 71 APIs) have agreed to re negotiate to sell the bulk drug at reduced price by affecting necessary changes to the price list applicable for India". These statements, according to the Assessing Officer, clearly establish that the prices at which the transactions have taken place with the AEs are actually governed by the selling prices of the FDFs and not the market forces regarding the API itself. The remand report thus reinforced the stand taken at the assessment stage. The elaborate submissions made by the assessee, against the stand taken by the TPO at the assessment and the remand stage, did not impress the Assessing Officer. While rejecting the submissions made by the assessee for the assessment year 2002-03, which has been followed in the subsequent years as well, learned CIT(A) has, inter alia, observed as follows:
The appellant has not given any cogent reasons as to why the TNM method is applicable to its case. In fact on page 16 of the E&Y report on Transfer Pricing, it has been stated that the TNM approach has been followed, based on the hypothesis that the since operating margins earned from the appellant's manufacturing and marketing are on an arm's length basis, then it must be assumed that the underlying payments to the AEs for imports of APIs too are on an arm's length basis. This assumption is wholly irrational and otiose. Just because the sales are at an arm's length basis, it cannot be said that the purchase too must therefore be at an arm's length basis. Such an assumption obliterates the very need for transfer pricing regulation. Further the contention of the appellant in the said report that the above hypothesis of arm's length transaction is supported by the fact that the cost of the imported APIs forms a significant component of the total cost of manufacture of FDFs by the appellant is also wholly irrelevant and does not in any manner support the application of the TNM method here. It has also not been established by the appellant as to how its net margins realized by it from the international transactions entered into with AEs are to be computed in relation to costs incurred or sales affected. I therefore uphold the stand of the ACIT-TP in rejecting the application of the TNM method, in respect of the import of Trimetazidine and Indapamide from its AEs.
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 10 of 71 The transactions between the appellant and its AEs for the import of the APIs were controlled transactions, which need to be compared with uncontrolled transactions to determine the arm's length price. The arm's length price is determined by comparing the results of uncontrolled comparable circumstances. The CUP method focuses more on the market price of the product when compared to the other methods, which focus on the functions performed by each party. An uncontrolled transaction shall be considered to be comparable to an international transaction if-
a. None of the differences (if any) between the transections being compared or between the enterprises entering into such transaction are likely to materially affect the price or cost charged or paid in, or the profit arising from such transactions in the open market; or b. Reasonably accurate adjustments can be made to eliminate the material effects of such difference. Then OECD guidelines at para 1.19 cite a number of features that may be relevant in comparing two products 'Characteristics that may be important to consider include the following in case of transfer of tangible property, the physical features of the property, its quality and reliability and the availability and volume of supply.
The instances cited by the ACIT-TP in respect of Trimetazidine and Indapamide, imported by certain other companies are found to be comparable, for the following reasons:-
a. Except for some internal studies, which are not of any independent or statutory authority, the appellant has not given any authoritative and unchallengeable data or document, to establish the superiority or purity better quality of the APIs imported by it, as compared to the instances cited by the ACIT-TP.
b. The differences in efficacy of the appellant's FDFs are compared with others too are not established by an independent and authoritative data.
c. The appellant has been unable to give contractual data in respect of the said APIs supplied by its AEs to third parties on comparable terms and circumstances, so as to establish that its own ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 11 of 71 international transactions with its AEs in this regard were on an arm's length basis.
d. The appellant's additional advantages, derived from its AEs in terms of manufacturing and marketing assistance by importing the products are not related to product imports in ordinary circumstances, but are actually technical and managerial services received for which normally royalty and fees is paid by a party. Perhaps the cost of such services which should have been added to the cost of the product, so as to keep the profits thereunder away from the domain of Indian taxation.
The law related to transfer pricing in India is of recent vintage and the Indian scene is bereft of any authoritative judgements. It is evident here to refer to a judgement of the US court (Bausch & Lomb Inc., Reference No.89-4156 dated 14.5.92), where it was held that uncontrolled sales are considered comparable to controlled sales if the physical property and circumstances involved in the uncontrolled sales are identical to the physical property and circumstances involved in the controlled sales, or if such properties and circumstances are so nearly identical that any differences either have no effect on price or such differences can be reflected by a reasonable number of adjustments to the price of uncontrolled sales. In a recent judgement of the Korean Supreme court, reported by K.R. Sekar in his book 'Transfer Pricing-Law and Practice', it was held that just one comparable instance is sufficient for applying the CUP method. For reasons stated above, I, therefore uphold the application of the CUP method, for determining the transfer pricing adjustment, for the import of Trimetazidine and Indapamide, by the appellant from its AEs. The ACIT-TP in the case of import of Trimetazidine, has allowed an adhoc addition of Rs.4850 per kg for differences in pharmacopoeias standards to the base price of Rs.11000 per kg under the CUP method. She has also allowed an adjustment of Rs.5000 per kg on account of the appellant's contention n for superior quality of Trimetazidine imported by the appellant, The assessing officer has stated that the appellant has failed to establish the superiority of the purity of Trimetazidine purchased by the appellant from its AE's, except referring to some internal studies of the appellant which cannot be relied upon, the allow ace of Rs.5000 per kilogram by the ACIT-TP towards purity/superiority difference is thus not supported by evidence. In the interest of ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 12 of 71 reasonableness and justice, I do not wish to reject the adjustment of Rs.5000 per kg as above and uphold the computation of transfer pricing adjustment of Rs.19533402 made by the assessing officer based on the order of the ACIT-TP.
17. Aggrieved by the stand so taken by the learned Commissioner (Appeals), the assessee is not satisfied and is in appeal before us. The assessee has raised several grounds of appeal which are no more than arguments in support of its short main grievance that on the facts and in the circumstances of the case, the CIT(A) erred in upholding the arm's length price adjustments made in the price of APIs purchased by the assessee from its associated enterprises. For ready reference, however, related grounds of appeal for the assessment year 2002-03 are reproduced below:
1. The learned CIT(A) has erred in upholding the addition of Rs.19,533,408 made by the ACIT pursuant to the order of the learned ACIT(Transfer pricing) to the total income of the appellant on account of computing the arm's length price relating to the international transaction pertaining to import of active pharmaceutical ingredients(ATP) namely, Trimetazidine and Indapamide, from associated enterprises.
2. The learned CIT(A) has erred in upholding the non-acceptance of Transactional Net Margin Method(TNMM) adopted by the appellant for determination of its arm's length price in connection with its international transaction relating to import of raw materials (Trimetazidine and Indpamide) from its associated enterprises. Your appellant submits that TNMM has been considered as the most appropriate method as per Rule 10C of the Income tax Rules 1962 and is a recognised method in accordance with law and accordingly ought to have been accepted in the facts of the case.
3. Your appellant submits that as provided under paragraph 55.11 of CBDT circular number 14 of 2001, it has discharged the primary onus to determine the arm's length price by applying TNMM as the most appropriate method. Accordingly, your appellant submits that the learned CIT (A) has erred in ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 13 of 71 upholding non-acceptance of the TNMM adopted by the appellant.
4. The learned CIT (A) has erred in stating that the appellant has not given any cogent reasons as to why TNMM should be applicable to its case. The findings of the learned CIT (A) are erroneous and ought to be set aside.
5. The learned CIT(A) has erred in upholding the adoption of comparable uncontrolled price (CUP) method by considering the prices of non-similar APIs available locally for determining the arm's length price in respect of appellant's international transaction relating to import of trimetazidine and indapamide.
Your appellant submits that the invocation of CUP method is solely at instance of the AO and the same is erroneous in the facts of this case and ought to be set aside.,
6. The learned CIT(A) has erred in upholding the applicability of the CUP method based on the information not available to the appellant at the time of undertaking its transfer pricing obligations in law and has also further erred in relying on transactions not undertaken during assessment year 2002-03. Your appellant submits that the above renders the application of CUP method contrary to law, erroneous and ought to be set aside.
7. The learned CIT(A) has erred in confirming the addition of Rs.19,533,408 by relying on transactions gathered by the Income tax department without furnishing to the appellant full details/information regarding the transactions in order to enable the appellant suitable opportunity to the Income Tax Rules, 1962 based on inaccurate particulars, granting inadequate opportunity for rebuttal and ought not to be relied upon.
8. The learned CIT(A) has erred in relying upon data obtained from other companies without producing the concerned officers in the other companies for cross-examination in order to determine that the transactions are comparable. Your appellant therefore prays that the addition be deleted, ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 14 of 71
9. The learned CIT(A) has erred in disregarding prices at which he appellant's associated enterprise has sold the two APIs, viz, Trimetazidine and Indapamide to unrelated parties, which are identical to the two APIs sold by the appellant's associated enterprise to the appellant. Your appellant submits that even if the CUP method is to be applied, the above data shows that no addition is required in your appellant's case and prays that the addition be deleted.
10. The learned CIT (A) has erred in not considering the order passed by Dy. Commissioner of Custom, GAT valuation cell, Mumbai accepting the import prices of the APIs imported by Serdia from its associated enterprises, including, inter alia, Trimetazidine and Indapamide, to be at arm's length. Your appellant submits that the above further proves that the transaction undertaken by the appellant with its associated enterprises is at arm's length and hence prays that the addition be deleted.
11. The learned CIT (A) has erred in not considering the results of the tests conducted by independent third parties on the quality of the APIs imported by the appellant and the APIs available in the local markets. Your appellant submits that the above further proves that the transaction undertaken by the appellant with its associated enterprises is at arm's length and hence prays that the addition be deleted.
12. The learned CIT (A) has erred in not considering the difference that the additional assistance obtained by the appellant by importing the products are not received by the local suppliers of the APIs and hence the APIs used for application of the CUP method by the learned ACIT-TP are not comparable at all to the APIs imported by the appellant. Your appellant submits that the above further proves that the transaction undertaken by the appellant with its associated enterprises is at arm's length and hence prays that the addition be deleted.
18. We will take up all above grounds of appeal together. The question that we are really required to adjudicate upon is whether, on the facts and in the circumstances of the case, impugned ALP adjustments are indeed sustainable in law - and if yes, to what extent. As a first step ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 15 of 71 in this direction, we have to decide whether the CIT(A) was justified in upholding application of Comparable Uncontrolled Price (CUP) method, for determining arm's length price (ALP), on the facts of this case.
19. Learned counsel for the assessee begins by making a presentation on the brief background on pharmaceutical industry. He submits that pharmaceutical industry develops, produces and markets drugs licensed for use as medications, and deal in generic and and branded medications. He gives an example of metaformin, which is a generic version of Glucophage XR, is used to treat diabetes and is manufactured by several pharmaceutical companies all over the globe. This industry, according to the learned counsel, centered around innovation and, therefore, patents play a very crucial role as, to use his words, "patent protection enables the owner to recover research and development costs and invest in future developments". It is pointed out that a patent drug entails significant costs of innovation as drug discovery and development is an expensive proposition, and that of all the compounds investigated for use and humans, only a small number of these compounds are approved by the regulators. As an example, according to the learned counsel, only 5 out of 5,000 compounds that enter pharmaceutical testing make it to human testing and, out of 5 compounds which are tested on humans, only 1 drug is approved. As against theses patented drugs, a generic drug is produced and distributed without any patent protection. Even a generic drug may have a patent on the formulation in the sense that a general drug manufacturer can duplicate the active pharmaceutical ingredient but not the colours, favours and other inactive ingredients. Learned counsel goes on to give example of a generic drug by the name of 'fluoxtine' launched by Dr. Reddy's Laboratories which is generic version of Eli Lilly's Prozac, with norfluoxteine as the common API. Learned counsel submits that principal reason of lower price of generic drugs is that there is more competition as there is a larger number of producers of the same drug, that generic drug ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 16 of 71 manufacturers donot incur the cost of drug discovery , that generic drug manufacturers donot bear the burden of proving the safety and efficacy of drugs through clinical trials, and that generic drug manufacturers may also enjoy the benefits of previous marketing efforts of the brand name. Learned counsel then takes us through details of various stages of drug discovery, product development, pre clinical research and clinic trials. Highlighting the importance of active pharmaceutical ingredients, it is submitted that an API is substance in the pharmaceutical drug which is biologically active, that a dosage form of a drug is composed on an API, which is drug itself, and excipients, which is the substance of the tablet, and that drugs are chosen primarily for their APIs. In his last few slides, learned counsel gives a brief background of Serdia group and activities. Learned counsel submits that Serdia India is principally engaged in the manufacturing and marketing of FDFs, based on APIs imported from its AEs in France ad Egypt, and that, in adopting prices of generic APIs for CUP analysis, "significant differences between the APIs imported by Serdia India and the generic products, in terms if efficacy, were ignored".
20. Learned counsel then takes us through an article ' Death of A Dream', with sub title as ' In spite of 16 years of arduous research, no new drug has made it out of the Indian labs - Here is why' , published in February 2010 issue of the magazine Businessworld. Learned counsel uses this article to reinforce the argument that developing a new drug is an entails huge costs and efforts, and that is the reason why original inventors need to charge higher prices for their products. It is thus submitted that the price at which a drug is sold by the enterprises which has invented the said drug can not be compared with the price at which other enterprises manufacture and sell the same drug.
21. Learned counsel then contends that the authorities below erred in rejecting the transactional net margin method (TNMM), adopted by the assessee for justifying arm's length price of its international transactions ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 17 of 71 with the AEs, and in thrusting upon the assessee comparable uncontrolled prices (CUP) method. It is submitted that it is fallacious to proceed on the basis that CUP method must be preferred over TNMM method, for ascertaining the arm's length price, for the alleged reason that "CUP method is most direct and reliable method " for ascertaining the ALP and for the reason that "TNMM is a method of last resort" for ascertaining ALP. Learned counsel submits that, under the scheme of the Indian Income Tax Act, there is no hierarchy of methods of ascertaining the arm's length price, and it is thus wholly inappropriate to proceed on the basis that any one method of ascertaining the ALP should have priority over other methods. It is submitted that the right to choose the most appropriate method, for determining the arm's length price, rests with the taxpayer, and unless the Assessing Officer can demonstrate that arm's length price so computed is not computed in the manner as prescribed in the regulations, he cannot reject the method chosen by the taxpayer. Learned counsel then refers to the CBDT circular no. 14 of 2001 which, inter alia, states that where the taxpayer has discharged the primary onus of determining the ALP as per the rules and substantiating the same with prescribed documentation, there can be no intervention in the ALP by the Assessing Officer. A reference is then also made to a coordinate bench's decision in the case Development Consultants Pvt Ltd Vs DCIT (115 TTJ
577) and Philips Software Centre Ltd Vs ACIT (26 SOT 226) in support of the proposition that taxpayer's documentation should be accepted, unless the Assessing Officer is able to controvert the same. Learned counsel then points out that the Assessing Officer did not have good and legally sustainable reasons to reject the transactional net margin method as adopted by the assessee, and takes us through the brief reasons, for doing so, recorded by the assessee. It is submitted that the Transfer Pricing Officer has not appropriately and fully dealt with the prescription of Rule 10C which deals with the criterion on which most appropriate method is selected, and, as such, justification for adopting CUP method for ALP determination is not sound. A reference is also made to Special Bench ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 18 of 71 decision in the case of Aztec Software & Technology Services Limited Vs. ACIT (15 SOT 49) in support of the proposition that the law requires TPO to first comprehensively prove why the methodology adopted by the taxpayer cannot be regarded as the most appropriate methodology, and it is only after proving so that the TPO has the right to use another transfer pricing methodology. No such exercise, according to the learned counsel, has been conducted in this case.
22. Learned counsel further submitted that the API manufactured by the assessee, which is inventor of the drug , can not be compared with the same API manufactured by other enterprises. Since there is no comparable API available for CUP analysis, according to the learned counsel, it is not a fit cases for applying the CUP method of ascertaining the ALP. It is submitted that, in terms of the provisions of Rule 10 B (1)(a) of the Income Tax Rules, the CUP method has strict comparability requirements and that, in order to apply the CUP method, it is necessary that there should be a comparable uncontrolled transaction and the price at which such uncontrolled transaction has taken place should be adjusted for differences between the controlled and uncontrolled transaction. A reference is then made to Rule 10 B(3) to highlight as to what, it is emphasized that only when 'reasonably accurate adjustments' can be made for differences between the controlled and uncontrolled transaction, that CUP method of ascertaining ALP can be applied. A references is also made to the OECD Guidelines which, inter alia, state that 'the CUP method is a particularly reliable method where the independent enterprises sells the same product as is sold between two associated enterprises', and that since product purchased by the taxpayer from its AEs is not the same, though may be similar to, as the generic drugs, CUP method is not appropriate to the facts of this case. In this context, our attention is invited to an observation made by Special Bench decision in the case of Aztec Software (supra) to the effect that " even minor differences in contractual terms or economic conditions, geographical areas, risks ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 19 of 71 assumed, functions performed etc could materially affect the amount charged in an uncontrolled transaction" and that "comparability under this method (i.e. CUP) depends on close similarities with respect to various factors". Learned counsel then invites our attention to Hon'ble Supreme Court's judgment in the case of CCE Vs Universal Glass Limited (182 ELT
3) wherein it is observed that simply because two goods are known by the same known or the same group, it does not mean that they are comparable goods and that even if they are assumed to be comparable, the relevant differences, all relevant differences, as far as possible, should be recognized. According to the learned counsel, these observations show that comparables proposed by the TPO cannot be considered to be comparable only because they are known by the same name.
23. Learned counsel then submits that, as observed by a co ordinate bench of this Tribunal in the case of Sony India Pvt Ltd Vs DCIT ( 118 TTJ
685) sales of ethical pharmaceuticals by a research-based multinational group would not be comparable with sales of generic pharmaceutical substances by a multinational group not engaged in research for, and the development of, innovatory products. A reference is also made to the decision of another coordinate bench in the case of Mentor Graphic Pvt Ltd Vs. DCIT (112 TTJ 408) in support of the proposition that if differences between the comparables are so material that adjustments cannot be made, then comparables are required to be rejected.
24. Learned counsel then elaborate made submissions in support of his core contention that the APIs manufactured by Serdia group enterprises are better, and submits that, as per studies conducted, the product efficacy of assessee's FDFs is better, that the product patent in respect of the FDFs is registered in, and these products are marketed in, over one hundred countries, that the FDFs prepared with Trimetazidine are better than FDFs prepared with the same API manufactured by other enterprises, that the quality standards adopted in the manufacturing ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 20 of 71 process of Trimetazidine are compliant with WHO - GMP (World Health Organization - Good Manufacturing Practices), and that the assessee is a market leader in respective FDF market in India. It is also submitted that the products manufactured with the APIs supplied by assessee's AEs are guaranteed for quality and these AEs also provide product liability cover in respect of FDFs manufactured out of such APIs. It is also submitted that Servier Group, being a responsible organization, is accountable to all its parents and medical fraternity worldwide to ensure quality and safety of its original drug, and typically such support is not received in respect of the other players in the Indian market. It is also submitted that there were procedural deficiencies in using the prices at which the locally produced API is sold, and these deficiencies were highlighted in detail.
25. Learned counsel then gives details of some of the sales instances by Servier France, in respect of Trimetazidine and Indapamide, to entities based in Japan, Portugal, Syria, Korea and Tunisia. While the prices of Trimetazidine range from € 1,610.26 to € 2,591.63 per kg, the prices of Indapamide ranges from US $ 12,043.37 to US $ 26,708.64 per kg. It is submitted that these prices should be treated as internal CUPs and since the prices at which Trimetazidine and Indapamide are supplied by Servier to the assessee at prices lower than these prices, the prices at which assessee has bought these APIs should be treated as ALPs. Elaborate submissions are also made on as to why these inputs about internal CUPs should be accepted, and as to why these inputs should not be treated as additional evidences.
26. It is then submitted that there is no contradiction in the stand of the assessee before the custom authorities vis-à-vis stand before the transfer pricing authorities. It was submitted that the assessee's stand before the custom authorities to the effect that the price of API has been renegotiated with the AEs, due to fall in the selling prices of the FDFs, only demonstrates that the AEs are unrelated parties and the appellant ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 21 of 71 negotiated and brought about the reduction in prices. It is submitted that even if it is assumed that FDFs manufactured by the assessee and those manufactured with locally produced APIs constitute the same market, there is a wide gap between the quality and characteristics of the same product. It is also submitted that since custom department has accepted the said valuation for custom purposes, it cannot be open to another wing of the Government to disregard the same. Reliance is placed on the decision of a coordinate bench of this Tribunal in the case of Kinetic Honda Motors Ltd Vs. JCIT (77 ITD 393) in support of the proposition that "when payments are approved by one wing of the Government, there is no question of such payment being treated as excessive or unreasonable having regard to legitimate business needs".
27. Learned counsel also relied upon the decision of this Tribunal in the case of UCB India Pvt Ltd Vs ACIT (118 TTJ 865) in support of the proposition that APIs imported by the assessee from the original inventor of the product cannot be compared with the product supplied by an "unknown Chinese company". It is submitted that the said observations in this case would squarely apply to the case of the appellant as well.
28. Learned counsel also submitted that , in terms of proviso to Section 92C (2), the Transfer Pricing Officer was required to allow variation of 5% in computation of arm's length price, and the TPO was clearly in error in declining the same. Learned counsel relies upon the decisions of coordinate benches in the cases of Development Consultants (supra) and Sony India (supra) in support of this proposition.
29. Learned counsel was asked to address us in the light of Canadian Tax Court's decision in the case of Glaxo Smith Kline Inc Vs Her Majesty The Queen (2008 TCC 324), and in the light of Federal Court of Appeal decision in the case of Glaxo Smith Kline Inc Vs Her Majesty The Queen (2010 FCA 201). It was pointed out that in Glaxo's case, Canadian Tax ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 22 of 71 Court, in a very comprehensive and detailed order, has held that for the purpose of ascertaining arm's length price of ranitidine, an API, manufactured by a Glaxo Group enterprises, which originally held patent for ranitidine, the prices at which the same API sold by other manufacturers of ranitidine in Canada could be taken into account. This decision has been confirmed by the Federal Court of Appeals except to the extent that the matter was sent back to Tax Court of Canada to determine the impact of licence agreement which enabled the buyer of API to sell the FDF in the brand name owned by the Glaxo, i.e. Zantac. We asked the parties to address us on the question whether the principles so laid down by the Canadian Courts in Glaxo's case will also govern the case before us. The hearing was adjourned by a day to enable the parties to peruse these decisions and address us on the same.
30. Learned counsel's preliminary objection is that these judicial precedents have no binding force of law in India and we need not be influenced by the same. He points out that the decisions from foreign courts, no matter whatever be the degree of respect that these decisions are extended by the judicial forums in other countries, have no binding precedent value. He also points out that the transfer pricing legislation in India is not in pari materia , including on the core question of hierarchy of methods of determining arm's length price. It is submitted that, as evident from paragraph 34 of the Federal Court decision, there is a hierarchy of methods implicit in Canadian transfer pricing legislation. The relevant observation in paragraph 34 of the said decision is that "(t)here was no dispute between the parties that the Cost-Plus and Resale Price methods were secondary methods to be used when the CUP method was not appropriate and that the Transactional Net Margin method was another alternative to be used when the Cost-Plus and Resale Price methods were not appropriate". It is submitted that as against this hierarchy of methods to determine the ALP, the choice of method of determining ALP rests with the assessee in India, and, unless the Assessing Officer demonstrates that ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 23 of 71 ALP so computed is contrary to the provisions of transfer pricing legislation in India, the choice of method cannot be disturbed. Learned counsel then submits that, as evident from a plain reading of Section 69(2) of the Canadian Income Tax Act - which is reproduced in the judgment by the Federal Court, the point in dispute was classification about nature of payment. It was pointed out that, as evident from a reading of Tax Court decision, the issue before the Court was whether the amount paid for purchase of API, on the facts of this particular case, was to be reclassified as dividend and to adjudicate upon tax withholding requirements from the same. This issue, according to the learned counsel, is not the issue in appeal before us, and, therefore, decision rendered by the Tax Court has no application in the case before us. It is submitted that all transfer pricing legislations are somewhat unique, and, therefore, it cannot be open to us to import the principles laid down by the foreign courts in the context of their own transfer pricing legislation which may not have much in common with Indian transfer pricing legislation.
31. Without prejudice to the arguments so advanced on inapplicability of the judicial precedents in Glaxo's case (supra), learned counsel submits that in Glaxo's case, Canadian Tax Court was dealing with a situation in which there were no differences in the API concerned. That is, according to the learned counsel, materially different vis-à-vis the situation before us in which the assessee has established the superiority of the API imported by the assessee, as against the same API being manufactured locally. Learned counsel for the assesse took us through these decisions and highlighted the differences between the facts of Glaxo's case and facts of the case before us.
32. Learned counsel vehemently opposed our suggestion for remitting the matter back to the file of the Assessing Officer. It was pointed out that substantial time has elapsed since the impugned assessments were framed, and the matter must reach finality now. It was ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 24 of 71 also contended that the revenue authorities cannot be allowed second innings to improve upon their case. It is once again reiterated that the assesse had applied the TNMM for ascertaining ALP, given full documentation in support of the same, and the Transfer Pricing Officer has rejected, without placing on record any cogent reasons, the ALP determination method adopted by the assessee. On these facts, according to the learned counsel, we must vacate the adjustments made by the Transfer Pricing Officer and uphold the grievance of the assessee.
33. In response to bench's query whether the assessee is in a position to give any further inputs on application of the CUP method for determining the ALP, beyond what has been filed at the assessment and appellate stage, or whether the assessee considers any of the same API being sold in India a comparable, learned counsel expressed regret for not being able to do so.
34. On the strength of all these arguments, as also on several other arguments on peripheral procedural issues and written submissions filed before us, learned counsel urged us to delete the impugned ALP adjustments.
35. Learned Departmental Representative submits that it is an undisputed position that the APIs in question are no longer patented drugs and the related patents have since expired. It is submitted that all these scholarly submissions by the learned counsel on patented drugs versus generic drugs are wholly irrelevant.
36. It is pointed out that, as submitted by the learned counsel himself in his presentation, it is because of the high costs of developing and launching a new drug that the patents are enforced and other enterprises are prohibited from making that drug, though for the period limited by the patents. The monopolistic conditions in the period when ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 25 of 71 patent is in force are meant to enable the owner to recover the he initial costs, but that period is now over so far as the APIs in question are concerned. Once the patent period expires, it is inevitable that even the company which has developed the API has to complete with generic API producers and, in such a situation, a market driven price alone can be an arm's length price. Learned Departmental Representative points out the words used by the assessee, in his initial presentation , to the effect that "patent protection enables the owner to recover research and development costs and invest in future developments". It is submitted that when admittedly owner of a drug patent uses the patent protected period to recover his initial costs of development, through artificial monopolistic conditions, it cannot be open to him to again factor for the costs of developing the drug, in computation of ALP in post patent protected period also.
37. Learned Departmental Representative accepts that the Indian transfer pricing regulations do not prescribe an hierarchy of methods of determining the ALP, but that is implicit in the scheme of selection of most appropriate method because as long as a direct method of computing ALP in available, which will have lesser external factors influencing the price, the same is preferable over an indirect method which will be influenced by irrelevant and extraneous factors. He submits that OECD guidelines may not be applicable in India, but the rationale of these guidelines will always be relevant.
38. It is pointed out that there are factors like debt funding component, inventory valuation method and revenue recognition principles etc., which are wholly irrelevant for determination for the ALP of a product, which govern TNMM comparison. A method which can be influenced by such extraneous and irrelevant factors cannot be preferred over a direct method like CUP method. We are taken through the orders of the authorities below to show as to why, on the facts of this case, CUP ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 26 of 71 method is a more appropriate method. Learned Departmental Representative vehemently relies upon the orders of the authorities in this regard.
39. It is submitted that the related APIs are products which are sold in the market, and, therefore comparable uncontrolled prices are easily available. As for the variations in quality, every producer makes a claim that his product is better than other similar products and that is more of a marketing gimmick than real differentiation. On the facts of this case, and particularly as API is a standard product for which transaction prices between unrelated parties are available and as it is a direct method with minimum distortions by irrelevant factors, it is a fit case for use of CUP method for determining the ALP. According to the learned Departmental Representative, the Transfer Pricing Officer has given liberal adjustments in respect of the quality differences claimed by the assessee. It is submitted that the Transfer Pricing Officer has given cogent, though perhaps brief, reasons for rejecting the TNMM for ascertaining the ALP. Learned Departmental Representative takes us through these reasons and justifies the same. It is also submitted that the powers of the Tribunal, in restoring the matter to the file of the Assessing Officer, are unfettered and of wide amplitude. Just because it is inconvenient to the assessee to go through the process of again appearing before the Transfer Pricing Officer or any other authority below, it cannot be said that the Tribunal must not remit the matter to any of the authorities below. It is submitted that transfer pricing legislation is of recent origin in India and we must bear the limited skills available to the field officer at the initial stages of its implementation. We must not, therefore, refrain from remitting the matter to the authorities below in deserving cases.
40. In any event, according to the Departmental Representative, the transfer pricing documentation given by the assessee is not legally sustainable because the TNMM computation of ALP is based on entity ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 27 of 71 basis comparison, whereas, as held by this Tribunal in UCB's case (supra), the comparison has to be on the basis of transactions rather than business entity itself.
41. Learned Departmental Representative then submits that hierarchy of methods of determining ALP is relevant only when two methods are equally appropriate and those two methods yield varying results. In the present case, however, CUP method is more appropriate on its own merits, and being a direct method, and therefore hierarchy of methods is irrelevant. Learned Departmental Representative takes us through the order passed by the Transfer Pricing Officer, justifies and supports the same. He submits that the Transfer Pricing Officer has given good reasons for rejecting the transactional net margin method for determining the arm's length price, because when the subject matter of sale in international transaction between the associated enterprises is a product which is sold in the open market, and a direct method of determining the arm's length price is available by way of CUP, there is no occasion to resort to any other, and particularly indirect, method of determining the arm's length price. Just because the reasons given by the TPO are brief, though precise, it cannot be contended by the assessee that the matter has not been properly examined by the TPO.
42. Learned Departmental Representative then takes us through the decisions of Tax Court of Canada and Federal Court of Appeals in Canada, in the case of Glaxo SmithKline Inc. (supra). While he does not dispute that these decisions have any binding precedence value in India, he submits that the logic and rationale of these decisions bind every reasonable persons. He points out that the hearing of Canadian Tax Court was spread over forty days and in coming to their conclusions, the judges was not only guided by illuminating legal arguments by tax experts but also by industry insight provided by several expert witnesses. It is more like a research paper, according to the learned Departmental Representative, ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 28 of 71 which deserves utmost respect and which succinctly explains the functioning of the pharmaceutical industry and demystifies their working. It is pointed out that, as rightly held by the Canadian Tax Court, to ascertain arm's length price of APIs manufactured even by the original patent holder, prices of the same API produced by a generic drug producer must be taken into account. We are urged to follow the same approach. As regards Federal Court of Appeal decision, it is pointed out that FCA decision does not disapprove the principle but adds that the arm's length price must also take into account the licence terms for FDF sale. That is not even the claim of the assessee before us. We are thus urged to reject the contentions of the assessee and approve the ALP adjustments made in the impugned assessments.
43. It is then submitted that in order to follow the principles from these decisions, it is not really a condition precedent that the transfer pricing legislations should be the same in India. What is material is that the questions which have been decided by these Courts should have relevance to the questions before us, and there is no dispute so far as this aspect of the matter is concerned. We are thus urged to follow the principles laid down in these decisions to the extent applicable on the fact situation before us.
44. Our attention is then drawn to certain observations made in the orders of the authorities below as also in the remand report filed by the Assessing Officer. Learned Departmental Representative takes us through the same and vehemently relies upon the same. We are urged to uphold the orders of the authorities below and decline to interfere in the matter.
45. In his brief rejoinder, learned counsel for the assessee broadly reiterates his submissions, and submits that it was the power but the propriety of remitting the matter to the file of the Assessing Officer, if that is what we were contemplating, that was subject matter of assessee's ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 29 of 71 submissions. Learned counsel then takes us through the chronology of events in the transfer pricing audit and submits that the assessee has complied with all reasonable requisitions of the Transfer Pricing Officer in whatever way it was possible for the assessee, that the assessee has duly cooperated with the Transfer Pricing Officer, and that the assessee has adopted a method which was most suitable for determining the ALP.
46. Learned counsel also submits that the hierarchy of methods of computing arm's length price has to explicitly stated in the transfer pricing regulations, and since it is not so set out, no such hierarchy can be inferred or assumed. In support of this proposition, reliance is placed on the judgment of Hon'ble Supreme Court in the case of CIT vs Tara Agencies ( 292 ITR 444). It is reiterated that in the absence of any such hierarchy of methods of determining the ALP, the choice of method rests only with the assessee and unless ALP computed on that basis is found to be contrary to the provisions of transfer pricing regulations, the Transfer Pricing Officer cannot reject the same. We are once again urged to set aside the orders of the authorities below and hold that the impugned ALP adjustments are indeed unsustainable in law.
47. We have duly considered the rival submissions, perused the material on record and duly considered the rival submissions as also the applicable legal position.
48. The first issue that we need to adjudicate on is whether, in the absence of a hierarchy of methods of determining the arm's length price, it is permissible for the Transfer Pricing Officer to reject the transactional net margin method to determine the arm's length price of the transactions with AEs, on the ground that the comparable uncontrolled price method to determine the ALP will be more appropriate and even as the Transfer Pricing Officer has not pointed out any defects in the method adopted by the assessee.
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 30 of 71
49. Let us deal with some fundamentals first. Section 92 C of the Act, which deals with determination of arm's length price in relation to international transactions between the associated enterprises, provides as follows:
Computation of arm's length price.
92C. (1) The arm's length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely :--
(a) comparable uncontrolled price method;
(b) resale price method;
(c) cost plus method;
(d) profit split method;
(e) transactional net margin method;
(f) such other method as may be prescribed by the Board.
(2) The most appropriate method referred to in sub-section (1) shall be applied, for determination of arm's length price, in the manner as may be prescribed:
Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices:
Provided further that if the variation between the arm's length price so determined and price at which the international transaction has actually been undertaken does not exceed five per cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the arm's length price.] (3) Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that--
(a) the price charged or paid in an international transaction has not been determined in accordance with sub-sections (1) and (2); or
(b) any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or
(c) the information or data used in computation of the arm's length price is not reliable or correct; or ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 31 of 71
(d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D, the Assessing Officer may proceed to determine the arm's length price in relation to the said international transaction in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him:
Provided that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the assessee to show cause, on a date and time to be specified in the notice, why the arm's length price should not be so determined on the basis of material or information or document in the possession of the Assessing Officer.
(4) Where an arm's length price is determined by the Assessing Officer under sub-section (3), the Assessing Officer may compute the total income of the assessee having regard to the arm's length price so determined:
Provided that no deduction under section 10A 27 [or section 10AA] or section 10B or under Chapter VI-A shall be allowed in respect of the amount of income by which the total income of the assessee is enhanced after computation of income under this sub-section : Provided further that where the total income of an associated enterprise is computed under this sub-section on determination of the arm's length price paid to another associated enterprise from which tax has been deducted or was deductible under the provisions of Chapter XVIIB, the income of the other associated enterprise shall not be recomputed by reason of such determination of arm's length price in the case of the first mentioned enterprise.
50. In terms of the provisions of Section 92 C(1), as evident from a plain reading of the said provision, the arm's length price in relation to an international transaction is to be determined by one of the prescribed methods, which is most appropriate method, having regard to the (i) nature of transaction, (ii) class of transaction, (iii) class of associated persons (iv) functions performed by such persons, or (v) such other relevant factors as the Board may prescribe. Section 92 C(2) provides that it is only the most appropriate method, as referred to in Section 92 C (1), which can be applied for determination of arm's length price, in the prescribed manner. The choice of method on the basis of which arm's length price is determined is, therefore, not an unfettered choice on the part of taxpayer, and, in our considered view, this choice has to be ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 32 of 71 exercised on the touchstone of principles, governing selection of most appropriate method, set out in Section 92 C (1). The first step in determination of arm's length price is the selection of the right method of computing the arm's length price. Once the right method is selected under section 92 C (1), the next step is application of the method so selected in computation of arm's length price - as is set out under Section 92 C (2). On both of these aspects of exercise of determining the arm's length price, however, the Assessing Officer has the overriding powers for course correction. These powers are set out in Section 92 C (3)(a) which provides that where, during the course of any proceeding for the assessment of income, the Assessing Officer is, inter alia, of the opinion that the price charged or paid in an international transaction has not been determined in accordance with Sections 92 C(1) and Section 92 C(2), the Assessing Officer may proceed to determine the arm's length price in relation to the said international transaction in accordance with Sections 92 C(1) and Section 92 C(2), on the basis of such material or information or document available with him. The Assessing Officer has the powers to determine arm's length price when the arm's length price computed by the taxpayer is not on the basis of correctly applying the method of computing the arm's length, in terms of the provisions of Section 92 C (2), as also when the method of selecting most appropriate method of computing the arm's length price is not determined in accordance with the scheme of things envisaged under section 92 C(1). This provision is, however, subject to the condition that the Assessing Officer has to give an opportunity of hearing to the taxpayer, on as to why he should not do so, by serving a show cause notice. The twin conditions of compliance with the provisions under section 92 C (1) and 92 C (2) have to be fully complied with by the taxpayer, and it is only when this onus is properly discharged by the taxpayer that the Assessing Officer is restrained from resorting to determination of arm's length price by him in terms of Section 92 C (3)(a). Of course, there are other situations, as se out in clauses (b), (c) and (d) of Section 92 C (3), in which the ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 33 of 71 Assessing Officer can proceed to determine the arm's length price under section 92 C(1) and (2), but, in the context of the situation that we are in seisin of , it is not really necessary to deal with the same.
51. In view of the above discussions, in our considered view, it is clear that the selection of method of determining the arm's length price is not on the unfettered discretion of the taxpayer. The duty of the taxpayer is to select such method of determining the arm's length price as is most appropriate method having regard to all the relevant factors, such as, (i) nature of transaction, (ii) class of transaction, (iii) class of associated persons (iv) functions performed by such persons, or (v) such other relevant factors as the Board may prescribe. Rule 10 C, which sets out the relevant factors prescribed by the Board, provides as follows:
Most appropriate method.
10C. (1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm's length price in relation to the international transaction. (2) In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account, namely:--
(a) the nature and class of the international transaction;
(b) the class or classes of associated enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises;
(c ) the availability, coverage and reliability of data necessary for application of the method;
(d) the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;
(e) the extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions;
(f ) the nature, extent and reliability of assumptions required to be made in application of a method.
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52. In terms of the provisions of Section 92 C(1) of the Income Tax Act, read with rule 10C(1) of the Income-tax Rules, the most appropriate method of ascertaining the arm's length price is the "method which is best suited to the facts and circumstances of each particular transaction, and which provides the most reliable measure of an arm's length price in relation to the international transaction", though, in relatively more specific terms, Rule 10C(2) lists out the factors to taken into account while selecting the most appropriate method. It is somewhat akin to the best rule method in Section 482 -1(C)(1) of US transfer regulations which provides that, " the arm's length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provide the most reliable measure of an arm's length result".
53. In a situation in which the Assessing Officer finds that the selection of most appropriate method is not appropriate to the all the relevant factors, he has the powers, as indeed the corresponding duty, to select the most appropriate method and compute the arm's length price by applying that method. It is not at all necessary, as has been contended by the assessee, that unless the Assessing Officer can demonstrate that arm's length price computed by the assessee is not computed in the manner as prescribed in the regulations, he cannot reject the method chosen by the taxpayer. The selection of most appropriate method of computing the arm's length price is a significant component of the process of determining the arm's length price and the assessee has to justify the same on sound reasoning. In our considered view, the onus is on the assessee to demonstrate that the method of ascertaining the arm's length price is chosen by the assessee is the most appropriate method of determining the arm's length price - as is the clear mandate of Section 92 C (1), as much as is the onus of the assessee that the method chosen by the assessee has been correctly applied in the prescribed manner in terms of provisions of Section 92 C (2). It is essential to bear in mind the fact that, in terms of the provisions of Section 92 C (1) read with Rule 10 ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 35 of 71 C, the arm's length price is to be determined on the basis of one of the specified methods but such a specified method must also be most appropriate method of determining the arm's length price 'which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm's length price in relation to the international transaction'. It is, therefore, clear that the assessee must not only select a specified method of determining the arm's length price but such a method must also be best suited to the facts of the case. The assessee cannot simply pick up any of the specified method without discharging the onus of demonstrating that the method so selected is indeed most appropriate to the facts of the case. Once the assessee places on record reasons for selecting a particular method of determining the arm's length price, that reasoning can be declined, though for cogent reasons, by the Transfer Pricing Officer, and that aspect of the matter can be challenged before the appellate authorities. It is, therefore, not really correct to claim that the assessee has an unfettered choice of choosing the method of determining arm's length price. The grievance raised by the assessee is ill conceived.
54. The other aspect of the matter is that even as the transfer pricing legislation does not provide for an order of preference of methods of determining arm's length price, such an order of preference being drawn up is an integral, though somewhat subliminal, part of the process of determining the arm's length price. As we have noted earlier in the order, in terms of the provisions of Section 92 C (1) read with Rule 10 C, the arm's length price is to be determined on the basis of one of the specified methods but such a specified method must also be most appropriate method of determining the arm's length price 'which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm's length price in relation to the international transaction'. The exercise of selecting most appropriate method essentially implies that ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 36 of 71 appropriateness of method is to be ranked in some order, and that one cannot put all the methods, even as all the methods may be appropriate to the facts of a case, at par in this respect. Undoubtedly, the transfer pricing legislation in India does not prescribe a particular order of preference about methods of determining the arm's length price, but the selection of most appropriate method of determining arm's length price, under Section 92 C(1) read with Rule 10 C, essentially requires the methods of determining the arm's length price to be ranked, on a sound and rationale basis, in an order of preference vis-à-vis the facts of every case. Compared with a situation in which transfer pricing legislation itself provides for order of preference in selection of method for determining arm's length price, the only difference absence of this 'order of preference' perhaps makes it is that while in the former case this order of preference cannot be challenged before the assessment and appellate authorities irrespective of peculiarities of the fact situation, in the latter, the order of preference adopted in ranking of methods can be challenged for good and sufficient reason.
55. In other words, the order of preference adopted in selecting the most appropriate method, in the absence of an order of preference set out in the statute itself, cannot be universal in approach, and must depend on peculiarities of the facts of the case. However, it is not open proceed on the basis, as has been urged by the learned counsel, that since there is no order of preference set out in the statute itself, a particular method of ascertaining the arm's length price cannot be treated as preferable over the other method, or methods, of ascertaining the arm's length price. Such a course of action being adopted will be contrary to the scheme of selecting most appropriate method of determining the arm's length price.
56. As regards learned counsel's reliance on observations made by this Tribunal in the case of Development Consultants Pvt Ltd Vs DCIT (supra) and Aztec Software Technology (supra), in support of the ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 37 of 71 proposition taxpayer's documentation should be accepted, unless the Assessing Officer is able to controvert the same, we are unable to see any merits in the stand of the assessee. As a matter of fact, in Aztec's case (supra), the Special Bench has, quite to the contrary, specifically cautioned that none of their observations should be co construed as "to suggest that Transfer Pricing Officer cannot determine ALP on some method other than furnished by the taxpayer" and only rider that the Special Bench has put on such an exercise " any changes in the most appropriate method of computing the arm's length price is to be dealt with by way of a speaking order". If anything, these observations support the stand of the authorities below. It is not the assessee's case that no reasons have been assigned by the Transfer Pricing Officer for rejecting the TNMM as most appropriate method on the facts of this case, but the case of the assessee, by his own admission, is that the reasons are brief and inadequate. That is a different aspect of the matter which we will be dealing with separately, as, at present, our concern is only with the broad proposition as to whether the most appropriate method selected by the assessee can be rejected by the Transfer Pricing Officer without recording a finding that the arm's length price computed by the assessee, on the basis of such a method of ascertaining arm's length price, is contrary to the transfer pricing legislation. As far as this aspect of the matter is concerned, in our considered view, the proposition advanced by the assessee has to be rejected by relying upon the observations made by Special Bench in Aztec's case.
57. As far as learned counsel's reliance on decision of the coordinate bench in the case of Philips Software (supra) is concerned, we find that the coordinate bench was in seisin of a situation in which none of the conditions set out in 92 C(3) (a) to (d) were satisfied, and yet the arm's length price as determined by the assessee was rejected. As a matter of fact, the coordinate bench, having taken note of the scope of Section 92 C (3), which have reproduced above, observed that "the above-mentioned ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 38 of 71 section clearly provides that before the arm's length price is determined, the Assessing Officer has to prove that at least one of the four conditions laid down in sub-section (3) above have been satisfied" and that "however, in the instant case, the Assessing Officer did not prove to the assessee that the above conditions were satisfied, either before initiating the transfer pricing assessment or during the course of the proceedings". The coordinate bench then noted the contention of the assessee to the effect "the Assessing Officer has failed to establish that any of these four conditions have been satisfied." and that " in particular, there is nothing in the order of the Assessing Officer or of the TPO to suggest that clause
(c) of section 92C(3) is satisfied." It was in this backdrop that the coordinate bench concluded that " it is clear that the intention of section 92C(3) has always been that scrutiny of the international transactions of an assessee can only be done if the Assessing Officer can prove that the circumstances enumerated in clauses (a) to (d) are satisfied." but since, in the case before the coordinate bench, there was no finding that any of these conditions is satisfied, the arm's length price determined by the assessee could not be rejected. While we are in respectful agreement with the views so expressed by the coordinate bench, we do not see any help to the assessee's case by these views. In the case of the assessee, as we have held earlier in this order, the provisions of Section 92C(3)(a) are clearly attracted, as the assessee has not applied the most appropriate method in accordance with the scheme of things envisaged under Section 92C(1). The observations made in the case of Development Consultants (supra) are not in the context of selection of most appropriate method of ascertaining the arm's length price, and, therefore, cannot be of any help to the assessee in the present context. In any event, Philips Software decision (supra) and Development Consultant decision (supra) are division bench orders and, even if these decisions are seemed to be in conflict with the decision of Special Bench in Aztec's case (supra), they must yield to the larger bench order which has, as we have noted above, held that the Transfer Pricing Officer can determine arm's length price on ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 39 of 71 the basis of a method other than one adopted by the taxpayer as long as such a change, in the most appropriate method of computing the arm's length price, is dealt with by way of a speaking order.
58. For the reasons set out above, we are unable to approve learned counsel's plea that, as the results arrived at by determination of arm's length price computed by the assessee were not contrary to the transfer pricing regulations, it was not open to the Transfer Pricing Officer to reject the most appropriate method adopted by the assessee. In our considered view, the Transfer Pricing Officer was well within his powers to go into the question as to whether the method of determining the arm's length price adopted by the assessee was indeed most appropriate method of determining the arm's length price on the facts of assessee's case, and, on being satisfied that it was not the most appropriate method of determining the arm's length price, the Transfer Pricing Officer was also justified in determining the arm's length price on the basis of, what he found to be, the most appropriate method on the facts of the case.
59. That takes us to the question as to whether, on the facts of this case, the CUP method is indeed preferable over the TNM method for determining the arm's length price.
60. The thrust of learned counsel's arguments is that since transfer pricing legislation does not provide for any order of preference in selection of the most appropriate method, no such order of preference - direct or implied, can be exercised by us either.
61. This issue is no longer res integra. In the case of ACIT Vs MSS India Pvt Ltd (32 SOT 132), a coordinate bench of this Tribunal, speaking through one of us (i.e. the Accountant Member), had, inter al ia, observed that "While there is no particular order or priority of methods which the assessee must follow, and no method can invariability be considered to ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 40 of 71 be more reliable than others, on a conceptual note, transactional profit methods (i.e., Transactional Net Margin Method and Profit Split Method) are treated as methods of last resort which are pressed into service only when the standard methods, which are also termed as 'traditional methods' (i.e., Comparable Uncontrolled Price Method, Resale Price Method and Cost Plus Method) cannot be reasonably applied". It was noted by the coordinate bench that the OECD Guidelines also recognize this approach, and the bench expressed its considered agreement with this approach. We are in considered agreement with the views so expressed by the coordinate bench. In our considered view, the traditional transaction method have an inherent edge over the traditional profit methods in most of the situations, and, therefore, wherever both the methods can be applied in an equally reliable manner, traditional transaction methods are to be preferred over traditional profit methods.
62. We are alive to the fact that in the 2010 version of OECD Guidelines, OECD has done away with hierarchical approach in selecting the method for determination of arm's length price. The OECD has abandoned its earlier position that transactional profit methods may be used "to approximate arm's length conditions when traditional transactional methods cannot be reliably applied alone, or exceptionally cannot be applied at all". In sharp contrast to the said observation, 2010 OECD Guidelines, in paragraph 2.4, recognize that "there are situations when transactional profit methods are found to be more suitable (vis-à- vis traditional transactional methods)" such as, in a situation, "where each of the party makes a unique contribution in relation to controlled transaction, or where the parties engage in highly integrated activities". This change in OECD approach is quite in line with Indian transfer pricing legislation which requires selection of most appropriate method rather than the method being picked up in the order of priority. To this extent, the approach of OECD and Indian transfer pricing legislation is now quite in harmony with each other.
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63. It will, however, be stretching the things too far to suggest that in the 2010 version of OECD Guidelines, all the methods of determining the arm's length price have been placed at par with each other. The change in the OECD Guidelines, as we see it, is in respect of the order in which suitability of the methods is to be considered and in recognition of the fact that there can be situations in which transactional profit methods can have an edge over traditional transactional methods. However, wherever transactional profit methods as also traditional transactional methods can be applied in equally reliable manner, the OECD Guidelines still consider the traditional transactional methods to be preferable, as is evident from following observations in paragraph 2.3 of the OECD Guidelines 2010:
2.3 Traditional transaction methods are regarded as the most direct means of establishing whether conditions in the commercial and financial relations between associated enterprises are at arm's length.
This is because any difference in the price of a controlled transaction from the price of a comparable uncontrolled transaction can normally be traced directly to the commercial and financial relations made or imposed between the associated enterprises, and the arm's length conditions can be established by directly substituting the price in comparable uncontrolled transaction for the price of the controlled transaction. As a result, where, taking into account the criteria established in paragraph 2.2, a traditional transaction method and a tradition profit method can be applied in a equally reliable manner, the traditional transaction method is to be preferred over traditional profit method. Moreover, where, taking into account the criteria established in paragraph 2.2, the comparable uncontrolled price method (CUP) and another transfer pricing method can be applied in a equally reliable manner, the CUP method is to be preferred.....
64. In other words, therefore, even as there may not be any order of preference in which methods of determining the arm's length price must be considered, the traditional transaction methods, and particularly CUP, have an edge in the sense that all things being equal, CUP and traditional transaction methods are preferred over the transaction profit method. We are broadly in agreement with these views. Whether we proceed on the basis that there is an order of preference in which transfer pricing ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 42 of 71 methods are to be applied, or whether we proceed without any such priority order, the fact remains that as long as CUP method can be reasonably applied in determining the arm's length price of an international transaction in a particular fact situation, and unless another method is proven to be more reliable a method vis-à-vis the fact situation of that particular case, the CUP method is to be preferred. The reason is simple. When associated enterprises enter into a transaction at such conditions in commercial and financial terms, which are different from commercial and financial terms imposed in comparable transaction between independent enterprises, the differences in these two sets of conditions in financial and commercial terms are attributed to inter relationship between the associated enterprises, and it is this impact of interrelationship between the associated enterprises that is sought to be neutralized by the transfer pricing regulations. As long as CUP method can be reliably applied on the facts of a case, it does offer most direct method of neutralizing the impact of interrelationship between AEs on the price at which the transactions have been entered into by such AEs.
65. While traditional methods seek to compute the prices at which international transactions would normally be entered into by the associated enterprise, but for their interdependence and relationship, transactional profit methods seek to compute the profits that the tested party would normally earn on such transactions with unrelated parties. It is only axiomatic that the profits earned by an enterprise is dependent on several factors, and not only on the prices at which transactions have been entered into with the associated enterprises. The profit based results thus admit possibility of vitiation of results by a number of factors which are not relevant to the determination of prices at which international transactions are entered into by the associated enterprises. These methods, which are a step removed from the methods of computing the prices at which independent transactions would normally take place in respect of the product or service, must therefore be put to service ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 43 of 71 when the traditional methods, which seek to compute prices in independent situations, fail or are incapable of being implemented, as there are large number of situations in which, for a variety of reasons, traditional methods are simply unworkable.
66. As we have seen above, and as clearly discernable even from the OECD approach discussed above and with which we are in considered agreement, whether we proceed on the basis that there is an order of preference in which transfer pricing methods are to be applied, or whether we proceed without any such priority order, the traditional transaction methods, and particularly CUP, are preferred methods in the sense that all other things being equal, CUP and traditional transaction methods lead to more reliable results vis-à-vis the results obtained by applying transaction profit method. As a result, when CUP method can be reasonably applied in determining the arm's length price of an international transaction in a particular fact situation, and unless another method is proven to be more reliable a method vis-à-vis the fact situation of that particular case, the CUP method is to be preferred. We are, therefore, of the considered view that in case CUP method is found to be appropriate to determine the arm's length price in a particular situation, there are good reasons, as discussed above, to prefer it over the other methods, even if of equal efficacy- though of not more efficacy, of determining the arm's length price.
67. The most fundamental aspect, therefore, that we must address ourselves to is whether CUP method of determining the arm's length price can be reasonably applied in the fact situation that we are in seisin of.
68. There are two judicial precedents on this issue which touch upon the issue whether CUP method can be used in the cases of generic drug manufacturers.
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69. In the first case, which is a Tax Court of Canada decision in the case Glaxo Smithkiline Inc Vs Her Majesty the Queen ( 2008 TCC 324 ). This is a case in which the agreed position between the parties was that CUP was the most appropriate method for determining the arm's length price for generic drug produced by the original patent holder of the said drug, as long as appropriate comparators could be found. This decision notes the agreed position as follows:
[64] Both parties called an expert witness to explain transfer pricing and to testify as to the appropriate method of establishing the transfer price between the appellant and Adechsa ( i.e. vendor of the generic drug manufactured by the original patent holder). Dr. J. Gregory Ballentine testified for the appellant. Dr. Jack Mintz testified for the respondent. Both experts agreed that the CUP method is the preferred method for determining transfer prices.
[65] Only in the absence of useful evidence of an uncontrolled transaction will it be necessary to use another method. For example, because no comparable transaction exists or because there are differences in the transactions that cannot be taken into account. The other methods are also useful in that they can be used as a check on each other.
(Emphasis by underlining supplied by us)
70. Closer home, in the second case, the same question fell for consideration before a coordinate bench of this Tribunal, in the case of UCB India Pvt Ltd Vs ACIT (supra). This was a case in which comparables cited by the Transfer Pricing Officer were inferred to have been produced by unknown duplicator Chinese companies and about which no data was available. It was in this background that the CUP method was held to be inapplicable for want of comparables. While holding so, the coordinate bench, inter alia, observed as follows:
Reasonable inference drawn by both the parties is that the suppliers are some Chinese companies, the details of which the revenue is not disclosing to the assessee. Though the argument of the revenue that ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 45 of 71 the law relating to drugs and cosmetics ensures uniformity in stands of quality, efficacy and safety of pharmaceutical products, the fact remains that the APIs produced and supplied by the originator, which is like a Branded Company Product, cannot be taken as identical or similar in all aspects, with the product supplied by a duplicator unknown Chinese company. No information is available in the public domain. It is common knowledge that Chinese goods are flooding international markets with a very low pricing. It is also true that the quality of these products is not rated by independent bodies to enable comparison in some cases. The assessee's repeated queries on the standards, processes, purity, barrels, etc. followed by those Chinese companies and many other details, data, information and parameters, could not be replied to or supplied by the revenue.
71. In UCB's case, as such, CUP method was rejected not because it was considered to be an inappropriate method for determining the arm's length price but because the comparables were not available. The comparables cited by the Transfer Pricing Officer were apparently from Chinese manufacturers of questionable credibility, and the coordinate bench did not approve these comparables. It was in this context that the coordinate bench made certain observations which are being heavily relied upon by the assessee. We donot think that these factual observations can be construed as of general application and as of precedence value on standalone basis. What is observed by a coordinate bench is on the facts of a particular case and in the nature of appreciation of facts rather than laying down a legal principle, even if with a tone and tenor of general observation, and is deeply influenced by the peculiar facts of the said case. In any event, these are the legal principles laid down by the judicial forums which can be subject matter of precedence value, and not on observations on factual matters. As to how should we construe the observations, we find guidance from the oft quoted observations made by Hon'ble Supreme Court, in the case of CIT Vs Sun Engineering Pvt Ltd (198 ITR 297), to the effect that " it is neither desirable nor permissible to pick out a word or a sentence from the judgment of this Court, divorced from the context of the question under consideration and treat it to be the complete 'law' declared by this Court". We must not, ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 46 of 71 therefore, proceed on the basis that since CUP method was rejected in the case of a generic drug being manufactured by innovator of that generic drug, the CUP method must also be rejected in all cases where generic drugs are manufactured by the innovators of that generic drug; essentially, a lot depends on the quality of CUP inputs as well.
72. While dealing with UCB's case, we may also add that it was a case in which the Tribunal did not give any finding about as to which method of determining the arm's length price was the most appropriate method, having regards to the facts of that case, and the matter was remitted to the file of the Assessing Officer for fresh adjudication on that question. UCB decision holds that transactional net margin method applied in that case as long as comparison is made for net profit margins realized by an enterprises from a transaction or aggregate of transactions, but not at an entity level, but then it is nobody's case before us that the said data is available in public domain, and one of the crucial factors governing the selection of most appropriate method, under rule 10C (2)(c) is "availability, coverage and reliability of data necessary for application of the method". When data for application of a method is not available at all, such a method cannot be termed as 'most appropriate method'. Therefore, the assessee does not derive any advantage from UCB decision in the present case where the question which is being considered by us is as to which is the most appropriate method of determining the arm's length price in the present case.
73. The other aspect of the matter is that on a conceptual plane, while selecting the most appropriate method of determining an arm's length price, there cannot be a rejection of method in vacuum, it has to be vis-à- vis the other methods considered in in the course of the said exercise. It is for the reason that there cannot be a situation in which all the prescribed methods are rejected. Even if all the methods are considered inappropriate for one reason or the other, the method which is less ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 47 of 71 inappropriate is to be applied, though with adjustments necessitated by such a peculiar situation. In UCB's case, the coordinate bench has rejected CUP method and approved transaction net margin method on the basis of comparing net profit on transactions, or aggregate of transaction, rather than entities. It cannot be treated an authority for the proposition that CUP method is not applicable in the cases of generic drug manufacturers. In our considered view, for precedence value, ratio of this decision mainly is that when assessee can apply TNMM at transaction level, rather than entity level, CUP method cannot be applied in the cases of generic drug manufacturer from which the generic drug is purchased is the original patent holder of the product. The assessee does not derive any advantage from this proposition for the short reason that TNMM at transaction level, in implied preference to which CUP method is rejected, cannot be applied in the present case for want of appropriate data inputs. UCB decision cannot, therefore, be an authority for the proposition that in the cases of generic drugs, in which drug is manufactured and sold by is the original patent holder, CUP method cannot be applied at all.
74. We also find that the prices at which the generic drugs are purchased by the assessee from its associated enterprises are admittedly not driven by the market forces but on considerations which have no role to play in a typical arm's length transaction. In the order dated 6 th May 2003 passed by the Deputy Commissioner of Customs, following stand of the assessee has been noted:
They (Serdia India) have stated that increased market competition in India has resulted in overall reduction in prices of selling price of their formulations manufactured by them in India.
In order to retain their market share in India, their suppliers (Servier Group) have agreed to renegotiate the to sell the bulk drug to them at reduced price by affecting necessary changes to the price list applicable for India.
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75. On the one hand, the assessee claims that he is a market leader and his FDFs sell at higher prices because of the premium its API commands, which justifies the higher price paid for the API, and, on the other hand, the evidence on record demonstrates that he must paid lower price for the API because his FDF was selling at a lower price. In a typical arm's length transaction, one does not reduce the price of the API because the buyer is not able to sell the FDF at corresponding higher prices - particularly when, as assessee claims, the product being sold is a unique product. The demand of a unique product can hardly be sensitive to marginal price movements but then, as admitted by the assessee, the prices were marginally reduced, by effecting 25% cut in the raw material price, to check the falling demand. As against imports of Trimetazidine at the rate of € 1,372 per kg till 1 st January 2002, the price of Trimetazidine was reduced to € 1,072per kg with effect from 1 st January 2002. In our considered view, these price movements and demand sensitivity to the price indicate that the APIs imported by the assessee are not unique items as claimed by the assessee, and that such business models, being adopted by pharmaceutical companies, leave ample scope for them to manipulate API prices so as to regulate profitability of their controlled entities in the end use jurisdiction.
76. In view of the above discussions, in our considered view, as long as appropriate comparables can be found, CUP method will indeed be the most appropriate method in respect of purchases of generic drug, even when such a generic drug is manufactured by its original patent holder.
77. In the present case, the assessee has purchased active pharmaceutical ingredients from its associated enterprises. In the assessment year 2002-03, the assessee has purchased two APIs - Trimetazidine and Indapamide. There is no dispute that these APIs were generic drugs at the relevant point of time, and not patent protected. In this view of the matter, all these erudite submissions on the costs and ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 49 of 71 process of developing a new drug and the need of higher price for the patented drugs are of no help to the assessee's cause before us. Quite to the contrary, these arguments seem to support the contention that patent protection is to enable the innovator of a drug to recover the high initial costs by allowing him a monopolistic market in the initial stages of marketing the drug, and, therefore, he must compete with the generic drug manufacturers, in post patent period, on selling prices.
78. The assessee claims that these are unique items in the sense that APIs manufactured its AEs are better, of proven effectiveness, employing manufacturing process compliant with WHO - GMP (World Health Organization - Good Manufacturing Practices), guaranteed for quality and these AEs also provide product liability cover in respect of FDFs manufactured out of such APIs.
79. The question whether an API can be considered to be unique product on such ground that GMP (Good Manufacturing Practices) and HSE (Health, Safety and Environment) standards were followed in its production process whereas such high standards were not maintained by other generic drug manufacturers, was also one of the issues which came up for adjudication before Tax Court of Canada in the case of Glaxo Smithkline (supra).
80. Briefly stated, the relevant material facts of Glaxo's case were like this. Ranitidine is the active pharmaceutical ingredient ("API"), used in a drug marketed by the assessee in Canada under the brand name Zantac. Ranitidine was discovered by the assessee's parent company in 1976 and was approved for sale in Canada in 1981. Zantac was launched by the taxpayer in 1982. During the period under appeal other pharmaceutical companies (generic companies) were selling generic versions of Zantac in Canada. These companies purchased ranitidine for much less than the price at which assessee purchased it from Adechsa, an AE based in ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 50 of 71 Switzerland, which in turn, purchased it from another group AE based in Siganpore, which manufactured the same. These AEs were part of the Glaxo group. According to the tax authorities, a reasonable amount for the taxpayer to have paid for ranitidine was the price paid by the other generic drug manufacturing companies selling ranitidine in Canada. For example, while the assessee paid as much C $ 1,512 for each kilo gram of ranitidine to Adechsa, the same API was sold in Canada for C $ 292 per kg. The GlaxoSmithKline Group's ("GSK Group") transfer pricing arrangements allowed the Singapore related party manufacturer to earn gross profits of approximately 90% on the sale of ranitidine to Adechsa. Adechsa was required to earn a minimum 4% profit (by agreement with the Swiss tax authorities), and the taxpayer earned gross profits of approximately 60% on the sale of Zantac. The tax authorities reassessed the taxpayer to dissallow a deduction insofar as the amounts paid to Adechsa for a kilogram of ranitidine exceeded the highest price paid by the generic companies for a kilogram of ranitidine at the appropriate time. The tax authorities also deemed the excess amount to be a dividend, subject to withholding tax at the reduced rate of 10% under the Canada- UK tax treaty. The assessee argued that the price it paid for the ranitidine "closely mirrored the price paid by independent third parties in comparable circumstances" and the amounts paid by the taxpayer were "reasonable in the circumstances" within the meaning of subsection 69(2) of the Canadian Income Tax Act. The assessee also submitted that its business model and circumstances are not comparable to those of the generic companies. The tax authorities' position was that it did not pay a reasonable price for the purchase of ranitidine in order to minimize profit in Canada and move the profit to a related corporation in a low tax jurisdiction. On these facts, the Tax Court endorsed the OECD Commentary on Article 9(1), which relies on the arm's length principle to determine the prices that multinational enterprises would charge for goods and services sold from one jurisdiction to another. The Tax Court also endorsed the OECD's hierarchy of transfer pricing methods. It ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 51 of 71 therefore concluded that the comparable uncontrolled price ("CUP") method is the preferred method and that the purchase price paid by the generic pharmaceutical producers is an appropriate CUP. The Court indicated that the highest price paid by the generic pharmaceutical producers represents a reasonable price that the taxpayer could have paid Adechsa. The judge did allow an additional C $ 25 per kilogram of ranitidine in acknowledgement that the ranitidine purchased from the related party manufacturer in Singapore was granulated.
81. This matter was heard at great length and in fine detail for over forty days, as noted in the order itself, and the Court was not only assisted by illuminating arguments by the learned counsel but also by expert witnesses, in a way, demystifying the pharmaceutical industry and sharing their insights on the manufacturing process of the APIs , as evident from the following observations in the said decision :
[93] A point in dispute is the impact of Glaxo's GMP. The appellant submits that the Glaxo ranitidine and that purchased by generic companies are not comparable because of the differences in GMP and HSE standards. The respondent agrees that there may be differences in GMP and HSE but states that those differences are of no significance to either safety or efficacy and therefore should have no bearing on the purchase price of ranitidine.
[94] GMP is a term used for the control and management of manufacturing and quality control testing of foods and pharmaceutical products. The appellant's expert, Mr. William Ment, a senior regulatory compliance consultant who was a branch director of the U.S. Food and Drug Administration ("FDA") until 1999, described GMP as:
policies, practices, written procedures that companies establish to ensure that the whole production process, which includes manufacturing, testing and release, reduces as much as possible the risk to that product having - being adulterated, having harmful impurities, et cetera, in it.
[95] In the view of Clive Rogers, Glaxochem Limited's purchasing ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 52 of 71 manager between 1988 and 1994, GMP:
...means that you are running your site efficiently with good housekeeping. You have trained personnel operating it. You are keeping full and comprehensive records of all your manufacture, all your batch records. You are doing proper chemical analysis on all the materials that you buy in, that you use in process. You segregate materials that are rejected that you bought in and only use good ones, and you can track a manufacturer right the way through from beginning to end and you know who has done what to it at what time and did it comply with a manufacturing process that was registered.
[96] A total of five science experts were called, all of whom attempted to put their testimony in layman's terms, to varying degrees of success. With respect to these issues the following facts are clear:
(a) During the years in appeal, Canada did not conduct inspections of or have GMP requirements for API manufacturers. The responsibility for ensuring the quality of the API was placed on the dosage form manufactures.
(b) Canada required the dosage form (secondary) manufacturers to manufacture their finished products in accordance with GMP;
(c) Generic ranitidine was chemically equivalent and bioequivalent to Glaxo's ranitidine and was approved for sale by HPB; and
(d) Glaxo Group had GMPs for the primary manufacture of the API; the generic suppliers did not.
[97] The appellant argued that Glaxo's standards differed from those of the generic API manufacturers in that Glaxo World required that its ranitidine be (1) manufactured under Glaxo's GMP standards (2) produced in accordance with HSE and (3) granulated to Glaxo World standards. The suppliers to the generic companies did not manufacture ranitidine according to Glaxo standards.
[98] When Mr. Ment was asked "[t]o what extent can test methods be developed to detect adventitious contamination, cross-contamination or all and any kind of chemical that may be found in a batch?" he ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 53 of 71 replied, "[i]t would be extremely difficult, if not impossible, to do that with a battery of tests that companies typically run for batch release testing. They are not designed to detect and to identify adventitious contamination, except to a very limited extent."
[99] A similar sentiment was expressed by Dr. Ian Keith Winterborn, the appellant's science nominee at discovery who also testified at the trial of these appeals. He said "[i]t is impossible to design - well, it is not impossible, but it would be onerous to try to design analytical tests which could detect and quantify any and all potential contaminants that might occur during manufacture, if the conditions under which the material is manufactured are not known and not understood."
[100] Mr. Ment said laboratory testing was aimed at detecting the most likely contaminants (based on the process used) and cross- contaminants (based on the other chemicals present in a multi- product facility) but even with such testing, he said that some contaminants might still slip through undetected.
[101] Appellant's counsel has not argued that his client's ranitidine was superior to the ranitidine used by the generic companies. He argued that Glaxo GMPs were superior and that this reduced the risk of contamination during manufacture. The respondent's expert, Dr. Leslie Benet, saw things differently. Dr. Benet, a professor of biopharmaceutical sciences at the University of California, San Francisco, was qualified as an expert in pharmaceutical sciences, pharmacology, bioequivalency, chemical equivalence and other scientific aspects of drug-related issues. He emphasized that the real issue is not contamination per se (which goes to quality) but harmful contamination (which goes to safety). According to Dr. Benet, for example, cross-contamination with Atenolol, a betablocker used for lowering blood pressure, would not be a concern because it has a very wide therapeutic index. Cross-contamination with penicillin, on the other hand, would be a concern because people have allergic reactions to penicillin. He testified that any differences in GMP and HSE are irrelevant. In his view companies may establish whatever internal standards they like but drug products are approved based on the regulatory standards in each country. The only issue, according to Dr. Benet, is whether the API met the Canadian standard. The appellant has admitted that the generic ranitidine was bioequivalent and chemically equivalent to Glaxo's ranitidine. This is the standard used by HPB to determine whether a Notice of Compliance for a New Drug Submission will be granted. In Dr. Benet's view this is enough to end the inquiry.
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 54 of 71 [102] The appellant has suggested that both the Zantac brand and Glaxo's reputation would be impacted if harmful contaminants were ingested by the ultimate consumer. The appellant's view, therefore, is that Glaxo World has an incentive to do more than just meet the basic regulatory requirements. To reduce the risk of contamination it was not unreasonable for the appellant, for its comfort and that of the Glaxo World, to purchase ranitidine produced under good manufacturing practices for a marginally higher price than one would pay for ranitidine that lacked GMP.
[103] The Therapeutic Products Directorate of the Health Products and Food Branch of Health Canada is the Canadian authority that regulates pharmaceuticals and medical devices for human use. The respondent's witness, Mr. Sultan Ghani, became the director of the Bureau of Pharmaceutical Sciences of the TPD in 2002. He was qualified as an expert in good manufacturing practices of the pharmaceutical industry in general, the drug approval process, quality assurance and GMP in the pharmaceutical industry in Canada.
[104] Mr. Ghani explained that, during the years in issue and right up to the time of his testimony, Canadian regulations placed the responsibility for the quality of the active pharmaceutical ingredient on the dosage form (or secondary) manufacturer, and that this was where Health Canada considered the responsibility to rest as well. However, this practice will soon change due to international efforts to bring GMP standards to API manufacturers.
[105] Mr. Ghani also said the number of GMP problems associated with API manufacturing was very, very small compared with the number of GMP problems associated with dosage form or secondary manufacturing and this was why Health Canada did not concern itself with API manufacturers. He also admitted that crosscontamination is a concern everywhere, including the API manufacturers, if proper cleaning and other precautions are not taken. In reexamination, Mr. Ghani acknowledged that there are limits to end-product testing and that GMPs do reduce the risk of contamination as much as possible
82. The differentiation in the product i.e. the API, on the basis of better manufacturing practices and higher standards followed in the ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 55 of 71 manufacturing process, was, however, unequivocally rejected by the Court. Speaking through Associate Chief Justice Gerald J Rip, as he then was, the Court observed as follows :
[118] Appellant's counsel argued that Glaxo's adherence to GMPs meant that its ranitidine was not comparable to that used by the generic companies. I do not accept this argument. Glaxo's GMP and HSE standards do not change the nature of the good. As Mr. Winterborn stated, "Ranitidine is ranitidine is ranitidine". Bernard Sherman, the Chairman of Apotex, insisted that the Glaxo ranitidine molecule and the generic ranitidine molecule are identical. The appellant has admitted that the generic ranatinde was chemically equivalent and bioequivalent as required by HPB. Thus, were it not for the Licence Agreement and Glaxo World's self- imposed standards, the appellant could have purchased ranitidine from the generic suppliers, packaged it as Zantac and sold it for the same price it was selling the Zantac which contained Glaxo- manufactured ranitidine. However, I do accept that GMPs may confer a certain degree of comfort that it has minimal impurities and is manufactured in a responsible manner. Granted, this has some value but it does not affect its comparability with the ranitidine used by the generic companies.
83. We are in considered agreement with the views so expressed by Tax Court of Canada. As they rightly put it, the high quality standards employed in manufacturing process do confer a certain degree of comfort in the sense that the API has minimal impurities and has been manufactured in a responsible manner, but this degree of comfort does not affect its comparability with the same API manufactured by generic drug companies.
84. It was in this backdrop that the Tax Court of Canada finally concluded as follows:
[161] CUP is the preferred method and the generic companies in Canada are an appropriate comparator using the CUP method. The appellant acquired granulated ranitidine from Adechsa at an amount in excess of the fair market value of ranitidine, and pursuant to subsection 69(2) of the Act the appellant is deemed to acquire it at a ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 56 of 71 reasonable amount. The price that would have been reasonable in the circumstances for Glaxo Canada to pay Adechsa for a kilogram of ranitidine is the highest price the generic companies paid for a kilogram of ranitidine. However, to this amount I would add $25 per kilogram as this was the approximate cost to Singapore for granulation. The ranitidine purchased by the generic companies was not granulated. The GMP performed by a Singapore may have increased the value of its ranitidine but only to the extent that, as stated earlier in these reasons, it gave some degree of comfort to the appellant that the product would probably have less impurities and contaminants than that of its generic competition. No submissions were made as to what this extra consideration should be. There is no evidence before me to consider what increase I might add to the generic price per kilogram of ranitidine on account of GMP. It would appear to be modest in any event. The evidence does not suggest any addition to the price of the ranitidine due to any HSE by Singapore. The appellant, in computing its income for a particular year, may not deduct the excess amount it paid to Adechsa.
85. Chief Justice Rip then proceeded to give an example for working of the above conclusions. He observed that, for example, if the appellant paid to the vednor $1,300 per kilogram for ranitidine and the highest price the generic companies paid for ranitidine was $380 per kilogram, the appellant would be permitted to deduct the amount of $380 per kilogram plus $25 per kilogram for granulation, a total of $405. What was thus finally held was that the arm's length price of ranitidine was the highest price paid for the ranitidine in the generic drug market, plus an additional allowance for better quality of the product.
86. Incidentally, it was broadly the same approach which was adopted by the Transfer Pricing Officer.
87. Coming back to Glaxo Smithkline decision by Tax Court of Canada, we may mention that the matter did not rest there and it travelled in further appeal before the Federal Court of Appeals. In its judgment dated 26 th July 2010, reported as Glaxosmithkline Inc. Vs. Her Majesty the Queen (2010 FCA 201), the Federal Court of Appeal, while agreeing that ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 57 of 71 the (CUP) method should apply in determining the appropriate price, reversed the Tax Court's decision on the basis that the Tax Court used incorrect comparables inasmuch as an inquiry should be made into those circumstances that an arm's length purchaser, standing in the shoes of the appellant, would consider relevant in deciding whether it should pay the price paid by Glaxo to Adechsa for its ranitidine. Federal Court of Appeal was of the view that the Tax Court of Canada failed to consider the business reality of the situation: "In the real business world, presumably an arm's length purchaser could always buy ranitidine at market prices from a willing seller. However, the question is whether that arm's length purchaser would be able to sell his ranitidine under the Zantac trademark." Therefore, the terms of the License Agreement need to be considered in determining the arm's length price. As a result, the Court sent the case back to the Tax Court to determine the arm's length price based on the terms of the License Agreement. The Federal Court of Appeals concluded as follows :
[74] ...... it is my view that the Judge was bound to consider those circumstances which an arm's length purchaser would necessarily have had to consider. In other words, the test mandated by subsection 69(2) does not operate regardless of the real business world in which the parties to a transaction participate.
[75] This is not what the Judge did. Rather, he determined the "fair market value" of ranitidine, which he found to be the price paid by Apotex and Novopharm, and then found that anything paid by the appellant over that amount, save for a $25 per kilo upward adjustment, was in excess of "the reasonable amount".
[76] Clearly, in the circumstances of this case, the Judge's approach was mistaken. In a real business world, presumably an arm's length purchaser could always buy ranitidine at market prices from a willing seller. However, the question is whether that arm's length purchaser would be able to sell his ranitidine under the Zantac trademark. In my view, as a result of the approach which he took, the Judge failed to consider the business reality which an arm's length purchaser was bound to consider if he intended to sell Zantac.
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 58 of 71 [77] I now turn to the circumstances which, in my view, the Judge should have considered in determining whether the price paid by the appellant for its ranitidine was in excess of "the reasonable amount".
[78] Because it was central to the appellant's business reality, and would be so if it were dealing at arm's length with Adechsa, the License Agreement with Glaxo Group was "a circumstance" which had to be taken into account by the Judge. In my respectful view, failing to consider that Agreement meant that the Judge made his determination in a fictitious business world where a purchaser is able to purchase ranitidine at a price which does not take into account the circumstances which make it possible for that purchaser to obtain the rights to make and sell Zantac. As the appellant argued at paragraph 54 of its Memorandum of Law
54. ... As a result, the Trial Judge ignored the key business circumstances of Glaxo Canada's purchase of ranitidine from Adechsa, and assumed a set of circumstances that did not exist in reality and would not exist in an arm's length transaction. ...
[79] In my view, there are a number of "circumstances" which satisfy me that the License Agreement was a crucial consideration in determining "the amount that would have been reasonable in the circumstances" if the appellant and Adechsa had been dealing at arm's length:
1. Glaxo Group owned the Zantac trademark and would own it even if the appellant was an arm's length licensee.
2. Zantac commanded a premium over generic ranitidine drugs.
3. Glaxo Group owned the ranitidine patent and would have owned it even if the appellant had been in an arm's length relationship.
4. Without the License Agreement, the appellant would not have been in a position to use the ranitidine patent and the Zantac trademark. Consequently, in those circumstances, the only possibility open to the appellant would have been to enter the generic market where the cost of entry into that market ould likely have been high, considering that both Apotex and Novopharm were already well placed and positioned.
ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 59 of 71 5 Without the License Agreement, the appellant would not have Had access to the portfolio of other patented and trademarked products to which it had access under the License Agreement.
[80] The appellant submits, and I agree entirely with that view, that these circumstances do not arise from the non-arm's length relationship between the appellant and Adechsa or between the appellant and Glaxo Group. To the contrary, these circumstances, and I quote the appellant, "arose from the market power attaching to Glaxo Group's ownership of the intellectual property associated with ranitidine, the Zantac trademark and the other products covered by its License Agreement with Glaxo Canada". As the Administrative Appeals Tribunal of Australia stated in Roche Product Pty Limited and Commissioner of Taxation, [2008] AATA 639 (July 22, 2008) at paragraph 153:
It is the intellectual property which is really the product, not the pill or capsule by which it is dispensed. The intellectual property included patent rights. The intellectual property came from very substantial expenditure on research and development, much of which would have produced no result. The profits from the exploitation of the intellectual property rights was something to which [the parent company which invented the product] had a special claim even though the profit would be collected for Australian sales by the Australian subsidiary.
[81] I now return to subsection to 69(2) of the ITA and the test which it sets out. That test required the Judge to determine whether an arm's length Canadian distributor of Zantac would have been willing, taking into account the relevant circumstances, to pay the price paid by the appellant to Adechsa. With respect, the Judge ignored all of those circumstances because of his view that Singleton, supra, required him to ignore the License Agreement. I again wish to emphasize that the above circumstances were circumstances that would have been present even if the appellant had been dealing at arm's length with Adechsa and Glaxo Group. Consequently, an arm's length appellant would necessarily have had to consider those circumstances in deciding whether it was willing to pay the price asked for by Adechsa for the sale of the Zantac ranitidine.
[82] As a result, I conclude that the Judge erred in law in failing to apply the proper test in determining "the amount that would have been reasonable in the circumstances" if the appellant and Adechsa had been dealing at arm's length. Counsel for the appellant argued ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 60 of 71 that in the event that we agreed with him that the Judge erred in not considering the License Agreement, we should then determine "the reasonable amount". In my view, that determination ought to be made by the Judge, who heard the parties for well over forty days, and not by this Court.
[83] Whether the consideration of the License Agreement as a circumstance relevant to the determination of "the reasonable amount" will lead the Judge to the conclusion sought by the appellant is not for us to say. For example, the Judge may find that the generic companies are no longer a good comparator and that another group is more appropriate. On the other hand, he may determine that no comparator is necessary for him to make a final determination. Consequently, I am not inclined to make the ultimate determination which the appellant seeks, but prefer leaving the matter to the Judge to make such a determination or any other determination which he finds to be warranted in the light of a full record on the issue. Whether the present record is sufficient to allow the Judge to perform that task, I cannot say. The Judge may be satisfied that the record is sufficient or he may request the parties to adduce additional evidence and submissions as a result of this Court's decision.
88. The grounds on which the Glaxo decisions of the Tax Court of Canada was overturned by the Federal Court of Appeal have nothing to do with claimed superiority of the product, as is the case before us, but on the basis of compulsions of the licence agreement, because of which the assessee was said under an obligation to purchase the API at a higher price.
89. In the case before us, the plea of the assessee is of superiority of APIs manufactured by its associated enterprises that the APIs purchased by the assessee command a higher price, and not that it was on account of the compulsions of license agreement that the assessee had to buy it at a higher price. In any event, the assessee has not even filed copies of any agreements, including the license agreement, before us. As we make these observations, we make it clear our observations should not be construed an expression of opinion on things not before us. That is a plea which ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 61 of 71 will have to be dealt with, on merits, when it is made. That apart, there are many other peripheral aspects which will have to be examined when such a claim is made by the assessee, such as, when assessee of claims that the higher price, independent of consideration paid in terms of the licence agreement, had to paid to the AE because of the licence agreement requirement, one will have to consider whether this excessive payment is de facto in the nature of a royalty payment, in the garb of payment for API, and whether, and to what extent, necessary corollaries to such a re characterization will follow. Of course, this approach presupposes that a higher payment, on the ground of compulsions of agreement, can be re characterized, even in the absence of a specific legal provision enabling such recharacterization-a proposition yet to come up for judicial scrutiny. Be that as it may, since there is no material on record to suggest that the higher prices of API were warranted, on account of commercial compulsions arising out of licence agreement, we need not deal with this aspect in any more details. Suffice to say that this aspect of the matter is not relevant in the present case, as it has not been specifically pleaded before us. Therefore, observations of the Court of Appeal in Canada do not, in any manner, dilute the decision of the Tax Court of Canada, to the extent it is relevant in appeals before us.
90. We are in considered agreement with the views of Tax Court of Canada, which, to the extent relevant to the case before us, have met the approval of the Federal Court of Appeal in Canada as well. The decision of Tax Court of Canada is not a binding precedent for us, but it certainly deserves utmost respect and consideration not only because it comes from a very eminent forum of tax judiciary in the world, but also because of its very comprehensive and painstaking analysis of all the related issues and its sheer technical excellence. The reasoning adopted in the Tax Court of Canada's decision appeals to us, as indeed it would appeal to any rational person, and we respectfully adopt the same.
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91. One of the contentions by the learned counsel was that since this Canadian decision deals with issues relating to characterization of a payment, and tax withholding implication thereon, it has no relevance in issue in appeal before us.
92. We, however, see no substance in this plea. When an excessive payment for goods or services is made to an associated enterprises, it has two implications - first, that domestic tax liability is reduced in respect of income of the enterprises situated in that tax jurisdiction, and - second, a payment for dividend, royalty or other income is made to the foreign AE in the garb of payment for such goods or services. Once it is held that a part of payment made to the foreign AE is wrongly characterized as payment of goods or services, it is only a natural corollary of this finding that the payment so made in excess of arm's length price must have some other character. While a lower deduction, on account of ALP adjustment, neutralizes the erosion of domestic tax base caused by reporting artificially lower profits, a simplictor ALP adjustment does not neutralize the non-taxability, in source country, of the payment of dividend, royalty or other incomes to the foreign AEs, in the garb of payment for goods or services. Many countries, including Canada - by way of Section 247(2) of Canadian Income Tax Act , neutralize this ill effect of a payment in excess of arm's length price by providing for re-characterizing the amount paid in excess of ALP. In India, re characterization provisions in respect of payments made in excess of ALP have not yet been legislated, but that does not mean that judicial precedents from the countries where recharacterization of payment in excess of ALP payment is permissible, cease to be relevant in India. These decisions, though they go a step further than the present legal position in India, continue to be as relevant and as useful as they would have been in the absence of such re characterization provisions in the respective countries. The rationale and logic of these decisions ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 63 of 71 continues to remain unaffected by these provisions. The objection raised by the learned counsel is devoid of legally sustainable merits.
93. As regards learned counsel's reliance on Hon'ble Supreme Court's judgment in the case of Universal Glass Limited (supra) wherein it is observed that simply because two goods are known by the same known or the same group, it does not mean that they are comparable goods, all we can say is that not only the APIs, whether made by the original patent holder of the drug or by other generic drug manufacturers, is not only known by the same, it is the same - though maybe with some variations of quality.
94. As regards observations, said to have been made by a coordinate bench in the case of Sony India (supra) , to the effect that sales of ethical pharmaceuticals by a research-based multinational group would not be comparable with sales of generic pharmaceutical substances by a multinational group not engaged in research for, and the development of, innovatory products, we find that these are not the observations of the Tribunal but extracts from the book "International Transfer Pricing in the Ethical Pharmaceutical Industry" ( IBFD publication; authored by Karl Wundisch), which have been reproduced in the order. These observations thus are no more than opinions of the learned author and, as we donot even know what was the context in which these observations were made, we donot find the same to be of any help to the assessee. We have, in the light of the analysis in foregoing paragraphs, rejected this line of reasoning.
95. Similarly, the assessee does not derive any help from coordinate bench decision in the case of Kinetic Honda Motors Ltd Vs. JCIT (supra) in support of the proposition that "when payments are approved by one wing of the Government, there is no question of such payment being treated as excessive or unreasonable having regard to legitimate business ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 64 of 71 needs", since, unlike in the case of Section 40A(2) with which this decision dealt, the Income Tax Act provides a specific mechanism for computation arm's length price, and it is only when determination of arm's length price is made in accordance with the scheme of the Act that the onus of the assessee is discharged. Merely because another arm of the Government considers this price at an arm's length price, even though for the purposes of customs duty, the assessee can not be relieved of the burden of establishing that it is an arm's length, for the purposes of transfer pricing requirements, in terms of the provisions of the Income tax Act.
96. In view of the above discussions, and bearing in mind entirety of the case, we are of the considered view that CUP method of determining the arm's length price is most appropriate method for determining arm's length price, on the facts of this case, and the selling price of related APIs in Indian market constitute good comparables for applying the said method.
97. As regards Indapamide, based on the information about competitor drugs submitted by the assessee himself, the Transfer Pricing Officer ascertained the purchase price of Indapamide from Torrent Pharmaceuticals was producing Lorvas and Lorvas SR, in competition with Natrilix and Natrilix SR being produced by the assessee, which was found to be Rs 40,375 per kg. This API was imported from Italy. As against this price of Rs 40,375 per kg, the assessee paid Rs 1,89,456 per kg for imports from Servier France.
98. The assessee has not seriously challenged the quality of Indapamide used as CUP, beyond making some general and vague observations about inherent superiority of Servier products.
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99. The internal comparable uncontrolled prices which are stated by the assessee are in respect of sales made to entities based in Portugal, Japan, Syria, Korea and Tunisia, and these prices range between US $ 12,043 to US $ 26,708. There is, however, nothing on record to evidence the aforesaid transactions and give any further details in respect of the same. In any event, since these internal CUP pertain to a different geographical market and the assessee has not even documented the same or made any efforts to show commercial parity in these markets, these inputs are of no assistance to us.
100. It is also not the assessee's case before any of the authorities below that the assessee was not duly confronted with the material gathered by the Assessing Officer, as is required in terms of the proviso to Section 92 C (3), and as the comparable used by the Transfer Pricing Officer pertains to Indian market as related imports were made by an Indian enterprises, for an Indian market, from an Italian enterprises, we see no infirmity in CIT(A)'s confirming the action of the Transfer Pricing in this regard. The arm's length price of Indapamide thus does not call for any interference. We confirm the same.
101. As regards Trimetazidine, the basic grievance of the assessee against the CUP in the domestic market being adopted is that not only inherent but demonstrated superiority, by way of test reports, of the Trimetazidine manufactured by the asseessee's AEs vis-à-vis the Trimetazidine manufactured indigenously.
102. The technical superiority of the APIs imported by the assessee is in terms of purity standards and in terms of the lower standards of manufacturing facilities of Nivedita Chemicals. The highest of differences between products as per Japanese Pharmocopia standards, as was being manufactured by Nivendita Chemicals and the same product as per British Pharmocopia standards, as was the product imported by the ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 66 of 71 assessee from its AE, worked out to Rs 4,850. In addition to the CUP of Rs 12,000 per kg, the Transfer Pricing Office allowed Rs 4,850 per kg for higher quality standard as also an additional allowance of Rs 5,000 towards impurities. The assessee has not made out a case for higher adjustments to be allowed in respect of the same, and it is not, therefore, the case that an adjustment for higher quality of product has been declined to the assessee. Even as we confirm the orders of the authorities below on this issue, we make it clear that the assessee is not prevented from making any such claim for adjustments in value, as he may deem appropriate and can justify, in future, and, to this extent, the issue is left open. Subject to these observations, in our considered view and on the given facts, these adjustments reasonably cover the variations in quality of API manufactured by Nivedita Chemicals vis-à-vis API manufactured by Servier Egypt which was purchased by the assessee for Rs 52,546 per kg.
103. As regards the internal CUPs furnished by the assessee, we find that these inputs are, strictly speaking, not internal CUP in the sense that while the assessee has imported Trimetazidine from Servier Egypt, the sale instances to unrelated parties are by Servier France. In any event, as in the case of Indapamide, the comparable uncontrolled sale instances are in respect of different geographic markets and without necessary supporting documentation. For all these reasons, we reject the internal CUP inputs provided by the assessee.
104. For the reasons set out above, we confirm the action of the CIT(A) in respect of ALP adjustments having been sustained in respect of imports of Trimetazidine as well. There is no need for our interference on this count either. In the result, all the ALPs sustained in appeal by the CIT(A) are confirmed by us as well.
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105. By way of an additional ground of appeal for the assessment year 2002-03, however, the assessee has taken up the ground of appeal to the effect that the reference to the Transfer Pricing Officer, having been made beyond 30 th June, 2003, was bad in law as it was in violation of circular dated 20 th May 2003. Even though learned Departmental Representative vehemently opposed admission of this additional ground of appeal, particularly as it is a pure question of law on undisputed material facts and in view of Hon'ble Supreme Court's judgment in the case of National Thermal Power Corporation Vs CIT (229 ITR 383), we have admitted this ground of appeal, and we proceed to dispose of the same on merits.
106. Learned counsel for the assessee has raised this objection for the assessment year 2002-03, on the ground that the reference made by the Assessing Officer to the Transfer Pricing Officer was time barred inasmuch as while the Central Board of Direct Taxes, vide circular dated 20 th May 2003, directed the field officers that "(t)he work relating to selection of cases for scrutiny and reference to the TPO in respect of pending returns filed for the assessment year 2002-03 should be completed by June 30, 2003", the actual reference to the Transfer Pricing Officer was made by the Assessing Officer on 20 th January 2004. He submits that these directions of the CBDT are mandatory and binding on the Assessing Officer and the CIT(A), as was noted by a five member bench of this Tribunal in the case of Aztec Software & Technology Services Ltd Vs Assistant Commissioner of Income Tax ( 294 ITR AT 32), and that, as held by Bilaspur bench of this Tribunal in the case of Sunita Finlease Limited Vs DCIT (118 TTJ 263), when an Assessing Officer carried out a scrutiny assessment beyond the time limit prescribed vide a CBDT instruction, the assessment order so passed was liable to be quashed as it suffered lack of jurisdiction. A reference was then also made to Hon'ble Andhra Pradesh High Court's judgment in the case of CIT Vs Nayana P Dedhia (270 ITR 572) which holds that selection of a case for scrutiny assessment in violation of directions of the Central Board of ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 68 of 71 Direct Taxes was legally unsustainable, and the assessment framed on the basis of such assessment was liable to be set aside. On the basis of these arguments, learned counsel submits that the reference made to the TPO was void ab initio as it was made after the time limit stipulated by the CBDT. We are urged to set aside the order passed by the Transfer Pricing Officer for this short reason alone. Learned Commissioner (Departmental Representative), on the other hand, vehemently opposes the submissions made by the learned counsel for the assesse. He submits that the directions contained in the circular dated 20 th May 2003, are merely recommendations and not directions. He submits that these directions do not prohibit the Assessing Officer from making references to the Transfer Pricing Officer, after 30 th June 2003, but merely suggest that, with a view to organize things in an orderly fashion, that 'selection of cases for scrutiny and references to the Transfer Pricing Officer' should be completed by 30 th June, 2003. It is pointed out that, as against this suggestion, the CBDT, wherever it so considered appropriate, has prohibited the Assessing Officer from resorting to selection of scrutiny cases in certain situations. As regards assessee's reliance on certain observations in Aztec's case (supra), learned counsel submits that these observations are not applicable as these observations are made in the context of threshold limit for references to the TPO which is not issue before us. Learned departmental representative thus urges us to reject the hyper technical objection raised by the assessee and proceed to decide the matter on merits. In his brief rejoinder, learned counsel for the assessee once again submits that the instructions issued by the CBDT are binding on the Assessing Officer, and an action of the Assessing Officer, which is in violation of the CBDT directions, cannot confer a legally valid jurisdiction to the Assessing Officer. Since the Assessing Officer has made the reference on a date later than the outer limit laid down by the CBDT, this reference has to be held as devoid of jurisdiction. He reiterates his submissions once again.
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107. Having given our careful consideration to the rival contentions, we are unable to sustain the preliminary objection raised by the assessee. We have noted that the Central Board of Direct Taxes has, vide instruction no. 3 (supra), issued the guidelines "in order to maintain uniformity of procedure and to ensure that work in this important area proceeds smoothly and effectively". In the guidelines so laid down, it was observed that the "(t)he Central Board of Direct Taxes, therefore, have decided that wherever the aggregate value of international transaction exceeds Rs. 5 crores, the case should be picked up for scrutiny and reference under section 92CA be made to the TPO" . Having so laid down the criterion, and having observed that "(t)he threshold limit of Rs. 5 crores will be reviewed depending upon the workload of the TPOs", it was recommended that "(t)he work relating to selection of cases for scrutiny and reference to TPO on the above basis in respect of pending returns filed for the assessment year 2002-03 should be completed by June 30, 2003". A plain reading of this instruction does not suggest that there was any bar on making of references to the TPO after 30 th June 2003 or that all these references will have to be necessarily completed before that date, as, for example was the position, in the context of CBDT instruction dealt by the Bilaspur bench of this Tribunal in the case of Sunita Finlease (supra), and by Hon'ble Andhra Pradesh High Court in the case of Nayana P Dedhia (supra). In the case of Sunita Finlease (supra), the coordinate bench was dealing with a situation in which the CBDT had specifically directed that "(f)or returns filed during the current financial year 2004- 05, the selection of cases for scrutiny will have to be completed within 3 months of the date of filing of the return" (emphasis supplied by us). Similarly, in the case of Nayana P Dedhia (supra), Their Lordships were dealing with a situation in which there was a specific bar from selecting a case in scrutiny assessment in which income offered to tax in the relevant assessment year was 30% more than the income offered to tax in the immediately preceding assessment year as the CBDT had, in its circular, inter alia stated that "(t)he Income-tax Department has decided not to ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08 Assessment year: 2002-03, 2003-04 and 2004-05 Page 70 of 71 select returns for the assessment year 1996-97 for detailed scrutiny if the total income declared is at least 30% more than the total income declared for the assessment year 1995-96" ( emphasis supplied by us). When cases were selected for scrutiny in violation of this specific bar on the Assessing Officer, the action of the Assessing Officer was held to be unsustainable in law. These situations are quite different from the situation before us, inasmuch as there is not even a suggestion of specific bar from making a reference to the TPO after 30 th June 2003, inasmuch as the instructions are specifically to 'ensure that work in this important area proceeds smoothly and effectively' rather than to vest a right for the assessee, and inasmuch as the expression 'should' stands for, in the given context, the suggestion that this references to the TPO ideally be completed before 30 th June 2003. In our humble understanding, this reference to 30 th June 2003 cannot be construed as outer limit for making references to the Transfer Pricing Officer, and that is in sharp contrast with, as highlighted above, situations that Hon'ble Andhra Pradesh High Court and Bilaspur bench of this Tribunal have dealt with in the cases relied upon by the learned counsel. Learned counsel's reliance on these judicial precedents is thus of no avail. As regards learned counsel's reliance on Aztec decision (supra), we find that the observations made by the Tribunal were in the context of the threshold limit and not in the context of the time limit for making references to the Transfer Pricing Officer. In any event, as we have noted above, the CBDT instruction does not restrict the powers of the Assessing Officer from making references to the Transfer Pricing Officer after 30 th June 2003.
108. In view of these discussions, and bearing in mind entirety of the matter, we reject the technical objection raised by the assessee. There is no legal infirmity in the reference made by the Assessing Officer to the Transfer Pricing Officer. The additional ground of appeal is also, therefore, dismissed.
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109. In the result, appeal for the assessment year 2002-03 is dismissed.
110. No independent arguments were advanced by either side for the assessment years 2003-04 and 2004-05. Learned representatives have agreed that whatever is decided for the assessment year 2002-03 will apply mutatis mutandis for these two assessment years well. As we have not found any merits in the appeal for the assessment year 2002-03, the appeals for the assessment years 2003-04 and 2004-05 are to be rejected as well. We do so.
111. In the result, all the three appeals are dismissed. Pronounced in the open court today on 31 st day of December, 2010.
Sd/xx Sd/xx
(N V Vasudevan) (Pramod Kumar)
Judicial Member Accountant Member
Mumbai; 31 st day of December, 2010.
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2. The respondent
3. Director of Income Tax (Int'l Taxation) , Mumbai
4. Commissioner (Appeals) - , Mumbai
5. Departmental Representative, L bench, Mumbai
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Assistant Registrar
Income Tax Appellate Tribunal
Mumbai benches, Mumbai