Income Tax Appellate Tribunal - Delhi
Samsung Telecomunication India Pvt. ... vs Assessee on 28 September, 2011
ITA NO. 5316/Del/2011
IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCH "I", NEW DELHI
BEFORE SHRI R.P. TOLANI, JUDICIAL MEMBER
AND
SHRI SHAMIM YAHYA, ACCOUNTANT MEMBER
I.T.A. No. 5316/Del/2011
A.Y. : 2007-08
Samsung India Electronics Private vs. Assistant Commissioner of
Limited, Income Tax, Circle 7(1),
(Formerly Samsung New Delhi
Telecommunication India Private
Limited)
3rd floor, Tower-C, Vipul Tech
Square, Sector-43, Golf Course
Road, Gurgaon-122002
(PAN: AAACS5123K)
(Appellant ) (Respondent )
Assessee by : Sh. M.S. Syali, Sr. Adv.,
Sh. Tarandeep Singh, FCA
Department by : Sh. Peeyush Jain, C.I.T.(D.R.)
ORDER
PER SHAMIM YAHYA: AM This appeal by the Assessee is directed against the Order of the Assessing Officer passed u/s. 143(3) read with section 144C of the I.T. Act vide order dated 28.9.2011.
2. The grounds raised read as under:-
Ground No. 1That the Ld. Assessing Officer /Hon'ble DRP has erred in law and on facts and in circumstances of the case, in confirming the TPO's order passed under section 92CA(3) of the Act, taking the arm's length price of 'royalty' paid to an associated enterprise (AE) at 'nil' in respect of goods manufactured and sold the other AEs.1
ITA NO. 5316/Del/2011 Ground No. 2 That the Hon'ble DRP has erred in law and on facts in concurring with findings of the Assessing Officer / TPO and disregarding the economic analysis undertaken by the appellant for establishing the arm's length price of the international transactions undertaken by the appellant without appropriate justification.Ground NO. 3
That the TPO/ Assessing Officer has erred in law and on facts in making an adjustment under section 92CA without returning a finding about existence of circumstance(s) specified in clauses (a) to (d) of sub-section (3) of Section 92C in case of the appellant.Ground No. 4
Ground No. 4.1 That the TPO/Assessing Officer has erred in law and on facts in holding that the ALP of royalty payment of Rs. 26,681,794/- paid by the appellant is 'nil' by resorting to various frivolous/ incorrect/ baseless statements and misplacing reliance on OECD guidelines which are not relevant to appellant's case so as to mislead the cause of justice, thereby clearly demonstrating a prejudiced mindset driven with the single minded intention to recommend a TP adjustment.
Ground No. 4.2 That the Id. TPO/AO has erred in law and on facts in holding that the position of the appellant company with regard to manufactured goods sold to the AEs is that of a 'contract manufacturer' and ignoring the fact that the Functional, Asset and Risk (FAR) profile of the appellant for sales made to unrelated parties is similar to the sales made to AEs;
2ITA NO. 5316/Del/2011 Ground No. 4.3 That the Id. TPO/ AO has erred in law and on facts in ignoring the fact that the royalty paid by the appellant pertains to use of technical know-how and expertise in manufacture of products and not for use of 'Samsung' brand name or logo and that the use of technical know-howl expertise is critical to appellant's operation;
Ground No. 4.4 That the Id. TPO/ AO has erred in law and on facts in adopting a completely contradictory position of accepting the Transactional Net Margin Method ('TNMM') as the most appropriate method on one hand, and yet seeking to question appropriateness of individual elements of operating cost on the other, thereby failing to appreciate fundamental TP principles;
Ground No. 4.5 That the Id. TPO/ AO has erred in law and on facts in failing to appreciate that, based on the TNMM applied by the appellant in its TP documentation study, its operating profit margin (as arrived at alter deducting its entire royalty) was higher than that of the comparable companies, thereby evidencing the arm's length nature of its international transactions (including the international transaction relating to payment of royalty on export sales made to Group Companies);
Ground 4.6 That the Id. TPO/AO has erred in law and on facts in holding that royalty is paid to same AE to whom the goods are sold, when in fact royalty is paid to one AE and goods are exported to other A Es, and in making erroneous remarks that such an arrangement tantamount to transfer of profits out of India in the garb of royalty.
Grounds relating to corporate tax matters Ground NO.5 3 ITA NO. 5316/Del/2011 That the Id. AO has erred in law and on facts in disallowing an amount RS.36,540,354 (net of depreciation @25 percent) by treating payment of royalty as capital expenditure.
Ground No.6 Ground No. 6.1 That the Id. AO has erred in law and on facts in not treating UPS connected to computers as 'Computers' and instead regarding it as an item of general' Plant and Machinery' for the purpose of allowing depreciation.
Ground No. 6.2 Without prejudice to the above ground, the Id. AO has also erred in not regarding said UPS as 'Electrical equipment being Automatic Voltage Controllers', eligible for depreciation @80% under item III(8)(ix)(E)(c) of Part A of Appendix I to the Income tax Rules, J 962 ('the Rules').
Ground NO.7 That the Id. AO has erred in law and on facts in disallowing the loss of Rs.18,894,690 incurred in connection with foreign exchange forward covers by treating the same as speculative in nature under section 43(5) of the Act.
Ground NO.8 The appellant craves leave to add, amend, vary, omit or substitute any of the aforesaid grounds of appeal at any time before or at the time of hearing of the appeal.
3. Apropos the issue of Transfer Pricing Adjustment to royalty of Rs.
2,66,81,794/-
2,66,81,794/-
M/s Samsung Electronics Company Limited (SEC Korea) is the ultimate parent company of Samsung Group and is a worldwide 4 ITA NO. 5316/Del/2011 leader in semiconductor, telecommunication and digital convergence technology. M/s Samsung Telecommunication India is a company incorporated in October, 2005 in India, is a wholly own subsidiary of Samsung Electronics, Korea. The international transactions of the company are as follows:-
S.NO S.NO. Nature of Transaction Value of Transaction 1 Purchase of raw material 4,100,174,143 2 Purchase of consumables 5,824,766 3 Exports sales 1,724,554,461 4 Sales support income 17,643,478 5 Purchase of capital items 22,852,397 6 Payment of technical 109,992,360 assistance fee / royalty.
7 Receipt of IT services 32,435,821 8 Cost recharges paid 21,987,043 9 Cost reimbursement received 411,441,804 3.1 The assessee has used Transactional Net Margin Method (TNMM) to benchmark its international transactions. For this bench marking the assessee clubs its international transactions and claimed that its profit margin (operating profit by sales) was 6.95% whereas Bench mark profit margin was 1.80%. Thus the assessee claimed that profitability was sufficient for establishing that the assessee's international transaction were carried out at arms length price.
3.2 Out of the above expenditure, TPO referred to the assessee's detail of royalty paid. He noted that the royalty has been paid for export sales as well as domestic sales. TPO further noted that on examination of the details on royalty paid, it would be seen that on total exports sales of Rs.
1,724,554,461/- to AE, the assessee had deducted the cost of goods sold and on the net sales of Rs. 333,522,421/- royalty @ 8% at Rs. 26,681,794/- had been paid. The TPO issued a show cause notice to the assessee as under:-
5ITA NO. 5316/Del/2011 "2. Vide submission dated 19.08.2010, you have submitted the breakup of total royalty paid into royalty paid for export sales and domestic sales along with the basis of computation (royalty). On examination of the details of royalty paid furnished vide Annexure A, it is seen that on total export sales of Rs. 1,724,554,461/- to AE, you have deducted the cost of goods sold and on the net sales of Rs.
333,522.42/- royalty @ 8% at Rs. 26,681,794/- has been paid.
3. In the transfer pricing documentation, it is stated that the company received all technological inputs from its parent/group companies for the manufacture of mobile phones. It also receives IT related services from its group companies which specifically cater to its technological needs. For the purpose or its manufacturing activity. the company procures proprietary/ critical raw materials, components etc. from group companies. The critical fixed assets etc required for manufacturing are also procured from overseas group entities. The assessee STI is responsible for the production of the hand sets on the assembly lines and also undertakes testing, quality assurance, etc.
4. It is also mentioned in Para 4.3.4 and 4.3.5 of the Transfer Pricing report that the Associated Enterprises own significant intangibles like designs, drawings, patents, knowhow, technical information. testing quality control standards, etc. which are a result the R&D activities of the Group that are used by Samsung Telecommunications India. Further, Group companies also own the corporate brand name/logo. Samsung Telecommunications India is a licensed manufacturer that utilizes technical know-how etc. provided by associated enterprises. It does not undertake any significant R&D that leads to the development of non routine intangibles.
5. As staled above, you are paying royalty to your group companies for use of license technology and brand name and logo to your AE. You may therefore show cause as to why royalty payment made on 6 ITA NO. 5316/Del/2011 export sales to the group companies itself of Rs. 26,681,794/- should not be held to be payment in respect of which manufacturing is carried out by assessee as a contract manufacturer and the arm's length price of the above royalty be treated as Rs. Nil as per CUP method?"
3.3 In response to the above show cause notice, assessee filed the following objections and submissions:-
"1. Royalty is paid by the assessee to SEC Korea for the receipt of technical knowhow and expertise and not for Samsung "brand name" or "logo";
2. Royalty payment made by the assessee (including on exports made to group companies) has "direct nexus" with and is incurred solely for the purpose of the assessee's business. The assessee cannot carry out manufacturing activity, (either in the export markets or the domestic market), without access to the technical know-how and expertise developed by SEC Korea;
3. Assessee operates as fullfledged licensed manufacturing company and not as a contract manufacturer. FAR profile of the assessee remains same similar in respect of its overall operations i.e. For sales made to group companies as well as for sales made to totally unrelated parties. Further, export sales made by the assessee to group companies are also driven by open market conditions just as sales made by the assessee to unrelated parties:
4. Payment of royalty is a pass through cost for the assessee, as it recovers the same from its customers, whether group companies or unrelated parties, by building it in the sales price of the goods;
5. Royalty paid by the assessee on sales made to overseas group companies as well as third party sales has been demonstrated to be at arms' length by the assessee in its TP study.7
ITA NO. 5316/Del/2011
6. Owing to the fact that the assessee has made some sales to some other overseas group companies,' SEC Korea cannot be deprived of its right to earn an arms length return on these sales, in return for the R&D investments it has made over the years."
3.4 Considering the above, TPO observed that the position of the assessee company with regard to manufacturing for the AEs is that of a Contract Manufacture. The assessee company is purchasing raw material from the AEs. Goods are manufactured in India and then part of it is exported to AEs. TPO opined that the royalty paid as a percentage of sales to the associated enterprise is not at arm's length because it amounts to collecting royalty on the sales to itself. He observed that all the AEs are typical within the umbrella of the multinational corporation. That even though it appears that the technical know-how is commercially exploited in India, in reality, the price for these activities are not fixed by the market force. TPO opined that whether the sales of the assessee are made within India to its AE or to the parent company does not make much difference to the principles of arm's length transactions. Assessing Officer referred to the guidelines of the OECD in respect of the exploitation of intangible are :-
6.14 "Arm's length pricing for intangible property must take into account for the purposes of comparability the perspective of both the transferor of the property and the transferee. From the perspective of the transferor, the arm's length principle would examine the pricing at which a comparable independent enterprise would be willing to transfer the property. From the perspective of the transferee, a comparable independent enterprise mayor may not be prepared to pay such a price, depending on the value and usefulness of the intangible property to the transferee in its business. The transferee will 8 ITA NO. 5316/Del/2011 generally be prepared to pay this license fee if the benefit if reasonably expects to secure from the use of the intangibles is satisfactory having regard to other options realistically available.
Given that the licensee will have to undertake investments or otherwise incur expenditures to use the license it has to be determined whether an independent enterprise would be prepared to pay a license fee of the given amount considering the expected benefits from the additional investments and other expenditures likely to be incurred."
3.5 TPO further observed that in some circumstances the price of intangibles may stand included in price of goods either sold by the associated enterprises or purchased from the associated enterprise by the related party. In such circumstances, associated enterprises may build in value of intangible in cost of goods transacted. In this regard, TPO referred the following OECD guidelines:-
"6.17 The compensation for the use of intangible property may be included in the price charged for the sale of goods when, for example. one enterprise sells unfinished products to another and, at the same time, makes available its experience for further processing of these products. Whether it could be assumed that the transfer price for the goods includes a license charge and that, consequently, any additional payment for royalties would ordinarily have to be disallowed by the country of the buyer, would depend very much upon the circumstances of each deal and there would appear to be no general principle which can be applied except that there should be no double deduction for the provision of technology. The transfer price may be a package price. i.e. for the goods and for the intangible property. in which case, depending on the facts and circumstances, an additional payment for royalties may not need to be paid by the purchaser for being supplied with technical expertise. This type of package pricing 9 ITA NO. 5316/Del/2011 may need to be disregarded to calculate a separate arm's length royalty in countries that impose royally withholding taxes."
3.6 In light of the above, TPO observed that the assessee had not been able to demonstrate as to the benefit it has derived from the payments of royalty. No independent party would enter into the such kind of contract in which royalty is being paid to the AE to whom export or goods are being made. TPO observed that in fact this is transfer of profits out of India in the garb of royalty.
3.7 In the background of the above discussions, TPO held that the payment of royalty to the extent of Rs.266,81,794/- in the international transaction is treated to be a payment against services having arms length value being NIL.
4. Assessee filed the objections against the order before the DRP. The DRP summed up the assessee's objections as under:-
a. Once TNMM has been selected as the most appropriate method, questioning the appropriateness of the individual elements of operating cost is against fundamental TP principles.
b. Royalty is not for use of 'Samsung' brand, name or logo but for use of technical know-how and expertise and that transaction of payment of royalty satisfies the principle of 'commercial expediency.' c. There is no difference in FAR profile of the assessee between sales made to overseas related parties versus unrelated parties, there is no reason why there should be a difference in terms of the royalty paid/payable by the assessee on both types of sales.
d. The assessee has made some sales to other overseas group companies, SEC Korea cannot be deprived of its right to earn 10 ITA NO. 5316/Del/2011 an arm's length return on these sales, in return of the R&D investment it has made over the years.
4.1 The DRP did not find cogency in assessee's objections. The DRP observed that purchases of the assessee from group companies may include cost of intangible property therefore the question of payment of additional royalty does not arise. The DRP affirmed the TPO's action and concluded as under:-
"5.3 Under TNMM method, each international transaction is not bench marked separately. The result of tested party is compared at entity level with the result of comparables. It does not mean that each international transaction is at arm's length. Therefore, it cannot be said that payment of royalty to group companies is at arm's length. The purchases of the taxpayer from group companies may include the cost of intangible property, therefore, the question of payment of additional royalty by the taxpayer does not arise. We, therefore, uphold the action of TPO and we decline to interfere in this respect."
5. Now the assessee is in appeal before us.
6. We have heard the rival contentions in light of the material produced and precedent relied upon. Assessee's submissions on issue of transfer pricing adjustment to royalty is as under:-
"Term "contract manufacturer" has not been defined under the Income Tax Act. OECD commentary at para 7.40 (copy enclosed page 290 of PB-III) has noted as under:
"7.40 Contract manufacturing is another example of an activity that may involve intra-group services. In such cases the producer may get extensive instruction about what to produce, in what quantity and of what quality.
11ITA NO. 5316/Del/2011 The production company bears low risks and may be assured that its entire output will be purchased, assuming quality requirements are met. In such a case the production company could be considered as performing a service, and the cost plus method could be appropriate, subject to the principles in Chapter II." {LdCIT(DR) at page 8 of his draft submissions has wrongly quoted a definition of term "contract manufacture" stating it to be from OECD. It is submitted that OECD has defined term "contract manufacturer" only in para 7.40 (quoted by us above). The definition purported by LdCIT(DR) is not envisaged under OECD}. The LdCIT(DR) may be directed to produce the source.
Analysis of the definition quoted above clearly establishes that there must exist:-
(i) Extensive instruction should exist as regards nature, quantity and quality, and
(ii) An assurance should exist that the entire production will be purchased.
None of the above are factually alleged or satisfied in the present case. If the above was met it ceases to be an independent manufacture and becomes rendering of a service to the person so instruction and purchasing. In Indian jurisprudence it means a works contract. In the present case, as stated supra, majority of sales are to non-AE's. Any mandamus on the modus of sale in specifically denied and not found to be untrue. Appellant is an independent manufacturer selling goods it manufacturer. Support may be drawn from:-
(i) Central Board of Excise and Customs Circular No. F.No. 249/1/2006-CX.4 dated 27th October 2008 (copy filed during the course of hearing on 19th March 12 ITA NO. 5316/Del/2011 2012). In this Circular CBEC has clarified that the legal interpretation adopted by it in its earlier Circulars wherein Contract Manufacturing activity of bottling of Indian Made Foreign Liquors, Country Liquors, etc was classified as a Business Auxiliary Service was incorrect in law.
(ii) Hon'ble Bombay High Court in the case of Glenmark Pharmaceuticals Ltd reported in 324 ITR 199(Bom) has held that (relevant at page 212, para 21 and page 220, para 34) "where by an agreement between a pharmaceutical company and a manufacturer, it is the manufacturer who procures the raw materials and manufactures the product under the specifications of the company and sells the end-
product to the company. In the third situation, the manufacturer may also affix the trademark or brand name of the company, which in turn markets the product" the transaction is of sale purchase of goods and not a works contract.
(iii) Section 194C in clause (iv) sub clause (e) of the Explanation appended to the section has stated that manufacturing or supplying a product according to the requirement or specification of a customer by using material purchased from parties other than such customer is not a works contact.
TPO in his order has not assigned any cogent reason for holding that assesse is a "contract manufacturer". The reasoning given by the TPO (tabulated above in para2) in this regard in his order is submitted to be factually incorrect. It is now trite law that while exercising quasi-judicial powers all jurisdictional facts must be brought on record by the concerned authority. In absence of same the entire exercise is vitiated. {Reference Arun Kumar vs. UOI 286 ITR 81(SC) @ 13 ITA NO. 5316/Del/2011 page 91}.To reiterate, onus to prove that the apparent is not real in on the party who alleges so {Reference CIT vs. Daulat Ram Rawatmull 87 ITR 349(SC) @ 360}. Law as regards discharging of onus in TP cases is also now well settled by the Special Bench decision of Hon'ble ITAT in case of Aztec Software & Tech Ltd reported in 107 ITD 141(Bang)(SB) @ page 246, para 132.
Without prejudice it is submitted that following facts clearly demonstrate that appellant is not a "contract manufacturer":
(i) TPO has wrongly recorded a fact in his order that "no independent party would enter into such kind of a contract in which the royalty is being paid to the AE to whom export of goods are being made. In effect this is transfer of profits of India in the garb of royalty". In this regard it is submitted that in appellant's case export sales are not made to SEC Korea to whom royalty is being paid. Export sales are to other fellow subsidiaries (i.e Samsung Singapore, Samsung UAE and Samsung Philippines) and independent third party distributors.
Reference:
• pg 149 of PB-II • this fact was also clarified to the TPO vide submission dated 19th October 2010 @ para 43 onwards. Copy enclosed in PB-III pages 250 to 251@ Pg. 262, para 43. • this fact was also stated before DRP at page 68, Ground No. 3
(ii) In the relevant assessment year only small portion of appellant's total sales are to AE's (i.eaprox 33.40% in AY 07-
08 and 16.40% in AY 08-09). Bulk of the other sales (i.e 66.60% aprox in AY 07-08 and 83.60% in AY 08-09) are to non AE's. If this be so then appellant can't be termed as a contract 14 ITA NO. 5316/Del/2011 manufacturer. {Reference SonaOkegawa Precision Forging ITA No. 4781/Del/2010 order dated 16th December 2011 copy enclosed pages 278 to 285 relevant @ page 284, 7th line from bottom}.
(iii) Appellant operates as a full-fledged licensed manufacturer. In fact on export sales it is claiming benefit of deduction u/s 10A which is being granted. FAR profile of the appellant remains same/similar in respect of its overall operations i.e., for sales made to group companies as well as for sales made to totally unrelated parties. It will be significant to mention that the appellant is not mandated to sell goods to overseas group companies in any manner whatsoever. Just like any arm's length/third party situation, the sales made by the appellant to overseas group companies is dependent on the outcome of the negotiations between the overseas group companies and the appellant on the terms of the contract. Therefore, if the appellant gets favourable terms of contract from the overseas group companies, then it sells goods to them, just as in the case of any third party contract. It may further be noted that if at any given point of time, the appellant obtains better terms of contract from unrelated party than a related party, it would enter into the former engagement, like any prudent businessman.
References:
• Written submissions to TPO dated 19th October 2010 copy enclosed pages 252 to 263 of PB - III relevant at pages 256 to 259, paras 19 to 34.
• Statement of Facts before DRP pages 65 to 67 of PB-I.
(iv) It is submitted that in the royalty agreement @ pg 218, "technical information" and "technology" have been defined, these don't include trademark. As per Samsung Group's Global=-8 practice, once a marketing company pays royalty for manufacturing then no separate royalty is charged for use 15 ITA NO. 5316/Del/2011 of trademarks {Reference DRP Petition, Pgs 61 and 62}.Royalty is being paid on know how enabling manufacture after purchase of raw material.
TPO has in his order has blown hot and cold on same sets of facts. TPO has alleged that vis-à-vis export sale to AE's only appellant is a contract manufacturer. It is submitted that had this been so then appellant's class I transactions should have been divided by TPO into two different functional sets. Further he should have then benchmarked the same accordingly. However, TPO doesn't doubt appellant's benchmarking of class I vis a vis transactions other than the Royalty payments made on AE related export sales. It will be relevant to note here that for balance export sales also royalty was being paid by the appellant @ 8% under the same royalty agreement to SEC Korea. Further the TPO (at page 127, last line) has held that the sales made in India or to AE's will not materially affect the arm's length principals of the transaction. While holding so he has ignored a crucial fact that in the instant case the basis of payment of royalty (i.enot lump sum but on a percentage of per unit basis of sale) is same whether the sales are domestic or export sales. For even export sales made to third independent parties royalty is being collected by SEC at the same rate.
TPO @ pg. 129, para 7.4 has confused the issue by noting that the payment of royalty is "to itself" i.e., holding company. Further the TPO at page 127, para 7.2 has observed that "all the AE's typically within the broad umbrella of the multinational corporation". While doing so endeavoured to reach the so called economic substance ignoring the legal substance accepted and admitted in five separate jurisdictions. In such a situation the viel has only to be looked at and not looked through.
16ITA NO. 5316/Del/2011 ... Vodafone 341 ITR 1 SC @ pg. 36, para 68 of ITR citation copy of relevant extracts enclosed in PB-III at pages 266 to
270. Once it is held that assessee is not a contract manufacturer the case squarely gets covered by decision of Hon'ble ITAT in case of SonaOkegawa Precision Forging reported in 2010-TII-41-ITAT-DEL-TP copy enclosed pages 271 to 277 of PB-II. In this case it has been held by Hon'ble ITAT as under:
"16. The royalty was paid by the assessee under the Technology Agreement, computed on the basis of the entire production/sales. This remains undisputed. Further, it is also undisputed, as noted by the ld. CIT(A), that for the purpose of computing the fees to be paid for production, no distinction was made between the products sold to the AE or to independent parties. As such, the fee was paid on the sales made to the AE also.
There was no material brought by the TPO to demonstrate that the price on sales made to the AE was not at an arm's length .That being so, it was at market determined prices that the sales were made by the assessee. Moreover, it goes unchallenged that the fees paid under the Technology Agreement comprises an integral part of the cost of production, which was recovered from the sale price. It was thus, that so far as regards the sales made to the AE, the amount of fees paid under the Technology Agreement was recovered by the assessee from the AE as part of sale price. This being so, such fee paid became revenue neutral, that is to say, in case the assessee did not pay the fees on the sales made to the AE, a corresponding reduction in the price charged to the AE would have to be given by the 17 ITA NO. 5316/Del/2011 assessee, lest the cost for the sale come down. Such latter methodology was not advisable, for it would create problems in the accounting. Also, the impact on the taxable profits would be nil.
17. It was on taking into consideration all of the above that the ld. CIT(A) deleted the addition wrongly made by the AO. We do not find any reason to record any variance with the well reasoned elaborate findings of fact recorded by the ld. CIT(A). The same are hereby upheld. The grievance sought to be raised by the Department is thus found to be without substance and shorn of merit. The same is hereby rejected."
TPO in support of his view has relied upon paras 6.14 and 6.17 of the OECD commentary. It will be relevant to note that para 6.14 of the OECD Guidelines deals with benefit derived by the assessee by making royalty payments. It is important to note that the TPO in his order has not doubted the benefits received by the assesse from payment of royalty. Infact, by accepting the arm's length nature of royalty paid on sales made to third parties, the TPO has also implicitly accepted the benefit derived by the appellant by making royalty payment (irrespective whether it is made to group companies or third parties). Therefore, the statement of TPO that the appellant has not been able to demonstrate the benefit and reliance placed on para 6.14 is baseless. Further, para 6.17 states that in some circumstances, the price of the intangibles may stand included in price of goods transacted with AEs and consequently, any additional royalty would have to be disallowed in the case of the buyer. It may be noted that in his order the TPO has not provided any specific reason for placing reliance on the above para. Further, the TPO has not demonstrated any facts or circumstances substantiating that 18 ITA NO. 5316/Del/2011 the transfer price of goods include license charge/royalty and therefore, any additional payment for intangibles needs to be disallowed. If that was the case, then the TPO should have demonstrated the impact of the same in the transaction value of raw material purchase from group companies. On the contrary TPO has accepted the transaction value of purchase of raw material and consumables to be at arm's length using the TNMM.
Without prejudice even applying CUP no adjustment is called for-
for Without prejudice it is also submitted that even if CUP is applied then too the rate of royalty (i.e 5% on domestic sales and 8% on export sales) is at Arm's Length.
• these rates are approved by the Ministry of Commerce and Industry and which can be adopted as a comparable CUP. {Reference SonaOkegawa Precision Forging ITA No. 4781/Del/2010 order dated 16th December 2011 copy enclosed pages 278 to 285 relevant @ page 283, para 5}. • refer also last yr. TPO order for AY 06-07, pg.264 to 265 • there is also an internal CUP in as much as on per unit export sales to independent third parties also royalty has been paid @ 8%.
The Approval of RBI, no doubt may not be binding on the Income Tax Authorities vis-à-vis its deductibility there under. However, for comparability if a benchmark is fixed which applies to all - guidance coupled with other factum can certainly be derived. Thus decision of Nestle reported in 337 ITR 103 (Del) on deductibility is certainly not on the issue. The above criteria illustrated, its acceptability without prejudice, under CUP with reference to several criteria-one of which cannot be relied upon out of context and negated.
19ITA NO. 5316/Del/2011 It is submitted by the Ld. CIT(DR) that commercial expediency has no role to play in Transfer Pricing. Commercial expediency it is accepted may have a role to play only in adjustments while ascertaining comparables, if two entities do not stand pariparsu. This argument of the LdCIT(DR), however, cuts into an allegation of the TPO/AO that benefits of paying royalty have not been shown. If as per the LdCIT(DR) it is irrelevant, why this be relevant criteria to reject. Irrelevant criteria having crept in, the adjustment cannot stand.
The reliance however on Perot Systems TSI India Ltd 130 TTJ 685(Del)/37 SOT 358(Del) is misplaced. If comparables are accepted, the ends of Transfer Pricing are achieved. This however is not to accept that there is no benefit derived:-
(a) But for this know how manufacture was not possible.
(b) If Royalty was embedded in purchase price of raw material, it was equally embedded in those parts from which domestic and third party exports were made. How can the royalty be segregated. If not, the allegation is contradictory.
(c) While considering deductibility of royalty under normal computational provisions it is rightly accepted that it is wholly and exclusively for the purpose of business. The allegation only is that it may be in capital field.
In Perot's case (supra) a factual finding was recorded by Hon'be ITAT that "it is noted that this is not a case of ordinary business transaction"(refer para 10 of TTJ or SOT citation).
6.1 Ld. Departmental Representative submissions on the issue are as under:-
"The TPO held that the assessee was akin to a contract manufacturer and is doing contract manufacturing for the group entities, as far as the assessee's related party exports 20 ITA NO. 5316/Del/2011 are concerned. As per OECD definition, a contract manufacturer is CONTRACT MANUFACTURER: A manufacturer, in most cases, located in a low cost jurisdiction, which has to license to use an intangible property developed by its parent company. The manufacturer uses the intangible property to produce tangible property which is then resold to the parent for distribution to ultimate customers.
The assessee's technology licence agreement with its group parent M/s Samsung Electronics Company Ltd., Korea , SEC dated 26.2.2006, article 6.2(d)&(e) thereof specifies responsibilities of the assessee as follows:-
The assessee company shall " (d) purchase and verify the quantity and quality of the raw and packaging materials, parts and machinery on the basis of SEC's advice and from suppliers and endorsed by SEC, (e) dispatch to SEC at the Company's expenses such samples of regular production of the Company's Products as SEC may reasonably request to allow SEC to verify that production continues to be in accordance with the designs, specifications, manufacturing standards and usage factors prescribed and that it conforms to the standards and quality established by SEC; (pl. see page 225 of the paper book) . An analysis of the above shows that effectively the assessee was doing contract manufacturing for its related parties, as it had obtained technology from the group entity and most of the raw materials were purchased from group entities and even the quantity and quality of raw and packaging materials, and machinery etc., and the suppliers were dictated by the Korean Parent (SEC). Even the export sales were to the related parties, or to distributors specified by the group. In such a situation, the assessee's activities relating to export of manufactured items to group 21 ITA NO. 5316/Del/2011 entities was akin to contract manufacturing. In a comparable situation as this, no one would pay and royalty. Payment of royalty in such a situation would amount to paying royalty to oneself. Therefore, the TPO rightly proceeded to determine the Arm's Length Price of payment of royalty relating to goods exported to group entities at NIL.
The assessee's argument of Commercial Expediency It is admitted that revenue cannot dictate how an assessee needs to carry out its business. But in a transfer pricing situation, the assessee needs to establish that the transactions carried out with its related parties were at Arm's length price. The argument of Commercial Expediency is not a valid argument in a transfer pricing situation.
Support is found from the ruling of M/s Perot Systems TSI India Ltd. vs. DCIT (Delhi Trib.) dated 30.10.2009, on Hon'ble Sh. AD Jain and Shamim Yahya 5 ITR (Trib.) 106 Del. 130 TTJ 685, 2010 37 SOT 358.
The assessee's argument of RBI approval for payment of royalty.:-
RBI and the other Govt. Authorities are not Transfer Pricing Authorities. It has been held in the case of M/s Perot Systems TSI India Ltd. vs. DCIT (Delhi Trib.) that RBI's approval does not put a seal of approval on the true character of the transaction from the perspective of TP regulations as the substance of the transaction has to be judged as to whether the transaction is at arm's length or not. This view was upheld by the Hon'ble Punjab and Haryana High Court in the case of M/s Coca Cola India, 209 ITR 194 and by the Hon'ble Delhi High Court in the case of M/s Nestle India Ltd. 337 ITR 103, para 15 thereof.22
ITA NO. 5316/Del/2011 The assessee did not specify as to how were the prices fixed between its AEs and itself The assessee did not specify as to how were prices arrived at between itself and its related parties. The assessee has claimed that it purchased goods from its AE at Arm's Length Price. If the assessee claims that had it not paid royalty to its AE it would have had to pay higher prices for its import of goods from its AE is self contradictory because the assessee claims that it had purchased goods from its AE's at Arms Length Price."
6.2 We have carefully heard the submissions and perused the records. We find that assessee in this case has paid the royalty to its AEs on total exports sales of Rs. 1,724,554,461/- to AE, the assessee had deducted the cost of goods sold and on the net sales of Rs. 333,522,421/- royalty @ 8% at Rs. 26,681,794/- had been paid. The TPO observed from the transfer pricing documentation that the assessee has received all technological inputs from its parent/group companies for the manufacture of mobile phones. It also receives IT related services from its group companies which specifically cater to its technological needs. For the purpose of its manufacturing activity, the company procures proprietary/ critical raw materials, components etc. from group companies. The critical fixed assets etc required for manufacturing are also procured from overseas group entities. The TPO opined that position of the assessee company with regard to manufacturing for the AEs was that of a Contract Manufacturer. That the assessee company is purchasing raw material from the AEs. Goods are manufactured in India and then part of it is exported to AEs. TPO opined that the royalty paid as a percentage of sales to the associated enterprise is not at arm's length because it amounts to collecting royalty on the sales to itself. That all the AEs are typically within the umbrella of the multinational corporation. Even though it appears that the technical know-how is commercially exploited in India, in reality, the price for these activities are not fixed by the market force.
23ITA NO. 5316/Del/2011 6.3 The above view of the TPO has been relied upon by the Ld. Departmental Representative. The Ld. Departmental Representative referred to the assessee's technology license agreement with its group parent M/s Samsung Electronics Company Ltd., Korea , SEC and observed that it specifies the responsibilities of the assessee as follows:-
The assessee company shall " (d) purchase and verify the quantity and quality of the raw and packaging materials, parts and machinery on the basis of SEC's advice and from suppliers and endorsed by SEC, (e) dispatch to SEC at the Company's expenses such samples of regular production of the Company's Products as SEC may reasonably request to allow SEC to verify that production continues to be in accordance with the designs, specifications, manufacturing standards and usage factors prescribed and that it conforms to the standards and quality established by SEC."
Ld. Departmental Representative has contended that an analysis of the above shows that effectively the assessee was doing contract manufacturing for its related parties, as it had obtained technology from the group entity and most of the raw materials were purchased from group entities and even the quantity and quality of raw and packaging materials, and machinery etc., and the suppliers were dictated by the Korean Parent (SEC). Ld. Departmental Representative further submitted that even the export sales were to the related parties, or to distributors specified by the group. In such a situation, the assessee's activities relating to export of manufactured items to group entities was akin to contract manufacturing. Ld. Departmental Representative opined that payment of royalty in such a situation would amount to paying royalty to oneself. Therefore, he submitted that TPO rightly proceeded to determine the Arm's Length Price of payment of royalty relating to goods exported to group entities at NIL.
6.4 As against the above, it is the submission of the assessee that royalty is paid by the assessee to SEC Korea for the receipt of technical knowhow and expertise. That the Assessee cannot carry out 24 ITA NO. 5316/Del/2011 manufacturing activity, (either in the export markets or the domestic market), without access to the technical know-how and expertise developed by SEC Korea. We find that this aspect of the submissions of the assessee has not been cogently rebutted by the TPO or the Ld. Departmental Representative. Under such circumstances, there is considerable cogency in the assessee's submission that assessee operates as ful-fledged licensed manufacturing company and not as a contract manufacturer. That FAR profile of the assessee remains same /similar in respect of its overall operations i.e. for sales made to group companies as well as for sales made to totally unrelated parties. Further, it has been submitted that export sales made by the assessee to group companies are also driven by open market conditions just as sales made by the assessee to unrelated parties. In this regard, TPO and Ld. Departmental Representative have not able to establish that exports sales made by the assessee to group companies are not driven by open market conditions. It is further noted that exports sales to AE were to fellow subsdiary (i.e. Samsung Singapore, Samsung UAE and Singapore, Phillipines). The royalty in this regard was paid to SEC Korea. In these circumstances, we find considerable cogency in the assessee's ubmissions that owning to the fact that the assessee has made some sales to some other overseas group companies, SEC Korea cannot be deprived of its right to earn an arms length return on these sales, in return for the R&D investments it has made over the years.
6.5 We further note that the contract manufacture has not been defined under the Income Tax Act. The definition of contract manufacture, as per OECD commentary at para 7.40 is stated as under:-
"7.40 Contract manufacturing is another example of an activity that may involve intra-group services. In such cases the producer may get extensive instruction about what to produce, in what quantity and of what quality. The production company bears low risks and may be assured that its entire output will be purchased, assuming quality requirements are met. In such a case the production 25 ITA NO. 5316/Del/2011 company could be considered as performing a service, and the cost plus method could be appropriate, subject to the principles in Chapter II."
6.6 From the above definition, it is clear that there must exist:-
(i) Extensive instruction should exist as regards nature, quantity and quality, and
(ii) An assurance should exist that the entire production will be purchased.
6.7 In this regard, we note that SEC, Korea keeps a close watch on the quality of the raw-material and the production process. However, it does not determine the quantity of production and the terms of sales. There is no assurance to the assessee company that its entire production will be purchased. Ld. Counsel of the assessee has submitted the sale prices to the AEs are determined by market force and not dictated by the SEC Korea. It is noted that in the relevant assessment year only small portion of assessee's total sales are to AEs (i.e. approx 33.40% in AY 07-08 and 16.40% in AY 08-09). Bulk of the other sales (i.e 66.60% approx in AY 07- 08 and 83.60% in AY 08-09) are to non AE's. In these circumstances, assessee cannot be termed as contract manufacturer.
Thus, Revenue has not been able to bring on record any evidence that assessee is mandated to sell goods to overseas group companies in any manner. It has been claimed by the ld. Counsel of the assessee that just like in arms length/third party situation, the sales made by the assessee to assessee group company is dependent at the outcome of the negotiation between the overseas group companies and assessee on the terms of the contract. It has further been submitted that at any point of time the assessee obtains better terms of contract from unrelated party, than the related then it, will enter into a formal engagement with the un- related party like any prudent businessman. The above submissions of the assessee has not been controvered by the Revenue in any cogent manner.
26ITA NO. 5316/Del/2011 6.8 It has further been submitted by the ld. Counsel of the assessee that the TPO has in his order blown hot and cold on same sets of facts. TPO has alleged that vis-a-vis export sale to AE's only assessee is a contract manufacturer. That had this been so then assessee's class I transactions should have been divided by TPO into two different functional sets. Further he should have then benchmarked the same accordingly. That however, TPO doesn't doubt assessee's benchmarking of class I transactions other than the Royalty payments made on AE related export sales. It has been submitted that for balance export sales also royalty was being paid by the appellant @ 8% under the same royalty agreement to SEC Korea. It has been submitted that the TPO has ignored the crucial fact that in the instant case, the basis of payment of royalty is not lump sum but on a percentage of per unit basis of sale. It is same whether the sales are domestic or export sales. For even export sales made to third independent parties royalty is being collected by SEC at the same rate.
6.9 Thus, we agree with the ld. Counsel of the assessee that TPO has confused the issue by noting that the payment of royalty is "to itself" i.e., holding company. In this regard, it has been submitted that TPO at page 127, para 7.2 has observed that "all the AE's typically are within the broad umbrella of the multinational corporation". It has been rightly submitted by the ld. Counsel of the assessee that that while doing so TPO endeavoured to reach the so called economic substance ignoring the legal substance accepted and admitted in separate jurisdictions. In such a situation the viel has only to be looked at and not looked through.
6.10 Furthermore, it has been contended by the ld. Counsel of the assessee that TPO in support of his views has relied upon para 6.14 and 6.17 of the OECD Commentary. That it will be relevant to note that para 6.14 of the OECD guidelines deals with benefits derived by the assessee by making the royalty payments. In this regard, ld. Counsel of the assessee has rightly pointed that the TPO in his order has not doubted the benefits received by the assessee from the payment of royalty. That in fact by accepting the arms length nature of royalty paid on sales made to 27 ITA NO. 5316/Del/2011 third party, the TPO has implicitly accepted the benefit derived by the assessee by making royalty payment (irrespective whether it is made to group companies or third parties). Thus, we agree with the contention of the ld. Counsel of the assessee that in these circumstances, the statement of the TPO that assessee has not been able to demonstrate the benefit is not sustainable and hence reliance placed on para 6.14 is devoid of cogency.
6.11 It has further been pointed by the ld. Counsel of the assessee that para 6.17 of the OECD Commentary states that in some circumstances, the price of the intangibles may stand included in price of goods transacted with AEs and consequently, any additional royalty would have to be disallowed in the case of the buyer. In this regard, we agree with the ld. Counsel of the assessee that in his order the TPO has not provided any specific reason for placing reliance on the above para. Further, the TPO has not demonstrated any facts or circumstances substantiating that the transfer price of goods include license charge/royalty and therefore, any additional payment for intangibles needs to be disallowed. That if that was the case, then the TPO should have demonstrated the impact of the same in the transaction value of raw material purchased from group companies. On the contrary TPO has accepted the transaction value of purchase of raw material and consumables to be at arm's length using the TNMM.
6.12 We further find that reliance placed by the ld. Counsel of the assessee upon the decision of the I.T.A.T, Delhi in the case of SonaOkegawa Precision Forging (Supra) is also germane and supports the case of the assessee on the facts and the circumstances of the case. In this case, the ITAT has held as under:-
"16. The royalty was paid by the assessee under the Technology Agreement, computed on the basis of the entire production/sales. This remains undisputed. Further, it is also undisputed, as noted by the ld. CIT(A), that for the purpose of computing the fees to be paid for production, no distinction was made between the 28 ITA NO. 5316/Del/2011 products sold to the AE or to independent parties. As such, the fee was paid on the sales made to the AE also.
There was no material brought by the TPO to demonstrate that the price on sales made to the AE was not at an arm's length .That being so, it was at market determined prices that the sales were made by the assessee. Moreover, it goes unchallenged that the fees paid under the Technology Agreement comprises an integral part of the cost of production, which was recovered from the sale price. It was thus, that so far as regards the sales made to the AE, the amount of fees paid under the Technology Agreement was recovered by the assessee from the AE as part of sale price. This being so, such fee paid became revenue neutral, that is to say, in case the assessee did not pay the fees on the sales made to the AE, a corresponding reduction in the price charged to the AE would have to be given by the assessee, lest the cost for the sale come down. Such latter methodology was not advisable, for it would create problems in the accounting. Also, the impact on the taxable profits would be nil.
17. It was on taking into consideration all of the above that the ld. CIT(A) deleted the addition wrongly made by the AO. We do not find any reason to record any variance with the well reasoned elaborate findings of fact recorded by the ld. CIT(A). The same are hereby upheld. The grievance sought to be raised by the Department is thus found to be without substance and shorn of merit. The same is hereby rejected."
6.13 We find that the facts of the above case are similar to the facts of this case as discussed hereinabove. Hence, the above decision also supports the case of the assessee.
29ITA NO. 5316/Del/2011
7. In the background of the aforesaid discussions and precedents, we hold that royalty payment on exports sales by the assessee to the AE's @ 8% at Rs. 266,81,794/- has been rightly paid the royalty paid is at arms length and no adjustment in this regard is called for.
7.1 Another facet of arguments in this case by the Ld. Counsel of the assessee is that there can be only one Most Appropriate Method (MAP) which can be applied to arrive at the arms length price. Once as per MAP the ALP is arrived, no further testing by applicability of another method is envisaged by or is permissible as per law. We find that the above issue has not been commented upon either by the TPO or the DRP. Since we have already on merits hereinabove held that the royalty paid to AEs was at arms length, the adjudication of this aspect is only of academic interest. Hence, we are not dealing with the same.
7.1 As regards the reliance placed by the ld. Counsel of the assessee on the fact that rates on royalty were approved by the Ministry of Commerce and there was approval of the RBI. We find that the same does not come to the assessee's rescue in view of the decision of Tribunal in Perot Systems (Supra). However, we find that the same is not relevant any more, as we have already held on merits hereinabove that the royalty paid to AEs was at arms length.
8. Apropos the issue of treating royalty as capital expenditure:
On this issue Assessing Officer noted that during the year under consideration the assessee has paid royalty of Rs. 7,54,02,267/- alongiwth Rs. 3,45,90,093/- as Technical Assistance Fee to its parent company, Samsung Electronics Corporation, Korea. Assessee was asked to show cause as to why the expenses claimed on royalty should not be capitalized. Assessee submitted that royalty was in connection to using knowhow to manufacture phone and it is based on sales percentage. This can be terminated at any time by giving 60 days notice, therefore, this expense should be treated as capital in nature. However, the Assessing Officer was not satisfied. He referred to the decision of the Hon'ble Apex 30 ITA NO. 5316/Del/2011 Court in the case of Southern Switch Gear Ltd. vs. C.I.T. 232 ITR 359 and Jonas Woodehead and Sons (India) Ltd. vs. C.I.T. 224 ITR 342. Referring to the above decisions, Assessing Officer noted that the above decisions establish positive test to determine as to when royalty payment would he held to be in the nature of capital expenditure these would be:-
i) The technical assistance covers establishment of factory and operation of thereof.
ii) Even after termination of agreement the assessee is entitled to continue manufacture.
iii) The right to make or manufacture certain goods exclusively in India itself is an independent right secured by assessee from foreign company.
8.1 In the background of the above, Assessing Officer observed that it will be clear that assessee company gets :-
i) Exclusive right to operate in the territory of India.
ii) The complete know how in such details and in such manner that average qualified technicians are able to manufacture the products.
iii) License to use trademark etc. for longer period of the giving it an enduring benefit.
8.2 Accordingly, Assessing Officer treated the payment of royalty as capital expenditure. Assessee objected about the above before the DRP. Assessee's main objections/contentions in this regard as noted by the DRP is as under:-
"As per the agreement, the assessee did not have exclusive rights of operation, as wrongly noted by the Assessing Officer. The relevant extract of Clause 3.1 of the Agreement is reproduced below:-31
ITA NO. 5316/Del/2011 "SEC hereby grants to the company upon the terms and conditions set forth in the Agreement, a non-exclusive and non-transferable license, with the Company's right to grant sub-license (the terms and conditions of which are to be determined by the parties), to use the Technical Information to use the Products at the facilities of the Company in India for sale in the domestic and international markets. "
As mentioned above, SEC has granted the assessee a non- exclusive and nontransferable licence to use the technical information in order to produce cellular phones for sale in domestic and export market. The payment is in the nature of running royalty and the rate is 5% and 8% of domestic and exports sales, respectively.
The Agreement is not for use of Trademark as wrongly noted by AO.
The Agreement can be terminated by either party by giving sixty (60) days notice, hence there is no enduring benefit.
The 'knowhow' obtained under the Agreement is for use during the currency of Agreement and on termination of the agreement, the assessee is required to stop using the technical know-how and to return the technical information to SEC.
Considering the various terms and conditions of the agreement, and keeping in mind the fact that payment is for mere 'use' of information in manufacture of phone and the payment is based on/ linked to sales, the same is a deductible expenditure under the Act.
32ITA NO. 5316/Del/2011 Royalty expenses were also disallowed by the AO in the preceding year i.e. Assessment Year 2006-2007 and the matter is pending before CIT(A) Rebuttal of AO's allegation: -
Exclusive right The AO's allegation on assessee being granted exclusive right to operate in the territory of India is wrong. Reference is invited to clause 3.1 of the Technology License Agreement which clearly provides that the Company has been granted a non-exclusive, non-transferable license to use technical information to produce the products and accordingly other manufacturers can also be granted a similar right.
License to use trademark etc. for longer period gives it enduring benefit The Agreement is not for use of any Trademark, but for granting it a Iicenece to use technical information for manufacture of products in India.
The Agreement can be terminated by either party by giving sixty (60) days notice, and on termination, the assessee is required to stop using the technical information and return the same to SEC.
It is argued before us that the cases relied upon by the AO are distinguishable for the following reasons:
a. A non-exclusive licence has been granted to the assessee to use technical information in order to produce cellular phones for sale in domestic and export market. b. That the payment is made in respect of an already established business and is not relating to setting-up of a factory.33
ITA NO. 5316/Del/2011 c. The technical information/know-how shall be returned to SEC on termination of the agreement.
The tax payer has relied upon the following decisions:
a. CIT Vs. Ciba of India Ltd. ('CIBA')(1968) (691TR 692) SC) b.CIT Vs. I.A.E.E. (Pumps) Ltd. (1997) 232 ITR 316 (SC).
c. Alembic Chemicals Works Co. Ltd. Vs. ClT 177 ITR 377 (SC) d. Denso Haryana Private Limited Vs. CIT (ITA No. 381 of 2009) e. CIT Vs. G4S Securities Systems (India) Pvt. Ltd 2011-TIOL-
430-HC-DEL-IT f. CIT Vs. Sharda Motor Industrial Ltd. 22.7 CTR 606 (Delhi HC) g. DCIT Vs. VRV Breweries and Bottling Industries Ltd. (85 TTJ
236)"
8.3 However, the DRP was not satisfied with the above. DRP held as under:-
"After going through the terms and conditions of the technical license agreement, it is found that the agreement was entered for continued production of mobile handsets of International standards in the very first month of beginning of productions. The technical information is made available to the taxpayer, whose personnel after getting proper training can continue production even without the assistance of SEC. It is also noticed from the head note of Article 7 that the payment for technical license fee, includes consideration for using trademark. Therefore the assessee has acquired enduring benefit and it was an important ,step forward to setting up the business of the assessee.
As regards to the ownership of technical information, we are of the view that during the currency of the agreement the assessee is the 34 ITA NO. 5316/Del/2011 owner of the technical know-how acquired from SEC. it can be said that the assessee is the partial owner of the technical know-how acquired from SEC. section 32(l)(ii) has envisaged such ownership for which depreciation is allowable under the Act ...
In view of the above discussion we decline to interfere with the proposed action of the Assessing Officer in this respect.
8.4 Considering the DRP's observations as above, Assessing Officer concluded as under:-
"In view of above, clearly whole expenditure is towards acquisition of assets by way "intangible assets" of the nature provided u/s 32(1)(ii) of I.T. Act. Since, the TPO in his order dtd. 29.10.2010 has restricted the payment of royalty by Rs.2,66,81,794, therefore, the balance amount of Rs. 4,87,20,473/- is held to be capital.
Accordingly, depreciation @ 25% being granted on such expenditure resulting in addition of Rs3,65,40,354/-. I am satisfied that assessee has failed to furnish true and correct particulars of its income, therefore, penalty proceedings u/s. 271(1)(c) are initiated separately."
8.5 Against the above order the Assessee is in appeal before us.
9. We have heard the rival contentions in light of the material produced and precedent relied upon. Assessee's submissions in this regard are as under:-
"Salient features of the agreement are summarised Annexure A. It is submitted that the AO has erroneously noted following facts in his order:
(i) That exclusive right is being given to appellant, and
(ii) That the agreement is for use of trademark.
A bare perusal of the agreement would show that both these facts are incorrect. This was specifically also pointed out before DRP @ page 31, last para of PB-1.
35ITA NO. 5316/Del/2011 DRP in its order has first recorded a fact @ page 32, para 6.3 that commercial production in mobile handsets commenced in February 2006 and the agreement was w.e.f. 26th February, 2006. However, at page 33, para 7 the DRP has erred in linking the supply of know-how with setting up of the business. Terms of the agreement clearly show that know-how was provided in the instant case to help in "continued production of mobile handsets" i.e. to help in manufacture of handsets. In fact from a perusal of chart at page 249 of PB-III would clearly show that royalty is being paid at sales minus cost of sales i.e the value addition taking place in the factory. Payment of royalty to SEC has nothing to do with setting up the business. If this be so them following cases support claim of appellant:
• TEI Technology P. Ltd., 304 ITR 262 (Del) @ pg 263. Copy enclosed pages 293 to 295 of PB-III • Munjal Showa Ltd., 329 ITR 449 (Del) @ 458, para
12. Copy enclosed pages 308 to 318 of PB-III Articles 5.1, 5.2 & 12.3 of the agreement clearly show that only a right to use of know-how has been provided to the appellant by SEC. The ownership of know-how is with SEC only. This satisfies the tests propounded by Delhi High Court in case of JK Synthetics Ltd., reported in 309 ITR 371 (Del) @ 412-413, paras (v) & (vi). Copy enclosed pages 325 to 370 of PB-III. It is submitted that the lower authorities have gloated over the fact that in the instant case "royalty" is not lump sum but is being paid as a % of sales made.
Since in the instant case royalty is a continuous process it will be revenue expenditure. References:
• Climate Systems India Ltd., 319 ITR 113 (Del) @ Pg. 118, para 8. Copy enclosed pages 296 to 302 of PB-III • Sharda Motor Industrial Ltd., 319 ITR 109 (Del) @ Pg 111, para 3 and Pg 112, para 8. Copy enclosed pages 303 to 307 of PB-III 36 ITA NO. 5316/Del/2011 • Ekla Appliances, 45 SOT 7 (Del) (URO) @ paras 23 to
25. Copy enclosed pages 319 to 324 of PB-III DRP at para 6.5 and 7 has also confused royalty payment with payments made for hiring/training of employees by SEC. Under the agreement separate consideration has been provided for (a) royalty for right to use the know-how; and (b) for imparting hiring/training.
DRP has ignored the fact that AO has made a disallowance of only royalty and not of hiring/training fee paid. {Refer Pg 149 of PB-II and Pg249 of PB-III. Royalty payment made is Rs.7.54 cr and total payments made during the year under consideration under the agreement are Rs.10.99 cr.}. Even otherwise, as held in Munjal Showa's case (supra)training in the instant case is only imperative to the manufacturing process and thus rightly allowed by AO as revenue expenditure.
DRP at Pg 34, para 8 has also wrongly relied upon provisions of section 32(1)(ii). Firstly, it is submitted that as clearly stated in Clause 5.1 & 12.3 of the agreement appellant is not the owner of the technical information/technology received by it from SEC. Secondly, even otherwise for section 32(1)(ii) to be applicable it is necessary to show that expenditure is capital in nature. A reverse logic is not applicable/sustainable in law {Reference Denso India Limited, ITA 16 of 2008 of Delhi High Court @ paras 15, 16, 18 and
19. Copy enclosed pages 371 to 390 of PB-III}.
The AO has relied upon the case of Southern Switch Gear Ltd 232 ITR 359(SC) - It is submitted that this case is not applicable to the facts of instant case. Hon'ble Supreme Court in this case has upheld the judgment of Hon'ble Madras High Court reported in 148 ITR 272(Mad). Following distinguishing features/points are highlighted from the judgment of Hon'ble Madras High Court:
(i) ITAT upheld disallowance of 25% of technical fees and 25% of royalty as capital expenditure (Pg 275 of ITR).
Royalty paid was lumpsum.
37ITA NO. 5316/Del/2011
(ii) Appellant in this case was starting up the work or establishment of the factory and the technical assistance contemplated in the agreement covered the establishment of the factory and the operation thereof for the manufacture of transformers of all kinds and types. (Pg 275, last para and pg 280, 2ndpara of ITR).
(iii) Exclusivity was provided thru a non-covenant clause in the agreement (pgs 277-78, para 5 of ITR) and a composite consideration was provided in the agreement for the provision of license information, goods and services rendered (pg 279, para 14 of ITR).
(iv) On these facts it was held by the Hon'ble Court that the conferment of an exclusive benefit to manufacture and sell the articles which were subject matter of the agreement and cannot be said to be a part of mere know how agreement. It was held that such a right was an independent right and therefore entire fee was not revenue. To that extent ITAT was right in attributing 25% of the composite fee to the non- covenant rights granted under the agreement.(Pg 280 of ITR)
(v) Praga Tools 123 ITR 773 (AP) (PB) case was also distinguished on similar terms holding that case to be a mere provision of know how (pg 281 of ITR).
This Southern Switch Gear's case has been distinguished by Delhi High Court in the case of Sharda Motor Industrial Ltd., reported in 319 ITR 109(Del) @ Pg 112, para 8 holding that lumpsum royalty was paid in case of Southern Switchgear contrary to item-wise sale % royalty.
The AO has also relied upon the case of Jonas Woodhead and Sons Ltd reported in 224 ITR 342(SC) - It is submitted that this was a case wherein under the terms and conditions of the agreement between the parties it was stipulated that the foreign firm would 38 ITA NO. 5316/Del/2011 give the appellant the technical information and know-how relating to the setting up of a plant suitable for manufacture of the products as well as the technical know-how relating to the setting up of the plant itself, the drawings, estimates, specifications, manufacturing methods, blue prints of production and testing equipment and other data and information necessary to manufacture the product and to set up proper and efficient plants.This distinction has also been highlighted in the case of Munjal Showa Ltd., reported in 329 ITR 449 (Del) relevant @ Pg 455, para 9. Copy enclosed pages 308 to 318 of PB-III}."
10. Ld. Departmental Representative on the other hand relied upon the orders of the authorities below. We have heard both the counsel and perused the records. On this issue Assessing Officer noted that assessee has paid royalty of Rs. 7,54,02,267/-. The fee was paid to its parent company Samsung Electronics Corporation, Korea. TPO opined that the above expenditure was capital in nature. In this regard, Assessing Officer has referred to the decision of the Hon'ble Apex Court in the case of Southern Switch Gear Ltd. vs. C.I.T. (Supra) and the case of Jonas Woodhead (Supra). Assessing Officer observed that in this case the assessee company gets exclusive right to operate in the territory of India, the complete know how is in such details and in such manner that average qualified technicians are able to manufacture the products and the license to use trademark etc. for longer period gives an enduring benefit.
11. In this regard, assessee has submitted that as per the agreements the assessee did not have exclusive rights of operations, as wrongly noted by the Assessing Officer. As per the relevant clause 3.1 of the agreement, the SEC has granted the assessee a non-exclusive and non-transferrable licence to use the technical information in order to produce cellular phones for sale in domestic and export market. The payment is in the nature of running royalty and the rate is 5% and 8% of domestic and exports sales, respectively. Thus, it is clear that the agreement is not for 39 ITA NO. 5316/Del/2011 use of trade mark, as wrongly noted by the Assessing Officer. But it is for grating it a license to use technical information for manufacture of products. Furthermore, the agreement can be terminated by either party in India by giving 60 days notice. Hence, there is no enduring benefit. The know-how obtained under the agreement is for use through the currency of the agreement and on termination of the agreement, the assessee is required to stop using the technical know how and to return the technical information to SEC. Thus, it has been submitted that considering the various terms and conditions of the agreement and keeping in mind the fact that payment is for mere use of information and manufacture of phone and the payment is based on / linked to sales, the same is a deductible expenditure under the Act.
12. We find that the above submissions of the assessee has considerable cogency. The facts of the case and the terms of agreement clearly point out the fact that royalty is being paid as revenue expenditure and it cannot be termed that the same is paid for acquiring benefit of enduring nature. We further agree with the submissions of the assessee's counsel that the DRP has erred in linking the supply of know-how with setting up the business. Terms of the agreement clearly showed that know how was provided in the instant case to help in continued production of mobile handsets i.e. to help in manufacture of handsets. As per the details of royalty paid, it is clear that royalty is being paid at sales minus cost of sales i.e. the value addition taking place in the factory. Payment of royalty to SEC has nothing to do with setting up the business. Assessee is only getting a right to use of know how from SEC. The ownership of know-how is with SEC only. Furthermore, royalty is not being paid in a lumpsum, but is paid as percentage of sales made. Hence, since the royalty in the instant case is continuous process, it will be revenue expenditure.
13. We further find that it has been rightly pointed out by the ld. Counsel of the assessee that the DRP has confused the royalty payment with payments made for hiring/ training of employees of SEC. Under the 40 ITA NO. 5316/Del/2011 agreement, separate considerations has been provided for (a) royalty for right to use the know-how; and (b) for imparting hiring / training. We find that the Assessing Officer has made the disallowance of only royalty and not of hiring /training fee paid. Thus, we find that revenue authorities have wrongly relied upon the provisions of section 32(1)(ii). The perusal of the agreement clearly states that assessee is not the owner of technical information / technology received by it from SEC. Furthermore, we note that in the assessee's submissions hereinabove, it has been clearly pointed out that the case of Sothern Switch Gear Ltd vs. C.I.T. (Supra) and Jonas Woodhead and Sons Ltd. (Supra) are not applicable on the facts of the case.
14. We further find that the case laws relied upon by the ld. Counsel of the assessee are germane and supports the case of the assessee.
14.1 In Munjal Showa Ltd. (Supra), it was held that expenditure incurred by the assessee on account of design and drawings fees and fees paid to foreign technicians for imparting training to Indian Technicians, related to the crafts of manufacturing and for a tenure and the documents, designs and specifications which have been supplied by the licensor are only for facilitating the said purpose of manufacturing and therefore, constituted the revenue expenditure.
14.2 In the case of Climate Systems India Ltd. (Supra), it was held by the Hon'ble High Court of Delhi that royalty paid by the assessee to the foreign collaborators had specified as percentage of its domestic export sales for using the technology and availing the technical services provided by the latter under the Technical Collaboration Agreement is allowable as revenue expenditure.
14.3 Furthermore, in the case of Sharda Motor Industrial Ltd. (Supra), the Hon'ble High Court of Delhi has held that running royalty paid by the assessee to the foreign collaborators at a specified rate per piece of product is revenue expenditure.
41ITA NO. 5316/Del/2011
15. In the background of the aforesaid discussion and precedents, we hold that royalty paid by the assessee to SEC, Korea was not of capital expenditure and it was a revenue expenditure and is to be allowed, as such.
16. Apropos issue of depreciation of UPS On this issue Assessing Officer noted that assessee had claimed depreciation @ 60% of UPS. Assessing Officer was of the opinion that UPS was mere accessories of the computer and it was not entitled to depreciation @ 60%. Assessing Officer allowed the depreciation @ 15% only.
17. The DRP affirmed the action of the Assessing Officer.
18. Against the above order the Assessee is in appeal before us. We have heard the rival contentions in light of the material produced and precedent relied upon. We find that UPS being a computer accessory / peripheral is entitled for depreciation @ 60%. In this regard, we draw support from the Hon'ble High Court decision in the case of C.I.T. vs. BSES Yamuna Powers Ltd. in ITA No. 1267/2010 vide order dated 31.8.2010 has held as under:-
"We are in agreement with the view of the tribunal that computer accessories and peripherals such as, printers, scanners and server etc. form an integral part of the computer system. In fact, the computer accessories and peripherals cannot be used without the computer. Consequently, as they are the part of the computer system, they are entitled to depreciation at the higher rate of 60%."
18.1 Following the ratio from the above decision of the Hon'ble Delhi High Court, we set aside the orders of the authorities below on this issue and allow the depreciation @ 60% on the UPS to the assessee.
19. Apropos disallowance of loss incurred in connection with Foreign Exchange Forward Covers On this issue Assessing Officer disallowed Forex Loss on Foreign Exchange contracts. The Assessing Officer disallowed the amount of Rs.
42ITA NO. 5316/Del/2011 4,14,02,228/- on the ground that these are of speculative nature and hence shall not be allowed to be set off against the normal business transactions. DRP in its order bifurcated the amount of Rs. 4,14,02,228/- as under:-
(a) Rs. 1,39,04,186/- being actual loss on account of difference in forex rates between the booking and payment on actual remittance during the year. It relates to fixed assets. The same has been added back by the assessee in computation of income, itself. .
(b) Rs. 86,03,353/- being actual loss on account of difference forex rates between the date of booking and payment on actual remittance during the year. It relates to revenue.
(c) Rs. 1,88,94,690/- being the actual expenses on part cancellation / surrender of unused forex contracts during the year.
- As regards (a) the DRP held that the forex loss is added by the assessee itself. Hence, there is no question of adding it again and again.
- As regards (b) the DRP held that there has been actual out flow of cash. Hence, it is allowable.
- As regards (c) the DRP held that there has been actual outflow of cash but it relates to cancellation / surrender of unused forex contracts. These contracts have been settled by the difference. The DRP was of the opinion that these are speculative losses, in view of Section 43(5) of the I.T. Act. The assessee agreed that these contracts were settled by way of difference. There has been no actual delivery of the underlying assets i.e. cash. It was further argued that forex contracts are not commodity, so section 43(5) will not apply. Further the following decisions were relied upon by the assessee before the DRP.
"1. The Delhi Bench of ITAT in the case of Munjal Showa Ltd.
vs. DCIT (94 TTJ 227) has held as under:-43
ITA NO. 5316/Del/2011 "...Foreign currency or any currency is neither commodity nor shares. The Sale of Goods Act specifically excludes cash from the definition of goods. Besides, no person other than authorized dealers and money changers are allowed in India to trade in foreign currency, much less speculate. S.8 of the Foreign Exchange Regulations Act 1973, provides that except with prior general or special permission of the RBI, no person other than an authorized dealer shall purchase, acquire, borrow or sell foreign currency. In fact, prior to the LERMS, residents in India were not even permitted to cancel forward contracts. The presumption of any speculative transaction is, therefore, directly rebutted in view of the legal impossibility and in view of the fact that foreign currency was neither commodity nor shares."
2. The Special Bench of ITAT Kolkata in the case of Shree Capital Services Ltd. vs. ACIT (121 ITD 498) has held that derivatives with underlying as shares and securities should be also considered as commodities as the underlying shares and securities as specifically included within the term commodities. Accordingly, transactions is security derivatives are subject to the provisions of s. 43(5). However, a currency cannot be termed as a commodity so as to attract the provisions of S. 43(5).
3. The Mumbai Bench of ITAT in the case of DCIT vs. Intergold (I) Ltd. (124 TTJ 337) has held that profits from cancellation of forward exchange contracts are business profits and not speculative profits.
19.1 Considering the above, DRP held as under:-
44ITA NO. 5316/Del/2011 "The commodity, as stated in the definition of speculative transactions, does not include only stock and shares but it includes much more than stock and shares. In the decision of ANZ Grindlays Banks vs. DCIT 88 ITD 53 (Del.), the ITAT held that;
"the word "commodity" in section 43(5) would not only include stock and shares but also securities and units in its plain and neutral meaning. Consequently, trading in such items would fall within the scope of "speculative transactions" subject to other conditions being fulfilled."
The derivatives referred in proviso (d) of section 43(5) are as referred to in clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956. As per which "derivative" includes:-
(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; (B) a contract which derives its value from the prices, or index of prices, of underlying securities;
Section 2(h) of Securities Control and Regulation Act defines "securities" to include derivative also. Therefore, derivative is also a commodity. Forward contracts are also derivatives. The dictionary meaning of "commodity" is "useful thing, article of trade". Therefore, currency, shares, securities and also units of UTI are also commodity. (Comfund Financial Services (I) Ltd. vs. DCIT 67 ITD 304 (Bang.) Hence, exchange loss of Rs. 1,88,94,690/- on part cancellation / surrender of unused forex contracts during the year is treated as speculation loss and it shall be carried forward and set off against the speculation income only for a period of 4 years in terms of Section 73 of the Income Tax Act."
20. Against the above order the Assessee is in appeal before us.
45ITA NO. 5316/Del/2011
21. Assessee has submitted before us that hedging contracts if entered in the normal course of business, will not be termed as speculative u/s. 43(5) of the I.T. Act. In this regard, assessee has relied upon the decision of Hon'ble Calcutta High Court in the case of C.I.T. vs. SurajmalNagarmull 129 ITR 169 (Cal.) and the decision of Hon'ble High Court of Bombay in the case of C.I.T. vs. BadridasGauridu (P) Ltd. 261 ITR 256 (Bom.).
22. Ld. Departmental Representative on the other hand supported the orders of the authorities below.
23 We have carefully heard the submissions and perused the records. We find that the Assessing Officer and the DRP in this regard have noted that the transaction in question are hit by the provision of section 43(5). It has been observed that these contracts were settled by way of difference. There was no actual delivery of the underlying assets i.e. cash. Hence, it has been held that the loss of Rs. 1,88,94,690/- on part cancellation / surrender of unused forex contracts during the year was speculative loss. On the other hand ld. Counsel of the assessee has submitted that these were only hedging contracts entered into in the normal course of business. Hence, they will not be termed as the speculative u/s. 43(5) of the I.T. Act.
23.1 In this regard, we find that in the case of C.I.T vs. SoorajmalNagarmull (Supra), the High Court of Kolkata has noted the facts and held as under:-
"The assessee firm carried on the business of import and export of jute. In the course of its business it used to enter into foreign exchange contracts in foreign exchange in order to cover the loss arising due to difference in foreign exchange valuation. The assessee had entered into foreign exchange contracts in 1952 with the Hindustan Mercantile Bank. The difference payable by the assessee on the forward contract was determined in December, 1952, but the assessee disputed its 46 ITA NO. 5316/Del/2011 liability. The dispute was settled in 1955, and its account in the bank was debited in June, 1955. The assessee claimed this loss amounting to Rs. 80,491/- as a revenue expenditure in the assessment year 1956-
57. The ITO disallowed the claim on the ground that the loss was a speculative loss and, in any event, as the assessee was following the mercantile system, it could not claim the loss in 1956-57. The AAC found that the transaction in which the loss arose was not speculative and this finding was upheld by the Tribunal. The AAC held that the loss did not relate to the relevant accounting year but the Tribunal held that the loss did not relate to the relevant accounting year but the Tribunal held that it was allowable in 1956-57 On a reference:
Held, (i) that the assessee was not a dealer in foreign exchange.
Foreign exchange contract were only incidental to the assessee's regular course of business. The AAC had made a categorical finding to this effect which had been upheld by the Tribunal. The loss was not a speculative loss but was incidental to the assessee's business and allowable as such.
(ii) That though the claim related to the breach alleged to have occurred in 1952, the settlement of liability was done by agreement between the parties in the year of account relevant to the assessment year 1956-57. The amount of Rs. 80,491/- was allowable in the assessment year 1956-57."
23.2 In this regard, we further find that in the case of C.I.T. vs. BadridasGauridu (P) Ltd. (Supra), the High Court of Bombay has noted the 47 ITA NO. 5316/Del/2011 facts and held as under:-
"The assessee was an exporter of cotton. The assessee had entered into forward contract with the banks in respect of foreign exchange. Some of these contracts could not be honored by the assessee for which it had to pay Rs. 13.50 lakhs, which was debited to the profit and loss account. The assessee claimed the same as business loss. The Assessing Officer held that the loss was not deductible as a business loss as it was incurred in a speculative transaction. The Tribunal held that it was a business loss. On further appeal to the High Court:
Held, dismissing the appeal, that the assessee was not a dealer in foreign exchange. The assessee was an exporter of cotton. In order to hedge against losses. the assessee had booked foreign exchange in the forward market with the bank. However, the export contracts entered into by the assessee for export of cotton in some cases failed. In the circumstances, the assessee was entitled to claim deduction in respect of Rs. 13.50 lakhs as a business loss."
23.3 We find that the ratio from the aforesaid decisions is clearly applicable on this case. The assessee in this case is not a dealer in foreign exchange. The assessee was dealing in electronic products -
mobile phones. The assessee had entered into hedging contracts in foreign exchange in the normal course of business. Hence, these transactions cannot be termed as speculative u/s. 43(5). Accordingly, we hold that the issue raised hereinabove is covered by the decision of the 48 ITA NO. 5316/Del/2011 Hon'ble High Courts as above. Under the circumstances, we set aside the orders of the authorities below and decide the issue in favour of the assessee.
24. In the result, the appeal filed by the Assessee stands allowed.
Order pronounced in the open court on 21/6/2013.
Sd/- Sd/-
[R.P. TOLANI]
TOLANI] [SHAMIM YAHYA]
JUDICIAL MEMBER ACCOUNTANT MEMBER
Date 21/6/2013
"SRBHATNAGAR"
Copy forwarded to: -
1. Appellant 2. Respondent 3. CIT 4. CIT (A)
5. DR, ITAT
TRUE COPY
By Order,
Assistant Registrar,
ITAT, Delhi Benches
49
ITA NO. 5316/Del/2011
50