Income Tax Appellate Tribunal - Delhi
Gap International Sourcing (India) ... vs Assessee on 27 July, 2011
IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCH "C" NEW DELHI
BEFORE SHRI R.P. TOLANI AND SHRI T.S. KAPOOR
ITA Nos. 5147/Del2011 & 228/Del/2012
A.Yrs. 2006-07 & 2007-08
GAP International Sourcing Vs. Asstt. Commissioner of
(India) Pvt. Ltd., Income-tax, Circle 12(1),
B-1/1-2, Mohan Cooperative New Delhi.
Industrial Estate, Mathura Road,
New Delhi-110044.
PAN: AACCG3437E
( Appellant ) ( Respondent )
Appellant by : Shri Rahul Krishna Mitra Adv.
Respondent by : Shri Piyush Jain CIT ( DR)
ORDER
PER R.P. TOLANI, J.M::
These are two appeals filed by the assessee against assessment orders passed consequent to directions of the Dispute Resolution Panel-II, New Delhi U/s 144C(5) of the Income-tax Act, 1961, relating to A.Y. 2006- 07 & 2007-08. Respective grounds are as under:
ITA no. 228/Del/12 (A.Y. 2006-07):
"1. The Learned Dispute Resolution Panel ("Ld. DRP') and the Ld. Assistant Commissioner of Income-tax ('Ld. A.O') (following the directions of the Ld. DRP), erred on facts and in law, in enhancing the income of the appellant by Rs. 236,22,31,473/- on account of the transfer pricing ('TP') adjustment u/s 92CA(3) of the Income Tax Act, 1961 ('Act') 2 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
made by the Ld. Additional Commissioner of Income-tax, Transfer Pricing Officer -1(1) ('Ld. TPO').
2. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in upholding the Ld. TPO's stance of not appreciating that the appellant is a low risk sourcing support service provider and disregarding the functional asset and risk ('FAR') profit of the appellant, on the basis of pre-conceived notions, surmises and conjectures , and without any cogent evidence, facts or basis whatsoever.
3. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in upholding the Ld. TPO's stance of disregarding the conservative benchmarking approach adopted by the appellant in its TP Documentation report for the year (full fledged distributors converted into service providers after making suitable working capital adjustments) to substantiate the arm's length nature of its international transactions.
4. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in upholding the Ld. TPO's stance of including the value of the goods sourced directly by the AEs of the appellant from third party vendors in the cost base of the appellant, for the purpose of computing the arm's length profit margin of the appellant on the alleged ground that it created supply chain and human asset intangibles in India and generated location savings in India which have not been factored into in its remuneration model.
5. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in upholding the Ld. TPO's stance of rejecting the appellant's reliance on relevant international judicial precedents on absolutely irrelevant, inconsistent and extraneous reasons.
6. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in disregarding the detailed submissions and extensive analysis to 2 3 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
demonstrate that the said adjustment(made by the Ld. TPO) results into an operating profit/ value added expenses (OP/VAE) ratio of 830.95% for the appellant, which is unrealistic, impractical and absurd.
7. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in applying the decision of the Hon'ble Delhi Tribunal rendered in the case of Li & Fung (India) Pvt. Ltd. Vs. DCIT in the case of the appellant without appreciating that the FAR profile of the appellant was entirely different than the assessee involved in the said case; and accordingly, the said decision could have no application in the instant case of the appellant.
8. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law in holding that the profit level indicator (PLI) adopted by the appellant for setting the price and also testing the arm's length aspect of the international transactions entered into by the appellant with its associated enterprise, being OP/VAE was not a valid PLI for the purposes of the Indian Transfer Pricing regulations.
9. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred in misinterpreting documents and evidences filed by the appellant to hold that the appellant created and owned valuable intangibles for doing business in India.
10. That the Ld. AO has erred on facts and in law, in enhancing the income of the appellant by Rs. 2,702,896 by allowing depreciation on computer peripherals, printers and UPS @ 15% instead of the correct rate of 60% as allowable under the Income Tax Rules, 1962.
11. While allowing depreciation @ 15%, the Ld. AO grossly erred in:
- erroneously concluding that the printers, scanners, UPS etc. cannot be said to be part and parcel of computer system and hence higher rate of depreciation is not admissible;3
4 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
- disregarding judicial pronouncements (in favour of the assessee ) while making the proposed adjustment.
12. On the facts and in the circumstances of the case and in law, the Ld. AO erred in initiating penalty proceedings under section 271(1)(c) read with section 274 of the Act."
ITA no. 5147/Del/11 (A.Y. 2007-08):
"1. The Learned Dispute Resolution Panel ("Ld. DRP') and the Ld. Assistant Commissioner of Income-tax ('Ld. A.O') (following the directions of the Ld. DRP), erred on facts and in law, in enhancing the income of the appellant by Rs. 2,628,618,693/- on account of the transfer pricing ('TP') adjustment u/s 92CA(3) of the Income Tax Act, 1961 ('Act') made by the Ld. Additional Commissioner of Income-tax, Transfer Pricing Officer -1(2) ('Ld. TPO').
2. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on facts and in law:
2.1. in upholding the Ld. TPO's stance of not appreciating that the appellant is a low risk sourcing support service provider and disregarding the functional asset and risk ('FAR') profile of the appellant, on the basis of pre-conceived notions, surmises and conjectures , and without any cogent evidence, facts or basis whatsoever.
2.2. in upholding the Ld. TPO's stance of disregarding the conservative benchmarking approach adopted by the appellant in its TP Documentation report for the year (full fledged distributors converted into service providers after making suitable working capital adjustments) to substantiate the arm's length nature of its international transactions.
2.3. in upholding the Ld. TPO's stance of including the value of the goods sourced directly by the AEs of the appellant from third party vendors in the cost base of the appellant, for the purpose of computing the arm's length profit margin of the appellant on the alleged ground that it created supply chain and 4 5 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
human asset intangibles in India and generated location savings in India which have not been factored into in its remuneration model.
2.4. in upholding the Ld. TPO's stance of rejecting the appellant's reliance on relevant international judicial precedents on absolutely irrelevant, inconsistent and extraneous reasons.
2.5. in disregarding the detailed submissions and extensive analysis to demonstrate that the said adjustment(made by the Ld. TPO) results into an operating profit/ value added expenses (OP/VAE) ratio of 830.95% for the appellant, which is unrealistic, impractical and absurd.
3. The Ld. DRP and consequently the Ld. AO (following the directions of the Ld. DRP), erred on the principles of natural justice to pass a proper and speaking direction under section 144C of the Act:
3.1. in disregarding the various submissions and extensive/ voluminous documentary evidence filed by the appellant during the course of the DRP/ assessment proceedings substantiating its actual FAR profile.
3.2. in failing to provide the appellant a reasonable opportunity to explain the contents of extensive/ voluminous documentary evidence filed by the appellant during the course of the DRP/ assessment proceedings despite verbally acknowledging during the DRP proceedings that the Ld. TPO had failed to examine such necessary documentary and evidences and that the TPO would be directed to examine the same and provide his comments to the Ld. DRP, a fact which the appellant also filed on record with the DRP vide a letter dated July 27,2011 before passing of the final directions by the DRP.
1.1. This is the second round of proceedings before ITAT in respect of A.Y. 2006-07 and first round for A.Y. 2007-08. In original proceedings for assessment year 2006-07 similar adjustment were proposed by Transfer 5 6 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
Pricing Officer (TPO) for the assessment year (AY) 2006-07, which were followed by AO and a draft assessment order was proposed accordingly. Assessee approached the Dispute Resolution Panel (DRP), which confirmed the order of AO by a non-speaking order. The Assessee filed an appeal before the Income Tax Appellate Tribunal (ITAT) in this regard. The ITAT, restored the case back to the DRP for fresh adjudication with directions to pass a speaking and reasoned order after considering the evidence and submissions/ documents presented by the assessee. During the pendency of set aside proceedings for A.Y. 2006-07, DRP upheld similar adjustments for A.Y. 2007-08. Thereafter DRP re-heard the matter for A.Y. 2006-07 and upheld the entire TP adjustments and AOs order thereon. Aggrieved assessee is before us in both the years.
2. Brief facts are assessee (referred to as 'GIS' India) is a wholly owned subsidiary of GAP International Sourcing Inc., USA, referred to as (GIS Inc.). During the AY 2006-07, the Appellant's business activity is claimed to facilitate sourcing of apparel merchandise from India for the GAP Group. Prior to this year similar services were provided by a liaisoning office, after incorporation as wholly owned subsidiary similar services are rendered by this assessee. It shall be pertinent to mention that LO was remunerated at cost+15% for these services.
2.1. Assessee filed its TP report claiming Transactional Net Margin Method (TNMM) with cost plus 15% remuneration to be most appropriate method for determination of Arms Length Price "ALP". TPO, however looking at the FAR and other factors which are mentioned herein below, rejected assessee's cost plus 15% ALP and held that commission @ 5% on 6 7 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
the FOB value of goods sourced by the foreign enterprise through Indian Vendors was the most appropriate PLI for determining ALP. TPO's report has been accepted by DRP. Thus apart from other issues main issue for our adjudication is, whether PLI based on cost plus mark-up or 5% of commission on FOB value of goods facilitated by the assessee for outsourcing is the most appropriate in given circumstance.
3. Ld. counsel for the assessee Shri Rahul Mitra FCA, vehemently argues that as a facilitator for sourcing of apparel merchandise from India by the Associated Enterprises ('AEs'), the Appellant operates as a limited risk bearing sourcing support service provider. In respect of this activity, the Appellant is remunerated on a cost plus 15% mark-up basis for acting as a co-ordination arm facilitator/ interface between the third party vendors in India and its overseas AEs. There is a marked difference between a risk bearing agent and low risk facilitator, the later amounts to a service provider only.
3.1. During the TP proceedings for the year, the Ld. TPO disregarded assessee's Functional-Asset-Risk (FAR) characterization. It has been assumed that the functions performed, assets owned and risks assumed by the Appellant were substantially more than limited risk and low value adding sourcing support services. It has been surmised that it created substantial intangible assets through its operations, ignoring that A.Y. 2006-07 was only the first year of assessee subsidiary. The Ld. TPO also alleged that on account of operating in a low cost economy, the assessee had generated location savings in India which have not been factored into in its remuneration model. TPO thus rejected the assessee's cost plus based 7 8 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
remuneration model on the basis of theoretical assumptions, which are unsustainable and not based on any evidence. Accordingly, the Ld. TPO held the remuneration model of cost-plus 15% to be not in line with the arm's length standards 3.2. TPO reconstructed the Profit & Loss account of the Appellant by notionally bringing the value of goods sourced by overseas AEs from India, which were neither fully sourced through it nor routed through its financial accounts and its Profit & Loss account. This resulted in phenomenally exorbitant TP adjustment of Rs. 2,362,231,473 in A.Y. 2006-07 and Rs. 2,628,618,693 in A.Y. 2007-08.
3.3. Assessee approached DRP where copious written submissions and arguments in support of its FAR profile as a limited risk bearing sourcing support service provider were submitted. It was claimed that assesses primary business activity comprised identification of vendors, provision of assistance to vendors in procurement of raw material, inspection and quality control, and co-ordination with vendors to ensure delivery of goods to GAP Group as per schedule supplied by GAP Inc. 3.5. DRP however reconfirmed the additions, hence these appeals.
4. Ld counsel for the assessee further contends that:
(i) The list of activities carried out by the Appellant as a sourcing support service provider as per "Service and Support Agreement"
placed on the Paper book , are as under:
- Product purchase support services relating to quality control and quality assurance and conducting product monitoring and 8 9 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
merchandise monitoring of goods manufactured by independent factories to assure timely delivery of product;
- Support services for the exportation of purchased products;
- Purchasing support services relating to identifying and evaluating new vendors; and
- Act as a liaison between GIS Inc. and local vendors.
(ii) The services are same as undertaken by earlier liaison office, where ALP working at cost + 15% basis has been accepted. In performance of the above mentioned services, the necessary inputs i.e. specifications and designs of the products to be sourced, names and addresses of vendors/ manufacturers, detailed information on potential or new vendors, operating softwares, training material, operating and process know-how etc., were all provided by the AEs. The assessee has inherited the set up enjoyed by L/A.
(iii) Besides, as per the "Intangible property" clause of the service and support agreement, GAP Group provides the following information to the assessee :
- Vendor list containing business information relating to the on-going sourcing of merchandise, yarn, fabrics, trim and packaging, which includes name of manufacturers or vendors, items, production capacity, price, production lead time, and quality; information on branded labels, zippers, buttons, plastic notions, snap fasteners, hasp and sliders, interlining, metal buttons/burrs and rivets; and information on printed paper and plastic;9
10 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
- Business information relating to existing or potential new manufacturing vendors and their facilities includes name of vendor companies or manufacturing plants, name of representatives, addresses, telephone numbers, fax numbers, email addresses, production or supply items, size of operations, production facilities, production capacity, and number of employees;
- Information pertaining to sample development and confirmed sample orders, which includes records on sample developers, sample materials, seasonal samples, and samples of products that has been produced and shipped in accordance with GAP Group's instructions;
- Software or other business processes used to order and track merchandise or used in any other way with sourcing activities;
- Training materials developed either by GIS India or by GAP Group;
- All know-how, processes and trade secrets relating to sourcing activities;
- All confidential and proprietary information relating to sourcing activities;
- Similar items as now exist or that may exist in the future that are developed either by GIS India, GAP Group or an affiliate of GAP Group in connection with sourcing activities.
(iv) Thus the relevant, assets required for the business (including intangible assets) like vendor lists, business information, software, business processes, etc. are developed and owned by GAP Inc. and are provided to the Appellant for the conduct of its business. Thus assessee has to render service on a fully guided modal and does not involve owing 10 11 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
or deployment of intangibles. It has to follow the instructions with no risk vis-a-vis third party vendors or GAP entities.
(v) GIS India and GIS Inc. had entered into a legally binding agreement which stipulates the role and responsibilities of both the parties to the agreement. They have not been considered at all by the Ld. TPO as well as Ld. DRP. Ld. TPO, rejected all these pertinent legal agreements and voluminous documents furnished by the assessee in support of its claims. TPO/AO did not adduce any supporting information/ documents to counter the assessee's contentions and support their own propositions. Appellant brought on record, before the Ld. TPO as well as the Ld. DRP, a number of evidentiary information/ voluminous documents to substantiate its arguments which have been summarily overlooked.
(vi) Goods sourced by the AEs from India are directly sold by the third party vendors to the overseas AEs. The Appellant's role in the entire process is limited to provision of liaisoning support services.
(vii) The authorities below have failed to appreciate the crucial points that GIS Inc. and not the assessee has no role to play in several key and critical activities in the Group's value chain such as:
- Develop global sourcing strategies;
- Deliver global cost of goods targets and savings;
- Develop global sourcing policies, procedures and standards;
- Develop global sourcing organization and operating structure;
- Manage global sourcing organization;11
12 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
- Own and maintain vendor relationships;
- Authorize and negotiate contracts with freight forwarders, carriers, delivery and other logistics companies;
- Factory and mill relationship management, including building and developing strategic relationships;
- Long-range planning with vendors and mills for capacity planning;
- Vendor level placement decisions for samples and bulk production and direct negotiations with vendors on cost, delivery, and quality; and
- Exception management to resolve production issues.
(viii) GIS Inc. also bears all the relevant risks in connection with undertaking the above activities and no risk is attributable to assessee which is a key factor in determining the FAR. In the sourcing value chain, the Appellant's role is limited to operating within the confines of the requirements/ standards prescribed by overseas AEs. It performs strictly routine/ low value-adding activities and does not bear any of the key business risks such as market risk, product liability risk, product design and development risk, credit risk, price risk, foreign exchange risk etc.
(ix) There is neither any basis nor supporting factual data for TPO to reach the conclusion that the Appellant had created any valuable / non- routine intangibles, for which a return on value of goods sourced by overseas AEs was required as consideration. Ld. TPO merely made a bald assumption that the Appellant had created valuable supply chain and human asset intangibles without giving proper reasonings evidential data / proof whatsoever to suggest that any intangibles have been created.
1213 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
(x) It is erroneously presumed that the 210 people employed with GIS India during the year were key decision making employees of the Company. It is emphasized that GIS India's role is to operate strictly within the confines of the standards prescribed by the overseas GAP Group Companies, where all the key decisions with regard to product design and quality, vendor acceptability/ rejection, vendor pricing, etc. are taken solely by the group companies and the risks arising there from are also borne entirely by the group companies. Assessee's employees have not gone beyond these confines.
(xi) The fact remains that the 210 employees of GIS India were engaged in activities of a support nature, with no decision making or entrepreneurial role embedded in their work profiles. TPO except quoting the numbers has offered no reasons as to how their activities led to creation/ development of any valuable supply chain or human asset. Most of these employees are administrative staff, graduates and some of them diploma holders in designs and procurement and are abundantly available in the market.
(xii) All the supply chain related intangibles such as vendor/ fabric supplier lists, sampling procedures/ techniques/ processes, quality control standards, etc., are owned by the overseas GAP group companies and not GIS India. The assessee has to carry out its functions strictly as per the service agreement between GIS India and GIS Inc. Thus, GIS India performs a limited role and bears limited / minimal risks as a result of its standalone liaisoning and co-ordination activities, undertaken on the detailed guidelines, standards, manuals, polices and procedures developed / created by the overseas group companies.
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5. The relevant documents submitted by the Appellant to support its contentions include:
- Vendor handbook/ manual which demonstrate the policies/ processes developed/ set by the GAP Group, which is a part of the core intangible property developed by the GAP Group over the years.
- Vendor Compliance Agreement entered into between the GAP retail companies and the Indian vendor describing in the clause IV ("Vendor's representation and warranty of originality of product design supplied by vendor") and clause V ("product performance standards and procedures") that the vendor bears the warranty and liability of the product in the event of not meeting the specifications and requirements set and prescribed by GAP US.
- Extract of Vendor Compliance Handbook/ Manual which contains a format of the vendor compliance agreement as well as conditions that in the event of failure to comply with any term or requirement of a Purchase Order, retail companies shall be entitled to cancel, reject shipments, insist on re-performance, withhold payments, recover cost, offset any amounts due, etc. This demonstrates that the product liability in case of defect rests with the vendors and GIS India does not have any role to play in this regard. Thus there is no risk involved on this account.
- Sample documents to substantiate that all product liability claims are settled between GAP Group and the vendor and GIS India only acts as a coordinator with no financial impact whatsoever.
- Sample documents to substantiate that GAP Group directly maintains all vendor relationships.14
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- Sample documents to substantiate that GAP Group drives all quality control strategy, standard and management requirement, whereas GIS India simply follows the instructions given therein which belies the allegation that assesses employees amounted to a human asset and there was creation of any intellectual property.
- Sample documents to substantiate that GAP Group drives all market intelligence and product costing strategies which are followed by GIS India for performing its functions.
- Sample documents including Strategy Meetings conducted by GAP Group's leadership team and guidance provided to local teams including GISS India on various vendor negotiating points.
- Sample documents containing agenda circulated for the 2 day U.S. Global Sourcing Team Meeting which substantiate that GAP Group drives all critical efforts related to Global Sourcing Strategy.
- Copies of email correspondences between the Appellant and its overseas counterparts, to support the fact that all the key activities in the value chain are performed by the overseas group entities, while the Appellant's role is limited to operating as a routine/ limited risk- bearing co-ordination and facilitation service provider.
- Annual Report of GAP Inc. (the ultimate parent of the GAP Group) for financial year ended December 2005 (relevant to India AY 2006-
07) which depicts that GAP Inc. classifies the total cost of sourcing operations (includes the entire cost of Indian sourcing operations) under the head 'Cost of Goods Sold and Occupancy Expenses' which is different from the cost of design and development which is classified as value added expense, demonstrate the fact that the design/ development function is carried out entirely in USA .
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- Sample copies of memos/ documents/ designs created by GAP US and sent to the Appellant (over e-mails) evidencing the fact that the key activities in the value chain, namely product designing, taking all vendor and sourcing related decisions, setting quality control norms etc., are performed by the overseas group entities.
- Document presenting/ depicting the entire product process (from concept to line-freeze), again evidencing that all key decisions are performed/ undertaken in the US by the relevant GAP US employees/ personnel.
- Documents setting out the in-season/ pre-season meeting schedules clearly evidencing that all key decisions are performed/ undertaken in the US by the relevant GAP US employees/ personnel.
- List of employees working in US for GAP Group's design, production and technical service teams. These lists amply demonstrate the fact that the design/ development function is carried out entirely outside India.
- Memo from GAP US stating that the vendor handbook is created only by GAP US and only GAP US is authorized to make any changes to it.
- Sample copies of Purchase Orders which clearly establish the fact that the goods are directly sold by GAP Inc. from the third party vendors.
- Relevant extracts of the company's website clearly evidencing/ corroborating the fact that the design/ development function is undertaken essentially in US, but certainly not in India.
- Process maps which document that design, specification development and fabric development all occur in the US while GIS India plays a limited liaison role.
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- Spreadsheets that contain the US design, merchandising and sourcing costs for years 2005 and 2006 as well as GIS India operating costs for the same period. The disparity in the costs incurred by US group entities vis-à-vis GIS India indicates the relative value addition done in the US vis-à-vis India.
5.1. There is no substance in TPO's holding that GIS India has also borne major business risks arising from its activities. The Ld. TPO has not given any examples to demonstrate as to which major business risks is borne by GIS India and how. It has been merely stated that since functions follow risks, and GIS India undertakes key functions, therefore it must have also born the consequent risks. This amounts to a mere guess work and surmise.
5.2. It has been mainly alleged that the Appellant is operating in a low cost economy and has generated location savings in India which have not been factored into in its remuneration model of charging value adding (operating) expenses plus a mark-up of 15%. It is worthwhile to mention that the intent of sourcing from low cost countries for a manufacturer / retailer is to provide a lower cost to its end-customers. Looking at the tough competition in garment marketing generally, the advantage of location savings is passed onto the end-customer in the form of lower sale prices. Thus, there is no question of any allocation attributable for location savings to GIS India, which has no role in sale prices.
5.3. It is important to note that any profits generated out of the manufacturing activity on account of location savings is earned by the different entities of the GAP Group. Besides any location savings generated by GAP Group from low raw material costs are passed on to end customers.
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In no circumstances, GIS India gets a return for the manufacturing activity or is entitled to a return on account of location savings as it only functions as a mere support service provider and a watch dog ensuring that the right quality of goods reaches at right place at the right time, and operates strictly within the confines of the standards prescribed by the overseas GAP Group.
5.4. GIS India and GIS Inc. have entered into a legally binding agreement which defines the role, responsibilities and remuneration of both the parties to the agreement. It should have been duly considered and appreciated by the Ld. TPO as well as Ld. DRP and in the absence of any adverse material is to be accepted on commercial principles.
5.5. Without prejudice to the above, it is pleaded that, even if it is assumed that location savings have indeed arisen in the instant case, then in that situation, the question of allocation truly needs to be addressed in light of the relative bargaining powers/ ownership of intangibles of the parties concerned and the competitive market position of the company based in the low cost jurisdiction, i.e. GIS India. In the instant case, all the valuable intangibles are owned by overseas group companies. As a result, the relative bargaining power of the overseas group companies is significant and not of the assessee. On the contrary, GIS India is a routine support service provider that undertakes routine liaisoning and co-ordination activities. Its bargaining power is negligible as compared to its overseas group companies.
5.6. Given the fact that GIS India does not have any unique intangibles or any distinctive competitive advantage vis-à-vis other similar sourcing companies in the market, which could have led to GIS India wielding 18 19 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
significant bargaining power vis-à-vis its overseas group companies, it cannot be entitled to any location savings.
5.7. The DRP, during the remanded proceedings, out of voluminous documents submitted by GIS India referred to only one of the email exchanged between the Appellant and its group company regarding fabric hedging and long term booking. Without appreciating the essence of the same, the Ld. DRP simply held that the functions carried out by GIS India is similar to that of a manufacturer. An out of context reference from this email is uncalled for, more so when the Ld. TPO had not drawn any such conclusion about assessees functional profile in his own order. This suggests that the DRP attempted to raise new issues in remanded proceedings merely for the sake of supporting the TPO's order.
6. Ld. counsel then drew our attention to the judgment passed by the Supreme Court of Netherlands in the case of Belgian Coordination Centre. The ruling adjudicated on the arm's length remuneration model to be followed in respect of procurement/ purchasing coordination activities performed by Belgian Coordination Centre (BCC). This is the only international judgment available, providing guidance on the pricing model to be followed in case of procurement support service providers. Relevant facts are as under:
(a) This dispute revolved around a Dutch Multinational Group (taxpayer) engaged in manufacturing of metal packaging, beverage packs, etc., for which it sourced raw materials from various suppliers in Europe. The taxpayer set up BCC which performed centralized purchasing activities on its / other operating companies within the 19 20 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
group's behalf. As part of its purchase coordination activities, BCC also conducted price negotiations (including talks on payment terms) with the suppliers. However, the operating companies were responsible for concluding and signing individual contracts and all other purchase related activities such as placing orders and making payments for the raw materials. The suppliers delivered the raw materials directly to the operating companies. Based on the above facts, the Supreme Court of Netherlands held that in respect of the procurement/ purchasing coordination/ support services provided, BCC is entitled to a return on its costs which was quantified to a 5% margin on costs.
(b) The activities carried out by BCC are in fact substantially more than the limited risk routine services carried out by the assessee. BCC carried out price negotiations with the suppliers also whereas the assessee only performs routine activities within the confines of the instructions provided by the AEs.
(c) Applying the ratio of this ruling, the remuneration model of charging a mark-up on the value adding costs incurred by the Appellant in its procurement/ purchasing coordination/ support services activity, should be accepted as the arm's length business model. Further, it may also be noted that the Appellant has charged a mark-up of 15% on the costs incurred by it in connection with its service provision activity (Value Added Costs), which is three times the cost plus margin specified in the aforementioned Dutch Ruling for purchasing coordination/ support services, the scope of which is anyway broader than those provided by the Appellant.
2021 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
6.1. Ld. TPO while working out adjustments, drew a totally irrelevant reference from the case of an out of court settlement between USA tax authorities & "Tommy Hilfiger". Tommy Hilfiger remunerated its buying agency affiliate on the basis of a commission (10% and subsequently 7.5%) on the value of goods sourced by it. The Ld. TPO thereby claimed that GIS India should also have been remunerated by a commission on value of goods sourced ignoring that the information was not in relation to a judicial pronouncement. The reliance on an out of court settlement between the US revenue authorities and Tommy Hilfiger has no persuasive value as it is not any judicial pronouncement on the matter. It is pertinent to note that this instance does not contain any information about the actual facts and ground realities of the case or the settlement reached, nor does it throw any light on the nature of issues under contention between the US revenue authorities and Tommy Hilfiger. Similarly nothing about nature of FAR, services and other services, has been mentioned. In the absence of this critical set of information and an objective analysis, it is not possible to use it while comparing the case for GIS India, which stands far apart on facts.
6.2. Transactional Net Margin Method (TNMM) as one of the methods to be used for determination of the arm's length price (ALP) under Indian TP Legislation. Accordingly the Appellant has used OP/VAE as a profit level indicator (PLI) which is a valid PLI. Rule 10(e)(i) of the Income Tax Rules, 1962 ('Rules') which states as follows:
(e) transactional net margin method, by which,-
(i) the net profit realised by the enterprise from an international transaction entered into with an associated enterprise is computed 21 22 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
in relation to the costs incurred or sales effected or assets employed or any other relevant base 6.3. Appellant's only costs were operating costs/ value added costs (expenses) as it did not pay for the price of goods sourced by GAP Group and therefore, never carried the cost in relation to price of goods. Therefore, the PLI used by the Appellant in its own case is actually OP/TC since the Appellant's VAE is equal to TC. The relevant Rule clearly suggests that based on the intensity of functions performed (which is measured by value added expenses), under TNMM, a relevant cost base i.e. VAE in the instant case, can be used. This concept is very well supported by the Ruling by the Hon'ble Delhi Tribunal in the case of DCIT vs. Cheil Communications India Pvt. Ltd. (ITA No. 712/Del/2010) (137 TTJ 539), which holds as follows:
"The rival contentions of both the parties have been considered and orders of the authorities below have carefully been perused. The only question that falls for our consideration is with regard to the method of computing profit/TC margin whether on gross basis as done by the TPO or net basis as worked out by the assessee. In this case the assessee has applied TNMM method to determine ALP, which has also been accepted by the Revenue authorities........
The payment made by the assessee to third party vendor/media agencies for and on behalf of the principal has not been included in the total cost for determining the profit margin, though, on the other hand, the TPO has included the payment reimbursed by the assessee's associate enterprise to the assessee on account of payment made to third party vendor/media agencies.........
We have gone through the invoices and purchase orders from third party vendors and find that they contain customers' name, and all the terms of advertisement are finalized after taking the approval from the customers. The assessee simply acts as an 22 23 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
intermediary between the ultimate customer and the third party vendor in order to facilitate placement of the advertisement. The payment made by the assessee to vendors is recovered from the respective customers or AEs. In the event customer fails to pay any such amount to the advertisement agency, the bad debt risk is borne by the third party vendor and not by the advertising agency i.e. the assessee. It is, thus, clear that the assessee has not assumed any risk on account of non-payment by its customers or AEs. At this stage a useful reference may be made to ITS 2009 Transfer Pricing Guidelines accepted by the OECD where it is laid down that when an AE is acting only as an agent or intermediary in the provision of service, it is important in applying the cost plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves, and, in such a case, it may not be appropriate to determine ALP as a mark-up on the cost of services but rather on the cost of agency function itself, or alternatively, depending on the type of comparable data being used, the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. In this type of case, it will be appropriate to pass on the cost of rendering advertising space, to the credit recipient without a mark-up and to apply a mark-up only to the costs incurred by the intermediary in performing it's agency function............
In the light of these guidelines, it would be, therefore, clear that a mark-up is to be applied to the cost incurred by the assessee company in performing its agency function and not to the cost of rendering advertising space on behalf of its AEs."
6.4. Ld. counsel then referred to the well recognized Berry ratio in determination of ALP. Berry ratio also propounds that routine distributors should earn a return commensurate to the distribution services performed, measured as a percentage of the value-adding (operating) expenses incurred by them. The value of the products being distributed, in other words, is irrelevant. Distributors must achieve a particular gross profit in order to 23 24 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
compensate them for their value-adding services, the costs of which are accounted for in their value-adding (operating) expenses. An excerpt from the article by Dr. Berry on this aspect reads as under:-
"Similarly, the cost of goods sold is excluded from the cost base because the measure indicates the value of the merchandise distributed, not the service rendered by the firm that distributes the merchandise. It was for exactly the same reason that I excluded in the case of advertising agencies, the cost of advertisement placement. The placement cost is a measure of the activities of the media carrying the advertising agency in planning and designing that advertising. If we use a cost plus method, and the Berry ratio is a cost plus method, we want a measure of the costs of the firm involved, i.e. the distributor or advertising agency in these examples, not something that measures only the value of the product distributed, or the value of the exposure provided by radio, television or print media".
6.5. It is contended that the Berry ratio is merely a variant of the cost plus method. If one were to think of the gross margins earned by a distributor as analogous to a firm's total revenues available to a distributor, and the operating expenses incurred to distribute products as analogous to the firm's total costs, then the ratio of gross margin to operating expenses would capture the mark-up on operating expenses that is afforded to the distributor.
6.6. The Berry ratio can also be applied to service providers, as it can be conceptualized as the mark-up earned on the costs of provision of services, by subtracting one from the Berry ratio expressed in unit terms as follows:-
Berry ratio - 1 = GP/VAE - 1 = (GP-VAE)/VAE = OP/VAE 24 25 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
wherein GP = gross profit; OP = operating profit; and VAE = value adding (operating) expenses.
The above concept and approach for routine distributors and service providers has also been well accepted by the Organization for Economic Co-operation and Development (OECD) in paras 2.100 to 2.102.
6.7. The search results from each of the regions also corroborate the findings of Dr. Berry with regard to the high degree of correlation between the level of operating expenses incurred as a percentage of turnover and the level of gross profits earned by distributors, as can be seen from the correlation coefficients between them. The search results clearly show that there is a high positive correlation between net margins and the Berry ratio for distributors. This implies that for a set of distributor companies, one cannot simply adopt a profit level indicator of return on sales (or total costs) without taking into consideration, the corresponding OP/VAE and Berry ratio of these comparables.
7. Ld. counsel contends that DRP relied on ITAT judgment in case of Li & Fung India (P) Ltd. Vs. DCIT 12 ITR (Trib.) 748. Relevant facts are -
7.1. Li & Fung India provided sourcing support services to its related party based in Hong Kong (Li & Fung HK) under an arrangement of cost plus 5% mark-up, and received a total remuneration of Rs 47.69 crore from Li & Fung (Trading) Limited (Li & Fung HK). The operating costs of Li & Fung India were Rs 45.42 crore and the mark-up @ 5% thereon was Rs. 2.27 crore. Li & Fung HK entered into sourcing agreements with its global customers for products sourced directly by such global customers from third 25 26 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
party vendors in India. For such sourcing services, Li & Fung HK received a commission of 5% from its global customers, on the value of goods procured by such customers directly from third party vendors in India.
7.2. The global customers of Li & Fung HK procured products worth Rs 1202.96 crore directly from third party vendors of India and accordingly paid a commission of Rs 60.15 crore to Li & Fung HK, computed @ 5%. Li & Fung HK in turn paid a remuneration of Rs 47.69 crore to Li & Fung India under a cost plus 5% model. The TPO challenged the cost plus 5% model of Li & Fung India and held that Li & Fung India should also receive a 5% profit on the value of products sourced from India. The DRP allowed partial relief by reducing it to 3%. On assessee's appeal, ITAT in short held as under:
(a) The assessee could not refute that it had actually performed all critical functions, assumed significant risks and also developed significant supply chain intangibles in India and Li & Fung HK did not have either any technical expertise or manpower to carry out the sourcing activities in HK.
(b) In view of the above, the Tribunal agreed that Li & Fung India should also receive a remuneration based on a percentage of value of goods sourced by the global customers of Li & Fung HK directly from third party vendors in India.
(c) However, the total amount of commission accruing for the Li & Fung Group as a whole, could not exceed 5% of the value of such goods, i.e. Rs 1202.96 crore.26
27 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
(d) Li & Fung HK had already paid remuneration to Li & Fung India under the cost plus 5% model, thus retaining, at its level, about 20% of the total receipts from the customer, i.e. Rs 60.15 crore.
(e) The ITAT held that in view of the above factual matrix, Li & Fung India should receive 80% of the total commission given by the end-customer in favour of Li & Fung HK and the balance 20% would be retained by Li & Fung HK and accordingly asked the TPO to recompute the TP adjustment.
7.3. Analysing Li & Fung case further ld. counsel pleads that:
(a) instead of 3%, even if entire 5% commission of Rs. 60.15 crore is retained with Li & Fung India, the same would have resulted in an operating profit of Rs. 14.73 crore, after deducting its actual costs of Rs. 45.42 crore or on other words, an OP/VAE of 32.43%, which is shown through the computation, as below:
Li & Fung India (Amount in Rs. crores) Service fees 60.15 Less: Operating Expenses (VAE) 45.42 Operating Profit (OP) 14.73 Return on Total Cost = OP/VAE 32.43%
(b) If the above OP/TC analysis or the ones discussed by TPO for FY 2007-08 TP order comparables are considered, the OP/TC results for a service provider like the Appellant essentially range between 15%-
30%, which clearly shows the inadequacy of the TP adjustment made in assessee's case where it is resulting into an OP/TC of 830.95%.
2728 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
(c) Thus even if the entire commission of 5% was retained with Li & Fung India, the maximum return on operating costs earned by it works out around 32% which is still possible for a commission agent/ service provider. Whereas, in case of GIS India, the 5% adopted resulted into a return on operating costs of 830.95%. This very distinction brings out the circumstantial differences in the two cases and the fact that Li & Fung case is nowhere comparable to that of the GIS India.
(d) It is stated that the Li & Fung's case rests on the peculiar facts of its case and does not have a general application for all sourcing companies/ activities. The following comparative table will show how facts are different from GIS India's case.
S. Li & Fung India GIS India No. 1. Li & Fung Group is one of the GAP Group is an international
world's largest leaders in export specialty retailer offering trading. apparel, accessories, and personal care products.
The Li & Fung India (along with its overseas AE - Li & GIS India is captive unit of Fung HK) is itself a sourcing GAP Group wherein, it is to be company and is engaged in the noted that the Group itself is business of providing sourcing not in the business of services to third party buyers/ providing sourcing services retailers. but the same being performed by just an in-house arm, The overseas AE of the tax operating in India.
payer is not the ultimate buyer of the products sourced from Indian vendors.
(Paras 2, 6 & 8 of the Ruling and refer to pages 1401, 1408 28 29 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
S. Li & Fung India GIS India
No.
and 1432 of the Paper book)
2. The Li & Fung India performed All intangibles including
all the critical functions, trademarks, processes, know-
assumed significant risks and how, technical data, operating/
used both tangibles and unique quality standards etc. are
intangibles developed by it over developed and owned by the a period of time (Intangibles overseas GAP Group included supply chain companies.
management which is important to achieve the strategic and GIS India does not create any pricing advantage, as well as valuable/ non-routine intangible human intangibles in the form and does not undertake any of technical capacity and owned activity on its account that leads manpower to perform the to the development of non-
critical functions). routine intangibles.
3. There have been ample
documents filed at various
levels (TPO, DRP) to evidence
the functional profile of the
overseas GAP Group companies
and the fact that they own
perform critical functions in
the supply chain and own
significant intangibles and
that GIS India primary
business activity is to serve as
a communication liaison
between GIS Inc. and the
third-party Indian vendors
that manufacture Gap Inc.'s
merchandise by leveraging
common spoken language and
geographic proximity to these
vendors.
4. An application of 5% Going by the TP order, if a
29
30 ITA 5147/Del/11 & 228/Del/12
GAP International Sourcing (I) P. Ltd.
S. Li & Fung India GIS India
No.
commission on the value of 6.07% (approx.) commission is
good sourced leads to a cost applied in GIS India's case, it
plus of around 32% which is leads to a cost plus of
still not absurd in case of a 830.95%, which is completely
service provider. absurd.
5. Based on the above functional In GIS India's case, there are
profile and facts, it was decided ample substantive evidences to that the Indian sourcing support demonstrate that the company should not receive a compensation based on cost cost plus form of remuneration, plus remuneration is justified. and should instead receive a percentage of commission on the value of goods.
(e) In the Li & Fung ruling, the Delhi Tribunal held that on the facts of the said case, the procurement company in India was entitled to a revenue linked remuneration.
(f) The decision in the case of Li & Fung proceeded on the specific findings of the TPO that the assessee was not able to establish that the foreign principal in Hong Kong had any important role. Thus, the Tribunal accepted the factual position that the Li Fung India actually carried out all the significant functions relating to procurement in India; and that very little or virtually nil functions were carried out at the level of Hong Kong.
7.4. However, the facts in the appellant's case are completely different in the sense that all the significant directions relating to procurement of goods from third party vendors in India, namely - (a) designs & trends of apparel;
(b) quality parameters of materials: (c) terms & conditions for dealing with 30 31 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
vendors, etc, are all provided by GAP US to the appellant through the voluminous vendor handbook & other correspondences from time to time; and the appellant merely executes the same with diligence.
7.5. The TNMM with cost plus mark-up as PLI is recognized by OECD guidelines, Berry ratio, Cheil communications propositions, as mentioned above. For mere non risk bearing facilitating functions, the appellant is not entitled to a share of FOB value of goods procured by GAP US from third party vendors in India. In the case of Li & Fung India, the assessee had actually carried out significantly value added functions in India. In the light of the facts that Li & Fung India carried out significantly high-end and value added functions in India, if the intensity of functions of Li & Fung India, are measured as a percentage of operating expenses or VAE of Li & Fung India to the value of goods procured, comes to 3.78%. In real terms, Li & Fung India had carried out virtually five times greater functions as compared to the appellant. The assessee's percentages VAE comes to 0.73% and 0.79% in the case of the appellant for AYs 2006-07 and 2007-08 respectively. Even if the entire commission of Li & Fung Group is assigned to Li & Fung India, then the OP/ VAE of Li & Fung India works out to 32.43%, as compared to 15% adopted by the appellant, which again, is within acceptable limits. looking at the insignificant FAR of the assessee.
7.6. Alternatively it is pleaded that, looking at the 5 times functional intensity of the Li & Fung group of the same can be estimated to a maximum of 1% of FOB value. The assessee's intensity of functions being less than one-fifth of Li & Fung, applying a 1% commission in the case of the appellant would yield in OP/ VAE margins of 36.90% and 26.56% for AYs 2006-07 and 2007-08 respectively. This according to ld. counsel it is 31 32 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
maximum to estimate to which T.P. adjustment can be stretched, as opposed to the exorbitantly adjustments s of 830% and 660% as applied by the TPO for AYs 2006-07 and 2007-08 respectively.
7.7. It is contended that even if the fundamental differences in the facts of the assessee's case & Li & Fung are ignored. A judicious application of Li & Fung's ruling also will not enhance the OP/ VAE margin of the appellant at any levels above 30 to 32% for AYs 2006-07 and 2007-08, as compared to the 15% mark up adopted by the assessee.
7.8. To summarize, the FAR (functions, assets and risk) of sourcing support entities as well as their overseas group companies needs to be evaluated in detail regarding the suitability of a remuneration model:
- A cost plus remuneration model is a world recognized method for a sourcing entity which performs limited functions and assumes limited risks, and does not contribute to the development of any intangible;
- a sourcing agent which undertakes greater functions, and assumes far higher risks would ideally may be entitled to a commission-based remuneration, the assessee's case does not fall in that category.
- a buy-sell sourcing entity, which would lie at the highest end of the value chain, would in fact be entitled to a "buy-sell" margin.
7.9. It is reiterated that a proper analysis of the "intensity of FAR" is crucial before drawing any inferences regarding remuneration model, as different business models may undoubtedly warrant different remuneration models. GIS India is a limited risk service provider, which would logically ascertain its operating profitability by measuring the profits earned as a percentage of the value added expenses incurred (or total costs in case of 32 33 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
GIS India). On this reasoning, the assessee searched for comparable sourcing support service providers from the databases but could not find any and therefore, it had to resort to an alternate search by identifying distributor companies and make suitable working capital adjustment, choosing OP/VAE as the PLI in order to make a closer and more like-to-like comparison of the operating profitability of GIS India with such distributor companies. Accordingly, for the chosen comparable companies as well, it was deemed appropriate to compute their operating profitability on a similar basis, i.e. with reference to the respective value added expenses incurred and not with reference to their total costs, which would also have included COGS or input costs, the companies being distributors.
7.10. Ld. Counsel at the end of his arguments summarized the arguments as under:
- Given the functional, asset and risk profile of the appellant, it is entitled to a remuneration model of a mark up or profit on only its operating expenses or VAE; and not on the value of goods sourced by GAP US from third party vendors in India.
- Incidentally, on identical facts, the Dutch Supreme Court had also approved a cost plus remuneration model for a similar procurement company; and not a commission linked to volume of goods procured, as the latter option would have resulted in exorbitant profit margin accruing to the procurement company, namely in excess of 600%.
- The appellant's mark up of 15% on operating costs have not been controverted by the TPO, who in fact, committed a grave error in taking the same comparables, as chosen by the appellant, but merely changing the PLI, without even appreciating that the intensity of 33 34 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
functions of such comparables were more than 25 times than that of the appellant for applying a turnover linked remuneration model
- In the extreme situation, even without admitting a factual similarity to the Li & Fung ruling, the mark-up on operating costs cannot exceed about 32%, after duly adjusting the intensity of functions of the appellant, vis-à-vis Li & Fung.
- In response to a separate show-cause notice issued by the TPO for AY 2006-07 itself, the appellant had carried out a search for service providers, which yielded an operating margin or OP/ VAE of 19%, which remains uncontroverted by the TPO and DRP.
- While conducting the TP assessment in the case of the appellant for AY 2008-09, the TPO had himself proposed in his show cause notice, an alternative search for selecting commission agents, which the appellant, with the objective to avoid protracted litigation, had formally offered to accept. The said set of comparables will result in a profit on operating costs of 26% for AY 2006-07.
- Thus, there are several data points available by now for comparable margins around the PLI of OP/ VAE, namely - (a) 3 comparables in the appellant's initial search for distributors, yielding 15.13% (b) 6 comparables in the appellant's subsequent search for service providers, yielding 19%; (c) 7 comparables chosen by the TPO in its search for commission agents during the TP assessment for AY 2008- 09, as updated with the results relating to AY 2006-07, yielding 26.01%. and (d) Li & Fung's result of 32.43%.
- The arithmetic mean of all the above results yield an OP/ VAE of [(3 x 15.13) + (6 x 19) + (7 x 26.01) + 32.43] / [3 + 6 + 7 + 1] = 21.99% or 22%.
3435 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
- Thus, the maximum margin on operating costs would still hover around 32% in the case of the appellant, with 22% as the centre of all the data points, without prejudice to the primary contention that the appellant's original margin of 15% on operating costs remains uncontroverted by the TPO & DRP.
8. Ld CIT(DR) Shri Piyush Jain on the other hand, vehemently supports the order of TPO, AO and DRP. At the outset it is pleaded that assessee is a wholly owned subsidiary of its foreign AE. Supporting agreements and similar documentary evidence are irrelevant for the purposes of determination of ALP as per the TP regulations laid down in IT Act in this behalf. TP authorities have statutory duty to evaluate such transactions on the basis of comparables and other relevant parameters and not on the basis of convenient agreements.
8.1. GIS India used multiple year data instead of contemporaneous comparable data. Thus assessee on its part has failed to give proper comparables. In this situation rule 10B(4) empowers the TPO to apply proper comparables for determinations of ALP. GIS India has used the weighted average of the financial data for the last couple of years to benchmark the international transactions. The provisions of Rule 10B(4) of the Income-tax Act prescribe that for the purposes of benchmarking international transactions the data of comparables used shall be the data for the year in which transaction took place.
8.2. TPO has reasonable indicators that the assessee performed all the critical functions, assumed significant risks and used both tangibles and unique intangible developed by it over a period of time. The critical 35 36 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
functions involve great care to be taken while selecting the quality, quantity and its feasibility at the sourcing stage. Any defect or infirmity in these services will result in huge adverse impact on the functions of various entities of GAP, USA. The risk though on paper is transferred to AE, it is to be tested on the basis of realities looking at the control of the AE over assessee subsidiary. Therefore, the real magnitude of risk is to be ascertained by a dispassionate view of the facts and circumstances. 8.3. It can be simulated by a projection that assessee was not there in India and GAP, Inc. had to procure similar type of services from a third party facilitator i.e. an uncontrolled situation. The question which arises is whether, the same services can be provided on cost plus basis or on % of FOB value. Similarly, if the assessee is allowed to render similar services for a third party, whether GAP, Inc. will allow assessee to charge cost plus basis or % of FOB for such services. This reply will be charging % of FOB and not cost plus markup. More so, when the assessee has not provided contemporaneous data in support of its TP working. The cost plus 15% compensation model offered by assessee is bereft of any justified basis, based more on mutual conveniences and planning rather than on TP regulations and uncontrolled determination of ALP transactions. 8.4. It is not correct to view that resources and establishment of assessee in India have not lead to development of any intangibles. The fact that the assessee has a well organized work force with various departments working in coordination indicate that it has earned a significant amount of supply chain intangibles, goodwill and name in India. Thus, assessee has developed substantial intangibles in terms of supply chain, human resources and goodwill for which it is to be suitably remunerated. If GAP, USA allows the assessee to render similar type of functions for a third party, these intangible 36 37 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
will give priority to assessee for soliciting such services to third parties, which constitutes advantage of intangibles.
8.5. In view of the facts of the case, assessee enjoys intangibles in terms of:
- GIS India owns human asset intangibles
- Goodwill as a procurement facilitator in garment trade.
8.6. The compensation model offered by the assessee lacks in proper valuation of use of such intangibles, which are availed by the AEs. TPO has correctly analysed assessee's FAR holding that it has developed a supply chain management intangible over a period of time which is all about having the right product in the right place, right price, right time and right conditions. In other words, the supply chain management as developed by the assessee is the management of the link between and organization and its suppliers and customer to achieve strategic and pricing advantage. This supply chain management ('SCM') as developed by the assessee in India is a part of the global supply chain management of the GAP group of the companies. The SCM as developed by the assessee consists of following proprietary informations:
- Knowledge of Vendors
- Knowledge of products and design
- Knowledge of acquisition and supply
- Knowledge of quality control
- Knowledge of storage
- Knowledge of logistic involved in exports of the goods.
8.7. All these activities provide significant value added trade benefit and strategic advantage to the AE. However, the compensation model does not 37 38 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
include the benefits attributable to the GIS India on account of location savings also. Globalization and continuous search for lower cost has resulted in transfer of manufacturing and procurement activities from high cost economy like European Union, Japan, UK and United States, to lower cost economics like Indian and china to stay competitive and to increase profits. In this case, GAP Group has recognized that India offers both cost and operational advantage such as lower salaries for the employees, low cost material and low cost manufacture. It is a recognized fact that for a trading company for procuring goods from India, location savings generally emerge when companies transfer their operation site from high cost economy to economies with low cost. In this case, the assessee is admittedly operating in low cost economy and has generated location savings for AEs due to huge difference in cost of procurement between high cost economy and low cost economy like India. From a transfer pricing perspective the additional profits attributable to location savings are to be factored. Assessee is responsible for identifying and qualifying the contracted manufacturer, for working with them and other designs to manufacture garments in the technical specifications, for selection of fabrics, for control over the manufacture, for identifying appropriate sourcing of fabrics and accessories, for quality insurance, transportation logistics, coordinating logistics etc. Therefore, the cost plus compensation @ 15% of direct cost is not at arm's length because it does not include profit attributable to the assessee on account of location savings.
8.8. A research report on location savings in garment industry is done by Werner International Management Consultants (WIMC), and published in the Hindustan Times, Delhi edition on 10-08-2010. This shows that the 38 39 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
average cost per operator in 2008 for workers in the garment industry is like:
(in USD) Japan 30.81 France 30.39 Germany 25.42 Spain 18.39 UK 17.7 US 17.41 Brazil 3.41 China 0.85 India 0.85 Pakistan 0.56 8.9. Ld. DR contends that assessee is not only availing lower procurement cost in India but also the lower prices of purchase of raw material from India. This arrangement at the first blush indicates that the cost plus formula has been devised by the GAP, Inc. to attribute lowest income to the Indian subsidiary. The WIMS details though is published in 2010, relate to market research in 2008 and a suitable adjustment to F.Ys. 2005-06 & 2006-07 should be considered. It is emphasized that the only appropriate remuneration model for compensation to Indian entity ought to be in terms of % of FOB and not the cost plus mark-up. Assessee except relying on its conservative method in earlier years with liaisoning office has failed to provide any justification to support its TP working based on cost plus markup. In these circumstances TPO was left with no choice but to hold ALP 5.22% on FOB value relying on arithmetic mean of following comparables and working.39
40 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
S.No. Name OP/TC(%)
1. Pantaloon Retail (India) Ltd. 6.70
2. Trent Ltd. 6.19
3. Jaypee Spintex Ltd. 2.77
Arithmetic Mean 5.22
Accordingly, the arms length price is worked out by TPO on FOB value of exports of Rs. 3963,38,34,240/- for A.Y. 2006-07; and Rs. 51,535,602,475/- for A.Y. 2007-08, resulting into respective additions.
8.10. It will be therefore just and proper that GIS India's commission is worked out in terms of percentage of the FOB price of goods sourced through the GIS India. The Indian revenue should not be deprived of due taxes in the pretext of in house convenient arrangements.
8.11. Ld. DR relied on the orders of DRP, TPO and Assessing Officer and out of court settlement between US revenue authorities Li Fung case and Tomy Hilfger comparison.
9 Decision on the Case 9.1 We have heard the rival contentions and perused the material available on record including the written submissions and synopsis filed by the assessee which is placed on the paper book. The Act prescribes a scheme for determining the arm's length price of every international transaction for ascertaining the ALP. To decide the same it is imperative to take the following factors into consideration:
9.2 Characterization of Assessee and its Associated Enterprises through Function, Assets and Risk (FAR) analysis of international transactions.40
41 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
The FAR analysis gives the basis of broad characterization for e.g. Manufacturer, Service Provider, Distributor, etc with a further sub- characterization including low-risk service provider, high risk service provider; Full-Fledged manufacturer, contract manufacturer, etc. These characterizations are vitally important to determine the arm's length price of international transactions.
i. Authorities below have proceeded on premise that assessee is a risk bearing AE and its functions are not in the nature of a service provider only. The FAR attributable to assessee are far greater than what are claimed. Assessee has developed substantial intangibles in the form of human resources and supply chain. Besides location advantages available to assessee have not been factored in the ALP.
ii. On these observations, and by putting reliance on the case of Li & Fung India, it has been held that assessee performs the functions of a risk bearing agent and therefore, cost plus PLI adopted by the assessee for ALP determination is not the most appropriate. Thereby the cost plus PLI has been substituted by 5% on FOB value of goods outsourced by the entities of foreign enterprises which has been considered to be the TP value.
iii. In our considered view, no supporting material has been brought on record that assessee; GIS India has borne any business risks arising from its activities with GAP USA. There are no adverse facts, material or evidence on the basis whereof Ld. TPO has made arrived at such a conclusion. The Ld. TPO has not given any examples or comparables whatsoever to demonstrate which major business risks much less any risk are borne by GIS India and how. In a sweeping 41 42 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
manner it has been held that as functions follow risks, and since, in his wisdom GIS India undertakes key functions, therefore it must also be bearing the consequent risks. The observation is flawed as from the handbook and guidelines it clearly emerges that assessee had no wisdom or discretion in these terms.
iv. Beside it is common trend in garment that goods are generally supplied on credit based which the suppliers have to extend to GAP, USA entities and assessee bears no risk. The assessee' role, functions and activities are limited to scrupulously follow the handbook and other instructions provided by the parent group. These facts and circumstances indicate lack of authority or discretion with assessee in deviating or changing from the policies and procedures prescribed by the parent company. Therefore, we are unable to agree with the view that assessee incurred any significant risk in its functions.
v. Coming to the issue about assessee having developed substantial human resources intangibles, there is no supporting material available on record to hold it against assessee. Except generalized assertions nothing reliable is placed on record to support these observations. Assessee had 230 employees on its payroll engaged in execution of preordained support nature activities as per the guidelines. Their qualifications are general and routine in nature and department has failed to demonstrate that any or few of employees were any acclaimed personalities or indispensable in garment procurement trade so as to constitute any human intangibles as alleged. With no decision making or entrepreneurial role embedded in their work profiles, it is not clear how the TPO or DRP can arrive at such a conclusion that 42 43 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
these routine activities led to creation/ development of any valuable supply chain or human asset. Majority of these employees are graduates or post graduate diploma holders. Employees with such educational qualifications are abundantly available in the Indian recruitment circles.
vi. Coming to the development of supply chain issue also, the conclusion is bereft of any discernible basis. Assessee's role, activities and suppliers are already identified merely following the guiding instructions cannot be assumed to create a supply chain. Supply chain of garment manufacturers in India was provided by GAP, USA and not assessee. Under these circumstances we are unable to accept this proposition.
vii. TPO has theoretically relied on a Hindustan Times news paper report published in 2008 in respect of cost of procurement services in various countries. In our view this news paper report by itself cannot partake the character of a comparable data. It is a fact the labor costs including procurement services are very low in India, Pakistan, Bangla Desh and China. But it does not impinge on the assesses profitability by drawing a assuming perceived location advantages. Location savings to developing economy arise to the industry as a whole, there is nothing on record that assessee on standalone basis was sole beneficiary. We find merit in the argument of Mr. Mitra that the intent of sourcing from low cost countries for a manufacturer / retailer is to survive in stiff competition by providing a lower cost to its end-customers. Generally, the advantage of location savings is passed onto the end-customer via a competitive sales strategy. The 43 44 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
arm's length principle requires benchmarking to be done with comparables in the jurisdiction of tested party and the location savings, if any, would be reflected in the profitability earned by comparables which are used for benchmarking the international transactions. Thus in our view, no separate / additional allocation is called for on account of location savings.
viii. In view of all these facts we are unable to agree with the propositions of TPO that assessee works as a risk bearing agent of the AE and it possesses human resources intangibles along with supply chain resources. The facts and circumstances lead us to a conclusion that assessee is a low risk procurement support service provider only.
9.3 Most Appropriate Method i. From records it is clear that the assessee proposed the use of Transactional Net Margin method ('TNMM') as the Most Appropriate Method with Net Profit / Total Cost as a Profit Level Indicator ('PLI'). Further, the department has accepted the use of TNMM with a percentage of FOB value of goods procured by parent as PLI. Accordingly, we proceed on the basis of TNMM as the most appropriate method without going into analysis or merits of other methods. The dispute is limited to the selection of PLI, where the assessee has proposed use of Net Profit / Total Cost whereas the department has used a percentage of FOB value of goods procured by parent as PLI. Consequently we proceed to deal with the issue of PLI.
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ii. The selection of most appropriate method and PLI depends upon the FAR and available data of comparables. We have to keep in mind the guiding principles in ALP determination that the method and PLI used should not lead to manifestly absurd results, so as to put one of the parties to transactions at abnormally higher profitability and the other party at significant loss. If a particular PLI results in abnormal results then one should move on to choose a method and PLI which provides rational results. The arm's length pricing should be the one which reflects commercial and economic realities of the industry and also should be the one which supports the FAR analysis of the subject international transaction. Absurd and distorted lead to create aberrations in dispensation of tax administrations. They reflect an adversarial approach on the part of administrators which best should be avoided.
iii. It is clear that the assessee is a low risk procurement support service provider. A service provider mostly works towards recovering its costs and earning a reasonable mark-up in line with its functions performed. The procurement service provider work on various models including the percentage of value of goods procured and the cost plus mark-up model depending upon the set of facts.
iv. In percentage model the procurement service provider is remunerated only in the event of goods procured by the procurer; if the goods are not procured then the service provider will incur loss to the tune of costs incurred in the process and notional loss on account of time spent by the service provider which it would have spent on other profit generating activity. Accordingly, percentage model puts the 45 46 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
procurer at significant advantage and the procurement service provider at significant market risk.
v. The cost plus mark-up model is in absolute contrast to the percentage model whereby the service provider is assured of cost recovery along with a mark-up irrespective of the fact whether the procurer purchases any goods or not. This model puts the procurer at the disadvantage with a significant advantage to service provider.
vi. It is important to note that the irrespective of the model followed, both procurer and service provider will set the terms which work in serving the best interest of both the parties, meaning putting both the parties at a win-win situation. In percentage model if the procurer feels that the percentage agreed is resulting in very high profitability for service provider, then the procurer would proceed to re-negotiate the percentage for bringing it down to reasonable level. Similarly, under the cost plus model if the service provider feels that reasonable mark- up would be more than the agreed mark-up then the service provider will take appropriate steps to get it corrected.
vii. The essence of above discussion is to the effect that market forces will interact in any business model and lead to reasonably acceptable profitability. Considering this we now proceed to decide the PLI which would result in reasonable profitability.
9.4 Li & Fung Case and TPO / DRP Stand i. The PLI of percentage of FOB value of goods procured by parent results in net profit / total cost of assessee at 830% and 660% for AY 46 47 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
2006-07 and AY 2007-08. Without going to any additional fact one can clearly mention that the use of this PLI has resulted in absurd and distorted results. Any business model followed would reflect in bottom line profitability of the assessee. The PLI and percentage proposed by department as the arm's length price may have demanded consideration provided it produces procurement service provider comparables which follow percentage based model and at the same time end up earning exorbitant mark-up over costs. In our considered view the department has failed to produce a single comparable supporting their stand.
ii. It has been placed on record that the TPO provided the alternate of using 7 commission agent comparables for AY 2008-09. The Assessee offered to accept those in order to avoid protracted litigation. These comparables with updated financial results for AY 2006-07 result in Net profit / total cost of 26.01%.
iii. The department has heavily relied on the Li & Fung India's case (supra). In this case, the Delhi Tribunal held that on the facts of the said case, the procurement company in India was entitled to a revenue linked remuneration. The decision in the case of Li & Fung proceeded on the specific findings of the TPO that the assessee was not able to establish that the foreign principal in Hong Kong had any substance, which the assessee was also not able to substantiate before the Tribunal. In these peculiar facts Tribunal accepted the factual position that the Indian assessee had actually carried out all the significant functions relating to procurement in India; and that very little or virtually nil functions were carried out at the level of Hong Kong.
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iv. However, the facts in the appellant's case are different in as much as all the significant directions relating to procurement of goods from third party vendors in India, namely - (a) designs & trends of apparel;
(b) quality parameters of materials: (c) terms & conditions for dealing with vendors, etc, are all provided by GAP US to the appellant through the voluminous vendor handbook & other correspondences which are placed on record and have not been controverted by the department. It emerges that assessee follows and executes them as a service provider. For such preordained support services, the assessee cannot be held to be entitled to remuneration in terms of Li & Fung case on FOB value of goods procured by GAP US from third party vendors in India. In the case of Li & Fung India, assessee actually carried out significantly value added functions in India, which is not the case before us.
v. Even if we overlook the factual dissimilarities between the Li & Fung India and assessee's case, the transactional profitability earned by Li & Fung India supports the case of assessee. The department has heavily relied on the fact that Li & Fung Hong' remuneration of 5% of value of goods procured should be used as benchmark rate by the assessee. The department overlooked the other extremely important fact of the profitability earned by Li & Fung through 5% procurement service model. The total remuneration earned by Li & Fung Hong Kong was Rs. 60.15 crores against cost incurred by Indian company of Rs. 45.42 crores and some minor costs incurred in Hong Kong. The ITAT bench held that considering the facts of the case, 80% of commission (Rs. 48.12 crores) earned by Li & Fung Hong Kong 48 49 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
should be attributed to Indian company. This attribution resulted in profitability of Rs. 2.72 crores (Rs. 48.12 crores - Rs. 45.42 crores) for the Indian Company resulting in the net profit / total cost of 6%. Department overlooked these important facts which must be taken into consideration using this example as benchmark for determining arm's length price of international transactions for taxpayers.
vi. Considering above we conclude that non risk bearing procurement facilitating functions which are preordained by contract and hand book, the appropriate PLI will be net profit / total cost and not the % of FOB value of goods sourced by AE. Accordingly, we uphold the net profit / total cost remuneration model adopted by the assessee. Having held so now we proceed to decide the percentage of markup to be applied to assessee's cost.
9.5 Determination of Cost Plus remuneration in assessee's case i. Ld counsel Shri Mitra has placed on the record a working suggesting that even if one were to assign the entire commission of Li & Fung Group to Li & Fung India, then the OP/ total cost of Li & Fung India worked out to 32.43%, as opposed to 15% adopted by the appellant, which again, is within acceptable limits. Thus at the end of the arguments, Shri Mitra thus pleads that in extreme scenario also, the cost+ mark up in assessee case cannot be stretched beyond 32% looking from Li Fung case or any other angle.
(ii) It is trite law that Income tax assessments and appellate proceedings are non adversarial in nature, held to be an exercise of fair 49 50 ITA 5147/Del/11 & 228/Del/12 GAP International Sourcing (I) P. Ltd.
determination of tax liability payable by the assessee. Looking at the sweeping observations of the TPO and DRP which are neither based on any cogent reasoning nor factual reliability, the assessments as framed give an impression of being work of adversarial approach in tax liability determination. Hon'ble Finance Minister generally and recently in particular gave a clarion call that the income tax proceedings should be fair and non adversarial in nature. This is rightly so as it is a sine qua none of a tax administration which usher into a rule of law which is predictable and based on sound reasoning and is not fraught with the perils of uncertainties and adversities for the taxpayers.
(iii) In view of the foregoing we have no hesitation to accept a candid proposal given by the assessee and hold that assessee TP adjustments be made by adopting the 32% cost plus mark up of the assessee for AY 2006-07 and 2007-08. The mark-up proposal of assessee is higher than mark-up over total cost earned by all comparables placed on record. The assessments should be framed accordingly. We may hasten to add that this mark we will be subjected to variation is subsequent years if the facts and circumstances of the case so warrant.
10. Coming to the issue about rate of depreciation it is by now settled that the computer peripherals are eligible for 60% depreciation which should be allowed to the assessee.
11. In view of the above both the appeals filed by the assessee are partly allowed.
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12. Before parting we wish to place on record our sincere appreciation of the clarity, eruditeness and timely completion of arguments by the Ld. Counsel Shri Rahul Mitra for the assessee and Ld. CIT (DR) Shri Piyush Jain for the department which greatly helped us in deciding these appeals. Order pronounced in open court on 18-09-2012.
Sd/- Sd/-
( T.S. KAPOOR ) ( R.P. TOLANI )
ACCOUNTANT MEMBER JUDICIAL MEMBER
Dated: 18-09-2012.
MP
Copy to :
1. Assessee
2. AO
3. CIT
4. CIT(A)
5. DR
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