Income Tax Appellate Tribunal - Bangalore
Ge Be Private Limited , Bangalore vs Assessee on 30 August, 2013
IN THE INCOME TAX APPELLATE TRIBUNAL
"B" BENCH : BANGALORE
BEFORE SHRI N.V. VASUDEVAN, JUDICIAL MEMBER
AND SHRI JASON P. BOAZ, ACCOUNTANT MEMBER
ITA No.815/Bang/2010
Assessment year : 2004-05
The Deputy Commissioner Vs. M/s. GE BE Pvt. Ltd.,
of Income Tax, 60, EPIP, Whitefield,
Circle 11(3), Bangalore - 560 066.
Bangalore.
PAN : AAACG 6714A
APPELLANT RESPONDENT
ITA No.846/Bang/2010
Assessment year : 2004-05
M/s. GE BE Pvt. Ltd., Vs. The Deputy Commissioner of
60, EPIP, Whitefield, Income Tax,
Bangalore - 560 066. Circle 11(3),
Bangalore.
PAN : AAACG 6714A
APPELLANT RESPONDENT
Revenue by : Shri Farahat Hussain Qureshi, CIT-II(DR)
Assessee by : Shri N. Venkataraman, Sr. Advocate
Date of hearing : 30.08.2013
Date of Pronouncement : 06.12.2013
ORDER
PER BENCH :
ITA No.815/B/10 is an appeal by the revenue, while ITA
No.846/B/11 is an appeal by the assessee. Both these appeals are ITA Nos.815 & 846/Bang/2010 Page 2 of 59 directed against the order dated 31.03.2010 of the CIT(Appeals)-IV, Bangalore relating to A.Y. 2004-05.
2. First we shall take up for consideration the appeal by the assessee in ITA No.846/Bang/2010.
3. Grounds No.1 to 6 raised by the assessee is with regard to the addition made by the AO consequent to the adjustment suggested by the TPO pursuant to the provisions of section 92 of the Act.
4. The material facts which are relevant for adjudication of the aforesaid grounds of appeal are as follows. The assessee is a joint venture between GE Mauritius Ltd. and Bharat Electronics Ltd. (BEL). The assessee is engaged in the business of manufacture of X-ray and CT tubes, HV Tanks, Detectors, parts and accessories for medical diagnostic imaging equipment, distribution of tubes, parts and accessories and provision of engineering services to its AE as contract manufacturer. During the previous year, the assessee carried out the following international transactions with its AE:-
Import of raw materials for control manufacturing activity : Rs.159,74,15,702 Purchase of fixed assets for contract manufacturing activity : Rs. 4,94,76,509 Sale of manufactured goods : Rs.373,12,86,546 Provision of engineering services : Rs. 4,19,96,848 Payment of training fees : Rs. 67,972 Reimbursement of expenses : Rs. 6,78,964 Recovery of expenses : Rs. 39,99,681 ITA Nos.815 & 846/Bang/2010 Page 3 of 59
5. The AO referred the determination of Arm's Length Price (ALP) in respect of international transactions entered into by the assessee. The subject matter of the dispute in grounds No.1 to 6 referred to above is with regard to determination of ALP in respect of international transaction of sale of manufactured goods by the Assessee to its AE. As already stated, the assessee is a contract manufacturer for the GEMS group, which is admittedly an AE. The price charged in respect of sale of manufactured goods was Rs.373,12,86,546. The assessee claimed that the price it received on sale of manufactured goods to its AE was at arm's length and in support thereof filed transfer pricing (TP) report. In Annexure-C to the aforesaid report, the assessee has given a list of AEs with which the assessee has entered into international transactions during the previous year relevant to A.Y. 2004-05. The assessee adopted the Cost Plus Method as the most appropriate method for determining the ALP. The assessee identified 19 comparables. The arithmetic mean of the margin (gross margin to cost of production) of these companies was 15.72% (page 31 of the TP study of the assessee). The gross margin based on cost of production of the assessee was 16.24%. The assessee thus claimed that the consideration received by the assessee from its AE in respect of international transaction was more than the arithmetic mean of the comparable companies chosen by the Assessee which was 15.72% and therefore the price received by the Assessee on sale of manufactured products is at arm's length, therefore no adjustment needs to be made.
ITA Nos.815 & 846/Bang/2010 Page 4 of 59
6. The TPO, to whom the determination of ALP was referred to by the AO, issued a show cause notice dated 12.10.2006. The TPO was of the view that the comparables selected by the assessee in its TP study related to automobile parts manufacturers. He was of the view that the industry segment vastly differs from that of the assessee which was manufacturer of medical equipment. More over, the TPO was of the view that there were manufacturers of medical equipments, who were not taken as comparables by the assessee. The TPO therefore held that the assessee has not chosen comparables using an objective, consistent, logical and transparent criteria. Accordingly the comparables chosen by the assessee in its TP study were rejected by the TPO. Thereafter the TPO on his own identified 4 comparable companies. The details of these companies are given as Annexure to the show cause notice dated 12.10.2006 issued by the TPO. It is not in dispute that these four companies were in the business of manufacture of either surgical equipment, medical equipment or pace makers. The cost plus margin of the comparables chosen by the TPO (arithmetic mean) was 44.527%. In one of the submissions (dated 10.11.2006) filed by the assessee before the TPO, the assessee took a stand that TNMM may be adopted as the most appropriate method by retaining the same comparables chosen by the TPO. The following were the relevant submissions made by the assessee:
"7. Consideration of alternate method We wish to bring to your kind attention, paragraph 2.38 of the OECD TP guidelines, which provide for an application of ITA Nos.815 & 846/Bang/2010 Page 5 of 59 alternate method to substantiate the results of the Cost Plus method in the following circumstances:
• If expenses reflect a functional difference, which has not been taken into account in applying the method, an adjustment to the cost plus mark up may be required.
• If expenses reflect additional functions that are distinct from the activities tested by the method, separate compensation for that function may need to be deemed.
Since, the comparables chosen by Your Honour perform functions which are beyond that of a contract manufacturer, the result obtained by the assessee through the application of the Cost Plus Method may also have to be substantiated through the application of the Transactional Net Margin Method.
Without prejudice to our submission that CPM is applicable and that the comparables chosen by the tested party satisfy the criteria as propounded in the Transfer Pricing Regulations, we wish to submit that the net margin of GE BE:
- is higher than the arithmetic mean of the net margins of the comparables used by the assessee; and
- is within +/- 5% variation from the arithmetic mean of the unadjusted net margins of the companies chosen by Your Honour.
7. The TPO dealt with the alternative claim made by the assessee as follows:-
"5.9.2.1 Methodology Taxpayer itself has chosen Cost Plus Method as the most appropriate method in the instant case. Sec.92C mandates the ALP needs to be computed using the most appropriate method from among the methods prescribed:
"(1) The arm's length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method."
No fact or evidence is brought on record by the taxpayer to show that CPM ceases to be the most appropriate method or to justify switching over to a less direct method TNMM. CPM is ITA Nos.815 & 846/Bang/2010 Page 6 of 59 the second most accurate method (after CUP) to determine pricing when an enterprise manufactures & sells to affiliates. The Arms Length sales Price is determined by adding the normal gross mark up on cost to the Costs incurred. Thus it is affected only by the cost of production. TNMM is influenced by a lot of other factors such as operational efficiencies. Thus the margin difference between two enterprises may not just be one account of price differences. On the other hand, similar margins cannot solely be attributed to similar pricing either, as the differences in the overhead levels would have neutralized the price differences. For example, suppose the tested party may earn as high a net margin as the comparable, simply because of higher operational efficiency, even if the products are sold at a lower rate to the affiliate customers. In such a situation, it cannot be said that the price charged is at arms length because, the net margins are identical, as the tested party is forced to part with the benefits of cost savings on its part to the customer, which an independent enterprise would not do. Thus, if the results of TNMM do not tally with the results of Cost Plus Method the latter being the more direct method should be relied upon. This being so, there is no reason to switch over from a direct method to an indirect method."
8. Thereafter the TPO proceeded to determine the ALP as follows:-
5.10.3 Comparables The following four comparables were identified in the show cause letter-dated 13.10.06:
Sl. Name of the comparable % of GP over costs
No.
1 Contential Surgical Suture Ltd 74.167
2 Polymedicure Ltd. 27.646
3 South India Surgical Co. Ltd. 37.833
4 Shree Pacetronix Ltd. 38.462
Avg. 44.527
Out of this Shree Pacetronix Ltd. is rejected as per the taxpayer's request since it had related party transactions. The final list is as follows:
Sl. Name of the comparable % of GP over costs
No.
1 Contential Surgical Suture Ltd 74.167
2 Polymedicure Ltd. 27.646
ITA Nos.815 & 846/Bang/2010
Page 7 of 59
3 South India Surgical Co. Ltd. 37.833
Avg. 46.55%
5.10.4 Adjustment towards Sales functions
As discussed, the normal spending on marketing. advertising & distribution comes to 8% of the sales. Therefore an 8% adjustment is given to ALP computed to neutralized the impact of these functions:
Cost incurred for contract A Rs.320,99,16,579 manufacturing activity Normal mark up on cost (arithmetic B 46.55% mean of comparables) Arms Length Price computed based C=A+A*B Rs.470,41,32,747 on normal gross markup @ 146.55% Adjustment towards marketing, D=C*8% Rs.37,63,30,620 advertisement & distribution @ 8% of Sales Arms Length Price as adjusted E=C-D Rs.432,78,02,127 5.10.5 Adjustment for Debtor's risk, Business Risks Taxpayer has subsequent to the issue of the Show Cause Notice claimed adjustments towards, differences in the risk level borne by the tested party & the comparables. These claims are on the premise that GEBE being a contract manufacturer is protected from various business risks, which are borne by independent manufacturers. Since the markets are expected to give extra returns for extra risks, the company has claimed a adjustment to the margins earned by the comparables.
The claim of the taxpayer has been considered. As stated earlier, while discussing the FAR profile of the company, the accounts of GEBE show, items such as Forex loss, financial costs etc. This shows that the company is exposed to as much business risks as any other comparable. The only assurance it has is that its produce will be lifted by the affiliates. For this an adjustment towards marketing function is already given. Under the circumstances no further adjustment is called for.
ITA Nos.815 & 846/Bang/2010
Page 8 of 59
Cost incurred for contract A Rs.320,99,16,579
manufacturing activity
Normal mark up on cost B 46.55%
(arithmetic mean of
comparables)
Arms Length Price C=A+A*B Rs.470,41,32,747
computed based on normal
gross markup @146.55%
Adjustment towards D=C*8% Rs.37,63,30,620
marketing, advertisement
& distribution @ 8% of
Sales
Arms Length Price as E=C-D Rs.432,78,02,127
adjusted
Price actually charged F Rs.373,12,86,546
Shortfall being adjustment G=E-F Rs.59,65,15,581
u/s. 92CA
9. Thus the addition by way of adjustment to ALP of the aforesaid sum was made. The same was added to the total income of the assessee.
10. Against the aforesaid addition made by the AO, the assessee preferred appeal before the CIT(A). One of the contention taken by the assessee before the CIT(A) was regarding the most appropriate method that needs to be applied in the present case. In this regard, the assessee raised the following contentions:-
"1.4. The Appellant submits that in case if your good self considers that the comparables used in the TP Study do not have the desired degree of comparability for applying CPM as the most appropriate method, we submit that it would be more appropriate to use TNMM as the most appropriate method instead of rejecting the comparables used in the TP Study.
ITA Nos.815 & 846/Bang/2010 Page 9 of 59 1.5. In this regard we submit that Para 3.27 of the OECD TP guidelines state that net margins used in the TNMM are less affected by transactional differences than is the case with price, as used in the CUP method. The net margins also may be more tolerant to some of the functional differences between controlled and uncontrolled transactions than gross margins (i.e., used in the RPM and the CPM). And, the differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but still earn broadly similar levels of net profits.
1.6. In our submissions to the Ld. TPO it has been clearly established that the functional profiles of the Company and the comparables used by the Ld. TPO ("alleged comparables") are vastly different. The significant variation in the gross margins and the net margins of the comparables used by the Ld. TPO in the TP Order is evident from the tabulation below:
Centenial Poly South India GE BE
Surgical Medicure Surgical
Suture Ltd. Co.
Ltd. Ltd.
Gross 79.41% 36.92% 27.44% 16.24%
margin
Net margin 7.90% 17.5% 10.60% 12.16%
1.7. It is clearly evident from the table above that although there is a vast variation between the gross margins of the alleged comparables and the gross margin of GE BE, at the net margin level the two sets of margins are not deviating significantly. This significant variation between the gross and net levels fortifies the fact that there are significant differences in the functional profiles of the alleged comparables and GE BE. In view of such differences, assuming without admitting, if the comparables selected by the Ld. TPO were supposedly used to determine the arm's length price the same cannot be done without undertaking appropriate adjustments for the Cost Plus Method which requires very close degree of functional similarity.
1.8. Further, the Appellant submits that to eliminate the effect of these functional differences and the subjectivity involved in the computation of the adjustments for these ITA Nos.815 & 846/Bang/2010 Page 10 of 59 functional differences, the TNMM can be used to test the arm's length nature of the international transaction.
1.9. It is therefore submitted that if the CPM is to be adopted, then the set of filters (and the resultant comparables) adopted by the appellant in its TP Study have to be respected as they pass the functional equivalence test. Without prejudice to the TP Study, if the set of comparables imposed by the Ld. TPO were to be considered, which do not have the same functional profile and need adjustment for functional differences for CPM, the TNMM which is more tolerant to functional differences, can alternatively be used to determine the arm's length nature of the transactions.
1.10. In response to our submission to use TNMM as the alternate method, the reasoning of the Ld. TPO in rejecting the same is that the Company itself has used CPM as the most appropriate method."
11. The assessee relied on the OECD guidelines as well as the guidelines of ICAI in choosing the most appropriate method. The assessee also submitted :
"1.24. We further submit that the exercise of transfer pricing assessment for determining arm's length price should not be directed towards making an adjustment, but should be carried out based on the rationales of economic and commercial principles. This is also supported by the statement of the Tax Tribunal in the case of Philips Software, wherein it was held that the action of the Ld. TPO was directed towards making a higher TP adjustment.
1.25. Further, in our submissions we have also clearly brought out the fact of significant functional dissimilarities between the Company and the alleged comparables. In view of such significant functional dissimilarities, CPM is liable to be rejected as the most appropriate method, and the TNMM has to be adopted as the most appropriate method, if the comparables proposed by the Ld. TPO are considered as comparables."
12. On the above submissions made by the assessee, the CIT(A) held as follows:-
ITA Nos.815 & 846/Bang/2010 Page 11 of 59 "6.3.4 As laid down in the case of Aztec Software (supra), the burden to establish that international transactions were carried out at ALP is on the taxpayer. Moreover, the burden to select the most appropriate method has also been held to be on the taxpayer. The decision of selecting the most appropriate method is to be substantiated by the assessee by an appropriate documentation as well as by substantiating why a particular method is considered best suited to the facts and circumstances of the international transaction and as to how it provides the most reliable result of the ALP. In view of this background, I am unable to accept the plea of the appellant that the TPO erred in rejecting the TNMM proposed by the appellant to the comparables selected by the TPO. As stated above, it is important to note that the appellant had itself adopted CPM as the most appropriate method in its TP study for the purpose of justifying the transfer price of its international transactions.
Since CPM is a preferable method in cases like the present one where the tested party is a manufacturer selling its produce to an affiliate, the TPO agreed that CPM was the most appropriate method on the facts and circumstances of the instant case. I do not find any error or infirmity in the action of the TPO in accepting CPM as the most appropriate method in case of the appellant. In this connection, it would not be out of place to consider the decision of the Hon'ble ITAT, Pune Bench in the case of ACIT v. MSS India (P) Ltd. (2009) 123 TTJ (Pune) 657 on the applicability of CUP and CPM vis-à-vis TNMM. The following propositions emerge from perusal of the said order:--
a) On a conceptual note, transactional profit methods (i.e. TNMM and profit split method) are treated as methods of last resort which are pressed into service only when the standard methods, which are also termed as 'traditional methods' (i.e. CUP method, resale price method and cost plus method) cannot be reasonably applied.
b) In a situation in which the assessee has followed one of the standard methods of determining ALP, such a method cannot be discarded in preference over transactional profit methods unless the Revenue authorities are able to demonstrate the fallacies in application of standard methods.
In light of the above principles, it was held that the assessee having determined ALP of its international transactions with AEs by applying CUP/CPM by offering the comparison of gross profit margin on transactions with unrelated companies, TPO was not justified in rejecting the method adopted by ITA Nos.815 & 846/Bang/2010 Page 12 of 59 assessee and making adjustments by applying TNMM on the ground that assessee had incurred loss in transactions with AEs and that the method employed by assessee was complex. Following the same analogy, where CPM has been selected by the appellant and accepted by the TPO as the most appropriate method in the instant case, it is for the appellant to demonstrate the fallacies in application of CPM before putting up a case for application of TNMM. It is for the appellant to show that TNMM is more appropriate than CPM and such an appropriateness of method must be shown on the touchstone of the factors set out in Rule 1OC(2). As the appellant has failed to make out a case for adoption of TNMM as the most appropriate method on the basis of cogent material and sound reasoning, the TPO was justified in rejecting the proposal of the appellant in this regard and her action in doing so is hereby sustained."
13. In grounds 3 & 4, the assessee has specifically challenged the action of the revenue authorities in not applying the TNMM as the most appropriate method.
14. We have heard the submissions of the ld. counsel for the assessee and the ld. DR. At the outset, it may be appropriate to set out the provisions of Rule 10B(1)(c) which lays down the situation in which the Cost Plus Method has to be adopted as the most appropriate method. These Rules read thus:-
Determination of arm's length price under section 92C.
10B. (1) For the purposes of sub-section (2) of section 92C, the arm's length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :--
a)....
b)....
(c) cost plus method, by which,--
ITA Nos.815 & 846/Bang/2010
Page 13 of 59
(i) the direct and indirect costs of production
incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined;
(ii) the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined;
(iii) the normal gross profit mark-up referred to in sub-clause (ii) is adjusted to take into account the functional and other differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market;
(iv) the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii);
(v) the sum so arrived at is taken to be an arm's length price in relation to the supply of the property or provision of services by the enterprise;
15. The ld. counsel for the assessee also pointed out that the ALP has to be determined by adopting the most appropriate method in relation to the international transaction. Rule 10B(2) & (3) with regard to comparability of an international transaction with an uncontrolled transaction provides as follows:-
(2) For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:--
(a) the specific characteristics of the property transferred or services provided in either transaction;
(b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;
ITA Nos.815 & 846/Bang/2010 Page 14 of 59
(c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;
(d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail. (3) An uncontrolled transaction shall be comparable to an international transaction if--
(i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or
(ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
16. The ld. counsel for the assessee submitted that a captive manufacturer works on cost of production plus his margin and does not perform post cost of production function such as selling, administrative cost associated to selling, distribution, licensing, etc. Whereas a full- fledged third party manufacturer is one who does not stop with mere manufacturing or production of goods, but it also performs post cost of production functions referred to above. When it does so, it is fundamental economic presumption that the return or the margins will not be earned or confined only to the cost of production. There will be margins or profit or returns even on activities associated with post cost of production i.e. the selling function. However even the margins or returns or profit of COP ITA Nos.815 & 846/Bang/2010 Page 15 of 59 gets assimilated or captured as a part of selling functions only at the net margin level and does not get factored at the gross margin level or as part of cost of production. Consequently by sheer force of law and accounting practices, a comparable for a cost plus method can only be a comparable who is either confined to activities of cost of production or gross margin level. Otherwise if the operations travel beyond the gross margin level, the additional functions, activities and the associated costs and returns thereto should be clearly visible or discernible. In a cost plus method, the tested party cannot be a person who is at gross margin level or cost of production level vis a vis a comparable, who performs both the functions i.e. manufacturing and sales possessed of functions attributable to net margins, such a comparable becomes an irrelevant or out of place comparable for a cost plus method.
17. The next submission of the learned counsel for the Assessee was that the term direct or indirect costs are not explicitly defined and is left to the industry practice and Cost Accounting Standards - CAS-4. There is no legal requirement for entities to maintain their cost records. It is therefore self-evident that the cost of production of comparable companies would never be available in the public domain. In the absence of a statutory compulsion, discretion is vested with the Manufacturers in defining or structuring direct and indirect costs of their business which may even vary with the industry norm or practice. In the absence of standardization or statutory compulsion or prescribed definitions for direct and indirect costs, the elements or functions which constitute the cost of production can be at variance. Secondly in absence of a transparent disclosure, the ITA Nos.815 & 846/Bang/2010 Page 16 of 59 inconsistencies in the accounting treatments of costs by the respective entities cannot be found out. As a result Cost Plus methodology cannot be resorted to, unless otherwise the data related to all the cost or functions are available in the public domain.
18. The next submission was that Rule 10(B) (1) (c) obligates determination of direct and indirect cost of production incurred by the enterprise in respect of property transferred or services provided. It obligates arriving at the normal gross profit markup to such costs and stipulates that the same should be computed according to the same accounting norms. Any uncertainty of the first two elements cannot be adjusted or reconciled in any manner. Adjustments are limited to only functional and other differences and not in either reconciling the direct and indirect costs or reworking the computation when the accounting norms are not the same.
19. It was further submitted the CIT(A) wrongly placed reliance on the decision of the Hon'ble Pune Tribunal's decision in the case of ACIT v. MSS India (P) Ltd. (2009) 123 TTJ (Pune) 657. It was pointed out that in the aforesaid case cost plus method was held to be the most appropriate method in light of availability of internal comparability analysis of MSS India which is absent in the case of the Appellant. Further, in the said case also the TPO himself has noted that cost plus method cannot be applied as the relevant data for applying this method is not available in the Prowess database or Capitalline database and thus has resorted to ITA Nos.815 & 846/Bang/2010 Page 17 of 59 TNMM. A holistic view of this case, which is also relied on by the learned Commissioner Appeals supports the plea of the Assessee.
20. Reference was made to Paras 2.44, 2.45, 2.46 & 2.48 of the OECD TP Guidelines which state as follows:
"Para 2.44 In addition, when applying the cost plus method one should pay attention to apply a comparable mark up to a comparable cost basis.
Para 2.45 For this purpose, it is particularly important to consider differences in the level and types of expenses - operating expenses and non- operating expenses including financing expenditures - associated with functions performed and risks assumed by the parties or transactions being compared. Consideration of these differences may indicate the following:
...b) If the expenses reflect additional functions that are distinct from the activities tested by the method, separate compensation for those functions may need to be determined. Such functions may for example amount to the provision of services for which an appropriate reward may be determined. Similarly, expenses that are the result of capital structures reflecting non-arm's length arrangements may require separate adjustment. In any of the above circumstances it may be appropriate to supplement the cost plus and resale price methods by considering the results obtained from applying other methods.
Para 2.46 Another important aspect of comparability is accounting consistency. Where the accounting practices differ in the controlled transaction and the uncontrolled transaction, appropriate adjustments should be made to the data used to ensure that the same type of costs are used in each case to ensure consistency. The gross profit mark ups must be measured consistently between the associated enterprise and the independent enterprise. In addition, there may be differences across enterprises in the treatment of costs that affect gross profit mark ups that would need to be accounted for in order to achieve reliable comparability.
ITA Nos.815 & 846/Bang/2010 Page 18 of 59 Para 2.48 :... "The distinction between gross and net margin analyses may be understood in the following terms. In general, the cost plus method will use margins computed after direct and indirect costs of production, while a net margin method will use margins computed after operating expenses of the enterprise as well. It must be recognized that because of the variations in practice among countries, it is difficult to draw any precise lines between the three categories described above."
21. Reference was to the Guidance Note on Report on International Transactions under Section 92E of the Income tax Act, 1961 (Transfer Pricing) issued by ICAI ('Guidance Note') states on Page 79 as follows:
"determine normal gross profit mark-up on costs in the comparable uncontrolled transactions. Such costs should be computed according to the same accounting norms. In other words, the components of costs of comparable uncontrolled transaction should be the same as those of international transaction."
It was pointed out that the Guidance Note further states that, "adjust the gross profit mark-up to account for functional and other differences between the international transaction and the comparable uncontrolled transaction. Such adjustment should also be made for enterprise level difference."
22. Attention was drawn to the OECD Transfer Pricing Guidelines in Page 75 Para 2.53 has also given an example to explain the crucial points to be borne in mind while applying the CPM and it states as follows:
"A is a domestic manufacturer of timing mechanisms for mass market clocks. A sells this product to its foreign subsidiary B. A earns a 5 percent gross profit mark up with respect to its manufacturing operation. X, Y, and Z are independent domestic ITA Nos.815 & 846/Bang/2010 Page 19 of 59 manufacturers of timing mechanisms for mass-market watches. X, Y, and Z sell to independent foreign purchasers. X, Y, and Z earn gross profit mark ups with respect to their manufacturing operations that range from 3 to 5 percent. Accounts for supervisory, general, and administrative costs as operating expenses, and thus these costs are not reflected in cost of goods sold. The gross profit mark ups of X, Y, and Z, however, reflect supervisory, general, and administrative costs as part of costs of goods sold. Therefore, the gross profit mark ups of X, Y, and Z must be adjusted to provide accounting consistency." This implies that accounting consistency is required between the controlled and uncontrolled transactions. Application of different accounting principles to the controlled and the uncontrolled transactions may result in inconsistent calculation of the gross profits.
23. Reference was also made to the Canadian transfer pricing regulations on application of CPM, which states that (Para no. 83) "it is most important that the cost base of the transaction of the tested party to which a mark-up is to be applied be calculated in the same manner as--and reflects similar functions, risks, and assets as--the cost base of the comparable transactions."
24. It was submitted that in the light of the above analysis, CPM method resorted to by the Revenue in the instant case is not the most appropriate method, as the Assessee produces to sell only to AEs and does not sell to third party and in the process not in possession of internal comparable cost data.
25. It was submitted that alternatively TNMM is the most appropriate method for the following reasons;
• TNMM operates at the net levels wherein the margins are more tolerant to functional difference than at gross levels; • If there exist any difference in the functions the same gets reflected in the operating expenses;
ITA Nos.815 & 846/Bang/2010 Page 20 of 59 • Adjustments for differences in the marketing & advertisement expenses do not result in accurate adjustment for the additional functions performed by the comparable companies vis-à-vis the Appellants with the application of CPM;
• Database limitation on account of Cost of Production (COP) can also be efficiently managed with the use of information at the net level;
• Differences, if any, in the cost structures also evens out at the net levels;
• The absence of comparables from the same industry calls for the selection of a broader set of comparables thereby making a perfect case for testing the margins at the net level with the application of TNMM.
• TNMM should be considered as the MAM where operating expenses represent additional functions but it is not clear how these additional functions are accounted for at the gross margin level, since TNMM includes this in its result.
26. In this regard, out attention was drawn to paragraph 2.62 & 2.69 & 2.4 of the OECD Transfer Pricing guidelines which states as follows:
Para 2.62 of the OECD guidelines :
"One strength of the transactional net margin method is that profit level indicators (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP Method. Net profit level indicators also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but still earn broadly similar levels of net operating profit indicators.
ITA Nos.815 & 846/Bang/2010 Page 21 of 59 Para 2.69 of OECD guidelines:
"Prices are likely to be affected by differences in products, and gross margins are likely to be affected by differences in functions, but operating profits are less adversely affected by such differences"
Paragraph 2.4 of OECD Guidelines:
"There are situations where transactional profit methods are found to be more appropriate than traditional transaction methods. One example is where, considering the functional analysis of the controlled transaction under review and an evaluation of the comparable uncontrolled transactions, it is found that a net margin analysis is more reliable than a gross margin analysis, e.g. because there are material differences in functions between the tested and the uncontrolled transaction which are reflected only in operating expenses below the gross margin level."
The OECD Para 2.62 :
".... Net profit indicators also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, this may lead to a wide range of gross profit margins but still broadly similar levels of net operating profit indicators. In addition, in some countries the lack of clarity in the public data with respect to the classification of expenses in the gross or operating profits may make it difficult to evaluate the comparability of gross margins, while the use of net profit indicators may avoid the problem."
27. Attention was also invited to the Australian transfer pricing guidelines provide that: [TR 97/20 3.52. on Profit methods] "....it might not be possible or practicable to use traditional methods because:
ITA Nos.815 & 846/Bang/2010 Page 22 of 59 i. there is insufficient reliable data to analyze comparability so as to determine an arm's length outcome other than through a profit split or a profit comparison at the net profit level. For example, if selling, general and administrative costs that are treated as part of costs of goods sold for an independent enterprise cannot be identified so as to adjust the gross margin in a reliable application of cost plus, it may be necessary to examine net margins in the absence of more reliable comparisons;
ii. the product or service in question is unique or contains out-
of-the-ordinary intangibles;
iii. while theoretically sound, the traditional methods may not be practicable because of the complexity of the business situation or the extent and diversity of the taxpayer's cross- border dealings with associated enterprises; iv. in many cases, there is a variety of transactions (transfers of tangible and intangible goods and services) back and forth between the associated enterprises, some of which may involve overlaps, and there may be no comparables for the combination of transactions. In these cases, profit methods may be a more reliable way to set or review the transfer pricing used in the dealings between the associated enterprises, or to check findings made using traditional methods if there is doubt about the reliability of the data used or the outcome produced;
28. It was submitted that considering the aforementioned legal principles, that TNMM should be applied instead of CPM. The net margins earned by Assessee are comparable to the comparables provided in the transfer pricing documentation and even the ones proposed by the TPO.
29. The ld. counsel for the assessee also highlighted as to how applying the Cost Plus Method would give absurd results as under:
ITA Nos.815 & 846/Bang/2010 Page 23 of 59 Gross margins and the net margins earned by the comparable companies and the Assessee is as follows:
GP / CoP (As per Financial the order giving Operating Company Name Year effect to the Profit/Total Cost CIT(A)'s order) Centenial Surgical Suture Ltd. 200403 74.17% 7.90% Poly Medicure Ltd. 200403 27.65% 17.50% South India Surgicals Company 200403 37.83% 10.60% Limited Arithmetic Mean 46.55% 12.00% GE BE 16.24% 12.16% It was submitted that the above figures would show that at the gross margin level the earnings of the Assessee are less than the comparable companies while at the net margin level the margin of the Assessee is higher. It was submitted that the above comparison of the Gross and Net profit level indicators (PLIs) only further demonstrates the irrationality of the application of CPM to the facts of the present case.
30. It was submitted that the following will be the revised profit margin of the Assessee after giving effect to the directions of the TPO GE BE's net margin based on the GP / CoP as per TPO Particulars Amount (INR) Sales 3,731,286,546 Add: TP Adjustment to income as made by 596,515,581 the learned TPO (as per TP order) Total Income revised after the TP adjustment A 4,327,802,127 made by the learned TPO Less: Cost of production Materials cost 2,960,589,360 Personnel cost 19,078,438 Consumables 45,584,322 Depreciation 108,652,580 ITA Nos.815 & 846/Bang/2010 Page 24 of 59 Particulars Amount (INR) Repairs and maintenance 37,932,517 Transport and packing 5,144,710 Excise duty 5,623,804 Power and fuel 54,102,259 Insurance 3,874,650 Add: Opening WIP 56,967,585 Less: Closing WIP (87,633,645) Cost of Production B 3,209,916,579 Gross Margin C = A-B 1,117,885,548 Gross Margin / CoP as considered by the D = C/ B 34.83% learned TPO Less: Other Operating expenses of GE BE Opening stock of finished goods 16975272 Closing stock of finished goods (4,150,577) Salary expense 34,258,518 Other Depreciation 24,832,551 Repairs and maintenance-Others 2,722,192 Subcontracting charges 12,132,002 Communication exp 8,092,662 Travel & Conveyance 8,027,514 Legal & Professional fee 7,111,653 Rent 2,465,865 Rates & taxes 897,175 Foreign exchange loss- net 430,831 Miscellaneous expenses 5,168,941 Total other operating expenses E 122,397,796 Total operating expenses F=B+E 3,332,314,375 Net Operating profit recomputed G = A- F 995,487,752 Operating Profit/Total Cost ('OP/TC') H=G/F 29.87% It was submitted that from the above calculation it would be clear the learned TPO has contemplated an increase in the revenue to arrive at the desired gross profit of approximately 35%, given the actual operating expense of the Assessee, the net margin of the Company is thus proposed to be considered at about a whopping 30%. It was ITA Nos.815 & 846/Bang/2010 Page 25 of 59 submitted that the above computation clearly demonstrates the fundamental absurdity in the approach followed by the learned TPO and applying CPM vis-à-vis TNMM which is the most appropriate method. It was further argued that based on the above computation of the net margin of the Assessee which is arrived at approximately 30%, it would be reasonable to assume that the comparable companies identified by the learned TPO must also achieve similar net profit levels. However, the OP / TC of the comparable companies is at about 12% as provided in the table in table given in paragraph 30 above. It was submitted that the above clearly demonstrates that the application of CPM is not only without any proper reasoning or basis and only with the objective of making the assessment proceedings onerous for the Assessee or to impose unwarranted tax liability on the Assessee.
31. The gist of the written submissions filed by the ld. DR can be summed up thus:
i) The Assessee had itself considered CPM as the MAM. The TPO also accepted it as MAM. Therefore, there is no reason for the Assessee to agitate before the Hon'ble ITT at least in AY 04-05 that MAM is TNMM and not CPM. The primary responsibility of identifying the MAM is on the Assessee and he had chosen CPM as the MAM and therefore the Assessee cannot take a ground that CPM is not the right method.
ii) One of the Assessee's plea was that functional similarity is to be first seen before choosing an appropriate method and ITA Nos.815 & 846/Bang/2010 Page 26 of 59 that the TPO in choosing CPM has given weightage to product similarity rather than functional similarity. The Assessee had further pointed out that the comparable chosen by the TPO were manufacturing medical consumables viz., disposal syringes, disposable sutures, disposable needles etc., and that the same cannot be compared with contract manufacturing of tubes, inserts, detectors, tanks and other parts and accessories for medical diagnostic imaging equipment which the Assessee manufactures and which are incorporated by the AE into equipment which are capital goods.
On the above submission, the learned DR has submitted that it cannot be said that product similarity has no relevance. Product similarity is also important. If there is no product similarity then even though there may be functional similarity then CPM may not be the right method. Without prejudice to the above submission, it was also submitted that in the present case, the TPO has given due weightage to functional similarity also.
iii) The Assessee had relied on para 1.41 of the OECD guidelines which provides that comparability even where products are different can be undertaken but the functions undertaken should be similar. On the above submission of the Assessee the learned DR has submitted that the TPO has ITA Nos.815 & 846/Bang/2010 Page 27 of 59 considered both product as well as functional similarity of comparable.
iv) The Assessee had submitted that Indian Accounting Standards do not give clear cut requirement for disclosure of gross profits and therefore there will be difficulty in computation of the cost of production and gross profit. The Assessee has relied on para 2.44 to 2.46 and 2.48 of the OECD TP guidelines as to how the details of cost of production and gross profit are important before applying CPM. On the above submission, the learned DR has contended that under para 2.46 of the OECD TP guidelines where the accounting practices differ in the controlled transaction and the uncontrolled transaction, appropriate adjustments should be made to the data used to ensure that the same type of costs are used in each case to ensure consistency. The learned DR thus submitted that CPM cannot be rejected outright but has to be applied after giving appropriate adjustments to the data on costs of the controlled and uncontrolled transactions.
v) The Assessee had submitted that the difference in functions performed by the Assessee and the comparable selected by the TPO would be clear from an analysis of the respective cost pattern and had in this regard highlighted that the Assessee's ratio raw material cost to sales is higher at ITA Nos.815 & 846/Bang/2010 Page 28 of 59 80.57% compared to 50.57 of the comparable. On the above submission, the learned DR has submitted before us that the above argument shows that the Assessee has accepted the fact that the products of the comparable and that of the Assessee are comparable and therefore the cost pattern of the comparable and that of the Assessee are not relevant.
vi) The Assessee had submitted that it is a contract manufacturer and does not perform functions like marketing, selling and distribution that are performed by the companies chosen by the TPO while applying CPM. On the above submission the learned DR has submitted before us that expenses on marketing, selling and distribution are expenses which will be relevant only when computing net profit and therefore those expenses are irrelevant while applying CPM. It is further submitted that similarity of functions to the gross profit level will only be relevant. In this regard the learned DR has also submitted that while confirming the order of the AO making addition consequent to adjustment of ALP, the CIT(A) has directed the AO to make adjustment to profit margins on account of marketing, selling and distribution expenses, the same cannot affect gross margins.
vii) On the submissions of the Assessee as to which method is superior whether CPM or TNMM, the learned DR has submitted that the issue is as to which method is most ITA Nos.815 & 846/Bang/2010 Page 29 of 59 appropriate to the facts of the present case and not which method is superior.
viii) The learned DR also submitted that the TP documents have been prepared by the Assessee bonafide and good faith and therefore rejection thereof is not warranted, in so far as MAM is concerned.
32. We have given a careful consideration to the rival submissions. We shall first recapitulate the sequence of events. The dispute raised by the Assessee in Gr.No.1 to 7 relate to the determination of Arm's Length Price (ALP) in respect of the international transaction of sale of manufactured goods by the Assessee to one its Associated Enterprise (AE). The Assessee manufactures components of medical devices and sells it to its AE. The pricing is claimed to be based on the GE Global pricing policy. The Assessee sources raw material and components, performs the manufacturing functions and supplies the entire produce to its AE. To justify the price that it receives from its AE is at Arm's Length the Assessee filed a Transfer pricing Study report. The Assessee claimed that it performed functions and undertook risks that are normally performed by a contract manufacturer. The Assessee chose Cost Plus Method (CPM) as the Most Appropriate Method (MAM) for determination of ALP. The Assessee identified 19 comparable companies which were in the business of manufacture of (i) steel forgings, (ii) automotive brake systems, (iii) compressors; (iv) colour TV picture tubes, (v) Axle shafts,
(vi) automotive gears; (vii) rear fork assembly; (viii) sheet metal ITA Nos.815 & 846/Bang/2010 Page 30 of 59 components, assemblies and sub-assemblies,(ix) auto head lights, (x) fuel tanks, axle housing; (x) steering gears; (xi) wheels for automobiles;
(xii) design engines; (xiii) steering gear assembly; (xiv) automotive air- conditioning systems; (xv) steel metal parts. The arithmetic mean of the comparable companies was 15.72% gross mark-up on cost. The Assessee's gross mark-up on cost was 16.24% and therefore it was claimed that the price received from the AE by the Assessee in respect of the international transaction was at Arm's length.
33. The TPO accepted the methodology adopted by the Assessee viz., CPM as the MAM. The profit level Indicator (PLI) chosen by the Assessee viz., Gross profit on cost was also accepted by the TPO. The TPO was of the view that the comparable chosen by the Assessee were not from the Medical equipment industry segment and in terms of Rule 10B(2) (a) the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the specific characteristics of the property transferred or services provided in either transaction. The TPO therefore was of the view that product comparability is very important. The TPO referred to para 2.18 of the OECD guidelines on Transfer Pricing wherein it is provided that although broader product differences can be allowed in the resale price method, the property transferred in the controlled transaction must still be compared to that being transferred in the uncontrolled transaction. The guidelines also lays down that closer comparability of products will produce better result. The TPO also referred to an Australian Tax Ruling ITA Nos.815 & 846/Bang/2010 Page 31 of 59 TR 97/20 which also lays down that to achieve an acceptable level of reliability, greater care is needed to ensure that the industry segment or group of segments being compared are sufficiently similar, especially in relation to functions performed and levels of profitability.
34. The Assessee justified its action in choosing comparable companies from auto ancillary and other industries for the reason that those companies also supply components/semi-finished goods to Original Equipment Manufacturers (OEMS) and was therefore akin to contract manufacturing. Those companies also did not perform functions like marketing and advertisement. The TPO on the above stand of the Assessee referred to para 1.20 of OECD Guidelines wherein it has been laid down that comparability should be based on functions performed and not on the basis of functions not performed. The TPO also referred to the advertising and marketing functions which were not being performed by the Assessee as well as the comparable companies identified by the Assessee as having no relevance because of the gross mark up on cost which is the PLI adopted by the Assessee and therefore for comparability at the level of gross mark up on cost of the products sold, those expenses were immaterial.
35. One of the objection of the Assessee before the TPO was that the comparable chosen by the TPO had low export turnover. On the above objection of the Assessee the TPO has observed that two of the comparable companies chosen by the TPO had export turnover.
ITA Nos.815 & 846/Bang/2010 Page 32 of 59
36. Thereafter the TPO chose comparable companies in the medical equipment components manufacturing sector. The following four comparables were identified by the TPO.
Sl.No. Name of the comparable % of GP over costs 1 Contential Surgical Suture Ltd 74.167 2 Polymedicure Ltd. 27.646 3 South India Surgical Co. Ltd. 37.833 4 Shree Pacetronix Ltd. 38.462 Avg. 44.527 Out of this Shree Pacetronix Ltd. was rejected as per the taxpayer's request since it had related party transactions. The final list of comparable companies was as follows:
Sl.No. Name of the comparable % of GP over costs 1 Contential Surgical Suture Ltd 74.167 2 Polymedicure Ltd. 27.646 3 South India Surgical Co. Ltd. 37.833 Avg. 46.55% The adjustment and consequent addition to the ALP was made by the AO.
37. The CIT(A) confirmed the reasoning of the TPO on all the above objections of the Assessee. On the question of product comparability being important the CIT(A) agreed with the view of the TPO. However with regard to the objection of the Assessee that the comparable ITA Nos.815 & 846/Bang/2010 Page 33 of 59 companies chosen by the TPO do not have export sales, the CIT(A) found merit in the argument advanced by the Assessee. He found that 2 out of the three companies chosen by the TPO viz., Centenial Surgical Sutures Ltd. And South India Surgical Company Ltd., had only 6.79% and 17.74% export sales to total sales. The CIT(A) found that the TPO selected these two companies as comparable based on the quantitative filter of export earnings without providing any minimum threshold level of such earnings. The CIT(A) also found that the Assessee was a 100% EOU and any comparison of its gross margins with companies having an insignificant proportion of export sales is not likely to yield meaningful results. He also found that the TPO has consistently adopted the quantitative filter of export revenue to operating revenue being greater than 25% in accordance with the comparability criteria laid down in Rule 10B(2)(d). He was of the view that domestic companies normally cannot be treated as comparable to those operating in the overseas markets because of the differences in geographic locations, conditions prevailing in the domestic and export markets, size of markets, cost of labour and capital, level of competition and overall economic development. The CIT(A) therefore felt that the TPO should be directed to apply the filter of exports revenues to operating revenues being more than 25% filter and re-compute ALP. The CIT(A) however gave a rider to his own direction as above by adding that if the TPO can demonstrate that there would be no difference in pricing as well as margins between the domestic and export sectors of the industry then he can ignore this filter.
ITA Nos.815 & 846/Bang/2010 Page 34 of 59
38. The first issue that needs to be addressed is with regard to the claim of the Assessee that TNMM should be adopted as the MAM instead of CPM. On the above issue, the Revenue authorities proceeded on the basis that once the Assessee has chosen a particular method as MAM then he cannot go back on it. The Revenue authorities further relied on a ruling of the Pune Bench of ITAT in the case of MSS India (P) Ltd. (supra) wherein it was held that Profit methods are pressed into service only when the traditional method which includes CPM cannot be reasonably applied. Once the standard method is applied it cannot be discarded in preference over transactional profit method unless the revenue authorities are able to demonstrate the fallacies in application of standard method.
39. This reasoning cannot be accepted. There cannot be any estoppel in taxation matters. If the Assessee can show that the stand he originally took was not sustainable in law and seeks to take a different stand either in the course of proceedings before the Assessing Officer or Appellate authorities, the claim of the Assessee has to be tested on the basis of the applicable provisions of law. It cannot be rejected solely on the basis that it was contrary to the stand which the assessee had taken originally. At the same time, it does also mean that the assessee could be allowed free license to vary the functional analysis and the method adopted at any time during the appellate proceedings.
The above proposition finds support in the decision of the ITAT, Pune, in the case of ACIT Vs MSS India (supra) reported in 2009-TII-67- ITA Nos.815 & 846/Bang/2010 Page 35 of 59 ITAT-Pune-TECHNICAL SERVICES dated 29.5.2009 is relevant. In this case, the ITAT had observed that a method chosen cannot be discarded unless there are compelling reasons for the same. While this ruling has been given in the context of the TPO changing the method during the TP audit, it would, in all fairness and equity, be equally applicable to the assessee as well.
The ruling of the Pune, ITAT in the case of MSS India Pvt. Ltd. (supra) at para 22 of the order is as under :
" The consideration as to which method will be more beneficial to the revenue authorities is certainly not germane to the selection of most appropriate method. While there is no particular order or priority of methods which the assessee must follow, and no method can invariably be considered to be more reliable than others, on a conceptual note, transactional profit methods (i.e. Transactional Net Margin Method and Profit Split Method) are treated as methods of last resort which are pressed into service only when the standard methods, which are also termed as 'traditional methods', (i.e. Comparable Uncontrolled Price Method, Resale Price Method and Cost Plus Method) cannot be reasonably applied. The OECD guidelines also recognize this fact and state that transactional profit methods might be used to 'approximate arm's length conditions when traditional methods cannot be relied / applied alone or exceptionally cannot be applied at all'. The transaction profit methods should be applied only when standard or traditional methods are incapable of being properly applied in the facts of a case. While traditional methods seek to compute the prices at which international transactions would normally be entered into by the associated enterprise, but for their interdependence and relationship, transactional profit methods seek to compute the profits that the tested party would normally earn on such transactions with unrelated parties. It is only axiomatic that the profits earned by an enterprise are dependent on several factors, and not only on the prices at which transactions have been entered into with the associated enterprises. The profit based results, thus, admit possibility of vitiation of results by a number of factors, which are not relevant to the determination of prices at which international transactions are entered into by the associated enterprises. These methods, which are a step removed from the methods of computing the prices at which independent transactions would normally take place in respect of the product or service must, therefore, be put to service when the traditional methods, which seek to compute prices in independent situations, fail or are incapable of being implemented, as there are a large ITA Nos.815 & 846/Bang/2010 Page 36 of 59 number of situations in which, for a variety of reasons, traditional methods are simply unworkable. The inputs necessary for applying the traditional methods are not always available and that is the reason that despite better results produced by these methods, these methods are not as much put to use. However, whenever necessary inputs for applying one of these methods are available and there is no dispute about comparability of those inputs, there is no good reason to resort to transactional profit methods. It would thus follow that in a situation in which the assessee has followed one of the standard methods of determining ALP, such a method cannot be discarded in preference over transactional profit methods, unless the revenue authorities are able to demonstrate the fallacies in application of standard methods. In any event, any preference of one method over the other method must be justified by the Transfer Pricing Officer on the basis of cogent material and sound reasoning. (Para 22)."
40. Of course the facts of the case in MSS Ltd. are little different from that of the facts in the instant case. In the case of MSS India, internal comparability analysis was available whereas it is absent in the case of the assessee. Further, in that case, the TPO had noted that CPM cannot be applied as the relevant data for applying the method was not available in the Prowess database or Capitoline database and thus resorted to TNMM. In the instant case, it is not the case of either the assessee or Revenue that relevant data is not available for applying a particular method. Hence it is all the more necessary to select the MAM based on the principles and the Rules enacted, rather than on other considerations. Therefore the principles enunciated in the case of MSS Ltd. (supra), that changingthe MAM is not tenable unless there are cogent reasoning for the same is squarely applicable to this case.
41. A reference can also be made to the provisions in the Act which deals with selection of the MAM. Most appropriate method. Sec.92C and Rule 10C(1) are relevant in this regard and they provide as follows:
"Computation of arm's length price.
92C. (1) The arm's length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or ITA Nos.815 & 846/Bang/2010 Page 37 of 59 functions performed by such persons or such other relevant factors as the Board may prescribe24, namely :--
(a) comparable uncontrolled price method;
(b) resale price method;
(c) cost plus method;
(d) profit split method;
(e) transactional net margin method;
(f) such other method as may be prescribed24 by the Board. (2) The most appropriate method referred to in sub-section (1) shall be applied, for determination of arm's length price, in the manner as may be prescribed."
"Rule 10C. (1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm's length price in relation to the international transaction. (2) In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account, namely:--
(a) the nature and class of the international transaction;
(b) the class or classes of associated enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises;
(c) the availability, coverage and reliability of data necessary for application of the method;
(d) the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;
(e) the extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions;
(f) the nature, extent and reliability of assumptions required to be made in application of a method."
42. In this regard, it is seen that in the TP Study submitted, the assessee has itself adopted. The Cost Plus Method ('CPM') as the Most ITA Nos.815 & 846/Bang/2010 Page 38 of 59 Appropriate Method ('MAM'). While doing so, the appellant has observed in the TP Study, at page 22, as under :
" Cost Plus Method The cost plus method ("CPLM")evaluates the arm's length character of a controlled transaction by referencing the gross profit mark up realized in comparable uncontrolled transactions. The arm's length price for the controlled transfer is the controlled taxpayer's cost of producing the property involved in the transaction, plus an amount equal to those costs multiplied by the appropriate profit mark up. One ordinarily uses the cost plus method to determine arm's length pricing for manufacturing, assembly, or other activities relating to the production of goods sold to related parties. As with the resale price method, comparability under the cost plus method is particularly dependent upon the similarity of functions, risks, and contractual terms.
Again, close physical similarity of the products involved in the controlled and uncontrolled transactions is not ordinarily necessary to establish the comparability of the manufacturers' gross profit mark-ups, although substantial differences in the products may indicate significant functional differences. Specific factors that may be relevant to this method include :
the complexity of the manufacturing or assembly; manufacturing, production, process engineering, procurement, purchasing, and inventory control activities; test functions; selling, general, and administrative expenses; foreign currency risks; and contractual terms (the scope and terms of warranties provided, sales of purchase volume, credit terms, etc.).
Applicabilty to contact manufacturing services In the case of the above referred services provided by GE BE, it has a long term contractual obligation to provide services to GEMS global and its affiliates. As the said services are provided predominantly to related parties, application of CPLM would be appropriate in this case. Further, based upon the similarity of functions, risks, and contractual terms, the CPLM would be suitable in arriving at the arm's length price. Based upon the above, it would be relevant to note that an external comparability analysis has been undertaken to substantiate the arm's length price."
Also, in the TP Study, the appellant has specifically rejected TNMM as the MAM, by observing as follows :
ITA Nos.815 & 846/Bang/2010 Page 39 of 59 "Applicability to contract manufacturing services :
TNMM is generally considered to be a residuary method and is relied upon when no direct comparables are available. In the instant case, due to availability of comparables, CPLM could be considered as the most appropriate method in determining arm's length price with respect to contract manufacturing services. Accordingly TNMM is not considered as most appropriate method."
43. The UN Practical Transfer Pricing Manual for developing countries, 2012 in para 5.3.6 lays down the following criteria for choosing MAM.
"5.3.6. Selection of Transfer Pricing Method 5.3.6.1. The most appropriate transfer pricing method will be selected taking into account the strengths and weaknesses of the method, the appropriateness of the method in the light of the nature of the controlled transaction (based upon a functional analysis), the availability of reliable information (especially on uncontrolled comparables) and the degree of comparability between the controlled and the uncontrolled transactions(including reliability of comparability adjustments needed).
5.3.6.2.Once the taxpayer has identified the transfer pricing methods that are potentially applicable to the controlled transaction, application of the most appropriate method rule involves a careful balance in which the following factors may be taken into account to assess the relative accuracy of the identified methods:
i. The extent to which the comparability factors (characteristics of the property or services, functional analysis, contractual terms, economic circumstances and business strategies) of uncontrolled transactions or entities are similar to the controlled transactions or entities, given the type of comparability that is required under each pricing method;
ii. The availability and reliability of financial and other information that is known about the comparable;
iii. Reliability and accuracy of the comparability adjustments; and ITA Nos.815 & 846/Bang/2010 Page 40 of 59 iv. Reliability of presumptions as well as deficiencies in data and presumptions."
44. The OECD Guidelines on Transfer Pricing in Para 2.2 also lays down similar approach to be adopted for choosing MAM. It lays down as follows:
"2.2 The selection of a transfer pricing method always aims at finding the most appropriate method for a particular case. For this purpose, the selection process should take account of the respective strengths and weaknesses of the OECD recognized methods; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information (in particular uncontrolled comparable) needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them. No one method is suitable in every possible situation, nor is it necessary to prove that a particular method is not suitable under the circumstances. (emphasis supplied) In this regard, it may be necessary to highlight here that there are certain key differences between OECD Guidelines and Indian Regulations in respect of the transfer Pricing methods. One of the differences is that while OECD guidelines, in exceptional circumstances, permit the use of more than one transfer pricing method to demonstrate the arms' length nature of related party transactions, the Indian TP Rules advocate the use of ONLY ONE TP method - 'the Most Appropriate Method'. Hence the assessee's contention of using TNMM as an alternate approach or method is not in tune with the Indian TP Rules, even though it may be permissible as per OECD guidelines. As per the Indian TP Rules, the assessee ITA Nos.815 & 846/Bang/2010 Page 41 of 59 is to select one method as the MAM. The Indian TP Rules does not give any scope or leverage to use different TP methods.
45. The U.N. Practical Transfer Pricing Manual for developing countries, 2012 in para 6.1.3.3 lays down as follows:
"6.1.3.3. Once a method is chosen and applied taxpayers are generally expected to apply the method in a consistent fashion. Assuming that an appropriate transfer pricing method is being applied, a change in method is typically required only if there are any changes in the facts, functionalities or availability of data."
The above guidelines presupposes an appropriate transfer pricing method being applied. The above guidelines emphasise on consistency being followed in applying the method. It also provides that the method can be changed, only if there are any changes in the facts, functionalities or availability of data. Assuming that there could be situations where on assessee may be required to change its chosen MAM for the same year between the time of his TP Study and the assessment / appellate proceedings, such a change can happen only if there are any changes in facts, functionalities or availability of data.
46. In the instant case, the assessee has not made out any case or adduced any evidence to demonstrate that there has been any change in the facts, functionalities or availability of data. Nor is it the assessee's case that any of these have been taken wrongly in the TP Study that warrant a change of method has become necessary. The only reason for seeking change of method is that the comparables ITA Nos.815 & 846/Bang/2010 Page 42 of 59 chosen by the TPO are different from that chosen by the assessee and that the functional profile of the comparables are different. While the aspect of functional difference has been discussed in the later part of the order, we can conclude here that the change of method sought by the assessee is not in tune with the Indian TP Rules, which finds support in the UN TP Manual.
47. The next aspect to be seen is as to whether in the case of a contract manufacturer MAM is Cost Plus Method. The UN Practical Transfer Pricing Manual for developing countries, 2012, in Para 6.2.20.2 and 6.1.3.3 lays down selection of MAM and the relevant guidelines are as under:
"6.2.20 When to Use the Cost Plus Method 6.2.20.1. The cost plus method is typically applied in cases involving the intercompany sale of tangible property where the related party manufacturer performs limited manufacturing functions or in the case of the intra group provision of services. The method usually assumes the incurrence of low risks, because the level of the costs will then better reflect the value being added and hence the market price. Note that if the contract is based on actual costs, the contractual terms may include incentives or penalties depending on the performance of the contract manufacturer.
6.2.20.2. The cost plus method is also generally used in transactions involving a contract manufacturer, a toll manufacturer or a low risk assembler which does not own product intangibles and incurs little risks. The related customer involved in the controlled transaction will generally be much more complex than the contract manufacturer in terms of functions performed (e.g. conducting marketing and selling functions, coordination of production and sales, giving instructions to the contract manufacturer about the quantity and quality of production, and purchasing raw materials in some cases), risks incurred (e.g. market risk, credit risk and inventory risk) and assets owned (product intangibles). The contract ITA Nos.815 & 846/Bang/2010 Page 43 of 59 manufacturer is thus the less complex and as such should be the tested party in the transfer pricing analysis.
6.2.20.3 The cost plus method is usually not a suitable method to use in transactions involving a fully-fledged manufacturer which owns valuable product intangibles as it will be very difficult to locate independent manufacturers owning comparable product intangibles. That is, it will be hard to establish a profit mark-up that is required to remunerate the fully fledged manufacturer for owning the product intangibles. In a typical transaction structure involving a fully fledged manufacturer and related sales companies (e.g. commissionaires), the sales companies will normally be the least complex entities involved in the controlled transactions and will therefore be the tested party in the analysis. The resale price method is typically more easily applied in such cases. 6.2.21 Case Examples of Cost Plus Method:
6.2.21.1. Example 1
(i) LCO, a domestic manufacturer of computer components, sells its products to FS, its foreign distributor. UT1, UT2, and UT3 are domestic computer component manufacturers that sell to uncontrolled foreign purchasers;
(ii) Relatively complete data is available regarding the functions performed and risks borne by UT1, UT2, and UT3, and the contractual terms in the uncontrolled transactions. In addition, data is available to ensure accounting consistency between all the uncontrolled manufacturers and LCO. As the available data is sufficiently complete to conclude that it is likely that all material differences between the controlled and uncontrolled transactions have been identified, the effect of the differences is definite and reasonably ascertainable, and reliable adjustments are made to account for the differences an arm's length range can be established.
6.2.21.2. Example 2 The facts are the same as in Example 1 except that LCO accounts for supervisory, general, and administrative costs as operating expenses, which are not allocated to its sales to FS. The gross profit mark-ups of UT1, UT2, and UT3, however, reflect supervisory, general, and administrative expenses because they are accounted for as costs of goods sold. Accordingly, the gross profit mark ups of UT1, UT2, and UT3 must be adjusted to provide accounting consistency. If data is not sufficient to determine whether such accounting differences ITA Nos.815 & 846/Bang/2010 Page 44 of 59 exist between the controlled and uncontrolled transactions the reliability of the results will decrease.
6.2.21.3. Example 3 The facts are the same as in Example 1 above, except that under its contract with FS, LCO uses materials consigned by FS.UT1,UT2, andUT3, on the other hand, purchase their own materials, and their gross profit mark ups are determined by including the costs of the materials. The fact that LCO does not carry an inventory risk by purchasing its own materials while the uncontrolled producers carry inventory is a significant difference that may require an adjustment if the difference has a material effect on the gross profit mark ups of the uncontrolled producers. Inability to reasonably ascertain the effect of the difference on the gross profit mark-ups will affect the reliability of the results of UT1, UT2 and UT3.
6.2.21.4. Example 4
(i) FS, a foreign corporation, produces apparel for PCO, its parent corporation. FS purchases its materials from unrelated suppliers and produces the apparel according to designs provided by PCO. The local taxing authority identifies 10 uncontrolled foreign apparel producers that operate in the same geographic market and are similar in many respects to FS;
(ii) Relatively complete data is available regarding the functions performed and risks borne by the uncontrolled producers. In addition, data is sufficiently detailed to permit adjustments for differences in accounting practices. However, sufficient data is not available to determine whether it is likely that all material differences in contractual terms have been identified. For example, it is not possible to determine which parties in the uncontrolled transactions bear currency risks. As the differences in these contractual terms could materially affect price or profits, the inability to determine whether differences exist between the controlled and uncontrolled transactions will diminish the reliability of these results. Therefore, the reliability of the results of the uncontrolled transactions must be enhanced."
As a general rule it can be said that the above guidelines advocate use of CPM in the case of Contract manufacturers. However, the provisions of Sec.92C(2) of the Act read with Rule 10C(1) & (2) make it clear that MAM ITA Nos.815 & 846/Bang/2010 Page 45 of 59 has to be determined on the basis of parameters laid down therein. One can therefore conclude this discussion by holding that as a general rule CPM would be the MAM in the case of Contract Manufacturers but that would be subject to the satisfaction of the parameters laid down in Rule 10C(1) & 2 of the Rules.
48. In this regard, we will examine the parameters laid down in Rule 10C(1) and 2 of the Rules, which have been already quoted in pre-Para 41 of this order. Rule 10C(1) states that the MAM shall be the method which is best suited to the facts and circumstances of each particular set of international transactions. As explained in earlier paragraphs and fortified by the UN TP Manual Guidelines, in case of contract manufacturers like the assessee, CPM is the MAM. Rule 10C(2) enumerates six factors that shall be taken into account in selecting the MAM. Out of these six factors, while there is no dispute in four of the factors, the objection of the assessee needs to be analysed in the light of Rule 10C(2)(d) and (e). It is the contention of the assessee the comparables chosen by the TPO, being full-fledged manufacturers, the degree of comparability required is not existing between the assessee's international transactions vis-à-vis the transactions of the comparable companies. This objection has been duly taken note of by the TPO and he has applied Rule 10C(2)(e) granting adjustments. While the assessee may well contend that the adjustments granted are not reliable and accurate, seeking a change of the method itself is not within the scope and coverage of Rule 10C.
ITA Nos.815 & 846/Bang/2010 Page 46 of 59 In this regard, it would be relevant to mention that the assessee had earlier adopted CPM as the MAM and had suggested TNMM ony as an alternative approach. For instance, in the submissions made before the CIT (Appeals) by letter dated 9.2.2009 at pages 115 and 116 of the paper book, the assessee has stated as under :
" Comparability analysis considering Cost Plus Method > The basic parameter on which the CPM operates is functional similarity. The appellant is a contract manufacturer and accordingly the comparables chosen by the appellant are perform functions akin / similar to that of a contract manufacturer. The appellant submits that the comparables arrived at by the appellant are primarily suppliers of components / semi finished goods to Original Equipment Manufacturers (OEMs) and the functions of such companies are comparable or similar to those of a contract manufacturer. The comparables determined by the company primarily perform manufacturing functions and the performance of other functions (e.g. marketing & advertisement) is negligible and insignificant, much the same as is the case with the appellant. Therefore, the profit margins of these companies are primarily reflective of the return on the manufacturing function.
> However, it would be worthy to note that the ld. TPO has given weightage to product similarity over the functional similarity thereby contradicting the basic premise of application of CPM. Base don this, the ld. TPO has chosen the set of comparables which fall under the broad category of "Medical Equipments" as classified in the Prowess database. The comparables chosen by the ld. TPO are engaged in the manufacture of medical consumables viz. Disposable syringes, Disposable sutures, Disposable needles, etc. On the other hand, the appellant is a contract manufacturer engaged in manufacturing Tubes, Inserts, Detectors, Tanks and other parts and accessories for medical diagnostic imaging equipment. Such components are incorporated by the Affiliates into equipment which are in the nature of capital goods. Hence, on the analysis of product comparability, the comparables chosen by the ld. TPO are not comparable with the products of GE BE as the comparison is primarily between consumables versus equipments. > Accordingly, comparables chosen by the ld. TPO also do not manufacture the same or similar products and hence would need to be rejected even if the product comparability criterion is considered to be relevant to the application of the CPM. Even otherwise, the set of comparables chosen by the TPO are functionally not comparable, being ITA Nos.815 & 846/Bang/2010 Page 47 of 59 engaged as they are in marketing and distribution functions, while not being predominantly contract manufacturers. > Assuming without admitting, that even if the ld. TPO comparables are to be considered for the purposes of comparability analysis by applying CPM as appropriate method, the appellant submits as follows :
- That there are significant differences in the functions performed by these comparables primarily with respect to the additional marketing and the selling function, vis-à-vis GE BE which does not perform any marketing or selling activity;
- This is evident from the significant marketing and selling expenses of these companies which further underline the differences in the functions performed as against GE BE which has no marketing or selling expenses;
- There is a return on these additional functions performed by the ld. TPO comparables which is embedded in the selling price and consequently in the gross margins of these companies; and
- Thus, in order to compute appropriate gross mark-up comparable to the gross mark-up of GE BE, an adjustment to the gross margins earned by these companies is warranted for applying the CPM as the appropriate method.
> It is noteworthy that the above rationale is also appreciated by the ld. TPO who has proceeded to provide such an adjustment by eliminating the selling and marketing cost form the sales and consequently its impact on the gross profits. Having said this, the appellant submits that the ld. TPO is grossly incorrect in providing an adhoc adjustment of 8% of sales for eliminating the functional differences between the comparables selected by the ld. TPO and GE BE.
> While the appellant also is in principle in agreement with the ld. TPOs philosophy of adjusting the gross mark-up, however, your goodself would appreciate that in order that the adjustments have the desired effect, the actual proportion of marketing expenses to sales ought to be considered for each comparable. This is more so necessary because the level of these expenses as a proportion of sales for each of the ld. TPO comparable varies.
> In this regard, the appellant would like to mention that Centenial Surgical ( a comparable selected by the ld. TPO) is a case in point, for the reason that its marketing expenses as a proportion of sales is 30% and the adjustment of 8% Tribunal sales granted by the ld. TPO would be grossly inadequate to eliminate the effect of the marketing, distribution and advertisement function on the gross profits.
> Therefore the appellant submits that the financial analysis by the ld. TPO to arrive at the appropriate gross margin is erroneous, and the adjustment for the differences in the marketing and selling functions ITA Nos.815 & 846/Bang/2010 Page 48 of 59 ought to be recomputed based on the actual expenses incurred by the companies.
Further, in the same written submissions, at page 117 of the paper book, it is submitted as under :
Analysis considering alternative approach using TNMM > Further, without prejudice to our submissions above, the appellant submits that if one were to argue that :
- the adjustments mentioned above are not to be considered; or
- that the comparables used in the TP Study do not have the desired degree of comparability for applying CPM as the most appropriate method.
- then alternatively it would be appropriate to use the Transactional Net Margin Method ('TNMM') as the appropriate method instead of considering adhoc adjustments or rejecting the comparables used in the TP Study."
A careful perusal and analysis of the assessee's submissions before the CIT (Appeals) (supra) clearly places the assessee's stated position as one that accepts CPM as the MAM, provided certain adjustments are made for the differences in the marketing and selling functions, based on the actual expenses incurred by the companies. We, therefore, clearly find that it is before the Tribunal that the assessee has changed its stand, stating that TNMM is the MAM and that it would be absurd to consider CPM to be the MAM. TNMM was broached as an alternative approach only during the appellate proceedings.
As we have already held, the concept of alternate approach or use of more than one method is not recognized in Indian TP Rules. The Indian TP Rules recognize use of only one method - the most appropriate method (MAM). Based on the discussions in the pre paragraph of this order, CPM is the MAM in this case.
ITA Nos.815 & 846/Bang/2010 Page 49 of 59
49. Having said so, one should embark upon the stand taken by the Assessee as to why TNMM is the most appropriate method to be adopted for determining ALP in the case of the Assessee. The arguments advanced on behalf of the Assessee have already been set out in the earlier part of this order and are not being repeated. The arguments proceed on purely theoretical basis without citing as to how the required data of direct and indirect costs of production of the property in the case of the comparable companies chosen by the TPO are not available. No specific instance as to how in the case of comparable companies chosen by the TPO, indirect costs of production has been taken at the net profit level. The other argument was that the Assessee is a contract manufacturer and the comparable companies selected should also perform a function performed by a contract manufacturer. If comparable companies perform functions beyond that of a contract manufacturer then they are not comparable. This argument is again general in nature without any particulars on the three comparable companies chosen by the TPO.
50. One of the pleas raised by the Assessee was that functional similarity is to be first seen before choosing an appropriate method and that the TPO in choosing CPM has given weightage to product similarity rather than functional similarity. The Assessee had further pointed out that the comparable chosen by the TPO were manufacturing medical consumables viz., disposal syringes, disposable sutures, disposable needles etc., and that the same cannot be compared with contract ITA Nos.815 & 846/Bang/2010 Page 50 of 59 manufacturing of tubes, inserts, detectors, tanks and other parts and accessories for medical diagnostic imaging equipment which the Assessee manufactures and which are incorporated by the AE into equipment which are capital goods. On the above submission, the learned DR has submitted that it cannot be said that product similarity has no relevance. Product similarity is also important. If there is no product similarity then even though there may be functional similarity then CPM may not be the right method. The conclusions of the CIT(A) in this regard are found to be correct in the present case. The TPO in the present case has given due weightage to functional similarity also. The argument on behalf of the Assessee by placing reliance on para 1.41 of the OECD guidelines which provides that comparability even where products are different can be undertaken but the functions undertaken should be similar is not applicable in the present case as the TPO has considered both product as well as functional similarity of comparable.
The difference in functions performed between the Assessee and the comparable, if any, calls only for adjustments to be made, which in the present case can be quantified. Therefore the claim of the Assessee that the comparable chosen has to be rejected cannot be accepted.
51. The argument on behalf of the Assessee that Indian Accounting Standards do not give clear cut requirement for disclosure of gross profits and therefore there will be difficulty in computation of the cost of production and gross profit is again an argument in the air without any specific instance having been pointed out referable to the three ITA Nos.815 & 846/Bang/2010 Page 51 of 59 comparable companies chosen by the TPO. In any event such differences as laid down in para 2.46 of the OECD TP guidelines, where the accounting practices differ in the controlled transaction and the uncontrolled transaction, appropriate adjustments should be made to the data used to ensure that the same type of costs are used in each case to ensure consistency.
52. The argument on behalf of the Assessee that a contract manufacturer and does not perform functions like marketing, selling and distribution. The expenses on marketing, selling and distribution are expenses which will be relevant only when computing net profit and therefore those expenses are irrelevant while applying CPM. Similarity of functions to the gross profit level will only be relevant. In such cases it has to be demonstrated as to how lower net profit and higher gross profit takes a comparable company out of the comparability. Alternatively, it can be shown as to why the gross margin of the comparable company need to be reduced because of items which are required to be considered while determining the gross margin have been considered only for determining net margin in the case of comparable companies. In that event appropriate adjustment to the gross margin of the comparable companies can be made.
53. It thus seen that the Assessee has not been able to point out as to how CPM is not the MAM in the present case. It can therefore be concluded that CPM, on the facts and circumstances of the present case, is the MAM.
ITA Nos.815 & 846/Bang/2010 Page 52 of 59
54. It is however seen that the TPO has not given any weightage to the various aspects pointed out by the assessee which call for making appropriate adjustments to the margins of the comparable companies, as required under Rule 10B(1)( c )(iii), (ic) & (v) of the Rules. The computation of adjustment at 8% made by TPO is not backed by proper reasoning or rationale. The comparables selected by the TPO perform additional functions in the nature of selling & marketing thus evidencing functional differences with the appellant. This fact has been acknowledged by the TPO, but while giving adjustment, the TPO has computed the adjustment at an adhoc figure of 8%. In view of the difference in functions, the assessee is entitled to adjustments which are reliable and accurate, as stipulated in Rule 10C(2)(e) of the Rules. If such adjustments are provided on actual basis, the difference in the functional profile with the comparable companies gets quantified as provided in Rule 10B(1)( c ) (iii) as applicable to Cost Plus Method (CPM). In the absence of such adjustment, a mere application of CPM on comparables with different functional profile will not be intune with the TP Rules. Therefore, as CPM is adopted as the MAM, the assessee should be allowed adjustment on actual basis, which will reliable and accurate, as stipulated in Rule 10C(2). Needless to add, the TPO will afford opportunity of hearing to the assessee with leave to file detailed submissions in this regards, if necessary. Thus the issues raised in Grounds 1 to 7 by the assessee are treated as partly allowed for statistical purposes.
ITA Nos.815 & 846/Bang/2010 Page 53 of 59
55. Grounds No.8 & 9 raised by the assessee reads as follows:-
"8. That the Learned CIT(A) erred in confirming the action of the Deputy Commissioner of Income-tax, Circle 11(3), Bangalore ("AO") in holding that profit of Rs. 8,79,838 derived from the business of the Export Oriented Unit ('ECU') by exporting spare parts, components etc., was ineligible for deduction under section 10B of the Act and thereby reducing deduction under the said section allowable to the Appellant.
9. That on the facts and in the circumstances of the case the Learned CIT(A) erred in confirming the action of the AO in treating the export of spare parts, components as a "trading activity".
56. The facts that are material for deciding the aforesaid grounds are as follows. The assessee apart from carrying out contract manufacturing and selling products to its AE, also exported spares components / parts. The assessee received a sum of Rs.54,77,838 on export of such spares. The corresponding cost of spares so exported was Rs.45,98,000. The assessee earned a net profit of Rs.8,79,838 on export of spares components. The question before the AO was as to whether this profit has to be considered as profits of the business while computing deduction u/s. 10B of the Act. According to the AO and the CIT(A), the condition for grant of deduction u/s. 10B is activity of manufacture and since income derived from trading is not eligible for deduction u/s. 10B of the Act, the income from trading of spares and components was excluded from the profits of the business while computing deduction u/s. 10B of the Act.
57. Before us, the ld. counsel for the assessee pointed out that the issue as to whether trading profits have to be excluded from the profits of ITA Nos.815 & 846/Bang/2010 Page 54 of 59 the business while computing deduction u/s. 10B is no longer res integra and has been settled by the Special Bench of the Tribunal in the case of Maral Overseas Ltd. v. ACIT, 136 ITD 177 (SB)(Indore) wherein the Special Bench held as follows:-
" 78. Section 10B of sub-section (1) allows deduction in respect of profits and gains as are derived by a 100% EOU. Section 10B(4) lays down special formula for computing the profits derived by the undertaking from export. The formula is as under :-
Profit of the business of the Undertaking x Export Turnover Total turnover of business carried out by the Undertaking
79. Thus, sub-section (4) of section 10B stipulated that deduction under that section shall be computed by apportioning the profits of the business of the undertaking in the ratio of turnover to the total turnover. Thus, notwithstanding the fact that sub-section (1) of section 10B refers the profits and gains as are derived by a 100%EOU, yet the manner of determining such eligible profits has been statutorily defined in sub-section (4) of section 10B of the Act.
As per the formula stated above, the entire profits of the business are to be taken which are multiplied by the ratio of the export turnover to the total turnover of the business. Sub- section (4) does not require an assessee to establish a direct nexus with the business of the undertaking and once an income forms part of the business of the eligible undertaking, there is no further mandate in the provisions of section 10B to exclude the same from the eligible profits. The mode of determining the eligible deduction under section 10B is similar to the provisions of section 80HHC inasmuch as both the sections mandates determination of eligible profits as per the formula contained therein. The only difference is that section 80HHC contains a further mandate in terms of Explanation (baa) for exclusion of certain income from the "profits of the business" which is, however, conspicuous by its absence in section 10B. On the basis of the aforesaid distinction, sub- section (4) of section 10A / 10B of the Act is a complete cost providing the mechanism for computing the "profits of the business" eligible for deduction under section 10B of the Act. Once an income forms part of the business of the income of the eligible undertaking of the assessee, the same cannot be excluded from the eligible profits for the purpose of computing deduction under section 10B of the Act. As per the computation made by the Assessing Officer himself, there is no dispute that both these incomes have been treated by the ITA Nos.815 & 846/Bang/2010 Page 55 of 59 Assessing Officer as business income. The CBDT Circular No.564 dated 5th July, 1990 reported in 184 ITR (St.) 137 explained the scope and ambit of section 80HHC and the mode of determination of profits derived by an assessee from the export of goods, ITAT, Special Bench in the case of International Research Park Laboratories Ltd. (supra), after following the aforesaid Circular, held that straight jacket formula given in sub-section (3) has to be followed to determine the eligible deduction. The Hon'ble Supreme Court in the case of P.R. Prabhakar V CIT (2006) 284 ITR 584/154 Taxman 503 had approved the principle laid down in the Special Bench decision in International Research Park Laboratories Ltd. (supra). In the assessee's own case the ITAT in the preceding years, after considering the decision in the case of Liberty India (supra) held that provisions of section 10B are different from the provisions of section 80-IA wherein no formula has been laid down for computing the eligible business profit.
80. In view of the above discussion, question NO.2 is answered in affirmation and in favour of the assessee. Accordingly, the assessee is eligible for claim of deduction on export incentive received by it in terms of provisions of section 10B(1) read with section 10B(4) of the Act."
58. Similar view was also expressed by the Mumbai ITAT in the case of T. Two International (P) Ltd. v. ITO, 122 ITD 279 (Mum) and ITAT Bangalore in the case of ACIT v. Motorola India Electronics Pvt. Ltd. in ITA No.1134 & 1139/Bang/2003, A.Y. 1998-99 & 2001- 02 by order dated 28.11.2006.
59. The ld. DR, however, pointed out that this Tribunal in assessee's own case for the A.Y. 2002-03 in ITA No.3624/Bang/2004 for the A.Y. 2001-02 by order dated 14.02.2007 has taken a view that profits from trading activity will not be eligible for deduction u/s. 10B of the Act.
60. We have considered the rival submissions and are of the view that the decision rendered by the Tribunal in assessee's own case for the A.Y. ITA Nos.815 & 846/Bang/2010 Page 56 of 59 2001-02 will no longer by binding in view of the decision of the Special Bench Indore in the case of Maral Overseas Ltd. (supra). It is clear from the decision of the Special Bench that as far as deduction u/s. 10B is concerned, it is the profits of the business which have to be considered. Such profits will include even profits from trading activity. The Special Bench has clearly laid down that in section 80HHC, the legislature restricted the meaning of the words 'profits of the business' in Explanation (baa) to section 80HHC, but in section 10B, no such restriction or exclusion is laid down. The Special Bench thus opined that profits of the business would include all profits having nexus with the business of the assessee. In view of the decision of the Special Bench referred to above, we are of the view that the claim of the assessee should be accepted. Accordingly, grounds 8 & 9 raised by the assessee are allowed.
61. Grounds 10 & 11 are with regard to excluding the turnover on account of spares and components from the export turnover without excluding the same from the total turnover while computing deduction u/s. 10B of the Act. This issue is no longer res integra and has been settled by the decision of the Hon'ble High Court of Karnataka in the case of Tata Elxsi Ltd. 348 ITR 98 (Kar), wherein the Hon'ble High court has held that whatever is excluded from the export turnover should also be correspondingly reduced from the total turnover while computing deduction u/s. 10B of the Act. Following the decision of the Hon'ble High Court of Karnataka, we direct the AO to exclude the turnover from export ITA Nos.815 & 846/Bang/2010 Page 57 of 59 of spares & components both from the total turnover as well as the export turnover.
62. In the result, the appeal by the assessee is partly allowed. ITA No.815/Bang/2010
63. Grounds 1, 6 & 7 are general in nature and calls for no adjudication.
64. Grounds 2 & 3 raised by the revenue reads as follows:-
"2. The learned CIT(A) has erred in holding that the income from scrap sales would form part of the profits of the undertaking eligible for deduction u/s. 10B of the Act.
3. The learned CIT(A) has erred in allowing the assessee's appeal following the decision of the Hon'ble ITAT in the assessee's own case in ITA No.3624/Bang/2004 dated 14/2/2007 without appreciating that there is no direct nexus between the scrap sales and the manufacturing activity."
65. It is not in dispute before us that in assessee's own case, this Tribunal has taken a view that income from sale of scrap should form part of profits of the undertaking eligible for deduction u/s. 10B of the Act. The grievance of the revenue is that there is no nexus between the scrap sales and manufacturing activity. We are of the view that there is no merit in the grounds raised by the revenue for the reason that this Tribunal has already taken a conscious decision in the order referred to in ground No.3 raised by the revenue. In the circumstances, following the decision of the Tribunal in assessee's own case, we uphold the order of ITA Nos.815 & 846/Bang/2010 Page 58 of 59 the ld. CIT(Appeals) and dismiss grounds No.2 & 3 raised by the revenue.
66. Grounds No.4 & 5 raised by the revenue reads thus:-
"4. The learned CIT(A) has erred in holding that 25% export earnings filter is to be applied even though it leaves only one company as a final comparable.
5. The learned CIT(A) has erred in holding that one comparable would be sufficient for comparability."
67. On the aforesaid grounds of appeal, the ld. counsel for the assessee submitted that this will have no impact on the TP adjustment, if those grounds are allowed. We are of the view that 25% export earning is an appropriate filter and the fact that by applying that filter only one company is left as a comparable, will not be a ground not to apply the aforesaid filter. We are therefore of the view that the ld. CIT(A) was correct in applying 25% export earnings filter. Grounds No.4 & 5 are accordingly dismissed.
68. Thus, the appeal by the revenue is dismissed.
69. In the result, the appeal by the assessee is partly allowed and appeal by the revenue is dismissed.
Pronounced in the open court on this 6th day of Dec., 2013.
Sd/- Sd/-
(N.V. VASUDEVAN ) ( JASON P. BOAZ )
Judicial Member Accountant Member
Ds / *Reddygp