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Transfer Pricing

Most Appropriate Method (MAM)

BCAS Study Course

21 February 2015

Page 2

Prescribed Transfer Pricing methods

► Tax payer may apply any of the above methods that is considered most appropriate for a transaction

► TNMM is the most frequently used method by Indian Corporate

► PSM sparingly used

► Sixth method has been introduced w.r.e.f 1 April 2012 in the Indian transfer pricing regulations vide Rule 10AB

Any other method as provided in

Rule 10AB

Transactional Net Margin

Method

Profit Split Method

Cost Plus Method

Resale Price Method

Comparable Uncontrolled

Price

Traditional Transaction Methods Transactional Profit Methods Other Methods

BCAS Study Course Transfer pricing – Most Appropriate Method

Page 3

► Considered the most appropriate method, for all transactions, if adequate information is available

► Compares the price charged in a controlled transaction with the price in an uncontrolled transaction

► Requires strict comparability in products, contractual terms, economic terms, etc

Comparison under CUP requires…► Identification of price charged or paid in comparable uncontrolled situations► Such price adjusted to account for differences if any between international

transaction and uncontrolled transactions► Adjusted price arrived above taken to be ALP

Comparable Uncontrolled Price Method


Page 4

► Compares the resale gross margin earned by tested party with the resale gross margin earned by comparable independent distributors

► An arms’ length gross margin should be sufficient for a reseller to cover its operating expenses and make an appropriate operating profit (in light of its functions and risks)

► Preferred method for a distributor buying purely finished goods from a group company (if no CUP available)

Group Manufacturer(France) Related Distributor

(India)

UnrelatedWholesalers

$65 $100

Resale Price Method


Page 5

► Compares the gross profit on costs which the tested party earns with thegross profit on costs earned by comparable independent companies

► Preferred method for:

► manufacturer supplying semi-finished goods

► company providing services

Manufacturer A(Indian)

Related Manufacturer

B (US)

Cost + 40%

Cost Plus Method


US Market

Page 6

► Calculates the combined operating profit resulting from a whole inter-company transaction based on the relative value of each AE's contribution to the operating profit

► The contribution made by each party is determined on the basis of a division of functions performed, valued, if possible using external comparable data

► Applicable for analysing tangible, intangible or services issues

Profit Split Method


Page 7

► Examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, assets etc) in respect of similar parties

► Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction

► Can compare to “comparable transactions” between independent parties► Applicable for any type of transaction and often used to supplement analysis

under other methods► Most frequently used method in India, due to lack of availability of comparable

uncontrolled prices and gross margin data required for application of the CUP method/ CPM/ RPM

Transaction Net Margin Method


Page 8

Sixth Method-Rule 10AB

“Rule 10AB - For the purposes of clause (f) of sub-section (1) of section 92C, the other method for Determination of the arms' length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non associated enterprises, under similar circumstances, considering all the relevant facts."

► Operative from 1 April 2012 and applicable for Assessment Year (‘AY’) 2012-13

► CBDT does not provide either clarity or guidance in terms of the manner of benchmarking a transaction under this method

Applicability► Where the application of the five specific methods is not possible due to

difficulties in obtaining comparable data or due to uniqueness of transactions► Intangibles or business transfers, transfer of unlisted shares, sale of fixed

assets, revenue allocation/splitting, guarantees provided and received, etc.


Page 9

Selection of Most Appropriate Method

Factors prescribed by the Income-tax Rules, 1962 for selection of most appropriate method:

► The nature and class of the international transaction;

► The class or classes of associated enterprises entering into the transaction and functions performed by them taking into account assets employed or to be employedand risks assumed by each enterprises;

► The availability, coverage and reliability of data necessary for application of the method;

► The degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;

► 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;

► The nature, extent and reliability of assumptions required to be made in application of a method.


Page 10

Case laws


Page 11

Global One India Private Limited

Facts of the case

► The assessee is engaged in providing seamless network connectivity to its customers across locations/ countries

► For providing such services, the network connectivity, which is owned and deployed by the other operating entities of the group, have to be used

► During AY 2007-08 and 2008-09, the assessee adopted PSM based on residual profit analysis as the MAM for benchmarking the transaction of provision of services to the group’s customers in India since the transaction involved contribution from the other group companies also


IndiaOutside India

AE 1 AE 2

Assessee

Third party customers

Provision of services in nature of internet direct connections, installation/ configuration of routers etc. to the Group’s customers in India

Page 12

Entire Transaction - Illustrative


Customer A (Overseas)

India

Outside India

AE Network Node

Landing station (Mumbai)

Customer A (Gurgaon)

License telecom services provider

(Gurgaon)

1

2

3

4

1 Transfer of email from customer’s overseas office to GlobalOne foreign entity’s node

Transfer of email from GlobalOne foreign entity’s node to Landing Station in Mumbai, India through international link provided by Flag Telecom

2

Transfer of email from Landing Station to license telecom service provider based at Gurgaon via separate network arrangement

3

4 Finally, transfer of email by license telecom services provider to the customer’s Gurgaon office

Page 13

Contentions

► The assessee applied PSM as follows:► Determination of the consolidated global operating profits/ loss of the Group from global

operations► Allocating basic arm’s length return to each of the operating entity for undertaking the respective

activities. Assessee’s arm’s length return benchmarked by comparing the return earned by comparables engaged in providing similar services in India

► Residual profits/ loss determined by deducting the routine arm’s length return of all the group entities from the consolidated profits and allocated to group companies in proportion to the relative contribution made to the combined global profits/ loss. Relative contribution determined based on the contribution of each entity to the key value drivers (ie sales and marketing operations/ net work operations and field operations) with weights based on the detailed functional analysis

► The above is demonstrated by way of an example below:


Particulars AmountGroup Profits XXArm's length return on costsGroup Co 1 (XX)Group Co 2 (XX)Group Co 3 (Assessee) (XX)

Residual Profits (Distributed amongst group companies based on contributions to key drivers) XX

Page 14

Contentions

► The revenue rejected the assessee’s PSM and applied TNMM based on the following:► Since costs incurred by the assessee independently identifiable, TNMM should be applied instead of

PSM► PSM not applicable in absence of reliable external market data for benchmarking the allocation of

residuary profits► Assessee unable to prove that its operations are integrated to disprove the applicability of TNMM► The key value drivers identified by assessee are routine in nature and do not lead to creation of any

unique intangible and marketing expenses are very low even though they constitute a key driver cost. Further, no basis provided by the assessee for determination of key value drivers

► Assessee unable to demonstrate any unusual reasons for losses during the relevant year

► The assessee’s contentions were as follows:► Residual PSM has been applied in line with accepted practices, both locally and internationally and non

residual portion compared with margins earned by external comparables► TNMM cannot be adopted as MAM since it does not take into account commercial/ business reasons

for losses► TNMM cannot be used for benchmarking returns earned by number of complex entities, where each

entity makes valuable and unique contributions irrespective of creation of any intangibles► The key value drivers have been identified based on a detailed functional analysis and further, each of

the value drivers is determined to be equally important for the global operations of the group, and hence, each driver has been given equal weight. Further, the value drivers are determined based on a detailed analysis of the audited financial statements. Accordingly, the residual group profit/ loss is divided equally among each of the value drivers.


Page 15

Tribunal Ruling

► The Tribunal observed that the assessee’s transactions were highly integrated, interconnected and interdependent and therefore, it was held that for the transaction to fructify, each entity has to make a contribution. The various entities which make such contribution, share the revenues that arise as a consequence to such contribution. Each such entity owns assets and also employs manpower in order to contribute towards the transaction

► Assessee’s contention that TNMM is not MAM as it does not take into account commercial/ business reasons for losses cannot be accepted as a general rule. TNMMcan be applied even in cases where there are commercial or other losses, after suitable adjustments, if required

► The TNMM analysis undertaken by the revenue was not suitable since the operating profit on an entity level instead of transactional level has been considered for the purpose of benchmarking which is not in line with the Rules

► The fact that assessee was operating in India as a standalone entity might lead to the conclusion that the assessee was an independent entrepreneur and therefore, TNMMshould be applied. However, since the transaction was integrated and interrelated and the associated costs and revenues were to be distributed amongst multiple entities, PSM was more suitable to benchmark the transaction


Page 16

Yamaha Motor India Private Limited

Facts of the case

► The assessee is engaged in manufacturing of motorcycles and spare parts under the brand name ‘Yamaha’

► During AY 2007-08, the assessee has sold motorbikes and spare parts to its AE which has in-turn sold the same to third parties

► The assessee adopted RPM as MAM for benchmarking the transaction of sale of motorcycles and CPM as MAM for the transaction of sale of spare parts

► The revenue rejected the assessee’sanalysis and applied TNMM as MAM and proposed an upward adjustment to the assessee’s taxable income


IndiaOutside India

Assessee

Third party customers

Sale of manufactured motorcyclesto AE

Imported motorcyclessold to third party customers

Sale of manufactured spare parts to AE

Assessee

CPM RPM

Page 17

Tribunal Ruling

► The approach and reasoning adopted by the revenue for rejecting ALP determined by the assessee was not justified. No error or defect in this analysis was actually pointed out except saying that the same was not reliable or not accepted

► The law requires ALP to be determined by any of the prescribed methods and the most appropriate method is to be applied. There is no condition that which method will have priority and which of the methods will not be applicable in particular circumstances

► The contention of the revenue that the basic condition of resale price method is that “the property has to be obtained by the enterprise i.e. the assessee from an associated enterprise” is incorrect

► In the Act as well as Rules, the words ‘enterprise’ and ‘associated enterprise’ have been used interchangeably. Definition of ‘enterprise’ and ‘associated enterprise’ in the Act nowhere indicates that the ‘enterprise’ shall mean the assessee and the ‘associated enterprise’ will mean other than the assessee. Thus the revenue’s contention that resale price method cannot be used in the case of the assessee company is devoid of any merit

► The Tribunal ruling in case of Ranbaxy relied upon by the DR held that foreign entity can be considered as tested party provided that relevant comparable data is made available by the assessee. The said ruling in turn, supports the consideration of AE as tested party by the assessee since relevant comparable data was furnished by the assessee


Page 18

Tribunal Ruling

► The same gets further supported by the fact that there is no such condition or prohibition provided in Section 92C as well as Rule 10B. In the absence of any such condition or prohibition it cannot be read into the Rule to mean that resale price method shall not be applicable in case the assessee company is selling its product to an associated enterprise

► The OECD guidelines provides that the following aspects are notable while applying RPM:

► Where applicable resale price is available and resale transaction is made within a reasonable time after the controlled sale;

► Where the distributor or reseller does not add significant amount to the value of the property by altering the product before resale; and

► Where the time gap between the purchase of goods and its sale by the reseller is small

► Further, the assessee had earned gross margin of 15.83% in respect of export of motorcycles to AE as against 10.75% in respect of export of motor cycles to unrelated parties. This itself proves that the margin earned by the assessee company from an associated enterprise was better than the margin earned from the non associated enterprises

► Considering the above, the Tribunal ruled in favour of the assessee and deleted the adjustment


Page 19

Facts of the case► The Assessee is engaged in the business of

manufacture and selling of confectionary products. It sells the products to its AEs as well as independent enterprises

► The Assessee has undertaken its activity with AE in the capacity of a limited risk contract manufacturer and the transaction with third parties as regular entrepreneurship risks

► The Assessee rejected CUP/ CPM as MAM at the time of benchmarking the transaction and considered TNMM as the MAM to determine the arm’s length nature of transaction of sale of goods to AE using external comparable companies

► For AY 2002-03 to AY 2005-06, the Assessee compared the budgeted net margin of the export transaction with the arithmetic mean margin earned by companies considered as comparable and held the transaction to be at arm’s length

► For AY 2006-07, the Assessee compared the actual operating margins (instead of budgeted cost) earned from its export transaction with the arithmetic mean margin earned by companies considered as comparable and held the transaction to be at arm’s length. The Assessee rejected CPM as the MAM stating that the functions and risks undertaken in case of related and unrelated party transactions are different

Wrigley India Private Limited

IndiaOutside India

AE

Assessee

Third Party

Undertaking manufacturing activity for AE in capacity of limited risk contract manufacturer

Undertaking of transaction with third parties in capacity of regular entrepreneur


Page 20

► The revenue rejected the use of TNMM as the MAM stating that TNMM requires the comparison of net margin realized by the Assessee with the net margin earned by comparables and comparison of budgeted margins with actual margins of comparables was not permissible

► The revenue selected the cost plus method as the most appropriate method and compared the gross mark on realized on domestic sales as internal comparable and made a transfer pricing adjustment for AY 2003-04

► Revenue made similar adjustment on the same lines for AY 2004-05, AY 2005-06 and AY 2006-07 as well

► The Assessee filed an appeal before the CIT(A) (for AY 2003-04 to AY 2005-06) against the order passed by the AO and with the DRP (for AY 2006-07)

► The CIT(A)/ DRP however upheld the use of CPM as the MAM. Aggrieved, the Assessee filed an appeal before the Tribunal

Revenue’s Contentions


Page 21

► The Tribunal stated that the dispute in the present facts of the case is confined to one question viz – whether or not the cost plus method is the most appropriate method for determining the arm’s length price

► The Tribunal held that while applying cost plus method apart from ascertainment of historical cost, the most important input would be the ascertainment of normal mark-up in a comparable uncontrolled transaction. The economically relevant characteristics of the situations being compared must be sufficiently comparable

► In the present case, the Assessee manufactures and sells the product to its AE and it is the AE who undertakes the all important marketing function which drives the sales in a FMCG company. Further, in case of domestic sales, the Assessee carries out all the functions of manufacturing, selling as well as marketing of the product

► The Tribunal held that the sale of FMCG product to an overseas AE without any costs being incurred on the marketing and sales promotion amongst the end users and the sale of FMCG product to a domestic independent enterprises with full responsibilities for marketing and sales promotion amongst end users are not comparable

Tribunal Ruling


Page 22

► The difference also extends to the fundamental business model itself as the export sale to AE is not to an end user but to a distributor whereas the domestic sale is to end users. The sale of products to the AE is more akin to contract manufacturing arrangement whereas the sale of products to domestic independent enterprises is regular business entrepreneurial venture

► The FAR in both the cases above is different and accordingly the profitability will also differ. The Tribunal held that when profitability levels in two business situations due to significant differences in FAR profiles are expected to be different, such transactions cease to be comparable transactions

► The Tribunal relied on the OECD guidelines and the UN transfer pricing manual and held that in the given case although the characteristic of the property transferred is the same certainly it is not the sole and decisive factor

► The Tribunal held that since FAR profile , contract terms, economic circumstances and business strategies were all different, CPM could not be applied as uncontrolled transactions were not comparable

► The Tribunal remanded the matter back to the revenue for fresh reexamination of ALP on the basis of TNMM

Tribunal Ruling


Page 23

Facts of the case► The Assessee is a wholly owned subsidiary of the Watson Labs, USA and has a facility

for R & D and also manufactures raw materials, API and intermediate products to support its internal product development. The Assessee also develops APIs for third parties

► The Assessee provides contract manufacturing and contract R&D services to its parent AE in the US, which is engaged in development, manufacture and sale and distribution of proprietary and off patent generic pharmaceutical products

► In respect of the contract manufacturing activity, the Assessee undertook detailed tests in its R&D laboratory and filed its results with US FDA after getting an approval, manufactured products for its AE

► The Assessee is compensated on a cost plus mark-up basis for both the activities

► For the year under consideration, the Assessee adopted TNMM as the most appropriate method in its TP study report to justify its international transactions with its AE

Watson Pharma Private Limited


Page 24

Revenue’s ContentionsProceedings

► The revenue changed the comparable companies in case of contract R&D activity and worked out the mean at 23.61% (as against the Assessee’s margin of 17.43%). Accordingly, an adjustment of 1.93 crores was worked out

► In addition to above, in case of the R&D activity and contract manufacturing segment, the revenue computed adjustment based on account of location savings

► The revenue contended that in case of contract manufacturing activity, cost of manufacturing in India (excluding raw material cost) is around 40% of cost in USA and thus adjustment based on the computation of differential costs was worked out at INR 25.19 crores for contract manufacturing segment

► Similarly the revenue contended that in case of Contract R&D activity, cost of R&D in India (excluding raw material cost) is around 50% of cost in USA and thus adjustment based on the computation of differential costs was worked out at INR 9.04 crores for R&D segment

► The revenue while computing the location savings has apportioned the same in the ratio of 50:50 between the Assessee and the AE


Page 25

Proceedings

► Further, while making the TP adjustment on location saving, the revenue has relied on

► Position taken by Indian tax administration in UN TP Manual Chapter 10

► US tax court’s cases on location savings namely:

► Sundstrand Corporation and Subsidiaries;

► Compaq Computer Corporation and Subsidiaries;

► Eli Lily & Co;

► National Semiconductor Corporation; and

► Bausch & Lomb

► Further on filing objections with the DRP, the DRP sustained the adjustment on location savings and excluded 1 comparable from the set of comparable companies and enhanced the adjustment from INR 1.93 crores to INR 2.04 crores

► The DRP during the proceedings stated that comparing profits realized by the Assessee vis-à-vis comparable companies would not be appropriate. What is to be compared is the sale price of the products sold by the competitor’s in the US market to determine whether the location savings was actually passed on to end customers

► Aggrieved, the Assessee preferred an appeal before the ITAT



Page 26

► No adjustment in respect of location savings is warranted as the Assessee had complied with the provisions of Section 92C(1) and 92C(2) of the Act for determining ALP of international transactions and revenue had erred in disregarding the same

► The information of the AE called for by the revenue was not submitted by the Assessee as it was not privy to such information. Assessee does not have exclusive access to factors that result into location specific advantages and as such no super profit arose in the entire supply chain

► Assessee operated in a perfectly competitive market and did not have any monopoly and in case there exists any location savings the same would be passed on to the end customers of the AE

► It has selected local Indian companies, operating in similar economic circumstances and thus the location savings that would have arise would be factored in the profit margin of the companies considered as comparable by the Assessee

► Reliance was placed on the judgment in case of GAP International Sourcing (India) Private Limited

Assessee’s Contentions


Page 27

► It was submitted by the Assessee that, the AE had operations across the globe and could procure the finished goods/services either from the Assessee or any other group companies or even third parties. Thus the AE had various alternatives available, which conferred bargaining power in hands of the AE. Thus arm's length allocation should be determined based on the bargaining power of the Assessee as well as the AE

► Location saving is not an intangible asset, till such time, where specific advantages are capable of being owned and controlled by an individual enterprise. In absence of such an intangible, the revenue’s approach of considering PSM as the most appropriate method for allocation of location savings (by following India chapter in UN TP Manual which is the opinion of tax administration and not the view of Indian Government) would be inappropriate.

► Once Assessee is remunerated at arms length by taking into consideration regular comparable companies then no location savings is to be attributed

► The revenue computed adjustment of location savings on the basis of the articles appearing in journals and websites which has not been accepted by any forum



Page 28

► The Assessee as well as the AE operate in a competitive market. Also the Assessee does not have exclusive access to the factors resulting in location savings advantages. Hence, there is no super profit arising in the entire supply chain and no unique advantages arising to the Assessee over its competitors

► Relying on the judgment in case of GAP International Sourcing (India) Limited, OECD guidelines and G 20 observations on Action 8 of the BEPS plan, Tribunal ruled that where local market comparables are available, specific adjustments for location savings are not required

► The financial results of the AE is not relevant as the Assessee was the tested party and the transactions of the Assessee should be compared with uncontrolled, unrelated comparable transactions. Accordingly, once the revenue has accepted the selection of TNMM by the Assessee as the most appropriate method, so long as the PLI is within the range of comparables, any benefit/ advantage accruing to the AE is irrelevant

► The revenue’s calculation of location savings was based on assumptions as the reliance was placed on articles published in 2012 whereas the Assessee’s case pertains to FY 2008-09. Further, web articles cannot be accepted in any forum

Tribunal Ruling


Page 29

► The Tribunal also ruled that the case laws relied upon by the revenue pertain to fiscal year’s 1970 and 1980 where the economic scenario was different and hence is primitive. Also, the tax payers were not operating in perfectively competitive market unlike in the case of the Assessee

► The reliance of the revenue on UN TP Manual was incorrect as the same is the view of the Indian tax administration and is not binding on tax authorities

► The approach of the revenue of marking TP adjustment based on location savings in inconsistent with the approach followed in earlier AY’s where no such adjustment was made. Considering that the facts of the case are same for both the AY, the approach followed is inconsistent

► The methodology used by the revenue for making TP adjustment is not recognized in any of the provision of the Act

► The Tribunal accordingly set aside the order of the DRP and directed the AO to delete the TP addition

Tribunal Ruling


Page 30

Hapag Lloyd India Private Limited

Facts of the case

► The assessee provided agency services to its AE with respect to coordination and marketing support services for the vessels owned, operated, chartered and managed by the AE in India for which it got remunerated at cost plus 10% mark-up

► The assessee further sub-contracted these services for some specific regions to a third party sub-agent in India

► The assessee benchmarked the transaction of provision of agency services by adopting TNMM as the MAM


IndiaOutside India

Assessee

AE

Provision of agency services in nature of coordination and marketing support services

Third party sub-agent

Undertaking of similar services in certain specific territories where the assessee does not undertake such activities

In the earlier years, prior to the appointment of the assesseeas agent by the AE, the current sub-agent (GESA)appointed by the assessee used to be a direct agent to theAE

Page 31


► The revenue rejected the TNMM analysis of the assessee based on the following:

► The price charged between the sub-agent and the assessee was comparable to the price paid by the AE to the GESA under their earlier agency agreement, and thus the latter formed an internal CUP. Further, as data upto two prior years data can be used for the purposes of determining ALP as per TP provisions, the earlier agreement between the AE and GESA could be used as internal CUP

► Secondly, since the terms of and services performed under the sub-agency agreement between the assessee and the sub-agent were similar to that of the main agency agreement between the assessee and the AE, the former formed an internal CUP.

► Therefore, the revenue applied internal CUP as MAM by considering the price charged by the sub-agent to the assessee for providing services as a sub-agent as CUP and proposed an upward adjustment to the assessee’s taxable income


Page 32


► The assessee contended as follows:

► The agreement between the AE and GESA was terminated in the earlier years and was not in existence during the financial year under consideration. Since there was no agreement existent and no services were rendered by the GESA to the AE during the year under consideration, then in the absence of current year data, the non-existing agreement cannot be considered as CUP

► The remuneration model of the two transactions (i.e. a) between the assessee and sub-agent, and (b) between assessee and AE is not comparable. The sub-agent was remunerated on a commission basis, whereas the assessee was remunerated at 10% from AE

► The nature of services rendered by the sub-agent to the assessee and services by the assessee to its AE were different in nature. The sub-agent provided customer service booking and documentation services to assessee under sub agency agreement, whereas the assessee did not provide such services to AE. The assessee was a long term service provider for AE as compared to the sub-agent. The sub-agent was required to furnish bank guarantee which is not required by the assessee. Further, the risk profile was also different in both the transactions.


Page 33

Tribunal Ruling

► The revenue misunderstood the rule which allows the use of prior years’ data for the purpose of undertaking comparability analysis. In an ordinary scenario, only current year/ contemporaneous data can be used for comparing uncontrolled price with the controlled price, and only in the case of exceptional circumstances, the data relating to earlier years but not more than two years prior to the current year can be used if such data reveals facts which can have an influence on the determination of arms length-price in relation to the international transaction. Therefore, in the current scenario, since GESA ceased to agent of AE in the prior year, the price then charged could not be considered for ALP determination

► The price between the sub-agent and assessee did not satisfy the basic ingredient of a transaction between an unrelated party and AE. Noting the sub-agency structure wherein, out of the total services provided to AE, a part was performed through sub-agent and the remaining was performed by the assessee itself. Therefore, using the same as CUP is contrary to the transfer pricing regulations

► The approach adopted by the revenue of carving out the service element of the sub-agent from the total services provided to the AE and adopting the same as CUP for benchmarking the assessee’s service element is inappropriate. The entire services provided by the assessee should be considered as one international transaction, and the price received by the assessee in total had to be compared with the ALP

► Based on the above, the Tribunal set aside the issue and guided to start afresh by considering the above discussion


Page 34

Toyota Kirloskar Auto Parts Private Limited

Facts of the case

► The assessee is engaged in the business of manufacturing of automobile parts for sale to its group company

► During AY 2007-08 assessee entered into various international transactions including purchase of raw materials, components and consumables, purchase of capital assets, payment of royalty, payment of IT support fee, payment of warranty claims etc with its AE

► The assessee aggregated all its international transactions and adopted TNMM as MAM for the purpose of benchmarking


IndiaOutside India

Assessee

AE

Payment of royalty for availing technical know-how

Page 35

Contentions

► The revenue accepted TNMM as MAM at enterprise level for all the international transactions of the assessee except for the transaction of payment of royalty

► Revenue held that ‘royalty’ is a class of its own and it required separate analysis. Therefore, CUP was applied as MAM

► Further, the revenue held that the assessee had not proved reasonableness of the royalty paid, and therefore held ALP of royalty as ‘NIL’ and accordingly, proposed an upward adjustment to the assessee’s taxable income

► The assessee contended that it had entered into a commercial agreement with its AE for supply of technical knowhow, technical assistance, training of personnel etc. The technologies invented by the AE were patented and cannot be used by others including the assessee without the permission of the AE and that it had regularly accessed the technologies of the AE for use in its local development and manufacturing processes

► The assessee also argued that technology formed integral part of the manufacturing process and thus the said transaction cannot be tested in isolation


Page 36

Tribunal Ruling

► The payment of royalty was not part of a composite contract/ agreement but was on account of a separate agreement entered into by the assessee with its AE and therefore the same was independent and not in any way interlinked or inter-connected with other transactions entered into with AEs. Therefore, the payment of royalty can be analyzed separately and the ALP of such a payment can be determined independently

► CUP method is the most direct method requiring higher degree of product similarity, because even minor differences in contracted terms or economic conditions could materially affect the amount charged in an uncontrolled transaction. The payment of royalty was for the use of technical know-how which was owned by AEs, thus, the transaction involved transfer of intangibles. Such transfers of intangibles would generally occur between group entities only & each intangible property was unique and not comparable. It was further observed that there are various factors in benchmarking intangibles like terms of transfer, stage of development, rights to receive updates, uniqueness of concerned intangible, duration of intangibles etc which pose difficulty in benchmarking royalty transactions

► Therefore, in such a situation, the perfect approach for indirectly benchmarking royalty payments is to bench mark the profit margin left in the tested party, after payment of lump sum fee or royalty with the profit margins of comparable uncontrolled companies

► Based on the above, the Tribunal restored the issue to the revenue to find comparable companies under TNMM for benchmarking the transaction of payment of royalty


Thank you

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