Alfa Laval (I) Ltd. v. Dy. CIT

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The Tax Publishers2014 TaxPub(DT) 0136 (Pune-Trib) : (2014) 149 ITD 0285 : (2013) 158 TTJ 0409 : (2013) 095 DTR 0239 Alfa Laval (I) Ltd. v. Dy. CIT INCOME TAX ACT, 1961 --Transfer pricing--Computation of ALPApplicability of TNMM vis-a-vis CPM--Where there were numerous differences between export segment and domestic segment of assessee-company on account of geographical factors, marketing functions, credit risk, product liability risk volume difference and other reasons and suitable adjustment were not possible, therefore, TNMM and not CPM was the most appropriate method for determining the ALP. Moreover, net margin in export segment being higher than the net margin in domestic segment, no addition was therefore warranted by applying internal TNMM. The TPO has rejected the TNMM. In this regard, it was submitted on behalf of the assessee that the assessee company has exported equipments to AEs for last several years. Right from assessment years 2002-03, onwards, the assessee has adopted TNMM as the most appropriate method for determining the ALP in respect of the transaction of export of equipments to the AEs. For all these years, starting from assessment years, 2002-03 to 2007-08, the department has accepted TNMM as the most appropriate method for determining the ALP in respect of the sale of equipments to the AEs. The copies of the orders passed for assessment years 2002-03 to 2007-08 have been placed at pp. 31 to 57 of the paper book 1. In this background, the learned Authorized Representative for assessee submitted that for last several years, the department has accepted TNMM as the most appropriate method for determining ALP in respect of the transactions of export of equipments. The facts for this year are similar to the facts involved for the earlier years. On the principle of consistency, the TPO should not have rejected TNMM as the most appropriate method. The courts have observed that when the facts involved are similar for various years and the department has accepted a particular stand in some of the years, there is no reason to take a different stand in the subsequent years. Assessee has placed the reliance on following decisions for this proposition. [Para 6.3] The stand of assessee has been that the various reasons given by the TPO for rejecting five out of the eight companies selected by the assessee are not correct. Firstly, in respect of Gansons Ltd. and Kilburn Engineering, the TPO has mentioned that there is substantial difference in the turnover of the said two companies and the assessee-company. Hence, by applying the turnover filter, the two companies were rejected. He has considered the turnover of the assessee at Rs. 744 crores and according to him, the turnover of Gansons is Rs. 51.47 crores. and that of Kilburn is Rs. 76.77 crores. In this regard, the stand of the assessee has been that the TPO has considered the total turnover of the assessee-company at Rs. 744 crores. It is to be appreciated that there are two main divisions of the assessee-company and the turnover of the equipment segment is Rs. 373 crores. in respect of which the comparable entities are selected. Therefore, to consider turnover of the entire company of Rs. 744 crores. is not justified. The assessee is comparing the equipment division profit whose turnover is Rs. 373 crores. vis-a-vis the turnover of Gansons and Kilburn of Rs. 51.47 crores. and Rs. 76.77 crores. respectively. Hence, if one compares the turnover of equipment division of the assessee company and the turnover of the said two companies, then there is no substantial difference and accordingly, the reason given by the TPO for rejecting the said two companies is not justified at all. [Para 6.3(A)VI.] In terms of rule 10B(1)(e) of IT Rules, internal comparables are permitted while adopting the TNMM. The external comparable should be considered for determining the ALP as per TNMM, even if, internal comparable is adopted. There is nothing on record to suggest that transaction relating to sale of equipments to the AEs is not ALP. The net margin in export segment is 21.12 per cent while the net margin in domestic segment is 18.05 per cent as detailed in chart given on p. 248 of paper book 1. Since the net margin of the export segment is more than the domestic segment, as per the internal TNMM as well, the transactions relating to export of equipments are at ALP. [Para 6.3(B)(V)] The assessee explained that there are various differences in the two segments in the form of marketing functions, credit risk, types of customers, product liability risk, etc. etc., and hence, the CPM could not be applied. Tribunal has held that considering the differences in the functions performed and the assets utilized, suitable adjustments are not possible to be made and hence, the CPM was not the most appropriate method for determining the ALP. [Para 6.3(C)(IV)] The TPO has ignored the detailed working submitted by the assessee-company wherein it has been demonstrated that the domestic segment included controlled transactions of about 25.18 per cent. The relevant chart has been placed at p. 241 of paper book 1 filed by the assessee. The TPO has erred in holding that all the imports of raw material are utilized for sale of equipments in export segment. While the part of the imports is utilized for the sale in domestic segment as well and hence, there is controlled transactions in the domestic segment. Further, the royalty is paid only on sales in domestic segment and not for sales in export segment. As the percentage of related party transactions in respect of sales of the domestic segment is much higher than 25 per cent, the domestic segment cannot be said to be an uncontrolled comparable entity and accordingly, the CPM adopted by the TPO is not justified. [Para 6.3(C)(V)] The assessee-company does not have to incur any marketing costs in respect of sales to its AEs vis-a-vis the sales in the domestic segment, logically, it has to factor the said expense while determining the sale price of the equipments in the domestic market. However, according to the TPO, under CPM gross margins are considered wherein only direct and indirect costs of production are to be taken into account. Therefore, the marketing and sales related costs do not affect the computation of ALP. The marketing and sales costs are not part of the direct and indirect costs of production. But, the TPO has not appreciated these factors while determining the gross margin. The gross margin is determined by considering the sales and reducing the direct and indirect costs of production. Thus, sales are a major factor while determining gross margin. The TPO states that the marketing and sales costs are not relevant to determine gross margin. When an entity determines the sale price of any product, it would certainly consider its marketing and sales costs while determining the final sale price. Accordingly, the sales and marketing costs are factored in the final sale price of a product and therefore, the sale price of the product should be adjusted to cover the marketing and sales costs. In the present case, the assessee does not have to incur any expenditure on the export of equipments to its AEs since the marketing and sales function is taken care by the AEs. However, in the domestic market, it has to incur substantial marketing costs. Now, this cost is definitely factored into the sale price of the equipments while selling in the domestic market. The selling price as well as the gross margin is certainly impacted by differences in marketing function. The marketing cost should be reduced from the sale price of the equipments sold in the domestic segment in order to adjust for the differences between the functions performed in respect to the export segment vis-a-vis the domestic segment. If the adjustment is not made for this difference, it would result in a distorted picture which is evident from the fact that the net profit of the export segment is much higher than that of the domestic segment. In view of this the TPO was not justified in not adjusting the sale price of the domestic segment by the selling and distribution expenses incurred by the assessee. [Para 6.3(D)(II)] The adjustment on account of bad debt risk of Rs. 59.05 lakhs should have been made while determining the gross margin in respect of the domestic segment. [Para 6.3(D)(III)] The total royalty paid by the assessee in this year is Rs. 1.20 crores pertaining to equipment division and the same should have been considered while determining the gross margins of the domestic segment. [Para 6.3(D)(IV)] Considering the huge volume difference, the assessee requests for an adjustment. Considering the huge volume differences an adjustment of about 20 per cent should have been given by the TPO. [Para 6.3(D)(V)] According to Departmental Representative, the assessee company had aggregated its equipment segment and project segment and applied TNMM on the results of the entire entity. According to him such an approach of the assessee of aggregating its equipment and project segment is not justified. He has stated that since both the segments differ significantly, such an aggregation approach adopted by the assessee is not correct. In this regard, stand of assessee has been that the contention of the CIT-Departmental Representative that the assessee has aggregated its project and equipment division and thereafter had applied TNMM on entity basis is not correct. It has not aggregated the two divisions for applying the TNMM. It has aggregated all the international transactions pertaining to equipment division and has computed the operating margin of the equipment division separately. This point has been clarified in the transfer pricing study report. The assessee has computed the operating margins of equipment division and project division independently and even the comparable entities are identified separately for the two divisions. The assessee clarifies that it has not aggregated the two divisions. The assessee has only aggregated all the closely linked transactions of equipment division and the project division separately and applied TNMM separately for both the divisions. Same was explained to the TPO that considering the fact that the other transactions pertaining to the equipment division like import of materials, spares, receipt of commission, etc. etc., were accepted as at ALP, there was no reason to make the addition only in respect of the transaction of export of equipments to the AEs. In view of above discussion the assessee has rightly computed the margin of both the divisions separately and applied TNMM for each division separately. Hence, contention of Departmental Representative that assessee has aggregated the two divisions is not correct. [Para 8] The assessee has given the working of the net margins in the two segments which reveals that the net margin of the export segment is higher. This point clearly highlights the case of the assessee that if there was any undercharging on the sales to the AE, the net margin of the export segment would have been much lesser than the net margin in domestic segment. Considering the facts of the case, Court find that in case the domestic and export segments are to be compared, internal TNMM has to be applied and as per which no addition is warranted. [Para 8.5] According to the Departmental Representative, the comparison of export and domestic segments is justified. According to him, as per the conditions in Indian market, the margins in export segment are always higher than the domestic segment. In this regard, in theory, the domestic and export segments can be compared. [Para 8.6] The entire marketing cost is pertaining to domestic segment and the same should be reduced from the selling price. Similarly, there are no bad debts in export segments and therefore, the amount of bad debts should be reduced from the selling price of the domestic segment. According to the Departmental Representative the assessee has not quantified any adjustments for volume difference. On that basis, the assessee had requested for an adjustment of about 20 per cent considering the fact that the top five AEs had cumulatively placed orders of more than Rs. 180 crores. In this regard, Court find that there are so many differences in the two segments and considering the fact that suitable adjustments are not possible, CPM has to be rejected. There are differences as accepted by the TPO and therefore, in view of the decision of Drilbits International (P) Ltd. (supra), CPM should not be applied. [Para 8.8] SUBSCRIBE FOR FULL CONTENT

The Tax Publishers2014 TaxPub(DT) 0136 (Pune-Trib) : (2014) 149 ITD 0285 : (2013) 158 TTJ 0409 : (2013) 095 DTR 0239

Alfa Laval (I) Ltd. v. Dy. CIT

INCOME TAX ACT, 1961

--Transfer pricing--Computation of ALPApplicability of TNMM vis-a-vis CPM--Where there were numerous differences between export segment and domestic segment of assessee-company on account of geographical factors, marketing functions, credit risk, product liability risk volume difference and other reasons and suitable adjustment were not possible, therefore, TNMM and not CPM was the most appropriate method for determining the ALP. Moreover, net margin in export segment being higher than the net margin in domestic segment, no addition was therefore warranted by applying internal TNMM.

The TPO has rejected the TNMM. In this regard, it was submitted on behalf of the assessee that the assessee company has exported equipments to AEs for last several years. Right from assessment years 2002-03, onwards, the assessee has adopted TNMM as the most appropriate method for determining the ALP in respect of the transaction of export of equipments to the AEs. For all these years, starting from assessment years, 2002-03 to 2007-08, the department has accepted TNMM as the most appropriate method for determining the ALP in respect of the sale of equipments to the AEs. The copies of the orders passed for assessment years 2002-03 to 2007-08 have been placed at pp. 31 to 57 of the paper book 1. In this background, the learned Authorized Representative for assessee submitted that for last several years, the department has accepted TNMM as the most appropriate method for determining ALP in respect of the transactions of export of equipments. The facts for this year are similar to the facts involved for the earlier years. On the principle of consistency, the TPO should not have rejected TNMM as the most appropriate method. The courts have observed that when the facts involved are similar for various years and the department has accepted a particular stand in some of the years, there is no reason to take a different stand in the subsequent years. Assessee has placed the reliance on following decisions for this proposition. [Para 6.3] The stand of assessee has been that the various reasons given by the TPO for rejecting five out of the eight companies selected by the assessee are not correct. Firstly, in respect of Gansons Ltd. and Kilburn Engineering, the TPO has mentioned that there is substantial difference in the turnover of the said two companies and the assessee-company. Hence, by applying the turnover filter, the two companies were rejected. He has considered the turnover of the assessee at Rs. 744 crores and according to him, the turnover of Gansons is Rs. 51.47 crores. and that of Kilburn is Rs. 76.77 crores. In this regard, the stand of the assessee has been that the TPO has considered the total turnover of the assessee-company at Rs. 744 crores. It is to be appreciated that there are two main divisions of the assessee-company and the turnover of the equipment segment is Rs. 373 crores. in respect of which the comparable entities are selected. Therefore, to consider turnover of the entire company of Rs. 744 crores. is not justified. The assessee is comparing the equipment division profit whose turnover is Rs. 373 crores. vis-a-vis the turnover of Gansons and Kilburn of Rs. 51.47 crores. and Rs. 76.77 crores. respectively. Hence, if one compares the turnover of equipment division of the assessee company and the turnover of the said two companies, then there is no substantial difference and accordingly, the reason given by the TPO for rejecting the said two companies is not justified at all. [Para 6.3(A)VI.] In terms of rule 10B(1)(e) of IT Rules, internal comparables are permitted while adopting the TNMM. The external comparable should be considered for determining the ALP as per TNMM, even if, internal comparable is adopted. There is nothing on record to suggest that transaction relating to sale of equipments to the AEs is not ALP. The net margin in export segment is 21.12 per cent while the net margin in domestic segment is 18.05 per cent as detailed in chart given on p. 248 of paper book 1. Since the net margin of the export segment is more than the domestic segment, as per the internal TNMM as well, the transactions relating to export of equipments are at ALP. [Para 6.3(B)(V)] The assessee explained that there are various differences in the two segments in the form of marketing functions, credit risk, types of customers, product liability risk, etc. etc., and hence, the CPM could not be applied. Tribunal has held that considering the differences in the functions performed and the assets utilized, suitable adjustments are not possible to be made and hence, the CPM was not the most appropriate method for determining the ALP. [Para 6.3(C)(IV)] The TPO has ignored the detailed working submitted by the assessee-company wherein it has been demonstrated that the domestic segment included controlled transactions of about 25.18 per cent. The relevant chart has been placed at p. 241 of paper book 1 filed by the assessee. The TPO has erred in holding that all the imports of raw material are utilized for sale of equipments in export segment. While the part of the imports is utilized for the sale in domestic segment as well and hence, there is controlled transactions in the domestic segment. Further, the royalty is paid only on sales in domestic segment and not for sales in export segment. As the percentage of related party transactions in respect of sales of the domestic segment is much higher than 25 per cent, the domestic segment cannot be said to be an uncontrolled comparable entity and accordingly, the CPM adopted by the TPO is not justified. [Para 6.3(C)(V)] The assessee-company does not have to incur any marketing costs in respect of sales to its AEs vis-a-vis the sales in the domestic segment, logically, it has to factor the said expense while determining the sale price of the equipments in the domestic market. However, according to the TPO, under CPM gross margins are considered wherein only direct and indirect costs of production are to be taken into account. Therefore, the marketing and sales related costs do not affect the computation of ALP. The marketing and sales costs are not part of the direct and indirect costs of production. But, the TPO has not appreciated these factors while determining the gross margin. The gross margin is determined by considering the sales and reducing the direct and indirect costs of production. Thus, sales are a major factor while determining gross margin. The TPO states that the marketing and sales costs are not relevant to determine gross margin. When an entity determines the sale price of any product, it would certainly consider its marketing and sales costs while determining the final sale price. Accordingly, the sales and marketing costs are factored in the final sale price of a product and therefore, the sale price of the product should be adjusted to cover the marketing and sales costs. In the present case, the assessee does not have to incur any expenditure on the export of equipments to its AEs since the marketing and sales function is taken care by the AEs. However, in the domestic market, it has to incur substantial marketing costs. Now, this cost is definitely factored into the sale price of the equipments while selling in the domestic market. The selling price as well as the gross margin is certainly impacted by differences in marketing function. The marketing cost should be reduced from the sale price of the equipments sold in the domestic segment in order to adjust for the differences between the functions performed in respect to the export segment vis-a-vis the domestic segment. If the adjustment is not made for this difference, it would result in a distorted picture which is evident from the fact that the net profit of the export segment is much higher than that of the domestic segment. In view of this the TPO was not justified in not adjusting the sale price of the domestic segment by the selling and distribution expenses incurred by the assessee. [Para 6.3(D)(II)] The adjustment on account of bad debt risk of Rs. 59.05 lakhs should have been made while determining the gross margin in respect of the domestic segment. [Para 6.3(D)(III)] The total royalty paid by the assessee in this year is Rs. 1.20 crores pertaining to equipment division and the same should have been considered while determining the gross margins of the domestic segment. [Para 6.3(D)(IV)] Considering the huge volume difference, the assessee requests for an adjustment. Considering the huge volume differences an adjustment of about 20 per cent should have been given by the TPO. [Para 6.3(D)(V)] According to Departmental Representative, the assessee company had aggregated its equipment segment and project segment and applied TNMM on the results of the entire entity. According to him such an approach of the assessee of aggregating its equipment and project segment is not justified. He has stated that since both the segments differ significantly, such an aggregation approach adopted by the assessee is not correct. In this regard, stand of assessee has been that the contention of the CIT-Departmental Representative that the assessee has aggregated its project and equipment division and thereafter had applied TNMM on entity basis is not correct. It has not aggregated the two divisions for applying the TNMM. It has aggregated all the international transactions pertaining to equipment division and has computed the operating margin of the equipment division separately. This point has been clarified in the transfer pricing study report. The assessee has computed the operating margins of equipment division and project division independently and even the comparable entities are identified separately for the two divisions. The assessee clarifies that it has not aggregated the two divisions. The assessee has only aggregated all the closely linked transactions of equipment division and the project division separately and applied TNMM separately for both the divisions. Same was explained to the TPO that considering the fact that the other transactions pertaining to the equipment division like import of materials, spares, receipt of commission, etc. etc., were accepted as at ALP, there was no reason to make the addition only in respect of the transaction of export of equipments to the AEs. In view of above discussion the assessee has rightly computed the margin of both the divisions separately and applied TNMM for each division separately. Hence, contention of Departmental Representative that assessee has aggregated the two divisions is not correct. [Para 8] The assessee has given the working of the net margins in the two segments which reveals that the net margin of the export segment is higher. This point clearly highlights the case of the assessee that if there was any undercharging on the sales to the AE, the net margin of the export segment would have been much lesser than the net margin in domestic segment. Considering the facts of the case, Court find that in case the domestic and export segments are to be compared, internal TNMM has to be applied and as per which no addition is warranted. [Para 8.5] According to the Departmental Representative, the comparison of export and domestic segments is justified. According to him, as per the conditions in Indian market, the margins in export segment are always higher than the domestic segment. In this regard, in theory, the domestic and export segments can be compared. [Para 8.6] The entire marketing cost is pertaining to domestic segment and the same should be reduced from the selling price. Similarly, there are no bad debts in export segments and therefore, the amount of bad debts should be reduced from the selling price of the domestic segment. According to the Departmental Representative the assessee has not quantified any adjustments for volume difference. On that basis, the assessee had requested for an adjustment of about 20 per cent considering the fact that the top five AEs had cumulatively placed orders of more than Rs. 180 crores. In this regard, Court find that there are so many differences in the two segments and considering the fact that suitable adjustments are not possible, CPM has to be rejected. There are differences as accepted by the TPO and therefore, in view of the decision of Drilbits International (P) Ltd. (supra), CPM should not be applied. [Para 8.8]