© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
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The Supreme Court admitted Revenue’s Special Leave Petition against Delhi High Court’s order rejecting Arm’s Length Price determination based on Free On Board value of goods in the case of Li & Fung India Private Limited

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Recently, the Supreme Court admitted Revenue’s Special Leave Petition against High Court’s order rejecting Arm’s Length Price determination based on Free On Board value of goods exported out of India by third party vendors to customers, in the case of Li & Fung India Private Limited.

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The Supreme Court admitted Revenue’s Special Leave Petition against Delhi High Court’s order rejecting Arm’s Length Price determination based on Free On Board value of goods in the case of Li & Fung India Private Limited

  1. 1. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. KPMG FLASH NEWS KPMG IN INDIA The Supreme Court admitted Revenue’s Special Leave Petition against Delhi High Court’s order rejecting Arm’s Length Price determination based on Free On Board value of goods in the case of Li & Fung India Private Limited 19 August 2014 Background Recently, the Supreme Court admitted Revenue’s Special Leave Petition (SLP) against High Court’s order rejecting Arm’s Length Price (ALP) determination based on Free On Board (FOB) value of goods exported out of India by third party vendors to customers, in the case of Li & Fung India Private Limited 1 . Facts of the case  During the financial year 2005-06, the taxpayer rendered sourcing support services to its Hong Kong-based Associated Enterprise (AE), for which it received a remuneration of cost plus 5 per cent. The taxpayer applied the Transactional Net Margin Method (TNMM) to determine the ALP of such remuneration, considering Operating Profit/Total cost (OP/TC) as the profit level indicator (PLI). _____________ 1 CIT v. Li & Fung India Pvt. Ltd. – SLP No(s). 11346/2014 - Arising out of impugned final judgment and order dated 16/12/2013 in ITA No. 306/2012 passed by the Delhi High Court.  The Transfer Pricing Officer (TPO), while accepting that TNMM was the most appropriate method for determination of ALP and accepting the comparable companies selected by the taxpayer, held that the cost for the purpose of the 5 per cent mark-up should include the FOB value of exports (by an Indian manufacturer to overseas third party customers) that have been facilitated by the taxpayer. The Dispute Resolution Panel (DRP) upheld the order of the TPO on principle, but reduced the markup to 3 per cent on the FOB value of exports.  The taxpayer preferred an appeal with the Income- tax Appellate Tribunal (the Tribunal) against the DRP order. The Tribunal, while upholding in principle the TPO’s findings that the cost plus markup methodology adopted by the taxpayer is not at arm’s length, held that the amount of adjustment cannot exceed the amount that has been retained by the AE out of the total remuneration received from third party customers. The Tribunal held that the distribution of total compensation received by the AE from its customers (i.e. 5 per cent of the FOB value of exports) between the taxpayer and the AE should be in the ratio of 80:20.
  2. 2. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.  The taxpayer’s contention that Rule 10B(1)(e) of the Income Tax Rules, 1962 (the Rules) made no provision for consideration of the cost incurred by third parties while computing the net profit margin of the taxpayer for the international transaction, was rejected by the Tribunal. The Tribunal also held that the taxpayer performed all the critical functions with the help of tangible and unique intangibles developed to fulfill the conditions of the agreements entered into by the AE with the third parties. Proceedings before the High Court  The taxpayer contended that for applying the TNMM, the net profit margin realised from the international transactions is to be computed only with reference to the cost incurred or sales of the taxpayer itself. The TPO, in this case, enhanced the cost base artificially by considering the cost of manufacture and export of finished goods by third party vendors which is inconsistent with the manner of application of TNMM. The TPO, without any basis and material on records, held that taxpayer has developed several unique intangibles, developed a supply chain management, human capital at its own risk without appreciating that the taxpayer was only a captive offshore service provider not undertaking any significant or independent enterprise risk. The taxpayer further contended that the transaction of export of finished goods is being undertaken by third party vendors to the overseas customers, where neither taxpayer nor the AE are parties. The advantage on account of location savings if any has been gained by the third party customers and not the taxpayer or its AE.  The TPO and the Tribunal contended that the taxpayer was involved in performing all of the crucial functions of the transaction, bore all significant risks and developed unique intangibles over a period of time, which were crucial to the conduct of the transactions. The taxpayer offered cost and operational advantages, while the AE had neither quantified location savings nor attributed any part of it to the taxpayer. Thus, the taxpayer must receive the majority of the receipts with regard to the execution of work and the markup should be based on the FOB value of the exports. High Court ruling  The High Court held that broad basing of the profit determining denominator as FOB value of the exports to determine the ALP is contrary to provisions of the Income Tax Act, 1961 and the Rules. Taxpayer’s compensation model is based on functions performed by it and the operating costs incurred by it and not on the cost of goods sourced from third party vendors in India. Rule 10B(1)(e) does not enable imputation of cost incurred by third parties to compute the taxpayer’s net profit margin for application of the TNMM. Attributing the costs of a third party manufacturer, when the taxpayer does not engage in that activity, and when those costs are clearly not the taxpayer’s costs is impermissible. The approach of the TPO and the tax authorities in essence imputes notional adjustment/income in the hands of the taxpayer which is outside the provision of the law.  The High Court held that the taxpayer is a low risk contract service provider exclusively rendering sourcing support to its AE. It did not bear any significant operational risks for its functions. Rather, it is the AE that undertakes substantial functions and assumes enterprise risks, such as market risk, credit risk, etc. Tax authorities should base their conclusions on specific facts, and not on vague generalities, without any material on record to establish such findings. SLP with the Supreme Court The Revenue filed SLP against the order of the High Court. Supreme Court admitted Revenue’s SLP against High Court order that rejects ALP determination based on FOB value of exports. Considering importance of issues raised in the appeal, Supreme Court admitted the SLP, condoning the delay in filing and directed the hearing to be held within one year from the date of the order admitting the SLP (11 August 2014). Our comments In the instant case, the High Court had affirmed some basic principles related to the application of the TNMM for determination of ALP in case of sourcing support services transactions. It was expected to provide relief in the cases of low risk and captive sourcing support service providers where the revenue authorities may try to impute a commission on FOB value of the goods sourced from India. The High Court had expressly stated that Rule 10B(1)(e), for the application of the TNMM, does not enable imputation of cost incurred by third parties while computing the taxpayer’s net profit margin from its international transactions with AEs. The High Court’s emphasis on tax authorities basing their conclusions on specific facts and not vague generalities was to strengthen taxpayer’s cases where the TPOs make adjustments on arbitrary basis. 
  3. 3. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Now with the Supreme Court admitting revenue’s SLP in this case, the issue is again open to debate. Given these circumstances, it would be prudent for taxpayers to ensure that they have robust documentation in place supporting the low risk nature of their transactions because reliance on the above mentioned High Court ruling by taxpayers may now be rejected by the revenue department till the issue reaches finality. 
  4. 4. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name, logo and “cutting through complexity“ are registered trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity. www.kpmg.com/in Ahmedabad Commerce House V, 9th Floor, 902 & 903, Near Vodafone House, Corporate Road, Prahlad Nagar, Ahmedabad – 380 051 Tel: +91 79 4040 2200 Fax: +91 79 4040 2244 Bengaluru Maruthi Info-Tech Centre 11-12/1, Inner Ring Road Koramangala, Bangalore 560 071 Tel: +91 80 3980 6000 Fax: +91 80 3980 6999 Chandigarh SCO 22-23 (Ist Floor) Sector 8C, Madhya Marg Chandigarh 160 009 Tel: +91 172 393 5777/781 Fax: +91 172 393 5780 Chennai No.10, Mahatma Gandhi Road Nungambakkam Chennai 600 034 Tel: +91 44 3914 5000 Fax: +91 44 3914 5999 Delhi Building No.10, 8th Floor DLF Cyber City, Phase II Gurgaon, Haryana 122 002 Tel: +91 124 307 4000 Fax: +91 124 254 9101 Hyderabad 8-2-618/2 Reliance Humsafar, 4th Floor Road No.11, Banjara Hills Hyderabad 500 034 Tel: +91 40 3046 5000 Fax: +91 40 3046 5299 Kochi Syama Business Center 3rd Floor, NH By Pass Road, Vytilla, Kochi – 682019 Tel: +91 484 302 7000 Fax: +91 484 302 7001 Kolkata Unit No. 603 – 604, 6th Floor, Tower – 1, Godrej Waterside, Sector – V, Salt Lake, Kolkata 700 091 Tel: +91 33 44034000 Fax: +91 33 44034199 Mumbai Lodha Excelus, Apollo Mills N. M. Joshi Marg Mahalaxmi, Mumbai 400 011 Tel: +91 22 3989 6000 Fax: +91 22 3983 6000 Pune 703, Godrej Castlemaine Bund Garden Pune 411 001 Tel: +91 20 3050 4000 Fax: +91 20 3050 4010

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