The Bangalore Tribunal adjudicates on the most appropriate method for contract manufacturers

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The Bangalore Bench of the Income-tax Appellate Tribunal in the case of GE BE Private Limited has adjudicated on the use of Cost Plus Method as the most appropriate method in the case of contract manufacturers.

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The Bangalore Tribunal adjudicates on the most appropriate method for contract manufacturers

  1. 1. KPMG FLASH NEWS KPMG IN INDIA The Bangalore Tribunal adjudicates on the most appropriate method for contract manufacturers 14 February 2014 Background The Bangalore Bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of GE BE Private 1 Limited (the company or the taxpayer) has adjudicated on the use of Cost Plus Method (CPM) as the most appropriate method in the case of contract manufacturers.  The arithmetic mean of the comparable companies was 15.72 percent gross mark-up on cost while the taxpayer had a margin of 16.24 percent.  During the course of TP assessment proceedings, the Transfer Pricing Officer (TPO) rejected the comparable companies selected by the taxpayer stating that the same were automobile parts manufacturers which vastly differs from the industry segment of the taxpayer. The TPO identified three new comparable companies and recomputed the arm’s length at 44.53 percent.  In response, the taxpayer drawing reference to the OECD guidelines took the position that Transaction Net Margin Method (TNMM) could be adopted as an alternate method to substantiate the results of CPM. The taxpayer further submitted that if TNMM was considered, the net margins of the comparable companies selected by the TPO would be less than the net margin of the taxpayer company and hence the transactions of the company would be at arm’s length.  However the TPO rejected the contentions of the taxpayer and made a TP adjustment of INR 596.5 million to the income of the taxpayer. The fact that Facts of the case   The taxpayer is engaged in the business of manufacture of X-ray and CT tubes, HV Tanks, Detectors, parts and accessories for medical diagnostic imaging equipments on contract basis for its Associated Enterprises (AEs). The pricing is claimed to be based on the GE Global Pricing policy. During the Assessment Year (AY) 2004-05, the taxpayer had entered into various international transactions with its AEs including the sale of manufactured goods. The taxpayer in its Transfer Pricing (TP) study, adopted CPM as the most appropriate method for determining the arms length price and identified 19 comparable companies. ____________________ 1 DCIT v. GE BE Pvt. Ltd. ITA (No.815/Bang/2010) © 2014 KPMG, an Indian 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.
  2. 2. the comparables selected by the TPO perform additional functions in the nature of selling and marketing thus evidencing functional differences with the taxpayer has been acknowledged by the TPO. However, the TPO while giving adjustment has computed the adjustment at an adhoc figure of 8 percent.   Observations and rulings of the CIT(A)  With regard to taxpayers request to consider TNMM as the most appropriate method instead of CPM, the CIT(A) held that since the taxpayer itself considered CPM as the most appropriate method in its TP study, the company cannot take a ground that CPM is not the right method.  The CIT(A) also held that product similarity was an important factor which could not be overlooked in determining comparabe companies.  The CIT(A) however agreed with the taxpayer on the use of export turnover filter and directed the TPO to apply the filter of exports revenues to operating revenues being more than 25 percent and re-compute ALP. The CIT(A) however gave a rider to his own direction 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. Against the aforesaid addition, the taxpayer preferred an appeal before the Commissioner of Income-tax (Appeals) [CIT(A)]. Taxpayer’s contentions before CIT(A) Before the CIT(A), the taxpayer raised the following contentions in respect of the Arm’s Length Price (ALP) determined for its international transactions:  Use of TNMM as the most appropriate method for the following reasons:  TNMM eliminates differences;  The disclosure of Cost of production (COP) is not statutorily required and therefore the COP of comparable companies would not be avaiable in the public domain, thus making it difficult to use the CPM. Moreover, there is no prescribed method for determining COP and the same varies for each company, thus making the use of CPM difficult;    the effect of functional References were made to OECD TP guidelines, Guidance Note on Report on International Transactions issued by ICAI and also to the Canadian Transfer Pricing Regulations to content that TNMM is the most appropriate method and not CPM. Further, references were also made to the Australian TP Guidelines which provides that it might not be possible or practicable to use traditional methods because of insufficient reliable data or because it involves unique or contains out of the ordinary intangibles or complexity of the business; It was further contended that at gross margin level, the earnings of the taxpayer is less than the comparable companies while at the net margin level the margin of the taxpayer is higher. It was contended that the above comparison of the Gross and Net profit level indicators only further demonstrates the irrationality of the application of CPM to the facts of the present case. The taxpayer also contended that the comparable companies selected by the TPO do not have export sales and requested that an export turnover filter should be used. Aggreived by the CIT(A) order both the taxpayer and tax department have filed seperate appeals before the Tribunal Contentions before the Tribunal Before the Tribunal, the taxpayer raised the following contentions in respect of the ALP determined for its international transactions:  Functional similarity should be the criteria to select comparables and not product similarity as suggested by the TPO;  The most appropriate method originally selected in the TP study could be changed during the TP assessment;  TNMM was the most appropriate method and not CPM. Before the Tribunal, the tax department raised a contention against the use of 25 percent export earnings filter as it leaves only one company as a final comparable. The taxpayer further contended that functional similarity should be the criteria to select comparables and not product similarity as suggested by the TPO. © 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.
  3. 3. Observations Tribunal     and ruling of the The Tribunal dismissed the plea of the taxpayer that the TPO in choosing CPM has given weightage to product similarity rather than to functional similarity stating that the TPO in the present case has given due weightage to functional similarity also by providing for an adjustment to the additional functions in the nature of selling and marketing thus evidencing functional differences.  With regard to the tax department’s contention, the Tribunal held that the 25 percent 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 enough grounds’ not to apply the aforesaid filter. Our comments The decision of the Bangalore Tribunal has the following takeaways:  Use of CPM as the most appropriate method for contract manufacturers; The Tribunal also dismissed the claim of the tax department that once the taxpayer had chosen a particular method as most appropriate method then, the taxpayer cannot subsequently change it. The Tribunal held that, there cannot be any estoppels in taxation matters. If the taxpayer can show that the stand the taxpayer originally took was not sustainable in law and seeks to take a different stand either in the course of proceedings before the AO or Appellate authorities, the claim of the taxpayer would have to be tested on the basis of the applicable provisions of law. The Tribunal further relied on the decision of MSS 2 India ruling which held that, method chosen cannot be discarded unless there are compelling reasons for the same.  Importance of product similarity in determining comparables in addition to functional comparability;  Use of 25 percent export turnover filter. It is pertinent to note that the comparability criteria laid down in Rule 10B(2)(d) of the Rules provides that geographical location in which the respective parties to the transactions operate is a criteria. Domestic companies cannot be treated as a 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; However with regard to selecting TNMM in the present case, the Tribunal observed that although the OECD guidelines, in exceptional circumstances, permits the use of more than one TP method to demonstrate the arms’ length nature of related party transactions, the Indian TP Rules advocate the use of only one TP method as the most appropriate method. Dismissing the appeal of the taxpayer, Tribunal held that, most appropriate method can be changed only if there were any changes in the facts, functionalities or availability of data.  Possibility of changing the most appropriate method selected in the TP study if there were any changes in the facts, functionalities or availability of data. Further the decision also contrasted the option of selecting multiple most appropriate methods in the OECD guidelines to the Indian TP regulations which prescribes a single most appropriate method to determine the arm’s length. The Tribunal relying on the UN Practical TP Manual for developing countries, 2012, also observed that, as a general rule the UN TP manual advocates use of CPM in the case of Contract manufacturers. The Tribunal held that since the parameters laid down in Rule 10C(1) and (2) of the Income-tax Rules, 1962 (the Rules) are satisfied by CPM in the case of contract manufacturers like the taxpayer, the same should be considered as the most appropriate method. ___________ 2 ACIT v. MSS India [2009] 32 SOT 132 (Pune) © 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.
  4. 4. 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 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 Bangalore Maruthi Info-Tech Centre 11-12/1, Inner Ring Road Koramangala, Bangalore 560 071 Tel: +91 80 3980 6000 Fax: +91 80 3980 6999 Kochi 4/F, Palal Towers M. G. Road, Ravipuram, Kochi 682 016 Tel: +91 484 302 7000 Fax: +91 484 302 7001 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 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 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. © 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.

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