In a recent case before the Income Tax Appellate Tribunal, the tribunal held that no method for calculating tax can be rejected without giving cogent reasons. In addition, Reserve Bank of India approval alone cannot be sufficient reason to state that remittances to an associated enterprise are at arm's-length price.
The assessee company manufactured and exported pharmaceutical for mulations and products. For its sales to Ukraine, the assessee routed the exports through its associated enterprise in Cyprus, citing political, economic and financial instability in Ukraine. The transfer pricing officer accepted the arm's-length price of export sales to the associated enterprise where the assessee had used the cost-plus method. However, the transfer pricing officer noted that the assessee had incurred unusually high expenditure on advertising, in regard to which the transfer pricing officer ruled that the money earned from the assessee's business in India was transferred to associated enterprises located in a tax haven. Direct investigation was not possible as the financial documents were in foreign languages. The transfer pricing officer applied the transactional net margin method, took an average of the marketing and advertisement expenditure incurred by the 17 top pharmaceutical companies, and accordingly made a transfer pricing adjustment.
On appeal, the commissioner of income tax removed the transfer pricing adjustment, holding that there were no defects in respect of the information and documents kept by the assessee, and that the assessing officer had accepted the assessee's transactions in earlier years. The commissioner further observed that the assessee's remittance overseas was approved by the Reserve Bank of India and other monitoring agencies. On using tax havens, the commissioner held that neither the assessing officer nor the transfer pricing officer presented any evidence that part of the money was returned to the assessee.
The Revenue appealed before the Mumbai bench of the Income Tax Appellate Tribunal on the grounds that the assessee had structured the business model such that all benefits were derived by the associated enterprise. On the other hand, the assessee contended that the transfer pricing officer's jurisdiction was limited to determining the arm's-length price of international transactions, and not related aspects of the genuineness of expenditure. The assessee also submitted that shares in the associated enterprises were transferred to other unrelated parties during that year, after which the assessee had no control over the associated enterprises. Further, on the merits, the assessee challenged the action of taking industry averages of business promotion expenses, which was not contemplated under the transfer pricing rules.
In ruling on the issue, the tribunal provided an explanation on the use and application of the transactional net margin method. The tribunal held that the transfer pricing officer's role should be focused on determining the arm's-length price, rather than on who should bear the marketing expenses. The tribunal opined that the transfer pricing officer's action (ie, rejecting the method adopted by the assessee without cogent reasons and applying the mean of the percentage of expenditure incurred by a selected set of pharmaceutical companies under the transactional net margin method as an arm's-length price) was incorrect. The tribunal also held that the mean of only a certain type of expenditure could form the basis for the arm's-length price. The transactional net margin method required establishing comparability at a broad functional level, as well as comparison of the net margins of uncontrolled transactions between independent entities. Comparing the average of expenditure without any analysis of the type of drug, the nature of markets or the period of advertisement was not the manner in which the transactional net margin method should be applied in terms of the transfer pricing provisions.
The tribunal did not accept the commissioner's reasoning for granting the relief to the assessee. It categorically stated that the commissioner was incorrect in basing his decision on the fact that the Reserve Bank of India had granted permission for the remittance. This was not grounds on which the appeal could be allowed, as every remittance would bear the bank's approval. Finally, the commissioner's order, to the extent of deleting the adjustment, was upheld on the ground that the transfer pricing officer had given no reason for rejecting the method adopted by the assessee.(1)
In recent cases the revenue authorities have made several attempts to disallow marketing and advertisement expenditure expenses by using transfer pricing methods. Accordingly, this ruling is welcome, as the Income Tax Appellate Tribunal held that use of the transactional net margin method by re-moulding the methodology to analyse the percentage of expenditure for verifying the arm's-length price of marketing and advertisement expenditure was incorrect. At the same time, the tribunal rejected the commissioner of income tax's reasoning that the payment was at arm's-length price, since it was approved by the Reserve Bank of India. In such scenario, where a practical methodology continues to elude the taxpayer and the authorities have not set down a defined procedure, the measure for an appropriate expense quantum will continue to be a source of disputes and litigation under transfer pricing law.
For further information on this topic please contact Ranjeet Mahtani at Economic Laws Practice by telephone (+91 22 6636 7000), fax (+91 22 6636 7172) or email ([email protected]).
Endnotes
(1) Asstt Commissioner of Income Tax v Genom Biotech Pvt Ltd ITA 5272/Mum/2007.