Foreign Associated Enterprise- Whether it
can be tested party in Transfer Pricing Analysis
In one of latest judgement,
Hon’ble Mumbai Tribunal in the case of Onward Technologies Ltd has held that
for Transfer Pricing analysis of Indian assessee, the foreign associated
enterprise cannot be taken as Tested party.
The facts of the case are as
under:-
1.
Assessee is parent company of Onward
Technologies Inc., USA and Onward Technologies Gmbh, Germany
2.
Onward group is global provider of Engineering
software Development services and solutions to end users.
3.
During the relevant previous year, assessee
rendered IT enables services to its AE in USA and Germany for Rs.22 Cr.
4.
Assessee subsidiaries in USA and Germany were
responsible for carrying out primarily sales and marketing activity along with
sales and site support services to clients in respective countries and
remunerate subsidiaries at cost plus 5% mark up. Further sale price received by
foreign AE from services ultimately sold to customers is equal to that charged by the assessee frim
its AE
5.
Assessee choose its foreign AE as tested party,
adopted TNMM as appropriate method and did TP study by comparing NP profit
margin of foreign AE with six foreign companies doing similar activities.
6.
TPO held that price determined by assessee in
providing IT enables services is not in accordance with 92C(1) & 92C(2) and
rejected assessee TP study.
Issue before Tribunal-Can Foreign AE be taken as Tested party for
TP study
Held
Foreign AE cannot be taken as
tested party by explaining TP law in India as under:-
a)
Section 92(1) provides that Any Income from International transactions shall be determined having
regard to the Arm’s length price
b) Section
92B defines international transaction to
be transaction between two or more associated enterprise
c)
Section 92C read with rule 10B(1)(e) specified
TNMM as one of method for determining ALP, which method provides that net
profit margin realised by the enterprise from an international transaction entered into with an associated enterprise
is computed in relation to cost incurred
or sale effected or assets employed or having regard to any other relevant base.
d)
The modus operandi of determining ALP of an
international transaction under this method is that firstly, the profit rate
earned by the assessee from a transaction with its AE is determined (say, profit A), which is then
compared with the rate of profit of comparable cases (say, profit B) for ascertaining as to whether profit A is
at arm’s length vis-à-vis the profit B.
e)
However, in so far as calculation of profit A is
concerned, there cannot be any dispute as the same has to necessarily result
only from the transaction between two or more associated enterprises, as is the
mandate of sections 92 read with 92B in juxtaposition to rule 10B. The natural
corollary which, thus, follows is that under no situation can the calculation
of `profit A’ be substituted with anything other than from the international
transaction, that is, a transaction between the associated enterprises. So, it
is the profit actually realized by the Indian assessee from the transaction
with its foreign AE which is compared with that of the comparables. There can
be no question of substituting the profit realized by the Indian enterprise
from its foreign AE with the profit realized by the foreign AE from the
ultimate customers for the purposes of determining the ALP of the international
transaction of the Indian enterprise with its foreign AE
COMMENTS:
The law as explained by
Hon’ble Mumbai Tribunal in afore-said case can be further illustrated as
under:-
A Ltd – Domestic Company-
Purchase Goods worth Rs. 10 Cr
B Ltd – AE of A Ltd. in
Foreign Country
A Ltd Sold goods to B Ltd for
Rs. 12 Cr
B Ltd sold all goods in
foreign company to independent buyers for Rs. 13 Cr
In these transactions A Ltd
earned profit of Rs. 2 Cr and B Ltd earned a profit of Rs. 1 Cr.
The international transaction is sale of goods by A Ltd to B Ltd worth
Rs. 12 Cr.
In order to earn profit, an
entity has to purchase and sold goods.
In above example, A has earned
profit of Rs. 2 Cr purchasing goods from non-associated enterprise and selling
goods to Foreign AE in International Transaction.
B Ltd has earned profit of Rs.
1 Cr by purchasing goods from foreign AE in international transaction and
selling goods to non-associate enterprise.
This both A & B has earned profit in series of transactions, where
International Transaction is common thread.
In above-said case, Hon’ble Tribunal has assumed that only India AE has
earned profit from International Transaction and Profitability of Foreign AE is
not linked to International Transaction, which is not the case.
The extracts of relevant
provisions under Transfer pricing chapter are once again reiterated to
substantiate the fact that foreign AE can be tested party.
Section 92C read with rule
10B(1)(e) specified TNMM as one of method for determining ALP, which method
provides that net profit margin realised by the enterprise from an international
transaction entered into with an
associated enterprise is computed in
relation to cost incurred or sale effected or assets employed or having regard
to any other relevant base
Section 92B defines international transaction to be transaction between two or more associated enterprise
Associated Enterprise is defined u/s 92A in relative manner by
providing that two enterprise shall be deemed to be associate if prescribed
conditions are fulfilled.
Enterprise is defined u/s 92F(iii) to means person who is or has
been or proposed to be engaged in prescribed activity.
Thus position of law can be
summarise as under:-
1.
Under TNMM, we are required to calculate net
profit realised by enterprise from an International Transaction.
2.
Section 92C read with rule 10B does not
prescribed that for application of TNMM, enterprise should be either resident
enterprise or domestic enterprise or enterprise based out of India.
3.
Thus for application of TNMM, net profit margin
of any one of the associated enterprise involved in international transaction
could be evaluated or any one of associated enterprise could be TESTED PARTY.
Alternatively
Considered the above example
again from Resale Price Method perspective
Suppose in above example A Ltd
is assuming all major risk and owning intangible. B Ltd is assuming the
function of low risk distributor.
In view of above-said
hypothesis, Resale price Method will be most appropriate method with B Ltd will
be taken as Tested party for which Gross margin will be evaluated and compared
with uncontrolled comparables.
If ruling of Hon’ble Tribunal
is followed, then it would not have been possible to follow resale price method
in the instant case.
Another Tribunal Decision
In AIA Engineering Ltd,
Hon’ble Ahmedabad upheld the use of foreign associated enterprise as tested
party for transfer pricing analysis of Indian AE.
OECE View on Tested Party
OECD Transfer Pricing
Guidelines, 2012 also advocate the use of either associate enterprise as tested
party in application of TNMM. The relevant extracts as :-
Para 2.59
However, a one-sided method
(traditional transaction method or transactional net margin method) may be
applicable in cases where one of the parties makes all the unique contributions
involved in the controlled transaction, while the other party does not make any
unique contribution. In such a case, the
tested party should be the less complex one.
Para 3.18
When applying a cost plus,
resale price or transactional net margin method as described in Chapter II, it
is necessary to choose the party to the transaction for which a financial
indicator (mark-up on costs, gross margin, or net profit indicator) is tested.
The choice of the tested party should be consistent with the functional
analysis of the transaction. As a
general rule, the tested party is the
one to which a transfer pricing method can be applied in the most reliable
manner and for which the most reliable comparables can be found, i.e. it will
most often be the one that has the less complex functional analysis.
UN View
UN Practice Manual –
Developing countries also echoes the views of OECD with respect of selection of
tested party.
The relevant extract are as
under:-
Para 6.3.2.1
The TNMM looks at the profits
of one of the related parties involved in a transaction, as do the cost plus
and resale price methods. The party examined is referred to as the tested party
Thus from the afore-said analysis, conclusion can be drawn that
selection foreign AE as tested party is not prohibited under Indian taxation
law.
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