Whether TPO was correct in applying CUP instead of TNMM

This set of cross appeals consisting of one appeal filed by the assessee and the other appeal filed by the Revenue is directed against the orders dt. 2.3.2006 passed by the Ld. CIT(A)-VIII, Mumbai for the assessment year 2002-03.

2. The only issue in assessee's appeal is against the adjustment of Rs.21,95,034/- made by the Transfer Pricing Officer in respect of transaction with associated enterprises which has been partly confirmed by Ld. CIT(A). The company is engaged in the manufacturing and trading of animal health and veterinary products. The product range of Intervet India includes pharmaceutical products, feed additives, poultry vaccines, canine vaccines, Foot and Mouth Disease Vaccine, viral and Bacteria. M/s. Intervet India is the wholly owned subsidiary of Intervet holdings B.V. Netherlands. Company belongs to Intervet Group Head quartered in Netherlands. The entities under the Intervet Group are part of the Akzo Nobal Group a multinational group with headquarters in Netherlands. During the year, it had two production centres, located at Hyderabad and Pune. Hyderabad Unit produces poultry vaccine and pig vaccine and the Pune unit manufacture pharmaceuticals and other veterinary vaccines.

3. The group entities are located in Singapore, Germany, France, Bangkok, Turkey, Austria, Indonesia and Netherlands. The raw material is mainly imported from intervet International B.V. Netherlands and Intervet Germany. It has exported the raw material/traded goods to group entities in France, Austria, Germany and Bangkok. It imported Traded/finished goods from group entities in Germany and Netherlands. The international transactions are:

(a) Import of Raw Material from Associated Enterprises(AEs).

(b) Import of Finished Goods from AEs

(c) Export of Raw Materials to AEs

(d) Export of Finished Goods to AEs

(e) Expenditure incurred on behalf of Fellow Subsidiaries and Reimbursed by them

(f) Expenditure incurred on behalf of holding Company and reimbursed by them

(g) Internal Audit Services

4. The Arm's Length Price of all the International transactions computed by the assessee was same as transaction value recorded in the books of account. The company used Transactional Net Margin Method by considering the operating profit margin as the profit level Indicator. The matter of transfer pricing in respect transactions between associate enterprises were referred to the Transfer pricing officer. The relevant extracts from TPOs report is as under:

"the Company exported five products to associated enterprises as well as to unrelated parties. In respect of four products, the price charged to associated enterprise, is more or less similar to charged to independent enterprises. In respect of Floxding 10% (50ml) the price charged to AEs is much less in comparison to charged to third parties. The details filed indicated that, though same manufactured products are exported to associated enterprises and independent enterprise, however, these transactions are not separately analysed in the TP Report. The sale price to independent enterprise of USD 3.66 per unit, is 3.12 times of the sale price USD 1.17 per unit, charged to associated enterprise. The assessee was asked to submit as to why not the comparable Uncontrolled Price Method, be considered as the most appropriate method, for computing the Arm's Length Price of the sale of this product. The company, vide letter dated 7.1.2005, submitted its objections, the same reads as:

"The transaction being referred as follows:

The following justification is offered to substantiate the difference between the Price charged to the Associate Enterprise and the third party. The difference between the two prices works out to 67.4% of the price charged in case of comparable uncontrolled transaction.

(a) Volume Factor:

The volume in case of the Associate Enterprise is ten times as that of the third party. It may be specifically mentioned here that the product in question is a long established product offered by almost all the veterinary pharmaceutical companies in India. There is no perceived quality difference in the product offered by various companies. As such, the price is the driving factor for the sales which is inversely related the volume sold.

The same is also evident from the trends in the domestic market. As per the Monthly Trade Scheme offered in the domestic market in respect of this product, the discount offered is in the range of 25-40% varying directly with the volume sold.

Considering the above, an adjustment factor up-to 40% can easily be considered with respect to the Arm's Length Price for the volumes sold to the Associate Enterprise.

(b) Credit Period

The following credit periods were offered:-

Associate Enterprise: 30 days from the AWB date Third Party - 45 days from the AWB

It can be agreed that, additional credit period entails blockage of working capital and interest thereon. Considering a conservative interest rate of 18% per annum (2001-02 rates), an adjustment factor of 0.75% can be considered for a period of lower credit period by fifteen days.

(c) Credit risk

It can be appreciated that the general risk factor on account of the above is higher in case of Third Parties as compared to the Associated Enterprises.

The same was also considered while deciding the prices.

(d) Annual & Future Business

It is a normal business practice that the prices of the products sold are also adjusted towards the factor of total annual business per customer. It may be noted that the total amount business for the A Y 2002-03 was as follows:

Also, as per the industry norms, a value of the customer is measured in terms of the future potential business and the relationship with the customer including the terms and conditions offered per transaction are influenced by the same. It can be observed that the quantities sold in respect of the product in question as well as the total business offered in case of the Associate Enterprise is substantially higher than that of the Third Party.

After considering the above mentioned factors, it can concluded that the Price charged to the Associate Enterprise was at Arm's Length."

As the same product is exported to associated enterprise and independent enterprise, therefore the Comparable Uncontrolled Price Method (hereinafter CUP) is considered to be the most appropriate method. The CUP method provides the most direct comparison, and its use is encouraged even if adjustment to the data are required to be made, provided that reliable adjustments can be made for material differences.

In light of provisions of the Rule, the contentions of the assessee are discussed hereunder:

(i) Volume factor: The company has sold various products namely Butox, Flox, Novaigin, Panacure Boli and Tono to Intervet (Thailand) Limited, The total sales to this company is of Rs.6,669,847/-(These details were filed by the company in Annexure VIII-B of the reply dated 20.12.2004). The sale of Flox 10% (50ml) is of R.1,662,825/- As mentioned above, the company has also sold Flox 10% (50ml) to two companies in Vietnam and one company in Ukraine.

(ii) In respect of Modern Veterinary Trading Co. Ltd Vietnam the company has sold Flox 10% (50ml) Floxidin 10% (15ml) Taktic 12.5% (250ml) and Tono (30ml), The total finished goods sales to this company are of Rs.1,379,233/- Considering these sales, Modern Veterinary Trading Co. Ltd Vietnam, cannot be considered a small client. The sales to Intervet (Thailand) Limited is Rs.6,669,847/- in comparison to Rs.1,379,233/- in case of Modern Veterinary Vietnam. The sales to related parties are nearly 4,8 times that of sales to unrelated parties. The company also submitted a discounting scheme which was prevalent during the month of March 2002 for the domestic sales. In case of Floxidin 50 ml, on purchase of 32 Ampoules 8 Ampoules were free (25%) and on purchase of 80 Ampoules 32 Ampoules were free (40%). ARs contended that as the volume increases, the discounts also increase. The sales to AE is nearly 10 times that of unrelated parties, therefore certainly the volume factor affects the sale price. However the effect of volume on the price cannot be quantified, because discount affects the setting of prices in both the cases. It is the differential discounts, which will reduce the price of sale to AE. The assessee's contention that volume factor will lead to adjustment upto 40%is without any basis and acceptable. A discount of 10% will be a reasonable discount. The assessee did not submit any contemporaneous document evidencing the setting the transfer price for AE and unrelated party. Considering this, a discount of 10% on account of volume difference is being considered reasonable while computing the Arm's Length Price.

(ii) Credit Period: The contention of the assessee regarding credit period is accepted, except the interest rate of 18% the prevalent interest rate during the year was around 12%. Due to this, the adjustment will be 0.5% of the sale price charged to unrelated party. This is calculated by considering 12% interest rate for 15 days differential of credit period.

(iii)Credit Risk: The contention of the assessee regarding credit risk is reasonable, because there is no credit risk in case of sales to associated enterprise. The ARs submitted that the payments are through bank with related and unrelated parties and the payments are not secured by any guarantee or by letter of credit. The risk of collection lies with unrelated party. On this account also a discount of 5% is considered appropriate.

(iv) Annual and Future Business: This contention is also unacceptable because this is the repetition of volume factor, which is already considered. Except the above stated three differences for which adjustments are required to be made, the transactions entered into with associated enterprises and independent enterprises are comparable considering the provisions of Rule 10B(2) of the I. T. Rules 1962. The comparability of these transactions briefly is discussed herein under:

(i) Specific characteristics of the property transferred in both the cases is identical. The same product i.e. Flox 10% (50ml) is exported to associated as well as independent enterprise.

(ii) Functions performed taking into account assets employed or to be employed and risks assumed by the respective parties to the transactions are same except the Credit Risk discussed above.

(iii) The delivery terms are same in both the cases. The payment terms differ for which necessary adjustment is being made,

(iv) The conditions prevailing in the markets in which the respective parties to the transactions operate can be considered as similar because the related entity is located in Thailand, and the unrelated party is located in Vietnam to whom exports are made. The parties are located in the South East Asian Countries, the geographical areas of the countries appear to be comparable the incidence of disease for which are medicine (Injectible Ampoule) are used, will most likely be the same. In both the countries the retail prices will also be similar.

Considering the above, the international transactions is comparable to the transactions entered into with unrelated parties. The per Ampoule Unit price charged to Modern Veterinary Trading Co. Ltd of USD 3.66, which can be taken a s the Arm's Length Rate, subject to adjustments, as provided in Rule 10B(1)(a)(ii). Considering this, the Arm's Length Rate, for per unit of the medicine is computed as below, as per Rule 10B (1)(a) of the I.T. Rules 1962.

The Company has sold 30,144 units to Intervet (Thailand) Limited. The Arm's Length Price of this transaction is computed at USD 93,205. The equivalent amount in Rupee Terms, by considering the exchange rate of Rs.47/- works out to Rs.4,380,646/- as against the transaction value of Rs. 1,662,825/- recorded in the books of account. Due to this, an upward adjustment of Rs.2,717,821/- is required to be made to the income of the assessee."

5. On the basis of the TPO's report the Assessing Officer had added a sum of Rs. 2,717,821/- as adjustments on account of transfer pricing between Associated Enterprises. Aggrieved the Assessee filed an appeal before the CIT(A). The first Appellate Authority concluded as under:

"44 The submission made by the appellant's representative has been considered. The first claim made in this respect is in regard to the decision of the TPO that the TNMM is not the appropriate method for the determination of the ALP in the instant case. Rather the comparable uncontrolled price method (CUP)is the appropriate method. In this regard it has to be said that the TNMM is the residual method and thus is to be adopted only if the other direct methods provided in section 92C(1) of the Act are found not applicable. Thus the TNMM is to be adopted as 'the appropriate method in terms of section 92C(1) of the Act only if any of the other direct methods such as CUP, Resale Price Method. Cost Plus Method are not found applicable in the determining Transfer Pricing Officer's notion of ALP.

45. On the other hand, the CUP method is to be considered the appropriate method where there is availability of information of the transaction of the same product or service having been entered into either by the same enterprise in an uncontrolled situation or by two independent enterprise in such uncontrolled situation. In the instant case, the basis of the TPO arriving at the conclusion is the fact of the appellant having a comparable transaction of same item in an uncontrolled situation. Under the CUP Method, the arm's length price is determined on the basis of analysis of price paid or received and comparison of price charged for related party transaction with the price charged for unrelated transaction in an identical or similar situation. Therefore no doubt the CUP method gives a better result. If similar product or service is identified with minor differences provided such minor differences are adjusted to arrive at the ALP.

46. Hence the identification of comparables and adjustments to comparables are of utmost importance where the CUP method is considered the appropriate method in the determination of the ALP.

47. Thus, if in the case of a company there exists an internal uncontrolled comparable transaction which is similar to the controlled product or service being consumed then, under the transfer pricing regulation such international uncontrolled comparable is to be taken as comparable and adjustment to the result obtained in such uncontrolled transaction if required is to be made in the determination of ALP. There is no case for ignoring the method altogether.

48. If the claim of the appellant is that the TNMM and not the CUP method should be the appropriate method is examined in the context of above parameters, in the instant' case, there exists an internal comparable in as much as the appellant has sold the same product that it has sold to an associate enterprise to the Vietnamese concern in an uncontrolled transaction. On the other hand, the associate concern is located at Thailand. Both these countries are located in far east Asia and have similar demographical constitution. Therefore in the circumstances where the product in the transactions is similar and location of the concerned parties are also somewhat similar it would not be correct to hold that on account of differences in economic condition volume of transaction the material difference is such that it cannot be overcome by way of adjustment in the price charged in the uncontrolled transaction and the ALP cannot be determined in respect of the transaction with the associate enterprise. Therefore the claim of the appellant to change the appropriate method from CUP to TNMM is liable for rejection.

49. Coming to the adjustment per se made, by the Transfer Pricing Officer and requested for by the appellant as has been brought out above, it is to be said that the claim of the appellant for adjustment of credit period at 0.6% as against 0.5% adopted by the TPO is to be accepted considering that the prime lending rate for the relevant year was higher than that adopted by the TPO for the purpose. Similarly, there is a case for further adjustment on account of volume factor and difference in the market conditions and development level taken together.

50. On the other hand the appellant has sought for adjustment on account of annual and future business as well. However there is no indication of the appellant having been guaranteed future business by the associate enterprise. Therefore there is no basis for making a claim for adjustment in this respect. Similarly, the claim for a higher adjustment on account of credit risk also cannot be accepted considering that there is no evidence of default in payment by the buyer and the appellant's interest is safe guardes on account of the export being made against the Letter of credit.

51. As far as the adjustment on account of volume factor difference in the market conditions and economic development level is concerned the Transfer Pricing Officer has allowed the adjustment to the extent to 10% while the appellant has sought for an adjustment of 50%. There is no doubt that the claim of the appellant is rather excessive, while that made by the Transfer Pricing Officer is rather on a lower side. Hence considering that in the local trading the appellant in similar circumstances has been providing discounts while there is a case for higher adjustment than what has been made by the Transfer Pricing Officer, it cannot be as high as sought for by the appellant. It would be reasonable if the adjustment for the purpose is restricted to 20% on this account as against 10% made by the Transfer Pricing Officer.

52. Accordingly in the determination of ALP, adopting the CUP Method for the transaction the appellant had with its associate concern, the adjustment on account of volume difference in the market conditions and economic development level is to be made at 20% as against 10% made by the Transfer Pricing Officer. Similarly the adjustment on account of credit period is to be made at 0.6% as against 0.5% adopted by the Transfer Pricing Officer. No other variation in the adjustment made by the Transfer Pricing Officer is called for.

53. The Assessing Officer shall rework the Arms Length Price for per unit of medicine in the manner computed by the Transfer Pricing Officer at page 9 of his order passed u/s 92CA(3) of the Act. He shall determine the adjusted ALP in terms of directions given above and consequently revise the addition made on this account to the income of the appellant. The appellant shall get relief in respect of the balance amount. The appeal in respect of Ground No. 3, is disposed off as partly allowed."

6. Aggrieved the assessee is in appeal before us. The learned Counsel for the assessee Shri Rahul Mitra submitted that the AO and the Ld. CIT(A) have not taken into account all the adjustment factors while making adjustments in comparing the sale price to an AE and a third Party while adopting the CUP method. The Assessee has submitted that Thailand (where the AE is situated) and Vietnam (where the unrelated party is situated) have totally different market conditions. Thailand is dominated by Poultry Vietnam is dominated by Pigs and hence the needs are different. Market sizes of the two countries are not comparable. Size of the Thailand market is large compared to that of Vietnam. It was also submitted that in view of some defects in the vaccine, it is difficult to sell it at higher price in a competitive and developed, market like Thailand. The assessee vide his letter dated 27.2.2006 addressed to the CIT(A) has pointed out that the sale price of vaccine by the AE in Thailand to an unrelated customer was only USD 2.90 and USD 3.14 which is less than the price charged by the assessee for its sale to the unrelated party in Vietnam. These factors would show that the market condition in Thailand is totally different from that prevailing in Vietnam. The learned DR relied on the reasoning of the lower authorities.

7. We heard both Parties. From the submissions made by the assessee the economic and market conditions of Thailand and Vietnam are totally different. The Ld. CIT (A) has held that both the countries are located in Far East Asia and have similar demographical constitution. Therefore in the circumstance, where the product in the transaction is similar and location of the concerned parties are somewhat similar, it would not be incorrect to hold that on account of differences in economic condition, volume of transaction the material difference is such that it cannot be overcome by way of adjustment in the price charged in the uncontrolled transaction and the ALP cannot be determined in respect of the transaction with an Associated Enterprise. While we concede that when there is a sale of identical product to an unrelated party, it will form the basis of determining the ALP in respect of sales to an Associated enterprise, but one of the essential prerequisite is that reasonably accurate adjustments are to be made to eliminate material factors affecting price, cost or the profit arising from such transaction. But at least all material factors should be considered in arriving at the adjustments. We find that the TPO and the CIT (A) have assumed similarity of markets and economic conditions and have made adjustments only for the volume discount, credit offered and a small adjustment of of credit risk. They have, completely ignored the disparate economic land market conditions of Thailand and Vietnam and have made no adjustment for the same. Mere geographical contiguity of two countries need not mean similarity in economic or market conditions. How can the sale prices to wholesale agents in two different countries be comparable, when the sale price to the final user in one country is less than the sale price to the whole sale agent in another country, unless adjustment for the same has been considered. Thus the adjustments merely for volume offtake, credit period and credit risk, though material are not sufficient to make the sale price to AE in Thailand comparable with the sale to unrelated party in Vietnam. Scope of adjustments has to be widened and all the submissions of the assessee regarding the disparity between the two transactions should be considered and suitable adjustments made for the same.

8. With the above directions the issue is set aside to the file of the Ld. CIT (A) for deciding the matter afresh after giving reasonable opportunity to the Assessee to present their case.

9. In the result, the appeal filed by the assessee is allowed for statistical purposes.

ITA No. 3185/M/06- Revenue's appeal

9. Ground No. 1 has not pressed by the Revenue therefore it is dismissed as not pressed.

10. The second ground has been dealt with in assessee's appeal in ITA No. 2845/M/06.

11. The third ground raised by the Revenue reads as under:

"On the facts and in the circumstances of the case and in law, the CIT(A) erred in deleting the disallowance of Rs. 83,726/-(@10%) made by the AO out of various expenses as the appellant failed to substantiate the claim."

12. Before the Ld. CIT(A), the assessee has contested the action of the AO of disallowing an amount of Rs. 83,726/- incurred under various heads of expenditure on adhoc basis. The AO has disallowed 10% of certain expenditure debited by the appellant under the caption 'Other expenses' within the following heads of expenditure.

13. In respect of the action of the AO the assessee's representative submitted before the Ld. CIT(A) that at the time of assessment, the AO had called for the details of these expenses and the same were submitted from time to time. The details of some expenses under respective heads were not specified as these comprised of petty amounts and were miscellaneous in nature. However, the quantum of other miscellaneous expenses as compared to total expenses is not material and was only 4.96% of the total miscellaneous expenses. The details of these miscellaneous expenses were not provided as it is difficult to trace them and classify them as the individual amounts are very small. The AR further submitted that the AO has on an adhoc basis disallowed 10% of the amount appearing under the head other expenses without any justification thereof. It was submitted that these expenses may be allowed in full, particularly having regard to the volume of business.

14. The Ld. CIT(A) held as follows:

The submission made by the appellant's representative has been considered. Considering the nature of business the total turnover the appellant company had on one hand, and on the other hand, the total expenditure it had incurred and claimed as deduction and the amount appearing under the head Miscellaneous expenses, a part, of which has been subjected to disallowance by the AO, the expenditure claimed is reasonable. Further, the accounts of the appellant company is duly audited and auditors have not drawn any adverse inference in regard to any amount of expenditure claimed as deduction. Therefore, there remains no basis for making adhoc disallowance where the appellant has been able to justify the reasons for non-maintenance of proper voucher in respect of some expenses. The disallowance of Rs. 83,726/-made on this account is therefore deleted. Appeal in respect of ground No. 4 is thus disposed- off as allowed."

15. We heard both the parties. We find no infirmity in the order of the Ld. CIT(A) as adhoc disallowance out of the business expenditure cannot be sustained. Following the ratio of decision in the case of Sunder Mal Sat Pal Vs ITO (2005) TTJ 94 (Asr) 423 and Ravi Marketing Pvt. Ltd. Vs CIT (280 ITR 519) = (2006-TIOL-47-HC-KOL-IT) we dismiss this ground of Revenue.

16. In the result, the appeal filed by the Revenue is dismissed.

(Order pronounced on this 31.3.2010)