Li And Fung India Pvt. Ltd vs. CIT (Delhi High Court)

Transfer Pricing: TNMM under Rule 10B(1)(e) contemplates ALP determination with reference to the relevant factors (cost, assets, sales etc.) of the assessee and not those of the AE or third party. Assessee’s study report cannot be discarded without showing how it is wrong. Finding that assessee is a risk bearing entity should be based on tangible material

The assessee, a wholly owned subsidiary in India of Li & Fung (South Asia) Ltd., Mauritius, was set up as a captive offshore sourcing provider. It entered into an agreement with Li & Fung (Trading), Hong Kong, an associated enterprise, for rendering “sourcing support services” for the supply of high volume & time sensitive consumer goods. The assessee was entitled to receive cost plus a mark up of 5% for the services rendered to the AE. The assessee claimed that it was a low risk captive sourcing service provider performing limited functions with minimal risk. It adopted the TNMM and computed the PLI at operating profit margin/total cost. Since the operating profit margin at 5.17% exceeded the weighted average operating margin of 26 other comparable companies, the assessee claimed that its remuneration was at arms’ length. The TPO did not dispute the TNMM or the comparables but held that the assessee ought to have received 5% on the FOB value of the goods sourced through the assessee (i.e. the exports made by the Indian manufacturers to overseas third party customers). He also held that the assessee was a risk bearing entity and an independent entrepreneur and it could not be said that the assessee is a risk-free entity. The DRP upheld the TPO’s order though it reduced the mark up to 3% of FOB value of exports. On appeal by the assessee, the Tribunal (143 TTJ 201) upheld the stand of the TPO. On further appeal by the assessee HELD by the High Court reversing the Tribunal:

(i) The assessee’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. Allotting a margin of the value of goods sourced by third party customers from Indian exporters/vendors to compute the assessee’s profit is unjustified. To apply the TNMM, the assessee’s net profit margin realized from international transactions had to be calculated only with reference to cost incurred by it, and not by any other entity, either third party vendors or the AE. Rule 10B(1)(e) does not enable consideration or imputation of cost incurred by third parties or unrelated enterprises to compute the assessee’s net profit margin for application of the TNMM. Rule 10B(1)(e) contemplates a determination of ALP with reference to the relevant factors (cost, assets, sales etc.) of the enterprise in question, i.e. the assessee, as opposed to the AE or any third party. The approach of the TPO in essence imputes notional adjustment/income in the assessee’s hands on the basis of a fixed percentage of the FOB value of export made by unrelated party venders;

(ii) The finding that the assessee assumed substantial risk is not based on any material. The assessee made no investment in the plant, inventory, working capital, etc., nor did it bear the enterprise risk for manufacture and export of garments. It merely rendered support services in relation to the exports which were manufactured independently. Thus, attributing the costs of such third party manufacture when the assessee did not engage in that activity and when those costs were clearly not the assessee’s costs, but those of third parties, is clearly impermissible. A contrary conclusion would amount to treating the assessee as the vendor/ exporters’ partner in their manufacturing business – a completely unwarranted inference;

(iii) Tax authorities should base their conclusions that the assessee bears “significant” risks on specific facts, and not on vague generalities, such as “significant risk”, “functional risk”, “enterprise risk” etc. without any material on record to establish such findings. If such findings are warranted, they should be supported by demonstrable reason, based on objective facts and the relative evaluation of their weight and significance;

(iv) Also, as the TPO did not discard the exercise conducted by the assessee of comparing its operating profit margin with that of the comparable companies, and it was not shown that the profit margin and cost plus model adopted by the assessee was distorted, he could not have proceeded to his own determination and calculations. The TPO must first reject the assessment carried out by the assessee before making further alterations. Where all elements of a proper TNMM are detailed and disclosed in the assessee’s study reports, care should be taken by the tax administrators and authorities to analyze them in detail and then proceed to record reasons why some or all of them are unacceptable.