ACIT vs. Tara Ultimo Private Limited (ITAT Mumbai)

Transfer Pricing: Important Principles of Cost Plus, CUP & TNMM Explained

The assessee, engaged in the business of manufacture and export of studded diamond and gold jewellery, imported & exported diamonds and exported jewellery to associated enterprises. For transfer pricing purposes, the ALP of the imported & exported diamonds was evaluated using the “Comparable Uncontrolled Price” (CUP) method while the exports of jewelry was evaluated using the “Cost Plus Method” (CPM). The TPO & AO rejected both methods on the ground that adequate material to support it was not available and instead adopted the TNMM and made an adjustment. On appeal, the CIT(A) upheld the adoption of CPM on the imports & exports of diamonds on the ground that total cost details were maintained and the average margin earned from AE transactions was higher than that earned from non AE transactions. However, he did not deal with the ALV on export of jewellery. On appeal by the department, HELD reversing the CIT(A):

(i) As regards the CPM, it had not been correctly applied. The application of CPM provides for (a) ascertaining the direct and indirect costs of property transferred, or services rendered, to the AE; (b) ascertaining the normal mark up of profit over aggregate of costs in respect of similar property or services to unrelated enterprises and (c) adjusting the normal mark up for differences, if any, in the material factors such as risk profile, credit period etc. While the benchmark gross profit can be set by taking into account several transactions with unrelated enterprise on a ‘global basis’, the benchmark cannot be applied on a global basis but has to be on a transaction basis. Eg. if the benchmark GP is 20% and the assessee charges a mark-up of 2% in one transaction with AE and 38% in another transaction with the AE, both transactions, will meet the ALP test resulting in an incongruity. On facts, while the normal mark up has been computed at 16.31%, and the average of mark up on sales to AEs has been taken at 17.08% and all AE transactions taken to be at ALP, there are individual instances which are less than the benchmark. This is not the correct way to apply the CPM. Also, the costs of inputs have not been verified and it is not shown that the terms of sale to the AEs and all other relevant factors are materially similar to the transactions with independent enterprises. Also, the CPM has been applied by comparing gross profit on sales, whereas the method requires comparison of mark up on costs on transactions with AEs vis-à-vis mark up on costs on transactions with non AEs (matter remanded to CIT (A) for de novo consideration);

(ii) As regards the CUP for import & export of diamonds (which was not decided by the CIT (A)), the assessee ought to have produced evidence to show that the transactions are at prevailing market prices;

(iii) As regards the TNMM, International transactions with AEs have three significant areas of impact on the overall profitability i.e. sales of finished goods to AEs, sales of raw materials to AEs and purchase of raw materials of AEs), and if the ALP cannot be reasonably determined by CUP or any other direct method (i.e. CPM and RPM) in respect of even one of these areas, the application of TNMM or other indirect method ( i.e. profit split method) is inevitable. On a conceptual note, when ALP of the transactions with AEs cannot be reasonably ascertained, the profit earned by the assessee entering into these transactions is to be estimated, and that is precisely what TNMM does. When TNMM is applied in the context of sales of finished goods to AEs, it is this figure which is taken as variable figure and it bears the impact of higher margins, and when TNMM is applied in the context of purchases of raw materials from AEs, it is the figure of purchases of raw material from AEs which is taken as variable figure and it bears the impact of higher margins. Beyond that, the cause of invoking TNMM does not make much material difference (point whether TNMM has to be applied to the transactions and not on overall profits left open);

(iv) The argument, relying on Indo American Jewellery Ltd 41 SOT 1, that no ALP adjustment can be made as the assessee enjoys s. 10A tax benefits and has no “motive” to avoid tax is not acceptable because those observations are “obiter dicta” without binding force and in view of Aztech Software 107 ITD SB 141 where it was held that tax avoidance motives need not be shown before invoking transfer pricing provisions.