CIT V. EKL APPLIANCES LTD

ITA/1070/2011

AI Insights

The case revolves around the appeals by the Commissioner of Income Tax (CIT) against EKL Appliances Ltd., concerning the disallowance of brand fee/royalty payments for the assessment years 2002-03 and 2003-04. The payments were made under an agreement with AB Electrolux, Sweden, which involved a brand fee of 1% of net sales under the brand name 'Kelvinator'. The Transfer Pricing Officer (TPO) initially found these payments unjustified, leading to their disallowance in the assessments. However, the CIT (Appeals) and the Tribunal reversed this decision, leading to the CIT's appeal to the High Court. The court's decision emphasized the importance of the economic substance of transactions over their form and supported the assessee's position based on OECD guidelines and previous judicial decisions.

• Counselvise Citation: [2012] 140 COUNSELVISE.COM (IT) 720373 (HC-DELHI)
• Appeal Type: Others
• Pronouncement Date: 29-03-2012
• Assessment Year: misc
• Other Referred Cases: CIT v. Bankam Investment Ltd., S.A. Builders Ltd. v. CIT, Eastern Investment Ltd. v. CIT, CIT v. Wel Chand & Co. etc., CIT v. Rajendra Prasad Moody, Sassoon J. David & Co. Pvt. Ltd. v. CIT
• Laws Referred To: Income Tax Act, 1961
• Result in Favour of: Others
• Court: HIGH COURT
• Department Lawyers: VP GUPTA; BASANT KUMAR; ANUJ BANSAL
• Assessee Lawyers: KAMAL SAWHNEY; AMI T SHRIVASTAVA
• Keywords: Arm's Length Price; Brand Fee; International Transactions; Royalty Payment; Transfer Pricing Officer
• Section: 143(3); 260A; 92CA(3)

Judgement Text

"* IN THE HIGH COURT OF DELHI AT NEW DELHI + I.T.A. No.1070/2011 Reserved on: 22nd February, 2012 % Date of Decision: 29th March, 2012 CIT versus ..... Appellant Through: Mr. Kamal Sawhney, Sr. Standing Counsel and Mr. Amit Shrivastava, Advocate EKL APPLIANCES LTD ..... Respondent CORAM: Through: Mr. V.P. Gupta, Mr. Bassant Kumar and Mr. Anuj Bansal, Advocates. HON'BLE MR. JUSTICE SANJIV KHANNA HON'BLE MR. JUSTICE R.V. EASWAR 1. Whether Reporters of local papers may be allowed to see the judgment? 2. To be referred to the Reporters or not? 3. Whether the judgment should be reported in the Digest? R.V. EASW AR, J.: For order see IT A No.1 068/2011. MARCH 29, 2012 hs ITA No.l070/2011 ~!~. (R.V. EASWAR) JUDGE ~--Jf'- (SANJIV KHANNA) JUDGE Page 1 ofl Digitally Signed By:AMULYA Signature Not Verified * IN THE HIGH COURT OF DELHI A 1r NEW IDJEJLJH[! ~!r .. , . ·'· + I.T.A. Nos.1068/20JI.l & 1070/2011: % CIT R(fserv~d on: 22nd February) 2012 Date of De&ision: 29 117 March. 2012 .. .:, ··· ..... Appellant Through: Mr. Kc:i1nal Sawhney, Sr. versus · Standi~g Counsel and Mr. Amit Shrivastava, Advocate ., EKL APPLIANCES LTD ..... Respondent Through:· Mr. V.p. Gupta, Mr. Bassant Kumat',and Mr. Anuj Bansal, Advocates. CORAM: HON'BLE MR. JUSTICE SANJIV: KHANNA HON'BLE MR. JUSTICE JR.V. EASW A.JR . I i ' 1. Whether Reporters of local papers may be al.lowed:jto see the judgment? 2. To be referred to the Reporters or not? ~ -VI: : 3. Whether the judgment should be reported in .the D1~est? · M :· .• R..V. EASW AR, J.: . In these appeals filed under Sectiori· 260A of the Income Tax Act, 1961 ('Act', for short) the Comn)issioner of Income Tax· ' ' challenges the common order passed by the Income Tax Appellate I ITA Nos.l068 & 1070/20~ l ., .. , e ·--··~·-,.----... -~.--·~· .-· ..,_,~ -------~--~ ... ..--~ .... ~~---.. __,·~-·~ t ~---. . :;. Page I. of25 .'; / '' ·'·-· .. ~· r: ... -·1·· . .: ~:;. ~ . Tribunal ('Tribunal', for short) -on years 2002~03 and 2003-04. '. ., ' ,, '·: 11.02':.2011 ' ' l for the assessment 't·. ' : 2. The appeals arise this ~hy. The as:sessee is a public limited '· ,I company engaged in the business· of manJfacturing of refrigerators,. . I washing machines, compressor and spare~ thereof and also trading all these items apd microw~~ve ovens, dist;i washers, cooking ranges, . ., . ,; air conditioners and spares· thereof.·: In ~espect of the assessment ' ·, years 2002-03 and 2003-0LJ., it filed: returns of income declaring • • ', • • I losses amounting to . ~ i:48;23,80,117/;- ·and ~ 1,14,59,660/- respectively. The Assessing Offi~er ~;noticed that there were . ,l international transactions enter~d into by the assessee during the 'l ., . . ) . . ·: relevant previous years 'and accordi.t;J.gly invoked the provisions of ;: . . :., Section 92CA(3) of the Act: and.· nyferred the question of . l _determination of the Arms Length Price:·(' ALP', for slhort) to tlhe Transfer Pricing Officer ('TPO', for short). The TPO examined tlhe ' , • I matter in considerable detail and noticed that AB Electro lux, Sweden ·held 76% of the assessee's equity as· on ~ 1.03.2002 and out of the k ' balance, 26% was held by the local joint venture partners and the . . ' balance 18% was held by the public~. He::noted that the turnover of ,., the assessee for the. assessment year ·2003):..04 amounted to ~ 440.97 . ' .( : crores including trading sales of~ 48:29 'Frores· pertaining to goods r': partl¥ imported from the associated ~~e~te~prises and also purchased ITA Nos.l068 & 1070/2011 C.·.: J;! ··:;· .. , ' •'· ·' ·~ I ., ., ·' ' ··~ Page 2 of25 ) - ~ locally. The maJor international transa~tions und.ertaken by the ' ' ,· assessee were also noticed by him and he has listed the same at page 2 of the order passed ~y him on 20.0~.2096 under Section 92CA (3) ., I of the Act. It is noticed from the qrder :that there are 13 types of international transactions entered into by the assessee in the previous ·' relevant year 2003-04. The TPO accepted all of them to be Arm's I • .; • Length Transactions, except the payt;nent .of brand fee/ royalty of ~ 3,42,97,940/-. The corresponding :figurt~ for the assessment year 2002-03 is.~ 3,99,51,000/-. We may clarify that the revenue has . filed before us the order passed by the TPO for the as·sessment year 2003-04 on 20.03.2006, but the order .passed by the TPO for assessment year 2002-03 has not ·been: made available. This, however, is not material because it is common ground that the facts . and the controversy arising in both the ass~ssment years are the same so far as the ALP is concerned. Revertin.~~ to the order of the TPO, he considered the payment of brand. fee/ royalty by the assessee to the associated enterprise namely AB Ele:btrolux, Sweden under an . ~·: ,, agreement dated 01.10.1998 to be unjustifi;ed. y •, 3. It is necessary to narrate the order. of the TPO on this aspect in som~ detail in order to appreciate the preG)se controversy. We have already noted that the brand fee paymient was 1nade . under an ~ . ; ~: ·agreement dated 01.10.1998. The. a~sessf~e was to pay brand fee at I I ' • IT A Nos.l 068 & 1070/2011 Page 3 of25 ,, . :.:. ), I the rate of 0.50% of the net sales ui:tder the brand, name of \"Kelvinator\". The · pay111:ent was . to l,)e made to M/s. White Consolidated Inc. of Ohio, USA. Howev·er, the payn1ent of the fee was waived till 01.01.2002 as advertising and launch support. On 27.09.2002, the agreement was modified 'to give effect to the new ' ·, name of M/s. White Consolidated INC.· It was thereafter lmown as Electrolux Home Products INC. The :modified agreement also recognized the amalgamation of ElectroJ;ux Voltas Pvt. Ltd. with Electrolux Kelvinator Ltd. Another chan~?;e made in the agreement was to change the brand fee to 1% qf the net sales. The agreement was to ~emain in force till 31.12.2008. It~· was under this agreement . that the assessee paid< 3,42~97,910/-. as brand fee for the assessment year 2003-04 and< 3,99,51,000/- for the a~sessment year 2002-03. 4. The TPO obtained the financial statements of the assessee since the commencement· of comm~rcial ,: production and examined the same and set out the crucial figuresf: in the fonn. of following table: - Year Pro:fnt/ (Ross) Tull!rJ!D.OVtllt' JBraimdl [ee/ (Rs.) (Rs.) ·: . ' RoyaH1ty (Rs.) 1996-97 . (23.4) cr '68 cr; 3 lac .. 1997-98 (17.2) cr. 215 cr; 3.27 cr { 1998-99 (8.19) cr 312cr:': 6.78 cr •' ·: •. ITA Nos.1068 & 1070/20il Page 4 of25 ,· 1999-2000 2.75 cr 298 cr 7.23 cr 2000-01 (39.5) cr 314 cr ,: 6.64 cr '!:' 2001-02 · (149.8) cr 481 cr.;, 5.08 cr 2002-03 · (195 .1) cr. -\" 428 cr 3.42 cr 5~ From the figures shown. abo:ve tfle TPO noticed that the ·assessee has been incurring huge loss,es year after year except for the financial year 1999-2000 and considering: the perpetual losses, \"the X payment of ~oyalty to the Associate Enterprise did not appear justified, as the technical knowhow/ brancii fee agreements with A.E. :l . . had not benefited the assessee company iiL achieving profits from its · operations\". The TPO further noted; that the assessee itself stopped the paymept from 01.10.1998 till. OL01.2002 and thus· \"the justification for payment of brand fee during the year under reference becomes questionable\". .. (t,, ~~~ 6. Having reached the aforesaid c.onclt}sion, the TPO called upo~ ·i': ;~ ' the assessee to submit the justification for: the payment of brand fee . .- ! I I ' The assessee submitted a detailed reply ra~.~ing the following points: (i) · The· payment of brand fee shq~,.Ild be examined on meiits( for each year; IT A Nos.l068 & 1070/2011 ·' .;• .. 1 •' ·'. r. (' ,, ••-·-.--~---- -,·-~~•-••--n~------•-u~ -~-., ). ;~ .•. Page 5 of25 (;J \" _] (ii) The Associated Enterprise . (' A.E. ', for short) had received similar brand ·fee from :~M/s. Fisher and Paykel ··'· Industries Limited, an unrelated part)r in New Zealand, and this transaction was comparable with i;he assessee's transaction with the A.E. and thus there ~annot ·be any doubt regarding genuineness ·of the ALP; (iii) The transaction was cert~fied by M/s. Ernst and Young,· the certification firm of globarrepute, who has stated that the fee paid by the assessee is lower tlpn the uncontrolled brand .1. fee· ' (iv) The allowance of branq fee: as· expenditure does not ~;' depend on the profitability of the ccibcern, but on the utility of ·,, the brand name and the technic~! knbwhow in respect of which the payment is made. The paym~nt may not immediately . result in profits but since the comp~ny is· in business with the I :,; motive to earn profit, it has to: incur all such expenditure that would be in the intetest of its busine~s. The brand fee payment is a legitimate expenditure which, :had it not been incurred, would have seriously affected the op:erations of the as.sessee.. It would have hampered the availa6,ility of the brand name \"Kelvinator\". ITA Nos.1068.& 1070/2011 Page 6 of25 •' ... ;, ·., '\" '• J ( v) H was due to availability of: the brand name that the assessee was able to achieve substantial increase in its turnover .as shown in the table set out above. Had it not been for. the :. 'fi brand name there would have beep more losses because of higher fixed cost coupled with lower: sales. 7. The TPO .considered the reply. of t~1e assessee containing the ' !:· I ' , justification for the payment of brand fe~·. He conceded that there was an increase ih the 'turnover but 0bserved that it has not resulted in any profit to the assessee. Accor~ing t9 him, despite the payment of the brand fee for several years, the as~!essee has not been able to make a turnaround. He further held that: the fact that the A.E. had . t charged similar brand fee from anoth~r co1;npany in New Zealand did not prove that the price paid by the qssessee for obtaining the use of the brand narne and the technical knowhow represented the ALP. He was of the view that the assessee :had to demonstrate the actual ' benefit derived by it by using the brand n~me which it had failed to . do. The continuous losses according to~:·the TPO showed that the ,;', assessee did not benefit in any way from the brand fee payment. For these reasons, the TPO held that the branq fee payment made by the assessee to the A.E. was unjustified and t~e ALP of the transactions ·, ' should be taken as nil. He accordingl~r held that the brand fee ·'· ., ITA Nos.10G8 & 1070/2011 Page 7 of25 I ·~-----~·------··----~ .. ·---.-~,----- __ , ' I ' l · payment of~ 3,42,97,940/- should be add ~ d back to the total income of the assessee. 8. A similar order would appear tp haye been passed by the TPO · for the assessment year 2002-03 also· by ~hich the brand fee/ royalty payment on ~ 3,99,51,000/- was added l;ack to the inco'me of the ' ~~ assessee. 9. Under Sec,tion 92CA (4) of the Act, the Assessing Officer is bound by the directions given by the TP:O in respect of the .ALP. ,. Accordingly, the Assessing Officer, for both the years under appeal . . . disallowed and added back the brand fee/: royalty payment made by . ~ the assessee to the A.E .. while completing the. assessments ull1der Section 143(3) of the Act. 10. The assessee preferred appeals to the CIT (; ppeals) in respect .t,: . ' of both the assessment years and question~d the determination of the . ;: ' '• ALP and the disallowance of the brand fee/ royalty paym.ent. The appeal for the assessment year 2002-03 v;ras disposed of vide order . :t . . dated 27.07.2009 whereas the appeal for r~he assessment year 2003- · 04 was disposed of by ~he order. d(;lted 27.11.2009. /Though, two separate orders have been passed by :the CIT (Appeals), the ~ : reasoning and conclusions are the same. ,jWe, therefore, proceed to notice the findings of the CIT (Appeals) ;:in a consolidated manner. . ' ~ . ITA Nos.1068 & 1070/2011 \"• ' .:~ i•'; ,. i' ---·-----~---------.-- ...... - ......... ~--.~ ~---r· --- -~· ··-··-- Page 8 of25 Cr .e • ' ,· - :-:-·-~ :1; Before the. CIT (Appeals) ,the assess~e. would appear to have raised several objections including the objection 'to the ~eference made tor the TPO which according to the asse~see was done mechanically by the Assessing Officer. On this point the CIT (Appeals) found ,, :.• himself unable to ag~ee with the assessee'~ objections, having regard to the judg1nent of this Court in the case of CIT v. Bankam Investment Ltd. (1994) 208 ITR 52: T~ereafter he addressed the question . whether the TPO was right i1i rejecting the economic !lh y~ analysis of the transaction undert~ken ;;by the asses~ee for the determination of the ALP vis-a-vis payme~t of royalty/ brand fee, in a situation where losses were being ihcuq,~d continuously by it. He noted the assessee's economic analysis ir~. great detail and recorded ·i the following findings for the assessment ~ear 2002-03: - ~ ~~ ' (i) The assessee was forced. to u~grade its technology with ' 'I the advent of tough cmnpetition from makers of frost free ,! ' refrigerators and large number of ~ntrants in the refrigerator ' market. Once the technology was~ upgraded by clearing the ! . usage of technical lmowhow for pa)iment of brand fee/ royalty ~!, the assessee was able to reduce tpe losses to a significant ,, extent. Therefore, the claim of the'i TPO that by securing the ' use of the technical knowhow the assessee did not benefit was not correct; ITA Nos.1068 & 1070/2011· . :1 ------------·-----~------·- '· ! ' Page 9 of2S -,:--- ... /~ (ii) There wc;ts significant increase, in the operating losses. on account of the increase in the employees' cost, finance charges, ' administrative expenses, depreciati9n and installed capacity. In this regard the comparative statement filed by the assessee to show the expenses over a peri6d of 5 years, the assets . ·' ·acqui~ed during the aforesaid perio~, the loans incurred over the said period, etc. was examined py the CIT (Appeals) who fo~nd that the statement supported: the claim of the assesse·e ' regarding huge. increase in the costs/ e~penses. He also found . ' that the acquisition by the assessee of other companies such as Intron Ltd. and Electrolux India~.L~d. had also contributed to the losses; . . (iii) From the .schedule of unsecu!ed loans furnished in the form of table over the period betwe~n 1999 to 2002, it is foun~ , I · that there was huge increase o( financial costs from ~ 5.12 ' : crores in 1997 to 41.10 crores in 2002. This was solely on . ! . • account of the increase in the unsecured loan from { 15.89 crores to~ 397.92 crores in the year 2002; •. ' ' (iv) Similarly, there was increase; in the depreciation costs I from~ 6.03 crores in 1997 to.~'67-88 crores m 2002 on IT A Nos.l 068 & 1070/2011 Page 10 of25 ' . ___________ ,_, _____ ., ____ . . , _ ~ · -·-- ·- - - - - ~ - - ~ I • /) account of increase in the gross hlock of the assets from { ? ' I , I . . 46.81 crores in 1997 to { 3 26 23 crores in 2002; . ' (v) The figures furnished by the a~sessee showed that though ' it was deriving gross profit: ~rom the operations, it was .. ' ' suffering losses due to expenses ;an~ other factors. The losses show . significant reduction after: tebhnical up gradation ·in the ' year 2000. Therefore, it wou;ld. n~t be inappropriate to state that the assessee started derivipg si~nificant monetary benefits due to the · technical upgradation received under the collaboration agreement with the A.~.; ' (vi) The OECD guidelines on Tr~·msfer. Pricing Regulations require that business strategies are relevant for determining the ' . . ' comparability .. of prices between c?ntrolled and uncontrolled ' transactions. The TPO has· disregarded the business arid ' commercial realities and strat'egi!es and has acted in a mechanical manner igno~ing the~ economic circumstances surrounding the transaction; (vii) It is not open to the TPO, tq q~estion the judgment of the assessee as to how it should conduct its business and regarding 1 : the necessity or otherwise of in~ur~ing the expenditure in the interest of its business. It is ertti~·ely the choice of the assessee. ITA Nos.1 068 & 1070/2011 . ... Page Jl] of25 • as to from whom it contemplates to source its technology or , •,' I technicaL knowhow and as to . w:ha~ steps should be taken to . ' • •i. I meet the competition prevalent in t~e market and to stave off •,, I the competitors. This is the domain pf the businessman and the ' I TPO has no say in the matter. As ~eld by the Supreme Court I • . in S.A. Builders Ltd. v. CIT (2006) 289 ITR 26 (SC) the . I ' Revenue cannot justifiably claim to place itself in the arm chair of businessman or in the position o(the Board of Directors and ' assume the role to decide hd'w i much is the reasonable ' expenditure having regardto the ¢ir~umstances of the case. I In respect of the assessment year ~003-04 more or l~ss the ~. t • same findings were recorded by the Clt ~Appeals). In fine, he held that the royalty/ brand fee payment for acquisition of use of technical ' ' knowhow was incurred for genuine busin~ss purposes aJ!d should be l t allowed even if the assessee had suff~re~ continuous losses in the I business. The losses are partly due to internal and external factors ;• I t : and according to the CIT (Appeals) it is difficult to \"subscribe to the ' !' : ' I T_PO 's view that if there was financial prunch then the appellant should have discontinued to payment to tbe A. E. on Brand Fee and . ' the payment of royalty on acquisition of technical knowhow/ brand . ' . I fee has not resulted in any financial benefi:t to the appellant\"; ' . . ITA Nos.1068 & 1070/2011 I ' ~~ ! ' I' . r ·~ ··---~-. ---~------··--····-~~ ... , ______ ~---r--)··~-+. . Page 12 of 25 ;r ·(f 11. Thus for both the assessment yea,rs under appeal the CIT . ' . (App.eals) decided the issue in favour of t~e assessee. The Revenue preferred appeals before the tribunaf f0r both the years. IT A No.4878inel/2009 was the appeal for thej assessment year 2002-03. The Tribunal after noticing the facts . an~ the rival contentions in some detail, agreed with the decision ~~f the CIT (Appeals) that the . \"·' ! royalty/ brand fee pay1nent was justifi~,d ~nd held that the TPO was ,; I ' totally wrong in disallowing the same on the footing that the assessee ' ' ' suffered continuous losses. ' ' ,! ' .:. ' ?\"! I •' ' ' I 12. For the assessment year 2003-04; th¢ Revenue's appeal in ITA I ' No.421/Del/2010 was dismissed by thcl T~ibunal which held that the . ' I + brand fee/ royalty payment cannot be dis~llowed by the TPO whi_le ' ' ' determining the ALP. In doing so, the Tri,bunal followed its decision ' ' ., for the assessment year 2002-03 in the apP:e~l filed by the department ' ' in ITA No.4878/Del/2009. j ' I 13. In ITA Nos.-1068/2011 and 107dY2011 before us the Revenue has challenged the. decision of the Tribu~al by which it upheJd the decision of the CIT (Appeals) deleting thefdisallowance of brand fee/ I royalty payn1ent ·for the assessment r:.rears respectively while computing the ALP. ~• ' ITA Nos.1068 & 1070/2011 ' . ' ' ' ' I . ' I ' ' ' ' ' 2003-04 and 2002-03 Page B of25 ·:-------------~--- -·-------=:-·-·-~--·--~-··: ---- f: I· ·' ;~' . ,.. '?t 14. On the submissions made by b~)tq the sides, the following substantial questions of law are framed: - ASSESSMENT ·YJEAJR 2003-04 ' \"Whether on the facts and· in the cir6umstances of the case and on a proper interpretation pf Sectioni 92CA of the Act and Rule 10B(1)(a) of the Income Tax Rule~, 1962, the Tribunal was right in confirming the orcfer of the CIT (Appeals) deleting the I • disallowance of the brand fee/: royalty payment of ~ 3,42;97,940/- macie by the assessee to its Associated I Enterprise, while determining the Ar~'s Length Price\"? ASSESSMENT YEAR. 2002-03 I I ' ,, I. I . \"Whether on the facts and in the bir9umstances of the case and on a proper interpretation of Section: 92CA of the Act and Rule I 10B(l)(a) of the Income Tax Rule~, 1962, the Tribunal was right in confirming the order of tpe ~IT (Appeals) deleting the disallowance of the brand · f&e/: royalty payment of ~ 3,99,51,000/- made by the. 0ss~ssee to its Associated Enterpt~ise, while determining thei Ai:m' s Length Price\"? 15. It seems to us that the decision ·tal~ en by the Tribunal is the .• . right decision. The TPO applied the GW method while examining ' ' the payment of brand fee/ royalty. The ~CUP 1nethod which in its • J• I • ' ~xpanded form is known as \"comparable ~ncontrolled price\" method js provided for in Rule 10B(l)(a) of the I~come Tax Rules·, 1962. It ' ' Js one of the methods recognised for determining the ALP. in relation . ' ; =to an international transaction. Rule l OB(1) says that for the ITA Nos.l068 & 1070/2011 . / ' ' ·, ' ,. ' L • :· Page ] 41 of 25 • . ., 'Y/ purposes of Section 92C(2), the ALP shall be detennined by any one . ' , I of the five methods, which . is' found tq be the most appropriate method, and goes on to lay down the .manner of determination of the . I ALP under each method. The five meth9ds recognized by the rule ·.' ! are (i) comparable uncontrolled price rrjuithod (CUP), (ii) re·-sale I price method, (iii) cost plus method, (i v) ~rofit split method and (v) transactional· net marginal method (TNM1}1). The 1nanner by which ' the ALP in relation to an internati01ial ; transaction is ·determined I ~ ~ . I ' ' under CUP is prescribed in clause (a) oft~e sub-rule (1) ofRule lOB. '· The following three steps have been presc~ibed:-:- , ' \"(a) comparable uncontrolledpric~ method, by which, . ' ' (i) the price charged :,r;r ! paid for property transferred or services prd;vi4ed in a compa,rable uncontrolle~ transaction, or : a. number of such transactions, is identified,· I (ii) such price · is adjitst~d to account for differences, if any, betWeery the· international transaction~ and the compdrable uncontrolled . ' transactions or between. the ~nterprises entering into such transactions, vt;:~iqh could materially affect the price in the open ~ndrket,· I ~ I ,. ' (iii) the adjusted price arrived at under sub- clause (ii) is taken to be an a~m 's length price in respect of the property tra~sferred or ·services provided in the internation'&l transaction,·\" :• I ITA Nos.1068 & 1070/2011 ' ~!. ) 'I ;~ I ' I ' I ' ' ' '· Page ]5 of25 r . • • .: ' ;_ .. ' 16.- The Organiza~ion for Econo.t:nic Co-operation and ~ . : Development ('OECD', for short) hasj laid down \"transfer pricing . . . . . guidelines\" for Multi-National Enterpdses, and Tax Administrations. ' - ' These guidelines give an introduction t~ the arm's length price ' ' principle and explains article 9 of the OEqD Model. Tax Convention. This artiCle provides that when conditiqns are made or imposed between tw9 associated enterprises in their commercial or financial ' - relations which differ from those which: would be made between ' ' independent enterprises then any profit W,hich would, but for those _ conditions, have accrued to -one of tije en~erprises, but, by reason of those conditions, if not ~o accrued, may b~ included in the profits of ' that enterprise and taxed accordingly:. By seeking to adjust the ' - . profits in the above manner, the arm';s l¢ngth principle of pricing ·; ! ' ' . follows the approach of treating the. members of a multi-national ' enterprise group as operating as seprrate entities rather than as . inseparable parts of a single unified i~~u~iness. After referring ·to ·(~. . ' article 9 of the model convention and : stating the arm's length '. . ' principle, the guidelines provide for; \"*ecognition of the actual transactions undertaken\" in paragraphs 1.3~ to 1.41. Paragraphs 1.36 to 1.38 are important and are relevant; to our purpose. Tlhese ·paragraphs are re-produced below: -_ ITA Nos.1068 & 1070/2011 l. ·:_ .. _,_,___.,_ ~---·---·-·-··-·· -f~ .... -:------ ~~ ·- 1 1 ic if Page 16 of25 ~;> . . ' \"1. 3 6 A tax administration's exarizin~tion of a controlled transaction ordinarily should be based on the transaction actually undert~ken ~by the associated enterprises as it has been ~tructure(! by them, usi'?g the methods applied by the taxpayer insofar as these are consistent with the methods describ~d in Chapters II and III. In other than exceptionql cases, the · tax administration should not disregard the actual · transactions or substitute other :'trqnsactions for them. ·Restructuring of legitimate busin,es~ transactions would be a wholly arbitrary exercise , the inequity of which .. could be compounded by double tai{ation created where ·the other tax administration do¢s ,not share the sqme views as to how the transaction SJf~ould be structured. .r. '.> 1.37 However, there are two Pi Wti:cular circumstances in which it may, exceptionally, b~ b:oth appropriate and legitimate for a tax administr:ation to consider disregarding the structure adopteq by' a taxpayer in entering into a controlled trani:action. The first circumstdnce arises where the eton:omic substance of a transaction differs from its form. ;i .lrl such a case the tax administration . may disregar~ the parties ' characterization of the transaCtion ~andre-charaCterise it in accordance with its substance.! An example of this circumstance would be an investment in an associated ' enterprise in the form of interest-b~aring debt when, at arm's length, having regard :to the economzc circumstances of the borrqwilag company, the investment would not be expected~ to: be structured in this way. In this case it might be; appropriate .for a tax ·' administration to characterizk the investment in ' ' accordance with its economic :subsi:ance with the result ... ii ITA Nos.1068 & 1070/2011 Page ]7 of25 • .. - ... -· 1 .. that the loan may be tre_ated as a subscription of capital. The second circumstance arises · w~ere, while the form and substance of the transaction : are the same, the arrangements made in. relatiot:z {a the transaction, viewed in their totality, differ jff{?m: those which would } 'I ' have,. been adopted by independer,zt (!:nterprises behaving in a commercially rational mbn~er and the actual structure practically impedes lhe! tax administration from determining an appropridte ;transfer price. An example of this circumstance. w~ulfl be a sale under a . long-term contract, for a lump~ ·sum payment, of unlimited entitlement to the inte~leC,tual property rights arising as a result of future researc~ for the term of the contract (as previously indicated in paragraph 1.1 0). While in this case. it may be pr&per to respect the transaction as a transfer of cJm1~ercial property, it would nevertheless be apptop:riate for a tax administration to conform the: term~ of that transfer in their entirety (and not simply by reference to pricing) to those that might reasonably hay~. been expected had the • - J l transfer of property been the si:tbj~ct of a transaction ir)volving independent enterprises. ~ Thus, in the case described above it might be· appr,opriate for the tax administration, for example, to adj~st the conditions of 'the agreement in a commerciall_i~ rqtional manner as a continuing research agreement. ·;t : . ' ~ : 1.38 In both sets of circumstand~s described above, the character of the transaction may derive from the relationship between . the ·par;tie~ · rather than· be determined by normal comm~rdai: conditions as may have been structured · by the taipayer to avoid or minimize tax. In such cases, the :totality of its terms ' ' ' ITA Nos. 1068 & 1070/2011 Page ns of25 I· ----·-----··--·-·----· ,. • ~ ' . would be the result of a condition :that would not have been made if the parties had beef! engaged in arm's length de.alings. Article 9: iyould thus allow an adjustment of conditions to reflect those which the • , I . parties would have attained had tfze transaction been structured in accordance with :the economic and commercia/reality of parties dea1ini at arm's length.\" 17. · The significance of the aforesaid:g'l#delipes lies in the fact that they recognise that barring exceptional cases, the tax administration ' should not disregard the actual tra;ns~ction or substitute other transactions- for them and the exmnination of a controlled transaction I should ordinarily be based on the tran?acfion as it has been actually · · ,. undertaken and structured by the asE/oc~ated enterprises. It is of ' further significance that the guidelines d~scourage re-structuring of ' legitimate business transactions. The :reason for characterisation of , I I such re-structuring as an arbitrary.·· e~ercise, as given in the I guidelines, is that it has the potential t9 create double taxation if the ' '<' I other tax administration. does not share th:e smne view as to how the. transaction should be structured. 18. Two exceptions pave been allowe~ to the aforesaid principle I and they are (i) where the economic subst(,lnce of a transaction differs . ' from its form and (ii) where the Joim and substance of the ·J. J • . transaction are the same but arrange~1e~ts made in relation to the ITA Nos.l068 & 1070/2011 ;: I . ,, I'' . ~:: t' ' ' ' .,:, !, )• I ... ' .i. ' ·, Page n9 of25 ·--.~ - ' ,· transaction, viewed in their totality, differ from those which would . . l ' have been adopted · by independent. e~terprises behaving lin a commercially rational manner. ' ' . 19. There is no reason why the OE,f=D guidelines should not be ,. taken as a valid input in the present ca~~e ~n judging the action of the \" :;, I TPO. In fact, the CIT (Appeals) has. re~erred to and applied them ', ' ~nd his decision has been affirmed by the Tribunal. These guidelines, in a different form, have·• b~en recognized in the tax . . ' jurisprudence of our country earlier. · lt h~s been held by our courts J ' that it is not for the revenue authorities :to dictate to the assessee as to . ' ' how he should conduct his business and it is not for them to tell the ' . ' . ' assessee as to what expenditure the a~ssessee can incur. We may .· I ' ' refer to a few of these authorities to· eluci4ate the point. In E@stern Investment Ltd. v. CIT, (1951) 20 ITR,1, it was held by the Supreme Court that \"there are usually many w~ys in which a given thing can be brought about in business circles but: it is not for the Court to decide which of them should have been e~1ployed when the Court is deciding a question under Section 12(~) ~fthe Income Tax Act\". It was further held in this case that \"it is P!o( necessary to show that the . ' , ' expenditure was . a profitable one or th~t in fact any profit was earned''. In CITv. W~.lch@nd & Co. e~c.,~ (1967) 65 ITR 381, it was held by the Supreme Court that in apply~ng the test of commercial ' . ' ITA Nos.l068 & 1070/2011 ~. ' --·~-·~~··--~·--~-~-·-· < :---:~\"~·:----.-!- o~.• ·-• • Page 20 of25 :•n •- .. ..,·· ~?' expediency for determining whether the e~penditure was wholly and exclusively laid out for the purpose o1; b~1siness, reasonableness of the expenditure has to be judged fro.m :the point of view of the businessman and not of the Revenue. ; It. was further observed that the rule that expenditure can only be justified if there is corresponding· increase in the profits was erroneous. It has been ' classically observed by Lord Thankerton in Hug/lues w. Bank of New ' . ' Zealand, (1938) 6 ITR 636 that \"expen~iture in the coui\"se of the I trade w~ich is unremunerative is none fhe: less a proper deduction if ·: wholly and exclusively made for the purp,oses of trade. It does not • • . I • ' . require the presence of a receipt on th~ credit side to justify the I ' deduction of an expense\". The questiop ~hether an expenditure can . f~ : be allowed as a deduction only if it h;~s resulted in any income or J :•, I ;· ! profits came to be considered by the StJpreme Court again in CJ'J' v. . . : c:w.:e llj . Rajendra Prasad Moody, (1978) 115 \"IT~ 519,ftwas observed as under:- : \"We fail. to appreciate how ;expenditure which is otherwise a prope.r expenditur:e · ca'n cease to be such · merely because there is no receipt o/ income. Whatever . is a proper outgoing by way of e~penditure must bf! · debited irrespective of whetheJ· there is receipt of. income or not. That is the plain. re'quireme.nt of proper accounting and the interpre(ation~ of Section 57(iii) cannot be different. The deductiO~ of the expenditure J r. ··~ ' IT A Nos.1 068 & 1070/2011 Page 21 of25 --------·~-~~--_..,..-·-··-~--- ;~~--~·r---~- ·--~· J,• .> ·~ cannot, in the circumstances, be hi.ld to be conditional upon the making or earning of the income.\" · It is noteworthy that the above observatioqs were made in the context .,, ' of Section 57(iii) of the Act whenl t*e language is somewhat . . ·' narrower than the language employed in. Section 37(1) of the Act. . ' ' This fact is. recognised in the judgment; itself. The fact that the I ~ I , language eJ!lployed in Section. 37(1)./:of: the Act is broader than ' ' ·~ :, I , :. I Section 57(iii) of the Act makes the position stronger. '· ' 20. . In the case of Sassoon J. David & Co. Pvt. Ltd. v. C/1', (1979) ·~: 118 ITR 261 (SC), the Supreme Court :referred to the legislative ' . . ' history and noted that when the Insome Tax Bill of 1961 · was .introduced, Section 37(1) required that t~e expenditure should have been incurred \"wholly, necessarily a~d ex~lusively\" for the purposes· of business in order to merit deduction. Pursuant to public protest, . ' the word \"necessarily\" was omitted fro{n the section. ' 21. The position emerging from the a;boye decisions is that it is not . r necessary for the assessee to show th~t ~ny legitimate .expenditure incurred by him was also incurred out of necessity. It is also not necessary for the assessee to show that m)y expenditure incurred by ' ' · him for the purpose of busin~ss car~ie4 on · by him has. actually , ~ I resulted in profit or income either in the $ame year or in any of the ,·• I ' subsequent years. The only conditio.n js t~at the expenditure should I ~ ' I ~ ,. ' ' ,;, : ITA Nos.1068 & 1070/2011 Page 22 of25 ·--·-=---·--.--~~-~-----··---·-----~-·- -~- ----~---~-··------ ~- :-~--··- --- . , I ' . . I'~ ·--...._,_ have been incurred \"wholly and ef<:c)usively\" for the purpose of business and nothing more. It is this :pri:nciple that inter alia Jfinds ' ' expression in the OECD guidelines, in the. paragraphs which we have quoted above: 22: Even Rule lOB(l)(a) does not aut~orise disallowance of any expenditure on the· ground that it was not necessary or prudent for the assessee to have incurred the same or that :in the view of the Revenue the expenditure was unremunerative or that in view of the continued losses suffered by the assessee in his bu~iness, he could have fared . ' better had he not incurred such expenditure. These are irrelevant • c :· ' ' considerations for the purpose of Rule ::1 0~. Whether or not to enter •. . . ?, ,. -' : . into the transaction is for the assessee t~ decide. The quantum of ' expenditure can no doubt be examined,. by the TPO as per law but in . '4 . .1, . : ' judging the allowability thereof lias b~'siness expenditure, he has no . j : authority to disallow the entire expenc.1it~re 'or a part thereof on the ' I ---~ ground that the assessee has suffer~d ~ continuous losses. The ' . financial health of assessee can ne~!er: be a criterion to judge . allowability of an expense; there is cert~inly no authority for that. o)~p.l ' : , What th~ TPO has ~ in the pndserh case is to hold that the assessee ought not to have entered into th~ agreement to pay royalty I brand fee, because it pas been suffering lo:sses continuously. So long :·· . . as the E(Xpenditure or payment has been demonstrated to have been • ' , I , ITA Nos.l068 & 1070/2011 ' ' ' ' '. I Page 23 of25 ----- ·---~---· : '·· • • ' . 'j, )& incurred or laid out for the purposes of b~siness, it is no concern of ' ' ' the TPO to- disallow the same on an:y extraneous reasoning. As . • r I . .. ' provided in the OECD guidelines, he is, expected to examine the international -transaction as he actually finds the same and then make 1.' t . ~ suitable adjustment but a wholesale disallpwance of the expenditure, particularly on the grounds which have· be~n given by the TPO is not contemplated or authorised. .. ··. 23. Apart from the legal position sta¥;ed[ above, even on merits. the . :i : disallowance of the entire brand fe~/ toyalty payment was not warranted. The assessee has furnished copious material and valid ~ . : . reasons as to why it was suffering losse·s cpntinuously and these have ' ' been referred to by us earlier. Full justi~cation supported by facts and figures have been given to demon:str(;lte that the increase in the employees cost, finance charges, :ad1ninistrative expenses, ' depreciation cost and capacity incre?-se~ have contributed to the . ' continuous losses. The comparative p;;siti!on over a period of 5 years from 1998 to 2003 with relevant figures have been given before the . CIT (Appeals) and they are referred to ,in :a tabular form in his order • • ~:. t • in paragraph 5.5 .1 ~ In fact there are four t~bular statements furnished ' by the assessee before the CIT (Appeals~ in support of the reasons for the continuous losses. There is o: material brought by the .· ' revenue either before the CIT (Appe~~s) ~or before the Tribunal or · . ~- :· ITA Nos.1068 & 1070/2011 --------·---.· ! ·,../ I ' ' ' ' ·::· . . _,. ·-·--·---·---~·-, ··--;----~-- Page 241 of 25 ;· -'\"\"' ··~ 5I even before us to show that these are inco~rect figures 'or that even on . I I . merits the reasons for the losses are no(genuine. :r ' ~~ : 24. We are, therefore, unable to hold tijat the Tribunal committed '· any errqr in ·confirming the order oft~,e CIT (Appeals) for both the years deleting the disallowance of th~ btand fee/ royalty payment while determining the ALP. Accordingly, the substantial questions r of law are answered in the affirmative:and in favour of the assessee . and ·against the Revenue. The appeals ~are accordingly dismissed with no order as to costs. MARCH: 29,2012 hs . ITA Nos.1068 & 1070/2011 ' (c) -~ ~ (R.V. JEASW AJR) .roDGJE A-z-·/(L- (SANJlV KJHLANNA) I : ruiDGJE . I ~r : ,!J; 1 ~·· ).\" ~J! .I . .( I I \" . Page 25 o£ 25 I I i I . . I . -----· \"\"'\"\"·-------·-··1·--··-- -.-- "