The Ahmedabad Bench of the Income-tax Appellate Tribunal held that the “internal cost plus method” (comparing profit margin on sales to related parties in relation to sales to non-related parties) could not be adopted to benchmark exports of finished goods to a related party when there were differences in the geographical location of the market and in the value chain and utility of the product. Thus, the tribunal rejected the position of the Transfer Pricing Officer.
With regard to payments of a royalty to related parties, the tribunal held that to benchmark the royalty payment transactions, as made to related parties (here, the parent company), intra-related party transactions (that is, rates payable by other group entities as a royalty to the parent company) could not be adopted as a valid comparable uncontrolled price input. The difference in the royalty rates applicable for domestic sales in relation to export sales by Indian entities was duly recognised by the tribunal and accepted by the regulatory framework in India.
The case is: Inductotherm (India) Pvt. Ltd v. DCIT
The taxpayer is a subsidiary of a U.S. company that manufactures induction melting systems and is a market leader in induction technology for melting, heating, and welding equipment.
The taxpayer exported finished goods, some 165 out of 2,500 types of products, to its related party and used the cost plus method in order to benchmark the transactions. In addition to the 165 types of products exported to the related party, 31 types of products were sold to non-related parties. Against a margin of 47.06% on exports to related parties, the taxpayer reported that it earned a margin of 194.43% on sales made to non-related parties.
The Transfer Pricing Officer (TPO) required the taxpayer to show why the 194.43% margin on non-related party sales could not be adopted under the “internal cost plus method.”
The tribunal—in addressing whether the cost plus method was the most appropriate method—held that even though the taxpayer had sold the same products to domestic entities as were exported to the related parties, the cost plus method could not be applied because of the difference in the geographical location of the market and with respect to the value chain and utility of the product. The tribunal rejected the Transfer Pricing Officer’s imposition of the internal cost plus method, and allowed the taxpayer’s application of the transactional net margin method (TNMM).
The taxpayer had paid a royalty to its parent company, and the royalty was computed at 5% for domestic sales and 8% for export sales.
The taxpayer had aggregated its payments of the royalty with other international transactions, and the entity-level profits were benchmarked using the TNMM.The taxpayer determined this was at arm’s length. The Transfer Pricing Officer rejected the taxpayer’s aggregation of all transactions (among other items).
The tribunal rejected the approach of the tax authorities, noting that it was a recognized standard that different royalty rates apply for domestic sales versus the rates that apply for export sales.
Often in transfer pricing proceedings, the Transfer Pricing Office places reliance on internal comparables. In this case, the tribunal rejected the internal comparables under the cost plus method, as proposed by the Transfer Pricing Officer, and instead focused on various factors of comparability—including geographic location, value chains, and utility of the products.
With respect to the royalty issue, the tribunal accepted the differential rate of royalty with respect to domestic sales vs. export sales, and found that an intra-related party transaction cannot be considered to be a comparable.
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