Transfer Pricing with respect to arm’s-length transactions should be calculated as per OECD guidelines

CLR Editorial Notes: In course of transfer pricing proceedings, Transfer Pricing Officer has to work out ALP of international transaction by applying methods recognized under Act and, he is not competent to hold that expenditure in question has not been incurred by assessee or that assessee has not derived any benefits from said payment and, consequently, ALP has to be considered as nil.


2013-ITS-81-ITAT-Festo Controls (P.) Ltd. -Vs- Deputy Commissioner of Income-tax, Circle 11(3), Bangalore* , On. January 4, 2013


Festo Controls (P.) Ltd.


Deputy Commissioner of Income-tax, Circle 11(3), Bangalore*

N. Barathvaja Sankar, Vice-President

And N.V. Vasudevan, Judicial Member

IT (TP) Appeal No. 969 (Bang.) of 2011

[Assessment year 2007-08]

January 4, 2013

Chavali Narayan for the Appellant. S.K. Ambastha for the Respondent.


N.V. Vasudevan, Judicial Member – This is an appeal by the assessee against the order dated 23.09.2011 passed by the Dy. Commissioner of Income-tax, Circle 11(3), Bangalore u/s. 144C of the Income-tax Act, 1961 [hereinafter referred to as “the Act” in short”].

2. The grounds of appeal raised by the assessee reads as follows:-

1. The order of the learned AO and directions of the Hon’ble DRP are based on incorrect interpretation of law and therefore are bad in law.

2. On the facts and in the circumstances of the case and in law and based on the directions of DRP, the learned AO erred in assessing the total income at Rs. 507,107,387 as against returned income of Rs. 484,241,580/- computed by the Appellant.

3. The learned AO/Transfer Pricing Officer (“TPO”) erred in making an addition of Rs. 22,865,807 to the total income of the appellant on account of adjustment in the arm’s length price (“ALP”) of one of the international transactions entered by the appellant with its associated enterprises.

4. The learned AO/TPO have erred, in law and in facts, by not accepting the transfer pricing analysis undertaken by the Appellant in accordance with the provisions of the Act read with the Rules, conducting a fresh economic analysis for the determination of the ALP for the impugned international transaction, and holding that the Assessee’s impugned international transaction is not at arm’s length.

5. The learned AO/TPO have erred, in law and in facts, by concluding that the Appellant has not been able to prove substantially that the SAP services have actually been rendered to it, that the Appellant has not derived any economic benefit from the SAP services received from the AE, and thereby holding that the ALP of the SAP service charges is Nil. The Hon’ble DRP, in turn, has erred by overlooking the Appellant’s objections on the subject and in concluding that the benefit derived by the Appellant was remote or indirect.

6. The learned AO/TPO have erred, in law and in facts, by incorrectly and unilaterally applying the Comparable Uncontrollable Price (“CUP”) method for determining the ALP of the impugned international transaction and in not providing the Appellant with an opportunity for evaluating the results of the new economic analysis undertaken before passing the transfer pricing order.

7. The learned AO/TPO have erred, in law and in facts, by concluding that the impugned international transaction is merely a means to siphon off profits from India.

8. The learned AO erred in levying interest of Rs. 112,245 and Rs. 840,878 u/s 234C and 234D of the Act respectively.

9. The learned AO erred, in law and in facts, in initiating penalty proceedings u/s 271(1)(c) of the Act.

The Appellant submits that each of the above grounds is independent and without prejudice to one another.

The Appellant craves leave to add, alter, amend, vary, omit or substitute any of the aforesaid grounds of appeal at any time before or at the time of hearing of the appeal, so as to enable the Hon’ble Tribunal to decide on the appeal in accordance with the law.

3. The assessee is a company. It is engaged in the business of manufacture and trading of pneumatic equipment. The assessee entered into international transactions with its Associated Enterprise (“AE”). Following are the international transactions entered into by the assessee with its AE, who are all non-residents.
International Transaction Amount (in Rs.)
Purchase of Raw materials for manufacture of Pneumatic and didactic Products 56,71,03,735
Purchase of Trading Goods for Resale 42,20,84,287
Purchase of Trading Goods for Resale 42,20,84,287
Sale of Pneumatic Products 10,66,86,944
Import of Equipments 1,12,83,428
SAP Charges Paid 2,28,65,807
Payment for use of exhibition items 15,09,090

4. In this appeal, we are concerned only with the international transaction by which the assessee paid a sum of Rs. 2,28,65,807 to Festo, Germany, an Associated Enterprise, for SAP service charges.

5. In its TP study, the assessee explained the nature of this payment as follows:-

“SAP Service Charges by Festo Germany

In order to achieve the optimum results in its distribution activity worldwide, Festo Group has implemented a standard ERP software namely SAP R/3. In this regard, the cost incurred to implement the software and the on-going cost towards user license and maintenance is allocated to each of the group companies on the basis of use. For the FY 2006-07, Festo Germany has allocated the actual cost incurred in relation to use of such software amounting to Rs.22,865,807 to Festo India.”

6. The stand of the assessee with regard to the charges paid as above as being one at arm’s length price (“ALP”) was as follows:-

“During the prior financial years Festo India has undertaken implementation of the SAP R/3 system for the entire business application such as sales, production, planning, finance support etc, which is directly integrated with the Festo Germany server. This project was a part of global initiative undertaken by Festo Germany, in order to bring about uniformity in the sales and distribution processes across Festo group companies worldwide. Also, as part of the SAP implementation activity, Festo Germany had provided frame relay connectivity and certain software to Festo India.

For the FY 2006-07, Festo Germany has allocated the actual cost incurred in relation to use of such software amounting to Rs. 22,865,807 to Festo India.

The provision of the SAP services by Festo Germany could be classified as a form of “intra-group service” provided by Festo Germany to Festo India. The Indian transfer pricing provisions indicate that provision of intra-group services should be on an arm’s length basis. The provisions, however, do not provide any specific guidance no the factors that need to be considered in determining the arm’s length price for intra group services.

The OECD Guidelines indicate that in an arm’s-length transaction, an independent enterprise normally would seek to charge for services in such a way as to generate profit, rather than providing the services merely at cost. Nonetheless, there are circumstances in which an independent enterprise may not realize a profit from the performance of service activities alone. In such a situation, the Guidelines recognize that an arm’s length price need not always result in a profit for an associated enterprise that is performing an intra-group service. There may be other reasons for the absence of profit to the service provider to satisfy arm’s-length requirements. The market value of intra-group services might, for example, not be greater than the costs incurred by the service provider. This could occur when the service is not an ordinary or recurrent activity of the provider, but the provider offers it incidentally as a convenience to the group.

With respect to the above services Festo India receives a commercial benefit from the services provided by Festo Germany. In the absence of support from Festo Germany, Festo India could have considered either performing the activity “in-house” or outsourcing the same to an independent vendor. Further the services provided by Festo Germany are not integral to its business. Festo Germany provides the service incidentally as a convenience to the group. In view of the guidance provided in the OECD Guidelines, a recovery of costs identifiable to the provision of the service to Festo India by Festo Germany should satisfy the arm’s length requirement.

Festo Germany allocates or apportions the costs pertaining to Festo India without any mark-up. In this regard, Festo India has obtained a management representation letter from Festo Germany stating that the above charges for the implementation activity is based on actual costs incurred by them without any mark-up. Accordingly, the same could be considered as the arm’s length price for the SAP services charged by Festo Germany to Festo India.”

7. The AO referred the determination of ALP in respect of the aforesaid transaction to the TPO u/s. 92CA of the Act. It is not in dispute that except the international transaction under which SAP charges were paid to Festo, Germany, all other international transactions of the Assessee with its AE were considered as at arm’s length by the TPO.

8. As far as international transaction in which SAP charges were paid by the Assessee to Festo, Germany, the AO was of the view that the assessee was not able to demonstrate the services rendered by Festo, Germany for which the payment was made. The conclusions of the TPO on the SAP charges paid to Festo, Germany were as follows:-

1. The taxpayer already paid for SAP implementation in the earlier years.

2. The taxpayer did not produce any evidence regarding the payment made for the SAP implementation by the AE and how it would be quantified at an arm’s length condition. As seen by the TPO, SAP implementation in an independent company with similar number of user licenses costs less than the amount paid by the taxpayer in the earlier years.

3. As per the agreement of the taxpayer with the AE regarding the SAP services, the taxpayer is obliged to pay only those costs that are incurred for providing SAP implementation services. But, the taxpayer already paid for these services during the earlier year i.e. FY 2004-05.

4. The taxpayer could not produce the details and quantum of expenditure spent by the AE in rendering services to the taxpayer in connection with SAP services even though he was asked specifically.

5. Just by describing various services, it will not suffice to justify the price charged in intra group services. The taxpayer is only describing various services rendered by the taxpayer, but did not give the actual amount spent in respect of these services; as such dealing between two independent parties would invariably boils down to the actual expenditure incurred in connection with such services and mark-up thereon.

6. First of all, the taxpayer has to prove that the services are rendered. The taxpayer did not prove substantially. The second aspect of intra group services is the quantification of such services in terms of actual expenditure incurred and commensurate benefits derived there from. This aspect is also not proved by the taxpayer. Even if we assume that the above services are incurred, the quantum of such services would not be to the extent of Rs. 2.28 crores. Moreover, when an expenditure is incurred for the benefit of the group as a whole, no charging of such expenditure is required as such expenditure is not incurred in connection with any individual member of the group and the benefit of such expenditure would be available to all the members of the group.

7. The taxpayer has not shown how such services would be valued by an independent entity dealing in similar circumstances. As discussed above, it is seen that independent companies spent between Rs 1.2 crores to Rs. 2 crores on SAP implementation for similar number of user licenses and the amount for SAP implementation was already paid in the earlier years.

8. The taxpayer’s SAP Service charges is nothing hut siphoning off profits from India with minimum incidence of tax as the taxpayer has paid only 10% when compared to the tax rate of 40% (30% tax + 10% dividend tax) if the same was shown as profits and remitted as dividend.

9. The imports from AEs constitute substantial portion of consumption of raw material/purchases indicating that the AEs are already compensated enough in the form of purchase price and also compensated for the value addition in India by way of royalty paid based on the technology received from AE.

10. The taxpayer did not prove the arm’s length nature of SAP Service charges paid to Festo Controls Pvt. Ltd. USA.

11. The taxpayer did not provide any details regarding how these services are valued between two independent entities dealing in similar circumstances.

Thus the arm’s length price of SAP Service charges paid is worked out as under.
Arms Length Price Rs. Nil
Price charged in the international transactions (Payment made for SAP Services) Rs.2,28,65,807
Excess paid being adjustment u/s 92CA Rs.2,28,65,807

The above excess of Rs. 2,28,65,807/- is being treated as an adjustment to the price shown by the taxpayer in its books of account in respect of payment made for SAP service charges.”

9. It is to be mentioned here that in the earlier financial years, the assessee had made payments for implementation of SAP. The payment made for implementation of SAP modules is different from the SAP charges paid which is the subject matter of this appeal. SAP charges with which we are concerned in this appeal is a maintenance charges paid by the assessee to meet the cost of providing the use of SAP software by the assessee. Reference is being made to this aspect of the matter, because the TPO in his order has taken the payments made for SAP modules by non-related parties for the purpose of comparison. In our view, the comparison so taken by the TPO are on a misapprehension that the payment made by the assessee to Festo, Germany for SAP charges is equivalent to payment for SAP modules, which is not correct.

10. As already seen, the TPO proceeded on the assumption that no services were rendered by Festo, Germany for which SAP charges were paid by the assessee. For this reason and also for the reason that no comparable instances have been provided by the assessee, the TPO treated the entire payment as not at arm’s length. The DRP confirmed the order of the AO rejecting the stand of the assessee that the TPO has no jurisdiction to go into the question as to whether the tax payer received services for which a payment has been made by the tax payer.

11. Before us, the ld. counsel for the assessee submitted that when an a reference is made by the AO to the TPO for determination of ALP of an international transaction, it was not open to the TPO and that he has no jurisdiction to hold that no services were rendered for which payments were made by the assessee and on that ground, the TPO cannot hold that the arm’s length price is NIL. In this regard, the ld. counsel for the assessee placed reliance on the decision of the Mumbai Bench of the ITAT in the case of Castrol India Ltd. v. Asstt. CIT [2013] 29 62. In the aforesaid decision, the TPO treated the ALP as NIL and made the addition of entire payments made by the assessee. On such an approach, the Tribunal held as follows:-

“7. In so far as the allocation/reimbursement of COE3 expenses to the extent of Rs.1,68,80,675/- is concerned, the learned counsel for the assessee has submitted before us that there is no dispute about the fact that significant costs were incurred related to COE3 project deployed by the BP group worldwide and the assessee company as a part of the said group had derived benefit thereof. As submitted by him, the dispute is about the basis of allocation and want of details in this regard. He has submitted that the copies of invoices raised in this regard by the AEs were furnished by the assessee along with respective allocation keys. Keeping in view this submission made by the learned counsel for the assessee as well as on perusal of the relevant details available on record, we agree with the contention of the learned counsel for the assessee that there is no justification in the action of the TPO in ignoring all these details and taking the ALP of the relevant transactions at Nil. In our opinion, it is incumbent upon the TPO to work out the ALP of the relevant transactions by following some authorized method and the entire cost borne by the assessee cannot be disallowed by taking the ALP at Nil keeping in view the facts and circumstances of the case and the relevant details furnished by the assessee. The learned counsel for the assessee in this regard has submitted that in the subsequent years i.e. assessment years 2005-06 and 2006-07, a similar issue was involved in the assessee’s case and the learned CIT(Appeals) has allowed the expenses allocated to the extent of 50%. We have perused the orders of the learned CIT(Appeals) passed in the assessee’s case for assessment years 2005-06 and 2006-07. It is noted that no convincing or sound basis has been given by the learned CIT(Appeals) therein in support of the 50% cost allocation accepted by him and such estimate has been made purely on adhoc basis. In our opinion, the exercise of ascertaining ALPs has to be done by the TPO keeping in view the well laid down scheme in the relevant provisions of the Act and addition, if any, on account of TP adjustment, has to be made only after doing such exercise. We, therefore, restore this issue to the file of the AO/TPO with a direction to do such exercise and make addition, if any, on this issue after completing such exercise in accordance with law. Ground No.2 of the assessee’s appeal is accordingly treated as allowed for statistical purposes.”

12. Our attention was also drawn to the decision of the Hon’ble Delhi High Court in the case of CIT v. EKL Appliances Ltd. [2012] 209 . In the aforesaid decision, the assessee entered into an agreement pursuant to which it paid brand fee/ royalty to an associated enterprise. The TPO disallowed the payment on the ground that as the assessee was regularly incurring huge losses, the know-how/ brand had not benefited the assessee and so the payment was not justified. This was reversed by the CIT (A) & Tribunal on the ground that as the payment was genuine, the TPO could not question commercial expediency. On appeal by the department, the Hon’ble Delhi High Court held that the “transfer pricing guidelines” laid down by the OECD make it clear that barring exceptional cases, the tax administration cannot disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the associated enterprises. The guidelines discourage re-structuring of legitimate business transactions except where (i) the economic substance of a transaction differs from its form and (ii) the form and substance of the transaction are the same but arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner. The OECD guidelines should be taken as a valid input in judging the action of the TPO because, in a different form, they have been recognized in India’s tax jurisprudence. It is well settled that the revenue cannot 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 assessee can incur (Eastern Investment Ltd. v. CIT [1951] 20 ITR 1 (SC), CIT v. Walchand & Co [1967] 65 ITR 381 (SC) followed). Even Rule 10B(1)(a) does not authorise disallowance of expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same.

13. In light of the aforesaid decisions, it was submitted that the approach of the TPO is not proper and the same should be held as not valid in law.

14. The ld. DR relied on the order of the TPO.

15. We have considered the rival submissions and are of the view that the stand taken by the assessee in this regard deserves to be accepted. It is clear from the decisions referred to above that the TPO has to work out the ALP of the international transaction by applying the methods recognized under the Act. He is not competent to hold that the expenditure in question has not been incurred by the assessee or that the assessee has not derived any benefits for the payment made by the assessee and therefore he cannot consider the ALP as NIL. We hold accordingly.

16. As far as the determination of ALP is concerned, we have already reproduced in the earlier part of this order that the TP study done by the assessee in support of the ALP. We are of the view that the TP study so done by the assessee does not give out any comparable instances of similar transactions between the unrelated parties. As far as the determination of ALP under the Act is concerned, the provisions lay down that the assessee has to adopt one of the methods laid down in section 92C(1) of the Act. The assessee has to substantiate the price that is paid to its AE as at Arm’s Length within one of the methods so prescribed. As already noticed, the TP study of the assessee is not in tune with the provisions of section 92C of the Act. Multinationals have a long-standing practice of providing certain services from a central point to one or more affiliates. The parent company provides centralized services or one affiliate provides services on a central basis to several other affiliates. In these situations, cost contribution (or shared-service) arrangements can be constructed to charge the costs of the service providers to the affiliates that benefit from the services they provide. As the unique bundle of services provided may vary significantly between taxpayers, it may be difficult to find a comparable price for such services or to evaluate the benefit received. Tax authorities therefore regard the area of cost sharing arrangement as prone to potential abuse. At the same time, the increasingly competitive global marketplace is demanding greater efficiency from multinational businesses. They must take every opportunity to minimise costs, so there is an ever greater need to arrange for the centralisation of business functions where possible. It is vital to establish the following:

¢ The exact nature of the services that are to be performed;

¢ Which entities are to render the services;

¢ Which entities are to receive the services; and

¢ What costs are involved in providing the services.

Once these facts are known, consideration can be given to selecting the basis for charging the recipient group companies. Sufficient evidence of costs involved and services actually rendered should be provided. The Assessee is also required to prove that benefit is derived from the services received and that such benefits are of a more than just remote or indirect benefit.

17. In the course of hearing, it was suggested that the cost of providing SAP charges by Festo, Germany to all entities of the Festo group worldwide and the basis of allocation of cost by Festo, Germany to various group entities across the world should be submitted by the assessee with a view to enable the TPO to ascertain as to whether there has in fact been any profit element involved or was it a case of mere reimbursement of actual cost incurred for the Assessee by the parent company. The stand of the assessee has been that the payment was merely reimbursement of cost and in this regard attention was drawn to invoices before us. These invoices are the invoices raised by Festo, Germany on other group entities in other parts of the world. The ld. counsel has also sought to file before us a chart regarding the benefits that the assessee received by paying the SAP charges and also that the payment was reimbursement of cost. In our view, these submissions require a fresh consideration by the TPO in the light of the observations made by us as above. We are therefore of the view that it would be just and proper to set aside the order of the Assessing Officer on this issue and remand the question of determination of ALP to the TPO for fresh consideration. It is made clear that the TPO shall not take into consideration the payments made for SAP modules which are not the subject-matter of the international transactions which is in dispute in this appeal. The assessee is also directed to file the TP study which is in accordance with the provisions of the Act and substantiate that the price paid by it to Festo, Germany is at arm’s length within the methods laid down in the Act. The TPO will consider the same in accordance with the law, after affording an opportunity of being heard.

18. The appeal of the assessee is accordingly treated as allowed for statistical purposes.

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