Transfer pricing: A. Y. 2006-07: The Assessing officer cannot substitute the method of ‘cost plus mark up’ with the method of ‘cost plus mark up on FOB’ value of exports without establishing that assessee bear significant risks or AEs would enjoy geographical benefits

Li and Fung India (P.) Ltd. vs. CIT; [2013] 40 taxmann.com 300 (Delhi):

The assessee, ‘LFIL’, entered into an agreement with its associate enterprise (‘AE’) for rendering sourcing support services for the supply of high volume, time sensitive consumer goods, for which it was remunerated at cost plus mark-up of 5 %.; During the course of Transfer Pricing assessment, the assessee contended that such a transaction was at Arm’s Length Price (‘ALP’) on an application of the TNM method. The Transfer Pricing Officer (‘TPO’) observed that assessee was performing all critical functions, had assumed significant risks and it had used both tangible and unique intangibles developed by it over a period of time, which had given an advantage to the AE in form of low cost of product, quality and had enhanced the profitability of AE. Thus, it held that the compensation of cost plus mark up of 5 % was not at ALP and applied a mark-up of 5 % on the FOB value of exports made by the Indian manufacturer to overseas third party customers. Therefore, the Assessing Officer made addition on the basis of order passed by TPO, which was further affirmed by the Tribunal

On appeal by the assessee, the Delhi High Court reversed the decision of the Tribunal and held as under:

“i) The impugned order had not shown how and to what extent assessee bore significant risks, or that the AE enjoyed such location advantages, so as to justify rejection of the Transfer pricing exercise undertaken by assessee.

ii)    Tax authorities should base their conclusions 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 reasons, based on facts and the relative evaluation of their weight and significance.

iii)    Where all elements of a proper TNMM are detailed and disclosed in the assessee’s reports, care should be taken by the tax administrators and authorities to analyse them in details and then proceed to record reasons why some or all of them are unacceptable;?

iv)    The impugned order, upholding the determination of certain margin over the FOB value of the AE’s contract, was an error in law. Therefore, the TPO’s addition of the cost plus 5 % markup on the FOB value of exports was without foundation and was to be deleted.”