Indian tribunal rules on entity characterization for transfer pricing purposes

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1 1 February 2012 International Tax Alert News and views from Transfer Pricing Indian tribunal rules on entity characterization for transfer pricing purposes Executive summary In a recent ruling, the Ahmedabad Bench of the Income-tax Appellate Tribunal (Tribunal), in the case of AIA engineering Ltd (Taxpayer) had to consider whether the Taxpayer s associated enterprise (AE) that was engaged in sales and marketing of the Taxpayer s goods outside India should be characterized as a distributor or as a marketing service provider for transfer pricing (TP) purposes. The Taxpayer had characterized the AE as a distributor and had used the AE s net operating profit margin (NOPM) as the profit level indicator (PLI) for testing the arm s length nature of the international transactions using the Transactional Net Margin Method (TNMM). The Tax Authority rejected this approach and characterized the AE as a marketing service provider and was of the view that the AE should be earning only a mark-up on its value added costs. The Tribunal held that there is a proper distribution agreement entered into between the Taxpayer and the AE, which has been adhered to with the AE performing all the functions of a distributor as well as bearing the credit risk and inventory risk. Accordingly, it cannot be regarded as a marketing service provider but should be regarded a distributor as rightly characterized by the Taxpayer. Background The Taxpayer is engaged in the business of manufacturing of grinding media, liners for mills, diaphragms, hammers and crushers, heat resistant cast steel, vertical spindle mill pares and mill control systems. The Taxpayer has three overseas AEs, namely, Vega UK, Vega USA and Vega UAE. The Taxpayer primarily sells its products in the domestic market whereas marketing and distribution of its products in the international markets is undertaken by AEs in their respective geographies. The Taxpayer had characterized Vega UAE as a distributor. The Taxpayer had

2 also paid a commission to Vega UK for sales support services. In determining the arm s length nature of the international transactions, the Taxpayer had considered the AEs as the tested party. During the course of TP audit, the Tax Authority made an adjustment with respect to the sales made by the Taxpayer to Vega UAE and with respect to commission paid to Vega UK. The Taxpayer filed its objections against these adjustments before the Dispute Resolution Panel (DRP). However, the DRP upheld the adjustments made and rejected the Taxpayer s objections. Aggrieved by this, the Taxpayer undertook an appeal before the Tribunal. Tax Authority s argument The Tax Authority rejected the TP analysis conducted by the Taxpayer on the basis that Vega UAE was not a distributor, but only a marketing service provider and hence the comparables chosen by the Taxpayer were those whose functions and risk profiles were not similar to that of Vega UAE. As a service provider, Vega UAE should be earning a mark-up on its value added costs. The Tax Authority considered the net operating margins of Vega USA determined using a PLI of operating profit to operating cost (OP/OC) as the arm s length price (ALP). The adjustment was made having regard to the difference in the net margins of Vega UAE and Vega USA. The TPO based his conclusion on the following reasoning: Vega UAE does not have the inventory risk as the products on certain occasions are being dispatched directly by the Taxpayer to the end customers and Vega UAE does not have any warehousing facility of its own. Vega UAE does not bear any credit risk as amounts are being paid to the Taxpayer after realization of revenues by Vega UAE from sales made to end customers. Manpower of Vega UAE has been created by the Taxpayer by transferring part of its own employees and Vega UAE does not have any personnel to look after the distribution and logistics but consists only of technical persons. Vega UAE does not have capacity to handle technical issues and final pricing. In relation to the commission paid by the Taxpayer to Vega UK, the Tax Authority made a downward adjustment on the grounds that Vega UK had not carried out all the functions related to commission earning activities and the geographic territory for its operations had also not been clearly assigned to it. In recomputing the ALP of the payment of commission made to Vega UK, the TPO again compared the net margins of Vega USA with Vega UK. The Tax Authority also observed that the focus of determining TP is on the reasonableness of the result and not the details of methodology employed and if comparability and reliability level is high, transactions with related parties can be regarded as comparable transactions. Taxpayer s argument The difference in the gross and net profit margins of various Vega entities is because of the difference in the ultimate sale price and level of operating expenses and not for the reason that different purchase price had been paid to the Taxpayer. The activities carried out by various Vega entities in their respective jurisdictions include: (a) estimation of market size and sales forecast; (b) customer visits; (c) quotation / offer to the customer; (d) interaction with customers for pricing and performance of products; (e) customer order/ contract; (f) supply of material; (g) installation of product and (h) billing and collection. Thus they carried out all the functions of a distributor. In relation to the distribution arrangement, the Taxpayer had entered into an intercompany distributor agreement with Vega UAE. Some of the key terms of the intercompany agreement are as follows: Sales made by the Taxpayer to Vega UAE are on a free on board (FOB) basis and once the goods leave the Indian customs station, the inventory risk with regard to the said goods are borne by Vega UAE and even the insurance cost for covering the risks associated with the transit of goods up to the customers chosen destination are borne by Vega UAE. 2 International Tax Alert Transfer Pricing

3 The Taxpayer is responsible to replace/repair defective products manufactured by it only if it receives intimation from Vega UAE that the Taxpayer s products are defective within a period of two weeks after the date of delivery to Vega UAE and/or the end customer. If Vega UAE is unable to intimate the defects in such products within such time, then it is exposed to inventory risk. Vega UAE is responsible for all the payments from its customers and hence, credit risk and risk of bad debts, if any, is by Vega UAE. Based on the above, The Taxpayer contended that the role of Vega UAE was of a distributor for its products as defined by way of a proper and validly executed agreement and it had also demonstrated consistency with the DA in its conduct with Vega UAE. Since the title to the goods actually passes to Vega UAE on their delivery at Indian ports on FOB basis, the fact that goods are being dispatched directly to some customers in keeping with commercial and industry practices is not determinative and does not support the incorrect re-characterization of Vega UAE as a marketing service provider. The financials of Vega UAE were produced to demonstrate that it functions as a distributor and has consistently shown purchases, sales and inventories and also provided for bad debts, when occasioned, demonstrating that it bears credit risk and bad debts risk as well. Ruling of the Tribunal The Tribunal rejected the contentions of the Tax Authority and held that the Taxpayer has executed a proper distributor agreement with Vega UAE and has adhered to the same. Also, on facts, Vega UAE is carrying both inventory risk, credit risk/risk of bad debts. Accordingly, Vega UAE is not a marketing service provider but is a distributor of the Taxpayer. It also observed that once it is accepted that Vega UAE is a distributor, ALP has to be determined on the basis of profit on sale of goods by the Taxpayer compared to the comparable companies. Based on the computation of net operating profit margins (NOPM) of the Taxpayer and the comparable companies furnished by the Taxpayer, the Tribunal held that the NOPM of the Taxpayer is at arm s length. It also considered the alternative working provided by the Taxpayer wherein it was demonstrated that the intercompany transactions are at arm s length with regard to the net margin of Vega US, Vega UK and Vega UAE and comparable companies. Based on the results under both the alternatives, the Tribunal held that the adjustments made by the Tax Authority are to be deleted. Further, in relation to considering the net margins of Vega USA as the arm s length margin, the Tribunal held that in doing so, it has to be kept in mind that the PLI of OP/OC depends on the level of operating expenses incurred by the respective entity and also the quantum of revenues generated by each of them. If the operating expenses of Vega USA are higher, it cannot be said that the profit margin of Vega UK and Vega UAE should be at par with the profit margin of Vega US. Accordingly, it struck down the approach of the Tax Authority of considering the net margins of Vega USA as the arm s length margin for comparability purposes. Citing similar reasons, the Tribunal also struck down the TP adjustment made by the TPO in relation to commission paid to Vega UK. Comments A crucial first step in a TP analysis is examination of the economically significant functions performed, risks assumed, and assets used by each party to the transaction. While the focus is often on actual functions performed, the importance of a detailed analysis of the relative risks assumed by each party should not be underestimated. These risks often account for key differences between the Taxpayer s business and the comparable benchmark. In addition, risk analysis is central to selection and application of the transfer pricing methods. This ruling emphasizes the importance of proper documentation of the allocation of risks between AEs and the adherence to the same for the purpose of determining the appropriate characterization of entities for transfer pricing purposes. The ruling also demonstrates that proper documentation of the risk allocation is a key component of a Taxpayer s defense in an audit. International Tax Alert Transfer Pricing 3

4 For additional information with respect to this Alert, please contact the following: Ernst & Young Private Limited, India Rajendra Nayak, Bangalore Vijay Iyer, New Dehli Ganesh Pai, Bangalore Adithya Shenoy, Bangalore rajendra.nayak@in.ey.com vijay.iyer@in.ey.com ganesh.pai@in.ey.com adithya.shenoy@in.ey.com International Tax Alert Transfer Pricing

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