Perfetti Van Melle India Pvt. Ltd., ... vs Assessee

Assessee By : Shri Vijay Iyer, CA, Shri Gagandeep Nagpal, Shri Nitin Jain & Shri Karan Bhatia Department By : Shri A. Vasanthan, Sr. DR

Date of Hearing : 01.06.2015 Date of Pronouncement : 02.06.2015

ORDER PER R.S. SYAL, AM:

This appeal by the assessee is directed against the final order

passed by the Assessing Officer (AO) on 5.1.2015 u/s 143(3) read with ITA No.407/Del/2015 section 144C of the Income-tax Act, 1961 (hereinafter also called 'the

Act') in relation to the assessment year 2010-11.

2. The only issue raised in this appeal is against the addition of

Rs.180,63,50,055/- made by the AO on account of transfer pricing

adjustment towards Advertising, Marketing and Promotion (AMP)

expenses.

3. Briefly stated, the facts of the case are that the assessee, an Indian

company, is a subsidiary of PVM. It is engaged in manufacturing a

variety of confectionary products from its factories in Tamil Nadu,

Haryana and Uttarakhand. The product brands of the assessee include

Big Babool, Alpenlibe, Center Fresh, Center Fruit, Center Shok, Chater

Patar, Chlor-mint, Choco-tella, Cofitos, Happydent White, Protex

Happydent, Marbels, Mentos, etc. The assessee reported 14

international transactions, which have been enlisted on page 2 of the

order passed by the Transfer Pricing Officer (TPO). The assessee

employed the Transactional Net Margin Method (TNMM) in respect of

six international transactions; the Comparable Uncontrolled Price

2 ITA No.407/Del/2015

(CUP) method in respect of three transactions; Cost Plus Method in

respect of one international transaction; and no method for four

international transactions of Reimbursement of expenses by AEs,

Reimbursement of SAP licence, Reimbursement of IT support services

and Reimbursement paid to AEs. On a reference made by the AO for

determining the arm's length price (ALP) of the international

transactions, the TPO accepted all the reported international transactions

at ALP. He, however, noticed that the assessee incurred Advertisement,

Marketing and Promotion (AMP) expenses to the tune of

Rs.183,73,82,000/-. To determine the ALP of the international

transaction of AMP expenses, the TPO chose certain comparable

companies. By applying the bright line test, he worked out the non-

routine AMP expenses in excess of bright line at Rs.152.61 crore.

Adding mark-up of 18.36%, he worked out a transfer pricing adjustment

of Rs.180,63,50,055. The assessee remained unsuccessful before the

Dispute Resolution Panel (DRP). Eventually, the AO, vide his final

order, made an addition for a sum of Rs.180.63 crore and odd on this

issue. The assessee is in appeal before us against this addition. 3 ITA No.407/Del/2015

4. We have heard the rival submissions and perused the relevant

material on record. It is an admitted position that the assessee under

consideration is a `Manufacturer' and not a `Distributor' (high or low/no

risk). The Special Bench of the Tribunal in the case of LG Electronics

India Pvt. Ltd. Vs. ACIT (2013) 152 TTJ (Del) 273 (SB), by its majority

decision, without drawing any distinction between manufacturers and

distributors, has held, inter alia, that AMP is a transaction and also an

international transaction within the meaning of section 92B of the Act

and that the TPO has jurisdiction to compute the ALP of this

international transaction despite the same not having been specifically

referred by the AO. On the question of determination of the ALP of this

international transaction, the Special bench approved the application of

bright line test for working out the amount of non-routine AMP

expenses and held that the ALP of AMP expenses should be determined

on Cost plus method by treating AMP transaction as a separate and

distinct from other international transactions. It further held that the

selling expenses directly incurred in connection with the sales do not

lead to brand promotion and hence should not be brought within the 4 ITA No.407/Del/2015

overall ambit of AMP expenses. The Special bench laid down certain

parameters to be taken into consideration for determining the ALP of

AMP expenses. In the ultimate analysis, the matter was sent back to the

TPO/AO for undertaking the exercise afresh in the light of its directions.

5. Following the said special bench order, various benches of the

Tribunal decided several cases involving AMP expenses, restoring the

matter to the file of AO/TPO for deciding this issue in conformity with

the directions given by the Special Bench in LG Electronics (supra).

Several assessees as well as the Revenue preferred their respective

appeals before the Hon'ble High Courts against the tribunal orders

following the Special bench order. A batch of appeals in relation to

`Distributors' (not Manufacturers) led by Sony Ericson Mobile

Communications India Pvt. Ltd. Vs. CIT has been disposed of by Their

Lordships of the Hon'ble Delhi High Court, delivering judgment on 16th

March, 2015, upholding the majority view of Special Bench in LG

Electronics (supra) treating AMP as an international transaction and also

conferring jurisdiction in the TPO to determine the ALP of the

5 ITA No.407/Del/2015

international transaction of AMP expenses. Dealing with the

computation of ALP of such transactions by a Distributor, the Hon'ble

High Court has held, inter alia, that the international transaction of AMP

expenses should be bundled/aggregated with other international

transaction carried out by the assessee as a distributor, who either simply

acts an agent of manufacturer or purchases goods from the manufacturer

for resale at his own account. The Hon'ble High Court held that where

the TNMM has been applied as the most appropriate method by a

Distributor, which method has not been disturbed by the TPO, then, the

international transaction of AMP and distribution activities should be

clubbed. It further held that for determining the ALP of such

transactions under a combined approach, only such comparables should

be chosen which conform to the AMP functions and other distribution

functions conducted by the assessee. If there is some difference in the

functions under these international transactions, including that of AMP,

between the assessee and the comparables, then, suitable adjustment

should be made to bring both the transactions at par. If probable

comparables are not performing similar functions as done by the 6 ITA No.407/Del/2015

assessee and no adjustment is possible for bringing the international

transactions of the assessee in an aggregate manner at par with those

undertaken by the comparables, then, segregation should be done and

the international transaction of AMP spend should be separately

processed under the transfer pricing provisions for the purposes of

determining its ALP separately. In such a determination of ALP of

AMP expenses in a segregated manner, proper set off on account of

excess purchase price adjustment should be allowed. The view taken by

the Special bench of the Tribunal in segregating routine and non-routine

expenses on the basis of bright line test has been set aside by the

Hon'ble High Court. Further, the decision taken by the Special Bench to

the effect that the expenses concerned with the sales, such as, rebates

and discounts etc., should be excluded from the ambit of AMP expenses,

has been upheld.

6. We can summarize the relevant position emanating from the

judgment of the Hon'ble High Court, as under : -

7 ITA No.407/Del/2015

AMP expense is an international transaction [Paras 52 & 53 of

the judgment] ;

The TPO has jurisdiction to determine the ALP of the

international transaction of AMP expenses [Para 50 of the

judgment];

Inter-connected international transactions can be aggregated and

section 92(3) does not prohibit the set-off [Paras 80 & 81];

AMP is a separate function. An external comparable should

perform similar AMP functions. [Paras 165 &166] ;

Bright line test cannot be applied to work out non-routine AMP

expenses for benchmarking [Para 194(x)];

ALP of AMP expenses should be determined preferably in a

bundled manner with the distribution activity [Paras 91, 121 &

others] ;

For determining the ALP of these transactions in a bundled

manner, suitable comparables having undertaken similar activities

of distribution of the products and also incurring of AMP

expenses, should be chosen [Paras 194(i), (ii), (viii) & others]; 8 ITA No.407/Del/2015

The choice of comparables cannot be restricted only to domestic

companies using any foreign brand [Para 120] ;

If no comparables having performed both the functions in a

similar manner are available, then, suitable adjustment should be

made to bring international transactions and comparable

transactions at par [Para 194 (iii)] ;

If adjustment is not possible or comparable is not available, then,

the TNMM on entity level should not be applied [Paras 100, 121,

194(iii) & (vi)] ;

In the above eventuality, international transaction of AMP should

be viewed in a de-bundled manner or separately [Paras 121&

194(xi)] ;

In separately determining the ALP of AMP expenses, the TPO is

free to choose any other suitable method including Cost plus

method [Para 194(xiii)];

In so making a TP adjustment on account of AMP expenses, a

proper set off/purchase price adjustment should be allowed from

the other transaction of distribution of the products [Para 93] ; 9 ITA No.407/Del/2015

Selling expenses cannot be considered as part of AMP expenses

[Paras 175 & 176 of the judgment].

7. The bright line test, disapproved by the Hon'ble High Court,

primarily concentrates on the quantitative aspects of the AMP expenses

alone. It overlooks the examination of the AMP functions carried out by

the assessee on one hand and the comparables on the other. The

Hon'ble High Court in Sony Ericson Mobile (supra), has held that AMP

expense is a separate international transaction and also bright line test is

not applicable for determining the ALP of AMP expenses. The manner

for the determination of the ALP of the distribution activity and AMP

activity has also been set out by the Hon'ble High Court to be

conducted, firstly, in a bundled manner by considering the distribution

and AMP functions performed by the assessee as well as the probable

comparables, and if probable comparables having performed both the

functions are not available, then to determine the ALP of AMP expenses

in a segregated manner. As such, it becomes immensely important to

separately examine the Distribution activity and AMP functions

10 ITA No.407/Del/2015

undertaken by the assessee as well as probable comparables. It is vital to

highlight the difference between the AMP expenses and AMP functions.

Whereas the AMP functions are the means by which the AMP activity is

performed, the AMP expenses are the amount spent on the performance

of such means (functions). To put it simply, an examination of AMP

functions carried out by the assessee and the probable comparables is

sine qua non in the process of determination of the ALP of the

international transaction of AMP spend, either in a segregate or an

aggregate manner. What Their Lordships have held is to bundle the

distribution activity with the AMP activity, being two separate but

connected international transactions, for the purposes of determination

of the ALP of both these international transactions in a combined

manner.

8. The ld. AR argued that the assessee applied TNMM in respect of

export of raw materials/finished goods and import of raw material from

manufactured stock/finished goods. He submitted that since the profit

margin declared by the assessee from such international transactions

11 ITA No.407/Del/2015

favourably compared with the average margin of the comparables,

which fact has not been disputed by the TPO, no adjustment should be

made on account of AMP expenses because such expenses stand

subsumed in the overall operating profit. The argument of the ld. AR, if

taken to a logical conclusion, will make the AMP spend a non-

international transaction, which, in our considered opinion, is contrary to

the verdict of the Hon'ble Delhi High Court in Sony Ericsson (supra).

Once AMP expense has been held to be an international transaction, it

is, but, natural that the functions performed by the assessee under such a

transaction need to be compared with similar functions performed by a

comparable case. If AMP functions performed by the assessee turn out

to be different from those performed by a probable comparable

company, then, an adjustment is required to be made so as to bring the

AMP functions performed by the assessee as well as the comparable, at

the same pedestal. If we concur with the contention of the ld. AR that

the addition on account transfer pricing adjustment of AMP expenses be

deleted without any examination of the AMP functions carried out by

the assessee as well as comparables, this will amount to snatching away 12 ITA No.407/Del/2015

the tag of international transaction from AMP expenses, assigned by the

Hon'ble High Court. What Their Lordships have held in the judgment is

that the distribution activity and AMP expenses are two separate but

related international transactions. It is only for the purposes of

determining their ALP that these two should be aggregated. The process

of such aggregation does not take away the separate character of the

AMP transaction, albeit related. An analysis and examination of the

distribution and AMP functions carried out by the assessee must be

necessarily done in the first instance, which should be then compared

with similar functions performed by some probable comparables. If the

distribution and AMP functions performed by the assessee turn out to be

different from those performed by probable comparables, then, a suitable

adjustment should be made to the profits of the comparable so as to

counterbalance the effect of such differences. If however differences

exist in such functions, but no adjustment can be made, then, such

probable comparable should be dropped from the list of comparables. If,

in doing this exercise, there remains no company doing comparable

distribution and AMP functions, then, both the international transactions 13 ITA No.407/Del/2015

are required to be segregated and then examined on individual basis by

finding out probable comparables doing such separate functions

similarly. For the international transaction of AMP spend, this can be

done by, firstly, seeing the AMP functions actually performed by the

assessee and then comparing it with the AMP functions performed by a

probable comparable. If both are found out to be similar, then the matter

ends and a comparable is found and one can go ahead with determining

the ALP of such a transaction. If the AMP functions performed by the

two entities are found to be different, then adjustment is required to be

made in the case of a probable comparable, so as to make it uniform

with the assessee. The assessee may have possibly done, say, four

different AMP functions as against the probable comparable having

done, say, only three. In such a scenario, again the adjustment will be

warranted. In another situation, the AMP functions performed by the

assessee and probable comparable may be similar but with varying

standards, which will also call for an adjustment. Crux of the matter is

that the AMP functions performed by the assessee must be similar to

those done by the comparable, in the same manner as such functions are 14 ITA No.407/Del/2015

compared in any other international transaction. However, in computing

ALP of AMP spend, the adjustment or set off, if any, available from the

distribution function, should be allowed. The essence of the judgment in

the case of Sony Ericson Mobile (supra) is that the two international

transactions of Distribution and AMP should be examined on the

touchstone of transfer pricing provisions, but on an aggregate basis.

Determining the ALP of two transactions in an aggregate manner

postulates making a comparison of both the functions of distribution and

AMP carried out by the assessee with the comparables, so that surplus

from the distribution activity could be adjusted against the deficit in the

AMP activity. The Hon'ble High Court has no where laid down that the

AMP functions performed by the assessee should not be compared with

those performed by the comparable parties. On the contrary, it turned

down the contention raised by the ld. AR urging for not treating AMP as

a separate function, which is apparent from the extraction from para 165

of the judgment : `On behalf of the assessee, it was initially argued that

the TPO cannot account for or treat AMP as a function. This argument

on behalf of the assessee is flawed and fallacious for several reasons. 15 ITA No.407/Del/2015

There are inherent flaws in the said argument'. It held vide para 165 of

the judgment that : `An external comparable should perform similar

AMP functions.' Thus it is manifest that comparison of AMP functions

is vital which cannot be dispensed with. Let us we go a step further with

the alternative prescription of the judgment that if ALP of both the

transactions of Distribution and AMP cannot be determined in a

combined manner, then the ALP of AMP function should be separately

done. The submission advanced by the assessee of considering the

profit on an entity level without making comparison of AMP functions

done by the assessee as well as the comparable, will render this

alternative approach incapable of compliance. Canvassing such a view

as argued on behalf of the assessee amounts to treating AMP spend as a

non-international transaction, which is patently incapable of acceptance.

The fact remains that as per the verdict of the Hon'ble High Court, the

AMP spend is an international transaction, which is required to be

processed under Chapter X of the Act by taking into account the AMP

functions performed by the assessee and then comparing such functions

with those performed by comparable entities. This can be done only by 16 ITA No.407/Del/2015

mandatorily making a comparison of the AMP functions performed by

the assessee and comparables and then making an adjustment, if any,

due to differences between the two, so that the AMP functions

performed by the assessee and comparable are brought to a similar

platform. In fact, this is also the prescription of Rule 10B(1)(e), which

provides as under :-

` (e) transactional net margin method, by which,--

(i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base ;

(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base ;

(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market ;

(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii) ;

17 ITA No.407/Del/2015 (v) the net profit margin thus established is then taken into account to arrive at an arm's length price in relation to the international transaction.'

9. A perusal of the sub-clause (iii) of this Rule divulges that net profit

margin under a comparable uncontrolled transaction as determined

under sub-clause (ii) should be: "adjusted to take into account the

differences, if any, between the international transaction and the

comparable uncontrolled transactions." It is only such adjusted net

profit margin in sub-clause (iii) of Rule 10B(1)(e) which is compared

with the net profit margin realized by the assessee as per the mandate of

sub-clause (iv) of Rule 10B(1)(e).

10. Sub-rule (2) of Rule 10B provides that 'for the purposes of sub-

rule (1)', the comparability of an international transaction with an

uncontrolled transaction shall be judged with reference to the following,

namely -- (a) the specific characteristics of the property transferred or

services provided in either transaction ; (b) the functions performed,

taking into account assets employed or to be employed and the risks

assumed, by the respective parties to the transactions ; (c) the contractual

18 ITA No.407/Del/2015

terms (whether or not such terms are formal or in writing) of the

transactions which lay down explicitly or implicitly how the

responsibilities, risks and benefits are to be divided between the

respective parties to the transactions ; (d) conditions prevailing in the

markets in which the respective parties to the transactions operate,

including the geographical location and size of the markets, the laws and

Government orders in force, costs of labour and capital in the markets,

overall economic development and level of competition and whether the

markets are wholesale or retail. Sub-rule (3) of Rule 10B stipulates that

an uncontrolled transaction shall be comparable to an international

transaction if (i) none of the differences, if any, between the

transactions being compared, or between the enterprises entering into

such transactions are likely to materially affect the price or cost charged

or paid in, or the profit arising from, such transactions in the open

market ; or (ii) reasonably accurate adjustments can be made to

eliminate the material effects of such differences.

19 ITA No.407/Del/2015

11. A comparative study of sub-rules (1), (2) and (3) of Rule 10B

makes it palpable that the international transaction and the uncontrolled

transaction with which comparison is sought to be made for determining

the ALP, in the first instance, must have overall similar characteristics.

It is vivid that if the goods/services are different, then no effective

comparison can be made. Once the goods/services under both the

transactions are broadly similar but there is a difference in them because

of certain specific characteristics; and/or the products/services in both

the transactions are identical, but still there are certain differences due to

the contractual terms or the geographical location etc., then, a

reasonably accurate adjustment should be made for eliminating the

material effects of such differences so as to bring the international

transaction and the comparable uncontrolled transaction on the same

podium. If due to one reason or the other, no reasonable accurate

adjustment can be made due to such differences, then, such uncontrolled

transaction should not be considered as a comparable transaction.

20 ITA No.407/Del/2015

12. It is discernible that the prescription of Rule 10B is in complete

harmony with the ratio of the judgment in the case of Sony Ericson

Mobile (supra), to the effect that the AMP functions carried out by the

assessee are required to be necessarily compared with the AMP

functions carried out by a comparable entity in determining the AMP of

ALP expenses. Difference between the functions, if capable of

adjustment, should be given effect to in the profit rate of the comparable

and if such difference cannot be given adjusted, then, the probable

comparable should be eliminated.

13. We have noticed above that the assessee is a `Manufacturer' and

not a `Distributor'. The judgment in the case of Sony Ericson Mobile

(supra) deals with a case of Distributor, though the initial discussion

about the character of AMP spend as an international transaction and the

jurisdiction of the TPO etc. are common to a distributor and also a

manufacturer. Similarly there are some other observations in this

judgment, which are common to both. Though this judgment lays down

at length some broader principles for the determination of ALP of AMP

21 ITA No.407/Del/2015

expenses in the case of a `Distributor', still certain principles dealing

exclusively with the determination of the ALP of AMP expenses in the

case of a `Manufacturer', have also been laid down. Such discussion has

been made in para 92 of the judgment, the relevant part of which is

reproduced here as under : -

`92. The majority judgment refers to an example where the Indian AE may have earned actual profit of Rs.140/-, but returned reduced net profit of Rs.120/- as the Indian AE had incurred brand building expenses to the tune of Rs.20/- for the foreign AE, whereas the net profit on sales declared by comparable uncontrolled transactions was Rs.100/- only. Thus, it was observed that the costs including AMP expenses are independent of cost of imported raw material/finished products having some correlation with overall profit. The example highlights the weakness of the TNM Method. The reasoning would be equally valid, where no AMP or ‗brand building' expenses are incurred. (See paragraph 21.8 to 22.10 of the majority decision). The net profit margins can be affected by variation of operating expenses. Thus, the requirement to select appropriate comparable and adjustment. It would be inappropriate and unsound to accept comparables, with or without adjustment and apply TNM Method, and yet conjecturise and mistrust the arm's length price. TNM Method would not be the most appropriate method when there are considerable value additions by the subsidiary AEs. In paragraph 22.9, the majority decision has observed that all costs including the AMP expenses are independent of cost of material. This indicates that the observations have been made with reference to manufacturing activities. It would not be appropriate and proper to apply the TNM Method in case the Indian assessed is engaged in manufacturing activities and distribution and marketing of imported and manufactured products, 22 ITA No.407/Del/2015

as interconnected transactions. Import of raw material for manufacture would possibly be an independent international transaction viz. marketing and distribution activities or functions. We have earlier used the term `plain vanilla distributor'. When we use the words `plain vanilla distributor' we do not mean plain vanilla situations, but value additions and each party making valuable unique contribution.'

14. It is discernible from the italicized part of the above para that the

application of TNM Method is not appropriate and proper in case the

assessee is engaged in manufacturing activities. In such circumstances,

the import of raw material for manufacture would be an independent

international transaction viz. marketing and distribution activities or

functions. The core of the above para is that in the case of a

`Manufacturer', the international transactions concerned with the

manufacturing activity cannot be aggregated with the AMP activities as

both are separate and distinct. Once both are held to be separate and

TNMM is not to be applied, the only thing which remains is that the

AMP transaction should be separately and independently processed

under the Chapter X of the Act as per any suitable method (other than

TNMM) including Cost plus method, but by excluding the selling

expenses from the overall base of AMP expenses.

23 ITA No.407/Del/2015

15. Turning to the facts of the case, we find that the TPO/AO have

followed the Special bench decision in LG Electronics (supra) for

determining the ALP of AMP expenses. There is no discussion about

the AMP functions carried out by the assessee or comparables. Now

since the Special bench order has been partly modified by the Hon'ble

Delhi High Court, including the non-applicability of the bright line test,

and no material has been placed on record by the ld. AR to, firstly,

demonstrate the AMP functions carried out by the assessee and then, to

compare such functions with those done by comparables, this issue

cannot be decided at our end. Under such circumstances, we set aside

the impugned order and remit the matter to the file of the AO/TPO for

deciding it afresh as per law. In this fresh exercise, the TPO will follow

the parts of the judgment in Sony Ericson (supra) as are common to both

Manufacturers and Distributors; apply the parts of the judgment as are

applicable to a `Manufacturer'; and ignore the parts of the judgment

which pertain exclusively to a `Distributor'. Needless to say, the

assessee will be allowed a reasonable opportunity of hearing in such

fresh proceedings.

24 ITA No.407/Del/2015

16. In the result, the appeal is allowed for statistical purposes.

The order pronounced in the open court on 02.06.2015.

Sd/- Sd/-

[C.M. GARG] [R.S. SYAL] JUDICIAL MEMBER ACCOUNTANT MEMBER

Dated, 02nd June, 2015. dk Copy forwarded to: 1. Appellant 2. Respondent 3. CIT 4. CIT (A) 5. DR, ITAT

AR, ITAT, NEW DELHI.

25