Facts of the Case

Li & Fung India Pvt. Ltd. (LFIL) was a wholly owned subsidiary of Li & Fung (South Asia) Ltd., Mauritius and acted as a captive offshore sourcing service provider. Its Associated Enterprise in Hong Kong entered into contracts with overseas retail customers for sourcing high-volume consumer goods.

Under an agreement, LFIL rendered sourcing support services and received remuneration on a cost plus 5% mark-up basis.

LFIL received buying support service fees amounting to approximately Rs.47.69 crores and considered these transactions as international transactions under transfer pricing provisions. LFIL adopted TNMM as the most appropriate method and benchmarked its transactions by comparing operating margins with comparable companies. LFIL demonstrated that its operating profit margin of 5.17% exceeded the weighted average margin of comparable companies at 4.07%, thereby claiming that transactions were at arm’s length.

However, the TPO did not dispute TNMM itself but held that LFIL performed significant functions and created valuable intangibles and therefore enhanced the cost base by applying 5% mark-up on the FOB value of exports amounting to Rs.1202.96 crores, leading to substantial transfer pricing adjustment.

Issues Involved

  1. Whether the Revenue’s assessment of Arm’s Length Price by applying TNMM was contrary to the transfer pricing provisions under the Income Tax Act and Rules?
  2. Whether the TPO’s method of applying a mark-up on the FOB value of exports sourced through unrelated third-party vendors was legally sustainable?
  3. Whether cost incurred by unrelated third parties could be included while computing the assessee’s net profit margin under Rule 10B(1)(e)?
  4. Whether locational savings and alleged intangible benefits justified modification of the cost base under TNMM?

Petitioner’s Arguments (Li & Fung India Pvt. Ltd.)

The petitioner argued:

  • TNMM requires computation of net profit with reference only to costs incurred by the assessee itself.
  • Rule 10B(1)(e) does not permit inclusion of costs incurred by unrelated third-party vendors.
  • The TPO had artificially enhanced the assessee’s cost base by considering manufacturing and export costs incurred by independent parties.
  • LFIL functioned merely as a captive sourcing support provider and did not undertake manufacturing activities or bear significant enterprise risks.
  • LFIL had no investment in manufacturing facilities, inventory, working capital or associated enterprise risks.
  • Earlier years consistently accepted TNMM with OP/TC as the Profit Level Indicator.
  • Locational savings primarily benefited end purchasers and could not justify transfer pricing adjustment in LFIL’s hands.

Respondent’s Arguments (Commissioner of Income Tax)

The Revenue contended:

  • LFIL performed critical functions and assumed significant risks.
  • LFIL developed valuable supply chain and human capital intangibles.
  • LFIL provided strategic and pricing advantages to the Associated Enterprise.
  • Since the AE earned remuneration based upon FOB value of exports, LFIL should receive compensation on a similar basis.
  • OECD guidelines permit authorities to examine substance over form and therefore the TPO’s approach was justified.
  • Failure to adopt FOB value would result in shifting of profits outside India.

Court Findings / Court Order

The Delhi High Court allowed the appeal in favour of the assessee and held:

  • The TPO’s approach of expanding the cost base by considering FOB value of exports of unrelated vendors was contrary to Rule 10B(1)(e).
  • Under TNMM, net profit margin has to be calculated only with reference to the assessee’s own costs, sales, or assets and not by considering costs incurred by third parties.
  • Tax authorities cannot introduce methodologies outside the framework prescribed by the Act and Rules.
  • Mere use of broad expressions such as “significant risks”, “functional risk” or “enterprise risk” without objective evidence cannot justify adjustment.
  • Since the Revenue accepted TNMM as the most appropriate method, distortions, if any, had to be addressed within that framework itself.
  • The TPO’s addition based upon FOB value had no legal foundation and was therefore liable to be deleted.
  • The ITAT order and transfer pricing adjustment were set aside. Questions of law were answered in favour of the assessee.

Important Clarification

The Court clarified several important transfer pricing principles:

  • Once TNMM is accepted as the most appropriate method, authorities cannot modify the methodology by importing unrelated cost elements.
  • Cost incurred by third-party vendors cannot be imputed into the assessee’s cost base.
  • Functional analysis (FAR analysis) must be supported by objective evidence and not assumptions.
  • Tax administrators cannot travel beyond statutory provisions while determining ALP.
  • Arm’s Length Price determination must remain strictly within the framework provided under the Income Tax Act and Rules.

Sections Involved

  • Section 92 – Computation of income from international transactions
  • Section 92A – Associated Enterprise
  • Section 92B – International Transaction
  • Section 92C – Computation of Arm’s Length Price
  • Section 92CA – Reference to Transfer Pricing Officer
  • Section 92D – Maintenance of documentation
  • Section 92F – Definitions including Arm’s Length Price
  • Section 144C – Dispute Resolution Procedure
  • Rule 10B(1)(e) – Transactional Net Margin Method (TNMM) under Income Tax Rules, 1962

Link to download the order - https://delhihighcourt.nic.in/app/case_number_pdf/2013:DHC:6459-DB/SRB16122013ITA3062012.pdf 

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