Facts of the Case


  • The Revenue filed appeals against a common order passed by the Income Tax Appellate Tribunal (ITAT) concerning Assessment Years (AY) 2007-08 and 2008-09.
  • The Assessing Officer (AO) had finalised the assessment based on the directions of the Transfer Pricing Officer (TPO).
  • To determine the Arm's Length Price (ALP) for the years in question, the TPO and AO increased the cost base of the total cost incurred by the assessee.
  • The ITAT noticed that the High Court had previously ruled on this matter for the same assessee in Li and Fung India Pvt. Ltd. vs. Commissioner of Income Tax (2014) 361 ITR 85 (Del).
  • The ITAT directed a remission of the matter to the AO to redetermine the cost base in alignment with the aforementioned High Court judgment.

Issues Involved


  • The primary question of law urged was whether the ITAT's order directing the AO/TPO to freshly determine the addition originally made on account of the Arm's Length Price was correct.
  • The underlying issue was whether the TPO could legally broaden the assessee's cost base by including costs incurred by third-party vendors for the application of the Transactional Net Margin Method (TNMM).

Petitioner’s Arguments (Revenue)


  • The TPO reasoned that the assessee's cost base should be enhanced by taking into account the cost of manufacture and export of finished goods (ready-made garments) carried out by third-party vendors.
  • The tax authorities essentially imputed a notional adjustment or income in the hands of the assessee based on a fixed percentage of the free on board value of exports made by these unrelated party vendors.

Respondent’s Arguments (Li & Fung)


  • The assessee's compensation model is strictly based on the functions it performs and the operating costs it incurs.
  • The compensation model is not based on the cost of goods sourced from third-party vendors within India.

Court Order/FINDINGS


  • The High Court dismissed the appeals filed by the Revenue.
  • The Court found that the question of law urged in the appeals did not arise because the matter was already settled in a previous order pertaining to the same assessee.
  • Relying on its previous judgment, the Court held that there is no legal authority under the Income Tax Act, 1961, or the Rules to broaden the cost base in the manner done by the TPO.
  • The Court held that allotting a margin on the value of goods sourced by third-party customers from Indian exporters/vendors to compute the assessee's profit is unjustified.
  • The Court ruled that the TPO's reasoning to enhance the cost base by considering costs incurred by third-party vendors (which were not incurred by the assessee) is nowhere supported by the TNMM under Rule 10B(1)(e) of the Rules.

Important Clarification


  • The Court clarified that when applying the TNMM, the assessee's net profit margin realized from international transactions must be calculated only with reference to the costs incurred by the assessee itself.
  • The calculation must not include costs incurred by any other entity, whether they are third-party vendors or the Associated Enterprise (AE).
  • Textually, Rule 10B(1)(e) does not permit the consideration or imputation of costs incurred by unrelated enterprises to compute the assessee's net profit margin.
  • The textual mandate is unambiguously clear that the determination of ALP must be with reference to the relevant factors (cost, assets, sales, etc.) of the enterprise in question (the assessee), as opposed to the AE or any third party.

Sections Involved

  • Income Tax Act, 1961.
  • Rule 10B(1)(e) of the Income Tax Rules.

Link to download the order: https://delhihighcourt.nic.in/app/case_number_pdf/2015:DHC:2392-DB/RKG11032015ITA5052014.pdf


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