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RPM (not TNMM) appropriate for distribution; losses are on account of business strategy; & no motive to shift profits as margins of associated enterprises are reasonable
In brief
In a recent ruling in the case of L’oreal India Pvt. Ltd.1 (the taxpayer), the Mumbai Bench of the Income-tax Appellate Tribunal (the Tribunal) held that
• There was no order of priority of methods. Resale Price Method (RPM) was one of the standard methods and was most appropriate when the taxpayer buys products from its associated enterprises (AEs) and sells to unrelated parties without any further processing/value addition (reliance placed upon
1 ITO v. L’oreal India Pvt. Ltd. [TS-293-ITAT-2012 (Mum)]
Transfer Pricing Guidelines laid out by the Organisation for Economic Co- operation and Development (OECD Guidelines)).
• Losses incurred by the taxpayer were on account of business strategy of the taxpayer and initial years of the distribution activity, rather than non-arm’s length transfer pricing.
• The taxpayer has no motive to shift profits as AEs earn reasonable margin of 2% to 4% (or even less) on their supplies to the taxpayer (reliance placed on certificates from AEs indicating the margin earned).
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• RPM had been accepted by the transfer pricing officer (TPO) in the preceding as well as the succeeding assessment years (AYs) and should therefore be acceptable in the current year as well.
Facts
• The taxpayer is a 100% subsidiary of L’oreal SA France and is engaged in manufacturing and distribution of cosmetics and beauty products. The taxpayer’s business was accordingly segregated into the manufacturing and distribution segments which have been separately benchmarked for transfer pricing purposes.
• No adjustment was made by the TPO in respect of manufacturing segment.
• However, in respect of distribution segment, i.e. in respect of the international transaction of purchase of finished goods, the taxpayer had applied RPM benchmarking the gross margin of the taxpayer at 4o.80% against that of comparables at 14.85%. The TPO rejected application of RPM by the taxpayer and instead adopted Transactional Net Margin Method (TNMM). An adjustment was made on the basis of operating margin of comparables at 0.36%, as against the taxpayer’s loss of (-)19.84%.
• Aggrieved, the taxpayer appealed to the CIT(A). The CIT(A) deleted the adjustment, aggrieved with which the Revenue appealed to the Tribunal.
Revenue’s contentions
• The taxpayer was consistently incurring losses and hence the pricing policy was not at arm’s length.
• Gross margins cannot be relied upon because of product differences in comparables.
• Degree of similarity in the functions performed, assets employed and risks assumed between the taxpayer and comparable companies was not sufficient for application of RPM but was so for application of TNMM.
• Adjustment of the margin/profits of the taxpayer was not permissible under Rule 10B of the Income-tax Rules, 1962 (the Rules).
• The taxpayer was incurring huge expenses on selling and distribution of products with the trade name ‘L’oreal’ and hence there was substantial value addition by the taxpayer to the goods being sold by it.
Taxpayer’s contentions
• As per OECD Guidelines (paragraph 2.22) and the guidance note issued by the Institute of Chartered Accountants of India (ICAI), RPM was most appropriate in case of distribution and marketing activities especially when goods are purchased from AEs and resold to unrelated parties which was so in the taxpayer’s case.
• Products of comparables selected by the taxpayer fall under the category of FMCG products which are for personal consumption of individuals.
• After making adjustment for marketing and selling expenses, profit of comparable companies works out to approximately (-)23.55% as against the taxpayer’s (-)19.84%. Thus, even based on TNMM, the arm’s length nature of the transaction of purchase of finished goods is justified.
• The taxpayer was following market penetration strategy since the commencement of its distribution segment in 2001. On the contrary, comparables had been present in the Indian market since 1980’s and early 1990’s and had established themselves firmly in the Indian market.
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• Net losses in the distribution segment were only for three years and thereafter the taxpayer had been earning increasing profits.
• Certificates from the AEs had been furnished confirming that their margins on supplies to the taxpayer were only 2% to 4% or even less. Hence, the TPO’s contention relating to profit shifting and AEs earning higher profits, was not justified.
• As per OECD Guidelines, TNMM is a residuary method and must be used as a last resort because the arm’s length price (ALP) in case of TNMM was determined in an indirect manner from net margins. A significant weakness of TNMM has been highlighted in paragraphs 3.29 and 3.35 of the OECD Guidelines, which states that the net margins of taxpayers can be influenced by various factors that either do not have an effect or have a less substantial effect on price or gross margins, because of the potential for variation of operating expenses across enterprises. To demonstrate this, a hypothetical situation was assumed, i.e., if net margins of comparables were to be 10.36%, the adjustment made would be of the entire purchase value (i.e. more that 100% addition) thereby implying that the taxpayer should have procured the goods at nil cost/price.
• The TPO made an adjustment of approximately 67% to the value of imports resulting in an anomalous situation.
• The TPO himself accepted RPM in the prior AY and also in the subsequent AYs.
CIT(A)’s order
The CIT(A) upheld the use of RPM and deleted the adjustment for the following reasons:
• There was no priority of methods. TNMM and Profit Split Method (PSM) are treated as methods of last resort only when the standard methods of Comparable Uncontrolled Price (CUP), RPM and Cost Plus method cannot be reasonably applied. The taxpayer had adopted RPM which was a standard method.
• RPM adopted by the taxpayer was based on similarity of functions performed by it and not on similarity of products distributed.
• Even the OECD Guidelines prefer methods which require computation of ALP directly based on gross margin over a method which requires computation of ALP in an indirect manner because comparing gross margins extinguishes the need for making adjustments in relation to differences in operating expenses, which could be different from enterprise to enterprise.
• The TPO’s contention relating to product differences cannot be accepted as the TPO had itself selected comparables for manufacturing segment from the category of FMCG products used for personal consumption.
• Losses incurred by the taxpayer were on account of business strategy of the taxpayer and the initial years of the distribution segment rather than non- arm’s length nature of the transfer pricing policy of the taxpayer.
• Profit margin earned by the AE needs to be considered for an all round approach in transfer pricing. The fact that the taxpayer was incurring losses and its AEs were earning low profits established that there was no motive to shift profits.
4 Tribunal ruling
As per the Tribunal, the only question for its consideration was whether to use RPM or TNMM for determination of ALP for the distribution segment. The Tribunal observed as follows:
• There was no order of priority of methods. RPM was one of the standard methods. The taxpayer buys products from its AEs and sells to unrelated parties without any further processing and as per OECD Guidelines, in such a situation, RPM is the most appropriate method.
• The taxpayer had also produced certificates from its AEs that margin earned by AEs on supplies to the taxpayer was 2% to 4% or even less. The Revenue had not disputed these certificates. Therefore, the TPO’s contention that the AEs have earned higher profit was not based on facts. On the other hand, profit earned by the AEs was also reasonable and hence there was no shifting of profits by the taxpayer to its AEs.
• RPM had been accepted by the TPO in the preceding as well as succeeding AYs.
In view of the above, the Tribunal did not find any infirmity in the order of the CIT(A) and the deletion of the adjustment.
Apart from the above, it may be noted there was another matter in dispute relating to costs allocated by AEs to the taxpayer. Briefly, the facts were that L’oreal Group had a centralised marketing division the costs of which were allocated to all affiliates including the taxpayer. The costs were marked-up by 5%. During the transfer pricing assessment proceedings, the TPO asked the taxpayer to evidence receipt of services and its benefit. However, no documentary evidence was submitted by the taxpayer to the TPO, in the absence of which the TPO adjusted the value of allocated costs to NIL. However, before the CIT(A), the taxpayer submitted fresh documents, based on which the CIT(A) deleted the TPO’s
adjustment, to which the Revenue objected as the same was done without seeking a remand report from the AO. The Tribunal restored the matter to the file of the AO to get it examined from the TPO as to whether taxpayer had received any benefit and if the taxpayer is able to produce requisite documents, based on which the TPO was directed to decide the taxpayer’s claim.
PwC observations
• In a first judicial precedent of its kind, the Tribunal has upheld the use of RPM over TNMM for distribution activities. In this regard, the Tribunal’s reliance on OECD Guidelines, once again endorses their significance in situations where guidance in the Indian regulations is lacking. Also, with respect to selection of method, although the Tribunal has not delved much into the facts of the case in the current year vis-a-vis previous/subsequent years, yet the Tribunal has ruled in favor of consistency in the position taken by the TPO on a year-on-year basis.
• Speaking of selecting the most appropriate method, any decision thereof must necessarily be preceded by a detailed analysis of functions performed, risks assumed and assets employed (FAR analysis). The FAR analysis of the transacting parties determines the characterisation of the entities, which in turn facilitates the selection of tested party. Typically, the tested party would be the least complex of the transacting entities, i.e. the simpler entity in terms of intensity of functions performed and risks assumed. It should also not own valuable intangibles.
• In the instant case, not much was discussed about the FAR of the transacting entities. However, it may be inferred that the taxpayer is operating as a regular risk taking distributor, which incurs start-up losses, and bears market as well as other regular distribution risks. On the other hand, the AEs may be operating under a relatively simpler and low risk operating model (possibly contract manufacturing) given that they are earning a low but steady return of
5 2% - 4% (or even less) on their supplies to the taxpayer. In the given facts,
assuming, brand and manufacturing related intangibles to be held by other entities of the L’oreal Group, it may have been worthwhile to explore the possibility of selecting AEs as the tested parties. In that case, the selection of method would have been influenced by the FAR profile of the AEs.
• While sanctioning the use of RPM over TNMM in the instant case, the taxpayer’s operating losses were not attributed to non-arm’s length nature of international transactions. Instead, the impact of business strategies has been appreciated and this is certainly a significant and welcome verdict.
Nonetheless, in similar situations, an upfront and well documented Transfer Pricing Policy clearly outlining the respective FAR profiles of the transacting entities, price setting mechanism along with financial forecasts of the relevant entities of the group, would work as a robust defence document and may go a long way in averting the dispute at the first level assessment stage itself.
• While adjudicating that the taxpayer had no motive to shift profits, the Tribunal has simply relied upon certificates from AEs providing the margins earned by them. While this undoubtedly works as a favourable precedent for the taxpayers, however, it appears rather simplistic as the reasonableness or not of margins can be established only when benchmarked, which has not been done in the instant case.
• Under the RPM, a comparison of gross margins must ideally be accompanied with a comparison of the level and composition of operating expenses (OEs).
This would be a test for appropriate comparability. OEs are a measure of the value added by an entity and a significant difference in the level and composition of OEs may indicate differences in intensity of functions performed by the taxpayer vis-à-vis comparables.
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