(2014) 361 ITR 85 (Del)
Determination of arm's length price
No. The mark-up must be applied to the taxpayer's own cost base. Costs not incurred by the taxpayer, and risks it does not assume, cannot be brought into the computation.
Can a mark-up be applied to the value of goods sourced by third-party vendors, where the taxpayer is a service provider that neither purchases nor bears risk on those goods?
The taxpayer provided sourcing support services to its overseas group company, assisting it in identifying Indian vendors, monitoring quality and coordinating delivery. It was remunerated on a cost-plus basis at a mark-up on its own operating costs. It did not purchase the goods, did not take title to them, held no inventory, and bore no credit or product risk; the goods were exported by unrelated Indian vendors directly to the overseas customers. The Transfer Pricing Officer accepted the cost-plus method but applied the mark-up to the free-on-board value of the goods exported by those third-party vendors, reasoning that the taxpayer's efforts had generated that value and that an independent enterprise would have earned a commission on the full value.
The Tribunal substantially upheld the approach of the Transfer Pricing Officer. The taxpayer appealed to the Delhi High Court.
For the assessee
A cost-plus determination operates on the costs the tested party actually incurs. The value of goods bought and exported by unrelated vendors is not the taxpayer's cost, and it assumed none of the risks associated with those goods. Expanding the cost base in this way attributes to a limited-risk service provider a return appropriate to an entrepreneur bearing inventory and market risk.
For the Revenue
The taxpayer's work was the reason the overseas group could source from India at all, and the economic value it created is reflected in the value of the goods sourced. Confining the return to a mark-up on its small operating cost base under-rewards the functions it performs.
The Court held that a transfer pricing adjustment must respect the functional and risk profile actually borne by the tested party. The exercise under Chapter X involves a functions, assets and risks analysis, and the remuneration determined must correspond to what the tested party does and what it bears. The taxpayer performed a support function on a limited-risk basis; it did not trade in the goods, take title, hold stock or bear credit risk. Applying a mark-up to the free-on-board value of goods traded by unrelated parties attributed to the taxpayer a cost base it never incurred and a risk profile it never assumed, which is a departure from the prescribed method and has no statutory support. The Court observed that if the Revenue considered the taxpayer to be performing entrepreneurial functions, the proper course was to establish that through a functional analysis, not to expand the cost base by assertion. It also rejected the suggestion that the presence of location savings or a cost advantage in India justified attributing the vendors' turnover to the taxpayer.
Directly relevant under Section 165 for captive service providers, sourcing offices, procurement support entities and global capability centres. It remains the standard authority where the Revenue seeks to expand the cost base beyond expenditure the taxpayer actually incurred, or to attribute third-party turnover to a support entity.