Transfer pricing not applicable between Indian Head Office and Foreign Branch

Akhilesh Gupta, Advocate for the Appellant. Neeraj Kumar, Sr. DR for the Respondent.

ORDER

R.S. Syal, Accountant Member – This appeal by the assessee emanates from the final assessment order dated 31.10.2012 passed by the Assessing Officer (AO) u/s. 143(3) read with section 144C of the Income-tax Act, 1961 (hereinafter also called ‘the Act’) in relation to the assessment year 2008-09.

2. The first issue agitated in this appeal is against the determination of arm’s length price (ALP) in respect of transactions of the assessee with its Branch Office in Canada.

3. Briefly stated, the facts of the case are that the assessee is an Indian company having branch office in Canada. In addition to that, it has a 100% subsidiary in USA. There were certain transactions between the assessee and its branch office in Canada, which were treated by the Transfer Pricing Officer (TPO)/AO as international transactions and their ALP was determined. The assessee is aggrieved against such determination of ALP of the transactions between the head office and branch office.

4. We have heard the rival submissions and perused the relevant material on record. It is undisputed that the assessee is an Indian enterprise having its branch office in Canada. Under these circumstances, a question arises as to whether a separate determination of ALP of the transactions between Indian head office and branch office, Canada, should be made so as to make an addition on account of transfer pricing adjustment.

5. It is simple and plain that no person can transact with self in common parlance. As such, one can neither earn any profit nor suffer loss from self. The same is true in the context of business as well. Neither any person can earn income nor suffer loss from dealings with self. It is called the principle of mutuality. When expanded commercially, the proposition which follows is that there can be no profit from trade with self. This has been fairly settled through a catena of judgments from the Hon’ble Apex Court including Sir Kikabhai Premchand v. CIT[1953] 24 ITR 506 and also the Hon’ble High Courts. In Betts Hartley Huett & Co. Ltd. v. CIT [1979] v. CIT [1979] 116 ITR 425 (Cal.), it has been held that there cannot be a valid transaction of sale between branch office and head office and hence profit on such sales is not includible in assessee’s computation of total income. Similar view has been taken in Ram Lal Bechairam v. CIT[1946] 14 ITR 1 (All.).

6. Coming to the context of transfer pricing provisions, it is noticed that section 92B(1) defines ‘International transaction’ to mean a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale . . . or provision of services. Going by this definition, there can be an international transaction only between two or more associated enterprises (AEs). Since branch office is not a separate enterprise, there can be no question of treating transaction between head office and branch office as an international transaction. At this juncture, it is pertinent to note that section 92F(iii) defines “enterprise” to mean ‘a person (including a permanent establishment of such person) who is. . . . . . engaged in any activity, relating to the production, storage, supply, distribution, acquisition or control of articles or goods. . . . . . of which the other enterprise is the owner or in respect of which the other enterprise has exclusive rights. . . . . . . whether such activity or business is carried on, directly or through one or more of its units or divisions or subsidiaries, or whether such unit or division or subsidiary is located at the same place where the enterprise is located or at a different place or places.’ When we consider the definition of ‘international transaction’ u/s. 92B(1) in juxtaposition to the definition of ‘enterprise’ u/s. 92F(iii), the position which prima facie appears is that since a branch office which is selling goods or providing services is an ‘enterprise’ as a permanent establishment of the general enterprise, all the transactions between the branch office and the general enterprise be subjected to the transfer pricing provisions. However, this prima facieimpression loses its substance when the general enterprise is an Indian entity and the branch office is located outside India. It is so for the reason that section 5 defining scope of total income provides through sub-section (1) that ‘Subject to the provisions of this Act, the total income of any previous year of a person who is a resident includes all income from whatever source derived which (a) is received or is deemed to be received in India in such year by or on behalf of such person; or (b) accrues or arises or is deemed to accrue or arise to him in India during such year; or (c) accrues or arises to him outside India during such year’. Thus it is apparent that a resident assessee is liable to tax for its world income, which not only comprises of Indian income but also the income which ‘accrues or arises to him outside India during such year’. The final accounts of foreign branch office, including all the items of income, expenses, assets and liabilities are merged with the accounts of head office and the accumulated income so determined is liable to tax in India. When the sale made by the Indian Head office is considered as purchase of the foreign branch office and the figures of head office and branch office are consolidated, any under or over invoicing becomes tax neutral. Even if for a moment, we accept the contention of the Revenue as correct that the head office earned profit from its branch office, then such profit earned would constitute additional cost of the Branch office. On aggregation of the accounts of the Head office and branch office, such income of the HO would be set off with the equal amount of expense of the BO, leaving thereby no separately identifiable income on account of this transaction. This can be understood with the help of a simple example. Suppose the Indian head office purchases goods worth Rs. 95 and transfers the same to foreign branch office at Rs. 100, which are in turn sold by the branch office for a sum of Rs. 120. The profit of the head office will be Rs. 5 (Rs. 100 minus Rs. 95) and the profit of the branch office will be Rs. 20 (Rs. 120 minus Rs. 100). The Indian general enterprise will be chargeable to tax in India on its world income of Rs. 25 (Rs. 5 plus Rs. 20). If for a moment, it is presumed that the ALP of the goods transferred to the branch office is Rs. 110 and not Rs. 100 and the figure is accordingly altered, the profit of the head office will become Rs. 15 (Rs. 110 minus Rs. 95) and that of the branch office at Rs. 10 (Rs. 120 minus Rs. 110). Again the Indian general enterprise will be chargeable to tax in India on its world income of Rs. 25 (Rs. 15 plus Rs. 10). There can never be any reason for an Indian enterprise to over or under invoice the goods or services to its foreign branch office because by virtue of section 5(1), it is its world income which is going to be charged to tax in India, which in all circumstances will remain same at Rs. 25 in the above example. So the over or under invoicing between the Indian head office and foreign branch office is always income-tax neutral in the case of an Indian enterprise having a permanent establishment outside India. Making a transfer pricing adjustment in respect of the international transactions between the Indian head office and the foreign branch office will result into charging tax on income which is more than legitimately due to the exchequer. Obviously, this is impermissible.

7. The rationale in not applying the provisions of Chapter-X on transactions between the head office and branch office is limited only on an Indian enterprise having branch office abroad. It is not the other way around. If a foreign general enterprise has a branch office in India, such Indian branch office will be considered as an ‘enterprise’ u/s. 92F(iii) and the transactions between the foreign head office and the Indian branch office will be ‘International transactions’ in terms of section 92B. This is for the reason that the total income of a non-resident in terms of section 5(2) includes all income from whatever source derived which (a) is received or is deemed to be received in India in such year by or on behalf of such person; or (b) accrues or arises or is deemed to accrue or arise to him in India during such year. Thus it is only the Indian income of a non-resident, which is chargeable to tax in India. In such circumstances, there can be an allurement to some non-resident assesses to resort to under or over-invoicing so as to mitigate the tax burden in India. It is with this background in mind that the legislature introduced Chapter X with the caption ‘Special provision relating to avoidance of tax’ so to ensure that the international transactions are reported at ALP. Some foreign associated enterprise instead of having an Indian enterprise may opt to have a branch office in India and then claim that since the Indian branch office is not a separate enterprise, the transfer pricing provisions should not be applied. Section 92F(iii) has been incorporated to ensure that not only the transactions between the foreign enterprise and its Indian associated enterprise but also the transactions between the foreign enterprise and its branch office in India are also determined at ALP so that the Indian tax kitty is not deprived of the rightful amount of tax due to it. Thus, the definition of ‘enterprise’ as per section 92F(iii) as also including its permanent establishment for the transfer pricing provisions is confined only in respect of a foreign general enterprise having a branch office in India and not vice versa.

8. Adverting to the facts of the instant case, we find that the extant assessee is also an Indian resident and as such is liable for tax in respect of the income earned in India (through its Head office in India) and also the income accruing from outside India (through its Branch office in Canada). The assessee has rightly offered income for taxation not only the amount earned by the Indian head office, but also whole of the income earned by Canada branch office. This position can be ascertained from the Annual accounts of the assessee, whose copy has been placed on record. Page C-6 of the paper book is copy of the Profit & Loss Account of the assessee, which gives a figure of ‘Revenue from services rendered.’ This figure has been depicted at Rs. 45.42 crore. Its break-up is available on page C-19, from where it is discernible that revenue earned by the Indian head office from exports stands at Rs. 9.50 crore and revenue of Canadian foreign branch at Rs. 35.92 crore. Not only the income but, also the expenses and all the items of balance sheet of branch office, Canada have also been merged with the figures of head office. It is the total income as also including the total revenue earned by branch office Canada, which has been offered for taxation. Under such circumstances and in the backdrop of the foregoing discussion, the transfer pricing provisions cannot apply in respect of transactions between the Indian head office and branch office in Canada. The impugned order is set aside pro tanto.

9. The next issue raised in this appeal is against the addition due to transfer pricing adjustment amounting to Rs. 2,59,26,400/-. Succinctly, the facts apropos this issue are that the assessee entered into international transaction of ‘Software development services’ with its AE, namely, Aithent Inc., USA. The assessee adopted Transactional Net Margin Method (TNMM) as the most appropriate method with Profit level indicator (PLI) of OP/OC. Certain comparables were chosen after applying certain filters, which have been listed on page 3 of the TPO’s order. That is how, the assessee claimed that its international transactions were at ALP. Not satisfied, the AO made reference to the TPO for determination of the ALP of this international transaction. The TPO disagreed with certain filters adopted by the assessee and finally applied the following filters for selecting the comparable companies: —

10. By applying the above filters, the list of comparables drawn by the assessee underwent change inasmuch as the TPO inducted certain new companies as comparable and also disqualified some of the companies which were considered as comparable by the assessee. The TPO computed arithmetical mean of the finally selected companies (after allowing working capital adjustment) at 24.66%. This arm’s length margin was applied to determine the transfer pricing adjustment amounting to Rs. 3.09 crore. The assessee objected to the calculation made by the TPO before the Dispute Resolution Panel (DRP). The DRP vide its order dated 24.9.2012 issued certain directions. Giving effect to the direction given by the DRP, the TPO passed the consequential order on 9.10.2012 down scaling the amount of transfer pricing adjustment to Rs. 2.59 crore by way of revision in the arithmetical mean of OP/TC at 20.57% of the surviving 18 companies in the list of comparables. The assessee is aggrieved against the inclusion of several companies in the list of comparables and also the exclusion of some of the companies which were claimed by it as comparable. The main thrust of the ld. AR’s arguments was on the application of some of the above filters, which in his opinion, were not correctly appreciated and resulted into the inclusion of unwarranted companies and the exclusion of certain requisite companies from/in the final list of comparables. The ld. AR urged us to decide on the correctness of some of the filters applied by the authorities below and then remit the matter to the TPO for passing order in the light of our decision on the correctness of such filters. The ld. DR fairly agreed to this proposition. Ex consequenti, we will take up the filters as adopted by the TPO that are under challenge.

(i) Companies whose software development service revenue <Rs. 1 crore were excluded.

11.1 The ld. AR contended that the assessee company earned revenue from services to the tune of Rs. 45.42 crore. It was submitted that the filter of exclusion of companies with service revenue of less than Rs. 1 crore was not fully correct. He did not raise any objection to the application of lower limit of filter at Rs. 1 crore, but, challenged the upper limit of turnover, which was left open by the TPO. The ld. AR contended that some sort of cap on the upper limit of turnover should have been considered by the TPO.

11.2 We are not convinced with the argument advanced on behalf of the assessee in this regard. When functionally similar companies are chosen and then average of the profit rate of such similarly functional companies is taken into account for determining the ALP of the international transaction undertaken by the assessee, the size of some of the companies in the whole lot of comparable companies, becomes meaningless. Averaging of the profit rates of the whole lot of functionally similar companies of different sizes, viz., some having higher while some others having lower turnover vis-à-vis the assessee, irons out the effect of such differences. The Hon’ble jurisdictional High Court in the case of ChrysVapital Investment Advisers (India) (P.) Ltd. v. Dy. CIT[2015] 376 ITR 183  (Delhi) has held that high profit/turnover cannot be a criteria to exclude an otherwise comparable company. This issue being no more res integra, does not deserve the acceptance by us of the argument advanced on behalf of the assessee. We, therefore, hold that the TPO was justified in applying this filter.

(ii) Companies who have less than 25% of the revenues as export sales were excluded.

12. After considering the rival submissions and perusing the relevant material on record, we find that the assessee’s export sales are Rs. 9.49 crore as against the total sales of Rs. 45.42 crore. This shows that the assessee’s export revenue is roughly 21% of total revenue. If we apply the filter of excluding the companies having less than 25% of the revenue’s from export sales, it would tend to eliminate the companies which are similarly placed as the assessee. In our considered opinion, this filter should not have been applied by the TPO, which has actually upset the selection process. Both the sides agreed that if, in the given circumstances, the filter of excluding the companies with export sales of more than 30% of the total revenue is applied, that would serve the purpose. In our considered opinion, this proposition put forth by the ld. AR and as accepted by the ld. DR, is in order.

(iii) Companies who have more than 25% related party transactions (sales as well as expenditure combined) of the operating revenues were excluded.

13.1 The TPO applied the filter of related party transactions (RPTs) of more than 25% of the operating revenue and accordingly short listed the companies in the final set of comparables. The ld. AR did not dispute the percentage of 25%. He, however, objected to the application of this 25% related party transactions to ‘sales as well as expenditure combined.’

13.2 Having heard the rival submissions and perused the relevant material on record, we find that the TPO has included sales as well as expenses in a combined manner as numerator with the denominator of operating revenue. This approach, in our considered opinion, is not correct. The percentage of numerator to denominator can be rightly calculated only when the contents of a part representing the RPT of a particular nature is seen with reference to the contents of whole of that nature. Both the numerator and denominator need to have the same nature of contents. This can be done by segregating transactions of one nature, like, comparing RPT of purchase with the total purchases or RPT of sales with the total amount of sales of the company. It is also possible to club small transactions of a distinct but related income producing activity with a large transactions of major income producing activity as one unit, both in the numerator as well as in the denominator. For example, RPT of major sale transaction and minor job income can be combined to find out the percentage of RPTs with the total of sales and job income taken together. This entire exercise can be done by firstly calculating the percentage of RPT purchases with total purchases and then of RPT sales and service income as one unit with the total of sales and service income again as one unit. The decision as to whether a company should be included in the list of comparables by applying the filter of more than 25% RPTs, would depend on the outcome of two such percentages of RPTs. If either of the two breaches the 25% threshold, then the company will cease to be comparable. The impugned order, combining sales and expenses, for calculating the percentage of the RPTs is set aside to this extent and the TPO is, accordingly, directed to apply this filter in the manner discussed above.

(iv) Companies who have diminishing revenues/persistent losses for the period under consideration were excluded.

14.1 The TPO applied this filter for excluding the companies from the final set of comparables which were having diminishing revenues or persistent losses. The ld. AR argued that this filter ought not to have been applied. This was controverted by the ld. DR who submitted that the Delhi Bench of the Tribunal in the case of Navisite India (P.) Ltd. v. Asstt. CIT[2015] 67 SOT 145 (URO) has approved this filter.

14.2 After considering the rival submissions and perusing the relevant material on record, we find the position of profit/loss earned by the assessee during the period relevant to the assessment year under consideration and six earlier years is as under:—

14.3 A careful perusal of the pattern of profit/loss earned by the assessee as per its audited accounts divulges that as against the current year’s profit of Rs. 62.39 lac, the earlier years’ profit was Rs. 92.74 lac. This manifests that the profit for this year has diminished from the earlier year. When we consider the figures of losses for the financial years 2005-06 and earlier years, it comes to light that there were losses right from financial year 2002-03 up to 2005-06. On an overview of the above extracted Table, it can be seen that the assessee’s profit is not steady, but, has diminished during the instant year from the preceding year. In such a situation, if we exclude the companies having diminishing profits, it would mean that the companies whose profit pattern is also similar to that of the assessee would face the axe. Doing so would mean excluding the comparable companies from the final tally, which is not appropriate. However, the companies having persistent losses, obviously, cannot be compared with the assessee because it has earned positive income not only in this year, but, in the preceding year as well. We, therefore, hold that the companies having diminishing revenue should not be excluded, but, only the companies having persistent losses should be expelled from the final tally of comparables.

(v) Companies whose onsite income is more than 75% of the export revenues were excluded.

15.1 The TPO excluded the companies whose onsite income was more than 75% of the export revenues. The ld. AR argued that the income earned by branch office, Canada was largely onsite income and, hence, this filter could not be applied. In support of his contention of the branch office, Canada earning onsite income, he placed on record certain agreements which show the rendering of onsite services by the branch office, Japan. The DR, however, opposed the argument of the ld. AR.

15.2 Having heard the rival submissions and perused the relevant material on record, we find that out of total revenue of Rs. 45.42 crore earned by the assessee, its revenue of the foreign branch is to the tune of Rs. 35.92 crore, which is roughly 80% of the total revenue. The ld. AR contended that the entire income earned by branch office, Canada, was from rendering onsite services. However, this proposition could be substantiated partly as only 2-3 copies of agreements entered into by the branch office, Canada with its clients were furnished as against numerous clients. If the argument of the ld. AR is correct that its foreign branch earned only onsite services income, then, the filter applied by the TPO excluding the companies whose onsite income is more than 75% of the export revenues, becomes meaningless. In such a situation, the companies whose onsite income is more than 75% of the export limit should be rather included. Since the necessary complete information is not available with the ld. AR for verifying the veracity of the contention of the foreign branch earning 100% onsite services, we consider it expedient to direct the TPO/AO to examine the break-up of the revenues earned by branch office, Canada, for seeing if the same is from onsite/offsite services. The application of the filter will be then decided accordingly by the TPO.

16. Having discussed the applicability or otherwise of the filters applied by the TPO as challenged before us, we now set aside the impugned order and remit the matter to the file of TPO/AO for considering the comparability or otherwise of the companies disputed by the assessee on the touchstone of the discussion made above and then determining the ALP of the international transaction.

17. The other objection taken by the ld. AR against the determination of ALP under this segment is in not allowing adjustment on account of idle capacity. The assessee claimed that during the year 42% of its employees remained idle and, hence, sought reduction in its operating cost to the extent of such extraordinary expense. The TPO jettisoned this proposition. The assessee now seeks reduction in its operating costs on account of such idle labour cost for the purposes of computing the transfer pricing adjustment.

18. We have heard both the sides and perused the relevant material on record. It is obvious that the TPO used the TNMM as the most appropriate method for calculating the ALP of this transaction, which was also considered by the assessee as the most appropriate method. The mechanism for determining the ALP under this method has been set out in Rule 10B(1)(e) as under:—

“(e) transactional net margin method, by which,—

19. It can be noticed from sub-clause (i) that the net profit margin realized by the enterprise from an international transaction is computed in relation to the costs incurred or sales effected, etc. Sub-clause (ii) talks of determining the net profit margin realized from comparable uncontrolled transactions. Sub-clause (iii) speaks of adjusting the net profit margin realized from comparable uncontrolled transactions determined in sub-clause (ii) by taking into account the differences, if any, between the international transaction and the comparable uncontrolled transactions. It is obvious from sub-clause (i) that the net profit margin actually realized by the assessee is always taken as such without any adjustment. The effect of differences between the international transaction and comparable uncontrolled transactions is always given in the net operating profit margin of the comparable uncontrolled transactions. There is no mandate for adjusting the assessee’s profit margin under the provisions of Rule 10B(1)(e). The assessee’s contention that its operating costs should be reduced to the extent its employees remained idle is, ergo, incapable of acceptance. The adjustment, if any, could have been allowed, if the assessee had demonstrated that the comparable companies had more under-utilization of their labour force vis-à-vis the assessee. The onus to prove such under-utilization of employees of the comparables, for claiming adjustment, squarely lies on the assessee. On a specific query, the ld. AR could not point out that the utilization of employees by the comparable companies was less than the assessee. Under such circumstances, we are of the considered opinion that no such adjustment can be granted. We, therefore, approve the view taken by the authorities on this issue.

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