The order of the Bench was delivered by
Smt. Asha Vijayaraghavan, Judicial Member - These cross appeals are filed by the Assessee and Revenue for the Assessment Year 2005-2006 against the Order of the CIT(A)-III, Hyderabad dated 21.03.2011 being ITA.No.1159/Hyd/2011 and ITA.No.1040/Hyd/2011 respectively.
1.1 ITA.No.1408/Hyd/2010 is filed by the assessee against the Order of the Disputes Resolution Panel, Hyderabad dated 24.09.2010 for the Assessment Year 2006-2007. Since, common issues are involved in these appeals, they were clubbed and heard together and are being disposed of by this single consolidated order. For the sake of convenience, we will take out facts of the case from assessee's appeal bearing ITA.No.1159/Hyd/2011 for the assessment year 2005-2006.
ITA.No.1159/Hyd/2011 - A.Y. 2005-2006 (Assessee's Appeal):
2. The assessee is a company which derives income from manufacture and supply of Air and Gas separation equipment and from providing related services. For the Asst. Year 2005-06 It has filed the return of income on 29.10.2005 showing Income of Rs.8,51,61,564/-. During the assessment proceedings, the AO noticed that during the F.Y 2004-05 the assessee has entered into international transactions with its Associated Enterprise (AE). For computation of the arm's length price (ALP) of such transactions, the AO has made reference to the Transfer Pricing Officer (TPO) u/s.92CA(l) of the Act. In response to this, after making necessary verification in the matter, the TPO noted that various international transactions made by the assessee with the AE, as reported in the audit report in Form No.3CB are at arm's length, except the International transactions pertaining to royalty paid to the AE, which was not reflected In the said Form No.3CB report.
2.1 The TPO noted that the assessee company which was incorporated In 1992, is engaged in undertaking design, manufacturing, marketing and sale of air and gas separation equipments/plants. He further noted that the assessee undertakes the function of delivering the products to the AEs. During the proceedings before him, the assessee has furnished a copy of Transfer of Technical know-how agreement with M/s. Air Liquid, France, as per which, in respect of all products the royalty will be at 5% for domestic sales and at 8% for exports. He noted that during the previous year the assessee has paid royalty of Rs.l,42,84,061/- to the AE on account of sale made to unrelated party through the AE. The said amount is debited to the profit and loss account. During the transfer pricing proceedings the TPO has asked the assessee to furnish the details in respect of such payment made to AE, The assessee has not furnished any details / explanation in that regard. Under the circumstances, the TPO held that such amount paid towards royalty is not allowable, In this context, he observed that when royalty Is paid to an AE on the sales made to AEs of the same group, it is very clear that there is no necessity for payment of royalty as the Indian subsidiary company is nothing but an extended arm of the AEs abroad. He further noted that in case of non-resident companies, their Indian branches, which are their permanent establishment in India, cannot pay any royalty to the parent company. He noted that on same analogy, the royalty paid by the assessee to the AE abroad, on sales made to the AE by utilizing the know-how given by the AE, cannot be allowed under the provisions of the Act. He further noted that, the same would amount to compensating one own-self and in that case such payment would be far away from the definition of arm's length transaction, in a business sense. With these observations, he held that the royalty paid by the assessee to its own AE cannot be allowed, the same being unreasonable and purely a cosmetic transaction. He further noted, for determination of ALP of such transaction the CUP method is to be adopted. Stating that in respect of sales made to non- AEs, the royalty payable Is @ 5% on net sales and on sales made to AEs the same i.e., royalty payable shall be taken as nil, he held that such entire amount of Rs.l,42,84,061/- shall be disallowed. Accordingly, vide his order passed u/s.92CA(3) of the Act, dated 31.10.2008, he suggested for adjustment of the said amount, treating the same as shortfall to the ALP of such transaction under TP regulations.
2.2 Later, in conformity with such order passed by the TPO, the AO made addition of Rs.l,42,84,061/- to the Income of the assessee, towards adjustment in the ALP of such transaction u/s.92CA(3) of the Act and completed the assessment determining total income at Rs.9,94,45,625/-, vide order dated 28.11.2008 passed u/s.143(3) of the Act.
3. The assessee has filed appeal before CIT(A) contesting said addition made in the assessment.
3.1 During the hearing of appeal before CIT(A) in the written submissions filed by the Id. Authorized Representative, it was submitted that during the relevant year the assessee company manufactured and sold certain goods to independent third parties and its associated enterprise. Objecting to such disallowance made by the TPO, after observing that permanent establishment in India of a non-resident company cannot pay any royalty to the parent company, it was submitted that, it is nowhere specified in the Act that royalty payment by branch office to the parent company is to be disallowed. It was further submitted that during subject assessment year' the royalty paid by the assessee is with respect to sales to independent third parties. It was stated that the TPO has wrongly observed that those sales have been made to the third parties though the AEs of the assessee.
3.2 It was submitted that royalty is being paid by the assessee to Air Liquide, France, as a consideration for right to use the technical know-how which is provided to it by the said company. Such right has been granted by that company to the assessee to design, engineer, procure, construct manufacture, erect, commission and sale the products as defined in the agreement entered into with the company. Referring to Articles 3, 4, & 5 of the said agreement, it was submitted that in the line of business, in which the assessee operates, technical improvement is a constant process. Furnishing a photo copy of an e-mail, claiming to be received from the AE, it was submitted that the same indicates that the assessee has received valuable inputs from that company.
3.3 It was further submitted that the assessee and its AE should be considered as separate legal entity having separate existence. Any sale by the assessee to its AE, is akin to sale to any. third party and thus royalty payment made for use of know-how for manufacturing goods for such sale, is to be considered as an allowable expenditure. It was stated that the TPO was not correct in stating that no royalty can be paid with respect to such sale and then erroneously applied CUP method to conclude that no royalty can be paid with respect to sales to independent third parties. objecting to such conclusion of the TPO, it was submitted that the assessee and the said company Air Liquide, Franch, should be treated as independent entities operating in uncontrolled situations, while determining the arm's length price. Further stating that he has not followed the methodology prescribed u/s.92C for determination of ALP, It was contended that such order passed by the TPO Is not justified. With these submissions, the Id. AR contender that such addition made by the TPO/AO may be deleted.
4. The CIT(A) after considering the submissions of the assessee held as follows :
"While trying to justify such payment to the AE, the assessee has submitted that the TPO was not correct in stating that tile sales have been made to third parties through the AE. However, the assessee has not answered with reference to such specific observation made by the TPO that such sales were made to the AE during the previous year. Even though the assessee contends that the company In their case and the said AE are independent entitles. It has not been stated that no sale has been made to the AE. In absence of details of the sales made during the previous year, furnished by the assessee, I am inclined to believe that the assessee has made sales to the AE during the previous year. Further, from the assessment record for this assessment year in case of the assessee, made available to me, it appears that the assessee has not furnished such details i.e., the details with respect to sales made during the previous year, during the assessment proceedings. Under such circumstances, even though the assessee has contended that it has made sales only to Independent third parties, such claim is not verifiable. However, it may be mentioned when the assessee has earlier stated that the company in their case and the AE are to be treated as independent entities, so far as the sales are concerned, it shows the assessee admits that some sales were made by them to the AE during the previous year under consideration. Further, from the statement of royalty payment furnished by the assessee before the A.O. during the assessment proceedings, as available in the assessment record, though it is seen that the assessee has raised those Invoices towards royalty payable to the AE, in respect of different projects, it is not known as to how the same has been arrived at, further from such invoices it Is seen that the assessee has also paid royalty in respect of some foreign projects. It has also paid royalty In respect of spares for certain project. It is not known as to how royalty can be paid for supply of spares to different projects. In any case when the assessee has not furnished nor explained the details in that regard before the TPO nor before me such claim for Rs.l,42,84,061/- cannot be allowed deduction. It may be further mentioned here that part of such payment pertains to domestic sales. It may be pointed out here that the TPO has not objected to such payment at 5% In respect of sales made to non AEs. Under all these circumstances, in my view, it would be proper and also reasonable to hold that' 50% of such payment towards royalty made to that AE, arose from sales made to the AE including foreign projects obtained through the said AE. As rightly pointed out the TPO, royalty cannot be allowed on sales made to the AE for sale of products etc., made to that AE using technical know-how availed from the same AE. Therefore, and having regard to the facts discussed above, out of such payment of Rs.l,42,84,061/- towards royalty made to the AE, deduction cannot be allowed in respect of 50% of said amount i.e., Rs.71,42,031/- pertaining to sales etc made to as well as through the said AE. Thus, out of such disallowance made by the AO, disallowance to the extent of Rs.71,42,031/- is confirmed and the balance amount is deleted".
5. Aggrieved by the Order of the learned CIT(A), the assessee is in appeal before us vide ITA.No.1159/Hyd/2011 and has raised the following grounds
'The following grounds of appeal are mutually exclusive of and without prejudice to each other.
"1.1 That on the facts and circumstances of the case and in law, the Commissioner of Income Tax (Appeals)-III ["CIT(A)"] has erred in law and on facts by making an adjustment of Rs. 71,42,031 to the income of the appellant and in holding that the transactions between the assessee and its associated enterprise were not at an arm's length price.
1.2 That on the facts and circumstances of the case and in law, the Transfer Pricing Officer ("TPO")/ Assessing Officer ("AO") / CIT(A) has erred in law and on facts, in making several observations and findings which are based on incorrect interpretation of law and without appreciating and understanding the intricacies of the facts of the case.
1.3 The learned TPO I AO has erred in law and on, in determining the arm's length price for an international transaction wherein no specific reference has been received by the AO, and thus the order of the AO I TPO is bad in law and should be set aside.
1.4 That on the facts and circumstances of the case and in law, the CIT(A) has erred in law and on facts, in holding the arm's length price in respect of royalty paid by Appellant to its associated enterprise to the extent of Rs 71,42,031 to be nil.
1.5 That on the facts and circumstances of the case and in law, the TPO / AO / CIT(A) has erred in observing that no royalty can be paid by an entity with respect to sales made to its associated enterprises where the entity avails technical knowhow from the said associated enterprises.
1.6 That on the facts and circumstances of the case and in law, the CIT(A) has erred in observing that assessee has paid royalty with respect to supply of spares for various projects.
1.7 That on the facts and circumstances of the case and in law, the learned TPO / AO / CIT(A) has erred in disregarding the commercial agreements entered into by the appellant without any valid and cogent reasons.
1.8 That on the facts and circumstances of the case and in law, the TPO/A.O./CIT(A) has erred by acting in a arbitrary and ad-hoc manner and not followed any prescribed Transfer Pricing methodology (as required under section 92C of the Income Tax Act, 1963 ("Act") read with rule 108 of Income Tax Rules, 1962.) while determining the arm's length price for payment of royalty.
1.9 That on the facts and circumstances of the case and in law, the learned CIT (A) has failed to appreciate that the A.O./TPO has erred by not satisfying any of the conditions prescribed under section 92C(3) of the Act while making Transfer Pricing adjustments. Thus the order passed by the AO / TPO should be set aside in its entirety".
1.10 The learned CIT(A) erred in law and on facts, by not adhering to the principles of natural justice by summarily rejecting the Appellant's objections and disregarding the material placed on records.
1.11 The learned TPO /AO/CIT(A) has erred by not allowing the Appellant the benefit of 5 percent range as provided by the proviso of section 92C (2) of the Act Other Grounds
2.1 That the learned AO has erred in initiating penalty proceedings under section 271(1)(c) & 271 BA of the Act.
2.2 The learned AO has erred, in law and on facts, in charging interest under section 234B and 234C of the Act.
The above grounds are independent and without prejudice to each other.
The Appellant prays for leave to add, alter, amend and / or modify any of the grounds of appeal at or before the hearing of the appeal'.
6. Aggrieved by the Order of the learned CIT(A), the Revenue is also in appeal before us vide ITA.No.1040/Hyd/2011 and has raised the following grounds
"1. The learned CIT(A) ought to have upheld the order of the TPO/A.O. in respect of adjustment made u/s.92CA.
2. In the absence of production of details of sales ma to non AEs and AEs which was in the possession of the assessee, the learned CIT(A) erred in assuming that 50% of sales were made to Non-AEs.
3. On identical facts and circumstances, for the detailed reasons recorded in the report of the TPO for the A. Y.2006-07 (which is also under appeal before the Hon'ble IT AT), the order of A.O./TPO may be upheld.
4. The learned CIT(A) ought to have noticed that the original agreement for transfer of know-how entered on 26-05-1992 was valid for ten years and as the assessee-company has absorbed the know how before the F. Yr.1999-2000, there was no need to pay any royalty in the year under consideration
5. The CIT(A) ought to have upheld the order of the TPO determining ALP as 'Nil' given the fact that the assessee admitted that there was reverse flow of technology and hence there can be no usage of technical know-how of the Associated Enterprise.
6. The CIT(A) ought to have noticed that the profit margins shown by the assessee is low compared to comparable cases which justifies disallowance of Royalty in toto.
7. Any other ground that may be urged at the time of hearing the appeal."
7. At the outset, we find that the TPO in his order had concluded as follows:
"17. Conclusion: From the discussion made in the foregoing paragraphs, there is no evidence with the taxpayer in support of any transfer of technology which entails payment from the taxpayer to its AE. FY 2006-07 is the 14th year of operation for the taxpayer. From FY 1999-2000 onwards, in every annual report it is mentioned that the technology is fully absorbed. There is no reason as to why the taxpayer should pay royalty in perpetually in the guise of technical services received. Documentation available on record reveal that the taxpayer has grown into a full blown technology company which is rendering technical services to its AEs and not vice versa. Therefore, when the royalty transaction is examined under CUP, the arms length price is taken at nil for the following reasons:
(a) Paragraph 11 of the commentary on Article 12 of the OECD Model Tax Convention gives the following definition: "Know how is all the undivulged technical information, whether capable of being patented or not, that is necessary for the industrial reproduction of a product or process, directly and under the same conditions, in as much as it is derived from experience, know how represents what a manufacturer cannot know form mere examination of the product and mere knowledge of the progress of technique". Know how thus may include secret process or formulae or other secret information concerning industrial, commercial or scientific experience that is not covered by patent.
(b) As per the agreement entered by and between the taxpayer and its AE for the first time on 26.05.1992, the duration of the said agreement was for 10 years, which is quite substantial for any manufacturing company to absorb the technology. In a time span of 10 years, the flow of technical information would be substantial which does not warrant any further transfer of technical know how as is the case with the taxpayer. Transfer of technical know how cannot be perpetual and eternal. Technology involved here is not a patented one.
(c) From last so many years, the taxpayer is in a position to transfer technology to its AEs as is evident from deployment of its own engineers to execute the projects at different locations outside the country. The services rendered by the engineers of the taxpayer encompassed all the areas of engineering that goes into manufacturing of ASUs. Engineers deputed on onsite at these locations were stationed for months together, which mean all the core functions in execution and commissioning of ASUs were actually performed by the Engineers of the taxpayer. In fact there is a reverse flow of technology from the taxpayer to its AEs and not vice versa.
(d) The taxpayer rendered engineering services to its AEs at a meager price which can be seen from the information furnished by the taxpayer. Further, major portion of the foreign travel expenses are borne by the taxpayer. AEs of the taxpayer in a way exploited the services of the taxpayer in their advantage by compensating the services received either at cost or below cost. The prices charged by AEs when they execute projects outside India vis-à-vis prices charged per man day if their man power is deployed remained unanswered by the taxpayer. Taxpayer cannot compare the prices charged to Reliance Industries Ltd. which is located in India with the prices for the services rendered to its AEs outside India. Economies and geographies play a significant role in determining the prices of goods and services, which is not accounted for by the taxpayer.
(e) When in fact the taxpayer is providing technical services to its AEs at cost or below cost, there is no need for any separate payment for technical services, which never received, in the guys of royalty.
(f) The net profit margin earned by the taxpayer both on cost and on sale is significantly lower as compared to the margins earned by the independent comparables as discussed in the foregoing paragraphs. Benefits received by the taxpayer from the payments made towards technical services are not substantiated with any evidence. Also, costs incurred/contributed by its AEs in the process of transfer or technical knowhow vis-à-vis payments received also remained unexplained.
(g) Royalty paid by the taxpayer to the tune of Rs.2,02,94,565 to its AE, Air Liquide, France, not only in respect of sales made to its own AEs that is Air Liquide, Australia and Air Liquide, North India, but also in respect of sales made to non AEs both external and internal is not at arms lengths price. As, technology is fully absorbed by the taxpayer long back that is by the year ending 31.03.2003, during which the first agreement was in force, there is no necessity of any payments on account of technical services to AE.
That said, the Armslength price of payment made by the taxpayer towards technical services is taken at Nil and accordingly, adjusted under sec. 92 CA."
8. We also find that the assessee had filed in the course of the TPO assessment as well as before the Hon'ble DRP detailed submissions, including Agreement between AE and assessee, justifying why the technical knowhow supplied by its AE was crucial to the running of its business over the sustained period of the agreement.
9. Having under stood the factual matrix of the case, we now direct our attention to CIT v. EKL Appliances Ltd. [2012] 345 ITR 241 HC, wherein the Hon'ble Delhi High Court had occasion to consider an issue of disallowance of royalty by TPO because the assessee in that case had been suffering losses; the Delhi High Court, while holding that so long as the expenditure or payment by assessee has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning, observed as follows:
“16. The Organization for Economic Co-operation and Development ("OECD", for short) has laid down "transfer pricing guidelines" for Multi-National Enterprises and Tax Administrations. These guidelines give an introduction to the arm's length price principle and explains article 9 of the OECD Model Tax Convention. This article provides that when conditions are made or imposed between two associated enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises then any profit which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, if not so accrued, may be included in the profits of that enterprise and taxed accordingly. By seeking to adjust the profits in the above manner, the arm's length principle of pricing follows the approach of treating the members of a multi-national enterprise group as operating as separate entities rather than as inseparable parts of a single unified business. After referring to Article 9 of the model convention and stating the arm's length principle, the guidelines provide for "recognition of the actual transactions undertaken" in paragraphs 1.36 to 1.41. Paragraphs 1.36 to 1.38 are important and are relevant to our purpose. These paragraphs are re-produced below: -
"1.36 A tax administrations examination of a controlled transaction ordinarily should be based on the transaction actually undertaken by the associated enterprises as it has been structured by them, using the methods applied by the taxpayer insofar as these are consistent with the methods described in Chapters II and III. In other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured.
1.37 However, there are two particular circumstances in which it may, exceptionally, be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction. The first circumstance arises where the economic substance of transaction differs from its form. In such a case the tax administration may disregard the parties' characterization of the transaction and re-characterise it in accordance with its substance. An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm's length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. In this case it might be appropriate for a tax administration to characterize the investment in accordance with its economic substance with the result that the loan may be treated as a subscription of capital. The second circumstance arises where, while the form and substance of the transaction are the same, the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price. An example of this circumstance would be a sale under a long-term contract, for a lump sum payment, of unlimited entitlement to the intellectual property rights arising as a result of future research for the term of the contract (as previously indicated in paragraph 1.10) While in this case it may be proper to respect the transaction as a transfer of commercial property, it would nevertheless be appropriate for a tax administration to conform the terms of that transfer in their entirety (and not simply by reference to pricing) to those that might reasonably have been expected had the transfer of property been the subject of a transaction involving independent enterprises. Thus, in the case described above it might be appropriate for the tax administration, for example, to adjust the conditions of the agreement in a commercially rational manner as a continuing research agreement.
1.38 In both sets of circumstances described above, the character of the transaction may derive from the relationship between the parties rather than be determined by normal commercial conditions as may have been structured by the taxpayer to avoid or minimize tax. In such cases, the totality of its terms would be the result of a condition that would not have been made if the parties had been engaged in arm's length dealings. Article 9 would thus allow an adjustment of conditions to reflect those which the parties would have attained had the transaction been structured in accordance with the economic and commercial reality of parties dealing at arm's length."
17. The significance of the aforesaid guidelines lies in the fact that they recognise that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the associated enterprises. It is of further significance that the guidelines discourage re-structuring of legitimate business transactions. The reason for characterisation of such re-structuring as an arbitrary exercise, as given in the guidelines, is that it has the potential to create double taxation if the other tax administration does not share the same view as to how the transaction should be structured.
18. Two exceptions have been allowed to the aforesaid principle and they are (i) where the economic substance of a transaction differs from its form and (ii) where the form and substance of the transaction are the same but arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner.
19. There is no reason why the OECD guidelines should not be taken as a valid input in the present case in judging the action of the TPO. In fact, the CIT (Appeals) has referred to and applied them and his decision has been affirmed by the Tribunal. These guidelines, in a different form, have been recognized in the tax jurisprudence of our country earlier. It has been held by our courts that it is not for the revenue authorities to dictate to the assessee as to how he should conduct his business and it is not for them to tell the assessee as to what expenditure the assessee can incur. We may refer to a few of these authorities to elucidate the point. In Eastern Investment Ltd. v. CIT, (1951) 20 ITR 1, it was held by the Supreme Court that "there are usually many ways in which a given thing can be brought about in business circles but it is not for the Court to decide which of them should have been employed when the Court is deciding a question under Section 12(2) of the Income Tax Act". It was further held in this case that "it is not necessary to show that the expenditure was a profitable one or that in fact any profit was earned". In CIT v. Walchand & Co. etc., (1967) 65 ITR 381, it was held by the Supreme Court that in applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of business, reasonableness of the expenditure has to be judged from the point of view of the businessman and not of the Revenue. It was further observed that the rule that expenditure can only be justified if there is corresponding increase in the profits was erroneous. It has been classically observed by Lord Thankerton in Hughes v. Bank of New Zealand, (1938) 6 ITR 636 (SC) that "expenditure in the course of the trade which is unremunerative is none the less a proper deduction if wholly and exclusively made for the purposes of trade. It does not require the presence of a receipt on the credit side to justify the deduction of an expense". The question whether an expenditure can be allowed as a deduction only if it has resulted in any income or profits came to be considered by the Supreme Court again in CIT v. Rajendra Prasad Moody, (1978) 115 ITR 519, and it was observed as under: - "We fail to appreciate how expenditure which is otherwise a proper expenditure can cease to be such merely because there is no receipt of income. Whatever is a proper outgoing by way of expenditure must be debited irrespective of whether there is receipt of income or not. That is the plain requirement of proper accounting and the interpretation of Section 57(iii) cannot be different. The deduction of the expenditure cannot, in the circumstances, be held to be conditional upon the making or earning of the income."
It is noteworthy that the above observations were made in the context of Section 57(iii) of the Act where the language is somewhat narrower than the language employed in Section 37(1) of the Act. This fact is recognised in the judgment itself. The fact that the language employed in Section 37(1) of the Act is broader than Section 57(iii) of the Act makes the position stronger.
20. In the case of Sassoon J. David & Co. Pvt. Ltd. v. CIT, (1979) 118 ITR 261 (SC), the Supreme Court referred to the legislative history and noted that when the Income Tax Bill of 1961 was introduced, Section 37(1) required that the expenditure should have been incurred "wholly, necessarily and exclusively" for the purposes of business in order to merit deduction. Pursuant to public protest, the word "necessarily" was omitted from the section.
21. The position emerging from the above decisions is that it is not necessary for the assessee to show that any legitimate expenditure incurred by him was also incurred out of necessity. It is also not necessary for the assessee to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred "wholly and exclusively" for the purpose of business and nothing more. It is this principle that inter alia finds expression in the OECD guidelines, in the paragraphs which we have quoted above.
22. Even Rule 10B(1)(a) does not authorise disallowance of any expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same or that in the view of the Revenue the expenditure was un-remunerative or that in view of the continued losses suffered by the assessee in his business, he could have fared better had he not incurred such expenditure. These are irrelevant considerations for the purpose of Rule 10B. Whether or not to enter into the transaction is for the assessee to decide. The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allow ability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the assessee has suffered continuous losses. The financial health of assessee can never be a criterion to judge allow ability of an expense; there is certainly no authority for that. What the TPO has done in the present case is to hold that the assessee ought not to have entered into the agreement to pay royalty/ brand fee, because it has been suffering losses continuously. So long as the expenditure or payment has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning. As provided in the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and then make suitable adjustment but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorised.
23. Apart from the legal position stated above, even on merits the disallowance of the entire brand fee/ royalty payment was not warranted. The assessee has furnished copious material and valid reasons as to why it was suffering losses continuously and these have been referred to by us earlier ….'
10. The Hon'ble Tribunal in the case of Ericsson India (P.) Ltd. v. Dy. CIT (ITANo. 5141/Del/2011), too, following the law laid down by the Hon'ble Delhi High Court, held that—
"It would be wrong to hold that the expenditure should be disallowed only on the ground that these expenses were not required to be incurred by the assessee".
11. In the case of Dresser Rand India (P.) Ltd. v. Addl. CIT (ITA No 8753/Mum/2010) the Hon'ble Mumbai bench of the Tribunal held that benefits derived by the assessee is not relevant criteria for determination of ALP of an expenditure incurred by the assessee.
12. Further, in the case of LG Polymers India (P.) Ltd. v. Addl. CIT (ITA No 524/Vizag/2010), the Hon'ble Visakhapatnam Bench of the Tribunal held as follows:
"13. We agree with the views of the Learned A.R on this issue. As submitted by him, it is the prerogative of the assessee to regulate its business affairs and it is not open for the department to question the same. Similar views have been expressed by the Hon'ble Supreme Court in the case of Dhanrajgiriji Raja Narasingirji, referred (Supra)"
13. We also draw support from the Ahmedabad Bench of Tribunal in the case of KHS Machinery (P) Ltd. v. ITO [2012] 53 SOT 100 (URO, wherein the Hon'ble Tribunal on the issue of disallowance made by the TPO of payment of royalty, has held as under:
"The assessee had not made the one-time payment but making the continuous payment to the know-how provider which has been accepted by the Department in the past. The assessee has been charging 5 per cent royalty on each and every transaction and therefore the said payment cannot be said to have been paid on the aggregate amount, as argued by learned CIT-Departmental Representative. The findings of the AO in considering the royalty charges as nil as ALP cannot be accepted since the AO in the present case has not brought on record, the ordinary profits which can be earned in such type of business. Therefore in our view the payment of royalty is not hit by the provisions of s. 92 of the Act and there is no reason to hold that the expenses should not be allowed under s. 37(1) of the Act, since the expenditure has been incurred by the assessee during the course of business and is having the nexus with the business of the assessee. Therefore the payment of royalty is a business expenditure which has been incurred wholly and exclusively for the purpose of business of the assessee and same is to be allowed in toto as a matter of commercial expediency. Therefore, the case laws relied upon by the learned CIT-Departmental Representative are of no benefit to the Revenue. The reasonableness of expenditure in the present circumstances and facts of case cannot be doubted and accordingly the AO is directed to allow the claim of the assessee and the order of learned CIT(A) is reversed. Thus, ground no. 3 of the assessee is allowed."
14. In the case of SC Enviro Agro India Ltd. v. Dy. CIT (ITA No 2057 & 2058/Mum/2009) the Hon'ble Mumbai Bench of the Tribunal held that—
"The TPO has to examine whether the price paid or amount paid was at arms length or not under the provisions of Transfer Pricing and its rules. The rule does not authorize the TPO to disallow any expenditure on the ground that it was not necessary or prudent for assessee to have incurred the same"
15. Further, the Hon'ble Delhi Bench of the Tribunal in the case of AWB India (P.) Ltd. v. Addl. CIT ITA No 4454/Del/2011 held as under:
"As also settled by judicial decisions (supra), the revenue authorities are not empowered to question the commercial wisdom of the assessee and it is entirely for the assessee to take such decisions as favour the advancement of the assessee's business."
16. Furthermore, it is not disputed that the assessee company maintained the necessary documentation of the international transactions as per Section 92D read with Rule 10D. The assessee company had also submitted details of the technology knowhow it obtained from its AE and the details of the Royalty payments made.
17. The TPO has not only refuted the justification of Royalty payments but also pointed out that there was "reverse flow" by analyzing the deputation of personnel by the Indian company for various projects. This has been countered by the assessee specifically. The TPO has not countered that argument effectively nor is there anything on record to indicate otherwise.
18. Hence, what we see is the TPO sitting on judgment on the business and commercial expediency of the assessee which is erroneous as per the provisions of the Act as laid down clearly by the Hon'ble Delhi High Court in EKL Appliances (supra).
19. It is also noted that various Tribunals such as Dy. CIT v. Sona Okegawa Precision Forgings Ltd. (ITA No. 5386/Del/2010), Hero Motocorp Limited vs Addl CIT (ITA No 5130/Del/2010), ThyssenKrupp Industries India Ltd vs Addl CIT (ITA No 6460/Mum/2012), Abhishek Auto Industries Ltd. vs. CIT (ITA No 1433/Del/2009) have taken a view that RBI approval of the Royalty rates itself implies that the payments are at Arm's Length and hence no further adjustment needs to be made viewed from this angle too.
20. Furthermore, we are of the opinion that once TNMM has been applied to the assessee company's transaction, it covers under its ambit the Royalty transactions in question too and hence separate analysis and consequent deletion of the Royalty payments by the TPO in the instant case seems erroneous. We draw support from the Hon'ble Mumbai ITAT decision in Cadbury India Ltd. v. Addl. CIT ITA No 7408/Mum/2010 and ITA No.7641/Mum/2010 wherein the Hon'ble ITAT upheld the use of TNMM for Royalty as well as relied on many of the above decisions to hold adjustment by TPO was erroneous:
"33. The TPO has made the disallowance in question mainly on the basis of the benefit test. In this regard, it is seen that the payment of royalty cannot be examined divorced from the production and sales. Royalty is inextricably linked with these activities. In the absence of production and sale of products, there would be no question arising regarding payment of any royalty. Rule 10A(d) of the ITAT Rules defines 'transaction' as a number of closely linked transactions. Royalty, then, is a transaction closely linked with production and sales. It cannot be segregated from these activities of an enterprise, being embedded therein. That being so, royalty cannot be considered and examined in isolation on a standalone basis. Royalty is to be calculated on a specified agreed basis, on determining the net sales which, in the present case, are required to be determined after excluding the amounts of standard bought out components, etc., since such net sales do not stand recorded by the assessee in its books of account. Therefore, it is our considered opinion that the assessee was correct in employing an overall TNMM for examining the royalty. The TPO worked out the difference in the PLI of the outside party (the assessee) at 4.09% and the comparables at 7.05%. This has not been shown to fall outside the permissible range.
34. The decision of the Tribunal in 'Ekla Appliances', 2012-TII-01-HCDel- TP, has been sought to be distinguished by the TPO, observing that the facts in that case are not in pari materia with those of the assessee's case. However, therein also, the benefit test had been applied by the TPO, as in the present case. The matter was carried in appeal before the Hon'ble High Court. The Hon'ble Delhi High Court has held that the so-called benefit test cannot be applied to determine the ALP of royalty payment at nil and that the TPO could apply only one of the methods prescribed under the law. A similar view has been taken in 'Sona Okegawa Precision Forgings Ltd.' (supra) and in 'KHS Machinery Pvt. Ltd. v. ITO' 53 SOT 100 (Ahm) (URO).
35. It is, thus, seen that the royalty payment @ 3% by the assessee is at arm's length. The Technical Collaboration Agreement stands approved by the Government of India. The royalty payment has been accepted by the department as having been made by the assessee wholly and exclusively for its business purposes. For Assessment Years 2004-05 and 2005-06, such payment of royalty has been allowed by the CIT (A). As per the FEMA Regulations, royalty can be paid on net sales @ 5% on domestic sales and @ 8% on export sales. The royalty payment by the assessee falls within these limits. It also falls within the limits of payment of royalty in the automobile sector, as per the market trend. This payment of royalty is at the same percentage as that paid by other auto ancillaries in the automotive industry. Then, in 'Ekla Appliances' (supra) and in 'Ericsson India (P.) Ltd. v. DCIT', 2012-TII-48-ITAT-Del-TP, it has been held that royalty payment cannot be disallowed on the basis of the so-called benefit test and the domain of the TPO is only to examine as to whether the payment based on the agreement adheres to the arm's length principle or not. That being so, the action of the TPO in the present case, to make the disallowance mainly on the ground of the benefit test, is unsustainable in law.
36. Keeping in view all the above factors, the disallowance made on account of royalty is found to be totally uncalled for and it is deleted as such. …".
21. Hence, following the ratio of the Hon'ble Delhi High Court in EKL Appliances Ltd. case (supra) and various other decisions as noted above and given the facts and circumstances of the instant case, we hold that the addition made by the TPO and upheld by the DRP is unsustainable and is to be deleted. Hence Ground No. 2 is held in favour of the assessee. Hence, the appeal of the Revenue ITA.No.1040/Hyd/2011 is dismissed and Assessee's appeal in ITA.No.1159/Hyd/2011 is allowed.
22. With respect to ITA.No.1408/Hyd/2010 for the A.Y. 2006-2007 the facts are identical and hence the conclusions drawn in ITA.No.1159/Hyd/2011 have to be applied. Further, the learned Counsel for the assessee had also invited our attention to page 53 wherein the operating cost has been declared at Rs.98,61,88,320/- and the same has been reflected in the P & L account for the year ending 31st March, 2005 at page 234 of the paper book. At page 245 of the paper book under 'Selling Expenses' the amount of Rs.2,02,94,565/-against royalty has already been taken into account. Hence, we find that royalty has been already considered and factored in and hence, the Assessing Officer's order has to be dismissed as unjustified. Since, we find force in the arguments of the learned Counsel, we allow the appeal of the assessee ITA.No.1408/Hyd/2010.
23. In the result, ITA.No.1040/Hyd/2011 of the Revenue is dismissed and ITA.No.1159/Hyd/2011 and ITA.No.1408/Hyd/2010 of the assessee are allowed.
The order pronounced in the open court on 13.02.2014