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CASE LAW

2017-TII-10-HC-AP-TP

PR CIT Vs RAK CERAMICS INDIA PVT LTD: ANDHRA PRADESH HIGH COURT (Dated: December 23, 2016)

Income tax - Section 92CA

Keywords - benefit test - royalty - receipt of technical knowhow - attribution of profit

The assessee, a wholly owned subsidiary of RAK Ceramics PSC, UAE, is engaged in manufacturing vitrified tiles and sanitaryware products in India for sale in domestic and international markets. During the subject year, the assessee entered into a Royalty Agreement with its AE, RAK Ceramics PSC, UAE. In consideration of the technical assistance on process and product improvement to be provided to the assessee, royalty equivalent to 3% of the net ex-factory sale price of the products on both domestic and export sales during the tenure of the said agreement was payable by the assessee to its AE. During TP proceedings, the deduction claimed by assessee in respect of this royalty amount was rejected on the ground that the assessee had clubbed an intangible transaction with tangible transactions while applying TNMM. The TPO held that the assessee did not fulfill the conditions of the ‘benefit test’ and that there was no perceptible change in the sale or profit which could be attributed to receipt of technical know-how from the AE to justify payment of royalty at 3% to it. He accordingly restricted the royalty payment to 2% instead of 3% of the net ex-factory sale proceeds.

On appeal, the ITAT took note of the fact that no analysis was undertaken by the TPO in fixing the ALP of royalty payment made to AEs. The Tribunal further found that TPO had not adopted any of the methods prescribed u/s 92CA r/w Rule 10B and rejected the application of ‘benefit test’ adopted by the TPO.

On appeal, the HC held that,

Whether payment of royalty by a wholly owned Indian subsidiary to its Foreign holding company, can be restricted, merely upon failure of the subsidiary to show attribution of profit towards receipt of technical knowhow - NO: HC

+ in so far as the acceptable study adopting the Comparable Uncontrolled Price method is concerned, it is not in dispute that the assessee offered three comparables with an average royalty payment of 3.65% as against its own rate of royalty at 3%. Significantly, the TPO rejected these comparables on the ground that they were US based, while the AE of the assessee was UAE based. Having rejected these comparables, it was for the TPO to come up with other comparables so as to justify reduction of the royalty payment. However, no such exercise was undertaken by the TPO and by going into the whys and wherefores of the improvement in the net sales and profit of the assessee, the TPO determined that the reason for the same was increased marketing along with offer of discounts and that there was no justification for payment of royalty at 3% to the AE by the assessee. This reasoning is without legal basis of law as it is not for the TPO to decide the best business strategy for the assessee;

Whether once it is admitted that assessee had claimed benefit from a royalty agreement entered into with its AE in the form of quantum increase in sales with no apparent increase in production, and consequently paid royalty in terms thereof, it is not for the TPO to determine other reasons for increase in assessee’s sales and profit - YES: HC

+ in case of Walchand and Co. Pvt. Ltd., the Supreme Court observed in the context of the Income Tax Act, 1922 that when a claim is made for an allowance by the assessee, the income tax authorities have to decide whether the expenditure claimed as an allowance was incurred voluntarily and on grounds of commercial expediency. The Supreme Court pointed out that in applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively for the purpose of business, it has to be adjudged from the point of view of the businessman and not of the revenue. The Supreme Court concluded that it is open to the revenue to come to the conclusion that the alleged payment was not real or that it had not been incurred by the assessee in the character of a trader or that it was not laid out exclusively for the purpose of the business so as to disallow it but it is not the function of the revenue to determine what remuneration should be paid to an employee by the assessee. Applying the same logic to the case on hand, once it is admitted by the Revenue that the assessee entered into a royalty agreement with the AE and the assessee claimed benefit from such agreement, in the form of quantum increase in sales with no apparent increase in production, minimal product recalls and low after sales maintenance cost, and consequently paid royalty in terms thereof, it was not for the TPO to determine as to what could be the other reasons for increase in the assessee’s sales and profit;

+ there is no explanation forthcoming as to why the TPO decided upon 2% instead of the contractual rate of 3% for payment of royalty. No reason is offered by the TPO for picking on 2%. This whimsical fixation by the TPO amounts to an arbitrary and unbridled exercise of power. In consequence, the TPO, having rejected the comparables cited by the assessee, did not take the trouble to examine alternate comparables so as to justify reduction of the rate for payment of royalty and by applying a wholly inapplicable methodology of determining the benefit from payment of such royalty, he capriciously reduced the rate for payment of such royalty from 3% to 2%. On the above analysis, there are no grounds to interfere with the cogent and well reasoned order passed by the Tribunal.

Revenue's appeal dismissed