22 October 2019
Benefit test is not a benchmarking method; Royalty can be benchmarked using aggregate approach under TNMM
Brief facts of the case
SNF India private Limited (Taxpayer) is a 100% subsidiary of French company engaged in the business of manufacturing water-soluble polymers. During the year under consideration (i.e. AY 2007-8 and AY 2008-09), the Taxpayer has entered into various related party transactions, including, purchase of raw materials and payment of Royalty to its overseas Associated Enterprises (AE). 
As regards the payment of royalty to AE (issue under consideration), the Taxpayer has used the Transactional Net Margin Method (TNMM) to justify the arm’s length nature in its transfer pricing study. Further, the Taxpayer claimed that the royalty transaction is closely connected and inextricably linked with its manufacturing operations and accordingly followed the aggregated approach for applying TNMM.
A. Outcome of Transfer Pricing assessment
The Transfer Pricing Officer (TPO) contended that the Royalty transaction cannot be aggregated with other related party transactions for benchmarking purposes. Further, the TPO suggested that for Royalty transaction, Comparable Uncontrolled Price Method (CUP) should be selected as the most appropriate method.
Accordingly, the TPO rejected TNMM as the most appropriate method of benchmarking and determined the ALP of Royalty at NIL by applying benefit test, holding that the Taxpayer did not receive any benefit from the payment of Royalty.
B. Outcome of Commissioner of Income Tax -Appeals [CIT(A)] proceeding
Upon review of details/evidences submitted by the Taxpayer in support of the benefits received towards the payment of royalty, the CIT(A) concluded that Taxpayer has received benefits from technical information provided by AE and that TPO was not justified in determining the ALP of royalty at NIL. 
Further, CIT(A) upheld that CUP cannot be used as the most appropriate method since the TPO could not identify any comparable data to benchmark payment of royalty under CUP and thus upheld TNMM as the most appropriate method.
C. Order by Hon’ble ITAT, Visakhapatnam Bench
Aggrieved by the order of CIT(A), the tax department (Revenue) filed an appeal before the Honourable Income Tax Appellate Tribunal (Hon’ble ITAT). The Revenue raised various grounds on legal as well as factual aspects of the case.
We have briefly summarized Hon’ble ITAT’s observations and judgment as below
  1. Benefit test is satisfied
    The Hon’ble ITAT upheld CIT(A)’s view that Taxpayer has derived benefits from technical information provided by AE based on the correspondence and e-mails submitted by Taxpayer. Hon’ble ITAT confirmed that the technical knowledge and information shared by AE from time to time with the Taxpayer has enabled it to improve the quality of the product and to stay relevant in the competitive market. Thus, the Hon’ble ITAT concluded that the Taxpayer has received benefits from its AE’s towards payment of royalty. 

    Although, the Hon’ble ITAT upheld that to benchmark a transaction, one of the prescribed methods is to be adopted and that benefit test is not a prescribed method.

  2. CUP method adopted by the TPO is defective
    Hon’ble ITAT observed that though the TPO has adopted CUP as the most appropriate method for determining the ALP of royalty, TPO did not bring any comparable cases. Therefore, adopting CUP method without the support of any comparable cases would be defective and thereby rejected CUP as the most appropriate method.

  3. Aggregation of transactions
    Relying on judicial precedents in case of Frigoglass India Private Limited (41702/2017) and Sony Ericsson Mobile Communications India Pvt. Ltd. (ITA no. 16/2014), Hon’ble ITAT stated that manufacturing activity of Taxpayer and continuous technical support for which royalty is paid are inter-dependent and interrelated.

    Hon’ble ITAT thus held that determination of Arm’s Length Price at NIL for payment of royalty is unjustified and that the most appropriate method for determining the royalty payment is TNMM. Thus, the Hon’ble ITAT upheld the aggregated approach to benchmark the payment of Royalty to AE. 
SKP's Comments
Hon’ble Tribunal answered quite a few questions of principle nature in this judgment regarding transfer pricing analysis, such as
  • That, aggregation approach for intangible related transactions such as Royalty can be evaluated
  • That, it is the duty of the tax authorities as well as Taxpayer to select one of the prescribed methods for the purpose of benchmarking; benefit test is not a prescribed method
  • That, in the absence of any comparable uncontrolled transaction, CUP cannot be used as the most appropriate method for benchmarking.
While transfer pricing as a subject, and especially the determination of arm’s length nature of intangible transactions (such as royalty) is a very fact-specific exercise, the said judgment is relevant and shall certainly carry a persuasive value for other similar cases under dispute.* 

*SKP Litigation team assisted the company in this case.
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