In the case of SC Enviro Agro India v DCIT the tribunal held that it is not the role of a transfer pricing officer (TPO) to assess whether a technology royalty was payable as a legitimate business purpose. The tribunal said the TPO’s role is to analyse only whether the payment was made at an arm’s-length price, and it is for the assessing officer (AO) to determine whether or not the royalty should have been paid.
SC Enviro Agro case
SC Enviro Agro (Enviro Agro) entered into a technical licence agreement with Sumitomo Chemical Company (SCC) which allowed it to produce certain chemical products commercially as part of its insecticide and pesticide manufacturing business.
The agreement entailed that Enviro Agro only sold its products to companies approved by SCC.
It also purchased any intermediate ingredients only from SCC.
The company to which most of Enviro Agro’s products were sold was a wholly-owned subsidiary of SCC.
In its transfer pricing study, Enviro Agro said its arrangement with SCC and its subsidiary was in the nature of contract manufacturing, though it argued in court that it was an independent manufacturer.
The TPO accepted that the price paid and received by Enviro Agro was arm’s length.
However, the TPO disallowed the royalty payment made by Enviro Agro to SCC, arguing that the taxpayer was only buying from and selling to related parties and there was no commercial exploitation of technical knowhow involved. As a contract manufacturer, Enviro Agro should not have paid royalties.
The TPO also contended that the royalty should have been paid only on third-party sales and not on related-party sales.
In its appeal, Enviro Agro said it was not a contract manufacturer but an independent manufacturer which obtained technical knowhow for the manufacturing of insecticides and pesticides from SCC and paid royalties on this basis.
Enviro Agro also said it had not paid royalties on the entire sales price, but only on the value addition made to the intermediates purchased from SCC. Therefore no royalty was paid on the purchase cost of the raw material, only on the value addition.
Ruling
The tribunal held that the nature of manufacturing activity, whether contract manufacturing or fully-fledged, cannot have any bearing on the payment of royalty.
Furthermore, the tribunal said the allowance of royalty cannot be restricted to third-party sales.
It also said that a TPO’s role is not to assess whether a royalty payment is in line with a taxpayer’s business; that is something for the AO to decide.
Since in this case the AO had not raised an issue with the royalty payment being made, and the TPO accepted the payment was at arm’s length, the tribunal decided in favour of the taxpayer.
Devang Buddhadev, of Deloitte, said the ruling is a welcome one as it favours taxpayers engaged in manufacturing activity in what is a vexatious transfer pricing issue in India – the payment of royalties to associated enterprises.
“The ruling will certainly help in justifying the payment of royalty by entities undertaking contract manufacturing, toll manufacturing or fully-fledged manufacturing for their group companies.”
Continued uncertainty
Ashish Bhatnagar, of ELP India, said the case highlights how the Indian tax authorities are subjecting taxpayers’ cases to stricter tests and making distinctions between various categories such as fully-fledged manufacturer, contract manufacturer and toll manufacturer.
“While this development is a welcome change, it makes the task of the taxpayer onerous in distinguishing and placing itself in a particular category which could make the difference in expectation of earnings, and comparable companies that the taxpayer should be pitted against,” said Bhatnagar.
Royalty payments made on account of the use of trade marks, trade names and know-how continue to generate uncertainty in India.
Ajit Tolani, also of ELP, said the revenue authorities will attempt to deny royalty payments to overseas IP holders in an inbound structure, while for outbound structures – typically India-centric multinationals – they insist on royalty receipts.
“Taxpayers should maintain some defence in the form of legally valid and tenable inter-company agreements, as well as a close watch on the behaviour pattern of their peers in the market-place,” said Tolani.
Indian taxpayers can also cite international transfer pricing practices when defending their position. Tolani said even when field-level officers are unwilling to tread on the taxpayer’s path, the good news is that the ITAT takes a fair and unbiased position when presented with evidence by the taxpayer.
“However, it should be kept in mind that there is no short-cut to having a transfer pricing solution. The solution lies in the taxpayer detailing the facts and analysis in a manner which would either help it get a clear result immediately at the field-officer level or, alternately, would make it very difficult for the revenue authorities to impose any transfer pricing adjustments,” said Bhatnagar.
