This content is from: India

Delhi Tribunal rules on transactional net margin method

Hasnain Shroff, Sanjeev Gupta and Tarini Nijhara in India look at the unreported judgement in the case of IL Jin Electronics (India) Private Limited.

In an interesting judgement, the Delhi bench of the Income-tax Appellate Tribunal provided vital guidance for ascertaining the arm’s-length price of an international transaction under the transactional net margin method (TNMM).

The taxpayer, IL Jin, an Indian company, entered into various international transactions with its associated enterprises (AEs) to carry out its operations, with the bulk of international transactions being that of purchase of raw material.

During the audit proceedings, the transfer pricing officer (TPO) objected to two of the comparables and accordingly, on the basis of average margin earned by the remaining comparables (5.29%) with regard to that earned by the taxpayer,(1.65%), the TPO made a downward adjustment to IL Jin’s international transaction of imports of raw material and held other transactions at arm’s length. In light of the TPO’s order, the assessing officer (AO) made additions to IL Jin’s taxable income which were  upheld subsequently by the commissioner of income-tax (appeal) [CIT(A)].

Aggrieved by the decision, IL Jin filed an appeal with the tribunal against the order. Among various grounds of appeal, the taxpayer averred that while ascertaining the arm’s-length price of the international transaction under TNMM, the total difference arising in operating profit cannot be exclusively attributed to the international transaction. In this regard, IL Jin brought the tribunal’s attention to the fact that for manufacturing printed circuit board, IL Jin consumed 45.51% imported and 54.49% indigenised raw material.

Therefore, the taxpayer contended that the profit margin of 5.29% of sales should be proportionately applied to arrive at the arm’s-length price of the imported raw material. Based on the facts of the case, the tribunal concurred with the taxpayer that only 45.51% of the operating profit arising from the sales can be attributed to the import of raw material and thereby directed the AO to reduce the adjustment proposed by the TPO.

Thus, the ruling provides insight into the mechanism for ascertaining the arm’s-length price of the international transaction under TNMM. In addition, the tribunal has proffered an implicit or tacit acceptance of the fact that a company can earn low-margins due to factors other than international transaction. The observations made by the tribunal once again resonate with the principle which has been upheld in the recent ruling of Global Vantage wherein the Delhi tribunal had espoused the philosophy that while assessing an international transaction, the evaluation needs to be restricted to the international transaction only.

However, the matter of debate will be how to apply the approach adopted in this judgment in more complex situations. For instance, under TNMM, the operating margin garnered by a company is a function of total sales, cost of goods sold and other expenses such that difference in operating profit earned by the tested party as compared to that earned by the comparable companies, can be due to any of these factors. However, due to non-availability of data for application of statistical tools, many times it is not possible to make appropriate adjustments for various differentiating factors, thereby resulting in attribution of the deficit in the operating margin entirely to the international transaction(s). To some extent, this issue dovetails with a broader challenge that is underway concerning the methodology for making ‘appropriate adjustments’ for enhancing comparability.

Hasnain Shroff (hshroff@kpmg.com), Sanjeev Gupta (sanjeevgupta@kpmg.com) and Tarini Nijhara (tnijhara@kpmg.com)

The material on this site is for financial institutions, professional investors and their professional advisers. It is for information only. Please read our Terms and Conditions and Privacy Policy before using the site. All material subject to strictly enforced copyright laws.

© 2019 Euromoney Institutional Investor PLC. For help please see our FAQ.

Instant access to all of our content. Membership Options | One Week Trial

Related