The Chennai Bench of the Income Tax Appellate Tribunal (ITAT) ruled on 4 February 2019 that since a royalty paid by an Indian subsidiary to its Korean parent company was lower than the industry average royalty rate, the payments were at arm’s length and no transfer pricing adjustment was required.
Facts of the case
The taxpayer, a wholly-owned subsidiary of a Korean company, is engaged in the business of the manufacture and sale of passenger cars within and outside India. It pays the Korean parent a royalty of 5% on domestic sales and 8% on exports for the use of technology and the trade name. The 5% and 8% rates are specified in regulations issued by the Reserve Bank of India that also specify what constitutes sales for the purposes of the royalty calculation. In the taxpayer’s transfer pricing documentation, the royalty transaction was aggregated with all other international transactions and benchmarked using the transactional net margin method (TNMM). During the assessment proceedings for the assessment year (AY) 2006-07, the Indian transfer pricing officer (TPO) determined that the royalty payment made by the taxpayer was excessive and made an ad hoc disallowance of 10% of the royalty.
The taxpayer filed an objection before the Dispute Resolution Panel (DRP). After considering the taxpayer’s arguments, the DRP called for a remand report requesting the TPO to reanalyze the case, with a specific direction to adopt the comparable uncontrolled price (CUP) method to benchmark the royalty transaction.
The TPO initiated a royalty benchmarking study but was unable to find any appropriate comparables. The TPO issued a notice requesting that the taxpayer conduct the study. In response to the notice, the taxpayer conducted a benchmarking study using a global commercial database of royalty rates and license agreements. The search yielded comparable agreements only for the manufacture of auto components and the taxpayer submitted 10 comparable agreements with an average royalty rate of 7.08%.
The TPO in the remand report selectively adopted the taxpayer’s report and considered only three comparable companies with an average royalty of 5%. On this basis, the TPO concluded that the 8% royalties paid on exports were not at arm’s length. The TPO also allocated a proportion of a lump sum technical know-how payment paid in previous years to AY 2006-07 and included this amount as part of the transfer pricing adjustment.
The taxpayer filed a response to the remand report issued by the TPO but the DRP did not consider the submission and confirmed the adjustment proposed by the TPO. The taxpayer appealed to the ITAT.
Issue before the ITAT
The ITAT was asked to consider:
Whether based on the facts and in law the DRP was justified in rejecting the TNMM and adopting the CUP method to separately benchmark royalty transactions. The taxpayer requested a without prejudice finding that the CUP method was incorrectly applied by the TPO by selecting as comparables agreements that did not relate to transactions for the manufacture and sale of passenger cars;
Even assuming the CUP was the most appropriate method, the DRP should have considered the industry average royalty rate of 4.7% as the arm’s length price;
The issue already had been addressed in an earlier case involving the taxpayer relating to AY 2007-08, when the average royalty payment in the automotive sector from a study of 35 publicly available licenses of 4.7% was compared with the average royalty paid by the taxpayer. The royalty payments were deemed to be at arm’s length and the adjustment on account of royalty was removed. Since the royalty agreements entered into by the taxpayer and its associated enterprises were valid for a period of 10 years, the royalty payments for AY 2006-07 were determined on the same basis as those for AY 2007-08 and, therefore, should be accepted as arm’s length; and
The TPO exceeded its jurisdiction by seeking adjustments in respect of the lump sum technical know-how payment, which was not a transaction in AY 2006-07.
Decision of the ITAT
The ITAT relied on the ruling in the taxpayer’s case relating to AY 2007-08 when the following observations were made:
The taxpayer had aggregated all the international transactions and benchmarked using TNMM, which demonstrated that the taxpayer’s operating margins were higher than the comparable companies;
The comparable companies selected by the TPO for benchmarking the royalty payment had controlled transactions and, therefore, the benchmarking analysis undertaken by the TPO was unreliable and could not be accepted; and
The TPO in another context and in respect of a different adjustment had observed that the average royalty payment in the automobile sector was 4.7%. This exceeded the taxpayer’s average royalty rate of 4.22% of net sales per the financial statements, so the royalty transaction was considered to be at arm’s length.
Applying the principles established in the ruling in the taxpayer’s case for AY 2007-08, the ITAT held that an average royalty payment of up to 4.7% on the sales was justified. Since the average royalty rate paid by the taxpayer in AY 2006-07 was 3.64% of net sales per the financial statements, the addition in respect of excess royalty should be removed from the assessment.
Comment
This is a significant ruling on the payment of royalties and the ITAT adopted a distinctive approach to determining the arm’s length price of the transaction.
The majority of previous judicial decisions in this area focused on one of the following principles:
Accepting the aggregation approach under the TNMM where the operating margins of the taxpayer after making the royalty payment are higher than the comparables;
Adopting royalty rates specified by the Reserve Bank of India (i.e. 5% and 8%) as the arm’s length price; or
Considering the Foreign Exchange Management Act 1999 guidelines for making royalty payments.
In the case at hand, the ITAT applied a different approach and accepted the average royalty rate prevailing in the automotive sector based on a study of 35 licenses conducted by an independent body as the arm’s length price for the purpose of benchmarking the royalty transaction. The Indian tax authorities traditionally have been reluctant to accept royalty benchmarking data from foreign databases. The tribunal’s decision to adopt publicly available industry average rates as the CUP for benchmarking royalty payments is welcome and may function as a precedent for other automobile companies facing similar issues.
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