Dispute Resolution Panel

Reasoned order — DRP is required to pass proper and speaking order under s 144c after giving proper consideration to the submissions made on behalf of the assessee — as held by MumTrib in DHL Lemur Logistics (P) Ltd v DCIT — In favour of: Others ; ITA No. 7361 (Mum.) of 2010 : Assessment Year: 2006–2007

DHL Lemur Logistics (P) Ltd. v DCIT

ITAT, Mumbai

ITA No. 7361 (Mum.) of 2010

Assessment Year: 2006-07

P.M. Jagtap, AM and V. Durga Rao, JM

Decided on: 18 May 2011

Counsel appeared:

Rahul Mitra and Kanchan Kaushal for the appellant

Narendra Singh for the respondent

Order

P.M. Jagtap, AM

1. This appeal filed by the assessee is directed against the order of Dy. Commissioner of Incometax-

8(1), Mumbai dated 20th August, 2010 passed under section 143(3) read with section

144C(13) whereby he made an addition to the total income of the assessee by way of transfer

pricing adjustments under section 92CA.

2. The assessee in the present case is a company which is engaged in the business of providing

logistic and related services. The return of income for the year under consideration was filed by

the assessee on 30-12-2006 declaring a total income of Rs.23,73,88,170. During the said year, the

assessee company had entered into international transactions involving freight expenses and

freight receipts with its associated enterprises. For the purpose of bench marking the said

transactions, the assessee company prepared a detailed T.P. study by applying Transactional Net

Margin Method (TNMM) and using "operating profit to value added expenses" (OP/VAE) as the

price level indicator. For comparative analysis, the assessee company identified four comparable

companies engaged in the business of providing logistic services which had earned a mean

operating OP/VAE margin of 23.67% as against the OP/VAE of 65.25% of the assessee. The

assessee company accordingly claimed that its international transactions were at Arm's Length.

 

3. The Transfer Pricing Officer (TPO) rejected the OP/VAE taken by the assessee as profit level

indicator and adopted operating profit to total cost (OP/TC) as the price level indicator. He also

required the assessee to undertake a fresh search for comparable companies using the financial

data of the year under consideration. A fresh search accordingly was undertaken by the assessee

which gave a set of 22 comparable companies. Out of the said 22 comparable companies, the

TPO rejected four companies being consistent loss makers and further rejected one more

company being functionally different. As the main operating margin of the remaining comparable

companies taking OP/TC as the price level indicator was found to be higher than that of the

assessee, TP adjustment of Rs.25,21,77,854 was sought to be made to the total income of the

assessee in the draft order proposed by the AO. Against the said order, the assessee approached

Dispute Resolution Panel-1 (DRP) raising various objections. The DRP, however, did not find

merit in the said objections and overruling the same, it confirmed the TP adjustment proposed by

the AO vide an order dated 5-8-2010 passed under section 144C(5). Accordingly, assessment

order under section 143(3) read with section 144C was passed by the AO making addition on

account of TP adjustment of Rs.25,21,77,854. Aggrieved by the said order, the assessee has

preferred this appeal before the Tribunal.

4. Although several grounds are raised by the assessee in this appeal, the learned counsel for the

assessee has submitted that the main preliminary issue involved in this case is raised in ground

No. 2.4 which reads as under:

"The Ld. DRP has grossly erred in agreeing with the Ld. Transfer Pricing Officer's (TPO)

action of failing to appreciate the economic rationale of using "Operating Profit/Value

Added Expenses" as the Profit Level Indicator ('PLI'), and instead using "Operating

Profit/Total Cost" as the PLI. The said approach is not in accordance with section 92 of

the Act read with Rule 10B(1)(e) of the Rules, and the OECD TP Guidelines."

5. The learned counsel for the assessee submitted that the main preliminary issue involved in

ground No. 2.4 relates to the determination of proper and appropriate "price level indicator" that

is to be applied in the facts of the assessee's case for doing exercise of transfer pricing applying

Transactional Net Margin Method. He contended that if "operating profit to value added

expenses" (OP/VAE) is taken as more appropriate and correct price level indicator than the

"operating profit to total cost" (OP/TC) adopted by the AO/TPO, the same shown by the assessee

being higher than the mean OP/VAE of the comparable companies, no TP adjustment is required

to be made and accordingly other issues involved in this case will become academic only. He

then proceeded to make various submissions in support of the assessee's case that the OP/VAE is

the most appropriate and correct price level indicator taking into consideration all the facts of the

case including especially the nature of assessee's business. He also filed a written note

summarizing all his submissions as under:

As detailed in paragraph 5.11 of the TP study report (filed with the TPO vide submission

dated January 27, 2009), the Appellant had considered Operating Profit/Value Added

Expenses ('OP/VAE') as the appropriate PLI to determine the arm's length price of the

international transactions [Please refer Page No.42 of the paper book for the relevant

reference in the TP report].

For your kind reference, the Appellant has detailed below the rationale for the use of

PO/VAE as the PLI to benchmark the international transactions.

Costs in logistics companies typically comprise of direct costs and value adding costs.

Direct costs are expenses incurred by a Logistics company to procure services from third

party service providers such as shippers/airlines, clearing and forwarding agents,

transporters etc. On the other hand, value adding expenses are incurred by a logistics

service provider on a day to day basis in support of its own operations. Personnel cost,

selling costs, establishment and administrative costs etc. are examples of value adding

expenses.

The TP treatment of any expense is based on principles of business economics. The

question is "what is the appropriate PLI to be used in TP analysis that would best

measure the relationship between profits of the controlled taxpayer (assessee in this case)

on one hand, and the functions performed by such taxpayer on the other hand."

In the instant case, it is imperative to measure value adding expenses (costs associated with the

Company's own functions) separately since a logistics service provider's efficiency can be

measured by the adequacy of the gross margin (Service income less direct third party costs) over

value adding expenses.

However the return on total costs does not measure this efficiency as it disregards the

composition of costs. It effectively assumes a common markup on all costs including direct costs,

which may differ from time to time depending on the volume of business. This will present a

skewed picture of the Appellant's profitability and therefore cannot be considered as an

appropriate PLI. [Please refer Page No. 271 of the paper book for the analysis of the direct costs

and total costs].

The return on value-adding expenses is an appropriate measure for companies where the cost of

service inputs obtained from third parties is significant (however, little or no value is added by the

company in respect of such inputs-as is the case of the Appellant). A variation in value-adding

expenses reflects different levels of operating capacity employed by the Appellant to

arrange/coordinate the services of third parties. Therefore, this measure can be thought of as an

approach to account for differences in nature and scale of functions/activities of a Logistics

company.

In the Logistics industry, Direct Costs in the nature of freight paid to airlines, customs clearance

costs etc. are "pass-through" costs for a Logistics company. The Appellant need not measure its

operating efficiency in relation to these "pass-through" costs. This is for the reason that little or

no value is added by the Company in relation to such services obtained from third parties. Such

services are relayed to the customer on an "as is" basis.

The above principle is fully supported by the OECD TP Guidelines, which explain that

agency/intermediary service providers need not apply a markup to "pass-through" expenses,

which are passed on to customers. We have reproduced below the relevant extract (para 7.36) of

the OECD Guidelines which for your ready reference.

Para 2.93

In applying a cost-based transactional net margin method, fully loaded costs are often used,

including all the direct and indirect costs attributable to the activity or transaction, together with

an appropriate allocation in respect of the overheads of the business. The question can arise

whether and to what extent it is acceptable at arm's length to treat a significant portion of the

taxpayer's costs as pass-through costs to which no profit element is attributed (i.e. as costs which

are potentially excludable from the denominator of the net profit indicator). This depends on the

extent to which an independent party in comparable circumstances would agree not to earn a

mark-up on part of the costs it incurs. The response should not be based on the classification of

costs as "internal" or "external" costs, but rather on a comparability (including functional)

analysis. See para 7.36.

Para 2.94

Where treating costs as pass-through costs is found to be arm's length, a second question arises as

to the consequences on comparability and on the determination of the arm's length range. Because

it is necessary to compare like with like, if pass-through costs are excluded from the denominator

of the taxpayer's net profit indicator, comparable costs should also be excluded from the

denominator of the comparable net profit indicator. Comparability issues may arise in practice

where limited information is available on the breakdown of the costs of the comparables.

Para 7.36

"When an associated enterprise is acting only as an agent or intermediary in the provision

of services, it is important in applying the cost-plus method that the return or mark-up is

appropriate for the performance of an agency function rather than for the performance of

the services themselves. In such a case, it may not be appropriate to determine arm's

length pricing as a mark-up on the cost of the services but rather on the costs of the

agency function itself, or alternatively, depending on the type of comparable date being

used, the mark-up on the cost of services should be lower than would be appropriate for

the performance of the services themselves. For example, an associated enterprise may

incur the costs of renting advertising space on behalf of group members costs that the

group members would have incurred directly had they been independent. In such a case,

it may well be appropriate to pass on these costs to the group recipients without a markup,

and to apply a mark-up only to the costs incurred by the intermediary in performing

its agency function."

The facts of the Appellant are similar. To illustrate this point, when the assessee delivers goods

by air for a customer, it contracts with the customer in the capacity of an agent of the airline or

the shipping line. The functions that are performed by the Appellant as an agent are co-ordination

functions, where it is responsible for bringing various third party service providers (such as a

airlines, transporters, clearing and forwarding agents, warehouse keepers) to a common platform

to provide integrated logistics services to a customer. The costs associated with such coordination

(agency) functions are embedded in the Company's own personnel cost, selling costs

and administrative costs (value added expenses).

The Appellant would like to submit that the choice of the PLI should be determined by the type of

activity performed by the tested party and the economic circumstances of the related party

transactions, as well as the reliability of available data for third party comparables. Also, the

Appellant would like to submit that while undertaking the benchmarking analysis, the Appellant

has excluded third party costs from its cost base as well as that of the comparable companies. The

Appellant would like to humbly submit that its approach of undertaking the economic analysis is

in line with the approach suggested by the OECD TP Guidelines.

The Appellant would like to submit that for the service providers such as the Appellant, the ratio

of OP/VAE is the appropriate yardstick to judge its profitability. At this stage, the Appellant

would like to draw your kind attention to the concept of Berry Ratio which is a ratio of Gross

Profit to Value Added Expenses ('GP/VAE'). In essence Berry Ratio considers the relationship

between the level of VAE and the level of Gross Profits earned by the service providers.

Conceptually, the Berry Ratio represents a return on the company's internal functions and

assumes that those functions are captured in VAE. In other words, the Berry Ratio can be a useful

measure of the mark-up earned on the VAE or the 'cost of provision'. To better understand that

relationship, it may be prudent to reduce the Berry Ratio in terms of operating profit by

subtracting one from the Berry Ratio as follows:-

Berry Ratio - 1 = GP/VAE-1

= (GP-VAE)/VAE

= OP/VAE

Wherein GP=Gross Profit; OP=Operating Profit; and VAE=Value Added Expenses.

Thus, the Appellant would like to submit that the ratio of OP/VAE is merely an alternative way to

conceptualise the Berry Ratio.

The Appellant would also like to draw your kind attention to the relevant extract of the revised

OECD Guidelines wherein the concept of Berry Ratio has been deliberated:

2.100 "Berry ratios" are defined as ratios of gross profit to operating expenses. Interest

and extraneous income are generally excluded from the gross profit determination;

depreciation and amortization may or may not be included in the operating expenses,

depending in particular on the possible uncertainties they can create in relation to

valuation and comparability.

2.101 The selection of the appropriate financial indicator depends on the facts and

circumstances of the case.

In order for a Berry ratio to be appropriate to test the remuneration of a controlled transaction

(e.g. consisting in the distributor of products), it is necessary that:

The value of the functions performed in the controlled transaction (taking account of

assets used and risks assumed) is proportional to the operating expenses.

The value of the functions performed in the controlled transaction (taking account of

assets used and risks assumed) is not materially affected by the value of the products

distributed, i.e. it is not proportional to sales, and

The taxpayer does not perform, in the controlled transactions, any other significant

function (e.g. manufacturing function) that should be remunerated using another method

or financial indicator.

The Appellant would like to submit that having regard to its functional analysis, it can be

concluded that the Appellant's case satisfies all the above tests. Accordingly, since the

facts of the Appellant are similar to the principle stated above, the Appellant submits that

use of OP/VAE as the PLI is the most appropriate approach.

In view of the above discussion, a qualitative analysis of costs by differentiating between passthrough

and agency/value adding costs is essential, so as to reach correct TP conclusions. This

situation is also envisaged in Rule 10B(e)(i) of the Rules, which sets out the manner of

application of the Transactional Net Margin Method ('TNMM')

"(e) transaction net margin method, by which,-

The net profit margin realized by the enterprise from an international transaction entered

into with an associated enterprise is computed in relation to costs incurred or sales

effected or assets employed or to be employed by the enterprise or having regard to any

other relevant base:....

As can be seen above, both the Rules and the OECD Guidelines envisage the

determination of the PLI, viz., net profit margin in relation to different bases depending

upon the facts and circumstances of each case, the intent being to select the appropriate

PLI that best measures the relationship between profits of the controlled taxpayer and the

functions of such taxpayer. Nowhere has it been mandated that in all cases, the net profit

margin should be computed only in relation to the total costs incurred by a controlled

taxpayer.

In view of the aforesaid discussion, the Appellant reiterates that in the Logistics industry,

direct third party costs (such as freight, cargo handling charges paid to ports, clearing and

forwarding costs etc.) incurred by a Logistics company are in the nature of pass-through

expenses, which ought to be excluded to determine the profitability of a Logistic service

providers operations. Accordingly, the Appellant respectfully, submit that OP/VAE

should be used as a PLI for application of the TNMM to benchmark the international

transactions undertaken by the Company during the year.

6. The learned DR, on the other hand, mainly relied on the order passed by the DRP overruling

the objections raised by the assessee in this regard and upholding the action of the AO in adopting

the OP/TC as the correct and appropriate price level indicator. The relevant portion of the order

of the DRP dealing with this issue, as relied upon by the learned DR, is reproduced hereunder:

"The assessee has objected to the AO's method, on the ground that there is no element of

profit in the freight. The DRP does not agree with the view of the assessee, because for

working out proper margins, the gross receipts and the gross expenses are the proper

figures and there is no provision for excluding any item of expenses or receipt from the

gross sales or gross expenses on the ground that such receipts or expenses does not

represent any element of profit. There is no provision for segregating the accounts for

excluding such items because it will give distorted picture and comparison will not be

possible with the others who are dealing in the similar activity not following such

method. Thus, the AO has rightly rejected the method of working out profit margin by

the assessee."

7. We have heard the arguments of both the sides on this preliminary issue and also perused the

relevant material on record. It is observed that the elaborate submissions made by the learned

counsel for the assessee in support of the assessee's case on this issue were also made before the

DRP in sum and substance. A perusal of the relevant portion of the DRP's impugned order as

reproduced above, however, shows that the same have been brushed aside without giving proper

and sufficient consideration. Most of the relevant points raised on behalf of the assessee on this

important issue even do not find any mention in the order of the DRP, much less any discussion

or consideration. In the case of Gap International Sourcing India (P.) Ltd. v. Dy. CIT [2011] 44

SOT 56/[2010] 8 taxmann.com 294 (Delhi), the coordinate bench of this Tribunal came across a

similar situation wherein voluminous submissions made by the assessee were found to be brushed

aside by the DRP without even a whisper in the order. The order passed by the DRP, therefore,

was held to be laconic by the Tribunal and the matter was remitted back to the DRP to consider

the same again and to pass a proper and speaking order. A similar situation arose in the case of

Vodafone Essar Ltd. v. Dispute Resection Panel-II [2011] 196 Taxman 423 (Delhi) wherein the

order passed by the DRP was quashed by the Hon'ble Delhi High Court and the matter was

remanded for fresh adjudication observing that when a quasi judicial authority deals with a lis, it

is obligatory on its part to ascribe cogent and germane reasons as the same is the heart and soul of

the matter. The Hon'ble Delhi High Court further observed that a well reasoned and well

discussed order also facilitates appreciation when the same is called in question before the

superior forum. Keeping in view the decision of the Hon'ble Delhi High Court in the case of

Vodafone Essar Ltd. (supra) as well as that of the coordinate bench of this Tribunal in the case of

Gap International Sourcing India (P.) Ltd. (supra) and having regard to the fact that the DRP has

passed the order giving directions to the AO under section 144C without giving proper

consideration to the elaborate submissions made on behalf of the assessee on the main

preliminary issue, we set aside the said order and remit the matter to the file of the DRP with a

direction to consider the objections of the assessee on this issue as well as the other issues once

again and pass a proper and speaking order giving direction under section 144C.

8. In the result, the appeal of the assessee is treated as allowed for statistical purposes.