Arm's length price should be based on the functional and asset profile of the company

Arm's length price should be based on the functional and asset profile of the company

Court : Mumbai Bench of the Income Tax Appellate Tribunal

Brief : The Mumbai Bench of the Income Tax Appellate Tribunal ('the Tribunal'), in the case of ITO v. Zydus Altana Healthcare Pvt. Ltd. [2010-TI I-29-ITAT–MUM-TP], while deciding the case in favour of the assessee, ruled that the determination of arm's length price should be based on the functional and asset profile of a company and profit margins earned by comparable companies should be adjusted for functional differences between the tested party and the comparables. The Tribunal also ruled that in case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment since in such a situation, there is no benefit to the assessee in charging its associated enterprise a lower mark-up.

Citation : ITO v. Zydus Altana Healthcare Pvt. Ltd. [2010-TI I-29-ITAT–MUM-TP]

Judgement :

Facts- The assessee is a Joint Venture between Cadila Healthcare Ltd., and Byk Gulden Lomberg GmbH Germany ("BGL"). The assessee, a 100% export oriented unit is engaged in the manufacture and export of pharmaceutical intermediates exclusively for BGL. The assessee also provides clinical trial services with respect to molecules developed from the research undertaken by BGL for which it is remunerated on a cost plus 5% basis. In addition, the assessee receives reimbursement from BGL of certain clinical trial expenses.

During the course of transfer pricing ("TP") assessment proceedings, the Transfer Pricing Officer ("TPO") accepted the assessee's export prices of pharmaceutical products to be at arm's length. The TPO, however, proposed an adjustment to the transfer price for the transaction involving clinical trial services provided by the assessee to its Associated Enterprise ("AE"). For this purpose, the TPO identified a set of companies providing clinical trial services to third parties and determined the arm's length cost plus mark up at 17.14%.

The Assessing Officer ("AO") passed an order, incorporating the transfer pricing adjustment proposed by the TPO, against which the assessee filed an appeal before the Commissioner of Income-Tax, Appeals ("CIT (A)"). The CIT(A), based on the facts of the case, deleted the adjustment proposed by the TPO, aggrieved by which the Indian Revenue authorities brought an appeal before the Tribunal.

Revenue Contentions

Key contentions of the Revenue were as follows:

•           The assessee as per the recitals of the research and development ("R&D") services agreement was entrusted to perform certain R&D service work on contract research basis on behalf of BGL. However, the CIT(A) did not examine the relevant articles of the R&D services agreement and wrongly held that the assessee is merely engaged in providing support services in the nature of facilitation/coordination services between BGL and the hospitals.

•           The nature of expense reimbursements made by the AE to the assessee for the clinical trial services clearly indicated that the assessee had full-fledged infrastructure facilities for conducting R&D activities.

•           Though the CIT(A) rightly referred to the guidelines provided by the Special Bench of Bangalore ITAT in the case Aztec Software Technology Services Ltd. v. ACIT [2007 - TII – 01 - ITAT – BANG – SB - TP] for selecting comparable companies based on functional analysis, the CIT(A) had not applied such guidelines to the facts of the present case thereby wrongly rejecting the search conducted by the TPO for comparable transactions with respect to the clinical R&D work undertaken by the assessee on behalf of the AE.

 Assessee Contentions

Key contentions of the assessee were as follows:

•           The assessee did not undertake clinical trials on its own. It only acted as a facilitator / co-ordinator between BGL and the hospitals which performed the clinical trials. This was evidenced by the fact that the reimbursement received by the assessee primarily related to expenses incurred towards hospitals for clinical tests undertaken by them on the molecules that were developed by BGL. Therefore, the functions performed by the assessee with respect to the clinical trials service transaction were limited and were essentially in the nature of administrative services, including data collation and compilation, maintenance of documentation, liaising with doctors, etc.

•           The assessee did not have the necessary infrastructure to undertake R&D activities. The TPO, during the course of the assessment proceedings, agreed to the fact that the assessee could not be characterised as a contract research organisation.

•           Comparables selected by the TPO were in a different line of business to that of the assessee.

Tribunal Ruling

The Tribunal held as follows:

•           The entire research activity relating to molecules was carried out in three phases. Under Phase I, the main molecules were generated by BGL and its effectiveness over Indian patients was to be examined by carrying out clinical trials in Phase II and Phase III. Thus, the major part of the research activity was Phase I in which molecules per se were generated, and not Phase II and Phase III, which involved only clinical trials being conducted by third parties i.e. hospitals, which the assessee only paid for. Further, the assessee's infrastructure was limited to furniture, vehicle, office equipments and computers, which were not sufficient for carrying out an entire research activity.

Therefore, the assessee's activity was more in the nature of coordinating / facilitating such clinical trials carried out at various hospitals rather than performing the R&D function itself, for which a return of 5 per mark-up on costs was suitable.

•           Referring to Rule 10B(1)(a)(ii) of the Indian Income-tax Rules, 1962 ("the Rules"), the Tribunal held that the TPO when selecting comparables should have made necessary adjustments for functional differences.

•           In case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment since in such a situation, there is no benefit to the assessee in charging its associated enterprise a lower mark-up.

Based on the above, the Tribunal upheld the order of the CIT(A) and rejected the transfer pricing adjustment made by the AO thereby deciding the case in favour of the assessee.

Conclusion

In establishing the functional profile of the assessee and evaluating its return, the Tribunal had correctly examined the nature of activities and contribution of the assessee in the value chain. It had also given due consideration to the tangible asset profile of the assessee. However, the Tribunal, in its ruling, did not provide its views on certain determinative aspects relating to who exercises control over the R&D function, who has the risk bearing capacity, who contributes to intangible creation, etc.

Further, with respect to comparability adjustments, although no guidance was provided, the Tribunal reiterated the need to make appropriate adjustments to comparables while applying a transfer pricing method and determining the arm's length price.

The Tribunal also ruled that in case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment.

Tags : Cadila Healthcare, Byk Gulden Lomberg GmbH Germany,  Zydus Altana Healthcare , transfer pricing , Arm's length price .