Royalty Payments held Sacrosanct by Delhi High Court- TPO can't hold it as 'NIL' and meaning of Contract Manufacturer explained.
(It seems that most likely, the respondent's name was inadvertently titled as Samsung India Electronics Pvt. Ltd., which is actually another group company. The correct title should have been Samsung Telecommunication India(‘STI’) since the entire appeal pertain to Samsung Telecommunication India and further the order copy of Tribunal decision of earlier year i.e. AY 2007-08 which has been extensively referred to in the said order pertain to ‘STI’ only)
2. STI, incorporated in October 2005, manufactures and sells mobile phones under the Samsung brand in India and overseas. Samsung Korea provides STI with design, know-how, and other critical components under a Technology License Agreement dated February 26, 2006. This agreement requires STI to pay for technical assistance and royalties. During the assessment year in question, STI paid INR 15,59,64,867 for technical assistance and royalties. Additionally, STI paid INR 1,99,57,161 as royalty on sales to other associated enterprises.
During Transfer Pricing Proceedings, TPO questioned the royalty payments to Samsung Korea. STI defended these payments as compensation for technical know-how and expertise, emphasizing its status as a licensed manufacturer making independent decisions, however the TPO did not agree and instead characterized STI as contract manufacturer.
In view of this, the TPO determined the Arm’s Length Price (ALP) for STI's royalty payments to be zero, resulting into addition of INR 1,99,57,161 to STI's total income. The DRP, also upheld the action of TPO.
3. The Court, while rendered its judgement, drew major help from the identical facts and decision in immediate earlier year AY 2007-08 which had the same issues the appeal for that year was decided by the Tribunal in terms of its decision dated June 21, 2013. In that year, the TPO considered STI's position as that of a Contract Manufacturer, reason being? that it purchased raw materials from the AEs, manufactured goods in India, and then exported part of these goods to the AEs. The TPO opined that the royalty paid on sales to the associated enterprise was not at arm's length, as it effectively meant collecting royalty on sales to itself. ?
4. However, STI argued that it paid royalty to Samsung Korea? for technical know-how and expertise, which is essential for its manufacturing activities in both export and domestic markets. Without this technical know-how, STI could not carry out its manufacturing. Further STI maintained that it operates as a full-fledged licensed manufacturer, not a contract manufacturer, and its functional, asset, and risk (FAR) profile is consistent for both group company sales and sales to unrelated parties. STI claimed that its export sales to group companies are driven by open market conditions, similar to its sales to unrelated parties.
Furthermore, it was also argued that its export sales to group companies were made to fellow subsidiaries like Samsung Singapore and Samsung UAE, whereas royalties were paid to SEC Korea. STI argued that SEC Korea should receive an arm's length return on these sales due to the R&D investments it has made over the years. The Tribunal found STI's arguments reasonable and supported by the circumstances.? The ITAT also observed that the term "contract manufacturer" is not defined under the Income Tax Act, however, according to the OECD guidelines at para 7.40 is stated as under:?
“7.40 Contract manufacturing is another example of an activity that may involve intra-group services. In such cases the producer may get extensive instruction about what to produce, in what quantity and of what quality. The production company bears low risks and may be assured that its entire output will be purchased, assuming quality requirements are met. In such a case the production company could be considered as performing a service, and the cost plus method could be appropriate, subject to the principles in Chapter II.”
From this definition, the Tribunal observed, two key points must be satisfied for an entity to be considered a contract manufacturer:
I>???? There must be extensive instructions regarding the nature, quantity, and quality of the production.
II>??? There must be an assurance that the entire production will be purchased.
5. The ITAT found that although SEC Korea closely monitors the quality of raw materials and the production process, it does not determine the production quantity or sales terms. There is no assurance that STI's entire production will be purchased by SEC Korea. The sales prices to AEs are determined by market forces, not by SEC Korea. Thus, none of the two conditions appear to be satisfied.
Additionally, during the relevant assessment years, only a small portion of STI's total sales were to AEs (approximately 33.40% in AY 2007-08 and 16.40% in AY 2008-09). The majority of STI's sales (approximately 66.60% in AY 2007-08 and 83.60% in AY 2008-09) were to non-AEs. Given these circumstances, the Tribunal held, STI cannot be termed a contract manufacturer.
Further, the Revenue failed to provide evidence that STI was required to sell goods to overseas group companies in a specific manner. STI argued that its sales to group companies were based on market negotiations, similar to arm's length transactions. If better terms were available from unrelated parties, STI would choose them.
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?This decision of Tribunal (AY 2007-08) was challenged in ITA 324/2017 before the Delhi High Court, but the appeal was dismissed on April 28, 2017, due to the rejection of application for condonation of delay application. Thus, the High Court had the first occasion to deal with this subject matter in AY 2008-09.
6. The Court noted that in the present case, The TPO considered STI a contract manufacturer when supplying to AEs. The TPO believed that the royalty paid as a percentage of sales to AEs was not fair, as it was like collecting royalties on sales to ‘itself’. The TPO noted that all AEs operate under the multinational corporation's umbrella. The AO and the DRP shared this view, thinking that STI, as a wholly-owned subsidiary, had no reason to pay anything to Samsung Korea, the parent company.
It was argued on behalf of the revenue that STI acted as a contract manufacturer for Samsung Korea, buying raw materials, making goods in India, and exporting them to its AEs. It was contended that the royalties should be paid to a third party for their expertise, like the technical knowledge needed for manufacturing and also supported the TPO's findings, which set the ALP of the royalty paid by STI to 'Nil' because the transaction wasn't fair and was like collecting royalties on exports made "to itself."
The revenue relied on the following judgment of DHC i.e. ‘Sony Ericsson Mobile Communication India P. Ltd. v. CIT, ITA 16/2014 judgment dated 16th March 2015, for the proposition that ‘where the economic substance of the transaction differ from its form, in such case, the tax authorities may disregard the parties’ characterisation of the transaction and re characterise the same in accordance with its substance’. It was thus argued that the transaction in the present case, between the parties was lacking in economic substance because royalty payments were in effect payments made by STI to itself. This argument was based on the idea that STI was a contract manufacturer, buying raw materials from its associated enterprises (AEs) and using them to produce goods that were then exported to the same AEs. In view of this, it was also suggested that the payments to Samsung Korea should be considered capital expenditures and not treated as an arm's length transaction. It was further argued by revenue that the STI, while making export sales to its overseas AEs, did not include in the export price the cost element towards the technical know-how used in manufacturing goods. It was therefore suggested that this arrangement was a way to shift profits, as the royalty payments to Samsung Korea would not affect STI’s profits.
7. In response, the assessee argued this case (Sony Ericsson) actually helps it in so far as in this case it was held that that tax authorities cannot arbitrarily recharacterize transactions between related parties based on their perceptions. They must assess transactions according to their actual substance and commercial rationality. While tax authorities have the authority to adjust transactions under specific exceptions—such as when the economic substance differs from the form or when arrangements deviate from what an independent entity would adopt—they must provide clear justification and evidence for such adjustments. The judgment emphasizes that any intervention by the authorities must be grounded in factual and rational considerations, reflecting actual market practices rather than theoretical constructs.
Further, the assessee also drew support from the Tribunal’s earlier decision in the ?assessment year 2007-08. It was argued that STI should not be viewed as a contract manufacturer, as it exported most of its products to third parties, not just to its AEs. It was emphasised that STI functioned as a full-fledged licensed manufacturer, not just a contract manufacturer.
8. It was highlighted that the Tribunal had in that earlier year (AY 2007-08) found that STI’s royalty payments were linked to receiving technical know-how from Samsung Korea, which supported STI’s role as a licensed manufacturer. The Tribunal concluded that STI's operations, whether selling to group companies or independent parties, were consistent with market conditions, and all royalty payments were properly accounted for.
Further, The Tribunal found that while Samsung Korea monitored the quality of materials and production, it did not control the quantity of production or the sales terms. There was no guarantee that Samsung Korea would buy all of STI’s production. STI's sales to its AEs were based on independent negotiations and contracts, not on any obligation to sell exclusively to them. Based on these findings, the Tribunal concluded that STI was not a contract manufacturer and that the notion of paying royalty “to itself” was unfounded.
?9. In respect of above argument the High Court also relied on its earlier decision in the case of Commissioner of Income-tax v. Keihin Panalfa, ITA 11/2015, judgment dated 9th September, 2015 wherein it was held that the royalty payment made by an assessee to its group companies cannot be set to "Nil" when determining the ALP. In this case, the controversy centered around the TP Adjustment made by the TPO for international transactions involving purchases and royalty payments by the assessee to Keihin Corporation, during the A.Y. 2004-05. The TPO held that the royalty payment of Rs. 1,24,41,118/- should/would not be paid if the transactions were at arm’s length. The TPO considered the assessee to be operating as a contract manufacturer, noting that all sales were made to Honda Siel Cars India Ltd., which is significantly owned by Honda Motors Co. Ltd. (Japan). Honda Motors Co Japan also owns a substantial stake in Keihin Corporation (KC), which in turn holds 74% shares in the assessee i.e. Keihin Panalfa. Since the products made by the assessee were specifically for Honda cars, and the technical designs and intellectual property were owned by parent/group companies, the TPO concluded that the royalty payments were unreasonable and only served to inflate operating costs. However, on appeal by the assessee, the CIT(A) allowed the same, holding that the functions performed by the Assessee included procurement and inventory management, production and manufacturing planning, co-ordination of production and sales, import of goods, maintenance of production facilities and quality control functions; therefore, the Assessee could not be considered as a contract manufacturer. The Tribunal declined to interfere with the decision of the CIT(A) and finally, the HC also observed no fault with the finding of CIT(A) and Tribunal that the Assessee had acted like any other Original Equipment Manufacturer (OEM) and could not be treated as a job worker or a contractor.
?10. Further, the DHC accepted the respondent’s contention that the TPO’s jurisdiction under rules 10A to 10 E of the Income Tax rules, 1962 is limited to assessing the appropriateness of the method used to determine ALP and evaluating comparable,? referring to the DHC judgment of Commissioner of Income-tax v. EKL Appliances Ltd. ITA 1068/2011 judgment dated 29th March, 2012 ?where the court had? explained the scope of authority of TPO and held that ?the quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allowability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the assessee has suffered continuous losses. The financial health of the assessee can never be a criterion to judge allowability of an expense; there is certainly no authority for that.
11. Similar observations pertaining to the powers of the TPO were rendered by a Coordinate Bench of this Court in the case of Commissioner of Income-tax v. Cushman and Wakefield (India) Pvt. Ltd., ITA 475/2012, judgment dated 23rd May, 2014, where it was held ?that the TPO is only authorized to determine the arm's length price of international transactions, not to assess whether the taxpayer actually benefits from the services in question. The assessment of the necessity and benefit of such services is the responsibility of the Assessing Officer. The TPO cannot disallow expenditures based on their view of the commercial wisdom of the taxpayer's decisions. The court emphasized that it is irrelevant whether the taxpayer benefits from the services; the focus should be on whether the price paid is comparable to what an independent entity would pay. The TPO can determine the arm's length price as 'nil' if appropriate, but cannot question the existence or benefits of the services, as that is beyond their authority.
?12. While dealing with the important question raised by TPO that the assessee company acted as a contract manufacturer for the AE instead of licensed manufacturer, ITAT earlier concluded that Samsung India operated as a licensed manufacturing company, not as a contract manufacturer for Samsung Korea. The court? considered that the Income Tax Act does not explicitly define the term "contract manufacturer". Instead, its meaning is derived from the OECD Guidelines of 1995 and 2022. It, therefore referred to those guidelines (supra)
?13. Finally , the court rejected the? Revenue's argument that Samsung India was acting as a contract manufacturer for Samsung Korea as TPO and DRP did not provide evidence showing that Samsung India's transactions were not commercially reasonable and held that there has been no material shows on the record to demonstrate that STI receives “any extensive instructions about what to produce, in what quantity and of what quality” or that it is performing any “low risk service” for Samsung Korea or any of the AEs?.
14. This decision by the Delhi High Court provides significant clarity on the limits of the TPO's authority in transfer pricing cases and reinforces the importance of following established guidelines and precedents. The ruling emphasizes that royalty payments cannot be arbitrarily disallowed by TPO by treating the need and benefit of such royalty as NIL and that economic characterisation of an entity must be evaluated based on the actual nature of their operations and transactions by undertaking a robust and careful analysis of all the activities and related commercial aspects.