SC Enviro Agro India is a manufacturer of household insecticides and pesticides and had entered into a technology license agreement with a related party – SCCL Japan – and it also purchases the requirement of intermediates from the said company only.
In the years in question, it has purchased intermediates and sold the products to the entities that approved by the SCCL. One of the company to whom most of the products were sold was SCI, a 100% subsidiary of SCCL.
In the transfer pricing report SC Enviro Agro India stated that the arrangement with SCCL and SCI was in the nature of contract manufacturing.
Following an audit, the tax authorities accepted the price paid/received as arm’s length price for purchase of insecticides and pesticides, intermediates from SCCL and sale of insecticides and pesticides to SCI. But in regards of the royalty payment of 5% to SCCL as per the technology license agreement, the authorities were of the opinion that since the purchase and sales are only from/to associate concerns and not to anybody else, there is no commercial exploitation of technical knowhow. SC Enviro Agro India was nothing but contract manufacturing and as such there was no basis for payment of royalty. Accordingly, deductions for royalty payments were disallowed in assessment year 2003-04 and assessment year 2004-05.
SC Enviro Agro India submitted that it has not paid royalty on entire sales price, but only on the value addition made to the intermediates purchased from the principal company, therefore, no royalty was paid on purchase cost of the raw material and only on the value addition. Furthermore, details of sales made to outside parties i.e. third parties was submitted so as to counter the observations that it has sold only to the related parties.
On that basis the tax authorities allowed royalty payment on the sales made to third parties and reduced the assessment.
An appeal was filed by SC Enviro Agro India in which it stated that since it had obtained technical knowhow from SCCL, 5% royalty on the entire value addition made should have been allowed rather than restricting to sales made to third parties. SC Enviro Agro India also stated that it was not a contract manufacturer. It was also further stated that since royalty was paid at 5%, it could not be disallow since it was within the safe harbor range of (+)/(-) 5%
Judgement of the Court
The Court decided in favour of SC Enviro Agro India and dismissed the assessment issued by the tax authorities.
“…Till assessment year 2003-04 there was no dispute with reference to the payment of royalty and even in the original assessment completed the royalty was allowed as eligible expenditure in the order under section 143(3). In assessment year 2004-05 this issue for the first time was examined by the TPO on the basis of the TP report of assessee wherein assessee submitted that the arrangement is in the nature of contract manufacturers in the FAR analysis. Since this was admitted by assessee, the TPO without examining the nature of agreement or the manufacturing activity of assessee or any other incidental factor came to a conclusion that since assessee admitted to be a contract manufacturer, there is no need to pay any royalty. In his order the TPO also mentions that assessee was not making any sales to outside parties, the fact of which is not correct. On the basis of his observations, he arrived at the royalty arm’s length price at Nil.”
“The TPO has to examine whether the price paid or amount paid was at arm’s length or not under the provisions of Transfer Pricing and its rules. The rule does not authorize the TPO to disallow any expenditure on the ground that it was not necessary or prudent for assessee to have incurred the same. On that principle alone, we cannot approve the order of the TPO as it not only considered the facts wrongly but also exceeded the jurisdiction available to the TPO in examining the arm’s length price on a transaction.”
“Even though admittedly assessee mentioned in the TP report that the arrangement is in the nature of contract manufacturing, the facts indicates otherwise. The royalty was paid as per the agreement on the value-added price to the SCCL for providing the license and technical knowhow. This payment is independent of whether assessee is full fledged manufacturer or a contract manufacturer or a toll manufacturer and the nature of manufacturing activity cannot have any bearing on the payment of royalty. “
“Since we do not find any reason to restrict the royalty to Nil, we are not in a position to approve the order of the CIT (A) on this issue. Without going into the nitty-gritty of determining whether assessee is a contract manufacturer or a full-fledged manufacturer, since royalty is paid for allowing assessee in utilizing the technical knowhow and the license for manufacturing activity, we are of the opinion that the payment of royalty is wholly and exclusively for the purpose of business. In view of this, we allow assessee’s ground and direct AO to allow the royalty as claimed.”
ITA Nos 2057 & 2058-Mum-2009 ORG