Executive summary
The Delhi High Court („High Court‟) recently pronounced its ruling in case of EKL Appliances Ltd („the taxpayer‟), wherein it held:
The Transfer Pricing Officer („TPO‟) can question the quantum of the transaction but has no authority to disallow the entire expenditure on the ground that the tax payer has suffered continuous losses.
The taxpayer is required to demonstrate that the expenditure has been incurred “wholly and exclusively” for the purpose of business. There is no need to justify the necessity of incurring the expenditure.
The taxpayer need not demonstrate that expenditure has resulted in profit so long as it is incurred for the purpose of business.
Facts
The taxpayer is a public limited company engaged in the business of manufacturing and trading of fast moving consumer goods („FMCG‟). The taxpayer paid brand fee/ royalty to its Associated Enterprises („AEs‟) for the use of the brand name. According to the TPO, the taxpayer has not been able to make a turnaround despite the payment of the brand fee for several years. The TPO further held that though the AE had charged similar brand fee to an unrelated party in New Zealand, this is not conclusive in proving that the price paid by the taxpayer for obtaining use of brand name and technical knowhow represents Arm‟s Length Price („ALP‟). According to TPO, the continuous losses prove that the taxpayer did not benefit in any way from the payment for use of brand name and hence determined the value of the transaction to be nil.
The taxpayer preferred an appeal to the Commissioner of Income Tax - Appeals [hereinafter referred to as CIT (A)]. The CIT(A) relying on S.A. Builders Ltd vs. CIT1 held that it is not open to the TPO to question the judgment of the taxpayer as to how it should conduct its business and regarding the necessity or otherwise of incurring the expenditure in the interest of its business.
CIT (A) also observed that as per the financials, the taxpayer was deriving gross profit from the operations and losses at net level were due to expenses and other factors. The Income Tax Appellate Tribunal [hereinafter referred to as “ITAT”] has also upheld the CIT (A) order.
The tax authorities filed an appeal before the High Court.
Issues before the High Court
Was the Tribunal right in confirming the order of the CIT (A) deleting the disallowance of Royalty / Brand fee made by the TPO on the grounds of perpetual losses.
Ruling of the High Court
Relying on OECD Transfer Pricing Guidelines2, it was observed that the tax administration should not disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the AEs.
The taxpayer need not show that any expenditure incurred by him for the purpose of business has actually resulted in profit.
Expenditure will be allowed as a deduction if it is proved that it is “wholly and exclusively” incurred for the purpose of the business.
Whether or not to enter into the transaction is for the taxpayer to decide. The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allowability thereof as business expenditure, TPO has no authority to disallow the entire expenditure or a part thereof on the ground that the taxpayer has suffered continuous losses.
The financial health of the taxpayer can never be a criterion to judge allowability of an expense.
It was also held that transfer pricing regulations3 does not authorize disallowance of any expenditure on the ground that it was not necessary or prudent for the taxpayer to have incurred the same in view of the continuous losses suffered by the taxpayer in his business.
Conclusion
The decision highlights the fact that the tax authorities cannot question the commercial rationale of legitimate business expenses incurred by the taxpayer as long as it is demonstrated that the transaction is at arm‟s length by application of the prescribed methods. Further, the taxpayer need not show that any expenditure incurred by him for the purpose of business has actually resulted in profit or income. The decision further highlights the fact that OECD guidelines can be relied upon for guidance wherever applicable.
The Delhi High Court („High Court‟) recently pronounced its ruling in case of EKL Appliances Ltd („the taxpayer‟), wherein it held:
The Transfer Pricing Officer („TPO‟) can question the quantum of the transaction but has no authority to disallow the entire expenditure on the ground that the tax payer has suffered continuous losses.
The taxpayer is required to demonstrate that the expenditure has been incurred “wholly and exclusively” for the purpose of business. There is no need to justify the necessity of incurring the expenditure.
The taxpayer need not demonstrate that expenditure has resulted in profit so long as it is incurred for the purpose of business.
Facts
The taxpayer is a public limited company engaged in the business of manufacturing and trading of fast moving consumer goods („FMCG‟). The taxpayer paid brand fee/ royalty to its Associated Enterprises („AEs‟) for the use of the brand name. According to the TPO, the taxpayer has not been able to make a turnaround despite the payment of the brand fee for several years. The TPO further held that though the AE had charged similar brand fee to an unrelated party in New Zealand, this is not conclusive in proving that the price paid by the taxpayer for obtaining use of brand name and technical knowhow represents Arm‟s Length Price („ALP‟). According to TPO, the continuous losses prove that the taxpayer did not benefit in any way from the payment for use of brand name and hence determined the value of the transaction to be nil.
The taxpayer preferred an appeal to the Commissioner of Income Tax - Appeals [hereinafter referred to as CIT (A)]. The CIT(A) relying on S.A. Builders Ltd vs. CIT1 held that it is not open to the TPO to question the judgment of the taxpayer as to how it should conduct its business and regarding the necessity or otherwise of incurring the expenditure in the interest of its business.
CIT (A) also observed that as per the financials, the taxpayer was deriving gross profit from the operations and losses at net level were due to expenses and other factors. The Income Tax Appellate Tribunal [hereinafter referred to as “ITAT”] has also upheld the CIT (A) order.
The tax authorities filed an appeal before the High Court.
Issues before the High Court
Was the Tribunal right in confirming the order of the CIT (A) deleting the disallowance of Royalty / Brand fee made by the TPO on the grounds of perpetual losses.
Ruling of the High Court
Relying on OECD Transfer Pricing Guidelines2, it was observed that the tax administration should not disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the AEs.
The taxpayer need not show that any expenditure incurred by him for the purpose of business has actually resulted in profit.
Expenditure will be allowed as a deduction if it is proved that it is “wholly and exclusively” incurred for the purpose of the business.
Whether or not to enter into the transaction is for the taxpayer to decide. The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allowability thereof as business expenditure, TPO has no authority to disallow the entire expenditure or a part thereof on the ground that the taxpayer has suffered continuous losses.
The financial health of the taxpayer can never be a criterion to judge allowability of an expense.
It was also held that transfer pricing regulations3 does not authorize disallowance of any expenditure on the ground that it was not necessary or prudent for the taxpayer to have incurred the same in view of the continuous losses suffered by the taxpayer in his business.
Conclusion
The decision highlights the fact that the tax authorities cannot question the commercial rationale of legitimate business expenses incurred by the taxpayer as long as it is demonstrated that the transaction is at arm‟s length by application of the prescribed methods. Further, the taxpayer need not show that any expenditure incurred by him for the purpose of business has actually resulted in profit or income. The decision further highlights the fact that OECD guidelines can be relied upon for guidance wherever applicable.
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