Mumbai High Court rules that once the Arm’s Length Price (ALP) of royalty paid by the assessee, if justified under four corners of the law, the tax authorites cannot make Transfer Pricing adjustments on account of bad debts suffered by the assesee – Payment of royalty to Associated Enterprise (AE) and sale of products to customers are two separate transactions

Facts
The assessee, CA Computer Associates India Pvt. Ltd., was appointed as a distributor of the computer software products of the AE, CA Management Inc., (CAMI) under a Software Distribution Agreement. As stipulated in this agreement, the assessee was liable to pay an annual royalty to CAMI at the rate of 30% of the total amount invoiced by the assessee to its customers. The assessee filed its return of income for the AY 2002-03 declaring a loss of Rs. 14.56 crores. Based on the Transfer pricing study conducted by the assessee, the Arm‟s Length Price („ALP‟) of royalty payments determined by the assessee was about Rs. 7.43 crores.
A reference was made by Assessing Officer („AO‟) to the Transfer Pricing Officer („TPO‟) u/s 92CA(1) of the Income Tax Act, 1961 („Act‟) for determination of ALP of the royalty payments to the AE. The AO contended that during the year under consideration, assessee had paid royalty to its AE even on the invoiced amount which turned out to be bad debts. The AO computed ALP of the royalty at Rs. 5.85 crores resulting in Rs. 1.50 crores of transfer pricing adjustment.
Aggrieved by the order of the AO, the assessee filed an appeal before the Commissioner of Income Tax (Appeal) [„CIT(A)‟]. The assessee contented that it had paid royalty to the AE at a lower rate than in the comparable transactions. The CIT (A) vide its order, observed that the ALP of this transaction was never disputed by the tax
department. CIT (A) therefore did not question the correctness of the royalty rate. CIT(A) observed that contention of assessee that it had paid royalty at a lower rate than in the comparable transactions was irrelevant and not an area of dispute. Confirming the order passed by the AO, the CIT(A) held that royalty payments to the AE on the invoiced amount appearing as bad debts cannot be allowed.
Aggrieved by order passed by the CIT(A), assesse filed a plea before the ITAT. The ITAT vide its order, ruled in favour of the assessee stating that merely because royalty was paid even in respect of products sold to clients, who had not paid for the same, it would make no difference to the determination of ALP of the transaction.
Against the order passed by the ITAT, department proceeded for an appeal before the Hon‟ble Bombay High Court („HC‟).
Question of law before the HC
Whether on the facts and circumstances of the case and in law, the ITAT was justified in deleting the disallowance made of royalty paid by the assessee to its AE for distribution of software products in India without appreciating that the royalty had been paid on the amount of bad debts even where the software had not worked at all.
Observations and Ruling of the HC
Referring to the provisions of section 92C as regards computation of ALP, the HC observed that section 92C does not either expressly or impliedly consider failure of the assessee's customers to pay for the products sold to them by the assessee to be a relevant factor in determining the ALP.
HC held that in the absence of any statutory provision or the transactions being colourable, bad debts on account of purchasers refusing to pay for the goods purchased by them from the assessee can never be a relevant factor while determining the ALP of the transaction between the assessee and its principal. Once it is accepted that the ALP of the royalty is justified, there can be no reduction in the value thereof on account of the assessee's customers failing to pay the assessee for the product purchased by them from the assessee.
HC further held that the payment of royalty and the sale of products to the customers were two separate and distinct transactions. HC ruled that absent a contract to the contrary, the vendor or licensor is not concerned with whether its purchaser / licensee recovers its price from its clients to which it has in turn sold / licensed such products. The two are distinct, unconnected transactions. The purchaser's / licensee's obligation to pay the consideration under its transaction with its vendor / licensor is not dependent upon its recovering the price of the products from its clients.
Thus, HC held that ITAT was justified in deleting the transfer pricing adjustment made by the AO and dismissed revenue appeal.
Conclusion
In light of this important ruling of the HC, it is worthwhile to note that bad debts suffered by the licensee cannot be the relevant factor while determining ALP of the royalty payments to the licensor. The transactions undertaken by the assessee relating to payment of royalty to AE and sale of products to the end customer are two separate transactions.

The role of TPO / AO is restricted only to examine whether the royalty paid by the assessee is at arm‟s length price as determined in accordance with provisions of the Act. Unless anything contrary explicitly mentioned in the intercompany agreement, the payment of royalty to AE cannot be linked to the recoveries of dues from the end customers.
Source: CA Computer Associates India Pvt. Ltd [TS-503-HC-2012(BOM)]