The Delhi Tribunal also held that profit attribution is required as the transfer pricing study does not adequately capture functions performed and risks undertaken by the Indian Company.

Brief Facts

  • Taxpayer, a Japanese company, is engaged in the development, manufacture, assembly and supply of air-conditioning and refrigeration equipment.
  • It sold air-conditioners to its wholly-owned subsidiary in India, Daikin Air-conditioning India Private Limited (DAIPL), and sold directly to Indian customers as well. In respect of direct sales in India, the taxpayer paid a commission of 10% to DAIPL.
  • DAIPL, pursuant to the commission agreement, was providing marketing support services in India in respect of direct sales made by the taxpayer. The services provided inter-alia included forwarding customers request, forwarding taxpayer's quotation and contractual proposal, etc.
  • The tax officer held DAIPL as DAPE of the taxpayer in India. Furthermore, the AO attributed some portion of income to the taxpayer's DAPE in India.

Issues involved

  • Whether the wholly-owned Indian subsidiary of the taxpayer (i.e., DAIPL) constitutes a DAPE in India as per Article 5 of India-Japan tax treaty.
  • Whether attribution of income to DAIPL in India is required even in cases where Indian subsidiary is remunerated at Arm's Length Price (ALP).

Taxpayer's contentions

  • The taxpayer contended that the role of DAIPL was limited to forwarding customer's requests, quotations and proposals between the taxpayer and the customers in India. In other words, DAIPL was acting merely as a communication medium between the taxpayer and the customers in India.
  • It was also contended that all the important activities like identifying customers, negotiation, finalization of prices with customers in India, etc. concerning direct sales made to customers in India was exclusively done by the taxpayer from Japan.
  • The taxpayer also submitted that certain employees visited India to carry out the activities (negotiation and finalization of prices) mentioned above.
  • Alternatively, the taxpayer also submitted that since the payment of commission to DAIPL was at arm's length (which was accepted by the transfer pricing officer of DAIPL), no further attribution of profits is required to the Indian PE. In this regard, taxpayer placed reliance on the decision of the Supreme Court in the case of Morgan Stanley & Co. 1

Revenue's contentions

  • The primary contention of revenue was that price charged by the taxpayer for goods sold directly to customers in India was higher than the price charged to DAIPL.
  • Revenue contended that all the major activities in India related to direct sales by the taxpayer were done by DAIPL along with its own distribution activity. The taxpayer could not produce any substantial evidence to negate this contention.
  • Revenue contended that the employees deployed in India by the taxpayer rendered consultancy services for which DAIPL was separately charged by the taxpayer. No relevant evidence was produced to prove that taxpayer's employees had come to India for making direct sales.
  • The Revenue contended that the emails pertaining to sales transactions were exchanged between the taxpayer and DAIPL, and not directly between the taxpayer and customers.
  • Revenue contended that DAIPL was habitually exercising authority in India by negotiating and finalizing the prices of the sale transactions although these contracts were formally signed by the taxpayer in Japan.

Tribunal's observations

On constituting DAPE in India

  • The tribunal observed that DAIPL had incurred huge selling and distribution expenditure in India while effecting sales as a distributor as against the taxpayer which did not incur any such expenditure while making direct sales in India though the customer base of the taxpayer was scattered all over India.
  • The tribunal also observed that the contention of taxpayer that it was making direct sales to institutional customers was also incorrect as there were sales made to individual customers for amounts less than INR 25,000.
  • The tribunal, ongoing through the e-mail communication, observed that the role of DAIPL was not merely limited to communication channel as contended by the taxpayer. Instead, all the essential activities involved in a sale transaction (like identification of customers, negotiations of prices, etc.) were performed by DAIPL.
  • On perusal of the emails sent out by the taxpayer, it was also observed that there was not even one direct email between the taxpayer and its customers in India which could substantiate the claim of the taxpayer that the taxpayer was making direct sales to customers in India. Also, the said emails explicitly evidenced that all the transactions were negotiated and finalized by DAIPL only.
  • The Tribunal also observed that mere signing of contracts outside India does not imply that the activities in connection with the contracts were performed by the taxpayer.
  • In light of the above, the tax tribunal held that DAIPL was habitually exercising authority in India to conclude contracts on behalf of the taxpayer, and hence DAIPL would constitute a DAPE in India.

On attribution of profits to PE in India

  • The Tribunal observed that since taxpayer did not maintain transfer pricing documents in India, there is no question of holding transaction of payment of commission to be at arm's length.
  • The Tribunal observed that DAIPL had reported the international transaction of commission payment which was accepted to be at ALP by the transfer pricing officer.
  • Furthermore, the Tribunal also observed that determination of ALP done by the transfer pricing officer was only based on the functions declared by DAIPL. The benchmarking of transaction was not done considering the whole range of function performed by DAIPL in selling products which included negotiating and finalizing the price, concluding contracts with customers in India.
  • It was also observed that these functions were neither declared by the taxpayer nor were they arising from the agreement. The tribunal observed that if the aforementioned transactions were declared, then the entire FAR analysis (i.e. functions performed and risks undertaken) would have undergone a complete change.
  • Tribunal held that this case falls within the exception spelt out by the Supreme Court in the case of Morgan Stanley (supra) and hence not applicable.
  • The tribunal rejected the manner of attribution of profits by Revenue. It estimated a net profit rate of 10% and then attributed 30% of such 10% profit to the Indian operations. Post this, the tribunal directed the tax officer to grant deduction of net commission expenses (i.e., commission paid less all direct and indirect expenses) which has already suffered tax in the hands of DAIPL.


1 (2007) 292 ITR 416 (SC)

SKP's comments

This decision is important in many ways as it highlights that the substance of transaction should corroborate with the documents/agreements. Also, it would be important to note that merely having a transfer pricing study carried out may not suffice unless the complete flow of value chain and FAR analysis is captured appropriately.

In our view, it would be important that all Indian marketing subsidiaries re-look at their on-ground business operations along with the transfer pricing documentation and inter-company agreement as to whether there is any risk of PE in India. This would become all the more important going forward in light of the expanded definition of DAPE adopted by India under the Base Erosion Profit Shifting Project (BEPS).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.