Bombay High Court Links Royalty Payment for Technology Usage with Manufacturing Activity

Bombay High Court Links Royalty Payment for Technology Usage with Manufacturing Activity

The Bombay High Court has ruled that the payment of royalty for technology usage is inherently intertwined with manufacturing operations, necessitating its consolidation with other international transactions within the manufacturing segment for benchmarking purposes.

In the context of the Assessment Year 2006-2007, the High Court Bench comprising Justices K.R. Shriram and Firdosh P. Pooniwalla noted that the Tribunal's assertion, indicating that the amalgamation of royalty payments with other international transactions within the manufacturing sector was based on a prior agreement involving royalty payments, was entirely erroneous.

The appellant, involved in the manufacturing and sale of Internal Combustion Engines, Spares, Components (including Bought-Outs), and Generating sets, along with services related to Engines, gensets, and allied equipment, operates a 100 per cent export-oriented unit located in Pirangut. This unit specialises in producing and exporting internal combustion engines, associated accessories, generator sets, and related accessories.

The filed returns of the assessee underwent scrutiny assessment as statutory notices were issued under sections 143(2) and 142(1). During its business operations, the assessee engaged in multiple international transactions with its Associated Enterprise(s).

The assessee had disbursed royalty payments to its Associated Enterprise, Cummins Inc., in exchange for the provision of technical know-how and expertise related to engine manufacturing, aimed at catering to customer needs.

The Transfer Pricing Officer (TPO) issued a notice expressing reservations regarding the amalgamation of royalty transactions with other activities on an entity level.

The TPO instructed the assessee to provide reasons for not employing the royalty rate applicable to domestic sales for benchmarking the royalty on export transactions as well.

In response, the assessee clarified that, for benchmarking, it had combined the royalty payment with other international transactions tied to manufacturing operations. The rationale behind this aggregation was the inherent connection between technology utilisation, royalty payments, and the assessee's manufacturing endeavours. Employing the Transactional Net Margin Method, external comparable companies were selected to benchmark the manufacturing segment. Through this benchmarking analysis, the assessee argued that its international transactions, inclusive of royalty payment, adhere to arm's length principles.

The TPO) issued an order, endorsing the assessee's stance of aggregating transactions and employing the Transactional Net Margin Method (TNMM) to assess the arm's length price (ALP) for the majority of the assessee's international transactions. However, concerning the royalty payment to the associated enterprise, the TPO acknowledged the receipt of technology from said entity but rejected the assessee's proposal to aggregate the royalty payment with other manufacturing-related international transactions for benchmarking purposes. As a result, the TPO effected an upward adjustment to the value of international transactions related to royalty payment for export sales.

The assessee lodged objections with the Dispute Resolution Panel (DRP). In response, the DRP issued directives under Section 144(5), dismissing the assessee's arguments and affirming that the royalty payment transactions for export sales should be evaluated individually and benchmarked on a transaction-specific basis, mirroring the TPO's approach. Subsequent to the DRP's directives, the respondent proceeded to finalize the assessment order, which encompassed transfer pricing adjustments in accordance with the DRP's guidance.

In response to the final assessment order, the assessee opted to initiate an appeal before the Income Tax Appellate Tribunal (ITAT) which affirmed the decisions taken by the lower authorities, thereby validating the transfer pricing adjustment pertaining to the international royalty payment transaction.