Cheil Communications India Pvt. Ltd. is a subsidiary of a Korean based advertising agency, Cheil Communications. The Indian affiliate had excluded pass-through costs from its cost base when determining the arm’s length remuneration for its activities. The tax authority included the the pass-through costs in the cost base and issued an assessment for FY 2005-06 where these costs were also marked up. Judgement of the Tribunal The Tribunal annulled the assessment and ruled in favor of Cheil Communications India. Excerpt “(…)For performing the functions for and on behalf of associated enterprises, the assessee is remunerated by its associated enterprises on the basis of a fixed commission/charges based on expenses or cost incurred by the assessee for release of a particular advertisement. It is also to be noted that advertising space (be it media, print or outdoor), has been let out by third party vendors in the name of ultimate customers and beneficiary of advertisement. We have gone through the invoices and purchase orders from third party vendors and find that they contain customers’ name, and all the terms of advertisement are finalized after taking the approval from the customers. The assessee simply acts as an intermediary between the ultimate customer and the third party vendor in order to facilitate placement of the advertisement. The payment made by the assessee to vendors is recovered from the respective customers or associate enterprises. In the event customer fails to pay any such amount to the advertisement agency, the bad debt risk is borne by the third party vendor and not by the advertising agency i.e. the assessee. It is, thus, clear that the assessee has not assumed any risk on account of non-payment by its customers or associated enterprises. At this stage a useful reference may be made to ITS 2009 Transfer Pricing Guidelines accepted by the OECD where it is laid down that when an associate enterprises is acting only as an agent or intermediary in the provision of service, it is important in applying the cost plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves, and, in such a case, it may be not appropriate to determine arm’s length price as a mark-up on the cost of services but rather on the cost of agency function itself, or alternatively, depending on the type of comparable data being used, the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. In this type of cases, it will be appropriate to pass on the cost of rendering advertising space, to the credit recipient without a mark up and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function. These guidelines are as under:- 3.41 In applying the transactional net margin method, various considerations should influence the choice of margin used. For example, these considerations would include how well the value of assets employed in the calculations is measured (e.g. to shat extent there is intangible property the value of which is not captured on the books of the enterprise) and the factors affecting whether specific costs should be passed through, marked up, or excluded entirely from the calculation. 41. In the proposed revision of Chapter I-III of the Transfer Pricing Guidelines issue don 9th September, 2009 – 9th January, 2010 by OECD, it has been provided in Para 2.134 as under:- “2.134 In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at arm’s length to treat a significant portion of the taxpayer’s costs as pass- through costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit margin indicator). This depends on the extent to which an independent party at arm’s length would accept not to be remunerated on part of the expenses it incurs. The response should not be based on the classification of costs as “internal” or “external” costs, but rather on a comparability (including functional) analysis, and in particular on a determination of the value added by the tested party in relation to those costs.” 42. Further, OECD in ITS 2009 Transfer Pricing Guidelines has laid down as under:- “7.36 When an associated enterprise is acting only as an agent or intermediary in the provision of services, it is important in applying the cost plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves. In such a case, it may not be appropriate to determine arm’s length pricing as a mark-up on the cost of the services but rather on the costs of the agency function itself, or alternatively, depending on the type of comparable data being used, the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. For example, an associated enterprise may incur the costs of rending advertising space on behalf of group members, costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a mark-up, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function.” 43. In the light of these guidelines, it would be, therefore, clear that a mark-up is to be applied to the cost incurred by the assessee company in performing its agency function and not to the cost of rendering advertising space on behalf of its associate enterprises. We further find that the method adopted by the assessee while submitting ...