TRANSFER pricing being one of the intricate branches of direct taxation legislation has witnessed a commendable development from the pronouncements of Delhi High Court. Delhi High Court as a paramount High Court in the country in terms of development of law has contributed significantly, interalia, towards the development of jurisprudence on transfer pricing. The present article provides an insight of five significant decisions under transfer pricing legislation authored by eminent Judge Justice S.Ravindra Bhat (who is now sitting judge of the Supreme Court) wherein the principles laid down in these decisions pursuant to a comprehensive & meticulous analysis of facts; issues involved & questions of law including various methods prescribed for determination of Arm's Length Prices (ALP) of International transactions; relevant statutory provisions etc provide a comprehensive & valuable factum judicas legem (judge made law) on the subject. These decisions provide clarity to the reader on applicability of most appropriate method of transfer pricing; important aspects of commonly used method of transfer pricing comprising of Transactional Net Margin Method ('TNMM'); relevant criteria for exclusion & inclusion of comparables and significance of OECD commentary in the context of Indian transfer pricing legislation. These decisions will act as important stare decisis for the Courts & Tribunals in adjudicating upon the transfer pricing issues.

1) Li and Fung India Pvt. Ltd. Vs Commissioner of Income Tax dated 16/12/13 - 2013-TII-18-HC-DEL-TP.

Facts of the case: The assessee was a wholly owned subsidiary of a company incorporated in Mauritius as a captive offshore sourcing provider. The assessee entered into an agreement with an Associated Enterprise ('AE') base in Hong Kong whereby the contract for rendering sourcing services was outsourced or sub-contracted to the assessee, for which it was remunerated at cost plus a mark-up of 5 per cent for services rendered. The assessee, during the relevant assessment year 2006-07, entered into international transactions of buying services for sourcing of garments, handicrafts, leather products, etc., in India for its associated enterprise, and was paid service charges of 5% of cost plus mark-up incurred for providing these services. The assessee worked out the arm's length price of the international transactions applying the transactional net margin method ('TNMM') by comparing the operating profit margin of 26 companies and the assessee's operating profits/operating costs taken at 5.17 per cent. It contended that it was a low risk captive sourcing service provider performing limited functions with minimal risk. The Transfer Pricing Officer held that the cost plus compensation at 5 % of cost of incurred by the assessee was not at arm's length and applied a mark-up of 5% on the free on board value of exports of Rs.1,202.96 crores made by the Indian manufacturer to overseas third party customers. The Dispute Resolution Panel reduced the mark-up of 5% of free on board value of exports to 3%. The Tribunal held that the assessee was performing all critical functions with the help of tangible and unique intangibles as well as supply chain developed, which helped the associated enterprise to enhance its business and resulted in location saving to the consumer, compensation for the services rendered by the assessee to the associated enterprise, equivalent to the cost plus 5% mark-up, was not at arm's length. The Tribunal accepted the Transfer Pricing Officer's reasoning for applying the 5% of the free on board value of exports to third parties by Indian manufacturers.

Question's of law before the Hon'ble Court: The following two questions of law were considered for determination by the Hon'ble Court:

(i) Whether the assessment of the Revenue of the arm's length price applying the transactional net margin method was contrary to the transfer pricing provisions under the Income-tax Act and Rules?

(ii) Whether the Transfer Pricing Officer's (TPO's) apportionment by considering the cost plus mark-up of 5% on FOB value of goods between third party enterprises, sourced through the appellant is in compliance with the law ?

Decision of Hon'ble Court : Following four important principles were laid down in this case as under:

(i). In order to apply the transactional net margin method the assessee's net profit margin realised from the international transactions had to be calculated only with reference to the cost incurred by it and not by any other entity either third party vendors or the associated enterprise. The Assessing Officer/Transfer Pricing Officer must operate textually, and within the bounds of the text. Rule 10B(1)(e) of the Income-tax Rules, 1962, does not enable consideration or imputation of cost incurred by third parties or unrelated enterprises to compute the assessee's net profit margin for application of the transactional net margin method. Rule 10B(1)(e) recognizes that the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise. It thus contemplates a determination of the arm's length price with reference to the relevant factors (cost, assets, sales, etc.) of the enterprise in question, i.e., the assessee, as opposed to the associated enterprise or any third party. The textual mandate, thus, is unambiguously clear ;

(ii).That the Transfer Pricing Officer's reasoning to enhance the assessee's cost base by considering the cost of manufacture and export of finished goods, i. e., ready-made garments by third party vendors (which cost was certainly not the cost incurred by the assessee), was nowhere supported by the transactional net margin method under rule 10B(1)(e);

(iii). That the assessee had neither made investment in the plant, inventory, working capital, etc., nor did it claim to have any expertise in the manufacture of garments. More importantly, and given no material to the contrary, the assessee did not bear the enterprise risk for manufacture and export of garments. The assessee's functional and risk profile thus was entirely different and had nothing to do with the manufacture and export of garments by unrelated third party vendors. The assessee rendered support services in relation to the exports, which were manufactured independently. Thus, attributing the costs of such third party manufacture, when the assessee did not engage in that activity, and more importantly, when those costs were clearly not the assessee's costs, but those of third parties, was clearly impermissible ;

(iv). That once the transactional net margin method was deemed the most appropriate method, the distortions, if any, had to be addressed within its framework. The unrelated transactions which were compared by the assessee had not been adversely commented upon, and neither had the choice of the transactional net margin method. The Transfer Pricing Officer, therefore, ignored relevant and crucial material, and straightaway proceeded to broaden the base for arriving at the profit margin, for attributed income of the assessee. Not only was this a clear infraction of the terms of the Act and Rules; he went ahead to introduce what was clearly alien to the provisions of law and travelled outside the Rules. Therefore, the Transfer Pricing Officer's addition of the cost plus 5% mark-up on the free on board value of exports among third parties to the assessee's calculation of arm's length price using the transactional net margin method was without foundation and liable to be deleted.

2. Commissioner of Income Tax Vs Cushman & Wakefield (India) Pvt. Ltd. dated 23/05/14 reported in - 2014-TII-07-HC-DEL-TP.

Facts of the case: The assessee, an Indian company, was engaged in the business of rendering services connected to acquisition, sales and lease of real estate and other services to several clients within and outside India. It reported its international transactions, one of these being payment of referral fee of Rs. 1,73,26,631 by the assessee to its associated enterprises for referring clients, and the other being payment of Rs. 1,06,39,865 as reimbursement to the associated enterprises in Singapore and Hongkong for costs incurred by them for co-ordination and liaison services in respect of the client, IBM. No benchmarking or transfer pricing analysis was conducted by the assessee as regards the reimbursement of expenses on the ground that these expenses incurred in connection with travel, boarding and lodging of employees had been charged back based on actual cost incurred by the associated enterprises, that the associated enterprises provided no additional service and that the assessee shared the cost of certain employees of its associated enterprises who assisted the group entities in maintaining relationships with its global clients. The assessee had in its own transfer pricing analysis conducted a benchmarking for the transactions resulting in payment of referral fees, through the comparable uncontrolled price method. The Transfer Pricing Officer drew no adverse reference as regards the payment of the referral fees but on the ground that the assessee did not file any evidence to support a claim that services were actually provided to the assessee and that benefit actually accrued to the assessee, he disallowed the deduction in respect of the reimbursement of costs to the associated enterprises. The Assessing Officer framed a draft assessment order disallowing the reimbursement and the referral fees as a deductible expenditure, stating that no benefit was derived by the assessee from the referral fees paid to the associated enterprises as no services were actually rendered for which referral fees were to be paid. The Dispute Resolution Panel concurred with the Assessing Officer. The assessee appealed to the Appellate Tribunal, which reversed the finding that there was no documentary evidence to support the rendering of services (apart from incidental benefits) and the finding that no services were rendered for payment of referral fees, on the grounds, firstly, that the Assessing Officer, after having referred the matter to the Transfer Pricing Officer, could not reopen or re-examine the transaction and secondly, that the assessee had submitted ample evidence to support the expenditure incurred with respect to revenue earned by the assessee on property transactions referred to the assessee by its associate enterprises.

Question of law before the Hon'ble Court: The following question of law was considered for determination by the Hon'ble Court:

"Is the Tribunal correct in holding that benchmarking was not necessary in respect of the cost reimbursement reported by the assessee that was later subject to disallowance by the Assessing Officer since the Transfer Pricing Officer held that the arm's length price in respect of this component was nil ?"

Decision of Hon'ble Court: Following three important principles were laid down in this case as under:

(i). The jurisdiction of the Assessing Officer under section 37 of the Income-tax Act, 1961, and that of the Transfer Pricing Officer under section 92CA, are distinct. The authority of the Transfer Pricing Officer is to conduct a transfer pricing analysis to determine the arm's length price and not to determine whether or not there is a service from which the assessee benefits. That aspect of the exercise is left to the Assessing Officer. That exercise of factual verification is retained by the Assessing Officer under section 37. The Transfer Pricing Officer can after a consideration of the facts state that the arm's length price is nil given that an independent entity in a comparable transaction would not pay any amount. However, this is different from the Transfer Pricing Officer stating that the assessee did not benefit from these services, which amounts to disallowing expenditure. That decision is outside the authority of the Transfer Pricing Officer;

(ii). A referral by the Assessing Officer to the Transfer Pricing Officer is only for the limited purpose of determining the arm's length price, based on a prima facie view that such a referral is necessary. It does not imply a concrete view as to the existence of services, or the accrual of benefit (such that allowance under section 37 must be permitted). The Assessing Officer can, therefore, determine under section 37 that the expenditure claimed was not for the benefit of the business and, thus, disallow that amount. This does not restrict or in any way bypass the functions of the Transfer Pricing Officer. The Transfer Pricing Officer determines whether or not the stated transaction value represents the arm's length price (including whether the arm's length price is nil), while the Assessing Officer makes the decision as to the validity of the deduction under section 37. This means the decision as to whether the expenditure was "laid out or expended wholly and exclusively for the purposes of the business" is a fact determination or verification to be undertaken by the Assessing Officer. That determination is not and cannot be made by the Transfer Pricing Officer. Nor is the authority of the Assessing Officer under section 37 curtailed in any manner by a reference under section 92C ;

(iii).The 2009 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations of the Organization for Economic Cooperation and Development are not binding. Whilst the factors enumerated in paragraph 7.6 are relevant, strict adherence to the guidelines, bordering on rigidity, is antithetical.

3) Chryscapital Investment Advisors (India) Pvt. Ltd. Vs Deputy Commissioner of Income Tax dated 27/04/15 reported in - 2015-TII-13-HC-DEL-TP.

Facts of the case: The assessee was engaged in providing investment advisory services, which were reimbursed on a cost-plus mark-up basis. In the assessment year 2008-09, the assessee entered into international transactions with associated enterprises relating to advisory services and reimbursement of expenses incurred on behalf of the associated enterprises amounting to Rs.56,61,99,829 and Rs. 4,49,72,912, respectively. For the purposes of determination of the arm's length price the assessee used the transactional net margin method ('TNMM'). The assessee treated the transactions relating to reimbursement received by it from its associated enterprises on actual basis, i.e., without mark-up at the arm's length price and since no value addition was done by it in relation to the expenses. The assessee identified four entities which were engaged broadly in the same economic activities as in its case and identified as comparables. The assessee's position was that because of fluctuation in the margins of the comparable entities, multiple years' data of the comparables was warranted to remove the effect of year specific aberrations. The assessee argued that using multiple years' data was consistent with the OECD guidelines as well as the transfer pricing regulations of several developed jurisdictions. The assessee's case was scrutinised by the Assessing Officer who referred the matter to the Transfer Pricing Officer. The Transfer Pricing Officer passed an order recommending transfer pricing additions of Rs. 20,93,34,155 to the income of the assessee. The Transfer Pricing Officer computed the operating margins of the four comparables using a single year's data, i.e., for the financial year 2007-08 and ignoring the data for two prior financial years, i.e., 2005-06 and 2006-07 while determining the arm's length price. The Transfer Pricing Officer concluded that multiple years' data for the assessee's comparables could not be used but introduced two new comparables with abnormal business profits. The Transfer Pricing Officer also retained a comparable in spite of its showing abnormal growth in the assessment year under consideration and considered reimbursable expenses as part of the operating expenses and corresponding reimbursement as part of operating revenue of the assessee for the purpose of determining the arm's length price. The Transfer Pricing Officer held that the assessee had not furnished any detail as to how the data for the earlier years had an impact on the profits in the concerned assessment year of the assessee or the comparables. Based on the Transfer Pricing Officer's report, the Assessing Officer passed the assessment order conforming to the recommendations of the Transfer Pricing Officer. This was confirmed by the Disputes Resolution Panel. All the lower authorities included three entities as comparables which had very high profit margins as compared with that of the assessee.

Question's of law before the Hon'ble Court : The following three question of law on transfer pricing issues were considered for determination by the Hon'ble Court:

(i) "Whether the proviso to rule 10B(4) of the Income-tax Rules, 1962, will be applicable in case of fluctuations in the operating profit margins of comparable companies during the relevant financial year under question as compared to earlier years ?

(ii) Whether comparables can be rejected on the ground that they have exceptionally high profit margins as compared to the assessee in transfer pricing analysis?

(iii) Whether factors like differential functional and risk profile coupled with high degree of volatility in operating profit margins is sufficient ground to reject comparables for transfer pricing analysis?"

Decision of Hon'ble Court: Following three important principles were laid down by the Court on transfer pricing issues as under:

i) The determination of the arm's length price in respect of an international transaction, has necessarily to conform to the mandate of rule 10B of the Income-tax Rules, 1962. The sequitur of rule 10B(2) and (3) is that if the comparable entity or entity's transaction broadly conforms to the assessee's functioning, it has to enter into the matrix and be appropriately considered. The crucial expression giving insight into what was intended by the provision can be seen by the use of the expression "none of the differences if any between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in such transactions in the open market". The other exercise which the Transfer Pricing Officer has to necessarily perform is that if there are some differences, an attempt to "adjust" them to "eliminate the material effects" should be made. Rule 10B(2) gives six methods outlined in clauses (a) to (f) of rule 10B(1), while judging the comparability. Rule 10B(3), on the other hand, indicates the approach to be adopted where differences and dissimilarities are apparent. Therefore, the mere circumstance of a company-otherwise conforming to the stipulations in rule 10B(2) in all details, presenting a peculiar feature-such as huge profits or a huge turnover, ipso facto does not lead to its exclusion. The Transfer Pricing Officer, first, has to be satisfied that such differences do not "materially affect the price... or cost"; and, secondly, an attempt to make reasonable adjustment to eliminate the material effect of such differences has to be made. The general rule as prescribed in rule 10B(4) mandates the tax authorities to take into account only the relevant assessment year's data. The proviso to rule 10B(4) permits data relating to two years prior to the relevant assessment year to be taken into account in the event that they have an influence on the determination of price. However, in such instances, the onus lies upon the assessee to establish the relevance of such data. The language of rule 10B(4) does not leave any scope for ambiguity on this issue;

ii) The Organisation for Economic Co-operation and Development (OECD) is an international economic organisation of 34 countries founded in 1961 to stimulate economic progress and world trade. India is not a member of this grouping; it has an observer status. The guidelines of the OECD have only persuasive status; they do not have legal sanction—unlike, for instance Double Taxation Avoidance Agreements which courts are duty bound to interpret and implement, in terms of municipal law, given the compulsion of the provisions of the Income-tax Act. Secondly, and more importantly, the provisions of the Constitution compel a national legislation, to embody the terms of a treaty, for it to be enforceable in courts in India. However, both the OECD guidelines as well as rule 10B(2) and (3) do not, in any manner, prescribe automatic exclusion of entities with extreme financial results;

iii) There is sufficient guidance and clarity in rule 10B on the principles applicable for determination of the arm's length price. These include the various factors to be taken into consideration, and the approach to be adopted ( functions performed, taking into account risks borne and assets employed, size of the market, the nature of competition, terms of labour, employment and cost of capital, geographical location, etc.) The extent of accurate adjustments possible, too, is a factor to be considered. Rule 10B (3) then underlines what the arm's length price determining exercise entails, if there are dissimilarities which materially affect the price charged, etc. The first attempt has to be eliminate the components which so materially affect the price or cost. In other words, given the data available, if the distorting factor can be severed and the other data used, that course has to be necessarily adopted.

4) Magneti Marelli Power Train India P. Ltd. Vs DCIT dated 25/10/16 reported in - 2016-TII-80-HC-DEL-TP.

Facts of the case: The assessee was a joint venture company of two companies based in Italy and Japan respectively. It was incorporated in India to manufacture and sell engine control units. The assessee entered into an agreement with its foreign associated enterprise for acquiring technology required for the purpose of manufacturing engine control units. It reported six international transactions including "Payment of technical assistance fee" to the extent of Rs. 38.58 crores. The assessee applied the transactional net margin method to benchmark its international transactions of import of raw materials, sub-assemblies and components, payment of technical assistance fees, payment of royalty, payment of software and purchase of fixed assets. All these were categorised under one broad head, namely, "manufacturing of automotive components". The ratio of the assessee's projected operating profit margin to the operating revenue at 18.78 per cent. was compared with the mean operating profit margin at 6.65 per cent. of comparables taken on the basis of past three years data of MMP. The assessee, on the basis of its analysis claimed that its international transactions under the broad head, which included "payment of technical assistance fee" were at arm's length price. The Transfer Pricing Officer rejected this holding that the transactional net margin method had to be applied separately for each international transaction and not collectively as done by the assessee. The Transfer Pricing Officer therefore, held all international transactions could not be at arm's length price merely because the overall operating profit was more than the comparables. The Transfer Pricing Officer consequently rejected the assessee's entity level approach applied by it to benchmark its international transactions which included technical assistance fees of Rs. 38.58 crores. According to the Transfer Pricing Officer, the comparable uncontrolled price method was more apt and had to be applied and accordingly, the arm's length price of the transaction was determined. The Dispute Resolution Panel confirmed this. The Tribunal remanded the matter to the Assessing Officer holding that neither the assessee had followed the correct methodology for determination of arm's length price nor had the Transfer Pricing Officer applied the comparable uncontrolled price method for determination of arm's length price in the correct perspective.

Question's of law before the Hon'ble Court: The following two questions of law were considered for determination by the Hon'ble Court:

i) "Whether the Income-tax Appellate Tribunal was right in holding that royalty and technical assistance fee did not form part of a composite transaction and have to be treated as two separate trans actions for the purpose of benchmarking and computing arm's length price?

ii) Whether the Income-tax Appellate Tribunal was right in holding that transactional net margin method should not be applied for benchmarking/computing arm's length price in respect of transaction relating to 'technical assistance fee' ?"

Decision of Hon'ble Court : Following two important principles were laid down by the Court as under:

i)That each year that international transactions were entered into with associated enterprises, the assessee had to file transfer pricing reports. These transfer pricing reports should be factually correct and the assessee had to satisfy the queries of the Transfer Pricing Officer. During the transfer pricing proceedings, the assessee was unable to substantiate the need for payment of technical assistance fees to its foreign associated enterprise. The assessee tried to establish its case for the arm's length nature of the transaction by stating that it gained in the form of higher sales. The assessee's argument that the technology itself would not have been given to it, but for the substantial fee, paid over and above the royalty payable, required a closer scrutiny. The initial burden was always upon the assessee to prove that the international transaction was at arm's length. Its transfer pricing report necessarily had to draw a comparison with other entities to show the general degree of profitability of the venture. The lower authorities correctly turned down the method of explaining the justification of the technical fee with "proof" of its necessity by relying on profits. Undoubtedly the assessee was obliged to make the payment and that obligation arose from the agreements, a pre-incorporation binding contract. However, existence of such contractual obligation could not ipso facto be the end of the enquiry. Arm's length price determination in respect of every payment that was part of an international transaction was to be conducted irrespective of such obligation undertaken by the parties. If the transactions were not at arm's length, the required adjustment had to be made, as provided in the Act, irrespective of the fact that the expenditure was allowable under other provisions of the Act. There could conceivably be various reasons not to subject such payments. However, to say that such a substantial amount had to necessarily be paid and that it was a commercial decision, dictated by the need for the technology, in the light of a specific query, it could not be said by the assessee that later profits justified it, or that has essentially precluded the scrutiny. Thus the explanation by the assessee that the payment of Rs. 38.58 crores in the circumstances was correctly not accepted. The Tribunal rightly remitted the matter;

ii) That having accepted the transactional net margin method as the most appropriate method, it was not open to the Transfer Pricing Officer to subject only one element, i.e., payment of technical assistance fee, to an entirely different method. The adoption of a method as the most appropriate one assured the applicability of one standard or criteria to judge an international transaction. Each method was a package in itself, as it were, containing the necessary elements that were to be used as filters to judge the soundness of the international transaction in an arm's length price fixing exercise. If this were to be disturbed, the end result would be distorted and within one arm's length price determination for a year, two or even five methods could be adopted. Therefore, the transactional net margin method had to be applied by the Transfer Pricing Officer in respect of the technical fee payment too.

5) Principal Commissioner of Income Tax Vs Makemy Trip India P. Ltd. dated 07/11/17 reported in - 2017-TII-92-HC-DEL-TP.

Facts of the case: The assessee was in the travel and tourism business. It provided on-line solutions for travel and other comprehensive services for the global traveller including air tickets, hotel reservations, car bookings and holidays. For the Assessment Year 2005-06, the Transfer Pricing Officer held that the adoption of the resale price method was appropriate in the circumstances. The Commissioner (Appeals) held that the services provided by the assessee in the two business segments, rendered them incomparable at the gross margin level and also that the resale price method was not appropriate on account of the high degree of functional congruence of the assessee. The Tribunal confirmed this finding of Commissioner of Income Tax (Appeals).

Issue before the Hon'ble Court: The issue involved before the Hon'ble Court was whether in case of an assessee engaged in the business of providing services in the nature of air ticketing, hotel reservations, car bookings and holidays then whether under these circumstances the resale price method (RPM) would be considered to be the most appropriate method as adopted by the TPO or the transactional net margin method ('TNMM') as adopted by assessee will have to be preferred over RPM.

Decision of Hon'ble Court: Held by the Hon'ble Court that selection of most appropriate method by the Transfer Pricing Officer of resale price method (RPM) is incorrect as resale price method is inapplicable to the facts of the assessee. Since the assessee performed routine back office services for its associated enterprises without being assigned or carrying out any key entrepreneurial function in relation to the offshore business of the associated enterprises, the assessee could be characterised as a routine back office service provider. Hence, the approach adopted by the assessee to benchmark such transactions using the transactional net margin method (TNMM) as the most appropriate method by finding comparables engaged in providing similar services was proper. Apart there from, while deter mining the arm's length price, the Transfer Pricing Officer has bench marked the margin of profit earned in sub-agent segment with the margin of profit earned by the assessee from its direct customers. In doing so, the Transfer Pricing Officer has failed to appreciate that associated enterprise of the assessee is not the customer of the asses see, and it is assessee who is the acting as sub-agent of the associate enterprise and in respect of such transactions, the assessee has also been remunerated. Since the direct customer segment and subagent segment are materially different as such, the margin of profit earned by the assessee in respect of transactions entered with its associated enterprise is not comparable with the margin of profit earned by the assessee with its direct customers. Further, if the approach of the Transfer Pricing Officer is to be applied then the effect of the com parison would be that assessee will receive 15.90 per cent. of the total gross profit earned by the associated enterprise, and in such circum stances proper adjustment would be to allocate the proportionate operating expenses incurred by the associated enterprise, and in such circumstances, the effect would be that there would be downward adjustment to the book value of international transactions of the assessee, which itself contravenes the section 92(3) of the Income-tax Act.

(The Author, Mr Piyush Kaushik, is a practising Delhi-based Advocate.)