The Bombay High Court has admitted a department appeal raising important questions concerning the manner in which international transactions are to be benchmarked under the transfer pricing provisions of the Income Tax Act, 1961. 

The Division Bench of Justice Suman Shyam and Justice Ranjitsinha Raja Bhonsale has specifically agreed to examine whether closely linked domestic and international transactions can be aggregated at the entity level while applying the Transactional Net Margin Method (TNMM) for determining the arm’s length price.

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The appellant/assessee is engaged in the manufacture and sale of internal combustion engines, spare parts and components, generating sets and allied equipment, besides providing engine and genset services and undertaking trading activities. The company also operates a 100% export-oriented unit manufacturing and exporting IC engines, accessories, generating sets and related products.

For AY 2006-07, the company filed its income-tax return on November 23, 2006, declaring total income of approximately ₹210.40 crore. The return was initially processed under Section 143(1) of the Income Tax Act and was subsequently selected for scrutiny. A reference was made to the Transfer Pricing Officer (TPO) under Section 92CA(1) in connection with the company’s international transactions.

The TPO proposed an adjustment of approximately ₹40.64 crore in respect of international transactions. Based on the TPO’s proposal, the Assessing Officer passed a draft assessment order under Sections 143(3) and 144C, incorporating the transfer pricing adjustment.

The assessee challenged the draft assessment before the Dispute Resolution Panel (DRP), Pune. The DRP rejected the objections and confirmed the draft assessment. The Assessing Officer thereafter passed the final assessment order determining the company’s total income at approximately ₹260.98 crore. This included the transfer pricing adjustment of ₹40.64 crore as well as a further corporate tax disallowance resulting in an addition of approximately ₹9.93 crore.

The assessee then approached the ITAT, Pune. The Tribunal partly allowed the appeal by its order dated March 3, 2017. The Revenue subsequently challenged the Tribunal’s decision before the Bombay High Court under Section 260A of the Income Tax Act.

The principal controversy before the High Court concerns the methodology adopted for benchmarking the assessee’s international transactions.

The Revenue contended that the Tribunal had erred by accepting an entity-level benchmarking approach that aggregated exports to associated enterprises (AEs) with domestic sales made to third parties. According to the Revenue, Section 92 requires the international transaction itself to be benchmarked and therefore domestic transactions with unrelated parties could not simply be combined with international transactions for the purpose of determining the arm’s length price.

The Revenue further questioned the Tribunal’s reliance upon the decision in Demag Cranes & Components (India) Pvt. Ltd., arguing that the factual circumstances in that case were materially different because the transactions involved there were AE transactions, whereas Cummins India’s benchmarking exercise involved both AE and non-AE transactions.

Another contention of the Revenue was that the Tribunal had disregarded the internal TNMM analysis undertaken by the TPO, which the DRP had found to be feasible and reliable. The Revenue argued that the Tribunal instead preferred an external comparability analysis at the entity level.

The department questioned the Tribunal’s decision to reverse the separate-transaction approach adopted by the TPO and confirmed by the DRP. It relied upon the Delhi High Court decision in Denso India and contended that international transactions should be benchmarked separately.

The department argued that the Tribunal had not provided adequate reasoning for rejecting the detailed allocation of various costs between the domestic and export segments of the manufacturing activity undertaken by the TPO.

Questions were also raised regarding the appropriate Profit Level Indicator (PLI). According to the Revenue, the Tribunal was not justified in directing the TPO to use Operating Profit/Operating Revenue (OP/OR) for benchmarking the export transactions with AEs when, according to the Revenue, the cost base was the more appropriate denominator.

The transfer pricing controversy also extends to the treatment of interest income.

The department challenged the Tribunal’s direction to treat interest receipts as operating income in the manufacturing segment. It relied upon Rule 10TA of the Income Tax Rules, contending that interest income is expressly excluded from the definition of operating income.

The Revenue also argued that the TPO had calculated operating profit on a profit-before-interest-and-tax basis, thereby excluding interest expenditure from the cost. According to the Revenue, interest income could consequently not be treated as operating income by analogy.

The petitioner argued that TNMM was the most appropriate method for benchmarking the international transaction in the circumstances of the case. The assessee therefore defended the Tribunal’s decision to interfere with the assessment made by the Assessing Officer.

The assessee also relied upon judicial precedents including Demag Cranes & Components (India) Pvt. Ltd. and Sony Ericsson Mobile Communications India Pvt. Ltd. The defence was that, in view of these decisions and the applicable transfer pricing principles, the substantial questions proposed by the Revenue did not arise for consideration by the High Court.

The Bombay High Court initially observed that the questions proposed by the Revenue appeared, at first glance, to be legal objections against the Tribunal’s order and might not qualify as substantial questions of law. However, after examining the record and the Tribunal’s judgment in detail, the Bench concluded that substantial questions of law did arise for consideration.

The Court accordingly admitted the department’s appeal and formulated three principal questions for determination.

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