TPO Cannot Reject Comparables Merely To Adopt Department's Preferred Set: Karnataka High Court

The Karnataka High Court on 28 August held that a Transfer Pricing Officer (TPO) cannot reject comparable companies selected by a taxpayer merely to replace them with a standard set of comparables preferred by the Income Tax Department, holding that the selection or exclusion of comparables must satisfy the requirements under the Income Tax Act and Rule 10B of the Income Tax Rules.

A Division Bench of Justices S.G. Pandit and K.V. Aravind allowed the batch of transfer pricing appeals, including one by SAP Labs India Private Limited, and noted that the TPO must justify the selection or exclusion of comparable companies based on the statutory requirements. It observed:

“The selection or exclusion of comparables is essentially a factual and data-driven exercise, and the TPO cannot reject the taxpayer's comparables merely to substitute them with a standard departmental set. Such determination must strictly conform to the requirements of Rule 10B of the Rules.”

The appeals had earlier reached the Supreme Court, which remitted the matters to the High Court for fresh consideration. The Supreme Court directed the High Court to examine whether the statutory provisions governing transfer pricing had been followed and whether the findings of the Income Tax Appellate Tribunal were perverse.

The High Court held that Chapter X of the Income Tax Act provides a self contained framework for transfer pricing. While the initial burden of determining the Arm's Length Price and maintaining the prescribed documents lies on the taxpayer, the TPO can interfere with the taxpayer's determination only after satisfying the conditions prescribed under Section 92C(3) of the Income Tax Act, which permits the Assessing Officer to disregard the taxpayer's computation of the Arm's Length Price in specified circumstances.

It further held that once the TPO rejects the taxpayer's transfer pricing determination and substitutes other comparables, the burden shifts to the TPO to justify the inclusion or exclusion of those companies.

On the turnover filter, the Bench held that an upper turnover limit of Rs. 200 crore was rational and legally sustainable. It noted that turnover, brand value, economies of scale, bargaining power and ownership of intangible assets can materially affect the comparability and profitability of companies.

It also held that a 15% Related Party Transaction (RPT) filter would ordinarily be preferable. A higher threshold of 20% or 25% may be adopted only after recording a specific finding that sufficient comparable companies meeting the lower threshold are not available.

On foreign exchange gains and losses, the Bench clarified that they can be treated as operating items only where there is a direct nexus with the international transaction. In the absence of such a nexus, foreign exchange gains or losses cannot be included in operating revenue or operating cost.

Further, it clarified that the ±5% range under Section 92C of the Income Tax Act is only a permissible variation and not a standard deduction. A transfer pricing adjustment becomes necessary where the variation exceeds the statutory limit.

Accordingly, the High Court held that transfer pricing comparables must be selected or excluded on the basis of the statutory criteria and relevant data, and cannot be replaced merely because the Department prefers a standard set of comparable companies.

Appearances: Senior Advocates K.K. Chythanya and T. Suryanarayana, along with Advocates S. Sharath, Tanmayee Rajkumar, K.K. Mallahar Rao and D.D. Nageshwar Rao, appeared for the respective assessees. Additional Solicitor General N. Venkataraman, along with Senior Standing Counsel E.I. Sanmathi and Standing Counsel Sushal Tiwari and M. Dilip, appeared for the Revenue.