Karnataka High Court: TPO Cannot Reject Taxpayer Comparables for Department's Standard Set

The Karnataka High Court has delivered a significant ruling on transfer pricing, holding 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. The division bench of Justices S.G. Pandit and K.V. Aravind also laid down comprehensive guidelines on several critical issues, including the turnover filter, related party transaction (RPT) threshold, treatment of foreign exchange gains and losses, and the retrospective application of the amended proviso to Section 92C.

Case Background

The judgment disposed of a batch of 11 appeals and a cross-objection filed under Section 260A of the Income Tax Act, 1961, challenging orders of the Income Tax Appellate Tribunal (ITAT) on transfer pricing adjustments for various assessment years. The disputes arose after the Assessing Officer referred the computation of arm's length price (ALP) to the TPO, who rejected the comparables used by the taxpayers and substituted them with a standard set of companies. The ITAT had partly allowed the taxpayers' appeals, leading to cross-appeals by both the Revenue and the assessees.

The Supreme Court, in SAP Labs India (P) Ltd. v. Income Tax Officer (2023), remitted the matters to the High Court with a direction to examine whether the statutory guidelines under the Act and Rules had been followed and whether the ITAT's findings were perverse.

Arguments Presented

The Revenue, represented by Additional Solicitor General N. Venkataraman, argued that the TPO is empowered to reject the taxpayer's transfer pricing study and undertake an independent analysis. It contended that the selection of comparables must be data-driven and that the ITAT erred in excluding certain companies and in treating the ±5% variation as a standard deduction.

The assessees, represented by Senior Advocates K.K. Chythanya and T. Suryanarayana, countered that the TPO had arbitrarily substituted comparables without satisfying the conditions under Section 92C(3). They argued that the selection of comparables is a factual exercise and that the ITAT's findings were based on proper application of the Rules.

Legal Analysis

The court meticulously examined the legislative scheme under Chapter X of the Income Tax Act and Rule 10B of the Income Tax Rules. It held that the initial burden of determining the ALP rests on the taxpayer, but the TPO can interfere only if one of the conditions in Section 92C(3) is met. The court observed that the TPO had not satisfied any of those conditions and had merely adopted a standard list of comparables, which was impermissible.

On the turnover filter, the court upheld the ITAT's adoption of an upper limit of Rs. 200 crores, noting that larger companies enjoy advantages like brand value, economies of scale, and bargaining power, which materially affect comparability. The court also ruled that a 15% RPT filter is ordinarily preferable, and a higher threshold can be applied only after recording a specific finding that sufficient comparable companies meeting the lower threshold are not available.

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

A crucial part of the judgment dealt with the ±5% tolerance range under Section 92C(2). The court held that this is merely a permissible variation and not a standard deduction. It further held that sub-section (2A) of Section 92C, inserted by the Finance Act, 2012, operates retrospectively from 1 April 2002, thereby withdrawing the benefit of the pre-amended proviso for all assessment years from 2002-03 onwards.

Key Observations

"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 tolerance of ±5% prescribed under Section 92C of the Act is merely a permissible variation and not a standard deduction , and transfer pricing adjustment becomes necessary whenever the variation exceeds the prescribed statutory limit."

"An RPT filter of 15% is ordinarily preferable, though a higher threshold of 20% or 25% may be adopted only upon recording a specific finding that sufficient comparable companies satisfying the lower threshold are unavailable."

Court's Decision

The High Court disposed of the appeals with specific directions. It held that the ITAT's exclusion of comparables like Hinduja TMT Ltd and Aftek Infosys Ltd required reconsideration in light of the retrospective application of Section 92C(2A). The matters concerning the treatment of foreign exchange gains and losses were remitted to the TPO for fresh determination. The cross-objection filed by the assessee was dismissed as not maintainable. The judgment provides a clear framework for future transfer pricing disputes, emphasizing that comparability analysis must be based on statutory criteria and cannot be supplanted by departmental convenience.