Facts of the Case

Mentor Graphics (Noida) Pvt. Ltd. was an Indian company and a wholly owned subsidiary of IKOS Systems Inc., USA, engaged in software development services and marketing support services for its parent enterprise. The company acted as a captive service provider and developed software solely according to the instructions of its parent company.

For Assessment Year 2002-03, the assessee entered into international transactions relating to software development services and adopted Transactional Net Margin Method (TNMM) as the most appropriate method for determining Arm’s Length Price.

The assessee calculated its Profit Level Indicator (PLI) at 6.99%.

The Transfer Pricing Officer (TPO) rejected the comparables used by the assessee and conducted an independent search using different filters and databases. Based on selected comparables, the TPO arrived at an average operating margin of 24.53% and consequently made a transfer pricing adjustment of ₹1,45,73,857.

The CIT(A) confirmed the addition. The Income Tax Appellate Tribunal (ITAT) later deleted the adjustment and held in substance that if even one comparable's PLI was lower than that of the taxpayer, the transaction could be considered at arm’s length.

Revenue challenged the ITAT order before the Delhi High Court.

 

Issues Involved

  1. Whether under the first proviso to Section 92C(2), where multiple comparable prices are available, Arm’s Length Price should be determined using the arithmetic mean of all such prices.
  2. Whether acceptance of a single comparable having a lower Profit Level Indicator than the taxpayer is sufficient to conclude that international transactions are at Arm’s Length.
  3. Whether the Tribunal was justified in selecting only one comparable rather than applying the arithmetic mean of accepted comparables.
  4. Whether the Transfer Pricing Officer correctly rejected the comparables selected by the assessee.

 

Petitioner’s Arguments (Revenue)

  • The Revenue argued that the Tribunal incorrectly interpreted the first proviso to Section 92C(2).
  • It was contended that once multiple prices are available under the most appropriate method, the statute expressly requires computation of the arithmetical mean.
  • The Tribunal erred in holding that acceptance of one comparable with a lower margin was sufficient to establish arm’s length pricing.
  • The Tribunal exceeded its jurisdiction by selecting isolated comparable indicators instead of applying the statutory mechanism.

 

Respondent’s Arguments (Assessee)

  • The assessee argued that the Transfer Pricing Officer wrongly rejected the comparables selected by it.
  • It was submitted that the TPO adopted incorrect filters and failed to conduct proper Functional Asset Risk (FAR) analysis.
  • The assessee contended that the TPO used financial year data not permissible under Rule 10B.
  • The assessee maintained that its selected comparables showed that its margin of 6.99% was already higher than the arithmetic mean of accepted comparable companies.

 

Court Order / Findings

The Delhi High Court partly allowed the Revenue’s appeal and clarified the legal position as follows:

  1. The Court held that the Tribunal committed an error in law by holding that satisfaction of one comparable with lower profit margin than the taxpayer was sufficient.
  2. The Court expressly held that where more than one price is determined under the most appropriate method, the Arm’s Length Price must be determined by taking the arithmetic mean of such prices as mandated by the first proviso to Section 92C(2).
  3. The Court held that the Tribunal should not have selected a single Profit Level Indicator from among various comparables.
  4. However, after applying the arithmetic mean to the accepted comparables, the Court observed that even then the assessee’s PLI of 6.99% remained higher than the arithmetic mean of accepted comparables, making the assessee's transfer pricing determination acceptable in law.
  5. The Court also clarified that OECD guidelines cannot override explicit statutory provisions where the Income-tax Act and Rules directly govern the issue.

 

Important Clarification

The Court clarified an important transfer pricing principle:

  • A Transfer Pricing Officer or Assessing Officer may determine Arm’s Length Price independently if any of the circumstances under Section 92C(3) exist.
  • However, where multiple comparables are accepted under the most appropriate method, the law mandates adoption of the arithmetical mean, and selection of a single favourable comparable is impermissible.
  • OECD Guidelines cannot be applied where specific statutory provisions under Indian law govern the issue.

This judgment became an important authority regarding interpretation of the first proviso to Section 92C(2) and computation of ALP under TNMM.

 

Sections Involved

Income-tax Act, 1961

  • Section 92 – Computation of income from international transactions having regard to Arm’s Length Price
  • Section 92C – Computation of Arm’s Length Price
  • First Proviso to Section 92C(2)
  • Section 92C(3)
  • Section 92CA – Reference to Transfer Pricing Officer
  • Section 92F – Definition of Arm’s Length Price

Income-tax Rules, 1962

  • Rule 10B(1)(e)
  • Rule 10B(2)
  • Rule 10B(3)
  • Rule 10B(4)


Link to download the order -

https://delhihighcourt.nic.in/app/case_number_pdf/2013:DHC:1680-DB/BDA04042013ITA11142008.pdf

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