(2012) 345 ITR 241 (Del)
Determination of arm's length price; reference to the Transfer Pricing Officer
No. The officer's mandate is to determine the price of the transaction, not to sit in judgment on whether the taxpayer should have entered into it. Commercial expediency is for the businessman to decide.
May the Transfer Pricing Officer disallow a payment to an associated enterprise on the ground that the taxpayer derived no benefit, or that the expenditure was commercially unnecessary?
The taxpayer paid brand fee and royalty to its foreign associated enterprise for the use of technology and trademarks in manufacturing. It had incurred losses over a number of years. The Transfer Pricing Officer reasoned that a company making continuous losses could not be said to have derived any benefit from the technology or the brand, and determined the arm's length price of the royalty and brand fee at nil, disallowing the payments in their entirety rather than adjusting their quantum.
The Tribunal deleted the adjustment, holding that the officer had exceeded his function. The Revenue appealed to the Delhi High Court, which considered the scope of the power to determine arm's length price and the circumstances in which a transaction may be disregarded.
For the assessee
The function of the officer is to determine the price at which the transaction would have been entered into between unrelated parties, not to ask whether it should have been entered into at all. Whether the expenditure yielded a benefit, and whether it was commercially prudent, are matters for the businessman. Continuing losses may have many causes and do not establish that the technology was worthless.
For the Revenue
If no benefit was received, an independent enterprise would not have paid anything, so the arm's length price of the payment is nil. Determining that price at nil is an exercise of the pricing function, not a disallowance on grounds of expediency.
The Court held that the transfer pricing provisions permit the price of a transaction to be adjusted to arm's length, but do not permit the transaction itself to be disregarded or recharacterised, save in exceptional situations. Drawing on the OECD Transfer Pricing Guidelines, it identified two such situations: where the economic substance of a transaction differs from its form, and where the arrangements, viewed in their totality, differ from those which independent enterprises behaving in a commercially rational manner would have adopted, and the actual structure practically impedes the determination of an appropriate price. Outside those circumstances, the transaction as structured by the parties must be respected. The Court held that it is not for the Revenue to question the commercial expediency of expenditure, a principle long established in the general law of deductions and equally applicable here. Whether a benefit resulted, and whether the taxpayer's judgment in incurring the expenditure was sound, are not the officer's concern. Losses may result from market conditions, pricing, competition or many other causes, and do not demonstrate that technology or brand rights conferred no value. The determination of nil was accordingly set aside.
Frequently invoked under Sections 165 and 166 whenever an adjustment is framed as a benefit test or a need test rather than a pricing exercise. It remains the principal authority limiting recharacterisation of intra-group service, royalty and management fee arrangements, and its adoption of the OECD recharacterisation threshold continues to be cited.