IT Appeal No. 2146 (Delhi) of 2007

[Assessment year 2004-05]

January 22, 2008

Section 92C, read with section 92CA, of the Income-tax Act, 1961 - Transfer pricing - Computation of Arm’s length price - Assessment year 2004-05 - Whether Assessing Officer in light of Instruction No. 3 of 2003, dated 20-5-2003 of CBDT is duty bound to refer matter to transfer pricing officer of international transaction exceeding Rs. 5 crores, having regard to purpose of specialized cell created by revenue department to deal with complicated and complex issues arising under transfer pricing mechanism - Held, yes

Section 92C, read with section 263, of the Income-tax Act, 1961 and read with Rule 10B of the Income-tax Rules, 1962 - Transfer pricing - Computation of Arm’s length price - Assessment year 2004-05 - Whether in determination of arm’s length price, specific characteristics of transaction of property transferred or services provided are required to be seen as a first step - Held, yes - Whether initial burden to prove that international transaction was carried out at arm’s length is an tax payer - Held, yes - Whether even as per OECD guidelines whole applying transactional net margin method not only comparability of transactions are to be kept in view but FAR analysis is also to be considered in evaluation - Held, yes - Whether tested party normally should be party in respect of which reliable data for comparison is easily and readily available and fewest adjustments in computations are needed; it may be local or foreign entity i.e. one party to transaction - Held, yes - Whether it is also true that generally least of complex controlled taxpayer should be taken as a tested party, but where comparable or almost comparable, controlled and uncontrolled transactions or entities are available, it may not be right to eliminate them from consideration because they look to be complex, if taxpayer wishes to take foreign AE as a tested party, then it must ensure that it is such an entity for which relevant data for comparison is available in public domain or is furnished to tax administration - Held, yes - Whether taxpayer is not then entitled to take a stand that such data cannot be called for or insisted upon from taxpayer - Held, yes - Assessee/taxpayer was a multinational company carrying on business of manufacture and sale of pharmaceuticals - During relevant previous year it had undertaken international transactions with its associated enterprises (AEs) by providing goods and services to them and charged price from its AEs in respect of goods and services at Arm’s Length Price (ALP) determined by applying Transactional Net Margin Method (TNMM) taking operating profit upon sales as profit level indicator - Assessing Officer accepted ALP as shown by assessee and completed assessment - Subsequently, Commissioner taking view that assessment made was erroneous insofar as it was prejudicial to interest of revenue initiated action under section 263 - In notice under section 263, Commissioner, inter alia, stated that while determining ALP by applying TNMM assessee had taken overseas AEs as tested parties instead of itself when reliable data for comparison in respect of itself was available in India; approach of assessee was not in consonance with rule 10B and, thus, method of determining ALP employed by assessee did not correct; assessee in audit report filed along with return did not give details and specific characteristics of transactions of property transferred or services provided except for giving amount of transactions merely mentioning that pharmaceuticals were sold either in shape of dosages, etc. - Assessee’s case was that overseas AEs were selected as tested parties as they were less complex compared to taxpayer; in view of numerous products and voluminous transactions, it was not possible to give details of transactions - Whether since there was good and reliable evidence for taking taxpayer as a tested party for comparison with Indian companies, yet foreign companies with different market conditions and economic realities were taken for comparison, Commissioner was justified in holding that taxpayer had wrongly selected AEs as tested party - Held, yes - Whether it could be said that Assessing Officer failed to examine fundamental questions relating to application of transfer pricing regulation, i.e., characteristic of transaction - Held, yes

FACTS

The taxpayer/assessee was a multinational company carrying on the business of manufacture and sale of pharmaceutical products as one of the leading concerns in India. The assessee had undertaken international transactions with Associated Enterprises (AEs), i.e., it had exported goods and services to its AEs, and charged prices from its AEs in respect of goods and services at Arms Length Price (ALP) determined by applying Transactional Net Margin Method (TNMM) taking operating profit upon sales as Profit Level Indicator (PLI). The assessee filed return for the assessment year 2004-05 along with audit report Form 3CEB containing details of international transactions. The assessee was asked to explain/give a note on application of provisions of section 92. Note of the assessee on ALP was accepted by the Assessing Officer and the Assessing Officer held that the prices charged by the assessee for transactions with AEs were at arm’s length and no adjustment was required. The Assessing Officer, accordingly, passed the assessment order. Subsequently, the Commissioner taking the view that the assessment made was erroneous insofar as it was prejudicial to the interest of the revenue, initiated action under section 263. In notice under section 263, the Commissioner, inter alia, stated that (1) the issue of determination of ALP was not referred to the Transfer pricing officer as required by Instruction No. 3 of 2003 dated 20-5-2003 of CBDT; (2) TNMM was used by the assessee taking operating profit upon sales as PLI; for this purpose the assessee had taken AEs as tested parties, instead of taxpayer when reliable data for comparison in respect of taxpayer was available in India, and their margins on mean basis and compared the same with mean of identified comparables; the approach of the assessee was not in consonance with rule 10B; considering the diverse conditions in which AEs were operating; hence, treating the tested parties to be AEs of the assessee bunched in a group did not go well the law and spirit of the transfer pricing legislation in force in India; thus, the method of determining ALP employed by the assessee did not appear to be correct; considering the aforesaid, to arrive the ALP of the international transactions, the assessee should have been made the tested party and TNMM should be applied with PLI as operating profit/sales taking major Indian pharma companies as comparables.

The assessee, inter alia, submitted that (1) non-reference to TPO was at best a procedural flaw and on this ground, assessee could not be held to be erroneous and prejudicial to the interest of the revenue; (2) overseas AEs of the assessee were rightly taken as tested parties and their margin of profit was compared with mean of profit margin of identified comparable; overseas AEs were selected as tested parties as they were less complex compared to Indian taxpayer; taxpayer was involved in multiple operations which, inter alia, include complex research and development, manufacturing operation at various locations, quality control processes besides owning valuable intangibles and on the other hand, its AEs were engaged in sales and distribution activities and few were engaged in secondary manufacturing, AEs assumed less risk as compared to taxpayer; margin of profit earned by it was more then other Indian pharmaceutical companies carrying on same business.

HELD

There can be no dispute that powers under section 263 can be invoked only when assessment is established to be erroneous and prejudicial to the interest of the revenue. It cannot be invoked merely for making a fishing inquiry. The taxpayer was also right in arguing that assessment cannot be revised merely because another reasonable view of the matter is possible in the case. At the same time, it is a settled law that assessment made without conducting proper inquiry and investigation as enjoined by law and warranted in the facts of the case is to be treated to be erroneous and prejudicial to the interest of the revenue. Assessment made in haste or without application of mind falls in the same category. [Para 27]

It was not disputed by the taxpayer that an assessment would be erroneous and prejudicial to the interest of the revenue if it is made without application of mind or without making proper inquiries into the facts and without considering statutory regulations applicable thereon. His submission was that Assessing Officer was not duty bound to refer the question of determination of arm’s length price to the Transfer Pricing Officer (T.P.O.) as he has ample power and discretion to carry that exercise. Even if it was necessary to refer the matter to the TPO, such failure was merely “procedural” and on account of the same, assessment could not be treated as erroneous and prejudicial to the interest of the revenue. On facts of the instant case, there was no justification to accept above of the taxpayer. The revenue had been able to establish fully that assessment in instant case was made without considering relevant and pertinent questions and without application of mind. [Para 29]

Under section 92(1), it is provided that any income arising from an international transaction shall be computed having regard to the arm’s length price. It is, therefore mandatory that in case of every international transaction, the price charged as per books must be shown to be arm’s length price. [Para 30]

It is clear from rule 10B in determination of arm’s length price under section 92C that specific characteristics of property transferred or services provided is first to be taken into consideration. Thereafter, functions performed, assets utilized or risk assumed (FAR) would have to be considered. Considerable significance is also attached to contractual terms relating to explicit and implicit division of responsibility, risks and benefits divided between the respective parties to the transaction. Economic conditions prevailing in the market including geographical locations, size of market, government orders in force are also required to be considered. Transfer pricing is an exercise of comparison of controlled and uncontrolled transaction between independent parties under similar or almost similar circumstances. If circumstances of transactions under comparison are different, then question of adjustment and their evaluation assumes importance; what are the differences and whether it is possible or not to adjust and what adjustments are needed. [Para 32]

Without going into the niceties, the characteristics of transactions are required to be seen as a first step. If one does not have the detail of transaction/transactions, what he is going to compare? [Para 33]

As per the accepted view, the initial burden to prove that the international transaction was carried out at arm’s length is on the taxpayer. This has been fully discussed by the Special Bench in Aztec Software & Technology Services Ltd. v. Asstt. CIT [2007] 107 ITD 141 (Bang.-SB) where after considering Indian regulations and regulations of several other countries, it has been held that such initial burden is on the assessee to show that transfer of goods and services is at ALP. [Para 34]

The Assessing Officer in the instant case accepted audit report and taxpayer’s transfer pricing study without raising any objection or query. But the Commissioner rejected report/study and gave direction for further investigation and enquiry. The taxpayer did not give in the report or in any other paper/document specific characteristics of the transactions, of property transferred or services provided except for giving the amount of the transactions merely mentioning that pharmaceuticals were sold either in the shape of dosages or API, technical know-how etc. From what was stated in the audit report, no information relating to correctness of transfer pricing could be gathered nor mechanism of Arm’s length price applied. The taxpayer was manufacturing and selling pharmaceutical products. It was manufacturing medicines mostly for human consumption. Such medicines have specific names. It was reasonable to assume that these very medicines or formula (or with some differences) were sold in India and were also exported to other countries or to independent concerns. Arm’s Length Price or transfer pricing could be seen or determined only if name and quantity of the product was made known. Only then it could be determined whether the taxpayer had sold same or similar or almost similar medicine to other independent concerns. Difference in transactions on comparison could be considered. Whether a similar product was sold by other pharmaceutical concerns in India and if sold, at what price. The taxpayer in the audit report, did not give details and specific characteristics of property transferred. The column title ‘Description of the transaction’ only state ‘Sale of API/Raw Material’, ‘Sale of spare parts’, ‘Sale and purchase of dosages’, ‘provision of technical assistance’ and know how. [Para 35]

The taxpayer did not give description of the international transaction as ‘numerous products and voluminous transactions’ were carried out by it. Can this be a ground for holding back the information about the description of the transactions? Now, if quantity and volume of goods transferred or services is not disclosed, can anybody find the price charged for goods? Therefore, it was clear that the taxpayer did not wish to give either name or volume of goods on which the price shown was charged by the assessee in transactions with its AEs. The Assessing Officer did not bother that basic and fundamental information to consider application of transfer pricing formulation was not available in the instant case. He did not bother to examine Note, i.e., “In view of the numerous products and voluminous transactions, it was not possible to give these details, furnished at the end of disclosures of transaction with AEs.” or see its implications. He accepted what was stated by the taxpayer in the Note and completed the assessment. The Assessing Officer failed to examine fundamental questions relating to application of transfer pricing regulations, i.e., characteristic of transactions. [Para 36]

As regards application of TNMM method, the taxpayer in the audit report, inter alia, stated that in applying the Transactional Net Margin Method for determining the ALP, the assessee had, having regard to the facts of the case, considered the net profit margin before tax of the entire business of Its Overseas Associated Enterprises, who are the tested parties. As the net profit margin before tax of such business was lower than the arithmetical mean of the net profit margin before tax of the overseas comparable companies, the assessee was of the opinion that transaction value of the aforesaid transactions as per its books of account met with the arm’s length principle. [Para 37]

No detail whatsoever of the company (enterprise) taken into consideration for comparison or working of their margin of profit or of overseas comparable companies taken into account was made available in the report in form 3CEB. No calculation was available in the audit report on form 3CEB. However, the Assessing Officer failed to note these deficiencies in the audit report. The Assessing Officer should have prima facie rejected such report as not conforming to statutory provisions of I.T. Rules on transfer pricing or should have raised pertinent questions relating to transfer pricing. The Assessing Officer only asked for the note on transfer pricing to be produced by the taxpayer. There was patent lack of application of mind to the requirement of transfer pricing regulations and also to what taxpayer had given in its report on Form 3CEB. The assessee argued that when TNMM method was applied and profit margin of tested party was taken into consideration for comparison, individual transactions lose their significance. Even effect of Functions, assets and risks (FAR) was minimized. He had referred to OECD guidelines. In the light of clear provisions of rule 10 duly considered in the case of Mentor Graphics (Noida) (P.) Ltd. v. Dy. CIT [2007] 109 ITD 101, there was no justification to accept above claim. [Para 38]

It is evident from the observations made by the Bench in Mentor Graphics (Noida) (P.) Ltd.’s case (supra) that even as per OECD guidelines while applying TNMM method not only comparability of transactions are to be kept in view but FAR analysis is also to be considered in evaluation. Enterprises carrying same functions in different economic sectors and markets can have different level of profitability. Further, OECD as per draft notes dated 10-5-2006 has accepted to exclude loss as well as high profit making enterprises from comparison where taxpayer is a captive enterprise like Mentor Graphics (Noida) Pvt. Ltd.’s case (supra). [Para 38]

The taxpayer submitted note on transfer pricing Study before the Assessing Officer along with the letter dated 24-3-2005, which was a document running to 104 pages. The taxpayer claimed that average profit earned by each of its enterprises was less than the profit earned by independent enterprise and filed relevant details in the note/transfer study in March 2005 [Para 40]

On consideration of submissions/details it was found that there was no detail of job profile/or of location of 8 companies in the above chart or other record. What constituted ‘Turnover’ and ‘Total cost’ of comparable and each of foreign AEs were important in order to see reliability of data for comparison, but these were left out and not disclosed. Only from column ‘Currency’ one could presume that comparable companies were operating in Europe, America or Malaysia (RM). These companies were taken as comparable to taxpayer’s foreign enterprises because these were manufacturing drugs in some part of the world. The taxpayer had transferred goods or services to its 17 associated enterprises spread over different continents operating in different environments which were significant factors. The taxpayer did not furnish details of transaction nor claimed that some or similar transaction with same profit margin were carried with all foreign AEs. It was not the case of the taxpayer that the price at which goods and services were transferred to all the 17 concerns was responsible for the margin of profit of the AEs. Influence of several other circumstance on ‘turnover’ or ‘total cost’ on margin of profit could not be ruled out. Other factors responsible for diversified margin of profit were required to be examined. Nothing was stated about those factors and whether any adjustment was required to be made for differences. The Assessing Officer in the assessment also showed least concern for above crucial aspect of the matter. It would have been appreciated if each of the foreign company was taken as a tested party, say AE in Peru and was compared with profit margin of pharmaceutical companies of same size carrying similar transactions in Peru. Malaysian AE was required to be compared with similar Malaysian companies with environmental advantages or disadvantages and after applying FAR test, results required to be seen. Similar exercise was required to be performed in respect of other companies situated in different countries or shown how selected companies were better placed than companies operating in India for comparison. This could have lent some credibility to transfer pricing study filed by the taxpayer in March 2005 although, no information was available in the audit report. Taking of companies with different locations and worked mean profit of 14.88 per cent without relevant details, could not be accepted particularly when it was not stated whether selected companies could also use or not use brand name. Examination and investigation of several circumstances in 17 countries was involved in the transactions. The Commissioner, therefore, rightly directed the Assessing Officer/TPO to re-do the assessment on the transfer pricing, with which one cannot find any fault. There was no logic in the comparable basis put forward by the taxpayer and in selecting companies without care for their geographic location, economic background and evidence of FAR analysis. On facts, there was no good reason to accept mean margin at 14.88 per cent as benchmark representing uncontrolled transaction or enterprise for all the 17 AEs. The Commissioner rightly applied provisions of section 263. [Para 41]

As regards grouping of transactions, taxpayer applied transaction by transaction basis. Grouping of all the transactions was justified, as ‘these can not be evaluated adequately on a separate basis’. [Para 42]

As regards, selection of the tested party, the claim of the taxpayer for aggregation of all the associated enterprises as tested parties in taking their margin of profit for comparison with some American companies and six other companies with location not disclosed was very difficult to understand. It is true that under rule 10AD, ‘transaction’ include number of closely linked transactions. As was clear from record, it was not even stated that all transactions carried with 17AEs were closely linked transactions. Justification given for taking all of them as one tested party/ parties was not convincing and difficult to accept on the facts of the case. Relevant details were not filed before Assessing Officer nor shown to be examined by him. How transactions carried with 17 AEs situated in South East i.e. in Thailand and Malaysia; in Africa i.e. in Nigeria; in South America i.e. in Brazil and Peru; in China, Republic of Ireland, Germany, Egypt, Netherlands, UK and several other places and related not only to pharmaceuticals but also transfer of know-how and technology, sharing of expenses could be taken as linked transactions to treat them as a single transaction and conclusion drawn about numerous transactions at arm’s length price. The Commissioner in the impugned order had rightly rejected all such claims. [Para 44]

The taxpayer had itself quoted para 1.42 of OECD TP guidelines wherein it is emphasized that ideally in order to arrive at most precise approximation of fair market value, the Arm’s Length transaction should be applied on a transaction-by-transaction basis. Why this ideal situation was not accepted and why transaction-to-transaction basis was not adopted is explained away in general reference ‘they cannot be evaluated adequately on a separate basis’. Separate transaction with far-flung situated entities are taken as closely linked or connected transactions for evaluation on above general observations. In fact, difficulty or inability to evaluate arose when all the transactions with all the 17 AEs were taken as a single transaction for comparison and conclusion of arm’s length price was drawn. The aggregation was done by the taxpayer observing ‘the primary activity of assessee constituted only cross border related party operation’. This assertion was factually wrong as multifarious activities were carried by the assessee. On facts, no justification was shown for clubbing fundamentally separate and independent transactions carried at different times and related to different parties situated in different continents. [Para 45]

The taxpayer was wrong in selecting overseas AEs as tested party for purposes of comparison to apply TP regulations. The taxpayer had vehemently contended that out of two entities in a group, one which was less complex and own no intangibles was to be adopted as a tested party for comparison. According to him, the Commissioner was wrong in taking the taxpayer as a tested party and comparing its result with other Indian pharmaceutical companies. It was contended that the taxpayer assessee on account of its assets, R&D and numerous activities was a complicated enterprise as compared with foreign AEs not possessing any valuable intangible property, etc. [Para 46]

Significant words ‘verified using the most reliable data – requiring the fewest and most reliable adjustments’ in US TP regulations and ‘reliable data can be identified in Para 3.43 of OECD guidelines’ were being conveniently ignored by the taxpayer in the instant case. It is no doubt true that under certain circumstances, foreign AE can be taken as a tested party for comparison. It will depend on facts and circumstances of each case. However, the spirit and purpose of OECD guidelines was not being adhered to and followed. Selective observations from the guidelines were picked up against the spirit of the guidelines to defeat the very purpose of the guidelines. Besides it was important to consider Indian Regulations and relevant facts. Guidelines cannot be treated of universal application irrespective of differences in situations and facts and circumstances involved. In the instant case, taxpayer had transferred pharmaceutical goods or know how from India to 17 different associated enterprises (AE) all over the world and, therefore, the following circumstances/conditions were also relevant. [Para 48]

Although not taken into consideration in the sweeping comparison of entities in 17 countries in instant case, the Market and economic conditions of enterprises in different geographies widely differ from one and other. This cannot be disputed. [Para 49]

On section of comparable from different locations US TP regulations provided that uncontrolled comparables ordinarily should be derived from the geographic market in which the controlled taxpayer operates, because there may be significant differences in economic conditions in different markets. If information from the same market is not available, an uncontrolled comparable derived from a different geographic market may be considered if adjustments are made to account for differences between the two markets. If information permitting adjustments for such differences is not available, then information derived from uncontrolled comparables in the most similar market for which reliable data is available may be used, but the extent of such differences may affect the reliability of the method for purposes of the best method rule. For this purpose, a geographic market is any geographic area in which the economic conditions for the relevant product or service are substantially the same, and may include multiple countries, depending on the economic conditions. [Para 50]

It was admitted by the taxpayer that similar transactions were carried out by the taxpayer with independent parties. Thus, it was evident that the “uncontrolled transactions” carried out by the taxpayer were available. These transactions were not taken into account as in those cases, according to the taxpayer, it did not undertake risk of success or failure of product which were undertaken in transactions with its associated concern. Success or failure of a product is normal incident of business. If terms here were different, these needed examination. Whether above risk did affect the comparable price and to what extend and so, what adjustments were required to be made is/was a pertinent question which was required to be looked into. The AO should have called for terms of contracts and details of similar controlled and uncontrolled transactions. It is settled position that for taking risks higher and additional compensation is demanded and this position is admitted even by the taxpayer. However, whether in fact higher than Uncontrolled price was charged had not been stated anywhere. It was to be seen whether the taxpayer had charged for additional risks. If not, why not? Contractual terms of the transactions were required to be placed on record as per rule 10B(2)(c). Without the contractual terms, benefit of the transaction could not be apportioned between the entities of the group to the International transactions. If independent Uncontrolled parties buying API from the taxpayer could not convert the API in ‘Ranbaxy’ brand dosage form then under what brand name these could be sold? This was required to be examined and evaluated. Substance of controlled and uncontrolled transactions were to be examined. Question of adjustment was also to be considered in the light of terms of the contract. Above fundamental material without which no meaningful comparison was possible was neither placed on record nor examined. Without examination of cogent material, the claim of the taxpayer that uncontrolled transactions were not comparable was wrongly accepted by the Assessing Officer. Those transactions were not taken for comparison as according to assessee, the assessee had undertaken risk in those transactions, which could not be evaluated. But the taxpayer had neither alleged nor proved that the uncontrolled enterprises selected for comparison had carried transactions with similar risks and were therefore selected. Further, on account of risk, the price charged from the associated concern has to be market price + compensation for the risk undertaken. But no evidence to the above effect was available on record. It could not be disputed that there were about 20 multinationals manufacturing and selling pharmaceutical products in India and, therefore, it would have been worthwhile comparing international transactions with transactions carried out by those concerns. The taxpayer was now itself relying upon enterprises operating in India and was seeking adjustments for differences which the Commissioner had asked to examine. Foreign AEs situated at different locations were operating under different market condition and economic realities. Evidence on record clearly showed that some AEs were making huge losses whereas others were making marginal profit or slightly more. How entities with different market and economic conditions could be taken as if it was single entity like that of taxpayer. Therefore, the taxpayer was not right in not selecting itself as a tested party. [Paras 51 and 52]

On examination of above facts, it was clear that the taxpayer failed to give specific details of International transactions carried out with 17 AEs although required to be given as per US TP Regulations. The pretext was the involvement of ‘numerous products and voluminous transaction’. This untenable plea had already been rejected. Next step was selection of reliable comparables. Uncontrolled transaction carried out by the taxpayers were available but not considered as comparable because with related AEs additional risks were undertaken by taxpayer. If it was done as per normal business practice, no adjustment was needed. But if it was abnormal favour to an associated enterprise, as it appeared to be, the question was required to be examined and evaluated. This crucial aspect needed examination. Entire transfer pricing regulations are concerned with adjustments of favourable treatment meted to related (associated) concerns. How such a situation was not examined was beyond comprehension. Next step in exercise of taxpayer was selection of tested party in respect of transfer of goods and services. Here again instead of selecting taxpayer as similar pharmaceuticals were operating in India, 17 foreign AEs were selected. The Commissioner had given list of 5 companies and taxpayer additionally 3-4 companies which were carrying on similar business with some difference. There was thus good and reliable evidence for taking taxpayer as a tested party for comparison with Indian companies yet foreign companies with different market conditions and economic realties were taken for comparison. OECD guidelines providing for selection of least complex party with no valuable tangibles was relied upon although the taxpayer did not satisfy above parameters. Relevant circumstances i.e. market conditions and economic realities, size of company etc. which materially affect determination of ALP were not considered. It was even evident from variations reflected in results of 17AEs of the taxpayer. Thus, instead of proceeding on the basis of reliable and easily comparable data and transactions for determining Arm’s length price, OECD guidelines were wrongly quoted. Actions of the taxpayer were accepted by the Assessing Officer without application of mind. On facts, in the instant case, interference by the Commissioner was fully justified. [Para 53]

From reading of assessment order it was found that apart from legal infirmities, the findings were factually erroneous and against record. Where was the comparison of transfer prices charged by the assessee from its associated enterprises and net margin thereon? The assessee did not give detail of the transactions as ‘numerous products and voluminous transactions’ were involved. The question of comparison of transfer pricing charged and net margin thereon by the assessee in respect of international transactions did not arise. Taxpayer withheld information relating to controlled transaction carried by it with its AEs as these were not comparable being complicated involving several risks. Further, the taxpayer was not taken as a tested party and profit margin of its 17AEs was compared. Therefore, question of taxpayer furnishing its net margin did not arise. However, the Assessing Officer went on to state ‘on comparison of prices charged by the assessee on international transactions and net margin thereon were at arm’s length’. These are erroneous observations. The Assessing Officer was also incorrect in observing that ‘declared margin profit as per books are higher than the profit margin computed as per Most Appropriate Method’. Where is the declared profit of the taxpayer? In fact, the case of the taxpayer, was just the reverse. It took up some eight companies and claimed that average margin of above eight uncontrolled enterprises was 14.88 per cent, which was higher than the margin of profit of any of its international enterprises. Wherefrom Assessing Officer found higher declared margin of profit as per books? It was quite obvious from Assessing Officer’s concluding remarks that for various reasons, he failed to apply mind to the issues that arose before him. Therefore, on facts, it will not be wrong to conclude that the Assessing Officer did not understand the complicated questions he was required to consider in five days between 24-3-2005 and 30-3-2005 and committed errors in passing order without understanding the case pleaded or the statutory provisions. [Para 55]

The transfer pricing involves approximation. A real transaction ordinarily is sought to be compared with situation of a hypothetical willing buyer of a comparable transaction and several presumptions and adjustments are required to be made. From above it could not follow that result of transfer pricing exercise must be blindly accepted although these look patently absurd and unrealistic. In India clear rule is that any interpretation of rule leading to absurdity or inconsistency is to be avoided. Here in the instant case, it would be absurd to accept that goods and services transferred in all the 17 cases were at arm’s length, it being immaterial whether profit margin was –42.17 per cent or +11.22 per cent because some formality under TNMM was carried. If –42.17 per cent transactions with margin of profit/loss are accepted, with transaction giving margin of profit of 11.22 per cent at ALP, without examination of other circumstances/factors, it is absurd to take variation of 53.39 per cent (-42.17 per cent + 11.22 per cent). It looked absurd to accept such inconsistencies without questioning and examination of other relevant facts. [Para 56]

The tested party normally should be the party in respect of which reliable data for comparison is easily and readily available and fewest adjustments in computations are needed. It may be local or foreign entity i.e. one party to the transaction. The object of transfer pricing exercise is to gather reliable data, which can be considered without difficulty by both the parties i.e. taxpayer and the revenue. It is also true that generally least of the complex controlled taxpayer should be taken as a tested party. But where comparable or almost comparable, controlled and uncontrolled transactions or entities are available, it may not be right to eliminate them from consideration because they look to be complex. If the taxpayer wishes to take foreign AE as a tested party, then it must ensure that it is such an entity for which the relevant data for comparison is available in public domain or is furnished to the tax administration. The tax payer is not then entitled to take a stand that such data cannot be called for or insisted upon from the taxpayer. [Para 58]

The correctness of the claim of the taxpayer that its foreign AEs were rightly adopted as tested parties for comparison and application of TNMM method was to be examined. The taxpayer had carried out several separate transactions with 17 AEs situated in different continents. It could have been appreciated if a particular entity in a particular country was sought to be computed with some similar entity in that very country as geographical situations in several ways influence the transfer pricing. [Para 59]

From above facts, it is quite evident that Assessing Officer did not apply his mind or carry any inquiry or investigation. Therefore, his order was erroneous in so far as prejudicial to the interest of the revenue. The Commissioner therefore was fully justified in exercising his power under section 263 and in setting aside the assessment with directions to re-do the exercise of transfer pricing. [Para 60]

The taxpayer contended that the Assessing Officer was fully competent to consider the question of Arm’s length price without making reference to Transfer Pricing Officer under section 92C. He has further submitted that reference to TPO under section 92CA(1) is not mandatory in the light of Instruction No.3 of 2003 of CBDT and the contrary view taken by Commissioner in the impugned order was erroneous and illegal. Alternatively, it was submitted that even if Instruction No. 3 is held to be mandatory and reference to T.P.O. necessary, then also it was only a case of breach of procedural provisions not affecting the legality of the order of the Assessing Officer. It was submitted that decision of Special Bench in the case of Aztec Software & Technology Ltd.’s (supra) was contrary to the decision of High Court in the case of Sony India (P) Ltd. v. CBDT [2006] 157 Taxman 125 (Delhi)/[2007] 288 ITR 52. [Para 63]

Under section 92CA(1), the Assessing Officer, if he considers it necessary or expedient so to do, may, with the previous approval of the Commissioner, refer to the computation of Arm’s Length Price in relation to international transaction under section 92C to the Transfer Pricing Officer. However, the CBDT, in exercise of its power under section 119, issued Instruction No.3 dated 25-5-2003 to all its officers. It was accordingly contended that decision of Special Bench of ITAT in the case of Aztec Software & Technology Ltd.’s (supra) is contrary to the decision of Hon'ble Delhi High Court in the case of Sony India P. Ltd. (supra) and that power of the Assessing Officer to carry out exercise and determine Arm’s Length price has remained unaffected and, therefore, assessment without making reference to TPO could not be termed as illegal. [Paras 64 and 67]

The question of binding nature of above Instructions was raised before the Special Bench in Aztec Software & Technology Ltd. (supra) and after relying upon the decision of the Delhi High Court in the case of Sony India Ltd.’s (supra), the Special Bench upheld the validity of the Circular. [Para 65]

On careful consideration of decision of Sony India P. Ltd.’s case (supra) and that of Special Bench in the case of Aztec Software (supra), there was no good reason to accept the argument of the assessee and interpretation he has put on the decision in the case of Sony India (P.) Ltd. (supra) leading to his inference that it is not necessary for Assessing Officer to make a reference to T.P.O. even when value of international transaction exceeds Rs.5 crores. [Para 68]

Further, it is not possible to hold that Instructions issued by CBDT under section 119 to regulate assessment proceeding can be treated as a waste paper by officers functioning under the Board (CBDT). If such a view is taken, it would lead to chaos in the country. If various guidelines issued by the CBDT for administration of Income Tax Department and for regulation of assessment etc. are not adhered to or made optional, then all schemes of assessment may fail and jeopardize the working of the department. This is neither the law of land nor there is any justification to accept such an argument. Thus, the Assessing Officer, in the light of instruction of CBDT, was duty bound to refer the matter to the TPO, having regard to the purpose of specialized cell created by the revenue department to deal with complicated and complex issues arising under the transfer pricing mechanism. The instant case was itself was a good example as to how department could be hoodwinked unless case was properly examined by persons having knowledge of principles of transfer pricing. The contention of the taxpayer was accordingly rejected. [Para 71]

As regards taxpayer’s contention that in not referring the question of determination of Arm’s Length Price to the TPO, the Assessing Officer merely committed a procedural error and, therefore, assessment order could not be said to be erroneous to invoke provision of section 263. The Assessing Officer failed to follow statutory regulations on a complicated issue like transfer pricing and made an assessment without application of mind. Accordingly, powers by Commissioner under section 263 were rightly exercised on facts and in the circumstances of the case. Even if for the sake of argument, it was accepted that reference to TPO is not mandatory and instructions not binding; on peculiar facts of the instant case, the assessment made without application of mind for purposes of section 263 was erroneous and prejudicial to the interest of the revenue. The Commissioner had rightly exercised his jurisdiction under section 263 in the instant case. [Para 72]

In the light of above discussion, there was no error in approach of the Commissioner.