The purpose of a benchmarking study is to select comparable transactions by rationally deriving arm’s length price based on the financial data of selected comparable. On one side the comparables selected by assesses are rejected in many cases particularly of loss making companies and on the other hand high margin comparables are cherry picked and applied. Moreover entire methodology of tax payer in selecting comparable is rejected by the tax authorities. In case of captive service providers or Global inhousecentres (GIC) the authorities have regularly denied adjustments of working capital, risk differentials etc. The approach of authorities is presenting a challenge before the assessee to price the transaction.
Every business has its own unique features. Key functions of a business vary from case to case. Even if the key functions are similar, still some peculiarities make one different from another. Only the concerned businessman knows its salient features. Therefore in such scenario can there be a concept of “super profit” or loss making company in the arm’s length price determining process in transfer pricing under the Income Tax Act, 1961 or the Rules framed there under, entitling TPO or assessee to include or exclude high profit making companies ‘or loss making companies in the list of “comparables”. And to achieve this can a TPO cherry pick companies as comparable or use secret comparables .Rule 10B does not provide any basis to exclude an entity or eliminate it from the list of companies solely on the basis of high profitability. The reading of various judgment Shows that the TPO and assessee are regularly adhering to such measures to arrive at arms length price. Therefore it is necessary to examine the relevant regulations and guidelines provided.
The para A 7.3 of OECD guide line discusses about comparability consideration in case of extreme results:
3.63 Extreme results might consist of losses or unusually high profits. Extreme results can affect the financial indicators that are looked at in the chosen method (e.g. the gross margin when applying a resale price, or a net profit indicator when applying a transactional net margin method). They can also affect other items, e.g. exceptional items which are below the line but nonetheless may reflect exceptional circumstances. Where one or more of the potential comparables have extreme results, further examination would be needed to understand the reasons for such extreme results. The reason might be a defect in comparability, or exceptional conditions met by an otherwise comparable third party. An extreme result may be excluded on the basis that a previously overlooked significant comparability defect has been brought to light, not on the sole basis that the results arising from the proposed “comparable” merely appear to be very different from the results observed in other proposed “comparables”.
3.64 An independent enterprise would not continue loss-generating activities unless it had reasonable expectations of future profits. See paragraphs 1.70 to 1.72. Simple or low risk functions in particular are not expected to generate losses for a long period of time. This does not mean however that loss-making transactions can never be comparable. In general, all relevant information should be used and there should not be any overriding rule on the inclusion or exclusion of loss-making comparables. Indeed, it is the facts and circumstances surrounding the company in question that should determine its status as a comparable, not its financial result.
3.65 Generally speaking, a loss-making uncontrolled transaction should trigger further investigation in order to establish whether or not it can be a comparable. Circumstances in which loss-making transactions/ enterprises should be excluded from the list of comparables include cases where losses do not reflect normal business conditions, and where the losses incurred by third parties reflect a level of risks that is not comparable to the one assumed by the taxpayer in its controlled transactions. Loss-making comparables that satisfy the comparability analysis should not however be rejected on the sole basis that they suffer losses.
3.66 A similar investigation should be undertaken for potential comparables returning abnormally large profits relative to other potential comparables.
Secret Comparable in OECD
The UN TP guidelinealso discusses about information available with tax authorities which otherwise is not available with the tax payer. And mentions that, it would be unfair to apply a transfer pricing method on the basis of such data unless the tax administration was able, within the limits of its domestic confidentiality requirements, to disclose such data to the taxpayer so that there would be an adequate opportunity for the taxpayer to defend its own position and to safeguard effective judicial control by the courts.
The Para 5.4.4 UN TP guideline  discusses the Cherry Picking of Companies.
220.127.116.11. It is frequently not possible to obtain information on perfectcomparables in practice, and it is therefore often necessary to use broad search criteria when identifying third party comparables. Itmust be ensured that potentially relevant external comparables are notexcluded because of “cherry picking” of favourable third party informationby either the taxpayers or the tax authorities, ignoring otherinformation that does not support the position argued for.
18.104.22.168. For example, extreme results may be rejected as comparablesafter careful consideration of reasons for such extreme results by thetax authorities as they tend to skew the data. While this could on theone hand be a correct application of the arm’s length principle in certain circumstances, on the other hand the reasons for a loss may be genuine and may not always justify rejecting the loss-making company from the pool of comparables. This may be e.g. where the lossis due to a recession year which hit the controlled and uncontrolled transactions in the same way, or where it is due to the independent enterprise being in a start-up phase while the associated enterprise is also in a comparable start-up phase, etc.
22.214.171.124. To come to a correct conclusion, an unbiased analysis of the facts and circumstances surrounding the transactions has to be carried out. Where one or more of the potential comparables are loss making,further examination would be needed to understand the reasons for such losses and confirm whether the loss-making transaction or company is a reliable comparable. The losses might be due to exceptional conditions met by an otherwise comparable third party.Simple or low-risk functions in particular are not expected to generate losses for a long period of time. This does not mean however that loss making transactions can never be comparable. In short, it is the facts and circumstances surrounding the company in question that should determine its status as a comparable, not its financial result.
126.96.36.199. Well-documented search procedures and comparability criteria make the comparability standard transparent, in that thecomparability standard that was applied is clearly stated and its scope can be evaluated. This will ensure that results are less susceptible to“cherry picking” since the reasons for rejection of each potential comparable are provided.
UN TP Guidelines on Use of Secret Comparables-
188.8.131.52. Concern is often expressed by taxpayers, especially MNEs, over aspects of data collection by tax authorities and its confidentiality. Tax authorities have access to, as they need to, very sensitive and highly confidential information about taxpayers, such as data relating to margins, profitability and business contracts. Confidence in the tax system means that this information needs to be treated care full,especially as it may reveal sensitive business information about that taxpayer’s profitability, business strategies and so forth.
184.108.40.206. A secret comparable generally refers to the use of information or data about a taxpayer by the tax authorities to form the basisof transfer pricing scrutiny of another taxpayer. The taxpayer under scrutiny is not given access to that information — it may, for example, reveal confidential information about a competitor (i.e., the first taxpayer —to which the data relates).
220.127.116.11. There is a need to exercise caution against the use of secretcomparables unless the tax administration is able, within the limits ofits domestic confidentiality requirements, to disclose the data to thetaxpayer whose transactions are being reviewed. This would enable an adequate opportunity for the taxpayer to defend its own positionand to safeguard effective judicial control by the courts. Taxpayers contend that the use of such secret information is against the basic principles of equity, as the taxpayer is required to benchmark its controlled transactions with comparables not available to it, without the opportunity to question comparability or argue that adjustments are needed. Taxpayers contend that it would be unfair if they face theconsequences of adjustments made on this basis, such as additions toincome, typically coupled with interest, penalties etc. Furthermore,double taxation may not be relieved if secret comparables cannot be disclosed to the competent authority of another country.
Section 92C(1) of the IT Act 1961, visualizes determination of the “arms-length price” (ALP) by any of five enumerated methods, “being the most appropriate method”, having regard to the “nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the board may prescribe, namely (a) comparable uncontrolled price method, (b) resale price method, (c) cost + method, (d) profit split method, (e) transactional net margin method, (f) any such other method as may be prescribed by the board. Where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be arithmetical mean of such prices.
Rule 10B of the Rules prescribes the determination of arm’s length price under Section 92C. The first step in all methods is evaluation of differences between the international transaction undertaken with the “unrelated enterprise performing the comparable functions” in similar circumstances. Rule 10B of the Income-tax Rules inter alia, provides for various methods for determination of the arm’s length price. Rule 10B (1) (e) prescribes the “transactional net margin method” (TNMM) which is the generally applicable method in benchmarking.
These provisions prescribe, therefore, that even under the TNMM, importance is given to “assets employed or to be employed” as relevant factors for consideration. Rule 10B (2), as the second step, requires application of functions, asset, risk test for judging comparability of international transaction with an uncontrolled transaction. It provides:
“10B (2). For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely: –
|(a)||the specific characteristics of the property transferred or services provided in either transaction ;|
|(b)||the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions ;|
|(c)||the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions ;|
|(d)||conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and the Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.|
|(e)||the extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction or the specified domestic transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions;|
|(f)||the nature, extent and reliability of assumptions required to be made in application of a method.”|
Rule 10B (3) stipulates the third step, and spells out when the TPO is obliged to hold an uncontrolled transaction as comparable with others. This provision reads as follows:
“(3) An uncontrolled transaction shall be comparable to an international transaction or a specified domestic transaction if-
|(i)||None of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or|
|(ii)||Reasonably accurate adjustments can be made to eliminate the material effects of such differences.”|
Rule 10B (4) provides what should be the basis of the calculations in terms of data, its contemporaneity, etc. It stipulates that:
“(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into:
Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.”
Recent Case Laws
Benches of ITAT appear to be divided in their opinion on this. There are numerous decisions on the matter either this way or other. It has been argued before the tribunal by the assessee thatsub-rule (3) of rule 10B clearly provides for further exclusion of the comparables selected by applying the test/criteria given in sub-rule (2) of rule 10B if there is any difference found between the enterprises entering into the transactions which materially affects the cost charged or the profit arising from such transaction in the open market. In other words high profit margin companies are excluded on the above pretext either by going through comprehensive FAR test or without it.
Classification of Services
Having regard to the relevant TP regulations as contained in Rule 10B(3) of 1962 Rules, it can be said that further dissection or classification of ITES services can be done depending on the facts and circumstances of each case so as to select the entities having a relatively equal degree of comparability. (Maersk Global Centres)
Is TNMM a Practical Solution
The ITAT suggests a way forward, that it is to be kept in mind that the TNMM may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences. When the comparable uncontrolled transactions being used are those of an independent enterprise, a high degree of similarity is required in a number of aspects of the AE and the independent enterprise involved in the transactions in order for the controlled transactions to be comparableMaersk Global Centres (supra).
On OECD Guidelines
There is contradiction on the applicability of OECD guidelines. The Mumbai Tribunal agreeing to the OECDsection A.7.3 of chapter III guidelines that on the facts and circumstances of each case inasmuch as potential comparable earning abnormally high profit margin should trigger further investigation in order to establish whether it can be taken as comparable or not. Such investigation should be to ascertain as to whether earning of high profit reflects a normal business condition or whether it is the result of some abnormal conditions prevailing in the relevant year. Otherwise, the entity satisfying the comparability analysis with its high profit margin reflecting normal business condition should not be rejected solely on the basis of such abnormal high profit margin.Maersk Global Centres (supra). WhereasDelhi tribunal says that the OECD guideline does not apply and Indian TP provisions are sufficient. 
The Delhi tribunal in Mercer Consulting (India)rules that every business has its own unique features. Key functions of a business vary from case to case. Even if the key functions are similar, still some peculiarities make one different from another. Only the concerned businessman knows its salient features. In the absence of any separately identifiable figures of each segment, mechanism for allocation of revenue and expenses depends upon the critical features of each business. In one business, such allocation may be justified on one yardstick, while in another; it may be justified on another. The crux is that it is not possible for an outsider to precisely calculate the profit realised of a particular segment when the results are reported on entity level. 
Comparability is Must
The Pune tribunal in PTC Software held that Where TPO rejected comparables without even examining as to whether they were functionally comparable or not, comparability analysis carried out by him was vitiated.
Rejection of Comparable by TPO without FAR analysis
In the cases where TPO have rejected companies without any FAR analysis ,The TPO orders have been set aside In many cases .The Delhi tribunal in VeriFone held that evenassessee’s submissions and objections in this regard has not been brought in TPO’s order. TPO has only mentioned that he has considered the assessee’s objections and submissions and reasoning is not provided in the order, assessee’s grievance is also that DRP has not given proper opportunity to the assessee of being heard.See also Adobe Systems India (P) Ltd. v. Additional Commissioner of Income-tax,  44 SOT 49 (Delhi).
Secret Comparables and Data not in Public Domain
The ICAI in its FAQabout use of secret comparable or data not available in public domain mentions that The ITPR do not provide any specific guidelines with respect to use of such information. An inference can be drawn from the OECD Guidelines which in Para 3.30 suggests that Commercial databases in which the accounts filed by various Companies with the relevant administrative bodies are compiled and presented in an electronic format should be considered for search of comparables. Further, in Para 3.33 OECD guidelines suggest that in addition to the commercial databases any other publically available information can be used for the purpose of comparability analysis. A question may arise whether the tax authorities can use the data not available in the public domain during the course of the assessment proceedings. In this regard the Bangalore bench of Income Tax Appellate Tribunal in the recent case of GenisysIntegrating Systems (India) Pvt Ltd (ITA No.1231 (Bang.)/2010) has concluded that if any information is sought to be used against the Taxpayer, then such information has to be furnished to the Taxpayer and the Taxpayer’s objections have to be considered by the TPO, before coming to a conclusion. Further, if the Taxpayer seeks an opportunity to cross examine the party from whom information is sought under s 133(6), the Taxpayer shall be provided with such an opportunity.
Exclusion /Inclusion of comparable is not automatic
The ITAT held that Rule 10B does not provide any basis to exclude an entity or eliminate it from the list of companies solely on the basis of high profitability The authorities – including ITAT, held that the decisive factors for determining inclusion or exclusion of any entity in/from the list of comparables are the specific characteristics of the services provided by the said entities, assets employed, risks assumed, the contractual terms and conditions prevailing including the geographical location and size of the market, cost of labour and capital in the markets, etc. and high or low profit margins could not be criteria for inclusion or exclusion of entities in the list of comparables. Lloyds TSB Global  33 taxmann.com 259 (Mumbai – Trib.)
The high operating margin companyor loss making company was also considered a valid ground for exclusion of the company. An entity making supernormal profits cannot be a comparable. If at all it were to be considered as a comparable, appropriate adjustments to the material differences would have to be made. However, normalization of the margins of super profit making companies is not envisaged on an ad hoc basis and has to be done as per the law.
The Delhi HighCourt in Chryscapital held that , the mere circumstance of a company – otherwise conforming to the stipulations in Rule 10B (2) in all details, presenting a peculiar feature – such as a huge profit or a huge turnover, ipso facto does not lead to its exclusion. The TPO, first, has to be satisfied that such differences do not “materially affect the price…or cost”; secondly, an attempt to make reasonable adjustment to eliminate the material effect of such differences has to be made.
The whole controversary about exclusion/inclusion of high profit/loss companies has been answered by the HonbleDelhi highcourt which ruled that the mere fact that an entity makes high/extremely high profits/losses does not, ipso facto, lead to its exclusion from the list of comparables for the purposes of determination of ALP. In such circumstances, an enquiry under Rule 10B(3) ought to be carried out, to determine as to whether the material differences between the assessee and the said entity can be eliminated. Unless such differences cannot be eliminated, the entity should be included as a comparable.Chryscapital Investment Advisors (India) (P.)Ltd. (supra)
Various tribunal and highcourt ruling have time and again endorsed the significance of functional comparability while conducting benchmarking exercise. The emphasis, while compiling the TP documentation, should be on undertaking a comprehensive analysis of potential comparables and not making rejections blindly on industry categorizations, high profit, loss making, turnover .The reasons for such identified distinguishing factor should be examined and in case, after conducting such analysis, it is found that the normal business conditions warrants, that enterprise should be selected /rejected as a comparable.
Thus it further reinforces the need to prepare robust records containing well documented data on the approach followed for choice of comparables, citing adequate reasoning for rejections.
 (Para A.7.3 of Chapter III of the OECD Transfer Pricing guidelines 2010 dealing with “extreme results : comparability considerations” )
 (ParaA.4.3.3 of Chapter III of the OECD Transfer Pricing guidelines 2010 dealing with ” Information undisclosed to taxpayers“)
 (U N Practical Manual on Transfer Pricing for Developing Countries 2013)
 Maersk Global Centres (India) (P.)Ltd  43 taxmann.com 100 (Mumbai -Trib.) (SB)
 Chryscapital Investment Advisors (India) (P.)Ltd.  56 taxmann.com 417 (Delhi)
 Mercer Consulting (India) (P.)Ltd  47 taxmann.com 84 (Delhi – Trib.)
 PTC Software (India) (P.) Ltd  52 taxmann.com 351 (Pune – Trib.)
  46 taxmann.com 232 (Delhi – Trib.)VerifoneSalesIndia (P.)Ltd. v.ITO.
 (question 47 of TRANSFER PRICING COMPLIANCES A PRACTITIONER’S HANDBOOK July 2012 issued by ICAI)
 Maersk Global Centres (India) (P.)Ltd  43 taxmann.com 100 (Mumbai – Trib.)(SB), PTC Software (India) (P.) Ltd  52 taxmann.com 351 (Pune – Trib.), Carlyle India Advisors (P) Ltd. v. Additional CIT, ITA No. 7901/Mum/2011 dated 04/04/2012 ; Deputy CIT v. Deloitte Consulting India Pvt. Ltd., ITA No. 1082/Hyd/2010 dated 22/07/2011 ; Sony India (P) Ltd. v. Deputy CIT,  114 ITD 448 (Delhi) ; E-gain Communication (P) Ltd. v. ITO,  23 SOT 385 (Pune) ; Prana Studios (P.) Ltd  54 taxmann.com 80 (Mumbai – Trib.); Acumen Fund Advisory Services India (P.) Ltd  50 taxmann.com 317 (Mumbai – Trib.) ;
 2014] 43 taxmann.com 419 (Hyderabad – Trib.) Invensys Development Centre (India) (P.) Ltd.v ADDL CIT; ITO v. Saunay Jewels (P) Ltd.,  42 SOT 2 (Mum);Adobe Systems India (P) Ltd. v. Additional Commissioner of Income-tax,  44 SOT 49 (Delhi); Teva India (P) Ltd v. DCIT,  44 SOT 105 (Mum). ; Sapient Corporation (P) Ltd. v. Deputy CIT,  11 Taxmann 69 (Delhi) ;Nortel Networks India (P) Ltd. v. Additional CIT,  36 Taxmann 439 (Delhi); Symantec Software Solutions (P) Ltd. v. Assistant CIT,  25 Taxmann 163 (Mum).Philips Software Centre v. ACIT,  26 SOT 226 (Bang.);Google India (P) Ltd. v. DCIT,  29 Taxmann412.;Cummins Turbo Technologies v. DDIT,  35 Taxmann 350; Syscom Corporation Ltd. v. ACIT,  35 Taxmann 600 (Mum).
 Chryscapital Investment Advisors (India) (P.)Ltd.  56 taxmann.com 417 (Delhi)