Reading The ‘Benefit’ Test Into Arm’s Length Price Determination: Throwing The Rulebook Out The Window
1. INTRODUCTION:
Transfer Pricing Law, at its core, strikes at the distortion of ordinary business transactions, that occurs when related parties transact on terms inconsistent with competitive market conditions. Reportedly resorted to by Multinational Corporations in some instances, related-party transactions are often structured to minimize tax liability by manipulating the commercial and financial relationships between related entities, which would otherwise vary, if conducted between independent enterprises. Amidst such dealings, there have been reported instances, wherein cost allocations are recorded in the books, although no actual transfer of goods or services takes place.
Intra-group services have been the center of controversy for want of specific law on the issue of determining arm’s length price in respect of such services. In Multinational Groups, it is common for one line of business to procure goods or services from another, rather than an outside enterprise. Say, in an IT Company, one segment of business may be providing legal solutions to other segments, rather than availing such services from any outsider. The economic value or commercial rationale of such transactions have been a subject of scrutiny for Taxation Authorities. It is often a concern that no specific tangible services are rendered against payments being made towards availing them. This is founded on the conception that where no benefit is identifiable out of the services, no services should be said to have been rendered itself. While in the commercial sense of affairs, benefits may arise either to the recipient entity, or both the parties, or to the group as a whole, Indian laws have given weight only to the singular approach i.e., a specific benefit to the recipient of intra-group services.
However, the concern of those at the helm of affairs is equally relevant insofar as corporates cannot be allowed to evade taxes in the garb of business prerogative. Thus, intra-group transactions per se cannot be granted absolute immunity from scrutiny. Bearing the same in backdrop, it was identified by lawmakers that there is a need to prevent artificial shifting of profits between related parties in order to safeguard market integrity and fiscal accountability. Consequently, the Income Tax Act, 1961 incorporated specific statutory provisions empowering the determination of the arm’s length price and establishing designated statutory authorities, namely Transfer Pricing Officers, to enforce these measures. Amidst various contentious issues arising therefrom, a recurring concern has emerged regarding the tendency of Transfer Pricing Officers to enter into purely commercial considerations viz, the need for the transactions in question, the benefits derived therefrom, etc., a territory falling within the exclusive domain of the taxpayer entity’s own business judgment.
2. WHAT IS ARM’S LENGTH PRICE?
Section 92F[1] of the Income Tax Act, 1961, prescribes that arm’s length price is the price applied or proposed to be applied between independent enterprises, under uncontrolled conditions. This principle proceeds with the assumption that operations between associated enterprises ought to be conducted as if they were between independent enterprises, at the prevailing market conditions.
For instance, consider there are three entities – A, B and C, out of which A and B are associated enterprises, and C is an independent third party. In the scenario that A pays a certain amount to C towards services rendered at a rate driven by market forces, A cannot justifiably pay an unreasonably higher amount to B for the same kind of services merely to book inflated expenses. Should such an arrangement see the light of the day, the Transfer Pricing Officer is well within its powers to determine the appropriate price vis-à-vis the arm’s length price, which would have been booked between unrelated entities under uncontrolled independent conditions.
3. DETERMINING THE ARM’S LENGTH PRICE: RELEVANT CONSIDERATIONS:
There is no gainsaying the fact that an authority which draws its substance from statute must act within the confines of that very statute, and acting dehors the statutory mandate renders the exercise of authority perverse in law. Section 92CA(3)[2] stipulates that the Transfer Pricing Officer shall determine the arm’s length price, taking into consideration, information and documents at his disposal u/s 92D[3], and as per the methodology prescribed under sub-section (3) of Section 92C.
Taking a holistic view of Section 92C[4], Rule 10B[5] and 10C[6], the Transfer Pricing Officer is broadly required to discharge the following functions: –
- Ascertaining the Most Appropriate Method for determining the arm’s length price, having regard to the nature of transactions, nature of enterprises, functional-asset-risk profile analysis, availability of data, degree of comparability, extent of potential adjustments, and similar considerations.
- Identifying the appropriate comparables in accordance with specific attributes of products or services transferred, F.A.R. analysis, the contractual terms outlining the division of risks and responsibilities, and prevailing market conditions. For instance, the price being paid by a group entity to another for procurement of coffee can be compared to an independent entity procuring coffee only, or at max, tea, the closest substitute.
- Assessing whether the prices charged or paid in respect of the international transaction are at par with the arm’s length price, or within the tolerance limit statutorily prescribed. For instance, A pays Rs. 1,00,000 to its subsidiary, B, for procuring IT services, whereas other entities in the market charge Rs. 30,000 at most for providing similar services. The Transfer Pricing Officer shall recompute the income of A by making necessary adjustments in conformity to market standards. However, to provide some degree of flexibility, statutory tolerance limits are prescribed. Put simply, in the above example, B may charge Rs. 40,000 for the same kind of services, as it is not abnormally higher than the price prevailing under uncontrolled independent circumstances.
- Verifying whether information or data pertaining to the transaction has been kept and maintained, in conformity with the provisions of Section 92D. For instance, just like any invoices are maintained for business purchases or payments to outside vendors, similar documentation in the form of invoices, bills, etc. shall be maintained in respect of intra-group services and furnished in the course of transfer pricing proceedings to substantiate the actual occurrence of transactions. A group entity cannot claim deductibility of business expenditure by mere recording in books and has to show that the transaction was actually given effect i.e., real time transfer of goods or services took place. Such documentation has to adhere to specific standards, as are stipulated u/s 92D.
- Assessing the correctness / reliability of information or data involved in the determination of arm’s length price. The requirement to furnish data to substantiate the transactions is not an empty formality, and it is incumbent upon the transfer pricing officer to check the authenticity of documents i.e., sham paperwork is not provided for the sake of furnishing proof.
- Computing the total income of the assessee in accordance with the arm’s length price so determined by TPO.
Evidently, the underlying rationale behind the whole exercise of determination of arm’s length price is to ascertain whether there exist material variances between the terms of transactions being undertaken between related parties, and those between independent enterprises operating under uncontrolled market conditions. By no stretch of imagination, can it be construed that the policymakers had envisaged to empower the TPO to look behind or scrutinize the decision-making process, or to assess the commercial expediency of transactions, in this determination. All that is due on part of the TPO is examining whether the benchmarking of transactions is in consonance with the statutory prescriptions and evaluating whether the transactions are at arm’s length. It is immaterial to delve into the question of business rationale or necessity of the transaction in question, as the same lies within the commercial prerogative of the taxpayer and falls outside the legitimate scope of powers conferred upon TPOs. This aspect has been overlooked in multiple instances by TPOs, which sets the stage for the instant discussion.
4. QUESTIONING THE COMMERCIAL EXPEDIENCY: STEPPING OVER THE LINE:
In order to understand the legal position surrounding this controversy, it is pertinent to reflect upon judicial standpoint on this issue, which shows that the practice of assessing benefits of a particular transaction while determining the arm’s length price has been consistently frowned upon. This is in support of the settled jurisprudence, that law is hard, but it is the law, hence, statutory authorities in exercising their powers ought to bear in mind that they derive their powers from the very statute and have to act within the scope statutorily prescribed.
In the case of Dresser-Land India (P) Ltd.[7]¸the ALP in respect of services received under a cost contribution arrangement was recomputed by the TPO, reasoning that the services were not needed by the assessee at all, since it already had management experts of its own who were competent to do the work. Disapproving the erroneous reasoning adopted by the TPO, the Hon’ble Mumbai Tribunal held that it is only elementary that how an assessee conducts his business is entirely his prerogative and it is not for the revenue authorities to decide what is necessary for an assessee and what is not. Furthermore, it even remarked that putting into question the commercial wisdom of assessee was not only beyond the powers of TPO, but even that of the Assessing Officer. As regards the allegations to the effect that the financial performance showed no benefits as a result of the services received, the Tribunal clarified that “whether a particular expense on services received actually benefits an assessee in monetary terms is not even a consideration for its being allowed as a deduction in computation of income, and by no stretch of logic, it can have any role in determining arm’s length price of that service.”
On similar lines, the Hon’ble Kolkata Tribunal in Deputy Commissioner of Income-tax, Circle 9(1) v. Apollo Gleneagles Hospital Ltd.[8], observed that the ‘benefit test’ is irrelevant vis-à-vis arm’s length price ascertainment, and the real question for determination is whether the price paid for the services is at par with the price, an independent enterprise would have paid for the same. This view is further fortified by a catena of decisions of other appellate tribunals, as well as High Courts including the Hon’ble Delhi High Court in Commissioner of Income-tax v. Benetton India (P.) Ltd.[9].
Thus, the Judiciary has come down heavily upon the practice of TPOs to go behind the commercial wisdom of assessee entities in determining the arm’s length price. Along the similar lines, it is relevant to throw light upon the decision of the Hon’ble Delhi Tribunal in Huawei Telecommunications (India) (P.) Ltd.[10], which has elucidated upon the same issue, highlighting that this practice amounts to exceeding jurisdiction. The relevant extracts are being reproduced herein below for the sake of reference: –
“… we are of the considered view that it is beyond the jurisdiction of ld. TPO to determine the benchmarking of technical services and project management services by applying the “benefit test” and “commercial expediency test” rather his jurisdiction is limited to determine the ALP of transactions with the standpoint of a businessman and not by sitting on the chair of the businessman.”
5. CRITICAL COMMENT:
So far, we saw how the framework for determination of arm’s length price operates in the Indian setup. Transfer Pricing Officers tend to incline towards reading the benefit test into the exercise of ALP determination, which, as of the latest development in law, is frowned upon by the Judiciary. The reason behind rejection of the said approach is simple, an absence of such test within the four walls of the statute. The question that arises is whether the TPOs are to be faulted with in toto.
Per the OECD Transfer Pricing Guidelines for Multinational Enterprises[11], there are two issues arising in the transfer pricing of intra-group services. The first pertains to the actual provision of the intra-group services, and the second pertains to the chargeability of intra-group services being in conformity with the arm’s length price principle. While the latter has been sufficiently provided for in the Income Tax Act, the former continues to be contentious, or rather, the methodology for determining it.
The OECD Guidelines prescribe that in determining whether intra-group services have actually been provided, it is pertinent to analyze the economic or commercial value arising to the recipient.[12] This is turn must be determined by assessing whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself.
In my opinion, although the OECD is not binding upon India stricto-sensu, the implications of the OECD demand appreciation. First, it is evident that the benefit test finds no direct reference within the statutory scheme, which provides merely for the transactions to be priced at arm’s length and the method of determining the arm’s length price. Moreover, in addition to ascertaining whether the prices charged for intra-group services are at arm’s length, the guidelines further add a layer of scrutiny i.e., looking behind the need for services from the lens of an independent enterprise. Instances highlighted in the earlier discission show that the TPOs have not only questioned the necessity of services from the standpoint of independent parties, but also by stepping into shoes of the very entity and looking behind the business needs of individual entities.
Another anomaly that arises is whether the statute is entirely silent on the aspect of ascertaining whether the intra-group services have actually been rendered. As discussed earlier, the statute itself requires preparation and maintenance of documentation in appropriate form, pertaining to the transactions with group entities. Thus, even the Income Tax Act, for a matter of fact, calls for proof of the actual occurrence of such transactions. What varies between the OECD Guidelines and the statute is the extent to which, scrutiny has been found permissible. Under OECD, it is required on part of taxation authorities to evaluate whether there is any substance in the transaction i.e., some commercial value is conferred upon the recipient of service, such as an independent enterprise would have been willing to pay for. However, even this exercise does not extend to questioning the necessity of the transaction, the same being guided by purely commercial considerations, and hence, it ought not to be put to scrutiny.
The discussion reveals that given a purposive reading of the Transfer Pricing provisions and the OECD guidelines, there arises a very thin line between what the TP Officer is authorized to do, and where the limits to the exercise of power are to be drawn. While questioning the actual existence of transactions is not unreasonable, digging into the need thereof and commercial wisdom of the businessmen is uncalled for. Hence, if the assessee is able to justify to the satisfaction of TP Officers, that the transaction was conducted at arm’s length principles, and of such character, which independent enterprises would have been willing to undertake, there is nothing further left on their part to establish. Accordingly, a robust statutory framework addressing the long contentious issue of ALP determination of intra-group services, and permissibility or non-permissibility of applying the benefit test in such exercise, would not only provide clarity to all concerned, but also reduce the number of litigations arising therefrom.
6. CONCLUSION:
Transfer Pricing Law, akin to other fiscal laws, is premised upon a subtle balance to be struck between combatting tax avoidance and respecting decisions of the businessmen taken within their legitimate domain, bearing in mind their financial and commercial considerations. Hence, although the TPO is within its competence to call into question, international or even specified domestic transactions, if found to vary materially from the ideal spend / receipt between independent enterprises, it is equally true that once found to be at arm’s length, it is beyond the jurisdiction of TPO to set the clock back, and revisit the commercial expediency and actual need for those transactions, as such scrutiny cannot be said to have been intended before putting transfer pricing provisions into place.
However, it remains a slippery slope as to whether the genuineness of transactions can be completely ignored by TPOs, and if not, to what extent does it warrant interference. Whereas commercial expediency is immune, it would be absurd to suggest that even sham transactions cannot be picked out, given a stricto-sensu interpretation of the powers conferred upon TPOs. Nevertheless, it can reasonably be concluded that the ‘benefit test’ or ‘commercial expediency’ analysis finds limited or no place within the ambit of the Income Tax Act, 1961 or the Rules, thereby calling for restraint on part of the TPOs and preventing frivolous litigation in this regard.
Notes:
[1] Income Tax Act, 1961, s. 92F.
[2] Income Tax Act, 1961, s. 92CA cl. (3).
[3] Income Tax Act, 1961, s. 92D.
[4] Income Tax Act, 1961, s. 92C.
[5] Income Tax Rules, 1962, r. 10B.
[6] Income Tax Rules, 1962, r. 10B.
[7] [2011] 13 taxmann.com 82 (Mumbai).
[8] [2023] 150 taxmann.com 210 (Kolkata – Trib.).
[9] [2025] 171 taxmann.com 536 (Delhi).
[10] [2021] 126 taxmann.com 241 (Delhi – Trib.).
[11] OECD (2022), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, OECD Publishing, Paris, https://doi.org/10.1787/0e655865-en.
[12] Id.
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