Is a tax avoidance motive necessary for application of Transfer Pricing provisions?

In a recent decision, ACIT v. MSS India, ITA No. 393/PN/07, the Pune Bench of the Income Tax Appellate Tribunal had to consider an interesting issue pertaining to the application of transfer pricing provisions. On an appeal after a transfer pricing assessment, the CIT (Appeals) had held in favour of the assessee; deciding that as the assessee was a 100% export oriented undertaking exempt from income tax, it could not be said to have a tax avoidance motive. In the absence of such a motive, transfer pricing provisions could not be resorted to. The CIT (Appeals) also went ahead to comment on the merits of the arms length price adjustments made by the Transfer Pricing Officer as well; again deciding in favour of the assessee.

The Revenue preferred an appeal before the Tribunal. The two issues which came up for the consideration of the Tribunal related to whether transfer pricing provisions for calculation of arms length price could be resorted to in the case of an assessee exempt from income tax (therefore, presumably, there being no tax avoidance motive); and if they could be so resorted to, what would be the appropriate method to be used for calculating arms length price.

On the question of whether a tax avoidance motive is necessary before invoking transfer pricing provisions, the Philips Software v. ACIT (2008 TIOL 471 ITAT Bangalore) decision had suggested that motive was a requirement. In that case, the Bangalore Bench had distinguished an earlier five-member Bench in Aztec Software and Technology Services v. ACIT (294 ITR AT 32).

ITAT Online had summarized an important portion of the Philips judgment as holding, “While the motive of tax avoidance need not be shown at the time of initiating transfer pricing provisions, the same is required to be shown at the stage of making the assessment. The AO has to show that the assessee manipulated prices to shift profits outside India. In view of the fact that the assessee enjoyed exemption u/s 10A, the transfer pricing provisions ought not to have been applied…” (The decision has been discussed on this blog here)

The Pune Bench in MSS India however took a different view and held that the decision in Philips Software was in reality conflicting with the decision of the 5-member Special Bench in Aztec Software. Further, it was held that there is no meeting ground between the two conflicting decisions. As such, the decision in Philips Software (being of a smaller Bench) could not be followed; and Aztec cannot be said to have been watered down by Philips. Therefore, the conclusion of the CIT (Appeals) that transfer pricing provisions could not be invoked at all could not be sustained.

On the merits of the adjustment, the Bench provided relief to the assessee. It was held (taking into consideration Rule 10C of the Income Tax Rules, 1962) that in a case where the Revenue sought determine the arms length price by a method different from that which had been adopted by the assessee, it was for the Revenue to demonstrate that its proposed method would be more appropriate than the assessee’s method. Also, it was held that the transaction profit methods of determination of arms length price should be used only when other standard or traditional methods are incapable of being properly applied to the facts of the case. On the facts of the case, the Revenue’s burden was held to be not discharged.

Thus, while the final result was that the Revenue’s appeal was dismissed, the case will be of use to the Revenue authorities in invoking transfer pricing provisions.