Transfer pricing margins must rest on actual figures; section 10A does not block arm's length adjustment or revised deduction computation.

Transfer pricing under the transactional net margin method must be based on actual realised margins, not projected profits, and any warranted adjustments are ordinarily made in the margins of comparables rather than in the assessee's own margin; the assessee's claimed foreign exchange and revenue-sharing adjustments were rejected on this basis. In the software comparables exercise, product companies, intellectual property-rich entities, functionally different companies, and entities with high related-party transactions or heavy outsourcing were treated as unsuitable comparables, while some exclusions were upheld and part of the exercise was remanded for fresh verification. Eligibility for deduction under section 10A does not bar arm's length adjustment under Chapter X, and no deduction is available on income enhanced by transfer pricing adjustment, but reversed income and the consequential effect of the depreciation disallowance were to be included in the section 10A computation.

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Issues: (i) Whether the assessee could compute its profit level indicator by including projected profits of subsequent years and obtain adjustments for foreign exchange fluctuation and revenue-sharing differences in the assessee's own margin; (ii) whether the inclusion and exclusion of certain software comparables was justified; (iii) whether eligibility for deduction under section 10A barred transfer pricing adjustment or further enhancement on the adjusted income; and (iv) whether the assessee was entitled to deduction under section 10A on the reversed income item and the depreciation-related disallowance.

Issue (i): Whether the assessee could compute its profit level indicator by including projected profits of subsequent years and obtain adjustments for foreign exchange fluctuation and revenue-sharing differences in the assessee's own margin?

Analysis: The relevant transfer pricing provisions require actual income from the international transaction to be tested at arm's length, and the transactional net margin method contemplates comparison of realized margins. The assessee's margin could not be replaced by hypothetical or projected profits. Adjustments for differences are to be made, if warranted, in the margins of comparables and not in the assessee's own realized margin. The claimed foreign exchange adjustment also failed on facts, and the revenue-sharing formula did not establish a comparable uncontrolled price for the assessee's transaction.

Conclusion: The assessee's method of computing profit level indicator was rejected, and the transfer pricing approach adopted by the Assessing Officer was sustained on these aspects.

Issue (ii): Whether the inclusion and exclusion of certain software comparables was justified?

Analysis: Product companies, companies owning valuable intellectual property rights, companies with materially different functional profiles, and companies with high related party transactions or substantial outsourcing could not be treated as comparables to a captive software development service provider. On that basis, certain companies were directed to be excluded, while some exclusions made by the lower authorities were upheld. For a group of companies whose comparability had not been properly examined, the matter required fresh verification by the tax authorities.

Conclusion: Some comparables were ordered to be excluded, some exclusions were upheld, and a part of the comparability exercise was remanded for fresh consideration.

Issue (iii): Whether eligibility for deduction under section 10A barred transfer pricing adjustment or further enhancement on the adjusted income?

Analysis: The statutory scheme contains no exemption from arm's length determination merely because the assessee is eligible for deduction under section 10A. The proviso to section 92C(4) also makes it clear that no deduction under section 10A is allowable on income enhanced due to transfer pricing adjustment. Therefore, section 10A does not prevent application of the transfer pricing provisions.

Conclusion: The contention that no transfer pricing adjustment could be made because of section 10A was rejected.

Issue (iv): Whether the assessee was entitled to deduction under section 10A on the reversed income item and the depreciation-related disallowance?

Analysis: Amounts earlier reducing the eligible unit's profits and later reversed in the year retained their character for section 10A purposes, and the corresponding reversal was required to be included in eligible profits. As to depreciation, the disallowance was correct because the opening written down value had been overstated, but the resulting enhancement also had to be considered while computing the 10A deduction for the eligible unit.

Conclusion: The assessee succeeded on the reversed income item and on the consequential section 10A effect of the depreciation disallowance.

Final Conclusion: The transfer pricing matter was partly sustained and partly sent back for fresh determination, while the assessee obtained relief on the section 10A computation issues relating to eligible profits.

Ratio Decidendi: In transfer pricing, the assessee's realized margin must be tested on actual figures, adjustments are ordinarily to be made in comparables and not in the assessee's own margin, and eligibility for section 10A does not bar computation of income at arm's length under Chapter X.

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