Arm's length pricing applies to interest-free loans between associated enterprises; speculative base-erosion arguments cannot defeat transfer pricing.

In an international transaction between associated enterprises, income must be computed at arm's length under section 92(1). Section 92(3) applies only where that computation reduces the assessee's own taxable income or increases its loss for the relevant year; it cannot be stretched to a speculative group-wide base-erosion argument based on future tax shields or carry-forward losses. Interest-free lending to an associated enterprise was also held capable of arm's length interest computation, because applying arm's length pricing is not re-characterisation and commercial expediency or non-receipt of actual interest does not displace the statutory mechanism. The transfer pricing provisions were therefore applicable in principle, and only the quantum of adjustment was remitted.

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Issues: (i) whether the transfer pricing provisions could be kept out of operation on the plea that an arm's length adjustment in respect of interest-free loans to an Indian subsidiary would not materially reduce the Indian tax base and (ii) whether, apart from that plea, interest could be imputed at arm's length on the international transaction of advancing an interest-free loan to the associated enterprise.

Issue (i): whether the transfer pricing provisions could be kept out of operation on the plea that an arm's length adjustment in respect of interest-free loans to an Indian subsidiary would not materially reduce the Indian tax base

Analysis: Section 92(1) requires income from an international transaction to be computed having regard to the arm's length price. Section 92(3) is an exclusionary provision, but it operates only where the computation under section 92(1) has the effect of reducing the income chargeable to tax or increasing the loss of the assessee whose income is being computed for the year in question. The Court held that this cannot be expanded into a holistic or group-wide test based on speculative future tax shields, carry-forward losses, or overall tax incidence across related entities. The alleged base-erosion effect in the hands of the Indian AE was held to be contingent, uncertain, and not supported by any enabling provision for corresponding deduction in the hands of the AE. CBDT circulars and foreign rulings could not override the plain statutory language.

Conclusion: The base-erosion objection was rejected and the transfer pricing provisions were held applicable.

Issue (ii): whether, apart from that plea, interest could be imputed at arm's length on the international transaction of advancing an interest-free loan to the associated enterprise

Analysis: The Court held that commercial expediency, shareholder motivation, absence of actual receipt, and the plea that the transaction was a non-income-bearing or re-characterised arrangement did not displace the mandate of section 92(1). A loan remains a loan, and assigning arm's length interest to that transaction is not re-characterisation. The fact that the assessee reported zero interest did not prevent computation of income on arm's length basis, because the transfer pricing regime is a computation mechanism for international transactions. Reliance on general income-tax principles against taxing notional income, and on decisions rendered in different contexts, was held to be misplaced.

Conclusion: Arm's length interest could be imputed on the interest-free loan, and the assessee's challenge on merits failed.

Final Conclusion: The Special Bench upheld the applicability of transfer pricing provisions to the impugned interest-free loan transaction in principle, but sent the matter back to the regular Bench for determination of the quantum of adjustment.

Ratio Decidendi: In an international transaction between associated enterprises, income must be computed on an arm's length basis under section 92(1), and the exclusion in section 92(3) applies only on the assessee's own year-wise income or loss, not on a speculative or group-wide theory of base erosion.

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