Transfer pricing operating income tests upheld; foreign exchange items included, windmill income excluded, and interest disallowance deleted.

Interest disallowance under section 36(1)(iii) was deleted because the record did not show diversion of borrowed funds to capital work-in-progress or other non-business use, and the Revenue failed to discharge that burden. Excess depreciation addition was also deleted as the year's computation was only consequential to the accepted position in the immediately preceding year. For transfer pricing, foreign exchange gain or loss linked to business transactions was treated as operating, while windmill income and the related expenditure were held to be non-operating because that activity was separate from the tested international transactions. The Revenue's appeal failed, with only consequential relief granted to the assessee.

---

---

Issues: (i) Whether the disallowance of interest under section 36(1)(iii) was rightly deleted, (ii) whether the excess depreciation addition was rightly deleted, (iii) whether foreign exchange gain or loss was to be treated as operating for transfer pricing purposes, and (iv) whether windmill income and the corresponding expenditure were to be treated as non-operating for computing arm's length price.

Issue (i): Whether the disallowance of interest under section 36(1)(iii) was rightly deleted.

Analysis: The assessee had capital work-in-progress, but the record did not show that borrowed funds were used for that purpose or that interest-bearing funds were diverted for non-business use. The burden lay on the Revenue to establish such diversion, and the finding in the immediately preceding assessment year had already gone against the Revenue on identical facts.

Conclusion: The deletion of the interest disallowance was upheld in favour of the assessee.

Issue (ii): Whether the excess depreciation addition was rightly deleted.

Analysis: The depreciation computation in the year under appeal was only consequential to the position already accepted in the immediately preceding year. No new factual basis was shown to disturb the earlier treatment, and the Revenue did not rebut the assessee's factual contention that the figures were derivative of the prior year's accepted working.

Conclusion: The deletion of the excess depreciation addition was upheld in favour of the assessee.

Issue (iii): Whether foreign exchange gain or loss was to be treated as operating for transfer pricing purposes.

Analysis: The transfer pricing exercise required inclusion of items forming part of the operating stream while determining arm's length price. Foreign exchange fluctuation linked to the business transactions was treated as an operating item, and the Revenue did not dislodge the legal position supported by the cited transfer pricing jurisprudence.

Conclusion: The exclusion of foreign exchange gain or loss from non-operating items was upheld in favour of the assessee.

Issue (iv): Whether windmill income and the corresponding expenditure were to be treated as non-operating for computing arm's length price.

Analysis: The windmill activity was separate from the international transactions under transfer pricing review. Income generated from captive power arrangements was not inseparable from the controlled transactions, and the mere fact that it was treated as business income for deduction purposes did not make it operating income for ALP computation. Consistently, the corresponding expenditure was also required to be kept out of operating results.

Conclusion: Windmill income and the related expenditure were held to be non-operating for ALP computation, with consequential relief granted to the assessee.

Final Conclusion: The Revenue's appeal failed in full, while the assessee obtained only limited consequential relief on the transfer pricing issue, leading to a partial acceptance of the cross objection.

Ratio Decidendi: For transfer pricing, only items forming part of the operating stream of the tested transaction may be included in the profit level indicator, while income or expenditure arising from a distinct and separable activity is to be excluded; similarly, an interest disallowance cannot survive unless the Revenue establishes diversion of borrowed funds to non-business use.

---