Transfer pricing comparables must be economically comparable; turnover extremes were excluded and adjustment limited to international transactions.

In ITES transfer pricing benchmarking, comparables with vastly higher turnover were held unsuitable because scale, bargaining power and business capability materially affect margins; the large-turnover companies were directed to be excluded. The transfer pricing adjustment was also confined to the international transactions actually subject to arm's length examination, and not applied at entity level. The disallowance under section 40(a)(i) for non-deduction of tax on testing charges was not finally sustained in this appeal and was restored to the Assessing Officer for fresh adjudication, following the course adopted in the assessee's earlier year. The assessee obtained partial relief on the transfer pricing issues.

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Issues: (i) Whether, in benchmarking the ITES segment, comparables with vastly higher turnover than the assessee could be retained and the transfer pricing adjustment sustained on that basis; (ii) whether the transfer pricing adjustment was to be confined only to the international transactions and not to the entity-level results; (iii) whether the disallowance under section 40(a)(i) for non-deduction of tax on testing charges was to be finally sustained or restored for fresh adjudication.

Issue (i): Whether, in benchmarking the ITES segment, comparables with vastly higher turnover than the assessee could be retained and the transfer pricing adjustment sustained on that basis.

Analysis: The assessee's ITES revenue was only about Rs. 4.53 crores, whereas several selected comparables had turnovers many times higher, running into tens, hundreds and even thousands of crores. The Court found that scale, bargaining power and business capabilities materially affect margins, and that the TPO's reasoning that turnover was irrelevant in a cost-plus model was not acceptable in the facts. Accordingly, the large-turnover comparables were held unsuitable for comparison.

Conclusion: The turnover-based challenge succeeded, and the identified large comparables were directed to be excluded from the transfer pricing set.

Issue (ii): Whether the transfer pricing adjustment was to be confined only to the international transactions and not to the entity-level results.

Analysis: The adjustment under transfer pricing can be made only in respect of the international transactions that are the subject matter of arm's length examination. The Court followed the principle that the exercise does not permit a blanket entity-level adjustment where only part of the assessee's dealings are international transactions.

Conclusion: The transfer pricing adjustment was directed to be restricted to the international transactions alone.

Issue (iii): Whether the disallowance under section 40(a)(i) for non-deduction of tax on testing charges was to be finally sustained or restored for fresh adjudication.

Analysis: The disallowance issue had already been considered in the assessee's own case for an earlier year and the Court followed the same course. The matter was not finally determined on merits in this appeal and was sent back to the Assessing Officer with similar directions for reconsideration.

Conclusion: The issue was restored to the Assessing Officer for fresh adjudication.

Final Conclusion: The appeal succeeded on the transfer pricing challenges, while the disallowance relating to tax deduction at source was remitted for reconsideration, resulting in a partial relief to the assessee.

Ratio Decidendi: In transfer pricing, comparables must be functionally and economically comparable, and materially dissimilar companies, including those with vastly different scale of operations, cannot be used to benchmark the assessee; any adjustment must also be confined to the international transactions actually tested.

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