SQL redefined: Silver lining or double-edged sword

  1. Sachin_AgrawalTP litigation in India

High-pitched transfer pricing (TP) assessments have been in headlines in India for about a decade now. The first round of TP assessments commenced during financial year (FY) 2004-05 and since then, the number of cases scrutinized and the quantum of TP adjustments have been rising with TP adjustments of approximately US$10.8 billion (INR70,000 crore) made in FY2012-13[1]. Once the adjustment is made, a taxpayer enters into a long-drawn litigation involving multiple tiers of appellate authorities and time/costs taken for a particular issue to reach finality is significant (up to 12-15 years).

While taxpayers have been resorting to alternative dispute resolution mechanisms, litigation has been inevitable until a taxpayer (223[2]) has signed an advance pricing agreement (APA). Accordingly, when the first batch of cases reached High Court (HC), there were discussions in relation to the manner in which it would look at TP cases keeping the criteria of Substantial Question of Law (SQL) in mind.

HCs have been admitting these cases and showed a flexibility, whereby those involving issues like comparability, filters and most appropriate method have been admitted.

  1. A sneak peek into the ruling

Karnataka HC in M/s Softbrands India Private Limited (TS-475-HC-2018 (KAR)) has delved in-depth into admissibility of appeals involving TP issues, wherein questions raised by the Income Tax Department (ITD) before HC were on comparable companies and related party transactions filter.

2.1 Prima facie opinion of HC on TP appeals

On the basis of the arguments put forth before HC, HC prima facie opined that the entire exercise of making TP adjustment involving fact finding and arm’s length price determination under Chapter X of Income Tax Act, 1961 (Act) is based on the estimate of authorities relying on the relevant material brought on record and hence, should be allowed to become final in hands of Income Tax Appellate Tribunal (ITAT) (final fact finding authority), unless HC believes that SQL is arising from the order of ITAT.

This opinion of HC gives a greater authority to ITATs on TP cases and casts significant onus on ITATs to decide cases in utmost rationale and logical manner within four corners of law. It would be interesting to look at the orders from ITATs, specifically Bangalore (jurisdictional) ITAT on TP matters going forward.

2.2 Understanding SQL

The HC deep dived into a comparative analysis of Section 260-A of Act and Sections 100 and 103 of Code of Civil Procedure basis which it established that the key to satisfy SQL threshold is perversity in finding of ITAT and its existence for maintaining an appeal.

The fact that only SQL could be taken to HC has been known and established, however, considering the factual nature of TP matters, HC has stressed on the presence of SQL without which TP matters should not be admitted before HC.

Since SQL has not been defined, HC referred to leading case laws and laid down guiding principles regarding the same. The HC mentioned that in case there are different views from ITATs, they cannot be considered to be perverse, thereby becoming SQL. Accordingly, one needs to be very careful regarding the issues/questions that might be raised before the HC, failing which there may be a risk of appeal not getting admitted.

2.3 Interesting mention by HC

In line with the government’s agenda of bringing about non-adversarial tax regime, HC mentioned that since substantial quantum of international trade depends upon fair and quick judicial dispensation, appeals as to whether comparable companies have been rightly picked up and filters have been righty applied, do not give rise to an SQL. This gives a sigh of relief and silver lining amidst dark clouds of TP litigation to taxpayers. The manner in which this would be followed by HCs is something to watch out for.

Furthermore, HC mentioned that in case while dealing with comparable companies and filters, if unequals are compared, i.e., if Infosys or Wipro are compared to start-ups, issue of comparable companies could be in realm of perversity attracting interference by HC. The ruling comes as the contribution of HC to add to subjectivity on TP matters. This makes the ruling a double-edged sword since it leads to an analogy that interpretation of TP issues and drafting of appeals before HC might gain a significant importance, going forward, as decision could tilt either ways.

HC further mentioned specific examples of TP matters involving SQL, i.e., interpretation of provisions of Double Taxation Avoidance Treaties, interpretation of provisions of the act, interpretation of Base Erosion and Profit Shifting (BEPS) guidance, etc. The mention of BEPS signifies an expectation that BEPS is likely to trigger litigation, for which even HC is prepared.

2.4 Fall out

Replying on the ruling in Softbrands case, Karnataka HC dismissed 68 other TP appeals involving issues pertaining to need and benefit test for royalty, treatment of foreign exchange gain/loss, selection of most appropriate method, risk adjustment, etc.

Dismissal of appeals on above aspects implies that HC has straight jacket rejected other important issues like benefit test analysis for royalty and economic adjustments-related grounds. This puts a greater onus on taxpayers to make sure that appeals before HC pass threshold and guiding principles are laid down, failing which admission of appeal could be risked.

  1. Far-reaching implications

These series of rulings are likely to have far-reaching implications not only on appeals to be filed before HC, but also on those already admitted by HC involving factual aspects. There could a possibility that the admitted appeals could be rejected by HC either on suo moto or on insistence from the involved parties.

Going forward, taxpayers would need to be extremely cautious while filing any TP appeal before HC (since risk of not getting admitted may be high) and handling department appeals on TP since the same could be contested for non-admission thereby reaching consensus on issues in dispute. This is an important aspect since non-admission of ITD appeals would mean attaining finality on an issue and coming out of spiraling litigation thereby saving significant efforts and costs involved.

Appeals that have been recently filed could be reviewed and questions raised before HC could be rephrased if warranted to avoid any risks going forward. Given these developments, taxpayers may consider alternative dispute resolution options, i.e., APA and MAP.

The author of this blog is Sachin Agrawal, Senior Manager, International Taxation and Transfer Pricing, EY India


[1] Source: Ministry of Finance – Annual Report for 2013-14

[2] Source: CBDT Press Release dated 4 July 2018