High court confirms appeals must relate to substantial question of law

Background: The highest tax court in India is the Supreme Court. The high courts sit below the Supreme Court and hear appeals from the Income Tax Appellate Tribunal (ITAT). The ITAT is the final fact finding court for tax cases and a high court can hear appeals against the ITAT rulings only if the appeal relates to a “substantial question of law.” Unless the court holds that the ITAT’s finding on fact is “perverse,” the court must respect the finding as final.

Bangalore (often known as India’s “Silicon Valley”) has witnessed a significant number of transfer pricing disputes, largely relating to the information technology sector. While the ITAT has been asked to rule in hundreds of transfer pricing cases and despite India’s transfer pricing legislation being in force for about 15 years, the Karnataka High Court has not issued a significant ruling on transfer pricing appeals. To clear the backlog of cases that had accumulated, a special tax bench was established within the court.

In the current case before the court, the appeal by the Indian tax authorities centred on the following issues:

• Whether the ITAT was correct to reject four named companies as comparable companies for TNMM analysis purposes?
• Whether the ITAT was correct to apply a 15% “related party filter” in selecting comparable companies?

The questions were to be considered in the context of arriving at an appropriate operating margin that the Indian company in the case should have earned, in comparison with margins earned by other comparable companies selected by the Indian tax authorities (and modified by the ITAT) as the result of a transfer pricing audit, under the TNMM.

The ITAT’s decision on whether to accept or reject companies deemed comparable was based on a comparison of the profile of the Indian company with the profile of each comparable company. The ITAT held that potentially comparable companies that derive more than 15% of their revenue from related party transactions could not be taken into account for the benchmarking analysis. The Indian tax authorities had sought to apply a filter of 25%.

Decision of the High Court: During the hearing, the Karnataka High Court articulated the scope of the appeals that can be decided by a high court. Citing legislation and supported by decisions of the Supreme Court, the court concluded that only a “substantial question of law” can be heard and decided by a high court in relation to appeals arising out of lower appeals court decisions. The court held that the same test applied to transfer pricing cases. Addressing the two specific questions that were put before it, the high court stated that the ITAT’s ruling could not be deemed perverse or arrived at without a rational basis. Aspects such as the choice of comparable companies, the choice of the appropriate filters and the application of those factors were a question of fact, and no question of law arose. The tax authorities’ appeals were accordingly dismissed. The court confirmed that the same test would apply for taxpayer appeals.

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