Comparable Companies have to be Functionally Similar when undertaking Benchmarking Analysis as per TNMM, rules Hon’ble Delhi High Court

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On 01/06/2025
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Comparable Companies have to be Functionally Similar when undertaking Benchmarking Analysis as per TNMM, rules Hon'ble Delhi High Court

When Transactional Net Margin Method (‘TNMM’) is selected as the Most Appropriate Method (‘MAM’) as per provisions of section 92C of the Income-tax Act, 1961 (‘the Act’) read with Rule 10B of the Income-tax Rules, 1962 (‘the Rules’), one of the important factors which need to be considered when selecting comparables for arm’s length analysis of the international transaction is that they must be functionally similar to the entity which is considered as the tested party for the purposes of the arm’s length analysis. This principle has been reaffirmed by the Hon’ble Delhi High Court in the case of Pr. Commissioner of Income-tax vs Fluor Daniel India (P.) Ltd.1

The summary of the judgment is as follows:

Background and facts of the case

The taxpayer is a subsidiary of a USA company and is engaged in the business of providing engineering and design services to its subsidiary.
The taxpayer is a captive service provider, i.e., engaged in providing services only to its holding company.
During the assessment year under consideration in the judgment, i.e., Assessment Year 2011-12, the taxpayer considered TNMM as the MAM for arm’s length analysis of the international transactions entered by it with its Associated Enterprise, i.e., the holding company in the USA.
The Learned Transfer Pricing Officer (‘TPO’) however rejected the comparability analysis undertaken by the taxpayer and included 4 new comparable companies.
The taxpayer filed its objections against addition of these 4 new comparable companies before the Hon’ble Dispute Resolution Panel (‘DRP’) on the grounds that the ‘Functions performed, Asset utilised and Risks assumed (‘FAR’) Analysis was not similar to its FAR Analysis.
The Hon’ble DRP however rejected the objections of the taxpayer and upheld the actions of the Learned TPO on the ground that TNMM is tolerant to functional dissimilarity.
On appeal to the Hon’ble Delhi ITAT, it held that the 4 comparable companies selected by the Learned TPO had a FAR profile which was different from the taxpayer and accordingly, held that they were not comparable to the FAR profile of the taxpayer. Further, the Hon’ble Delhi ITAT gave detailed reasons for rejection of the 4 comparable companies selected by the taxpayer.
Accordingly, the Income Tax Department filed an appeal against the judgment of the Hon’ble Delhi ITAT in the Hon’ble Delhi High Court
As the Assessee, a captive service provider to its AE. The 4 comparable companies are providing high end services to the customers and having huge operation.
Assessee also had an argument that the Kitco Ltd is owned by the government and it is not functionally comparable.

Ruling of the Hon’ble Delhi High Court

The Hon’ble Delhi High Court relied on the observations of the Hon’ble Delhi ITAT for rejection of the 4 comparable companies selected by the Learned TPO and upheld by the Hon’ble DRP. A summary of the same is as follows:

[1] [2024] 169 taxmann.com 508 (Delhi)

Sr. No.	Name of comparable company	Reasons for rejection
1.	Kitco Ltd.	ITAT in its order mentioned that the company is involved in executing the huge operations with a motive to earn profits and rejected the assesses contention that the company is government owned, concluded that company is functionally not comparable.
2.	Project and Development India Ltd.	The company was engaged in providing engineering and consultancy services, maintained strength in the sector and was ready to take up new challenges in executing the expansion projects. The company is rejected as it is not functionally comparable.
3.	TCE Consulting Engineers Ltd.	The company was engaged in providing high end engineering consulting services like managing complex engineering projects and provided infrastructure facilities such as Airports, Railways projects and ITAT mentioned that the functions performed by this company are incomparable with assessee.
4.	Mahindra Consulting Engineers	ITAT mentioned that the company is providing high end technical support services, and the company had proved capability to execute innovative projects providing infrastructure engineering and consulting services. The company is considered as functionally incomparable.

Basis the detailed reasoning given by the Hon’ble Delhi ITAT, the Hon’ble Delhi High Court held that the 4 comparable companies selected by the Learned TPO were not comparable as they were functionally dissimilar.

KNAV Comments

The judgment of the Hon’ble Delhi High Court reaffirms the proposition that comparable companies have to be functionally similar when undertaking benchmarking analysis as per TNMM. Although product dissimilarity is allowed to a certain extent, functional dissimilarity is not allowed. This reinforces the need for a robust Transfer Pricing Documentation mentioning the FAR Analysis as well as benchmarking study in detail.