In its recent decision in SAP Labs India Private Limited vs. the Income Tax Officer, the Supreme Court of India overruled the decision of the High Court of Karnataka in the Softbrands case. The high court held that once the Income Tax Appellate Tribunal has determined the arm’s length price for an international transaction between associated enterprises, the court is precluded from scrutinizing or re-examining this determination.

Section 260A of the Income-tax Act, 1961 provides that an appeal shall lie to the high court from every order of the tribunal only if the high court is satisfied that the case involves a substantial question of law. Various high courts in India have ruled that the Income Tax Appellate Tribunal remains the final fact-finding authority in tax disputes. Once the tribunal determines the arm’s length price in relation to transfer pricing proceedings, the high courts can’t re-examine such determination in an appeal under Section 260A, as the determination doesn’t involve a substantial question of law.

Supreme Court’s Take

In SAP Labs India, the key question before the Supreme Court was “whether in every case where the Tribunal determines the arm’s length price, the same shall attain finality and the High Court is precluded from considering the determination of the arm’s length price determined by the Tribunal, in exercise of powers under Section 260A of the Act.”

The tax authorities submitted that in every case where the tribunal determines the arm’s length price in relation to an international transaction between associated enterprises, the tribunal must follow the specific guidelines as provided under the domestic income tax law. Where the tribunal doesn’t follow such guidelines, the arm’s length price so determined would remain subject to scrutiny by the high courts under Section 260A.

The taxpayers argued that once the tribunal determines the arm’s length price in accordance with the relevant guidelines prescribed under domestic income tax law, any challenge to such determination doesn’t involve a “substantial question of law” that can be examined or scrutinized by the high court in an appeal under Section 260A. It was submitted that the tribunal is the final fact-finding authority in such disputes, and in the absence of any demonstrated unreasonableness in the tribunal’s findings, the high court can’t interfere with such findings.

The taxpayers further argued that the question of comparability of two companies or selection of filters is usually a question of fact, that primarily depends on the functions performed, assets employed, and risks assumed by the tested party, as well as comparable transactions. Unless there is any demonstrated unreasonableness in the tribunal’s findings by placing material on record, the high court can’t interfere with such findings under Section 260A.

Considering the arguments advanced by the tax authorities and taxpayers, the Supreme Court observed that while determining the arm’s length price, the tribunal has to follow the guidelines prescribed under domestic income tax law. And where the determination of the arm’s length price is de hors the prescribed guidelines, that determination can be considered as unreasonable and can be scrutinized by the high court, as being considered a “substantial question of law.”

The Supreme Court, while overruling the decision of the Karnataka High Court in Principal Commissioner of Income Tax vs. Softbrands India Private Limited, observed that the proposition can’t be accepted that in transfer pricing cases, determination of the arm’s length price by the tribunal is final and can’t be examined by the high court. It stated that in every case, the high court should examine whether the guidelines provided under the Income-tax Act, 1961 for determining the arm’s length price have been followed, and whether the findings recorded by the tribunal while determining it are unreasonable.

The Supreme Court observed that while determining the arm’s length price the high court can also examine whether the comparable transactions have been properly taken into consideration by the tribunal.

Impact of Supreme Court’s Decision

The Supreme Court’s decision in SAP Labs has set aside the Karnataka High Court’s decision in Softbrands that precluded the high courts from scrutinizing the determination of arm’s length price by the tribunal in transfer pricing cases.

One of the immediate implications of this decision may be a surge in litigation concerning such determination, as the parties can now contest any adverse findings by the tribunal with respect to arm’s length price before the high courts.

While the decision provides clarity to tax authorities and taxpayers in relation to admissibility of appeals against the tribunal’s findings in transfer pricing cases, it would now be open for both sides to challenge the determination of the arm’s length price by the tribunal before the high courts.

Taxpayers are also apprehensive that, based on the Supreme Court’s decision in SAP Labs, the tax authorities can have every arm’s length price determination by the tribunal re-examined by the high court.

A possible interpretation of the decision to allay taxpayers’ concerns could be that the high courts can only scrutinize the tribunal’s determination of the arm’s length price in a case where the tribunal hasn’t followed the guidelines prescribed under the domestic income tax law. Effectively, it is only when the determination is unreasonable or contrary to the scheme of the transfer pricing regulations that the high courts can examine the matter on its merits—which in a way, remained the settled legal position even before the Supreme Court’s decision in SAP Labs.

Given that the ruling may lead to an increase in litigation, taxpayers may be nudged to explore alternative mechanisms for avoiding disputes, such as entering into advance pricing agreements or taking benefit of the domestic safe harbor rules, which can help in reducing uncertainty and the risk of drawn-out litigation.