Foreign Exchange Fluctuation and Cost Allocation under TNMM: Analysis of ITAT Delhi Ruling in Sara Sae Pvt. Ltd. Vs ACIT

Background and Context

In Sara Sae Pvt. Ltd. Vs ACIT, the Delhi Bench of the ITAT adjudicated multiple important issues relating to transfer pricing and interest deduction for Assessment Year 2013-14. The appeal arose from an order passed under Section 143(3) read with Section 144C and Section 92CA(3) of the Income Tax Act 1961, following directions of the Dispute Resolution Panel (DRP).

The assessee, Sara Sae Pvt. Ltd., is engaged in manufacturing machinery and equipment used primarily in the oil and gas sector. It operates through two distinct business segments:

  • Capital Goods Segment – manufacturing specialized, customized machinery such as BOP units, accumulator units, high-pressure test units, hydraulic power tongs, and similar equipment.
  • Commodity Products Segment – dealing in fast-moving commodity items and spares like hammers, unions, swivels, joints, pup joints, ring joints, gaskets, flanges, valves, castings, and other MS products used in oil and gas as well as other industries.

Though the assessee had several international transactions with its Associated Enterprises (AEs), the core dispute before the Tribunal concerned the Commodity Products Segment, specifically the sale of finished goods to its AE located in the USA. The value of this international transaction was ₹51.68 crores.

The assessee benchmarked this transaction under the Transactional Net Margin Method (TNMM) using the operating profit to operating cost (OP/OC) as the chosen Profit Level Indicator (PLI). The assessee’s transfer pricing study concluded that its margin exceeded the margin of comparable companies, and therefore, the transaction was at Arm’s Length Price (ALP).

However, the Transfer Pricing Officer (TPO) made a transfer pricing adjustment of ₹3,65,84,151, primarily due to:

  • Exclusion of foreign exchange gain from operating income.
  • Reallocation of common expenses between units based on turnover instead of profit.
  • Rejection of four out of five comparables adopted by the assessee.

In addition, there was a separate controversy relating to disallowance of interest expenditure under Section 57(iii) on borrowed funds partly used for investment in equity of a wholly owned subsidiary and partly advanced as an interest-bearing loan.

The Tribunal partly allowed the appeal, remanding transfer pricing issues back to the TPO/AO with specific directions, and granting relief on the Section 57(iii) claim.

Transfer Pricing Dispute: Overview of Method and Margins

Characterisation of International Transaction

The international transaction under scrutiny involved sale of finished goods by the Commodity Products Segment to the AE in the USA, aggregating to ₹51.68 crores.

The assessee adopted:

  • Method: TNMM as the Most Appropriate Method (MAM).
  • Tested Party: The assessee itself.
  • PLI: Operating Profit / Operating Cost (OP/OC).

As per the transfer pricing documentation:

  • Assessee’s PLI: 6.61%.
  • Working capital–adjusted arithmetic mean of five comparables: 1.55%.

Since the assessee’s margin exceeded the mean margin of comparables, the assessee considered its international transaction to be at ALP.

Intervention by the TPO

The TPO disturbed this conclusion by making two key modifications:

  1. Excluding foreign exchange gain of ₹2,38,83,566 from operating income.
  2. Reallocating common expenses between the Delhi and Dehradun units based on turnover, instead of the profit-based allocation followed consistently by the assessee.

Following these changes, the TPO recomputed:

  • Assessee’s revised PLI: (-) 1.39%.

The TPO further accepted only one comparable, Hilton Metal Forgings, with a PLI of 5.59%, and rejected the remaining four comparables. Based on this single comparable and revised margins, the TPO computed a transfer pricing adjustment of ₹3,65,84,151.

The computation adopted by the TPO was as follows:

  • Operating Cost: ₹84,36,88,039
  • Arm’s length margin (5.59%): ₹4,71,62,161
  • Arm’s Length Price: ₹89,08,50,200
  • Price charged by the assessee: ₹83,19,60,967
  • Difference: ₹5,88,89,233
  • Proportion of international transaction to total revenue: 62.12%
  • Proportionate adjustment: ₹3,65,84,151

The assessee challenged these adjustments before the ITAT.

Treatment of Foreign Exchange Gain: Operating vs Non-Operating

Issue

A pivotal question was whether foreign exchange fluctuation gain of ₹2,38,83,566 arising in the Commodity Products Segment should be treated as operating income for the purpose of computing PLI under TNMM, or as non-operating, as held by the TPO.

Tribunal’s Analysis

The Tribunal noted that this controversy has been consistently considered by various benches, and the prevailing judicial view is that: