Inter-office service charges, expatriate CEO salary, and repo interest are deductible, while specific transfer pricing comparables and adjustments require verification.

ORDER

Amit Shukla, Judicial Member.- These cross appeals have been preferred by the assessee, J.P. Morgan Chase Bank N.A. (formerly known as The Chase Manhattan Bank), and the Revenue against the order dated 30.03.2006 passed by the learned Commissioner of Income-tax (Appeals), Mumbai, for the assessment year 2002-03, arising from the assessment framed under section 143(3) of the Income-tax Act, 1961 (hereinafter referred to as “the Act”). Since both appeals arise from the same assessment proceedings and certain issues concerning the determination of the arm’s length price of international transactions and attribution of profits to the Indian permanent establishment are interconnected, they were heard together and are being disposed of by this consolidated order. For the sake of convenience, we shall first take up the assessee’s appeal in ITA No. 3839/Mum/2006 and thereafter the Revenue’s appeal in ITA No. 3784/Mum/2006.

2. The assessee has raised nine grounds of appeal, which, without reproducing them verbatim, may be summarised as follows: (i) disallowance of salary expenditure of Rs.99,89,796 pertaining to the Chief Executive Officer of the Indian branch, notwithstanding that the services were stated to have been rendered exclusively for the Indian banking operations; (ii) partial confirmation of the transfer-pricing adjustment relating to correspondent banking services; (iii) partial confirmation of the adjustment concerning cheque-processing services; (iv) partial confirmation of the adjustment relating to investor services; (v) non-consideration of the permissible variation of ±5% under section 92C(2) while determining the arm’s length price; (vi) determination of the arm’s length price of Head Office expenditure of Rs. 1,48,07,863 at nil; (vii) determination of the arm’s length price of hub expenditure of Rs.3,11,81,346 at nil; (viii) inclusion of Rs.85,24,546 in the taxable profits of the Indian permanent establishment notwithstanding the assessee’s claim for exclusion under Article 7(3) of the India-USA Double Taxation Avoidance Agreement (DTAA); and (ix) the finding concerning the scope of section 92CA(4), particularly whether the Assessing Officer was required to independently examine or record reasons while adopting the arm’s length price determined by the TPO. Ground Nos. 5 and 9, relating respectively to section 92C(2) and section 92CA(4), have been treated as academic and do not require separate adjudication. The remaining grounds involve questions concerning the deductibility and attribution of expenditure incurred for the Indian banking operations, benchmarking of services rendered to overseas offices and the treatment of specified intra-enterprise dealings under Article 7 of the treaty.

3. In the Revenue’s appeal, three grounds have been raised challenging the relief granted by the learned CIT(A). The first concerns allowance of the loss of Rs.7,79,516 arising from diminution in the value of investments held by the assessee in the course of its banking business. The second challenges deletion of the disallowance of Rs.1,06,58,000 claimed as interest expenditure on repurchase transactions in securities. The third concerns the direction of the learned CIT(A) to adopt the average of the arithmetic means based upon financial data for assessment years 1999-2000, 2000-01 and 2001-02, instead of the data pertaining to financial year 2001-02 adopted by the TPO for determining the arm’s length price. While the first two grounds relate to computation of the assessee’s banking income, the third has a direct bearing upon the transfer-pricing exercise which is also under challenge in the assessee’s appeal. The issue concerning the relevant financial-year data shall, therefore, be considered in the course of adjudicating the transfer-pricing controversy, and the finding recorded thereon shall govern the corresponding ground raised by the Revenue.

4. On a consideration of the grounds raised in both appeals, the principal controversies which require adjudication are the deductibility of remuneration paid by the Head Office to an expatriate executive managing the Indian branch; determination of the arm’s length price of correspondent banking, cheque-processing and investor services, including functional comparability, relevant financial data, depreciation adjustments and allocation of operating expenditure; the treatment of Head Office and hub expenditure incurred outside India and claimed as attributable to the Indian operations; and the allocation of corporate and indirect expenditure amongst different service segments. A separate and substantial question arises concerning the amount of Rs.85,24,546, representing the excess of revenues recorded by the Indian branch over the corresponding expenditure incurred in rendering correspondent banking and investor services to the Head Office and other overseas offices. The assessee claims that the said amount is not liable to be taken into account in determining the profits attributable to its Indian permanent establishment by virtue of the reciprocal provision contained in Article 7(3), whereas the Revenue maintains that the amount represents business profits arising from the functions performed by the Indian branch and is taxable under Article 7(2). The determination of this issue necessarily involves consideration of the relationship between the distinct-and-independent-enterprise hypothesis under Article 7(2), the specific provisions of Article 7(3) and the domestic transfer-pricing provisions contained in Chapter X of the Act.

5. The brief facts are that the assessee is a banking company incorporated in the United States of America and was carrying on banking business in India through its Mumbai branch during the relevant previous year. It is an admitted position that the Indian branch constitutes a permanent establishment (PE) of the assessee in India under the India-USA DTAA. The assessee filed its return of income declaring total income of Rs.28,90,00,100, which was subsequently revised to Rs.28,10,32,880. During the assessment proceedings, the Assessing Officer noticed that the assessee had undertaken various international transactions involving its Head Office and overseas branches or associated enterprises, including services rendered by the Indian branch in connection with the worldwide banking operations and expenditure allocated to the Indian operations by the Head Office and regional processing hubs. A reference was accordingly made to the Transfer Pricing Officer under section 92CA for determination of the arm’s length price of the relevant transactions. The TPO examined the transfer-pricing study and supporting material furnished by the assessee and, upon considering the nature of the transactions, functional profiles, comparable companies, financial data and allocation of expenditure, did not accept several components of the benchmarking exercise. The Assessing Officer thereafter completed the assessment under section 143(3), incorporating the adjustments determined pursuant to the transfer-pricing reference and making certain other disallowances in the computation of the Indian branch’s income. In appeal, the learned CIT(A) granted relief on certain issues, modified some components of the transfer-pricing computation and sustained the remaining additions and disallowances. Both parties are aggrieved by the respective findings of the learned CIT(A).

6. The international transactions giving rise to the principal transfer-pricing controversies were undertaken in the course of the assessee’s worldwide banking operations, wherein different branches and offices performed different functions as constituent establishments of the same banking enterprise. The Indian branch, inter alia, rendered correspondent banking services involving marketing, customer-interface, liaison and coordination in relation to banking products and facilities offered through overseas branches; cheque-processing services involving processing and transmission of cheque-related information and allied clearing support; and investor services comprising tradesettlement assistance, securities and cash reconciliation and other operational functions. The assessee benchmarked these transactions by adopting the Transactional Net Margin Method (TNMM), using operating profit to operating cost as the profit level indicator and selecting comparable companies for the respective service segments. In addition, executive and general administrative expenditure incurred centrally by the Head Office and operational and technological expenditure incurred through regional processing facilities at Hong Kong and Bournemouth were stated to be attributable to the Indian operations. The TPO questioned the selection of certain comparable companies, the financial data and depreciation adjustments adopted, and the allocation of corporate, Head Office, hub and indirect expenditure to the operating cost of the respective services. The adjustments arising from these objections form the subject matter of Ground Nos. 2, 3, 4, 6 and 7 of the assessee’s appeal.

7. Another issue arose from the accounting treatment adopted by the assessee in respect of correspondent banking and investor services rendered by the Indian branch to its Head Office and overseas offices. The assessee had recorded the amounts charged for such services as revenues in its books, together with the corresponding expenditure incurred in rendering them. However, while computing its taxable income in India, it excluded the excess of such revenues over expenditure on the premise that Article 7(3) did not permit recognition of the profit element arising from specified charges between different establishments of the same enterprise, otherwise than towards reimbursement of actual expenses. The relevant figures emerging from the computation furnished by the assessee are as under:

The assessee accordingly excluded Rs.85,24,546 from its taxable income by invoking the reciprocal clause of Article 7(3). The Revenue, however, treated the amount as profits arising from services rendered by the Indian permanent establishment and liable to tax in India. It is material that the dispute does not concern merely an additional hypothetical mark-up independently determined by the TPO, but the taxability of the excess of revenues actually recorded by the assessee over the corresponding costs, which had been excluded in the computation of income on the strength of the treaty. The assessee had also separately disclosed net interest income of Rs.40,38,331 arising from offshore placements with overseas branches and offered the same to tax, recognising the specific exception concerning interest in the case of a banking enterprise under Article 7(3). Thus, the controversy requires a distinction between interest arising from intrabank lending arrangements and charges for specified services rendered by one establishment to another. The amount of Rs.85,24,546 also requires separate consideration from the transfer-pricing adjustments relating to correspondent banking and investor services, so that the same profit element is neither subjected to overlapping adjustments nor excluded more than once.

8. The disputes concerning the arm’s length price of the service transactions and attribution of profits under Article 7, though arising from the same banking operations, involve distinct enquiries. The transfer-pricing exercise is concerned with determining whether the remuneration attributable to the functions performed by the Indian branch satisfies the arm’s length standard prescribed under Chapter X, which requires examination of functional comparability, relevant financial data, operating margins and the expenditure properly attributable to each transaction. The claims concerning Head Office and hub expenditure involve the further question whether expenditure incurred centrally outside India has been established as attributable to the Indian operations and whether its allocation and deductibility have been correctly examined under the applicable provisions. The controversy concerning Rs.85,24,546, on the other hand, raises a specific question of treaty interpretation, namely, whether the excess of inter-office charges over actual expenditure is required to be recognised in determining the profits of the Indian permanent establishment notwithstanding the reciprocal provision of Article 7(3). These issues have to be considered in their respective statutory and factual settings, while ensuring consistency in the ultimate computation of taxable profits.

9. We shall first notice the facts relating to Ground No. 1 concerning disallowance of salary expenditure of Rs.99,89,796 pertaining to Mr. Dominic Price, who was functioning as the Chief Executive Officer of the Indian branch during the relevant previous year. The banking operations of Morgan Guaranty Trust Company of New York came to be merged with J.P. Morgan Chase Bank N.A. on 10 November 2001, consequent upon which Mr. Dominic Price assumed responsibility for managing the Indian operations with effect from November 2001. Prior to the merger, the position was held by Mr. Mahesh Aras, an Indian executive. The assessee claimed that Mr. Price was exclusively engaged in managing and supervising the Indian banking business and that the remuneration attributable to the services rendered by him constituted expenditure incurred wholly and exclusively for the purposes of the Indian operations. The salary of Rs.99,89,796 was, however, paid directly by the Head Office outside India and was not debited in the books maintained by the Mumbai branch. In the original return, the assessee had claimed salary expenditure of Rs.23,67,301, which was enhanced to Rs.99,89,796 in the revised return. During the assessment proceedings, the Assessing Officer called upon the assessee to explain the enhancement and establish the admissibility of the expenditure under section 37(1). The assessee explained that although the remuneration had been discharged by the Head Office, the underlying services were rendered exclusively for the Indian operations and, therefore, neither the place of payment nor the absence of a debit in the branch accounts could determine its deductibility. It was further pointed out that the remuneration had been disclosed by Mr. Price in his Indian return of income and the corresponding tax liability had been discharged. Reliance was also placed upon the earlier appellate orders in the assessee’s own case and the decisions of the Hon’ble Bombay High Court concerning expenditure incurred outside India for the purposes of an Indian branch.

10. The Assessing Officer did not accept the explanation. According to him, the assessee was required to establish not merely that Mr. Price had rendered services in India but also that the expenditure claimed had actually been incurred by the Indian branch. He observed that the salary was neither recorded in the books of the Mumbai branch nor paid by it and that the entire remuneration had been directly discharged by the Head Office. On this basis, he held that the expenditure could not be regarded as having been incurred by the Indian branch for purposes of section 37(1). The Assessing Officer further observed that expenditure incurred by the Head Office was subject to the restriction prescribed under section 44C and that the assessee could not claim the amount independently under section 37(1) merely by asserting that the employee had rendered services for the Indian operations. As regards the judicial precedents and favourable appellate orders for the earlier assessment years, he recorded that the Department had not accepted those decisions and appeals had been preferred before the Tribunal. He accordingly disallowed the entire salary expenditure of Rs.99,89,796.

11. Before the learned CIT(A), the assessee reiterated that the remuneration represented expenditure incurred for services rendered by the Chief Executive Officer exclusively in connection with the Indian banking operations and that the requirements of section 37(1) stood satisfied notwithstanding that the salary was paid by the Head Office. Reliance was placed upon the earlier appellate orders in the assessee’s own case, wherein salary expenditure incurred outside India in respect of senior executives deployed for the Indian operations had been allowed. The learned CIT(A), however, distinguished the factual position prevailing in those years. He noticed that the earlier claims related to Mr. David K. Baggs, whose appointment and deployment for the Mumbai branch had been supported by material considered sufficient to establish the requisite nexus with the Indian operations. In the present case, the learned CIT(A) observed that Form No. 16 furnished in respect of Mr. Dominic Price covered only the period November 2001 to March 2002, that the employment contract had not been produced and that the audited financial statements bearing his signature as Chief Executive Officer had been signed on 25 June 2002, after the close of the relevant financial year. He also referred to the absence of a satisfactory explanation for enhancement of the salary claim from Rs.23,67,301 to Rs.99,89,796 and the fact that no corresponding liability had been recognised in the books of the Indian branch. The learned CIT(A) distinguished the decision of the Hon’ble Bombay High Court in Commissioner of Income-tax v. Emirates Commercial Bank Ltd. [2003] 262 ITR 55  (Bombay), on the factual ground that the expenditure in that case had been established as incurred for the Indian branch and appropriately recovered or attributed. Holding that the assessee had not furnished sufficient evidence establishing that the entire remuneration was incurred exclusively for the Indian operations, he confirmed the disallowance of Rs.99,89,796.

12. We shall now take up Ground No. 2 concerning the determination of the arm’s length price of correspondent banking services. The assessee, in the course of its worldwide banking operations, rendered marketing, customer-interface and relationship-management services in India in connection with banking products and facilities offered by its overseas branches. The customers principally comprised Indian private and public sector banks and other financial institutions requiring banking arrangements outside India, including foreign-currency accounts maintained with overseas offices. Depending upon the nature of the currency and banking requirements, the Indian branch undertook marketing and coordination activities relating to foreign-currency account facilities, letters of credit, export-bill collections, remittance facilities and other correspondent banking arrangements. Its functions included identifying potential customers, maintaining relationships with existing customers, coordinating with overseas branches and attending to customer enquiries, including providing information concerning Nostro accounts and statements of account. The assessee’s transfer-pricing study proceeded on the basis that these were essentially marketing, liaison and customer support functions, whereas the substantive overseas banking transactions and the associated financial risks were undertaken by the respective overseas branches. For benchmarking the remuneration attributable to the Indian functions, the assessee adopted TNMM, with operating profit to operating cost as the profit level indicator. In the segmental working, revenue from correspondent banking services was shown at Rs.3,18,18,289 against direct expenditure of Rs. 1,90,12,504 and indirect expenditure of Rs.88,58,096, aggregating to an operating cost of Rs.2,78,70,600. The operating profit was determined at Rs.39,47,689, yielding a margin of 14.16% on costs. The assessee selected six comparable companies, namely, Allianz Securities Ltd., Centrum Finance Ltd., Integrated Enterprises (India) Ltd., Kinetic Trust Ltd., Pioneer Investcorp Ltd. and PNR Capital Services Ltd. The arithmetic mean of their weighted average operating margins, as adopted in the transfer-pricing study, was determined at 14.77%. Since the margin earned by the assessee was considered comparable with the aforesaid arithmetic mean of 14.77%, the assessee treated the international transaction relating to correspondent banking services as having been undertaken at arm’s length and, accordingly, did not propose any adjustment in its transferpricing study.

13. The TPO, however, did not accept the benchmarking analysis undertaken by the assessee in its entirety. Although he did not dispute the broad search process adopted in the transfer-pricing study, he found that two of the six companies selected by the assessee, namely, Kinetic Trust Ltd. and PNR Capital Services Ltd., did not provide a reliable basis for comparison. Kinetic Trust Ltd. was excluded principally on account of the substantially lower scale of its operations, having regard to its turnover and asset base, which, according to the TPO, rendered its operating results unsuitable for comparison with the functions undertaken by the assessee. In the case of PNR Capital Services Ltd., the TPO noticed that during financial year 2001-02 the company had substantially shifted towards investment-oriented activities, as distinguished from the fee-based financial services which had formed the basis of its original selection. He accordingly excluded both companies from the comparable set. The TPO further disagreed with the assessee’s reliance upon weighted average financial data pertaining to financial years 1999-2000 and 2000-01 along with the relevant year. Referring to Rule 10B(4) of the Income-tax Rules, 1962, he observed that the financial data pertaining to the year in which the international transaction was undertaken was required to be considered for determining the arm’s length price. The circumstance that the relevant-year data was not available when the assessee originally prepared its transfer pricing documentation did not, according to him, justify continued reliance upon earlier-year information once the financial data for 2001-02 had become available during the assessment proceedings. He therefore adopted the operating margins of the four retained comparable companies for financial year 2001-02, namely, Allianz Securities Ltd. at 5.48%, Centrum Finance Ltd. at 44.38%, Integrated Enterprises (India) Ltd. at 32.09% and Pioneer Investcorp Ltd. at 88.97%, resulting in an arithmetic mean of 42.73%, as against 14.77% adopted by the assessee. Apart from substituting the comparable margin, the TPO also examined the expenditure included in the operating cost base of correspondent banking services and was of the view that certain corporate, Head Office and hub expenditure, which had not been considered by the assessee while determining its segmental operating costs, was required to be appropriately allocated to the services rendered by the Indian branch to its overseas offices.

14. In examining the operating cost base, the TPO identified three broad categories of expenditure which, according to him, had not been appropriately considered in determining the cost of the services rendered by the Indian branch. These comprised hub expenditure of Rs.3,11,81,346, Head Office expenditure of Rs. 1,48,07,863 and corporate expenditure aggregating to Rs.1,66,75,944. The corporate expenditure included severance payments arising from restructuring, rental expenditure relating to the Vakil House premises following relocation, retainership and public-relations expenditure, directors ‘fees and expenditure incurred in shifting equipment to the premises from which the Indian branch subsequently operated. The aggregate expenditure pool was thus worked out at Rs.6,26,65,153. The TPO proceeded on the premise that these expenses had been incurred in connection with the banking operations and that an appropriate portion thereof was attributable to the services rendered by the Indian branch to its overseas offices. For allocating such expenditure amongst the respective service segments, he adopted the proportion of salary and bonus expenditure attributable to each segment to the total salary and bonus expenditure of the Indian operations. In the case of correspondent banking services, the relevant employee cost was taken at Rs.66,90,714 against the total salary and bonus expenditure of Rs.11,69,42,000, yielding an allocation ratio of 5.72%. Applying this ratio to the additional expenditure pool, the TPO allocated Rs.35,84,446 to correspondent banking services, thereby increasing the operating cost from Rs.2,78,70,600 to Rs.3,14,55,046. Upon applying the revised arithmetic mean margin of 42.73%, he determined the arm’s length price of correspondent banking services at Rs.4,48,95,787. It is material that the TPO did not ultimately compute the adjustment relating to correspondent banking services in isolation, but aggregated its arm’s length value with that determined for cheque-processing services and compared the combined result with the aggregate transaction value reported by the assessee in Form No. 3CEB. Upon receipt of the TPO’s order dated 30 December 2004, the Assessing Officer afforded an opportunity to the assessee to explain the proposed adjustments. The assessee reiterated its objections in its reply dated 3 March 2005, but the Assessing Officer observed that no further material had been furnished which warranted any departure from the determination made by the TPO and accordingly incorporated the combined transfer-pricing adjustment in the assessment.

15. The learned CIT(A), while considering the assessee’s challenge to the aforesaid adjustment, examined the selection of comparable companies, the financial data adopted by the TPO and the expenditure included in the operating cost base. Insofar as Kinetic Trust Ltd. was concerned, he agreed with the TPO that the scale of operations, turnover and asset base were relevant considerations in evaluating comparability, particularly having regard to the functions performed, assets employed and risks assumed, and accordingly upheld its exclusion. He also sustained the rejection of PNR Capital Services Ltd., noticing that the company’s activities during financial year 2001-02 had undergone a material change towards investment-oriented business and could not be regarded as comparable with the fee-based services rendered by the assessee merely because it had undertaken different activities in earlier years. However, on the question of financial data, the learned CIT(A) did not agree with the TPO’s approach of relying exclusively upon financial year 2001-02. He observed that although Rule 10B(4) ordinarily contemplated the use of financial information pertaining to the year in which the international transaction had been entered into, its proviso also permitted consideration of data relating to the preceding two financial years where such data revealed facts capable of influencing determination of the transfer price in relation to the transactions being compared. The learned CIT(A) noticed that the assessee had prepared its original transfer-pricing study on the basis of financial information then available and that the data pertaining to financial year 2001-02 had become available subsequently. More importantly, he found that, after exclusion of Kinetic Trust Ltd. and PNR Capital Services Ltd., the arithmetic mean operating margin of the remaining four comparable companies, based upon the earlier-year data considered in the assessee’s transfer-pricing study, worked out to 12.23%, whereas the corresponding margin determined by the TPO on the basis of financial year 2001-02 was 42.73%. The substantial variation between the two margins weighed with the learned CIT(A), who was of the view that the TPO was not justified in concluding that the earlier-year financial information did not reveal any facts capable of influencing the determination of the arm’s length price. He accordingly directed that the arithmetic mean should be determined by taking the average of the arithmetic means of the operating profit to operating cost margins of the four retained companies based upon financial data pertaining to financial years 1999-2000, 2000-01 and 2001-02. Thus, while sustaining the exclusion of Kinetic Trust Ltd. and PNR Capital Services Ltd., the learned CIT(A) modified the benchmarking exercise by directing adoption of the three-year financial data. This direction has been specifically challenged by the Revenue in Ground No. 3 of its cross appeal, and its correctness shall be examined while adjudicating the corresponding issue under Rule 10B(4).

16. The learned CIT(A) thereafter examined the assessee’s objections concerning the inclusion of corporate expenditure and allocation of Head Office and hub expenditure in the operating cost base of correspondent banking services. The assessee had contended that corporate expenditure aggregating to Rs.1,66,75,944 comprised several items which were either exceptional in nature or incurred for the general banking establishment and did not have any direct nexus with the services rendered to overseas offices. Particular reference was made to severance payments arising from restructuring consequent upon the merger, rental expenditure relating to the Vakil House premises after their vacation, expenditure incurred in shifting equipment, retainership and public-relations expenditure and directors ‘ fees. According to the assessee, these items could not automatically be treated as operating expenditure of correspondent banking services merely because they had been incurred in connection with the banking business as a whole. The learned CIT(A), however, did not accept this contention. He noticed that while determining the operating margins of the comparable companies, the TPO had excluded certain items such as interest and bank charges, preliminary expenditure, losses on investments and losses on sale of fixed assets, which were regarded as non-operating in character. The expenditure disputed by the assessee, according to the learned CIT(A), could not necessarily be equated with those items. He observed that severance payments, rental expenditure and expenses connected with shifting equipment, though arising in the context of restructuring and relocation, were nevertheless incurred in connection with the business operations. Similar reasoning was adopted in relation to retainership fees paid to the public-relations firm and directors ‘fees. He also noticed that the assessee’s claim concerning write-off of fixed assets had already been accepted by the Assessing Officer. On these considerations, the learned CIT(A) upheld the treatment of the aforesaid corporate expenditure as operating expenditure and sustained its allocation to the service segments. However, a different conclusion was reached in respect of Head Office expenditure of Rs.1,48,07,863 and hub expenditure of Rs.3,11,81,346. The learned CIT(A) noticed that the TPO had separately determined the arm’s length price of these expenditure transactions at nil and that the corresponding amounts had consequently been disallowed while computing the taxable income of the Indian branch. He found merit in the assessee’s objection that the same expenditure could not simultaneously be disallowed as a separate transaction and again be included in the operating cost base of correspondent banking and other services, since such treatment would result in duplication of the disallowance. Accordingly, while sustaining the treatment of corporate expenditure as operating expenditure and the principle of allocation of common costs, he directed the Assessing Officer to exclude Head Office and hub expenditure from the operating cost base of the service transactions to the extent the same expenditure had already been separately disallowed. The ground concerning correspondent banking services was thus partly allowed, with directions for consequential recomputation of the arm’s length price in accordance with his findings concerning the comparable companies, financial data and allocation of expenditure.

17. We shall now advert to Ground No. 3 concerning the determination of the arm’s length price of cheque-processing services. During the relevant previous year, the Indian branch was rendering cheque-processing services for the overseas banking operations, which broadly involved scanning and microfilming of cheques, recording the relevant particulars, generating electronic copies, transmitting the requisite information to the concerned overseas branches and facilitating processing of the instruments through the clearing mechanism. The assessee characterised these functions as routine information-technology-enabled processing services involving limited operational risks, without undertaking any entrepreneurial banking or financial activity. For benchmarking these transactions, the assessee adopted the Transactional Net Margin Method (TNMM), with operating profit to operating cost as the profit level indicator, and selected four comparable companies through searches conducted on the Prowess, Capitaline and NASSCOM databases. The direct expenditure attributable to chequeprocessing services was shown at Rs.59,31,870 and support expenditure at Rs. 4,18,634, aggregating to Rs.63,50,504. The assessee reported an operating margin of 14.71% against the arithmetic mean margin of 14.36% of the comparables selected in its transfer-pricing study and accordingly treated the transaction as being at arm’s length. The TPO, however, did not accept the benchmarking analysis in its entirety. He noticed that Nucleus Netsoft & GIS India Ltd., one of the companies selected by the assessee, was not reflected under the relevant classification of software-service providers in the database and was engaged in specialised activities which, according to him, were not functionally comparable with the routine cheque-processing operations undertaken by the Indian branch. He accordingly excluded this company from the comparable set. The TPO also rejected the depreciation adjustment claimed by the assessee on the premise that differences in depreciation policies followed by the tested party and the comparable companies affected their operating margins, observing that the nature and financial effect of such differences had not been satisfactorily established. Insofar as the remaining comparables were concerned, the TPO noticed that financial information for financial year 2001-02 was available only in respect of Ace Software Exports Ltd., whose operating profit to operating cost margin was determined at 22.25%. He consequently proceeded with the available financial information of the retained companies, including preceding-year data, and determined the arithmetic mean operating margin at 26.10%, which was adopted for computing the arm’s length price of cheque-processing services.

18. Apart from modifying the comparable set and rejecting the depreciation adjustment, the TPO also examined the operating expenditure attributable to cheque-processing services and found that certain indirect expenditure, which could not be separately identified between correspondent banking and cheque-processing activities, had been included by the assessee in the cost base of correspondent banking services. According to him, a portion of such common expenditure was also attributable to cheque processing and therefore required appropriate allocation. He accordingly redistributed the indirect expenditure and further included the proportionate allocation of corporate expenditure, Head Office expenditure and hub expenditure, following the methodology adopted for correspondent banking services. Upon applying the revised operating margin to the enhanced cost base, the arm’s length price of cheque-processing services was determined at Rs.1,14,72,583. Before the learned CIT(A), the assessee challenged both the comparable analysis and the manner of allocation of expenditure, particularly contending that the TPO had allocated additional indirect expenditure to cheque-processing services without making a corresponding reduction from the expenditure already included in the cost base of correspondent banking services, thereby resulting in duplication. The learned CIT(A) found merit in this objection and directed the Assessing Officer to verify the allocation and reduce the indirect expenditure of correspondent banking services to the extent the same had been allocated to cheque processing. However, insofar as the exclusion of Nucleus Netsoft & GIS India Ltd. was concerned, he agreed with the TPO that the company was engaged in specialised web-mapping and location-based services, which were materially different from the cheque-processing functions undertaken by the assessee. He also upheld the rejection of the depreciation adjustment, observing that although differences in depreciation methods, including the straight-line and written-down-value methods, could affect operating margins, the assessee had not furnished reliable material quantifying their actual effect upon comparability. On the question of financial data, the learned CIT(A) noticed that the TPO had been able to obtain relevant-year information for only one of the retained comparables and had accordingly considered preceding-year data for the remaining companies. He accepted this approach by invoking the proviso to Rule 10B(4). Thus, while the learned CIT(A) sustained the principal findings concerning the comparable set, depreciation adjustment and financial data, he granted relief to the extent of correcting duplication of indirect expenditure and directed consequential recomputation of the arm’s length price.

19. Ground No. 4 relates to the determination of the arm’s length price of investor services rendered by the Indian branch in connection with the overseas banking operations. The functions performed in this segment broadly comprised trade-settlement support, securities and cash reconciliation, processing and maintenance of transaction-related information and other operational and customer-support activities connected with investment transactions undertaken through the overseas offices. The assessee’s transfer-pricing study proceeded on the basis that these were routine operational functions involving limited risks and that the Indian branch was not undertaking the substantive investment, trading or entrepreneurial functions of the overseas banking enterprise. Having regard to the asserted similarity between the operational characteristics of investor services and cheque-processing services, the assessee adopted substantially the same comparable search and benchmarking methodology as employed for cheque processing. The operating margin of the investor-services segment was stated to be 12.08% on the relevant operating costs, and the assessee treated the transaction as being at arm’s length with reference to the comparable analysis undertaken in its study. The TPO, however, did not accept the computation and applied the revised benchmarking approach adopted for processing-service activities, including the changes in comparable selection, financial data and depreciation adjustment. He further enhanced the operating cost base by allocating additional corporate, Head Office, hub and indirect expenditure in accordance with the costallocation methodology applied to the other service segments. The arm’s length price of investor services was consequently determined at Rs.7,26,94,045 as against the transaction value of Rs.5,35,06,676 recorded by the assessee, resulting in an upward adjustment of Rs. 1,91,87,369. The Assessing Officer incorporated the aforesaid adjustment in the assessment, observing that the assessee had not furnished any further material warranting departure from the determination made by the TPO.

20. The learned CIT(A), while examining the aforesaid adjustment, noticed that the assessee itself had adopted substantially the same comparable search and benchmarking methodology for investor services as in the case of chequeprocessing services, having regard to the similarity claimed in the nature of the functions performed. He therefore considered that the common objections concerning selection of comparables, depreciation adjustment, financial data and allocation of corporate, Head Office and hub expenditure could appropriately be governed by the findings recorded in relation to cheque-processing services. Accordingly, instead of undertaking a separate examination of each common issue, the learned CIT(A) directed that the principles adopted for determining the comparable set, treatment of depreciation and financial information and allocation of expenditure in cheque-processing services should also be applied while recomputing the arm’s length price of investor services. The effect of this direction was that the assessee obtained consequential relief to the extent permitted by the findings concerning common expenditure and cost allocation, while the principal approach adopted by the TPO concerning the comparable companies, depreciation adjustment and benchmarking methodology was substantially sustained. The assessee has challenged this finding, inter alia, on the ground that the functional characteristics and expenditure attributable to investor services required independent examination and that the application of the same benchmarking approach as cheque processing, without adequately considering the particular functions and costs of investor services, did not necessarily yield a reliable arm’s length result.

21. Thus, the adjustments relating to correspondent banking, cheque-processing and investor services, though arising from three distinct international transactions, involve certain common issues concerning the application of TNMM, functional comparability, relevant financial-year data, depreciation adjustments and allocation of corporate, Head Office, hub and indirect expenditure. The learned CIT(A) granted partial relief in the first two segments and extended the relevant common directions to investor services, while sustaining several components of the TPO’s benchmarking and cost-allocation exercise. One significant aspect of his findings was that Head Office expenditure and hub expenditure, whose arm’s length price had separately been determined at nil and which had consequently been disallowed, could not simultaneously be included in the operating cost base of the service transactions, as that would result in duplication. The correctness of the cost-allocation exercise, however, also depends upon whether the determination of the arm’s length price of Head Office and hub expenditure at nil was itself justified under Chapter X, read with Article 7(3) of the India-USA DTAA. We shall therefore examine the nature of these expenditure transactions, the material furnished by the assessee in support thereof, the reasons recorded by the TPO and the findings of the learned CIT(A).

22. Ground No. 6 concerns the determination of the arm’s length price of Head Office expenditure of Rs. 1,48,07,863 at nil. The assessee, being a branch of a foreign banking enterprise, claimed deduction in respect of certain executive and general administrative expenditure incurred centrally by its Head Office for the worldwide banking organisation, including the Indian operations. According to the assessee, the Head Office performed managerial, administrative, supervisory, financial-control and other common functions supporting the business carried on through different branches, and the expenditure incurred in relation to such functions could not always be directly identified with an individual establishment. The expenditure was therefore accumulated in a common corporate overhead pool and allocated amongst the respective branches by adopting an identified methodology, principally having regard to their relative revenues. The assessee claimed that the expenditure so allocated to the Indian branch was incurred for the purposes of its banking business and was deductible in computing the profits attributable to the Indian permanent establishment, subject to the restriction prescribed under section 44C of the Act. The deduction claimed amounted to Rs.1,48,07,863, representing five per cent of the adjusted total income as computed by the assessee for the purposes of section 44C. It was explained that, owing to commercial and regulatory considerations governing the accounting and settlement of transactions between the Indian branch and its overseas offices, the expenditure had neither been physically paid by the Mumbai branch to the Head Office nor debited in the profit and loss account prepared under the applicable banking regulations. Nevertheless, the assessee maintained that the expenditure represented an appropriate allocation of costs incurred centrally for the Indian operations and was therefore deductible while computing its taxable income. In support, reliance was placed upon a certificate issued by PricewaterhouseCoopers LLP describing the corporate expenditure pool and the methodology employed for allocating the expenditure amongst different establishments of the banking enterprise.

23. The TPO, upon examining the claim, observed that the assessee had not furnished sufficient contemporaneous material establishing the actual expenditure incurred by the Head Office for the purposes of the Indian operations. He noticed that the notes accompanying the computation of income themselves indicated that the details of Head Office expenditure were not available and that the deduction had been computed by applying the ceiling of five per cent of the adjusted total income under section 44C. According to him, the statutory provision did not confer an automatic entitlement to deduction merely because the amount claimed fell within the prescribed ceiling; the assessee was still required to establish the nature of the expenditure, its actual incurrence and its relationship with the Indian business. The TPO further noticed that the expenditure had neither been debited in the books of the Indian branch nor supported by any debit note or invoice raised by the Head Office, and no corresponding liability had been recognised. He also examined the certificate issued by PricewaterhouseCoopers LLP and found that it related to the year ended 31 December 2002, whereas the previous year relevant to the assessment under consideration ended on 31 March 2002. No corresponding allocation statement or certificate covering the earlier period had been furnished. The TPO further observed that the expenditure pool reflected in the certificate included certain items relating to philanthropic activities, aircraft, finance and marketing functions, and that the assessee had not satisfactorily established how such expenditure was connected with the functions performed by the Indian branch or what services and benefits had actually been received by it. In his view, allocation of common expenditure could not be accepted merely upon the existence of a global allocation formula without demonstrating the nature of the services and the basis upon which an independent enterprise would have agreed to bear the corresponding costs. The absence of an actual payment or inter-office charge was also regarded as relevant, since the TPO considered that the expenditure had not been shown to constitute a liability of the Indian branch. On these considerations, he determined the arm’s length price of the transaction at nil, and the Assessing Officer incorporated the corresponding adjustment of Rs. 1,48,07,863 in the assessment.

24. Before the learned CIT(A), the assessee reiterated that the expenditure was incurred centrally for the business of the banking enterprise and that section 44C specifically contemplated deduction of Head Office expenditure attributable to the Indian operations, notwithstanding that the expenditure was incurred outside India. It was submitted that the provision prescribed a ceiling upon deduction and that the absence of a debit in the Indian branch’s books or a separate invoice raised by the Head Office could not, by itself, establish that the expenditure was inadmissible. The learned CIT(A), however, did not accept the contention. He observed that the statutory ceiling under section 44C did not dispense with the requirement of establishing the nature and prima facie allowability of the expenditure claimed. According to him, the proposition advanced by the assessee might stand on a different footing where expenditure was actually allocated or charged by the Head Office and recognised as a liability of the Indian branch, but the present case involved expenditure which had neither been paid nor debited in the branch accounts and for which the supporting material was considered inadequate. The learned CIT(A) particularly noticed that the PwC certificate pertained to the year ended 31 December 2002 and that no corresponding allocation for the year ended 31 December 2001 had been furnished. He also referred to the TPO’s observations concerning philanthropic expenditure, aircraft expenses and certain finance and marketing costs included in the certified expenditure pool, whose nexus with the Indian operations had not been established. The learned CIT(A) distinguished the decision of the Hon’ble Bombay High Court in Commissioner of Income-tax v. Emirates Commercial Bank Ltd. [2003] 262 ITR 55  (Bombay), observing that the expenditure in that case had been established as incurred specifically for the Indian branch and had been recovered through an appropriate debit note. He also considered the decisions relied upon by the assessee in Kedarnath Jute Mfg. Co. Ltd. v. Commissioner of Income-tax [1971] 82 ITR 363 (SC), and DIT (IT)-I, Mumbai v. American Express Bank Ltd.  (SC), but held that those authorities did not dispense with the requirement of establishing the liability and the factual nexus of the expenditure in the circumstances of the present case. He accordingly confirmed the TPO’s determination of the arm’s length price at nil and sustained the adjustment of Rs.1,48,07,863.

25. Ground No. 7 concerns expenditure of Rs.3,11,81,346 stated to have been incurred through regional and centralised processing hubs maintained by the assessee’s worldwide banking organisation. The assessee explained that, having regard to the nature and geographical spread of its banking operations, certain processing, technological and operational functions were centralised at regional facilities rather than duplicated at every branch. The principal facilities relevant to the present controversy were situated at Hong Kong and Bournemouth in the United Kingdom. The Hong Kong hub was stated to perform various operational functions, including wire-room operations involving telex and money-transfer facilities, processing and supervisory support for loan operations and processing of deposits, payments and remittances. The Bournemouth facility, on the other hand, was described as a global data-processing centre maintaining mainframe systems and centralised technological infrastructure utilised by different establishments of the banking enterprise. The services rendered through these facilities included processing and monitoring of moneymarket and foreign-exchange transactions, trade-finance operations, letters of credit, guarantees and other banking arrangements, besides maintaining systems for tracking credit exposures and providing operational information to the constituent branches. The assessee also referred to technological and operational support provided through regional systems, including money-transfer systems, branchteller and deposit systems, commercial-loan systems and customer-information facilities. According to the assessee, these were not services independently procured by the Mumbai branch from unrelated third parties, but functions performed through common facilities maintained within the same banking enterprise, whose costs were allocated amongst the establishments receiving or utilising the relevant services. The amount of Rs.3,11,81,346 was accordingly claimed as expenditure attributable to the Indian operations, although it had been incurred and accounted for through the overseas facilities and was not directly debited in the books of the Mumbai branch. Reliance was placed upon Article 7(3) of the India-USA DTAA, which expressly recognises deduction of expenditure incurred outside India for the purposes of the business of the permanent establishment, including expenditure incurred for the enterprise as a whole or that part thereof which includes the permanent establishment.

26. The TPO did not accept the aforesaid claim and determined the arm’s length price of the hub-expense transactions at nil. His principal objection was that the assessee had not produced adequate documentary evidence demonstrating the precise nature of the services rendered by the Hong Kong and Bournemouth facilities, the total expenditure incurred at those centres and the basis upon which the expenditure had been allocated to the Indian branch. He specifically noticed that the assessee had not furnished the relevant agreements or arrangements under which the Indian branch participated in the centralised processing facilities, particulars of the other participating branches or establishments, the aggregate costs incurred at the respective centres and the allocation keys employed for distributing those costs amongst the beneficiary locations. He further observed that no invoices or debit notes evidencing the charges had been furnished and that the Indian branch had not made actual payments towards the expenditure claimed. According to him, the absence of payment or a corresponding liability, coupled with inadequacy of supporting documentation, raised a question whether the expenditure had actually been accepted or incurred by the Indian branch for its business. The TPO also considered that the assessee had not demonstrated the nature and extent of benefits received by the Indian operations or furnished sufficient evidence to establish that an independent enterprise would have borne a comparable charge for the services claimed. The explanation concerning the centralised nature of the facilities and the practical difficulty of obtaining individual invoices for each service was not regarded as sufficient to establish the arm’s length character of the expenditure. Accordingly, the TPO concluded that the assessee had failed to substantiate the actual rendition of services, the expenditure incurred through the overseas processing facilities and the basis upon which such expenditure was attributable to the Indian branch. He was of the view that, in the absence of adequate supporting material establishing the nature of the services, their utilisation by the Indian operations and the reasonableness of the allocation, the expenditure claimed could not be accepted as representing an arm’s length charge for each service was not regarded as sufficient to establish that the expenditure represented an arm’s length charge. Accordingly, the TPO concluded that the assessee had failed to substantiate the actual rendition of services, the expenditure incurred through the overseas processing facilities and the basis upon which such expenditure was attributable to the Indian branch. He was of the view that, in the absence of adequate supporting material establishing the nature of the services, their utilisation by the Indian operations and the reasonableness of the allocation, the expenditure claimed could not be accepted as representing an arm’s length charge. He therefore determined the arm’s length price of the hub expenditure at nil. The Assessing Officer, while completing the assessment, adopted the determination made by the TPO and made the corresponding adjustment of Rs.3,11,81,346. Thus, the disallowance proceeded principally upon the alleged inadequacy of documentary evidence concerning the underlying services and expenditure, the absence of actual payment or recognition of a corresponding liability in the Indian branch’s accounts, and the failure to establish the allocation methodology and the economic benefit derived by the Indian operations.

27. The learned CIT(A), while examining the aforesaid adjustment relating to hub expenditure, noticed that similar claims had arisen in the earlier assessment years and that the first appellate authority had decided the issue against the assessee for assessment year 2001-02, following the view taken for assessment year 2000-01. In those proceedings, the expenditure claimed under section 37(1) had not been accepted principally on the ground that the assessee had failed to establish that the amounts allocated by the overseas processing facilities were actually incurred wholly and exclusively for the purposes of its business in India. The learned CIT(A) observed that the deficiencies noticed in the earlier years continued to remain relevant for the year under consideration. In particular, he referred to the absence of agreements governing the participation of the Indian branch in the Hong Kong and Bournemouth processing facilities, the lack of complete particulars concerning the other participating establishments, the aggregate expenditure incurred at the respective hubs and the allocation keys employed for distributing the costs amongst different branches. He also took note of the TPO’s finding that the assessee had neither made actual payments towards the expenditure claimed nor furnished adequate documentary evidence demonstrating the precise nature and extent of the services received by the Indian branch. The learned CIT(A) was of the view that the mere existence of centralised processing facilities within the worldwide banking organisation did not establish that the amount allocated to the Indian branch represented expenditure incurred for its business or that the allocation satisfied the arm’s length standard. He accordingly upheld the determination of the arm’s length price at nil and sustained the adjustment of Rs.3,11,81,346. At the same time, following his findings concerning correspondent banking and cheque-processing services, he reiterated that expenditure relating to Head Office and hub functions, whose arm’s length price had separately been determined at nil and which had consequently been disallowed, could not again be included in the operating cost base of the service transactions so as to result in duplication. The assessee has challenged the confirmation of the aforesaid adjustment, placing reliance upon the regulatory approvals granted by the Reserve Bank of India, the arrangements governing the centralised processing facilities and the orders of the Tribunal in its own case concerning similar expenditure incurred in earlier assessment years.

28. We shall now take up Ground No. 8, which raises a substantive question concerning the taxability of Rs.85,24,546 under Article 7(3) of the India-USA DTAA. As noticed briefly in paragraph 7, the assessee, while rendering correspondent banking and investor services to its Head Office and other overseas branches, had recorded revenues exceeding the corresponding expenditure incurred by the Mumbai branch. The excess amounted to Rs.36,60,303 in respect of correspondent banking services and Rs.48,64,243 in respect of investor services, aggregating to Rs.85,24,546. Although these amounts formed part of the revenues recorded in the books of the Indian branch, the assessee excluded the excess over expenditure while computing its taxable income on the premise that Article 7(3) specifically prohibited recognition of amounts charged by a permanent establishment to its Head Office or other offices of the same enterprise, otherwise than towards reimbursement of actual expenses, by way of commission or other charges for specific services performed or for management. According to the assessee, the Indian branch and its overseas offices constituted different establishments of the same juridical banking enterprise and, therefore, the profit element arising from such intraenterprise dealings could not be treated in the same manner as income earned from an independent third party. During the transfer-pricing proceedings, the TPO noticed this treatment and, while examining the transactions involving correspondent banking and investor services, observed that the claim for exclusion of Rs.85,24,546 required examination in the light of Article 7(3). He also referred to the OECD Commentary concerning attribution of profits to a permanent establishment and the circumstances in which services performed by one establishment for another might appropriately carry an arm’s length remuneration. However, the TPO did not make a separate adjustment of Rs.85,24,546 under section 92CA(3), but suggested that the Assessing Officer should examine the claim with reference to the relevant treaty provisions. It was pursuant to this observation that the Assessing Officer independently considered the taxability of the aforesaid amount in the course of assessment proceedings.

29. The Assessing Officer, while examining the claim, referred to the notes accompanying the computation of income and observed that the assessee had admittedly recorded revenues exceeding the expenditure incurred in rendering correspondent banking and investor services to the overseas offices. In respect of correspondent banking services, the revenue was Rs.4,02,63,333 against expenditure of Rs.3,66,03,030, whereas in respect of investor services, the revenue was Rs.5,35,06,676 against expenditure of Rs. 4,86,42,433, resulting in an aggregate excess of Rs. 85,24,546 which had not been offered to tax. In response to the specific query raised during assessment proceedings, the assessee furnished its explanation vide letter dated 3 March 2005, contending that the latter portion of Article 7(3) expressly provided that no account should be taken of amounts charged by a permanent establishment to its Head Office or other offices for specified services, otherwise than towards reimbursement of actual expenses. The Assessing Officer, however, did not accept this interpretation. According to him, the assessee was admittedly carrying on banking business in India through a permanent establishment, and the transactions in question were ordinary business transactions undertaken in the course of its banking activities. Once the Indian branch had rendered services, recorded corresponding revenues and incurred expenditure for earning such revenues, the resultant excess constituted business profits arising from the activities of the permanent establishment and was required to be considered while computing its taxable income. The Assessing Officer also referred to Article 7(6), which preserves the operation of other Articles of the Convention dealing separately with particular categories of income, and Article 7(7), which defines business profits to include income derived from trade or business, including income from furnishing services other than included services as defined in Article 12. Relying upon these provisions, he reasoned that the amounts in question represented profits earned from services rendered in the ordinary course of banking business and could not be excluded merely because the corresponding services were rendered to other offices of the same enterprise. He accordingly rejected the assessee’s interpretation of Article 7(3) and added Rs. 85,24,546 to the taxable income as business profits attributable to the Indian permanent establishment.

30. Before the learned CIT(A), the assessee challenged the aforesaid addition, contending that the Assessing Officer had failed to give effect to the express language of Article 7(3), particularly its reciprocal provision dealing with amounts charged by a permanent establishment to its Head Office or other offices of the same enterprise. It was submitted that Article 7(2), which embodies the distinct-and-independent-enterprise hypothesis for attribution of profits, expressly operates subject to paragraph 3 and, therefore, the general arm’s length principle contained in paragraph 2 could not override the specific treatment prescribed in paragraph 3 for identified categories of intra-enterprise dealings. The assessee also questioned the observations made by the TPO concerning the interpretation of Article 7(3), contending that his statutory function under section 92CA was confined to determination of the arm’s length price and did not extend to deciding the ultimate treaty character of the amount sought to be taxed. It was further submitted that the OECD Commentary, though relevant as an interpretative aid, could not be employed to defeat the specific language of the treaty negotiated between India and the United States. Reliance was also placed upon section 90(2), with the submission that the more beneficial treaty provisions were required to be given effect in determining the assessee’s tax liability. The learned CIT(A), however, did not accept these contentions. He first observed that the TPO had merely suggested examination of the claim under Article 7(3) and that the Assessing Officer was competent to consider those observations while independently deciding the taxability of the amount. The learned CIT(A) thereafter examined Article 7(2) and Article 7(3) in the light of the OECD Model Tax Convention Commentary, particularly paragraph 17 of the Commentary contained in the January 2003 condensed version. He noticed that the Commentary itself recognised the need to reconcile the distinct-and-independent-enterprise principle under paragraph 2, which ordinarily contemplated arm’s length attribution of profits, with paragraph 3, which permitted deduction of expenditure incurred for the purposes of the permanent establishment and contemplated particular treatment of dealings between different establishments of the same enterprise. Referring further to the Commentary concerning services rendered by one part of an enterprise for another, he observed that a distinction was required between functions forming part of the general management or common activities of an enterprise and services which conferred a real and identifiable economic advantage upon the recipient establishment and constituted a significant part of the activities of the establishment rendering them. According to the learned CIT(A), correspondent banking, investor services and chequeprocessing activities were substantive business functions performed by the Indian branch, which conferred an identifiable commercial advantage upon the overseas offices. He therefore considered that the profits arising from correspondent banking and investor services could not be excluded under the reciprocal provision of Article 7(3) and were required to be recognised in accordance with the arm’s length principle embodied in Article 7(2).

31. The learned CIT(A) further proceeded on the reasoning that Article 7(2) and Article 7(3) had to be construed harmoniously so that neither provision was rendered ineffective. According to him, Article 7(2) specifically contemplated attribution of profits to a permanent establishment on the hypothesis that it was a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm’s length with the enterprise of which it formed part. He observed that the interpretation advanced by the assessee, if accepted in its entirety, would effectively prevent application of the arm’s length principle to services rendered by the Indian permanent establishment to its overseas offices, notwithstanding that such services constituted substantive business activities capable of generating identifiable profits. In support of the principle of harmonious treaty interpretation, the learned CIT(A) referred to the decision of the Mumbai Bench of the Tribunal in Hindalco Industries Ltd. v. Assistant Commissioner of Income-tax [2005] 278 ITR (AT) 125 (Mum), wherein it was observed that treaty provisions must be construed as a whole and in a manner which gives effect to their respective objects without rendering any provision redundant. Applying this principle, the learned CIT(A) held that the reciprocal provision contained in the latter portion of Article 7(3), commencing with the expression “Likewise”, could not be interpreted independently of the immediately preceding provision dealing with amounts paid by the permanent establishment to its Head Office or other offices. He proceeded on the premise that the latter provision concerning amounts charged by the permanent establishment could become operative only where the preceding provision concerning disallowance of specified payments by the permanent establishment had first been attracted. Since the present case did not involve any disallowance under the preceding limb, he considered that the assessee could not invoke the reciprocal clause for excluding the profit element arising from correspondent banking and investor services. The learned CIT(A) accordingly concluded that the excess of Rs. 85,24,546 represented business profits attributable to the Indian permanent establishment and confirmed its inclusion in the taxable income. Thus, the principal question arising from this ground is not whether the Indian branch performed services capable of generating business profits, which is not seriously disputed, but whether the reciprocal language of Article 7(3), read with the express qualification contained in Article 7(2), permits exclusion of the excess of inter-office revenues over the corresponding expenditure notwithstanding that such revenues were recorded in the accounts. The correctness of the learned CIT(A)’s distinction between general enterprise functions and substantive services, his reliance upon the OECD Commentary and, in particular, his interpretation that the reciprocal clause concerning amounts charged by the permanent establishment becomes operative only where the preceding clause concerning payments by the permanent establishment is attracted, shall be examined in the light of the treaty language and the relevant principles governing attribution of profits to a permanent establishment.

32. We have heard the rival submissions and perused the material placed on record, including the assessment order, the order passed by the TPO, the findings recorded by the learned CIT(A), the transfer-pricing documentation and the written submissions filed by the assessee. Shri Perci Pardiwala, learned Senior Counsel appearing for the assessee, initially addressed Ground No. 1 concerning disallowance of salary expenditure of Rs. 99,89,796 pertaining to Mr. Dominic Price. He submitted that the authorities below had proceeded on an erroneous understanding of the character of the expenditure by treating the place from which the salary was disbursed and its non-recording in the books of the Indian branch as decisive of its deductibility. It was pointed out that consequent upon the merger of Morgan Guaranty Trust Company of New York with J.P. Morgan Chase Bank N.A. on 10 November 2001, Mr. Dominic Price assumed the responsibilities of Chief Executive Officer of the Indian branch and was exclusively engaged in managing its operations during the period November 2001 to March 2002. Prior to the merger, the position was held by Mr. Mahesh Aras, an Indian executive, and therefore the objection of the learned CIT(A) concerning the absence of salary particulars of Mr. Price for the earlier part of the financial year proceeded without appreciating the change in management consequent upon the merger. The learned Senior Counsel drew our attention to the audited financial statements of the Indian branch bearing the signature of Mr. Price in his capacity as Chief Executive Officer, Form No. 16 evidencing the salary received by him, the approval granted by the Reserve Bank of India on 24 January 2002 for his appointment and the declaration furnished during the appellate proceedings confirming that he was exclusively managing the Indian banking operations. It was further pointed out that the remuneration received by Mr. Price had been offered to tax in India and that the fact that the Head Office had discharged the salary directly outside India could not alter the character of expenditure incurred for the purposes of the Indian business. The learned Senior Counsel submitted that section 44C had no application to such expenditure because clause (iv)(b) of the Explanation thereto contemplated salary and related expenditure pertaining to employees employed in or managing the affairs of an office outside India, whereas Mr. Price was managing the affairs of the Indian branch. Reliance was placed upon the decision of the Hon’ble Supreme Court in American Express Bank Ltd. (supra), the decisions of the Hon’ble Bombay High Court in Emirates Commercial Bank Ltd. (supra), and American Express Bank Ltd. (supra), besides the orders of the Tribunal in the assessee’s own case for earlier assessment years and the decision in Inspecting Asstt. Commissioner (supra). It was accordingly submitted that the remuneration was directly attributable to the Indian banking operations and allowable under section 37(1), without attracting the restriction applicable to Head Office expenditure under section 44C.

33. Coming to the transfer-pricing grounds, the learned Senior Counsel submitted that the principal controversy should first be examined in the light of Ground No. 8 concerning exclusion of Rs.85,24,546 under Article 7(3) of the India-USA DTAA, since the determination of arm’s length remuneration for services rendered by the Indian branch to its overseas offices necessarily involved the anterior question whether the profit element arising from such intra-enterprise dealings was liable to be recognised in computing the taxable profits of the Indian permanent establishment. He clarified that the amount of Rs. 85,24,546 was not an additional or hypothetical mark-up independently computed by the TPO, but represented the excess of revenues actually recorded by the Indian branch over the corresponding expenditure incurred in rendering correspondent banking and investor services. The assessee had recorded revenue of Rs.4,02,63,333 against expenditure of Rs. 3,66,03,030 in respect of correspondent banking services and revenue of Rs. 5,35,06,676 against expenditure of Rs.4,86,42,433 in respect of investor services. The resultant excess of Rs. 36,60,303 and Rs. 48,64,243 respectively had been excluded while computing taxable income on the premise that the amounts represented charges raised by the Indian branch upon other offices of the same banking enterprise for specified services performed. Elaborating the scheme of Article 7, the learned Senior Counsel submitted that Article 7(1) undoubtedly recognised India’s right to tax the profits attributable to the Indian permanent establishment, while Article 7(2) prescribed the distinct-and-independent-enterprise hypothesis for determining such profits. However, paragraph 2 expressly commenced with the words “Subject to the provisions of paragraph 3”, which, according to him, made the general arm’s length attribution principle subordinate to the specific prescriptions contained in Article 7(3). He submitted that the first limb of paragraph 3 permitted deduction of expenditure incurred for the purposes of the permanent establishment, including reasonable allocation of enterprise-level expenditure incurred elsewhere; the second limb restricted deduction of specified amounts paid by the permanent establishment to the Head Office or other offices, otherwise than towards reimbursement of actual expenses; and the third limb reciprocally provided that no account should be taken of specified amounts charged by the permanent establishment to the Head Office or other offices, otherwise than towards reimbursement of actual expenses. The latter provision, according to him, operated upon the credit side of the computation and specifically governed the amounts sought to be brought to tax in the present case. The learned Senior Counsel further submitted that the exception concerning interest in the case of a banking enterprise was confined to interest on monies lent between different offices and did not extend to commission or other charges for specified services. In fact, the assessee had separately offered to tax net interest income of Rs. 40,38,331 arising from offshore placements with overseas branches, recognising the operation of the banking exception. It was therefore urged that the specific reciprocal provision concerning service charges could not be rendered ineffective merely by invoking the general arm’s length principle contained in Article 7(2).

34. In support of the aforesaid interpretation, the learned Senior Counsel placed considerable reliance upon the historical OECD and UN Commentaries on Article 7, particularly the discussion concerning reconciliation of the distinct-enterprise hypothesis with the treatment of expenditure and dealings between different establishments of the same enterprise. Referring to paragraph 17 and the related discussion in paragraphs 17.5 to 17.7 of the OECD Commentary, as considered in the UN Model Commentary, he submitted that a distinction had historically been recognised between functions forming part of the general activities of an enterprise and services constituting a distinct commercial activity capable of being rendered to outside customers. In the former category, the appropriate treatment ordinarily involved allocation or reimbursement of actual expenditure without an independent profit element, whereas a profit-bearing internal charge might be contemplated where the enterprise carried on a specialised service activity, offered comparable services to outside customers or performed functions constituting a significant and independently identifiable part of its business. The learned Senior Counsel pointed out that the assessee’s principal business in India was wholesale banking, involving loans, overdrafts, guarantees, custodial services and other banking products, whereas the correspondent banking functions performed for overseas offices were essentially marketing, customer-interface and relationship-management activities. Similarly, cheque processing and investor services comprised operational and support functions and did not constitute an independent specialised service business of the nature contemplated in the Commentary. The expenditure attributable to these services also constituted only a limited portion of the overall expenditure of the Indian branch. Reliance was placed upon the commentary of Klaus Vogel concerning the circumstances in which an internal service could legitimately carry a profit element. It was further submitted that the Revenue’s interpretation would render the express reciprocal language of Article 7(3) redundant, notwithstanding that Article 7(2) itself was made subject thereto. In support of the proposition that the more beneficial treaty provisions must receive effect, reliance was placed upon section 90(2), CBDT Circular No. 333 dated 2 April 1982 and the decisions of the Hon’ble Supreme Court in Union of India v. Azadi Bachao Andolan [2003] 184 CTR 450/263 ITR 706  (Mumbai – Trib.)/ITA No. 3530/Mum/2009, dated 22 December 2023, submitting that the controversy in that case had arisen in the context of a transfer-pricing adjustment and that the precise question concerning exclusion of a profit element already recorded in the accounts under the reciprocal limb of Article 7(3) had not arisen in the same factual setting. As regards Article 9 of the treaty, it was submitted that the said Article governed associated enterprises constituted by distinct juridical persons and could not displace the specific treatment of dealings between different establishments of the same enterprise under Article 7. The learned Senior Counsel accordingly submitted that if Ground No. 8 was accepted, the related transfer-pricing adjustments under Grounds 2 to 4 would necessarily require consideration in that light, though the assessee had also raised independent objections to the benchmarking of each service segment.

35. In relation to correspondent banking services, the learned Senior Counsel submitted that the TPO and the learned CIT(A) had not adequately appreciated the limited functional profile of the Indian branch and the material differences between the activities performed by it and those undertaken by the companies retained in the comparable set. The functions of the Indian branch were confined principally to identifying potential Indian banking customers, marketing products offered by overseas branches, maintaining customer relationships, coordinating with overseas offices and attending to enquiries concerning foreign-currency accounts and other banking arrangements. The Indian branch did not undertake the substantive overseas banking transactions or assume the financial and entrepreneurial risks ordinarily associated with such transactions. Particular objection was raised to Pioneer Investcorp Ltd., Centrum Finance Ltd. and Integrated Enterprises (India) Ltd., which had originally been selected in the transfer-pricing study but whose exclusion was subsequently sought by way of an additional ground filed on 22 July 2022, supported by annual reports and other functional material. In the case of Pioneer Investcorp Ltd., it was pointed out that the company was registered as a Category I merchant banker and was engaged in merchant banking and underwriting activities, deriving income from management fees and underwriting commission, without furnishing reliable separate segmental results corresponding to activities comparable with those of the assessee. Reliance was placed upon Deputy Director of Income-tax (International Taxation) v. Commerzbank A. G.  (Mumbai – Trib.), wherein Pioneer Investcorp Ltd. had been found functionally incomparable in the context of correspondent banking services. As regards Centrum Finance Ltd., it was submitted that the company was engaged in diversified financial-services activities comprising merchant banking, investment banking, corporate finance, leasing, hire-purchase and syndication, involving functions and risks materially different from the marketing and relationship-management activities undertaken by the Indian branch. The company reported only one business segment and followed an accounting year from July to June, which also raised an objection concerning the availability of corresponding financial-year data. Reliance was placed upon the decisions in Carlyle India Advisors (P.) Ltd., Principal Global Services Pvt. Ltd. and PTC Software (I) Pvt. Ltd. concerning functional comparability and differences in accounting periods. In the case of Integrated Enterprises (India) Ltd., the learned Senior Counsel pointed out that substantial income arose from depository-participant activities, share-transfer and registry services, securities broking and other capital-market-related activities. It was further submitted that in the assessee’s own case for assessment year 2005-06, the learned CIT(A) had considered this company functionally incomparable with correspondent banking services. The learned Senior Counsel therefore urged that the aforesaid three companies should be excluded from the final comparable set and that, upon their exclusion, the operating margin earned by the assessee would satisfy the arm’s length standard without any adjustment.

36. Without prejudice to the aforesaid objections concerning comparable companies, the learned Senior Counsel challenged the inclusion of corporate, Head Office and hub expenditure in the operating cost base of correspondent banking, cheque-processing and investor services. He submitted that the TPO had proceeded upon an erroneous premise that every expenditure incurred by the Indian branch or allocated to it from the worldwide banking organisation necessarily constituted an operating cost of the particular services rendered to overseas offices. According to him, corporate expenditure aggregating to Rs. 1,66,75,944 comprised several exceptional and entity-level items which did not bear any direct relationship with the ordinary functions constituting the tested transactions. The severance expenditure of Rs.86,83,501 arose from restructuring and rationalisation of personnel consequent upon the merger; rental expenditure of Rs.31,81,633 related to the Vakil House premises after their vacation; and expenditure of Rs. 20,40,751 was incurred in shifting equipment from those premises to the Mafatlal Centre. These expenses, it was submitted, arose from the restructuring and integration of the banking operations and were not incurred in the ordinary course of rendering correspondent banking, cheque-processing or investor services to the overseas offices. Similarly, retainership fees of Rs. 26,80,000 paid to the public-relations firm were incurred for maintaining the corporate image and supporting the local banking operations, while directors ‘fees of Rs.90,059 represented expenditure incurred at the entity level. Neither category, according to the learned Senior Counsel, had an identifiable functional nexus with the international transactions under examination. He further submitted that Head Office expenditure represented executive and general administrative expenditure incurred for the worldwide banking enterprise, whereas hub expenditure related to centralised operational, technological and infrastructure facilities supporting the banking operations generally. Merely because such expenditure might be attributable to the Indian branch for purposes of computing its overall business profits did not necessarily establish that it constituted an operating cost of services rendered by the Indian branch to its overseas offices. Particular objection was raised to the adoption of employee cost as a common allocation key without examining whether the nature of each expenditure justified allocation on that basis or whether the expenditure had any direct or reasonably ascertainable relationship with the functions being benchmarked. The learned Senior Counsel emphasised that the Indian branch was itself rendering correspondent banking services to overseas offices and, therefore, expenditure incurred by the Head Office for its general management could not automatically be treated as expenditure incurred by the Indian branch for rendering those services. Similar objections were raised concerning hub expenditure, which supported the overall banking operations rather than the particular international transactions under examination. It was also pointed out that certain indirect expenditure had already been allocated to correspondent banking services and was again included in the cost base of cheque-processing services, resulting in duplication, a defect which had partly been recognised by the learned CIT(A). It was accordingly urged that the operating cost base should be confined to expenditure bearing a demonstrable functional nexus with the respective services and that exceptional, unrelated or duplicated expenditure should be excluded before applying the arm’s length margin.

37. Insofar as Ground No. 3 concerning cheque-processing services is concerned, the learned Senior Counsel submitted that the TPO had substantially altered the benchmarking analysis without adequately appreciating the functional characteristics of the services rendered and the principles governing selection of comparable companies. The Indian branch was engaged in routine processing of foreign-currency cheques, involving scanning and microfilming of instruments, recording relevant particulars, transmitting electronic information to overseas branches, sorting and forwarding instruments for clearing and attending to related customer enquiries. These activities were essentially informationtechnology-enabled processing and support functions involving limited operational risks and were not comparable with activities requiring assumption of substantial financial or entrepreneurial risks. The assessee had selected four companies, namely, Ace Software Exports Ltd., Apex Logical Data Conversion Ltd., Giltedge Infotech Services Ltd. and Nucleus Netsoft & GIS India Ltd., and had determined an arithmetic mean operating margin of 14.36% against its own operating margin of 14.71%. The TPO, however, excluded Nucleus Netsoft & GIS India Ltd., rejected the depreciation adjustment and adopted an arithmetic mean of 26.10% for the remaining three companies. The learned Senior Counsel submitted that Nucleus Netsoft & GIS India Ltd. had been identified through the database search and its exclusion merely because it appeared under a different database classification was not justified without examining the actual functions performed by the company. He further contended that differences in depreciation policies and methods adopted by the tested party and the comparable companies, including the straight-line and written-down-value methods, could materially distort the operating margins and that an appropriate adjustment was necessary wherever such differences could reasonably be quantified. The learned Senior Counsel also questioned the manner in which financial data had been adopted by the TPO, particularly when relevant-year information was available only for one of the retained companies and the margins of the remaining companies were derived from preceding-year data. According to him, the benchmarking exercise had to be undertaken upon reliable and consistent financial information, and the exclusion of a company or rejection of a comparability adjustment could not rest merely upon database classification or general observations unsupported by the actual functional and financial material. It was accordingly submitted that the exclusion of Nucleus Netsoft & GIS India Ltd., rejection of depreciation adjustment and adoption of the margin of 26.10% were not justified on the material available on record.

38. The learned Senior Counsel further submitted that, independently of the dispute concerning the comparable margin, the TPO had substantially enlarged the operating cost base of cheque-processing services by allocating additional indirect expenditure and proportionate corporate, Head Office and hub expenditure. Correspondent banking and cheque processing services were undertaken within the treasury business of the Indian branch, and certain common indirect expenditure had initially been included in the cost base of correspondent banking services because the remuneration for both activities was determined under a common billing arrangement. While examining the segmental working, the TPO considered that a portion of such expenditure should also be attributed to cheque processing and accordingly redistributed the common costs. The assessee’s objection, however, was that the expenditure so allocated to cheque processing was not correspondingly reduced from the operating cost of correspondent banking services, resulting in the same expenditure entering the cost base of both transactions. The learned Senior Counsel referred to the indirect-cost allocation of Rs. 26,24,081 discussed in the transfer-pricing working and the additional indirect cost of Rs. 22,05,447 reflected in the final computation, submitting that the figures required reconciliation so that no expenditure was duplicated. He pointed out that the learned CIT(A) had himself recognised this defect and directed consequential reduction of the expenditure already allocated to correspondent banking services, but the same principle had not been adequately applied to the allocation of corporate, Head Office and hub expenditure. Coming to Ground No. 4 concerning investor services, it was submitted that the Indian branch performed trade-settlement support activities, securities and cash reconciliation, processing of transaction-related information and other customer-support functions, which were essentially operational in character and involved limited risks. The assessee had earned an operating margin of 12.08% against the arithmetic mean of 14.36% determined in its transfer-pricing study, whereas the TPO applied the revised margin of 26.10% and further increased the operating cost base by allocating additional expenditure of Rs. 99,07,360. According to the learned Senior Counsel, the learned CIT(A) had disposed of the investor-services adjustment substantially by following his findings concerning chequeprocessing services, without independently examining whether the functions performed and the expenditure attributable to investor services justified precisely the same treatment. It was emphasised that although certain operational similarities existed between the two service segments, the functions actually performed, the nature of expenditure incurred and the corresponding allocation of costs required examination with reference to each transaction. The objections concerning selection of comparables, depreciation adjustment, financial-year data, allocation of corporate and indirect expenditure and duplication of costs were therefore equally relevant to investor services. However, the final benchmarking exercise had to reflect the particular functional profile and operating cost of that segment rather than mechanically adopting the results determined for cheque-processing services. The learned Senior Counsel accordingly submitted that the transfer pricing adjustment sustained by the learned CIT(A) could not be upheld without examining the functional comparability of the selected companies and the correctness of the operating cost base, and that the adjustment should either be deleted or recomputed after excluding expenditure which did not bear the requisite nexus with the investor-services activities.

39. Coming to Ground No. 6 concerning Head Office expenditure of Rs. 1,48,07,863, the learned Senior Counsel submitted that the authorities below had fundamentally misconstrued the scope of the TPO’s jurisdiction by treating the determination of the arm’s length price as an occasion to adjudicate upon the commercial necessity, business expediency and ultimate deductibility of the expenditure. He submitted that section 92CA empowered the TPO to determine the arm’s length price of an international transaction in accordance with the methods prescribed under section 92C, whereas the question whether an expenditure was deductible under the ordinary computation provisions of the Act was a distinct enquiry falling within the jurisdiction of the Assessing Officer. According to him, the TPO had not demonstrated, by applying any of the prescribed methods, that the arm’s length value of the centrally incurred expenditure was nil, but had proceeded principally upon the absence of individual invoices or debit notes, non-recording of expenditure in the books of the Indian branch, alleged deficiencies in the supporting documentation and his own perception of the commercial benefit which the Indian operations ought to have derived. These considerations, it was submitted, could not justify determination of the entire arm’s length price at nil without undertaking the statutory enquiry contemplated under Chapter X. Reliance was placed upon the decisions in Dresser-Rand India (P.) Ltd. v. Addl. CIT, Range – 6(2), Mumbai 141 TTJ 385/[2012] 13 ITR(T) 422/53 SOT 173 (Mumbai),CIT-1, Mumbai v. Lever India Exports Ltd. 297 CTR 480 (Bombay), wherein the distinction between determining an arm’s length price in accordance with the prescribed methods and questioning the commercial wisdom or necessity of incurring expenditure had been considered. Elaborating the nature of the expenditure, the learned Senior Counsel submitted that the Head Office performed executive, managerial, administrative, financial-control, risk management, legal, compliance and other centralised functions for the worldwide banking enterprise, including the Indian branch. The expenditure incurred in relation to such functions was accumulated in a common corporate overhead pool and allocated amongst different establishments under a consistently followed methodology, whereby the relevant expenditure was identified, an appropriate portion was attributed to the parent establishment and the balance was distributed amongst the branches having regard to their relative revenues. The certificate issued by PricewaterhouseCoopers LLP, describing the expenditure pool and the allocation methodology, was relied upon as independent evidence supporting the claim. It was further submitted that section 44C itself recognised the admissibility of Head Office expenditure incurred outside India for the purposes of the Indian business, subject to the statutory limitation, and that neither the absence of a separate debit in the books of the Indian branch nor the absence of physical remittance to the Head Office could, by itself, establish that the expenditure was not incurred for the Indian operations. Reliance was placed upon Emirates Commercial Bank Ltd. (supra), Doha Bank QSC v. Deputy Commissioner of Income Tax, (International taxation) 2(2)(2), Mumbai 187 ITD 125 (Mumbai – Trib.) and CBDT Circular No. 202 dated 5 July 1976, explaining the legislative object underlying section 44C. The learned Senior Counsel accordingly submitted that the expenditure could not be rejected in its entirety merely because it was incurred centrally and allocated to the Indian branch rather than separately billed to it.

40. The learned Senior Counsel also addressed the objections raised by the TPO concerning the sufficiency of the supporting documents and the period covered by the PwC certificate. It was submitted that the transfer-pricing provisions contained in Chapter X had become applicable with effect from assessment year 2002-03 and that the documentation requirements under Rule 10D had been notified during the relevant previous year. In this context, reliance was placed upon CBDT Circular No. 12/2001 dated 23 August 2001, which recognised the practical difficulties faced by taxpayers during the initial implementation of the transfer-pricing regime and clarified the circumstances in which adverse action under section 92C(3) should not be taken merely on account of non-maintenance of prescribed documentation in respect of transactions entered into during the initial period. According to the learned Senior Counsel, this clarification was relevant while appreciating the adverse inference drawn by the TPO substantially on account of the absence of detailed contemporaneous documentation. He further submitted that an independent professional certificate identifying the expenditure pool and explaining the allocation methodology constituted relevant evidence which could not be rejected merely because every constituent expenditure was not supported by a separate invoice addressed to the Indian branch. Reliance was placed upon the decisions in Jabil Circuit India Pvt. Ltd. and CLSA India Pvt. Ltd., wherein the evidentiary relevance of professional certifications and costallocation workings had been considered in the context of intra-group services and transfer-pricing adjustments. It was emphasised that expenditure incurred for enterprise-level management, supervision, compliance and administrative functions did not necessarily produce an immediate or separately quantifiable increase in revenue, and the arm’s length principle did not require every expenditure incurred for the business to yield an independently measurable commercial benefit. Without prejudice to the principal claim of Rs. 1,48,07,863, the assessee had also furnished alternative computations demonstrating that the entire expenditure could not, in any event, be assigned a value of nil. The first alternative was based upon extrapolation of the Head Office expenditure attributable to assessment year 2003-04 by applying the ratio of revenues pertaining to the respective assessment years, whereas the second alternative was based upon the expenditure supported by the available PwC certificate for the period January to March 2002, which, according to the assessee, established at least a proportionate allocation of Rs. 23,05,957. The learned Senior Counsel submitted that these alternative computations were advanced without prejudice to the primary claim and required independent consideration even if the entire amount was not accepted. It was therefore urged that the determination of the arm’s length price at nil was unsustainable and that the expenditure should either be allowed as claimed or, alternatively, the amount reasonably attributable to the Indian operations should be determined upon the basis of the available evidence, subject to the provisions of section 44C and Article 7(3) of the India-USA DTAA.

41. In relation to Ground No. 7 concerning hub expenditure of Rs. 3,11,81,346, the learned Senior Counsel submitted that the authorities below had failed to appreciate the manner in which the operations of a multinational banking enterprise were organised, particularly the centralisation of processing, technological and control functions at regional facilities rather than their duplication at every branch. The Hong Kong and Bournemouth facilities performed identifiable functions relating to money-transfer operations, loan processing, deposits and payments, foreign-exchange transaction systems, money-market processing, trade-finance systems, monitoring of credit exposures, technological infrastructure and other operational support activities. These facilities, according to him, were utilised by the Indian branch in carrying on its banking business, and the expenditure allocated to it represented a proportionate share of actual costs incurred through the centralised establishments. Particular reliance was placed upon the approvals granted by the Reserve Bank of India permitting offshore processing of banking data relating to the Indian operations at the Hong Kong processing centre, subject to the applicable regulatory safeguards. It was submitted that these approvals constituted contemporaneous evidence demonstrating that the centralised processing arrangements were genuine and formed part of the recognised operational framework of the banking enterprise, rather than arrangements subsequently devised for tax purposes. The learned Senior Counsel also referred to the agreement governing the services rendered through the overseas facilities, which, according to the assessee, identified the nature of the services, the respective responsibilities and the basis of allocation of expenditure amongst participating establishments. It was further submitted that the centralised hub arrangements continued during the year under consideration without any material change in the nature of services, the operational framework or the manner in which expenditure was allocated to the Indian branch. In this connection, reliance was placed upon the Tribunal’s order in the assessee’s own case for assessment year 1999-2000, wherein substantially similar expenditure incurred through overseas processing facilities had been examined and accepted having regard to the nature of services rendered, the supporting arrangements and their nexus with the Indian banking operations. The learned Senior Counsel pointed out that neither the TPO nor the learned CIT(A) had brought any material on record demonstrating that the services were not actually rendered during the relevant previous year or that the centralised facilities had ceased to support the Indian operations. The absence of individual invoices, debit notes or physical remittances between establishments of the same banking enterprise could not, according to him, constitute sufficient reason for determining the arm’s length price at nil when the underlying services were rendered through common facilities and the expenditure was allocated amongst the participating branches. The regulatory approvals, the service agreement and the earlier-year adjudication, when considered cumulatively, were stated to provide adequate evidence of the existence and commercial character of the arrangements. It was further contended that the TPO had exceeded the legitimate scope of his enquiry by questioning the business necessity of availing the centralised services and the adequacy of the benefits derived therefrom, instead of determining the arm’s length price in accordance with the methods prescribed under section 92C. The expenditure, according to the learned Senior Counsel, was incurred for the purposes of the Indian banking operations and was deductible under section 37(1), read with Article 7(3), which expressly recognised expenditure incurred outside the State in which the permanent establishment was situated. He accordingly urged that the determination of the arm’s length price of Rs. 3,11,81,346 at nil be set aside and the expenditure be allowed in computing the profits attributable to the Indian permanent establishment, particularly when substantially similar expenditure arising from the same centralised arrangements had already been accepted by the Tribunal in an earlier assessment year.

42. Per contra, the learned DR strongly relied upon the reasoning adopted by the Assessing Officer/TPO and the findings recorded by the learned CIT(A), insofar as the additions and adjustments had been sustained. On the principal controversy concerning exclusion of Rs. 85,24,546 under Article 7(3) of the India-USA DTAA, the Revenue’s case was that the interpretation advanced by the assessee overlooked the distinct-and-independent-enterprise principle expressly embodied in Article 7(2). Once the Indian branch admittedly constituted a permanent establishment of the foreign banking enterprise, the profits attributable to the functions performed through that establishment were required to be determined upon the hypothesis that it was a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm’s length with the enterprise of which it formed part. The Indian branch had admittedly rendered correspondent banking and investor services to the overseas offices and recorded revenues exceeding the expenditure incurred in rendering such services. The excess of Rs. 85,24,546 was, therefore, not an amount artificially brought into existence by the TPO, but represented the profit element already reflected in the accounts of the Indian branch, which the assessee had excluded while computing its taxable income. According to the Revenue, the services in question constituted identifiable business activities undertaken by the Indian establishment and conferred a real economic advantage upon the overseas offices. The reciprocal provision contained in Article 7(3), therefore, could not be interpreted so broadly as to remove from taxation profits arising from substantive business functions performed by the permanent establishment. Particular reliance was placed upon the reasoning of the learned CIT(A), who had examined the OECD Commentary concerning reconciliation of Article 7(2) and Article 7(3) and the distinction between general administrative functions performed for the enterprise as a whole and specific services constituting a substantive part of the activities of the establishment rendering them. The learned CIT(A) had proceeded on the reasoning that the latter category of services was appropriately remunerated on an arm’s length basis and that the reciprocal provision concerning amounts charged by the permanent establishment to its Head Office or other offices could not be construed independently of the preceding provision governing specified payments made by the permanent establishment. The learned DR submitted that an interpretation which excluded the entire profit element arising from identifiable services rendered by the Indian branch would substantially defeat the operation of Article 7(2) and render the arm’s length principle ineffective in relation to dealings between different establishments of the same enterprise. Reliance was also placed upon the Assessing Officer’s reference to Article 7(6) and Article 7(7), particularly the definition of business profits encompassing income derived from trade or business, including income from furnishing services. It was accordingly contended that the excess of revenues over expenditure represented business profits attributable to the Indian permanent establishment and that the learned CIT(A) had correctly sustained its inclusion in the taxable income.

43. In relation to the transfer-pricing adjustments concerning correspondent banking, cheque-processing and investor services, the learned DR supported the determination undertaken by the TPO and the findings of the learned CIT(A) to the extent the benchmarking methodology and allocation of expenditure had been sustained. It was submitted that the assessee’s own transfer-pricing documentation recognised the services rendered to overseas offices as international transactions requiring determination of their arm’s length price under Chapter X and that the TPO was therefore entitled to examine the functions performed, assets employed, risks assumed, comparable companies, financial information and expenditure forming part of the operating cost base. In respect of correspondent banking services, the TPO had rejected Kinetic Trust Ltd. on account of the substantial difference in scale of operations and PNR Capital Services Ltd. because its activities during financial year 2001-02 had materially shifted towards investment-oriented business. The learned CIT(A) had upheld both exclusions after examining the relevant functional characteristics. As regards the remaining comparable companies, the Revenue relied upon the TPO’s determination of the arithmetic mean operating margin at 42.73% on the basis of financial data pertaining to financial year 2001-02. It was specifically contended, as also reflected in Ground No. 3 of the Revenue’s cross appeal, that Rule 10B(4) contemplated use of financial data relating to the year in which the international transaction had been entered into and that the learned CIT(A) was not justified in directing adoption of the average of arithmetic means derived from financial data pertaining to three different years merely because the margins disclosed substantial variation. In relation to cheque-processing and investor services, the Revenue supported the exclusion of Nucleus Netsoft & GIS India Ltd. on the ground that its specialised activities were not sufficiently comparable with the routine processing functions undertaken by the Indian branch. The rejection of the depreciation adjustment was also supported on the basis that the assessee had not established through reliable material the nature and extent of differences in depreciation policies or their actual effect upon the operating margins of the tested party and the comparable companies. Insofar as allocation of corporate and indirect expenditure was concerned, the learned DR submitted that expenditure incurred in connection with the business operations could not be excluded from the operating cost base merely because it arose in the context of restructuring, relocation or general administration. The TPO had adopted employee cost as an allocation key for distributing common expenditure amongst the service segments, and the learned CIT(A) had substantially accepted the treatment of corporate expenditure as operating in character. At the same time, the learned CIT(A) had granted consequential relief to eliminate duplication of indirect expenditure and to prevent Head Office and hub expenditure, whose arm’s length price had separately been determined at nil, from being simultaneously included in the operating cost base of the service transactions. The learned DR accordingly supported the transfer-pricing adjustments to the extent sustained by the learned CIT(A), while maintaining the Revenue’s independent objection concerning the direction to adopt three-year financial data.

44. As regards Head Office expenditure of Rs. 1,48,07,863 and hub expenditure of Rs.3,11,81,346, the learned DR relied upon the findings recorded by the TPO and the learned CIT(A) concerning inadequacy of supporting documentation, absence of corresponding debit notes or invoices and failure to establish satisfactorily the expenditure actually attributable to the Indian operations. The principal contention was that neither section 44C nor Article 7(3) conferred an automatic entitlement to deduction merely because the Head Office or an overseas processing facility allocated a portion of its costs to the Indian branch. Section 44C prescribed a ceiling upon deduction of qualifying Head Office expenditure but did not dispense with the requirement of establishing that the expenditure was actually incurred and otherwise attributable to the business carried on in India. Likewise, Article 7(3), while recognising reasonable allocation of enterprise-level expenditure incurred outside the State in which the permanent establishment was situated, necessarily required a factual foundation demonstrating the nature of expenditure, its nexus with the business of the permanent establishment and the reasonableness of the allocation. The TPO had noticed that the PwC certificate furnished in support of Head Office expenditure pertained to the year ended 31 December 2002, whereas the relevant previous year ended on 31 March 2002, and that adequate supporting material for the earlier period had not been furnished. Certain items included in the expenditure pool, such as philanthropic activities, aircraft expenditure and finance and marketing costs, had also not been satisfactorily explained in relation to the Indian operations. Similarly, in the case of hub expenditure, the TPO had questioned the absence of complete particulars concerning the agreements governing the arrangements, the participating establishments, the aggregate costs incurred at the respective facilities and the allocation keys employed for distributing those costs. The learned DR submitted that the TPO was entitled to examine whether the services underlying the expenditure were actually rendered, whether they related to the Indian branch and whether the amount allocated represented an arm’s length charge. Such an enquiry was distinguishable from substituting the TPO’s commercial judgment for that of the assessee. The regulatory approvals granted by the Reserve Bank of India and the existence of centralised processing arrangements were undoubtedly relevant circumstances, but could not, by themselves, establish the quantum of expenditure properly attributable to India or its arm’s length character. Reliance was also placed upon the factual deficiencies recorded in earlier appellate proceedings concerning similar expenditure. It was therefore submitted that the learned CIT(A) had correctly sustained the determination of the arm’s length price of Head Office and hub expenditure at nil. In relation to salary expenditure of Rs. 99,89,796 pertaining to Mr. Dominic Price, the learned DR supported the disallowance by referring to the absence of a debit in the books of the Indian branch, the salary having been paid directly by the Head Office, enhancement of the claim in the revised return and the deficiencies noticed by the learned CIT(A) concerning the period of employment and supporting documentation. It was contended that the assessee was required to establish the direct nexus of the entire expenditure claimed with the Indian operations before deduction could be allowed.

45. In rejoinder, the learned Senior Counsel submitted that the Revenue’s interpretation of Article 7 proceeded by giving primacy to the general distinct-and-independent-enterprise hypothesis contained in paragraph 2 while failing to give proper effect to the express qualification making that paragraph subject to paragraph 3. He reiterated that the assessee did not dispute India’s right to tax profits genuinely attributable to the functions, assets and activities of the Indian permanent establishment; the controversy concerned the specific treatment prescribed by the treaty for amounts charged by one establishment to another establishment of the same enterprise. The fact that the corresponding revenues had been recorded in the books of the Indian branch did not, according to him, conclude the question of their taxability, since the computation of taxable income was required to be made in accordance with the provisions of the Act read with the treaty, wherever the latter was more beneficial. He emphasised that the reciprocal provision commencing with the expression “Likewise” was not dependent upon an actual disallowance arising under the preceding limb of Article 7(3), but constituted an independent prescription governing the recognition of specified charges raised by the permanent establishment upon its Head Office or other offices. The interpretation adopted by the learned CIT(A), according to him, introduced a condition which neither appeared in the language of the treaty nor followed from its scheme, and would substantially deprive the reciprocal clause of its intended operation. He further submitted that the OECD and UN Commentaries could legitimately assist in understanding the context and object of Article 7, but could not be employed to override the express language agreed upon by the contracting States. Insofar as the transfer-pricing adjustments were concerned, he reiterated that the assessee’s objections were not confined to the quantum of margins but extended to the functional characteristics of the comparable companies, the relevant financial-year data, the treatment of depreciation and, more particularly, the inclusion of expenditure which did not bear a demonstrable nexus with the respective service segments. The mere circumstance that an expenditure was incurred for the banking business as a whole did not establish that it formed part of the operating cost of correspondent banking, cheque-processing or investor services. Regarding Head Office and hub expenditure, the learned Senior Counsel maintained that the Revenue had failed to distinguish between the existence and attribution of expenditure, determination of its arm’s length price and its ultimate deductibility under the applicable provisions of the Act. The supporting certificates, regulatory approvals, service arrangements and earlier-year decisions, when considered together, could not be disregarded merely because the expenditure had been incurred centrally or had not been separately debited in the accounts of the Indian branch. He accordingly submitted that the adjustments sustained by the learned CIT(A) were not justified either upon the facts or under the applicable statutory and treaty provisions and reiterated the relief sought in the respective grounds of appeal.

46. We have considered the rival submissions and examined the material placed on record, including the assessment order, the transfer-pricing determination, the impugned appellate order, the relevant treaty provisions and the judicial authorities relied upon by the parties. The principal question arising under Ground No. 8 concerns the treatment of Rs. 85,24,546, representing the excess of revenues recorded by the Indian branch over the corresponding expenditure incurred in rendering correspondent banking and investor services to the Head Office and other overseas offices. The assessee claims that the amount is liable to be excluded by virtue of the reciprocal provision contained in Article 7(3) of the India-USA DTAA, whereas the Revenue maintains that it constitutes business profits attributable to the Indian permanent establishment under Article 7(2). The controversy, therefore, requires consideration of the relationship between the general principle of attribution of profits to a permanent establishment and the specific treatment prescribed by the treaty for amounts paid or charged between different establishments of the same enterprise. Since the language of Article 7(3), particularly the expression “Likewise” and the words “no account shall be taken”, forms the foundation of the dispute, we shall first examine the statutory and treaty provisions and the relevant interpretative material before applying them to the transactions under consideration.

47. Section 90(2) of the Act provides that where the Central Government has entered into an agreement with the Government of another country for avoidance of double taxation, the provisions of the Act shall apply to an assessee to whom such agreement applies only to the extent they are more beneficial to that assessee. The provision thus recognises that, although the charge to income-tax arises under the Act, the extent to which India may exercise its taxing jurisdiction in respect of income covered by a Double Taxation Avoidance Agreement is governed by the treaty wherever its provisions are more beneficial. The Hon’ble Supreme Court in Azadi Bachao Andolan (supra), has recognised the statutory efficacy of agreements entered into under section 90 and the principle that the beneficial provisions of the treaty are entitled to prevail in determining the tax liability of an assessee covered thereby. CBDT Circular No. 333 dated 2 April 1982 also recognises that where a specific provision of a double taxation avoidance agreement differs from the corresponding provision of the Act, the treaty provision would prevail to the extent it is more beneficial to the assessee. In the present case, there is no dispute that the assessee is a banking enterprise incorporated in the United States of America and that its Indian branch constitutes a permanent establishment under the India-USA DTAA. Equally, there is no controversy concerning India’s right to tax profits properly attributable to the business carried on through that permanent establishment. The dispute is confined to the manner in which such profits are required to be determined and, more particularly, whether the profit element included in the charges raised by the Indian branch upon other offices of the same enterprise can be brought to tax notwithstanding the specific language of Article 7(3). The answer must therefore emerge from the treaty itself, read in the context of the domestic provisions governing computation of income and determination of the arm’s length price.

48. Chapter X of the Act, which became applicable under the present transfer-pricing framework with effect from assessment year 2002-03, provides the machinery for determining income arising from international transactions having regard to the arm’s length price. Section 92(1) requires income arising from an international transaction to be computed having regard to the arm’s length price, while section 92C prescribes the recognised methods for its determination. Section 92CA provides for reference to the Transfer Pricing Officer and determination of the arm’s length price in accordance with the statutory framework. The definition of “enterprise” under section 92F(iii) includes a permanent establishment of a person, thereby recognising that the transfer-pricing provisions may have relevance to activities undertaken through different establishments of the same juridical enterprise. Thus, the mere circumstance that the Indian branch and the overseas offices form part of one banking enterprise does not, by itself, exclude consideration of the arm’s length principle under Chapter X. However, the existence of a statutory mechanism for determining the arm’s length price and the ultimate question whether a particular amount constitutes income taxable in India under the applicable treaty are not necessarily identical enquiries. The former concerns the appropriate valuation of a transaction falling within the statutory framework, whereas the latter concerns the extent of profits which the treaty permits India to attribute to the permanent establishment. The machinery provisions of Chapter X must therefore be applied consistently with the chargeability and attribution rules governing the income under consideration. Where the treaty expressly prescribes a particular treatment for specified dealings between the permanent establishment and other offices of the same enterprise, that prescription cannot be disregarded merely by invoking the general principle of arm’s length remuneration. Equally, the treaty cannot be interpreted as rendering the transfer-pricing provisions inapplicable to every transaction involving a permanent establishment. The two sets of provisions must be read harmoniously, giving effect to the particular language employed by the contracting States.

49. We may now examine Article 7 of the India-USA DTAA. Paragraph 1 recognises the right of the State in which the permanent establishment is situated to tax so much of the business profits of the enterprise as is attributable to that establishment, subject to the particular attribution rules contained in the Convention. Paragraph 2 embodies the distinct-and-independent-enterprise hypothesis and provides that the profits attributable to the permanent establishment shall be those which it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm’s length with the enterprise of which it is a permanent establishment. The significance of paragraph 2, however, lies not merely in the adoption of the arm’s length hypothesis but also in the express qualification with which it commences, namely, “Subject to the provisions of paragraph 3”. The contracting States have thus not enacted the attribution principle under paragraph 2 as an unqualified rule. Its application has been expressly made subject to the provisions contained in paragraph 3, which deals with expenditure incurred for the purposes of the permanent establishment and the treatment of specified amounts paid or charged between different establishments of the same enterprise. The qualification cannot be regarded as a matter of form, for the words employed in a treaty must ordinarily be given their intended operation unless the context requires otherwise. Accordingly, while Article 7(2) provides the general basis for attribution of profits, the specific provisions contained in Article 7(3) must receive effect in determining the treatment of transactions falling within their scope.

50. Article 7(3) assumes particular significance because it contains three connected but distinct prescriptions. The first recognises deduction of expenditure incurred for the purposes of the permanent establishment, including reasonable allocation of executive and general administrative expenditure, research and development expenditure, interest and other expenditure incurred for the enterprise as a whole or that part thereof which includes the permanent establishment, irrespective of whether such expenditure is incurred in the State where the permanent establishment is situated or elsewhere, subject to the limitations prescribed by the taxation laws of that State. The second prescription provides that no deduction shall be allowed in respect of amounts paid, otherwise than towards reimbursement of actual expenses, by the permanent establishment to the Head Office or other offices of the enterprise by way of royalties, fees or similar payments for the use of patents or other rights, commission or other charges for specific services performed or for management, or, except in the case of a banking enterprise, interest on monies lent to the permanent establishment. The third prescription is expressed in reciprocal terms and provides that, likewise, no account shall be taken, in determining the profits of the permanent establishment, of amounts charged, otherwise than towards reimbursement of actual expenses, by the permanent establishment to the Head Office or other offices of the enterprise by way of royalties, fees or similar payments for the use of patents or other rights, commission or other charges for specific services performed or for management, or, except in the case of a banking enterprise, interest on monies lent to the Head Office or other offices. The provision thus deals with both sides of specified intra-enterprise dealings, namely, amounts paid by the permanent establishment and amounts charged by it. The exception concerning interest in the case of a banking enterprise is expressly incorporated in both directions. It is this reciprocal treatment of specified charges, and particularly its application to charges for specific services performed, which falls for interpretation in the present case.

51. The first limb of Article 7(3) proceeds upon the recognition that expenditure incurred centrally by an enterprise may nevertheless be incurred for the purposes of a permanent establishment situated in another Contracting State. It accordingly permits deduction of expenditure attributable to the business of the permanent establishment, subject to the limitations prescribed under the domestic taxation laws. This aspect has relevance to the separate claims concerning Head Office and hub expenditure, which shall be examined subsequently. The second limb, however, restricts deduction of specified amounts paid by the permanent establishment to the Head Office or other offices of the same enterprise, otherwise than towards reimbursement of actual expenses. The object of this restriction is to prevent recognition, merely on the strength of internal charges, of a separate profit element in respect of the specified dealings within the same enterprise. The third limb proceeds in the converse direction. By employing the expression “Likewise”, it provides that no account shall be taken of corresponding amounts charged by the permanent establishment to the Head Office or other offices, otherwise than towards reimbursement of actual expenses. The language is significant. Whereas the second limb speaks of non-allowance of deduction, the third directs that no account shall be taken of specified charges in determining the profits of the permanent establishment. The contracting States have thus adopted corresponding restrictions on the debit and credit sides of specified intraenterprise dealings. The exception for reimbursement of actual expenses preserves recognition of the underlying expenditure, while the exception relating to interest in the case of banking enterprises recognises the special character of inter-office lending arrangements in the banking business. The question before us is whether the reciprocal prescription concerning commission or other charges for specific services performed applies to the excess of revenues over expenditure recorded by the Indian branch in respect of correspondent banking and investor services.

52. Article 7(5) provides a further indication of the manner in which profits are to be attributed to a permanent establishment. The provision confines the profits attributable under Article 7(1)(a) to those derived from the assets and activities of the permanent establishment. This limitation recognises that the source State’s taxing entitlement is founded upon the economic activities and assets of the establishment situated within its jurisdiction and not upon the entire worldwide profits of the foreign enterprise. The provision must, however, be read along with paragraphs 2 and 3, which prescribe the manner of determining the profits so attributable. The fact that an activity is performed through the Indian permanent establishment is undoubtedly relevant in determining the profits attributable to that establishment, but it does not, by itself, answer the separate question whether a particular internal charge is required to be recognised where paragraph 3 expressly prescribes its treatment. Article 7(5) therefore reinforces the need to identify the profits arising from the assets and activities of the permanent establishment, without dispensing with the particular computational rules contained in the preceding paragraphs. In the present case, the Revenue relies upon the services actually performed by the Indian branch, while the assessee relies upon the reciprocal treatment of specified inter-office charges. Both considerations must be examined within the scheme of Article 7 as a whole.

53. The Protocol appended to the India-USA DTAA, which forms an integral part of the Convention, also requires consideration. In relation to Article 7, the Protocol addresses the treatment of executive and general administrative expenditure and the operation of limitations imposed by the domestic law of the State in which the permanent establishment is situated. Its significance lies in the express recognition that the treaty provisions governing deduction of expenditure incurred for the purposes of the permanent establishment are to be applied in conjunction with the domestic statutory restrictions, subject to the protection provided by the Protocol. This assumes relevance particularly in relation to the claims under section 44C, which are dealt with separately in the succeeding portion of this order. The Protocol does not, however, dispense with the necessity of interpreting the reciprocal provisions concerning amounts paid or charged between the permanent establishment and other offices of the enterprise. The specific language governing such charges remains contained in Article 7(3) itself. The Protocol, therefore, provides part of the treaty context but does not independently resolve the controversy concerning Rs. 85,24,546.

54. The OECD Commentary on Article 7, in the historical form relevant to the treaty and relied upon during the appellate proceedings, recognises the difficulty which may arise in reconciling the distinct-and-independent-enterprise hypothesis with the treatment of dealings between different establishments of the same enterprise. The hypothesis underlying paragraph 2 contemplates attribution of profits by reference to the functions and economic activities of the permanent establishment, whereas paragraph 3 recognises that certain expenditure and services may arise within a single enterprise without necessarily giving rise to independently recognisable profit-bearing transactions between its constituent establishments. The Commentary accordingly discusses the distinction between expenditure incurred for the general purposes of an enterprise and services which may constitute a separate and significant part of the activities undertaken by an establishment. In the former situation, allocation or reimbursement of actual expenditure may provide the appropriate treatment, whereas the latter may require consideration of an arm’s length remuneration where the relevant functions possess the characteristics of independently remunerable commercial activities. This distinction is relevant to the submissions advanced by both parties. The assessee maintains that the Indian branch performed support and coordination functions for the overseas banking business, while the Revenue contends that correspondent banking and investor services were substantive activities capable of generating independent commercial profits. The Commentary provides useful interpretative guidance concerning these competing positions. Nevertheless, it must be appreciated that the Commentary is an aid to understanding the treaty and cannot be employed to substitute a different rule for the express language adopted by the contracting States. Its relevance must therefore be examined in the context of the particular India-USA Convention and the words actually employed in Article 7(3).

55. The UN Model Commentary also recognises the importance of the treatment of expenditure and internal dealings between a permanent establishment and other establishments of the same enterprise. The India-USA DTAA contains language which reflects the traditional approach to such dealings, including the express restrictions upon specified payments and corresponding charges between the permanent establishment and the Head Office or other offices. The distinction between reimbursement of actual expenditure and recognition of an independent profit element is therefore not foreign to the treaty framework. At the same time, the Commentary recognises that the economic substance of the activities performed by a permanent establishment cannot be disregarded merely because the services are rendered to another part of the same enterprise. The proper enquiry is consequently directed towards the nature of the functions performed, the character of the amounts charged and the language of the applicable treaty. The Commentary cannot be read as creating an unrestricted exclusion for every amount arising from an intra-enterprise dealing, nor can it justify disregarding an express treaty restriction whenever the underlying services possess commercial value. The interpretative exercise must give effect to the provisions negotiated between the contracting States, having regard to their context and the purpose of the attribution rules.

56. The Technical Explanation issued in relation to the India-USA Convention is another relevant interpretative aid. It explains the scheme of Article 7 and the relationship between the attribution of profits to a permanent establishment and the allowance of expenditure incurred for its business. The Technical Explanation must, however, be considered as explanatory material rather than as an independent source of taxing authority. The rights and obligations of the contracting States ultimately arise from the treaty itself. In construing Article 7, the ordinary meaning of its terms, the context in which they occur and the object of the Convention must therefore remain controlling considerations. The interpretation of a treaty cannot proceed by isolating the general attribution principle from the specific qualifications and restrictions expressly incorporated by the contracting States. Equally, the reciprocal provisions cannot be read without regard to the functions actually performed and the nature of the charges under examination. These considerations assume particular importance in the present case because the amount sought to be taxed represents a profit element already recorded in the books of the Indian branch, rather than an additional mark-up independently determined by the TPO.

57. On a consideration of the statutory provisions, the language of Article 7 and the interpretative material referred to above, two distinct questions emerge. The first is whether the functions performed by the Indian branch constitute activities giving rise to profits attributable to the permanent establishment under Article 7(1) and Article 7(2). The second is whether the particular amounts charged by the Indian branch to the Head Office or other offices fall within the specific reciprocal prescription contained in Article 7(3). The answer to the first question does not necessarily conclude the second, because paragraph 2 has expressly been made subject to paragraph 3. At the same time, the application of paragraph 3 requires identification of the nature of the charges and cannot rest merely upon the fact that the payer and recipient are different establishments of the same enterprise. It is in this context that the reasoning of the learned CIT(A), particularly his distinction between general enterprise functions and substantive services and his interpretation of the expression “Likewise”, requires examination. We shall therefore consider whether the conditions which the learned CIT(A) read into the reciprocal provision are borne out by the treaty language and whether the amount of Rs. 85,24,546 falls within its scope.

58. The learned CIT(A), while sustaining the addition, proceeded on the reasoning that correspondent banking and investor services were substantive activities undertaken by the Indian branch, conferring an identifiable economic advantage upon the overseas offices, and that the profits arising from such services were consequently required to be recognised under Article 7(2). He also relied upon the OECD Commentary distinguishing general enterprise functions from services capable of attracting independent remuneration. In our view, the nature of the services performed is undoubtedly relevant, but the conclusion reached by the learned CIT(A) does not adequately address the express qualification contained in Article 7(2) and the corresponding prescription in Article 7(3). The contracting States have specifically provided that the distinct-and-independent-enterprise hypothesis shall operate subject to paragraph 3. The latter provision, in turn, expressly refers to commission or other charges for specific services performed or for management. Thus, the mere circumstance that services were actually performed or possessed commercial value cannot, without more, establish that the reciprocal provision has no application. If every service capable of being commercially remunerated were, merely on that account, excluded from the operation of the reciprocal provision, the express reference therein to “commission or other charges for specific services performed or for management” would be deprived of much of its intended significance. The treaty does not employ the expression “general administrative services” in the reciprocal clause, nor does it expressly confine its application to services which are incidental or ancillary to the business of the enterprise. On the contrary, the contracting States have consciously referred to specific services performed, while separately providing an exception for reimbursement of actual expenses and another for interest on monies lent in the case of a banking enterprise. The distinction drawn by the learned CIT(A) between general enterprise functions and substantive commercial services may be relevant in appreciating the economic character of the activities under the historical OECD Commentary, but it cannot, without adequate support in the treaty language, be elevated into an overriding condition governing the application of Article 7(3). The Commentary must be read in aid of the Convention and not as a means of qualifying or restricting its express provisions. Equally, the fact that Article 7(2) contemplates attribution of profits upon the hypothesis of an independent enterprise does not justify overlooking the words “Subject to the provisions of paragraph 3”, which the contracting States have specifically incorporated. These words indicate that the general attribution principle must yield to the particular treatment prescribed under paragraph 3 wherever the transaction falls within its scope. The question, therefore, is not merely whether correspondent banking and investor services were capable of commanding remuneration in an independent commercial arrangement, but whether the charges raised by the Indian branch upon its Head Office and other offices answer the description of amounts contemplated in the reciprocal provision. That question must be determined upon the nature of the services, the character of the inter-office charges and the language of the treaty, rather than solely upon the commercial value of the functions performed. The reasoning adopted by the learned CIT(A), insofar as it treats the substantive or commercially remunerable character of the services as sufficient in itself to displace the reciprocal provision, therefore requires closer examination in the light of the express words employed in Article 7(3).

59. The interpretation placed by the learned CIT(A) upon the expression “Likewise” also requires examination. According to him, the reciprocal provision dealing with amounts charged by the permanent establishment to its Head Office or other offices could become operative only where the immediately preceding provision concerning amounts paid by the permanent establishment had first been attracted. In other words, the learned CIT(A) proceeded on the premise that unless there was an actual disallowance of expenditure under the preceding limb of Article 7(3), the corresponding provision concerning exclusion of amounts charged by the permanent establishment could not independently operate. We are unable to subscribe to this construction. The expression “Likewise”, in its ordinary grammatical sense, signifies correspondence or similarity in treatment; it does not, without qualifying language, make the operation of the succeeding provision conditional upon an actual event occurring under the preceding provision. The second limb of Article 7(3) provides that no deduction shall be allowed for specified amounts paid by the permanent establishment to the Head Office or other offices, otherwise than towards reimbursement of actual expenses. The succeeding limb adopts the converse formulation and directs that no account shall be taken of corresponding amounts charged by the permanent establishment to those offices. The two provisions thus deal with opposite directions of specified intra-enterprise dealings. One governs the debit side of the computation, while the other governs the credit side. Their relationship is reciprocal in character, but reciprocity does not necessarily imply that both transactions must arise in the same assessment year or that the operation of one provision depends upon an actual disallowance under the other. Had the contracting States intended to impose such a condition, the treaty could have expressly provided that the exclusion of amounts charged by the permanent establishment would be available only to the extent corresponding amounts paid by it had been disallowed. No such qualification appears in the language employed. The construction adopted by the learned CIT(A) would, in effect, introduce a condition which the contracting States have not prescribed and would make the treatment of an amount charged by the permanent establishment depend upon the existence of an unrelated payment made by it to another office. Such an interpretation would also produce an anomalous result, because identical charges for specified services could receive different treatment merely depending upon whether the permanent establishment had, during the same year, made any corresponding payment falling within the preceding limb. In our view, the expression “Likewise” establishes symmetry in the treatment of the specified categories of intra-enterprise dealings and not a condition precedent requiring simultaneous operation of both provisions. The learned CIT(A), therefore, was not justified in restricting the reciprocal clause by making its application dependent upon an actual disallowance under the preceding provision.

60. The aforesaid interpretation is also consistent with the manner in which Article 7(3) has been structured. The provision first recognises deduction of expenditure incurred for the purposes of the permanent establishment, including reasonable allocation of enterprise-level expenditure, subject to domestic statutory limitations. It thereafter restricts recognition of specified amounts paid by the permanent establishment to the Head Office or other offices and correspondingly prescribes the treatment of amounts charged by the permanent establishment to those offices. The evident purpose of the latter provisions is to regulate the recognition of specified internal charges between establishments of the same juridical enterprise, distinguishing reimbursement of actual expenditure from amounts carrying an independent profit element. The exception concerning interest in the case of a banking enterprise is particularly instructive. The contracting States have expressly excluded interest on monies lent between different offices of a banking enterprise from the general restriction applicable to specified internal charges, thereby recognising the particular commercial character of inter-office lending in the banking business. The exception is confined to interest and cannot, by implication, be extended to commission or other charges for specific services performed or for management. The assessee has, in fact, separately offered to tax net interest income of Rs. 40,38,331 arising from offshore placements with overseas branches, and no dispute has been raised concerning the application of the banking exception to that income. The controversy before us concerns a different category of dealings, namely, charges for correspondent banking and investor services rendered by the Indian branch to other offices of the same enterprise. The fact that the treaty expressly provides a special exception for interest in the case of banking enterprises reinforces the necessity of giving effect to the language actually employed for other categories of internal charges. It would not be permissible to introduce a further exception for commercially remunerable services merely because such services possess economic value or might command an independent fee in transactions between unrelated enterprises. At the same time, the reciprocal provision cannot be extended to amounts which do not answer the description of specified inter-office charges contemplated therein. Its application must therefore rest upon the actual character of the transactions, the identity of the establishments between which the charges arise and the nature of the amounts sought to be recognised in computing the profits of the permanent establishment.

61. We have also considered the reliance placed upon the historical OECD and UN Commentaries and the distinction drawn therein between general enterprise functions and services constituting an independent commercial activity. There can be no dispute that the Commentary recognises circumstances in which services performed by one establishment for another may appropriately be remunerated upon an arm’s length basis, particularly where the enterprise carries on a specialised service activity or provides comparable services to outside customers. Equally, the Commentary recognises that expenditure incurred in performing general management, administrative or other common functions may require allocation or reimbursement without necessarily recognising an independent profit element between different establishments of the same enterprise. These principles provide useful guidance in understanding the economic considerations underlying attribution of profits to a permanent establishment. However, the interpretative enquiry in the present case cannot conclude merely upon characterising correspondent banking and investor services as commercially valuable or substantive activities. The India-USA DTAA contains a specific reciprocal provision concerning commission or other charges for specific services performed or for management. The language of that provision has to be given effect according to its ordinary meaning, read in the context of Article 7 as a whole. The Commentary cannot be employed to restrict the express provision to general administrative or incidental services when the contracting States have not incorporated such a qualification. Nor can it be used to treat every service capable of independent commercial remuneration as falling outside the reciprocal clause, for such a construction would substantially diminish the scope of the words “specific services performed”. The learned CIT(A) relied upon the Commentary to conclude that correspondent banking and investor services constituted substantive banking activities conferring identifiable benefits upon the overseas offices and, therefore, required recognition of the corresponding profit element. The commercial character of those services is not in dispute. What requires determination is whether the treaty, notwithstanding their commercial character, prescribes a particular treatment for the charges raised between different establishments of the same enterprise. The Commentary may assist in appreciating the nature of the activities and the economic rationale of attribution, but it cannot displace the specific treatment negotiated under Article 7(3). We therefore find that the distinction relied upon by the learned CIT(A), though relevant to functional analysis, does not, by itself, justify exclusion of the present transactions from the reciprocal provision.

62. The decision of the coordinate Bench in Bank of Nova Scotia (supra), also requires consideration, since it concerns the interaction between Article 7 and the transfer-pricing provisions in the context of banking services rendered by an Indian branch to its overseas offices. In that case, the Tribunal examined the attribution of profits arising from correspondent banking activities and the relevance of the arm’s length principle in determining the income of the Indian permanent establishment. The decision recognises that the transfer-pricing provisions cannot be disregarded merely because the transactions are undertaken between different establishments of the same banking enterprise and that the profits attributable to the Indian functions must be determined in accordance with the applicable statutory and treaty framework. We respectfully agree with the general proposition that the existence of a permanent establishment does not render Chapter X inapplicable and that the functions performed by the Indian branch are relevant in determining the profits attributable to it. However, the present controversy requires examination of a particular factual and legal distinction. The amount of Rs. 85,24,546 does not represent an additional mark-up independently computed by the TPO upon an international transaction whose consideration had not otherwise been recognised. It represents the excess of revenues already recorded in the books of the Indian branch over the corresponding expenditure, which the assessee excluded in the computation of taxable income by specifically invoking the reciprocal clause of Article 7(3). The TPO did not separately determine an adjustment of Rs. 85,24,546 under section 92CA(3), but suggested that the Assessing Officer should examine the claim under the treaty. The Assessing Officer thereafter brought the amount to tax by rejecting the assessee’s interpretation of Article 7(3). Thus, the immediate question is whether the specific treaty provision permits recognition of the profit element already embedded in the inter-office charges, rather than merely whether the Indian branch performed functions capable of commanding arm’s length remuneration. Nevertheless, the distinction between a recorded profit element and an imputed mark-up cannot, by itself, determine the applicability of the ratio of Bank of Nova Scotia. To the extent that the coordinate Bench has laid down a general proposition concerning the relationship between Article 7(2), Article 7(3) and arm’s length attribution of profits from correspondent banking services, that proposition must receive due consideration irrespective of the accounting treatment adopted by the assessee. The present decision, therefore, rests upon our interpretation of the specific reciprocal language of Article 7(3), the character of the amounts charged and the particular issue arising from their exclusion in the computation of income. The factual distinction concerning the recorded charges is relevant to identifying the controversy, but does not dispense with the necessity of examining the legal principle laid down in the coordinate Bench decision.

63. Coming to the facts of the present case, the material on record shows that the Indian branch rendered correspondent banking and investor services to the Head Office and other overseas offices of the same banking enterprise and recorded the corresponding revenues and expenditure in its accounts. In respect of correspondent banking services, the revenue amounted to Rs. 4,02,63,333 against expenditure of Rs. 3,66,03,030, leaving an excess of Rs. 36,60,303, whereas in respect of investor services, the revenue amounted to Rs. 5,35,06,676 against expenditure of Rs. 4,86,42,433, resulting in an excess of Rs. 48,64,243. The aggregate amount of Rs. 85,24,546 was excluded by the assessee while computing its taxable income on the strength of the reciprocal provision contained in Article 7(3). The Assessing Officer did not dispute the identity of the establishments between which the transactions had taken place, nor did he find that the amounts represented consideration received from independent third parties. His principal objection was that the services constituted substantive banking activities performed by the Indian permanent establishment and that the excess of revenues over expenditure represented business profits taxable under Article 7(2). The learned CIT(A) substantially endorsed this reasoning, placing particular emphasis upon the commercial character of the services and the distinction drawn in the OECD Commentary between general enterprise functions and independently remunerable activities. In our view, however, the existence of commercially valuable functions and the applicability of the reciprocal provision are not necessarily mutually exclusive considerations. The former establishes the economic character of the activities performed by the Indian branch, whereas the latter concerns the particular treatment prescribed by the contracting States for specified charges between establishments of the same enterprise. The transactions under consideration were admittedly undertaken between the Indian branch and other offices of the same banking enterprise, and the amounts were recorded as charges for services performed by the Indian establishment. The question is whether such charges fall within the expression “commission or other charges for specific services performed or for management” employed in Article 7(3). Having regard to the nature of correspondent banking and investor services described in the transfer-pricing documentation and the findings recorded by the authorities below, we find that the charges arose from identifiable services performed by the Indian branch for its overseas offices. The fact that these services were capable of commercial remuneration does not, by itself, take them outside the express description of specific services performed. Equally, the fact that the charges were recorded as revenues in the books of the Indian branch cannot conclusively determine their treatment under the treaty. Accounting recognition and treaty attribution are related but distinct enquiries, and the taxable profits must ultimately be determined in accordance with the applicable provisions of the Act read with the treaty. The assessee’s claim, therefore, requires examination by applying the reciprocal provision to the actual character of the charges rather than by treating their commercial value or accounting recognition as sufficient grounds for rejecting the exclusion.

64. There is another aspect which assumes significance. The amount of Rs. 85,24,546 represents the excess of recorded revenues over the expenditure attributed to the two service segments and not the entire consideration charged by the Indian branch to the overseas offices. The assessee has not sought exclusion of the expenditure incurred in performing those services; its claim is confined to the profit element arising from the inter-office charges. The reciprocal provision of Article 7(3), while referring to amounts charged otherwise than towards reimbursement of actual expenses, recognises the distinction between reimbursement of expenditure and the additional amount charged in respect of specified intraenterprise dealings. The claim must therefore be examined in the context of the computation actually made by the assessee, so that the underlying expenditure is neither deducted twice nor the same amount excluded more than once. The Revenue’s contention that the Indian branch performed substantive functions giving rise to attributable profits undoubtedly merits consideration under Article 7(2), but that proposition cannot be applied in isolation from the express qualification making paragraph 2 subject to paragraph 3. Similarly, Article 7(5), which confines attribution to profits derived from the assets and activities of the permanent establishment, identifies the economic source of the profits but does not dispense with the particular computational treatment prescribed elsewhere in Article 7. The learned CIT(A), while relying upon the commercial character of the services, did not satisfactorily explain why charges expressly referable to specific services performed should be excluded from the reciprocal provision merely because the underlying functions constituted substantive activities of the Indian branch. Nor does the language of Article 7(3) support his further conclusion that the reciprocal provision becomes operative only upon an actual disallowance of a corresponding payment under its preceding limb. These considerations, in our view, materially affect the sustainability of the reasoning adopted in the impugned order. The correct approach is to give effect to the treaty language as a whole, recognising the general attribution principle under Article 7(2), the specific prescription under Article 7(3) and the distinction between the reimbursement of actual expenditure and the profit element embedded in specified internal charges. The Revenue’s reliance upon the arm’s length character of the transactions cannot, without resolving the operation of the reciprocal provision, furnish a complete answer to the assessee’s claim. At the same time, our conclusion concerning the treatment of the recorded excess must remain confined to the transactions and amounts actually examined and cannot be understood as a general proposition that every dealing between different establishments of a banking enterprise is incapable of giving rise to taxable profits in India.

65. In the light of the foregoing discussion, we find that the learned CIT(A) was not justified in sustaining the addition of Rs. 85,24,546 merely upon the reasoning that correspondent banking and investor services constituted substantive and commercially remunerable activities and that the reciprocal provision of Article 7(3) could operate only where the preceding provision concerning payments by the permanent establishment had first been attracted. The latter condition does not emerge from the language of the treaty, while the former consideration, though relevant to attribution of profits under Article 7(2), does not independently resolve the treatment of specified inter-office charges under paragraph 3. On the facts recorded by the authorities below, the disputed amount represents the excess of revenues charged by the Indian branch to its Head Office and other overseas offices for correspondent banking and investor services over the expenditure incurred in performing those services. These are dealings between establishments of the same banking enterprise, and the amounts in question arise from charges for specific services performed. The assessee has separately recognised and offered to tax the net interest income arising from offshore placements with overseas branches, which falls within the express banking exception contained in Article 7(3). The amount presently in dispute does not arise from such lending arrangements. On a conjoint reading of Article 7(2) and Article 7(3), and having regard to the reciprocal language employed by the contracting States, we hold that the excess of Rs. 85,24,546 arising from the specified inter-office service charges is not liable to be included in the profits attributable to the Indian permanent establishment in the circumstances of the present case. The contrary interpretation adopted by the learned CIT(A), particularly his construction of the expression “Likewise” as creating a condition precedent dependent upon an actual disallowance under the preceding limb, cannot be sustained. We accordingly set aside the finding of the learned CIT(A) on this issue and direct the Assessing Officer to exclude Rs. 85,24,546 from the taxable income of the assessee. It is clarified that this direction concerns the identified excess of revenues over expenditure in respect of correspondent banking and investor services and shall not result in exclusion of the underlying expenditure or any other amount more than once. The separate transfer-pricing controversies concerning the determination of the arm’s length price of the respective service transactions shall be dealt with in the succeeding paragraphs, and the consequential computation shall be undertaken consistently with the present finding so that there is no overlapping taxation of the same profit element. Ground No. 8 raised by the assessee is accordingly allowed.

66. We shall now examine Ground Nos. 2, 3 and 4 concerning the determination of the arm’s length price of correspondent banking, cheque-processing and investor services. The nature of these transactions, the functional profile of the Indian branch, the benchmarking analysis undertaken by the assessee, the modifications made by the TPO and the findings of the learned CIT(A) have already been discussed in the preceding paragraphs. The principal issues which survive for adjudication concern the functional comparability of certain companies retained in the final comparable set, the financial data required to be adopted under Rule 10B(4), the claim for depreciation adjustment and the expenditure properly includible in the operating cost base of the respective transactions. Although the three service segments involve different functions, certain objections concerning financial data and allocation of expenditure are common. It is therefore necessary to examine those objections consistently, while recognising that the arm’s length price of each transaction must ultimately be determined with reference to the functions actually performed, assets employed and risks assumed in that particular segment. The determination cannot proceed merely upon the similarity of the accounting or administrative arrangements under which the services were rendered. Equally, expenditure incurred for the Indian banking establishment as a whole cannot automatically be treated as operating expenditure of every service segment. We shall accordingly examine the disputed comparable companies and the financial and cost adjustments before recording the consequential directions applicable to each transaction.

67. Insofar as correspondent banking services are concerned, the assessee has challenged the retention of Pioneer Investcorp Ltd., Centrum Finance Ltd. and Integrated Enterprises (India) Ltd. in the comparable set. These objections were raised through an additional ground filed on 22 July 2022, supported by the annual reports and functional particulars of the respective companies. The additional ground concerns the correctness of the comparable set adopted for determining the arm’s length price and arises from the same transfer-pricing adjustment which is already the subject matter of Ground No. 2. The material relied upon is principally the financial and functional information of the companies selected in the benchmarking exercise, and the Revenue has had an opportunity to address the objections. The additional ground does not introduce a new transaction or an independent source of income, but questions whether the existing adjustment has been determined upon a reliable comparable set. Having regard to its direct bearing upon the correct determination of the arm’s length price, and applying the principle recognised by the Hon’ble Supreme Court in National Thermal Power Co. Ltd. v. Commissioner of Income-tax [1999] 157 CTR 249/[1998] 229 ITR 383  (SC), we admit the additional ground and proceed to examine it on merits. The assessee’s original selection of these companies does not preclude examination of their functional comparability, since the object of the transfer-pricing exercise is to determine a reliable arm’s length result and not merely to preserve a comparable set originally adopted by either party. At the same time, the burden of demonstrating material functional differences cannot be discharged by referring only to the nomenclature of the activities or the industry classification appearing in a database. The actual functions, revenue streams, assets and risks emerging from the relevant annual reports must provide the basis for exclusion. The objections raised by the assessee are therefore considered upon that footing.

68. On examining the functional characteristics of the disputed companies, we find that Pioneer Investcorp Ltd. was engaged in merchant-banking and underwriting activities, deriving income from management fees and underwriting commission. Such activities involve functions and risks materially different from the marketing, liaison and customer relationship functions performed by the Indian branch in connection with correspondent banking arrangements undertaken by overseas offices. The Indian branch did not itself undertake the substantive merchant-banking or underwriting functions, nor did it assume the corresponding financial risks. The absence of reliable segmental results separating activities which might possess some functional similarity from the company’s other activities further affects the reliability of its operating margin as a comparable. The decision of the coordinate Bench in Commerzbank A. G. (supra), wherein Pioneer Investcorp Ltd. was considered in the context of correspondent banking services, also supports the need for a closer functional distinction. Centrum Finance Ltd. was engaged in diversified financial-services activities, including merchant banking, investment banking, corporate finance, leasing, hire-purchase and syndication. The revenue arising from these activities cannot, without reliable segmental information, be regarded as reflecting the operating profitability of routine marketing and coordination services. The difference in the company’s accounting year, extending from July to June, also requires consideration because the relevant financial data must correspond to the period prescribed under Rule 10B(4), subject to the permissible adjustments contemplated under the Rules. In the absence of reliable information permitting segregation of the relevant functions and alignment of the financial data, its entity-level margin does not provide a sufficiently dependable basis for comparison. Integrated Enterprises (India) Ltd., on the other hand, was substantially engaged in depository-participant activities, share-transfer and registry services, securities broking and allied capitalmarket functions. These activities involve a different functional and regulatory profile from the correspondent banking services rendered by the assessee, and the available material does not establish that the operating results of any comparable segment can be reliably isolated. We also find merit in the assessee’s reference to the earlier appellate consideration of this company in its own case for assessment year 2005-06, although the determination for the present year must rest upon the functions and financial information relevant to the year under consideration. The three companies, therefore, cannot be retained merely because they operate broadly within the financial-services industry. Functional comparability under Rule 10B(2) requires a closer examination of the actual services rendered and the risks assumed. We accordingly direct exclusion of Pioneer Investcorp Ltd., Centrum Finance Ltd. and Integrated Enterprises (India) Ltd. from the comparable set for correspondent banking services. The remaining comparable companies shall be examined and the arm’s length margin recomputed in accordance with the findings recorded herein, without introducing fresh comparables except to the extent necessarily required by the consequential exercise and permissible in law.

69. The next common issue concerns the financial data adopted for determining the operating margins of the comparable companies. The assessee had originally relied upon weighted average financial information relating to financial years 1999-2000 and 2000-01, along with the relevant-year information available at the time of preparation of the transfer-pricing study. The TPO, upon obtaining the financial data for financial year 2001-02, adopted the margins pertaining to that year for correspondent banking services, resulting in an arithmetic mean of 42.73% for the four retained companies. The learned CIT(A), however, noticed the substantial difference between that margin and the arithmetic mean of 12.23% emerging from the earlier-year information and directed adoption of the average of the arithmetic means based upon financial data for financial years 1999-2000, 2000-01 and 2001-02. This direction has been specifically challenged by the Revenue in Ground No. 3 of its cross appeal. Rule 10B(4), as applicable to the relevant assessment year, provides that the data to be used in analysing comparability shall ordinarily relate to the financial year in which the international transaction was entered into, while its proviso permits consideration of data relating to a period not exceeding two years preceding that financial year where such data reveals facts capable of influencing determination of the transfer price in relation to the transactions being compared. The rule thus gives primacy to contemporaneous financial information. Preceding-year data may be considered where the statutory condition is satisfied, but the proviso does not authorise routine substitution of a multi-year average merely because the margins derived from the relevant-year data differ substantially from those of earlier years. A variation in operating margins may itself call for examination of the underlying economic circumstances, but the variation does not establish, without further analysis, that preceding-year information reveals facts influencing comparability. The learned CIT(A) relied principally upon the difference between the margins and the circumstance that the assessee had prepared its documentation before the relevant-year financial statements became available. Neither circumstance, by itself, establishes the condition prescribed under the proviso. Once reliable financial information pertaining to financial year 2001-02 became available during the assessment proceedings, it was required to be considered in determining the arm’s length price, subject to the other comparability adjustments permissible under the Rules. We therefore hold that the direction of the learned CIT(A) to adopt the average of arithmetic means derived from three financial years cannot be sustained. The financial data pertaining to financial year 2001-02 shall be adopted for the relevant benchmarking exercise, subject to the findings concerning the comparable companies and other adjustments recorded herein. This conclusion also governs Ground No. 3 raised by the Revenue, which shall be formally disposed of while adjudicating its cross appeal.

70. We shall now examine the objections concerning chequeprocessing and investor services, particularly the exclusion of Nucleus Netsoft & GIS India Ltd. and the rejection of the depreciation adjustment. The TPO excluded Nucleus Netsoft & GIS India Ltd. principally upon noticing that the company was engaged in specialised web-mapping and location-based services and was not reflected under the relevant database classification of software-service providers. The learned CIT(A) sustained the exclusion, having regard to the difference between those activities and the routine cheque-processing functions undertaken by the Indian branch. We find that the mere classification of a company in a particular database cannot be decisive of functional comparability, since the enquiry prescribed under Rule 10B(2) is directed towards the actual characteristics of the services, the functions performed, the assets employed and the risks assumed. Nevertheless, where the available functional material establishes that the company is engaged in specialised technological activities materially different from the routine scanning, recording, transmission and processing of cheque-related information undertaken by the tested party, its operating results cannot be adopted merely because both activities may broadly fall within the category of informationtechnology-enabled services. In the present case, the assessee has not demonstrated, on the basis of reliable segmental information, that the operating results of Nucleus Netsoft & GIS India Ltd. relate to functions sufficiently comparable with the cheque-processing activities of the Indian branch. We therefore find no reason to interfere with the exclusion of this company. As regards depreciation adjustment, the assessee has contended that differences in the depreciation methods and policies followed by the tested party and the comparable companies materially affected their operating margins. There can be no dispute that depreciation may constitute a relevant comparability factor, particularly where differences in accounting methods, useful lives of assets or the composition of fixed assets produce a material distortion in the operating margins. Rule 10B(3) recognises that differences materially affecting the price or profit arising from the transactions under comparison must be eliminated through reasonably accurate adjustments before the transactions can be regarded as comparable. However, an adjustment cannot be granted merely upon establishing that different depreciation methods have been followed. The assessee must demonstrate the actual financial effect of those differences and furnish a reasonably reliable basis for making the adjustment. The learned CIT(A) sustained the rejection principally because the requisite quantification had not been furnished. We therefore direct that the depreciation adjustment, if supported by the relevant financial particulars already forming part of the record and capable of reasonably accurate computation, shall be considered in accordance with Rule 10B(3). No adjustment shall be made merely on an estimated or generalised basis without establishing the material effect of the differences upon the operating margins. The same principle shall apply to investor services insofar as the assessee has adopted the corresponding benchmarking analysis, subject to the functional characteristics of that segment.

71. The next issue concerns the operating cost base adopted by the TPO for correspondent banking, cheque-processing and investor services. The assessee had determined the operating costs of the respective segments by identifying direct expenditure and allocating the relevant support expenditure, whereas the TPO considered that certain common indirect expenditure and proportionate corporate, Head Office and hub expenditure had not been adequately reflected in those costs. He accordingly enhanced the operating cost base by allocating expenditure through a common ratio derived from the salary and bonus expenditure attributable to the respective segments. The learned CIT(A) substantially accepted the treatment of corporate expenditure as operating expenditure but recognised that certain indirect expenditure had been allocated to cheque-processing services without a corresponding reduction from the cost base of correspondent banking services. He also directed that Head Office and hub expenditure, whose arm’s length price had separately been determined at nil and which had consequently been disallowed, should not simultaneously be included in the operating cost base of the service transactions. In our view, the controversy cannot be resolved merely by determining whether a particular expenditure was incurred for the purposes of the banking business as a whole. The operating cost of a tested transaction must bear a reasonable functional relationship with the activities undertaken in rendering the particular services being benchmarked. Expenditure may be allowable in computing the overall profits of the Indian branch and yet not constitute an operating cost of correspondent banking, chequeprocessing or investor services. Conversely, expenditure which supports the rendering of more than one service cannot be excluded merely because it is not capable of direct identification with a particular segment; in such circumstances, a reasonable allocation based upon the economic factors giving rise to the expenditure may be necessary. The cost base must therefore be determined by examining the actual nature of the expenditure, the functions which it supports and the reasonableness of the allocation methodology. A general allocation based upon employee cost may provide an appropriate measure for expenditure substantially driven by personnel deployment, but it does not necessarily furnish a reliable basis for distributing every category of corporate or administrative expenditure. The methodology adopted must have a rational connection with the expenditure sought to be allocated and should be applied consistently across the relevant segments. Further, where expenditure has already been attributed to one service segment, its allocation to another segment must be accompanied by a corresponding adjustment so that the same expenditure does not enter the operating cost base twice. These considerations, rather than the mere classification of expenditure in the books, must govern the consequential recomputation.

72. The corporate expenditure disputed by the assessee includes severance expenditure of Rs. 86,83,501 arising from restructuring, rental expenditure of Rs.31,81,633 relating to the Vakil House premises following their vacation, expenditure of Rs. 20,40,751 incurred in shifting equipment to the Mafatlal Centre, retainership and public-relations expenditure of Rs. 26,80,000 and directors ‘fees of Rs.90,059. The TPO treated these items as part of the expenditure incurred in connection with the banking business and allocated a proportionate amount to the service segments, while the learned CIT(A) substantially upheld their operating character. The assessee, on the other hand, contends that the severance, relocation and shifting expenses arose from exceptional circumstances connected with the merger and restructuring of the banking operations, whereas the public-relations and directors ‘fees related to the general corporate functions of the Indian establishment. We find considerable force in the objection that the mere incurrence of expenditure in connection with the banking business does not establish its relationship with the tested service transactions. Severance expenditure arising from restructuring, rental expenditure relating to premises no longer occupied and expenditure incurred in shifting equipment require examination to ascertain whether they formed part of the ordinary cost of rendering services during the relevant year or arose from exceptional activities connected with the reorganisation of the establishment. Similarly, expenditure incurred for public relations or general corporate management cannot automatically be attributed to correspondent banking, cheque-processing or investor services merely because those services formed part of the overall banking operations. At the same time, the assessee’s description of expenditure as exceptional, restructuring-related or corporate in character cannot, by itself, justify its exclusion if the underlying expenditure demonstrably supports the functions performed in the tested transaction. The appropriate enquiry is directed towards the actual purpose of the expenditure and its nexus with the services rendered. We therefore hold that the wholesale inclusion of the aforesaid corporate expenditure in the operating cost base, merely upon the application of an employee-cost ratio, cannot be sustained without examining the nature of the individual items and their relationship with the respective service segments. The Assessing Officer/TPO shall accordingly undertake a category-wise examination of the disputed expenditure on the basis of the material available on record and include only such expenditure as bears a direct or reasonably ascertainable operating nexus with the particular service segment. Expenditure arising from exceptional restructuring or relocation activities, or incurred for general corporate purposes without the requisite nexus with the tested services, shall not be allocated merely by applying a common ratio. Where expenditure is found to support more than one segment, the allocation shall be made through an economically rational and consistently applied key, with corresponding adjustments to prevent duplication. This exercise concerns the correct determination of the operating cost of the international transactions and shall not, by itself, determine the deductibility of the expenditure in computing the overall business profits of the Indian branch.

73. The aforesaid findings shall govern the consequential determination of the arm’s length price of the three service segments. In the case of correspondent banking services, the comparable set shall be recomputed after excluding Pioneer Investcorp Ltd., Centrum Finance Ltd. and Integrated Enterprises (India) Ltd., while adopting the relevant financial-year data and the correct operating cost base in accordance with our findings. In the case of cheque-processing services, the exclusion of Nucleus Netsoft & GIS India Ltd. is sustained, subject to the directions concerning financial data, depreciation adjustment and allocation of expenditure. The TPO shall particularly reconcile the indirect expenditure allocated between correspondent banking and chequeprocessing services and ensure that any amount transferred from the former to the latter is correspondingly reduced from the cost base in which it was originally included. In respect of investor services, the functional characteristics of the services and the expenditure attributable thereto shall be independently considered, notwithstanding the assessee’s adoption of substantially the same benchmarking approach as cheque-processing services. The same comparable analysis may be employed only to the extent justified by the actual functions performed and the availability of reliable financial information. The determination of the arm’s length price shall also take into account the separate findings concerning Head Office and hub expenditure, so that expenditure which is not properly attributable to the tested services is not loaded into their operating cost base and no expenditure is duplicated. The consequential exercise shall remain confined to giving effect to the specific findings recorded herein and shall not be treated as an unrestricted reopening of the transfer-pricing proceedings. Accordingly, Ground Nos. 2, 3 and 4 raised by the assessee are partly allowed for statistical purposes, in the terms indicated above.

74. We shall now examine Ground No. 6 concerning Head Office expenditure of Rs. 1,48,07,863, whose arm’s length price was determined at nil by the TPO and sustained by the learned CIT(A). The nature of the expenditure, the allocation methodology adopted by the assessee, the objections raised by the TPO and the findings of the learned CIT(A) have already been discussed in the preceding paragraphs. The principal infirmity in the approach adopted by the authorities below is that three distinct enquiries appear to have been substantially conflated, namely, whether the expenditure was actually incurred and reasonably attributable to the Indian operations, whether the amount allocated to the Indian branch represented an arm’s length charge under Chapter X, and whether the expenditure, once found attributable to the Indian business, was deductible under the applicable computation provisions, including section 44C. These enquiries, though interconnected, are governed by different statutory considerations and cannot be resolved merely upon the absence of a corresponding debit in the books of the Indian branch or a separate invoice raised by the Head Office. The assessee is a branch of a foreign banking enterprise whose worldwide operations involve centralised managerial, administrative, supervisory, financial-control, risk – management and other functions performed at the Head Office level. Expenditure incurred in relation to such functions may legitimately be attributable, wholly or partly, to the Indian operations, notwithstanding that it is incurred and discharged outside India. The absence of a corresponding accounting entry in the books of the Indian branch does not, by itself, establish that the expenditure was not incurred for the purposes of its business. At the same time, the mere existence of a global expenditure pool or an allocation methodology does not establish that the entire amount claimed was incurred for the Indian operations or that the allocation necessarily satisfies the arm’s length standard. The PwC certificate furnished by the assessee constitutes relevant evidence concerning the composition of the expenditure pool and the basis upon which costs were distributed amongst different establishments of the banking enterprise. However, the TPO had specifically noticed that the certificate related to the year ended 31 December 2002, whereas the relevant previous year ended on 31 March 2002, and that corresponding particulars for the earlier period had not been furnished. He had also questioned the inclusion of expenditure relating to philanthropic activities, aircraft, finance and marketing functions, whose relationship with the Indian operations had not been satisfactorily established. These objections concern the factual foundation of the claim and require objective examination. Nevertheless, deficiencies in the supporting material cannot, without an appropriate enquiry under the statutory transfer-pricing framework, justify determining the arm’s length price of the entire expenditure at nil merely upon the perception that the services were commercially unnecessary or that the Indian branch had not derived an immediate measurable benefit.

75. The deductibility of Head Office expenditure must be examined in the light of section 44C, read with Article 7(3) and the Protocol to the India-USA DTAA. Section 44C, notwithstanding anything contained in sections 28 to 43A, restricts the deduction of expenditure in the nature of Head Office expenditure incurred by a non-resident assessee to the lesser of five per cent of the adjusted total income and the amount of such expenditure actually attributable to the business or profession carried on in India, subject to the statutory qualifications and computation prescribed therein. Clause (iv) of the Explanation defines “head office expenditure” to mean executive and general administration expenditure incurred outside India, including expenditure relating to rent, rates, taxes, repairs or insurance of premises outside India, salary, wages and other remuneration paid or allowed to employees or other persons employed in or managing the affairs of offices outside India, travelling expenditure of such persons and other prescribed matters connected with executive and general administration. The scope of this provision has been authoritatively considered by the Hon’ble Supreme Court in American Express Bank Ltd. (supra). The Hon’ble Supreme Court has clarified that section 44C does not draw a distinction between expenditure incurred commonly for several establishments and expenditure incurred exclusively for the Indian branch. Once an expenditure satisfies the statutory definition of Head Office expenditure, the circumstance that it was incurred exclusively for the Indian operations does not, by itself, take it outside the restriction prescribed under section 44C. The Court has further explained that the expenditure must satisfy three cumulative requirements: it must have been incurred outside India; it must be in the nature of executive and general administration expenditure; and it must fall within one of the categories specifically enumerated in clauses (a), (b) or (c) of Explanation (iv), or within such other category as may have been prescribed under clause (d). Thus, the statutory definition cannot be enlarged to include every expenditure incurred outside India merely because it emanates from the Head Office, nor can qualifying expenditure be excluded from section 44C solely on the ground that it was incurred specifically for the Indian branch. The Hon’ble Supreme Court has also explained that the earlier view in Emirates Commercial Bank Ltd. (supra), insofar as it proceeded upon the proposition that expenditure incurred exclusively for the Indian branch necessarily fell outside section 44C, did not correctly state the law. The controlling consideration is therefore the actual nature of the expenditure and its satisfaction of the statutory definition. This distinction assumes importance in the present case because the assessee has computed its claim of Rs. 1,48,07,863 by applying the ceiling under section 44C, whereas the authorities below have principally questioned the existence, attribution and supporting evidence of the expenditure without separately examining whether the particular items satisfy the statutory definition.

76. Article 7(3) of the India-USA DTAA expressly recognises deduction of expenditure incurred for the purposes of the permanent establishment, including reasonable allocation of executive and general administrative expenditure and other expenditure incurred for the enterprise as a whole or that part thereof which includes the permanent establishment, irrespective of whether such expenditure is incurred in the State where the permanent establishment is situated or elsewhere. The provision, however, makes such deduction subject to the limitations prescribed by the taxation laws of the State in which the permanent establishment is situated. The Protocol further addresses the operation of domestic restrictions concerning executive and general administrative expenditure. Thus, the treaty recognises the deductibility of expenditure incurred centrally for the purposes of the Indian permanent establishment, while preserving the operation of the applicable statutory limitations. Section 44C, therefore, constitutes the relevant restriction where the expenditure satisfies its statutory definition, but the provision does not independently confer a deduction merely because the assessee has computed its claim within the prescribed ceiling. Equally, expenditure which does not satisfy the definition of Head Office expenditure cannot be brought within section 44C merely because it was incurred outside India. The appropriate course is first to ascertain whether the expenditure was actually incurred and whether the amount attributed to the Indian branch bears a reasonable relationship with its business operations. Its nature must thereafter be examined to determine whether it falls within Explanation (iv) to section 44C, applying the principles laid down by the Hon’ble Supreme Court in American Express Bank Ltd. (supra). Where the expenditure satisfies that definition, the deduction otherwise admissible shall be governed by the statutory ceiling, read with Article 7(3) and the relevant Protocol. Where it does not satisfy the definition, its deductibility must be considered under the otherwise applicable provisions of the Act. The transfer-pricing enquiry under Chapter X remains distinct. The TPO is entitled to examine the actual rendition of services or performance of functions, the expenditure incurred, the composition of the common cost pool, the exclusion of unrelated or duplicated expenditure and the economic reasonableness of the allocation methodology. However, he cannot determine the arm’s length price at nil merely because, in his perception, the expenditure was commercially unnecessary or the benefit derived by the Indian branch was not commensurate with the amount allocated, without undertaking an examination consistent with the prescribed methods. Conversely, the existence of a professional certificate or a global allocation formula does not preclude the TPO from examining whether the underlying expenditure was actually incurred and reasonably attributable to the Indian operations. The enquiry must therefore remain directed towards the actual nature of the expenditure and the reliability of its attribution, rather than the mere absence of a debit note or physical remittance between establishments of the same banking enterprise.

77. Applying the aforesaid principles, we find that the determination of the entire Head Office expenditure of Rs. 1,48,07,863 at nil cannot be sustained in the manner adopted by the TPO and affirmed by the learned CIT(A). The expenditure claimed arose from centralised functions which, by their very nature, may support the operations of different branches of a multinational banking enterprise, including the Indian establishment. The assessee has furnished a PwC certificate describing the corporate expenditure pool and the allocation methodology, principally based upon the relative revenues of the participating establishments. Such material cannot be disregarded merely because individual invoices were not raised upon the Indian branch or the expenditure was not separately debited in its books. Nevertheless, the certificate must be examined with reference to the period actually covered by it, particularly since the year ended 31 December 2002 does not correspond with the previous year ended 31 March 2002. The extent to which the certificate supports expenditure attributable to January to March 2002 and the availability of corresponding particulars for the preceding period require verification. Similarly, the objections concerning philanthropic expenditure, aircraft expenses and certain finance and marketing costs cannot be rejected without examining whether those items formed part of executive and general administrative expenditure incurred for the Indian operations or represented expenditure unrelated to the business of the Indian branch. The TPO did not undertake a sufficiently differentiated examination of these matters, but proceeded to determine the entire arm’s length price at nil substantially upon the absence of accounting entries, debit notes and supporting particulars. The learned CIT(A), while sustaining the adjustment, also placed considerable emphasis upon those deficiencies without separately examining the extent to which the expenditure could reasonably be attributed to the Indian operations and thereafter subjected to the applicable statutory restriction. The decisions in DresserRand India Pvt. Ltd. (supra)andJohnson & Johnson Ltd. (supra), support the principle that the arm’s length price cannot be determined merely upon a subjective assessment of commercial necessity or the adequacy of benefit, without an examination consistent with the transfer-pricing provisions. At the same time, these decisions do not dispense with the assessee’s obligation to establish the factual foundation of the expenditure and the reasonableness of its allocation. In these circumstances, neither the determination of the entire amount at nil nor an unconditional allowance of the full claim would be justified without examining the underlying material. The appropriate course is therefore to restore the matter for limited verification, while setting aside the determination of the arm’s length price at nil.

78. The Assessing Officer/TPO shall accordingly examine the claim of Rs. 1,48,07,863 with reference to the actual expenditure incurred, the functions to which it relates, its nexus with the Indian banking operations and the reasonableness of the allocation methodology, upon the basis of the material already placed on record and such supporting particulars as may be necessary for explaining or reconciling that material. The PwC certificate shall be considered objectively, particularly the period covered by it, the composition of the expenditure pool and the basis upon which the Indian allocation has been determined. Expenditure demonstrably unrelated to the Indian operations, duplicated elsewhere or otherwise not attributable to the Indian business shall be excluded. The Assessing Officer shall thereafter determine whether the expenditure so identified satisfies the statutory definition of Head Office expenditure under Explanation (iv) to section 44C, applying the principles laid down by the Hon’ble Supreme Court in American Express Bank Ltd. (supra). Where the expenditure falls within that definition, the deduction shall be restricted in accordance with section 44C, read with Article 7(3) and the Protocol; where it does not, the claim shall be considered under the otherwise applicable computation provisions. The alternative computations furnished by the assessee shall also receive specific consideration. The first proceeds upon revenue-linked extrapolation of Head Office expenditure attributable to assessment year 2003-04, while the further alternative seeks allowance of expenditure relatable to January to March 2002 on the basis of the available PwC certificate. The underlying figures, period of expenditure and allocation methodology shall be examined, and any departure from the computations shall be supported by specific reasons. The assessee shall be afforded a reasonable opportunity to explain and reconcile the relevant particulars. We clarify that the exercise is confined to verification of the expenditure, its attribution, arm’s length character and ultimate deductibility under the applicable statutory provisions. It shall not be treated as an unrestricted remand for reopening the entire transfer-pricing determination, nor shall the arm’s length price again be determined at nil merely by reiterating the objections concerning commercial necessity, non-payment or absence of an immediate quantifiable benefit. Further, expenditure ultimately found attributable to the Indian operations shall not automatically be included in the operating cost base of correspondent banking, cheque-processing or investor services unless its functional nexus with the particular transaction is independently established in accordance with our earlier findings. Accordingly, Ground No. 6 raised by the assessee is partly allowed for statistical purposes.

79. We shall now take up Ground No. 7 concerning the determination of the arm’s length price of hub expenditure of Rs. 3,11,81,346 at nil. The expenditure relates to centralised processing, technological and operational facilities maintained at Hong Kong and Bournemouth, whose functions and the supporting material relied upon by the assessee have already been discussed. Unlike general Head Office expenditure, the hub expenditure is stated to arise from identifiable operational and technological functions performed through centralised facilities maintained by the banking enterprise. The Hong Kong facility was engaged, inter alia, in wire-room operations, money-transfer processing, loan operations, deposit and payment processing and allied supervisory functions, whereas the Bournemouth facility maintained centralised systems and technological infrastructure supporting money-market and foreign-exchange transactions, trade-finance activities, credit-exposure monitoring and other banking operations. The assessee has relied upon the approvals granted by the Reserve Bank of India permitting offshore processing of banking data relating to the Indian operations, the agreement governing the services rendered through the overseas facilities and the allocation of the corresponding expenditure. These documents constitute relevant evidence concerning the existence and operational character of the arrangements. The regulatory approvals do not, by themselves, establish the arm’s length quantum of the expenditure, but they cannot be disregarded while examining whether the underlying arrangements were genuine and formed part of the banking infrastructure utilised by the Indian branch. The assessee has also relied upon the Tribunal’s order in its own case for assessment year 19992000, wherein substantially similar hub expenditure arising from centralised banking-support arrangements was examined and relief was granted upon consideration of the underlying services and their nexus with the Indian operations. It has been specifically submitted that the nature of the services and the centralised processing arrangements continued during the relevant year without any material change. Where expenditure arises from a continuing arrangement which has already been examined in an earlier assessment year, the earlier adjudication deserves due consideration unless there is a material change in the functions performed, the governing arrangements or the evidentiary position. Nevertheless, the earlier-year decision cannot dispense with verification of the amount claimed for the present year, particularly when the TPO has raised objections concerning the aggregate expenditure incurred at the respective facilities, the participating establishments and the allocation keys employed. The proper enquiry is therefore whether the centralised services were actually rendered or made available for the Indian operations, whether the corresponding expenditure was incurred, whether its allocation reasonably reflected the services utilised by the Indian branch and whether the amount claimed included unrelated or duplicated expenditure.

80. Having regard to the aforesaid circumstances, we find that the determination of the entire hub expenditure at nil, without adequately examining the regulatory approvals, service arrangements, functional description of the facilities and the earlier-year Tribunal decision, cannot be sustained. The learned CIT(A), while confirming the adjustment, substantially relied upon the deficiencies noticed by the TPO and the earlier first-appellate orders without adequately addressing the evidentiary significance of the material furnished by the assessee or the findings subsequently recorded by the Tribunal in the earlier year. The existence of centralised processing facilities and the performance of identifiable banking-support functions cannot be disregarded merely because the expenditure was incurred outside India or the corresponding amount was not separately debited in the books of the Indian branch. Equally, the existence of regulatory approvals or a general service arrangement does not establish that the entire expenditure allocated to India necessarily represents an arm’s length charge. The Assessing Officer/TPO shall therefore undertake a limited verification of the expenditure claimed with reference to the nature of services rendered through the Hong Kong and Bournemouth facilities, the approvals granted by the Reserve Bank of India, the relevant service agreements, the allocation methodology and the supporting material already placed on record. Due consideration shall be given to the Tribunal’s findings in the assessee’s own case for assessment year 1999-2000, particularly insofar as the nature of the centralised processing arrangements and their nexus with the Indian operations have already been examined. If the underlying arrangements and services are found to be materially identical, the earlier findings shall not be departed from merely because the expenditure pertains to a different assessment year, unless there is an identifiable change in the factual position or material demonstrating that the amount claimed for the year under consideration was not attributable to the Indian operations. The verification shall principally concern the actual expenditure incurred, the basis of allocation amongst the participating establishments, the amount reasonably attributable to the Indian branch and the exclusion of unrelated or duplicated expenditure. The Assessing Officer/TPO shall also bear in mind that the absence of separate invoices, debit notes or physical remittances between establishments of the same enterprise cannot, by itself, establish that the services were not rendered or had no economic value. The determination of the arm’s length price shall be undertaken in accordance with Chapter X, without substituting a subjective assessment of commercial necessity or immediate benefit for the prescribed arm’s length enquiry. Once the expenditure is found to have been incurred for the purposes of the Indian banking operations and its reasonable attribution is established, its deduction shall be considered under section 37(1), read with Article 7(3) and the other applicable provisions of the Act. The restriction under section 44C shall not be invoked merely because the expenditure was incurred outside India, unless it independently satisfies the statutory definition of Head Office expenditure. The expenditure ultimately found attributable to the Indian operations shall not automatically enter the operating cost base of the service segments unless its functional nexus with the particular transaction is established, and the same expenditure shall not be duplicated through separate disallowance and inclusion in the operating cost base. The assessee shall be afforded a reasonable opportunity of explaining the allocation workings and reconciling the supporting particulars. Accordingly, the determination of the arm’s length price of hub expenditure of Rs. 3,11,81,346 at nil is set aside, and Ground No. 7 raised by the assessee is partly allowed for statistical purposes, in the terms indicated above.

81. We shall now revert to Ground No. 1 concerning the disallowance of salary expenditure of Rs. 99,89,796 pertaining to Mr. Dominic Price, who was functioning as the Chief Executive Officer of the Indian branch during the relevant previous year. The relevant facts, the reasons recorded by the Assessing Officer and the findings of the learned CIT(A) have already been discussed in the preceding paragraphs. The Assessing Officer had disallowed the expenditure principally on the ground that the remuneration was directly paid by the Head Office outside India, was not debited in the books maintained by the Mumbai branch and, therefore, could not be regarded as expenditure incurred by the Indian branch under section 37(1). The learned CIT(A), while sustaining the disallowance, had additionally noticed that Form No. 16 furnished in respect of Mr. Price covered only the period November 2001 to March 2002, that the employment contract had not been produced, that the audited financial statements bearing his signature were signed on 25 June 2002 and that the assessee had not satisfactorily explained the enhancement of the salary claim from Rs. 23,67,301 in the original return to Rs. 99,89,796 in the revised return. The learned CIT(A) also distinguished the earlier appellate orders in the assessee’s own case concerning remuneration paid to expatriate executives deployed in India. However, these objections have to be examined in the context of the merger of Morgan Guaranty Trust Company of New York with J.P. Morgan Chase Bank N.A. on 10 November 2001, consequent upon which Mr. Dominic Price assumed responsibility for managing the Indian banking operations. Prior to the merger, the position was held by Mr. Mahesh Aras, an Indian executive. Thus, the absence of salary particulars of Mr. Price for the period April to October 2001 cannot, by itself, constitute an adverse circumstance when his appointment to the relevant position arose only consequent upon the merger in November 2001. The assessee has furnished the approval granted by the Reserve Bank of India on 24 January 2002 concerning his appointment as Chief Executive Officer, Form No. 16 relating to the remuneration received by him during November 2001 to March 2002, the audited financial statements bearing his signature in that capacity and a declaration confirming that he was exclusively managing the Indian banking operations. These documents, considered together, constitute material evidence concerning the capacity in which Mr. Price functioned and the relationship of his remuneration with the Indian business. The fact that the financial statements were signed after the close of the financial year does not detract from their evidentiary relevance, since financial statements are ordinarily finalised and authenticated after the conclusion of the accounting period. The question which therefore requires determination is whether the remuneration was incurred for the purposes of the Indian banking business and whether, having regard to the nature of the employment and the functions discharged by Mr. Price, the expenditure falls within the restriction prescribed under section 44C.

82. The scope of section 44C has already been examined in the context of Head Office expenditure, particularly in the light of the judgment of the Hon’ble Supreme Court in American Express Bank Ltd. (supra). The principle emerging therefrom is that the applicability of section 44C depends upon the nature of the expenditure and its satisfaction of the statutory definition contained in clause (iv) of the Explanation, and not merely upon whether the expenditure was incurred commonly for several establishments or exclusively for the Indian operations. Clause (b) specifically refers to salary, wages and other remuneration paid or allowed to employees or other persons employed in or managing the affairs of offices outside India. Thus, the place from which the remuneration is disbursed cannot be treated as the sole determinant of the applicability of section 44C. The statutory enquiry is directed towards the office in which the employee is employed or whose affairs he manages, together with the other conditions governing the definition of Head Office expenditure. Where an employee is employed in or manages the affairs of an office outside India and the expenditure otherwise satisfies the statutory definition, the restriction under section 44C would apply notwithstanding that the employee may also perform functions beneficial to the Indian operations. Conversely, where the remuneration pertains to an employee who is exclusively employed in and manages the affairs of the Indian branch, the expenditure does not fall within the particular category contemplated by clause (b) merely because the payment is made by the Head Office outside India. In such a case, its deductibility has to be examined under the otherwise applicable computation provisions, including section 37(1). The latter provision permits deduction of expenditure, not being capital or personal expenditure or expenditure covered by sections 30 to 36, which is laid out or expended wholly and exclusively for the purposes of the business. It does not prescribe that expenditure must necessarily be discharged from the bank account of the particular branch or separately debited in its books before its deductibility can be recognised. The accounting treatment may constitute relevant evidence, but it cannot override the actual nature of the expenditure or the statutory conditions governing its allowance. Equally, the fact that the remuneration has been offered to tax by the employee in India is a corroborative circumstance concerning the receipt and character of the payment, though it does not independently establish deductibility in the hands of the banking enterprise. The decisive consideration remains whether the expenditure was genuinely incurred for the purposes of the Indian business and whether it falls within any statutory restriction applicable to its deduction.

83. Applying the aforesaid principles, we find that the material placed on record sufficiently establishes that Mr. Dominic Price was functioning as the Chief Executive Officer of the Indian branch and was responsible for managing its banking operations during the relevant period. The merger of the banking entities on 10 November 2001 explains the change in the executive position, while the approval granted by the Reserve Bank of India on 24 January 2002, Form No. 16, the audited financial statements and the declaration concerning the functions discharged by Mr. Price provide a consistent evidentiary foundation for the assessee’s claim. There is no material brought on record by the Revenue to demonstrate that Mr. Price was employed in or managing the affairs of any office outside India during the relevant period or that any identifiable portion of his remuneration was attributable to functions performed for an overseas establishment. The absence of a separate employment contract, in the circumstances of the present case, cannot outweigh the other documentary evidence establishing his appointment and the nature of the responsibilities discharged by him. Similarly, the fact that the audited financial statements were signed after the close of the financial year does not affect their evidentiary value, particularly when the appointment and functions of Mr. Price are independently supported by the RBI approval and other material. The learned CIT(A), in our view, attached undue significance to the absence of a debit in the books of the Indian branch and the fact that the remuneration was directly paid by the Head Office, without adequately appreciating that the Head Office and the Indian branch are establishments of the same juridical banking enterprise. The statutory scheme does not require every expenditure incurred for the purposes of the Indian business to be physically disbursed by the Indian branch or separately recorded in its books before its deductibility can be recognised. What is material is whether the expenditure was genuinely incurred for the purposes of the business carried on in India and whether it satisfies the conditions prescribed under the applicable provisions of the Act. The enhancement of the claim from Rs. 23,67,301 in the original return to Rs. 99,89,796 in the revised return also cannot, by itself, constitute a ground for disallowance when the revised computation identifies the expenditure and the supporting material establishes its nature and relationship with the Indian operations. Insofar as section 44C is concerned, the remuneration of an executive exclusively managing the Indian branch does not fall within clause (b) of Explanation (iv) merely because the payment was made by the Head Office outside India. The Revenue has not established that the expenditure otherwise satisfies the cumulative conditions necessary for bringing it within the statutory definition of Head Office expenditure. Consequently, the restriction prescribed under section 44C cannot be invoked merely on the basis of the place from which the salary was disbursed. Once the expenditure is found to have been incurred for the services rendered by the Chief Executive Officer exclusively in connection with the Indian banking operations, its deductibility has to be determined under section 37(1). The fact that the remuneration was disclosed by Mr. Price in his Indian return of income lends further corroboration to the genuineness and character of the payment, though the deduction itself rests upon the expenditure having been incurred for the purposes of the assessee’s business. In the absence of any material suggesting that the remuneration was capital or personal in nature, related to activities outside the Indian operations or was otherwise inadmissible under the Act, we find that the disallowance made by the Assessing Officer and sustained by the learned CIT(A) lacks adequate factual and legal foundation. We accordingly hold that the salary expenditure of Rs. 99,89,796 incurred in respect of Mr. Dominic Price, who was exclusively managing the Indian banking operations during the relevant period, is allowable as deduction under section 37(1) and is not liable to be restricted under section 44C merely because the remuneration was discharged by the Head Office. The finding of the learned CIT(A) is accordingly set aside, and the Assessing Officer is directed to allow the deduction of Rs. 99,89,796. Ground No. 1 raised by the assessee is accordingly allowed.

84. Before taking up the Revenue’s appeal, we may briefly record the result of the substantive grounds raised by the assessee. Ground No. 8 concerning exclusion of Rs. 85,24,546 under Article 7(3) of the India-USA DTAA and Ground No. 1 relating to salary expenditure of Rs. 99,89,796 have been allowed. Ground Nos. 2, 3 and 4 concerning the arm’s length price of correspondent banking, cheque-processing and investor services have been partly allowed for statistical purposes, with directions for recomputation in accordance with our findings concerning functional comparability, financial-year data, depreciation adjustment and allocation of expenditure. Ground Nos. 6 and 7 relating to Head Office expenditure of Rs. 1,48,07,863 and hub expenditure of Rs. 3,11,81,346 have also been partly allowed for statistical purposes, the determination of their arm’s length price at nil having been set aside for the limited verification indicated hereinabove. Ground Nos. 5 and 9, having been treated as academic, do not require separate adjudication. The consequential computation shall be made consistently with the findings recorded on the respective grounds, without duplication of expenditure or overlapping taxation of the same profit element. Accordingly, the assessee’s appeal in ITA No. 3839/Mum/2006 is partly allowed, including for statistical purposes.

85. We shall now take up the Revenue’s appeal in ITA No. 3784/Mum/2006, wherein three grounds have been raised challenging the relief granted by the learned CIT(A). Ground No. 1 concerns the direction to allow the loss of Rs.7,79,516 arising from diminution in the value of investments held by the assessee in the course of its banking business. The brief facts relating to this issue are that the assessee, being a banking enterprise regulated by the Reserve Bank of India, held certain securities as part of its current investments, which, according to the assessee, constituted stock-in-trade of its banking business. In accordance with the accounting policy consistently followed by it and the applicable RBI guidelines, the securities were valued at cost or market value, whichever was lower, at the close of the accounting year, and the resultant diminution of Rs.7,79,516 was debited to the profit and loss account. The Assessing Officer did not accept the claim and disallowed the amount, principally following the stand adopted in the earlier assessment years. He observed that although similar claims had been allowed by the learned CIT(A) in the preceding years, the Department had not accepted those decisions and had preferred appeals before the Tribunal. Before the learned CIT(A), the assessee submitted that the securities were held as stock-in-trade in the ordinary course of its banking operations and that their valuation at cost or market value, whichever was lower, was a recognised and consistently followed method of accounting. It was further contended that the resultant diminution was not a provision for an unascertained or contingent liability but represented the consequence of applying the accepted method of valuation to trading securities held at the close of the year. Reliance was placed upon the decisions of the Hon’ble Supreme Court in United Commercial Bank v. CIT [1999] 156 CTR 380/240 ITR 355/106  (SC), the Hon’ble Bombay High Court in CIT v. Bank of Baroda, Commissioner of Income-tax v. Bank of Baroda [2003] 262 ITR 334/129  (Bombay), and the Hon’ble Kerala High Court in CIT v. Nedungadi Bank Ltd. [2003] 182 CTR 403/264 ITR 545  (Kerala), besides the appellate orders passed in the assessee’s own case for the earlier assessment years. The learned CIT(A), after examining the nature of the securities, the accounting treatment followed by the assessee and the aforesaid judicial precedents, accepted the contention. He observed that the assessee had consistently followed the mercantile system of accounting and, in accordance with the RBI guidelines, regularly recognised the profit or loss arising from valuation of its current investments. Following the principles laid down by the Hon’ble Supreme Court in United Commercial Bank (supra) and the Hon’ble Bombay High Court in Bank of Baroda (supra), as well as the favourable appellate orders in the assessee’s own case for assessment years 1999-2000 and 2001-02, he directed the Assessing Officer to allow the loss of Rs.7,79,516. The Revenue is aggrieved by the aforesaid direction.

86. We have considered the rival submissions and the findings recorded by the authorities below. In our view, the learned CIT(A) has correctly appreciated the nature of the expenditure and the principles governing valuation of securities held as stock-in-trade by a banking enterprise. The material consideration is the character in which the securities are held and the method consistently followed for their valuation at the close of the accounting period. Where securities constitute stock-in-trade of the banking business, valuation thereof at cost or market value, whichever is lower, is a recognised method for determining the true profits of the business, and the diminution arising from application of such method cannot be equated with a provision for an unascertained liability. The Hon’ble Supreme Court in United Commercial Bank (supra) has recognised the permissibility of valuing stock-in-trade at cost or market value, whichever is lower, while the Hon’ble Bombay High Court in Bank of Baroda (supra), applying the aforesaid principle in the context of securities held by a banking enterprise, has upheld the corresponding deduction arising from diminution in their value. The mere circumstance that securities are described as investments in accounts prepared in accordance with banking or regulatory requirements does not, by itself, conclusively determine their character for purposes of computation of taxable business income. What is relevant is whether the securities are held as trading assets and whether the method of valuation has been consistently followed. In the present case, the learned CIT(A) has recorded that the assessee regularly traded in current investments and consistently followed the method of valuation at cost or market value, whichever was lower, in accordance with the applicable RBI guidelines. The Revenue has not brought before us any material which would dislodge this factual finding or demonstrate that the method of valuation was altered during the relevant year with a view to artificially reducing the taxable income. Significantly, the Assessing Officer has not identified any specific defect in the valuation methodology or demonstrated that the diminution of Rs.7,79,516 was incorrectly computed. The disallowance was made principally because the Department had not accepted the favourable appellate orders passed in the preceding years. Mere pendency of departmental appeals against those orders cannot constitute an independent basis for rejecting an otherwise admissible claim, particularly when the legal principle stands recognised by the Hon’ble Supreme Court and the jurisdictional High Court. We therefore find no infirmity in the direction of the learned CIT(A) allowing the loss of Rs.7,79,516. Accordingly, Ground No. 1 raised by the Revenue is dismissed.

87. Ground No. 2 concerns the deletion of disallowance of Rs. 1,06,58,000 claimed by the assessee as interest expenditure arising from repurchase transactions in securities. The Assessing Officer, while examining Schedule 15 to the profit and loss account, noticed that the assessee had debited the aforesaid amount under the head “Interest on repurchase of securities”. The assessee explained that the expenditure arose from repurchase transactions, commonly referred to as repo transactions, under which a holder of securities sells them to another party with an agreement to repurchase the securities at a predetermined date and price. The repurchase price is ordinarily fixed so as to provide the counterparty with an agreed return or spread over the period of the transaction, and the corresponding financing cost is recognised as interest expenditure. It was explained that the amount of Rs. 1,06,58,000 represented interest incurred on such repurchase transactions undertaken during the financial year ended 31 March 2002 and had been accounted for in accordance with the applicable RBI guidelines. The Assessing Officer, however, proceeded to treat the amount as a loss arising from revaluation of outstanding forward foreign-exchange contracts and, on the premise that such loss represented a notional or unrealised loss on contracts remaining unmatured at the close of the accounting year, disallowed the deduction. Before the learned CIT(A), the assessee specifically pointed out that the Assessing Officer had proceeded upon an erroneous factual premise by treating interest expenditure on repurchase transactions as though it represented a loss on unmatured foreign-exchange contracts. It was submitted that the two transactions were entirely distinct in their nature and accounting treatment. The amount of Rs.1,06,58,000 was separately disclosed in Schedule 15 under the head “Interest on repurchase of securities”, whereas the assessee had, in fact, earned gains of Rs. 7,26,66,000 on unmatured foreign-exchange contracts, which had been offered to tax in its return of income. Thus, there was no question of the impugned expenditure representing an unrealised loss arising from foreign-exchange contracts. The learned CIT(A), after examining Schedule 15 and the explanation furnished by the assessee, found that the amount of Rs. 1,06,58,000 was specifically reflected as interest expenditure on repurchase of securities and that the narration in the accounts was consistent with the nature of the transaction explained by the assessee. He further observed that the Assessing Officer had not furnished any reason or material for concluding that the amount represented a loss on outstanding forward foreign-exchange contracts. The discussion contained in paragraphs 7.2 to 7.5 of the assessment order was found to relate to the treatment of forward foreign-exchange contracts rather than the repurchase transactions giving rise to the expenditure actually claimed. Having regard to this fundamental factual distinction, the learned CIT(A) held that the disallowance proceeded upon an erroneous appreciation of the nature of the expenditure and directed deletion of Rs. 1,06,58,000. The Revenue has challenged the aforesaid finding.

88. After considering the findings recorded in the assessment order and the impugned appellate order, we do not find any reason to interfere with the conclusion reached by the learned CIT(A). The controversy essentially turns upon the correct identification of the transaction from which the expenditure arose. The amount of Rs. 1,06,58,000 was expressly disclosed in Schedule 15 to the profit and loss account as interest expenditure on repurchase of securities, and the assessee had explained the nature of the underlying repo transactions and the financing cost arising therefrom. The Assessing Officer, however, proceeded to disallow the expenditure by applying considerations relevant to an altogether different accounting item, namely, an unrealised loss arising from valuation of outstanding forward foreign-exchange contracts. The learned CIT(A) has correctly noticed that the Assessing Officer did not demonstrate how the expenditure specifically described as interest on repurchase of securities could be recharacterised as a loss on unmatured foreign-exchange contracts. On the contrary, the assessee had separately recognised gains of Rs. 7,26,66,000 arising from unmatured foreign-exchange contracts and had offered the same to tax. The existence of such separately accounted foreign-exchange transactions does not alter the character of the interest expenditure arising from repurchase transactions in securities. The deductibility of an expenditure has necessarily to be examined with reference to the transaction giving rise to the liability, and a claim cannot be rejected by importing considerations applicable to another and unrelated item merely because both are reflected in the accounts of the same banking enterprise. There is no finding that the underlying repurchase transactions were not genuine, that the interest liability had not accrued during the relevant previous year or that the expenditure was capital in nature or otherwise unrelated to the banking business. Once the expenditure is found to represent interest arising from repurchase transactions undertaken in the ordinary course of banking operations, its deductibility cannot be denied on the premise that it represents a notional foreign-exchange loss. The Revenue has not brought before us any material which would controvert the factual distinction recorded by the learned CIT(A) or establish that the impugned amount represented anything other than interest expenditure on repurchase transactions. In these circumstances, the very foundation upon which the Assessing Officer proceeded to make the disallowance does not survive. We accordingly uphold the finding of the learned CIT(A) deleting the disallowance of Rs. 1,06,58,000. Ground No. 2 raised by the Revenue is dismissed.

89. Ground No. 3 raised by the Revenue concerns the direction of the learned CIT(A) to adopt the average of the arithmetic means based upon financial data pertaining to assessment years 1999-2000, 2000-01 and 2001-02, instead of the financial data for financial year 2001-02 adopted by the TPO for the relevant transfer-pricing analysis. This issue has already been examined by us in paragraph 69 hereinabove while adjudicating the corresponding transfer-pricing controversy in the assessee’s appeal. We have held therein that Rule 10B(4), as applicable to the relevant assessment year, gives primacy to contemporaneous financial data pertaining to the financial year in which the international transaction was entered into, while the proviso permits consideration of preceding-year data only where such data reveals facts capable of influencing determination of the transfer price in relation to the transactions being compared. The mere circumstance that the operating margins derived from preceding-year data differ substantially from those pertaining to the relevant financial year does not, by itself, justify adoption of an average of arithmetic means derived from three different years. The learned CIT(A) had principally relied upon the substantial variation between the margins determined from the earlier-year information and those computed by the TPO for financial year 2001-02, without identifying any particular facts or economic circumstances emerging from the preceding-year data which satisfied the conditions prescribed under the proviso to Rule 10B(4). We have accordingly held that the direction to adopt the three-year average cannot be sustained and that the financial data pertaining to financial year 2001-02 is required to be adopted for the relevant benchmarking exercise, subject to the other findings recorded by us concerning functional comparability, the appropriate comparable set and the correct operating cost base. Since the issue has already been examined in detail and a specific finding has been recorded, we do not consider it necessary to repeat the same reasoning. The direction of the learned CIT(A) on this limited issue is accordingly reversed, and the approach of the TPO concerning adoption of financial data pertaining to financial year 2001-02 is restored, subject to the consequential recomputation directed in the assessee’s appeal. Ground No. 3 raised by the Revenue is accordingly allowed.

90. In the result, the appeal filed by the assessee in ITA No. 3839/Mum/2006 is partly allowed, including for statistical purposes, whereas the appeal filed by the Revenue in ITA No. 3784/Mum/2006 is partly allowed. The Assessing Officer/TPO shall give consequential effect to our findings and directions in accordance with law, restricting the exercise of verification and recomputation to the matters specifically restored, without disturbing the findings and issues conclusively adjudicated by us.