Cost Recovery Mark-up & Merger Deduction AY 2026-27 ITAT Ruling

What Happened?

The Income Tax Appellate Tribunal (ITAT) in Hyderabad has issued a landmark ruling that brings relief to multinational enterprises (MNEs) and merged entities. The tribunal has held that transfer pricing mark-ups are not applicable to pure cost recovery arrangements involving seconded employee reimbursements. Additionally, the ITAT has clarified that deductions under Section 35DD of the Income Tax Act 2025 (amalgamation and merger expenses) are not restricted to only five years and can extend beyond the fifth assessment year, provided conditions are met.

Background & Legal Context

Understanding Transfer Pricing on Cost Recovery

When an Indian subsidiary or branch receives services from a parent company or related entity—such as seconded employees—and reimburses the actual cost, transfer pricing rules under Section 92 of the Income Tax Act 2025 typically apply. The Indian tax authorities have often insisted on adding an arm's length mark-up (typically 5-10%) to such reimbursements to ensure "transfer pricing compliance."

However, the ITAT's ruling now clarifies that pure cost recovery involves no profit element. When a company simply passes through actual costs incurred (salary, benefits, travel, accommodation) without any markup, there is no "transfer" of value that would attract transfer pricing adjustments. This aligns with the "cost plus" methodology recognized globally under OECD Transfer Pricing Guidelines.

Section 35DD – Merger and Amalgamation Deductions

Section 35DD of the Income Tax Act 2025 permits deduction of expenditure incurred in connection with the amalgamation or merger of a company. The original concern was whether such deductions must be completed within five years from the year of amalgamation.

The statute uses the language: "...in the year in which the amalgamation takes place and in each of the four years immediately following that year." This created ambiguity—whether deductions were strictly capped at five years or whether they could be allowed across multiple years without a fixed time limit.

The ITAT's latest ruling clarifies that Section 35DD deductions are allowed as long as the expenditure is incurred in connection with the merger, not strictly limited by calendar years. The five-year reference is about the timing of incurrence, not an absolute prohibition on deduction timing.

What Does This Mean for You?

For IT Service Companies and MNEs

• Cost Recovery Reimbursements Need No Mark-up: If your company seconded employees to a related entity and charged back actual costs (salary, benefits, travel), you can now defend those cost reimbursements without transfer pricing adjustments. This removes the risk of transfer pricing penalties under Section 271AA of the IT Act 2025 and corresponding benefit adjustment by the assessing officer.
• Documentation Remains Critical: You must maintain clear segregation between cost recovery and profit-bearing services. If services include any consulting, management fees, or overhead allocation, those components will still require transfer pricing documentation.
• Practical Relief in Audits: During Income Tax audits for AY 2025-26 and AY 2026-27, you can cite this ruling to challenge any transfer pricing adjustments on genuine cost recoveries. This significantly reduces litigation risk and compliance burden.

For Merged and Amalgamated Companies

• Extended Deduction Period: If your company underwent a merger in AY 2021-22 or earlier, and Section 35DD deductions were restricted to five years only, you may now have grounds to claim additional deductions beyond the fifth year if expenses were incurred post-year five but connected to the merger.
• Revision/Rectification Opportunity: This ruling could support filing revised returns under Section 139(5) of the IT Act 2025 for AY 2024-25 and AY 2025-26 to claim deductions previously rejected.
• Loss Carry-Forward Impact: If merger expenses were denied earlier, increased deductions now could reduce computed income and expand loss carry-forward positions—valuable for future profitable years.

Administrative Relief

Both rulings reduce the compliance and litigation burden for businesses during assessment proceedings and transfer pricing audits. The ITAT's stance signals that the income tax authorities should focus on genuine profit transfer risks rather than technical mark-ups on cost pass-throughs.

What Should You Do Now?

Immediate Action Items

1. Audit Your Cost Recovery Arrangements

• Review all inter-company cost reimbursements from the last 5-7 years (AY 2020-21 onwards).
• Segregate pure cost recoveries (no markup, no profit) from service charges (which require transfer pricing documentation).
• Prepare a detailed cost breakup showing salary, benefits, travel, accommodation, etc., with supporting invoices and payment evidence.

2. Review Open Assessments

• If the assessing officer has made transfer pricing adjustments on cost recoveries in any open AY (typically last 3 years), you now have grounds to challenge through first or second appeal.
• Engage your transfer pricing advisor to draft a detailed submission citing the ITAT ruling.

3. For Merged Entities – Check Section 35DD Claims

• Retrieve all merger-related expenditure records: legal fees, stamp duty, regulatory filings, IT integration costs, employee severance, etc.
• If you stopped claiming deductions after year five (AY ending 5 years post-merger), re-examine whether additional expenses can be claimed.
• File a revised return if the statute allows (within 2 years of the original return due date under Section 139(5) IT Act 2025).

4. Update Transfer Pricing Documentation

• Revise your transfer pricing study to clearly distinguish between cost recovery and profit-earning transactions.
• Include a section explaining why cost recoveries do not attract arm's length mark-ups, citing the ITAT ruling.
• Ensure consistency across all cost recovery transactions—if one is marked up, all must be marked up consistently.

5. Proactive Disclosures in Pending Returns

• If you haven't filed returns for AY 2025-26 yet, disclose cost recovery arrangements clearly with zero markup, supported by detailed workings.
• This reduces the likelihood of transfer pricing scrutiny and demonstrates good faith compliance.

Key Takeaways

• Cost Recovery Clarity: Pure cost pass-throughs without profit margins do not require transfer pricing mark-ups under Section 92, significantly reducing compliance complexity for MNEs and service providers.
• Section 35DD Extended Benefit: Merger and amalgamation deductions are not strictly capped at five years; they continue as long as expenditure is incurred in connection with the merger.
• Litigation Risk Reduced: The ITAT ruling provides strong legal precedent to defend cost recovery positions in audits and appeals, lowering both legal and financial exposure.
• Revised Returns Opportunity: Taxpayers can explore filing revised returns for AY 2024-25 and AY 2025-26 to claim deductions previously denied or not claimed due to misconception about the five-year limit.
• Documentation is Non-Negotiable: Even with favorable rulings, detailed documentation segregating cost recoveries from profit-bearing services remains essential to withstand scrutiny.

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