ITAT Ruling 2026: Foreign Banks Expatriate Salary Deduction & Transfer Pricing

What Happened?

In a significant decision delivered in July 2026, the Income Tax Appellate Tribunal (ITAT) Mumbai ruled in favor of a foreign bank on multiple contested taxation issues. The tribunal allowed deduction of expatriate salaries, upheld relief under India's Double Taxation Avoidance Agreement (DTAA), partially sustained transfer pricing (TP) adjustments made by tax authorities, and rejected disallowance claims under section 40(a)(i) of the Income Tax Act 2025. This ruling is a landmark judgment for multinational banks and foreign financial institutions operating in India.

Background & Legal Context

The Key Sections Involved:

• Section 40(a)(i) of IT Act 2025: This section disallows deductions for payments made to non-residents where tax has not been deducted at source (TDS) or has been deducted but not deposited. The assessing officer had invoked this section to disallow certain head office expenses paid by the Indian branch to the foreign parent company.
• Section 92 (Transfer Pricing Rules): The transfer pricing provisions require that transactions between related entities be conducted at arm's length prices. The authorities had made TP adjustments, which the ITAT partially upheld based on comparable data and functional analysis.
• Article 24 & Chapter X-A of IT Act 2025: These provisions govern DTAA relief for foreign banks and enable them to claim benefits of bilateral tax treaties signed by India. The tribunal confirmed that DTAA relief was correctly claimed and properly documented.
• Section 195 of IT Act 2025: TDS provisions for payments to non-residents. The ITAT examined whether proper TDS compliance had been maintained on various payments.

What Was the Dispute?

The assessing officer during AY 2025-26 assessment had questioned three main areas:

• Whether expatriate salaries paid to foreign nationals posted in the Indian branch should be fully deductible or partially disallowed as personal expenses
• Whether head office expenses paid to the parent company constituted taxable income or allowed deductions under section 40(a)(i)
• Whether transfer pricing adjustments were correctly computed based on comparable companies and functional analysis

The bank appealed to ITAT contending that all these items were legitimate business expenses with proper commercial substance and international tax compliance.

What Does This Mean for You?

For Foreign Banks & Financial Institutions:

• Expatriate Salary Deduction Now Clearer: The ITAT has confirmed that salaries paid to foreign expatriate employees posted in India are deductible business expenses, provided they are reasonable, commercial in nature, and not inflated. This is a significant relief for multinational banks that maintain international talent pools. The tribunal rejected the tax officer's argument that such expenses are personal in nature. Foreign banks can now confidently claim these deductions in their TP documentation and ITR filings for AY 2025-26 onwards.
• Section 40(a)(i) Disallowance Rejected: The tribunal made a critical finding: section 40(a)(i) cannot be invoked merely because TDS was not deducted. The assessee must be given opportunity to deposit the tax, and only if tax is genuinely not deposited (with evidence), can disallowance apply. This protects taxpayers from harsh disallowances for procedural delays. For your AY 2025-26 return, ensure TDS is properly deposited within the due date to avoid any issues.
• DTAA Relief Is Safe: The ruling confirms that properly documented DTAA claims cannot be rejected without solid evidence that the treaty benefit is not available. Foreign banks can continue claiming treaty benefits for Indian-sourced income without fear of arbitrary disallowance, provided documentation is complete.
• Transfer Pricing: Partial Win: The tribunal upheld some TP adjustments but rejected others based on inadequate comparable company analysis by the assessing officer. This teaches that TP documentation must be robust, with strong functional analysis and current comparable data. If you are a foreign bank or multinational, strengthen your TP study with recent comparables and proper functional analysis.

For Multinational Enterprises Broadly:

This ruling extends beyond banks. Any MNE with expatriate employees, head office charges, or intra-group transactions will benefit from clearer jurisprudence on these issues. The ITAT has signaled that:

• Reasonable expatriate compensation is deductible
• Head office charges require proper allocation methodology and transfer pricing support
• Section 40(a)(i) is not a catch-all disallowance tool
• TP adjustments must be backed by credible comparable company data

Tax Officer Perspective:

Assessing officers are now on notice that blanket disallowances under section 40(a)(i) or TP adjustments without proper functional analysis will face tribunal scrutiny. This moderates aggressive assessment practices and promotes balanced tax administration.

What Should You Do Now?

Immediate Actions for Assessment Year 2025-26:

• Review Expatriate Salary Treatment: If your business employs foreign nationals in India, document the commercial purpose, market rate comparison, and business necessity for each posting. Ensure salaries are reasonable and not inflated. Claim deduction confidently based on this ITAT ruling.
• Audit Section 40(a)(i) Compliance: Review all payments made to non-residents in FY 2024-25 (AY 2025-26). Verify that TDS was properly deducted and deposited. If not, deposit immediately with late fee to mitigate disallowance risk. Keep evidence of deposit dates and TDS challans.
• Strengthen Transfer Pricing Documentation: If you have related-party transactions (especially with foreign parents or subsidiaries), ensure your TP study includes:
• Current comparable company analysis (not outdated data)
• Detailed functional analysis of your entity vs. comparables
• Economic benchmarks from recognized databases
• Clear allocation methodology for head office charges
• DTAA Compliance Checklist: If you are claiming treaty benefits:
• Obtain valid tax residency certificate from the other country
• Maintain documentation on the type of income (business profit, service income, etc.)
• File Form 10F (for tax residents of other countries) where applicable
• Keep correspondence with foreign tax authorities if relevant
• Prepare for Disputes: If an assessment notice raises section 40(a)(i) or TP issues, cite this ITAT ruling in your response. Demand that the assessing officer provide proper comparable data before making TP adjustments. Request opportunity to deposit any TDS shortfall.

For Tax Professionals and Auditors:

Update your guidance to clients on expatriate expense policies, TP documentation standards, and section 40(a)(i) compliance. This ITAT decision strengthens the case for taxpayer-friendly interpretation of these provisions.

Key Takeaways

• Expatriate salaries are deductible: Foreign banks and MNEs can claim deductions for reasonable expatriate compensation without fear of blanket disallowance, provided commercial purpose and market rates are documented.
• Section 40(a)(i) is not automatic disallowance: Tax officers must show that tax was actually not deposited, not merely that TDS was delayed. Taxpayers get opportunity to regularize before disallowance applies.
• DTAA relief is protected: Properly documented treaty benefit claims cannot be arbitrarily rejected. Foreign banks and tax residents of treaty countries can confidently claim relief with complete documentation.
• Transfer pricing requires strong comparables: Generic TP adjustments without credible comparable company data will not survive tribunal scrutiny. Invest in robust, current TP studies.
• Functional analysis is critical: Simply citing transfer pricing provisions is insufficient. Detailed functional analysis comparing your business model to comparables strengthens your position in dispute.

Bottom Line: This July 2026 ITAT ruling is a watershed moment for foreign banks and multinational enterprises in India. It resets the balance in taxation of international transactions, emphasizing commercial substance over procedural technicality. For AY 2025-26 assessments onward, ensure your expatriate policies, TDS compliance, and transfer pricing documentation reflect this judgment. Proactive compliance now will shield you from aggressive assessment later.

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