The Delhi Tribunal last week delivered a Diwali gift to Japanese trading giant Mitsubishi Corporation. The judgment has positive implications for Japanese companies and should go a long way in encouraging India-Japanese trade and investment. Rarely do transfer pricing rulings make a splash that has a direct impact on a business model, but this one that upholds the adoption of the Berry Ratio (gross profit/operating expenses) for Sogo Shosha companies (a Japanese expression for general trading companies) as a profit level indicator (PLI) comes as a fillip to foreign companies doing business in India and would enable them to do business with certainty. By upholding the adoption of such a profit level indicator, it also sends a message to the international investor community that Indian courts will not shy away from appreciating global business models and Indian regulations are to be interpreted in a manner that is harmonious with business reality.
Sogo Shosha companies are unique in that they engage in high-volume, low-margin trading activity across a spectrum of commodities—as the ruling notes, from noodles to missiles. They are almost peculiar to Japanese trading houses which account for 10% of global trade. Mitsubishi is one such Sogo Shosha company, which like other trading giants, is engaged in two types of activities—a simpliciter buy-sell/distribution function and an indenting/agency function. Regardless of nomenclature, the key differentiator is that Sogo Shosha companies do not take ownership and possession of goods and typically play the role of a matchmaker. This being the case, their profitability, a subject matter of transfer pricing analysis and dispute, is a function of their ability to connect buyers and sellers, regardless of their value. The transfer pricing dispute historically has been around the appropriate measure of profitability (profit level indicator) for comparability purposes. There is no doubt that transfer pricing is the comparison of a controlled transaction with an uncontrolled one, but a plain reading of Indian regulations suggests that for the application of the transactional net margin method, the operating profit has to be measured relative to an appropriate base, for example sales. This measure is reasonable when the profit of a distribution entity is the function of the value of goods it deals in, but what happens when, under a Sogo Shosha, such distribution takes the character of a service? The Berry Ratio is internationally used and recognised to deal with precisely this situation. The Berry Ratio is, in effect, a mark-up on operating costs of the trading activity that is measured by comparing the extent to which the gross profit covers operating costs, without reckoning the value of traded goods.
The revenue authorities challenged such position on the ground that it was not consistent with the Indian transfer pricing regulations. This was despite the transfer pricing officer’s own finding that Sogo Shosha is a unique trading model which entails that low-risk, high-volume, and observations of the Delhi High Court in Mitsubishi Corporation’s own case that it is “akin to trading”, (but not trading). It was a case where the revenue authorities fell back on the literal language of the statute, without giving any consideration to the business realities, being extremely thin margins.
The tribunal put the matter in pictorial perspective, stating that if a line were to be drawn between two extreme points, one being trading and the other being agency, then the Sogo Shosha would fall somewhere in between. And it is precisely because of the model’s uniqueness that comparability poses a challenge; there are no Indian Sogo Shosha companies and hence it warrants a different measure of profitability for comparability purposes. The Tribunal, after deeply analysing the uniqueness of the model, held that the PLI has to be consistent with the functional analysis, regardless of the accounting treatment; hence, the Berry Ratio is an appropriate profit level indicator.
The impact of this ruling could be massive. Japanese businesses have made advocacy efforts with Indian government, including approaching Prime Minister Narendra Modi during his recent visit to Japan, arguing for ease of doing business in India. And responding to which the government has committed a conducive environment to grow, and upgrading its relationship to the level of a Special Strategic and Global Partnership.
In this context, the ruling of the Tribunal, which makes a specific parting remark—“At a time when there is a clarion call by the government of India, at the highest level, to simplify the process of implementing the laws, and ensure certainty friendly measures to the foreign enterprise doing business in India, we would perhaps fail in our duty if we do not, though within whatever be our inherent limitations, rise to the occasion and discharge our judicial functions in a comprehensive, rather than superficial, manner, and contribute to the dispute reaching finality sooner rather than later”—comes as a shot in the arm. The currency of the ruling is notable—the location savings theory advanced by the revenue authorities is demolished with reference to the OECD guidance on intangibles, as part of the ongoing base erosion and profit shifting (BEPS) project. Several Sogo Shosha companies have filed for advance pricing agreements (APAs)—most Japanese APAs are bilateral —and this ruling, coupled with the amendment to Japanese transfer pricing regulations in 2013, recognising the Berry Ratio as an acceptable profit level indicator, consistent with the OECD guidelines, should pave the way for a far more rational and business-friendly environment.
Assisted by Suchint Majmudar
The author is managing partner, BMR Legal. Views are personal