The I-T Tribunal ruling has much larger relevance and application, not only for sogo shoshas but also for limited-risk distributors and traders
General trading companies or sogo shosha (as they are called in Japan) have been a subject of transfer-pricing disputes and litigations in India since a long time. The issues involved range from functional differences between the sogo shosha and normal trading activities to the selection of profit-level indicators for the purpose of benchmarking arm’s length price for such activities.
Recently, the Delhi Bench of the Income-tax Appellate Tribunal , in the case of Mitsubishi Corporation India Private Limited, upheld the difference between sogo shosha (general trading) and normal trading activities. The Tribunal also agreed that the berry ratio can be used as an appropriate profit level indicator (PLI) in such cases where the business does not assume any significant inventory risk or perform any functions to add value to the goods traded.
The Tribunal has reiterated the importance of the functional, asset and risk (FAR) analysis in transfer-pricing and brought out its importance in determining the appropriate PLI. This column summarises the ruling’s key points and their relevance for companies having similar business models from a transfer-pricing perspective.
Sogo shosha are trading companies engaged in both import and export of a diversified range of products. Such companies are not defined by the products or services they offer. They offer a wide range of goods and functions and are distinct in the world of commerce, and play an important role in linking buyers and sellers of a wide range of products. Although the sogo shosha companies perform trading activities which involve transferring the title in goods, in substance, the functions carried out by them are merely in the nature of service-providers, facilitating their principal suppliers and buyers in procurement and selling related activities.
Considering the limited functions performed, sogo shosha companies can be characterised as service providers and, accordingly, the mark-up for the functions performed should be considered on their ‘value-added expenses’ or ‘operating expenses’ and not on the value of goods handled by them.
In determining the appropriate pricing/remuneration model, the Tribunal highlighted an important factor with respect to the level or cost of inventory associated with operating expenses. It was of the view that in the cases where no economic risk for inventory is assumed and no value addition is performed in respect of the inventory, except to facilitate trading of the same, it is appropriate to exclude inventory cost from the cost base. Emphasis was placed on the insignificant risk associated with low inventory-level vis-a-vis other comparables earning additional profit on account of presence of inventory risk.
The Tribunal has addressed the issue raised by the tax authorities that while using the berry ratio (gross profit/operating expenses) as an appropriate PLI, the taxpayer has ignored the cost of goods sold (COGS) for determination of arm’s length price, whereas COGS is accounted for in the financials of the taxpayer. This, according to the tax authorities, was creating a conflict between the accounting principles and economic principles.
The Tribunal observed that though accounting principles require the accounting of the COGS for the purposes of financial analysis, however, when it comes to determination of arm’s length price, the economic principles will prevail. The very fundamental of such determination is that assessees should make profits that are commensurate with their “functions performed, risks assumed and assets utilised” (FAR analysis). This economic exercise of determining arm’s length price cannot depend on the accounting entries to such a large extent that it ignores the FAR analysis. Hence, once it was concluded that the COGS was not relevant to the FAR of the taxpayer, it was wholly justified to exclude the COGS from the formula of determining arm’s length price.
The Tribunal observed that whether a taxpayer is entitled to a return on the value of goods traded by it would actually depend on the functions performed and the related risks borne, with respect to the goods. If the taxpayer has only held a flash title in goods sometimes and not undertaken any significant risks with respect of the goods, all the functions performed by the taxpayer would be reflected in the value-added expenses and the value of goods traded would not have any impact on the FAR of the taxpayer.
The Tribunal observed that the claim of the tax authorities that intangibles like supply-chain and human assets were developed in the taxpayers’ case and the same were not compensated for, had to be substantiated legally and could not be based on vague generalities.
The Tribunal also observed that mere existence of routine supply-chain or human asset intangibles in the taxpayer’s case does not automatically confirm the existence of non-routine intangibles and the need to allocate additional returns for the same. It is important to note that such intangibles should be unique, i.e., it may not be possessed by the comparable companies. If the comparables involved in a similar activity also have the same, no additional compensation can be justified or warranted.
This landmark ruling has much larger relevance and application not only for sogo shosha companies, but also to limited-risk distributors and traders, where they perform no or limited functions and, accordingly, assume nil or minimal risks with respect to the inventory held by them.
The ‘value-added’ functions performed and risk assumed by limited risk distributor/trader is a critical factor in determining their return and the ruling favours the use of the berry ratio.
By Rohan Phatarphekar
The author is Partner and Head, Global Transfer Pricing Services, KPMG in India. Views are personal