Mitsubishi Corporation India Pvt. Ltd vs. DCIT (ITAT Delhi)

DATE: October 21, 2014 (Date of pronouncement)
DATE: October 22, 2014 (Date of publication)
AY: 2007-08
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In a case of "sogo shosha" business model (high volume, low risk, trading of goods), the "berry ratio" (benchmarking gross profit and/ or net revenues (after subtraction of cost of sales) against operating expenses is an appropriate PLI. To avoid discrimination under Article 24(3) of the India-Japan DTAA, the benefit of no disallowance u/s 40(a)(ia) (in the cast of residents) for want of TDS if the recipient has paid the tax has to be extended to non-residents u/s 40(a)(i)

As regards the transfer pricing adjustment:

(i) Even the TPO does not dispute that (a) MCI is a low risk activity in the field of trading, (b) MCJ group is primarily involved in high volume sales, or ‘colossal sales’ of a wide range of merchandise; (c) MCJ, following the sogo shosha business model, has global network and MCI is a part of this network. The low risk high volume business model of the assessee is thus not even in dispute. It is also not the case of the revenue that the assessee is only playing an assigned role in linking the buyers and sellers and is not engaged in the sogo shosha activity as a whole. As a corollary to this accepted position, the unique intangible of sogo shosha business model, even if that can be treated as a unique intangible asset, belongs to the MCJ group and not the MCI individually;

(ii) The assessee plays an assigned role, which is essentially a support function, in the core sogo shosha activity of the parent company MCJ. While sogo shosha is a Japanese expression which means, when translated literally, a general trading company, in business parlance a sogo shosha is something much more than a general trader. Sogo shosha is a unique business model in the world of commerce. A sogo shosha cannot be equated with a general trading company in all material respects;

(iii) In case the normal PLI of operating profit to operating costs (including inventory costs) or operating profit to sales was applied, every comparable which is picked up for comparing trading activity of the assessee, which is admittedly an integral part of sogo shosha activities of the MCJ group, will, therefore, have its inherent limitations because functional profile of the assessee’s trading activity is, and cannot be, the same as that of the comparables. It is, therefore, important to find out a way, by selecting the appropriate profit level indicator, to eliminate this critical difference between sogo shosha activity of the assessee and any other trading activity that the comparables may have. As a matter of fact, it is the level of inventory which is crucial factor in determining the kind of trading activity an assessee has carried out. The CBDT has defined wholesale trader with reference to, inter alia, its monthly inventory level being less than 10% and prescribes a lower tolerance range at one third the level of normal tolerance range. This notification is in the context of tolerance range, prescribing lesser tolerance range for the whole traders implying that the margin of profits for wholesalers must move in a lower range which can only happen when margins are also lower vis-à-vis margins in wholesale trading, but this also indicates that lower inventory levels lead to lower inventory risks and generally resultant lower profit levels also. There is thus a direct relationship between the normal inventory levels and the normal profitability;

(iv) It is beyond dispute and controversy that the comparables carrying on the trading activity similar to assessee group’s trading activity are difficult to find. Here is a case in which true comparables are difficult, or almost impossible, to find and, therefore, a way is to be found to find such comparison meaningful by adopting a profit level indicator which ignores the impact of vital dissimilarities in inventory levels between the assessee and the comparables;

(v) What follows is that use of transfer pricing mechanism, on the facts of this case, should be in such a manner in such a manner so as to minimise the impact of higher risks assumed by, and higher assets employed by, a normal trader vis-à-vis a sogo shosha entity. It is, therefore, worth an examination whether use of berry ratio, which assessee has all along contended to be appropriate to eliminate differences between an ordinary trader and the assessee, could indeed help in elimination of this vital difference of profile of the assessee vis-à-vis normal trading entities which may be available as comparables;

(vi) The answer to the fundamental question of whether a taxpayer should be entitled to a return on the value of goods handled by it, would actually depend on the functions performed and the related risks borne by it, with respect to the goods; and not on whether the taxpayer has taken title to the goods, shorn of the assessee’s FAR profile;

(vii) On facts, neither the assessee has performed any functions on or with respect to the goods traded by it, beyond holding flash title for the goods in some of the cases, nor has the assessee borne any significant risks associated with the goods so traded. All the functions, assets and risk of the assessee are quite reasonably reflected by the operating costs incurred and the value of goods traded does not have much of an impact on its analysis of FAR. The cost of goods sold would be relevant if and only if the assessee would have assumed any significant risks associated with such goods sold and when monetary impact of such risks is not reflected in operating expenses of the assessee. The berry ratio should, therefore, be equally useful in the present case as well. In the case of the traders like assessee, who neither assume any major inventory risk nor commit any significant assets for the same and particularly as there is no value addition or involvement of unique intangibles, the berry ratio should also be equally relevant as in the case of a limited risk distributor;

(viii) What berry ratio thus seeks to examine is the relationship of the operating costs with the operating profits. It thus proceeds on the basis that there is a cause and effect relationship between operating costs and the operating profits. The factors, however, which can also have substantial impact on the operating profits, and thus dilute this direct relationship, could be factors like (a) in terms of functions – processing and value addition to the goods; (b) in terms of assets – fixed assets such as machinery, inventory, debtors and otherwise high assets, including intangible assets; and (c) in terms of risks – risk associated with holding inventories;

(ix) In typical cases of pure international trading, there is neither any processing of goods involved nor is there use of any significant trade or marketing intangibles. The inventory levels are also extremely low, at least with respect to the goods traded, since the nature of activity does not require maintenance of inventories and there is sufficient lead time between order being received and the actual procurement activity. There are no other factors, in addition to the operating costs, which affect direct relationship between operating costs and operating profits. Therefore, except in a situation in which significant trade or marketing intangibles are involved or in a situation in which there is further processing of the goods procured before selling the same or in a situation which necessitates employment of assets in infrastructure for processing or maintenance of inventories, the use of berry ratio does seem to be quite appropriate;

(x) There is, therefore, neither anything inappropriate in the use as such of berry ratio per se, nor there are any real issues with respect to accounting policies of the assessee vis-à-vis accounting policies of the comparables finally selected. Obviously, as final comparables are not yet selected, there cannot be any question of the accounting policies adopted by the comparables vis-à-vis accounting policies of the assessee being so significantly different that the very comparability is not possible;

As regards disallowance u/s 40(a)(ia) for alleged failure to deduct TDS:

(xi) The onus of establishing that the recipient of an income has a PE in India, so as to invite its taxability in India, is on the revenue authorities. The existence of PE cannot be inferred on assumed on the basis of some vague and sweeping generalizations. It is wholly inappropriate to proceed on the basis of assumption that since the recipient entities were following certain business model, these entities must be having a PE in India. In any event, normal purchases from non-resident companies cannot give rise to taxability of income from such purchases, in the hands of the non-resident vendor, unless such non-resident companies have a permanent establishment in India;

(xii) As regards cases where the non-resident has filed a ROI, as s. 40(a)(i) does not have an exclusion clause similar to the second proviso to s. 40(a)(ia), payments made to non-residents, without deduction of tax at source will be disallowable even in a situation when the non-resident recipient has taken into account such payments in computation of his income, has paid taxes on the same and filed the income tax return. However, this creates discrimination in terms of Article 24(3) of the India Japan DTAA in the deductibility of payments made to resident entities vis-à-vis non-resident Japanese entities. Accordingly, the relaxation under second proviso to s. 40(a)(ia) is to be read into s. 40(a)(i) as well and it is required to be treated as retrospective in effect in the same manner as second proviso to s. 40(a)(i) has been treated. Such an interpretation will lead to the deduction parity as envisaged in Article 24(3) of Indo Japan DTAA.

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