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Big win for Sogo Shoshas

Author : Mukesh Butani, Partner
Dated: Oct 31, 2014

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.

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Indirect transfer - not just an Indian phenomenon

Author : Mukesh Butani, Partner
Dated: Oct 27, 2014

A debatable topic in international tax relating to cross-border transaction that has held the attention of tax/transaction advisors and tax payers, has been, 'indirect transfer' of assets. The debate surrounds taxability of an offshore transaction (of a resident state), which has underlying assets in a foreign jurisdiction, and if that jurisdiction in its capacity as a source country, has the right to tax such transactions. In India alone, the subject has been debated post-apex court verdict, which has led law makers to resort to retrospective law to overrule the judiciary's verdict.

In the recently concluded International Fiscal Association Congress 2014 in Mumbai, the debate occupied centre stage from an international tax and treaty policy perspective. This piece is devoted to capture the debate.

While one may agree that the roots of 'indirect transfer' can be traced back to tax treaty provisions providing for taxability of capital gains derived by a resident (of the resident state) on indirect transfer of immovable property situated in the source state, the 'Chongqing' case(1) and 'Vodafone's case(2) did prove to be controversy's springboard. A technical debate on 'indirect transfer' law usually starts with fundamental principles for enacting laws to administer cross border transaction, i.e.extra-territoriality and jurisdictional aspects.

From an Indian standpoint, Article 245 of the Constitution does provides sufficient basis to law makers for levying tax on 'indirect transfer'of Indian assets by non-residents. However, the debate on 'extra-territoriality and jurisdictional aspects' is still relevant to evaluate whether such an approach is appropriate when viewed from bilateral and multilateral treaty standpoints, and from the point of view of sharing tax revenues between the source and the resident states. Countries typically resort to two approaches - Ex ante and Ex post approaches - for levying tax on 'indirect transfer'. Whilst Ex-ante approach involves enacting specific provisions (as implemented by countries like India, Israel), under Ex post approach, countries (like China) invoke General Anti-Avoidance Rules regime to tackle such situations.

Israel has had fairly detailed provisions in its domestic law since 2009, before the controversy gathered momentum in India and China, asserting its source right to levy tax. Holistically speaking, whilst domestic tax law provisions are the backbone for enforcing tax regime for 'indirect transfer', the domestic tax law provisions need to be calibrated with treaty provisions. Whilst fundamentally, tax treaty wording needs to be respected for interpretation purpose, the literature available in model tax conventions(3) and commentaries serve as a useful guidance.

Reviewing the 'indirect transfer' in the backdrop of Model Conventions(and commentary), it appears that insofar as a source state's right to tax transfer of assets is concerned, the limited situation envisaged deals with taxability of capital gains on indirect transfer of immovable property, situated in the source state.

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A perfect-10 verdict for investment

Author : Mukesh Butani, Partner
Dated: Oct 13, 2014

The Bombay High Court’s ruling in the Vodafone taxation matter strikes at the tax administration’s adventurism.

In a landmark verdict rendered on October 10, the Bombay High Court has held that issuance of shares by an Indian company to its overseas parent is not exigible to arm’s-length price (ALP) test under Chapter X of the Income Tax Act, which houses the transfer-pricing (TP) law. The HC, allowing Vodafone’s writ, declared the order null and void and decided the question of ‘jurisdiction’ against the tax administration, holding that shares issuance at premium (or inadequate premium) is merely tantamount to capital account transaction and didn’t warrant the rigours of transfer pricing adjustment, a position that has shaken investor confidence in the past few years. The HC’s verdict scores 2-0 in favour of Vodafone, following its earlier order (in November 2013) directing the tax administration to determine the preliminary question of jurisdiction. The ruling was pronounced in the wake of Vodafone’s challenge (round 2) to the Dispute Resolution Panel’s (DRP) directions upholding the tax administration’s alleged jurisdiction in the issue.

Whilst the tax administration could consider seeking remedy under Article 32 in a Special Leave Petition, the HC ruling is a significant outcome not just for Vodafone but a group of multinationals facing similar disputes emerging from indiscreet ‘tax adventurism’ in transfer-pricing matters.

Largely, disputes in the Vodafone case and others had emerged on the account of retrospective amendments brought in by the Finance Act 2012 to the definitional aspects of the 2001 law, which had the effect of bringing ‘capital financing’ and ‘business restructuring’ transactions within the fold of ‘international transactions’. Setting aside the debate on retrospective law, the amendment, though intended to bring with in its ambit certain specified transactions, surely gave a handle to the administration to apply it indiscreetly. The HC unequivocally held that even in relation to such transactions, transfer-pricing rigours can be applied only if the transaction yields income to the associated enterprises (AEs), e.g., interest income on a loan transaction, etc, and if its applicability to share capital transaction was in abstract. The ruling assumes significance given the manner in which the HC has comprehensively refuted the tax administration’s allegations insofar as applicability of the law to capital account transaction, even though the administration in its pleadings oscillated between a range of allegations to argue taxability of shortfall in premium. In a well-crafted ruling, the court has chronicled key milestones in the multi-million dispute, on the question of whether shortfall in premium on share issuance could be brought to tax as notional income under Chapter X even though the alleged notional income failed to pass the litmus test of the ‘income’ definition, thereby failing the charging provision. The court found the tax administration’s arguments on taxing such notional income entirely unfounded as the latter was trying to recharacterise ‘measure’ of tax as ‘charge’ of tax; to allege shortfall of share premium as being liable for transfer-pricing adjustment.

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SC’s NTT ruling strikes at tribunalisation

Author : Mukesh Butani, Partner
Dated: Oct 09, 2014

The judgment gives the govt a chance to come up with a more robust legislative framework for the tax tribunal.

The fate of the National Tax Tribunal (NTT) is sealed as the Supreme Court, in its landmark ruling, has declared the legislative edifice of NTT as unconstitutional and an attempt to encroach upon the Judiciary’s powers. Since the enactment of NTT Act in 2005, multiple challenges—to its constitutionality—from the State Bar Associations marred its beginning. Indeed, NTT could never see the light of the day before it was struck down on the grounds of the rule of separation of powers between the Executive and the Judiciary; and other being on judicial independence.

Tracking backwards, the idea of a national tax court or tribunal was first mooted by the first Law Commission constituted in 1955. Later in 1970, the Wanchoo and N Palkhivala Committee recommended the creation of separate tax benches in the high courts, and gradual transition to ‘Central Tax Court’ forum to accelerate tax dispute resolution. Significant efforts had been made in the decades ever since to usher in judicial reforms.

The National Tax Tribunal Act, 2005, legislated by Parliament was an outcome of prolonged Executive deliberations on not just facilitating speedy dispute resolution but also on bringing in uniformity in the interpretation of statutes. The NTT Act provided transfer of appellate jurisdiction, vested in the high courts involving ‘substantial question of law’; on its constitution, the orders of Income Tax Appellant Tribunal (ITAT) and Customs Excise and Service Tax Appellate Tribunal (CESTAT) were to lie before the NTT, thus ousting the jurisdiction of the high courts.

The NTT Act was largely predicated on Parliament’s quasi-judicial powers under Article 323B, which empowers legislature to constitute administrative tribunals to exclude jurisdiction of higher courts except for the Supreme Court. Post economic reforms, Parliament has exercised its powers to set up several such tribunals to deal with disputes in the area of capital markets (Sebi), telecom (TDSAT), etc whose orders can be appealed directly with the SC. Whilst the constitutionality of Article 323B has been upheld by the apex court (in the case of S P Sampath Kumar vs Union of India), the Court cautioned that the power of judicial review under the Constitution could rest only with the Supreme Court or the high courts under Article 32 and 226, respectively.

The unanimous ruling by the five-member bench recognises the Constitutional convention, which does not prevent legislative action, to vest adjudicatory functions of the superior court with an alternative institutional mechanism; however, the Supreme Court has held that such abrogation of powers shall not stand the test of constitutionality if the legislature fails to ensure that the delegated tribunal has all trapping and standards of a Court.

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