Benchmarking the Appropriate Gross Margin for an Indian Trading Affiliate with TNMM—Part 1

The transactional net margin method (TNMM) is both often used and heavily criticized. There are numerous issues that must be addressed before one decides that TNMM provides any insights with respect to the transfer pricing issue being addressed.

Consider as an illustration a multinational that manufactures mobile phones in China for distribution to Indian customers. Should the transfer price be evaluated in terms of the markup that the Chinese manufacturing affiliate receive under a contract manufacturer approach? If the multinational generates significant operating profits on this line of business, this version of TNMM would result in substantial profits received by the Indian distribution affiliate. TNMM applied to the Indian affiliate, however, would imply a much higher price leaving the Indian affiliate with only modest profits are the routine return for distribution.

The key issue in such a situation is what are the valuable intangible assets? While the product and process intangibles are likely owned by affiliates outside of India, the Indian tax authorities could reasonably assert that the Indian affiliate owns the marketing intangibles. As such, another method such as the Residual Profit Split approach would be more appropriate than a naïve application of TNMM.

Even if TNMM applied to a particular affiliate is an appropriate method, there are also numerous issues with respect to the applications of TNMM. The Indian courts have seen numerous litigations where TNMM has been applied to the Indian affiliate by both the tax authority and the taxpayer. In an earlier article, I praised the use of “well articulated TNMM approaches” in certain Indian litigations (“Indian Transfer Pricing Cases: Good News for Well-Articulated TNMM Approaches”, Journal of International Taxation, March 2013). I also recently critiqued the abuse of TNMM by the Indian tax authorities in the evaluation of the appropriate markup for certain types of service affiliates. This article notes several litigations involving soga shoshas, which are Japanese-based global trading companies.

Sogo shosha refers to Japanese-based general trading multinationals trade in a wide range of products. Marubeni, Mistubishi, Mitsui, and Sumitomo are four of the larger sogo shoshas and each has been involved with transfer pricing disputes with respect to the profitability of their Indian affiliates.

Sogo shoshas often have both buy/sell operations as well as commission activities. The gross profit margins for the buy/sell operations are generally low and the commission rates are even lower. Table 1 provides an illustration of their income statements that is roughly based on the financials for Marubeni during the years when their financials still reported turnover, which includes the sales of goods in the commission sector. The financials are based on the following assumptions:

• Buy/sell revenues = $1 billion;
• Gross profits on buy/sell operations = 6.5%;
• Turnover with respect to commission operations = $1 billion; and
• Commission income = 3.5% of turnover with respect to commission operations.

Overall gross profits represent a weighted average of the buy/sell gross margin and the commission rate. Since turnover with respect to commission operations is the same as buy/sell revenues, gross profits relative 5% of overall turnover.

Table 1 also presents total operating expenses as 4% of total turnover, which implies that operating profits represent 1% of total turnover and a 25% markup over operating expenses. Table 1 also reasonably assumes that $48.5 million of operating expenses relate to the buy/sell operations, while $31.5 million of operating expenses relate to commission activities. With this allocation of operating expenses, the buy/sell operating margin is 1.65% representing a 34% markup over operating expenses. Operating profits for the commission activity represents 0.35% of turnover with respect to commission activity or an 11.1% markup over operating expenses. That markup over operating expenses for the buy/sell sector is higher than the markup over operating expenses for commission activity is a reflection of the fact that buy/sell distributors hold working capital while commission agents do not.

Table 1: Illustration of the Financials for a Sogo Shosha

Economists prefer to see the contributions of Dr. Charles Berry as the presentation of an economic model for the gross profit margin of distributors or the commission rate for a commission agent rather than some ratio to be mechanically applied. Letting S = sales, E = value-added or operating expenses, A = tangible assets, the model can be expressed as:

Gross margin = a + b(E/S) + r(A/S), where r = the return to tangible assets, b = the impact of higher functions on the gross margin, and a represents the profits attributable to intangibles (if any). Since the operating margin = the gross margin minus operating expenses, the model can be restated as:

Operating margin = a + m(E/S) + r(A/S), where m = b – 1.

A capital-adjusted Berry ratio for the routine return for a distributor assumes that the entity does not own valuable intangibles, which would be represented by the assumption that a = 0. As an illustration, assume a commission agent that does not own assets and has an expense to sales ratio equal to 5%. If the markup over expenses is (m) 10%, the arm’s-length commission rate. The capital adjusted Berry ratio in this case would be 1.1. A distributor with the same expense to sales ratio but with an asset to sales ratio = 20% should receive a 6.5% gross margin if the return to tangible assets (r) = 5%. The capital adjusted Berry ratio in this case would be 1.3. We apply the logic of this model to three Indian litigations involving the Indian affiliates of Japanese trading company multinationals.

Mitsui & Co. India Pvt. Ltd

Mitsui & Co. India Pvt. Ltd v.. DCIT involved the appropriate compensation for Mitsui’s Indian affiliate, which was primarily a commission agent. Table 2 attempts a presentation the key financials for this case, where the court noted:

“The activities of purchase and sale i.e. trading involves risk and finance whereas in the activity of support services i.e. intending transactions the assessee has neither to incur any financial obligation nor carries any significant risk. The nature of two activities is absolutely different. The activities of trading i.e. purchase and sale are highly insignificant as compared to activity of support service which constitutes the core business activities of the assessee. The TPO and DRP are wrong in applying the trading margins ignoring the facts of the case that the assessee being a service provider the trading margins cannot be applied. Further, with respect to Berry Ratio being adopted as the most appropriate PLI, the tribunal opined that, in a situation in which a business entity does not assume any significant inventory risk or perform any functions on the goods traded or add any value to the same, by use of unique intangibles or otherwise, the right profit level indicator should be operating profit to operating expenses i.e. Berry Ratio. In such a situation, no other costs are relevant since (a) the cost of goods sold, in effect, loses its practical significance, (ii) there is no value addition, and, accordingly, there are processing costs involved, and (iii) there is no unique intangible for which the business entity is to be compensated.”

This endorsement of the Berry ratio for commission activity is warranted but could also be used to support a capital adjusted Berry ratio approach for distribution activities as well. Table 2 focuses on the commission activities given that the appropriate compensation for these activities was the key issue. The total payments to the supplier were 45,910 million rupees of which 884 million were retained by the Indian affiliate as the commission agent. As such, the commission rate was 1.93%. Table 5 assumes operating expenses were 755 million or 1.64% of turnover. Under this transfer pricing policy, the Indian affiliate retained 129 million rupees in profits, which represented less than 0.3% of turnover or a 17% markup over operating expenses. The taxpayer presented evidence from 20 third-party distributors were the markup over operating expenses ranged from 9% to 34%.

Table 2: Illustration of Mitsui India’s Key Financials

The tax authority argued that the transfer pricing policy should afford the commission agent with operating profits = 4.66%. This position would be consistent with a 6.3% commission rate. Under this policy, the ratio of commission income to operating expenses (the Berry ratio) would be 3.83. Operating profits relative to operating expenses would represent a 283%. The court rejected the tax authority’s reasoning for what was clearly a very aggressive position.

Lorraine Eden and Tatiana Amba noted the following about this litigation (“The Berry Ratio”, Practical Guide to U.S. Transfer Pricing (Matthew Bender, Fourth Edition, 2020)):

“The Indian tax court upheld the taxpayer’s approach due to limited functional profile of the local Indian entity. Mitsui & Co. India did not bear any risk related to possession of goods, nor did it bear financial risk, or warranty risk, because all trading activity was performed by the Japanese parent. In addition, the commission-based transfer pricing approach proposed by Indian tax authorities was rejected due to the substantial difference in the nature of products and items traded. The premise was that commission fees significantly fluctuate with respect to high-value and commodity products.”

If the products traded were commodities such as iron ore or copper, one would reasonably expect commission rates less than 2% as the operating expense to sales ratio for trading companies in this sector are often near 1.5%.

Mitsubishi Corporation India Pvt Ltd.

Mitsubishi Corporation India Pvt Ltd v. DCI ITAT Delhi involved the appropriate compensation for Mitsubishi Corporation India as a buy/sell distributor with commission activities. The financials presented in the court decision were partial and somewhat confused in terms of identifying a sensible income statement but suggested that this entity had almost 1 billion rupees in gross profits on buy/sell operations and over 200 million rupees in commission income. The court decision noted:

“The Transfer Pricing Officer further noted that the assessee has used TNMM (Transactional Net Margin Method) as the most appropriate method, and that the PLI (profit level indicator) selected is ‘Berry Ratio’ which, as stated in the transfer pricing study, benchmarks gross profit and/ or net revenues (after subtraction of any potential cost of sales) against operating expenses. The assessee’s claim was that since MCI’s three year’s average Berry ratio is 1.19, whereas in the case of 22 comparables set out in the report, using three year data, the average Berry ratio is 1.14 and adjusted average Berry ratio is 1.13, the international transactions entered into by the assessee are at arm’s-length price. The TPO contended that, as against non inclusion of cost of sales by the assessee, entire costs are included in computing margins in the cases of all the comparables, selected by the assessee, in the transfer pricing study. The TPO was further of the view that so far as service/ commission income segment is concerned, the right course of action will be to treat the same as equivalent to trading segment, because what the assessee has disclosed as service/ commission income is in fact trading income. Accordingly, the cost of goods sold by the AEs, which was Rs 29,279.205,406, was also to be included in cost base of service/commission segment.”

Table 3 offers a representation of the potential financials for this litigation that starts with two assumptions:

• Buy/sell revenues = 18 billion rupees; and
• Commission turnover = 6 billion rupees.

Table 3: Illustration of the Issues in the Mitsubishi India Litigation

Table 3 assumes that the operating expense to sales ratio for the buy/sale division is 4.85% and the operating expense to turnover ratio is 3.15%, which is the same as what we assumed in table 4 for Marubeni. The overall operating expense to total turnover ratio is 4.43% reflecting the fact that the buy/sale division reflects 75% of total turnover. Table 3 also assumes a 3.5% commission rate for the commission division but allows the gross margin for the buy/sale division to be only 5.9%. The overall gross margin is 5.3% so overall operating profits represent only 0.88% of total turnover or a return to operating expenses just under 20%.

Had the gross margin for the buy/sale division been 6.5%, the overall gross margin would have been 5.75%. Operating profits would be 1.33% and the return to operating expenses would be 29.94%. The low return to value added expenses for the buy/sale division may be seen as an indication that the 5.9% gross margin is slightly below the arm’s-length standard unless the tangible asset to sales ratio for this division is lower than the tangible asset to sales ratio for Marubeni’s buy/sale division.

The Indian tax authority took a much more aggressive position, which is similar in spirit to the aggressive positions of other income tax authorities when challenging modest profits margins for limited function distributors. This aggressive approach takes the operating margins for third party distributors with greater functions than the limited function distribution affiliates. These aggressive application of TNMM often suggest operating margins from 2% to 4% even when the operating expense to sales ratio of the tested party is only 5% or less.

The last column of Table 3 presents an approximation of the position of the Indian tax authority by assuming that it had targeted a 2.5% operating margin. This approach would raise the affiliate’s income from 210 million rupees to 600 million rupees. The overall gross margin under this approach would be 6.93%, which represents a 56.5% return to value added expenses. The court’s rejection of this aggressive application of TNMM by the Indian tax authority was initially seen as an endorsement of the Berry ratio.

The Mitsuibishi litigation would have benefited from a clear exposition of the financials for the buy/sale division and the commission division. The same model could be used on the segmented financials for the two divisions with different estimated arm’s-length financial ratios that depend on the capital intensity of each division.

Sumitomo Corporation India Pvt. Ltd.

Eden and Amba note another Indian trading company litigation where the taxpayer used TNMM with the Berry ratio as its metric for evaluating profitability:

“Sumitomo Corporation India Pvt. Ltd. v. CIT involved export and import activities of the Indian subsidiary of the sogo shosha Japanese parent. In 1997, Sumimoto Corporation, Japan established its subsidiary in India, Sumimoto Corporation (India) Pvt. Ltd (“SCI”) to facilitate export and import activities of its parent. SCI operated trading and indenting business segments that for transfer pricing purposes were jointly tested via the Berry Ratio due to their limited risk profile. Indian tax authorities contested the application of the TNMM with the Berry Ratio as a PLI towards bundled segments based on the functional incomparability of the businesses.”

The taxpayer presented a TNMM analysis with 23 third party distributors where the average Berry ratio was 1.18. The Indian affiliate’s overall gross profit to operating expense ratio exceeded the average Berry ratio of these comparables. The court decision also noted:

“The TPO noticed that the Assessee’s transactions could be classified into two types - “Indent sales” and “Proper sales”. In respect of “Indent sales”, the Assessee merely indents for the goods which are supplied directly by the supplier to the purchaser; the Assessee only receives commission on the value of the invoice or the quantity of goods supplied. In case of “Proper sales”, the Assessee purchases the goods and sells the same. The purchases made are against confirmed orders and thus, the transactions of purchase and sale are back to back. The Assessee acquires the title to goods only for a brief moment; this is described as a “flash title”. Such sale transactions are on a profit margin. The Tribunal referred to the tabular statement wherein the TPO had computed the gross profit margin from trading transactions with AEs at 4.80%; gross profit margin on trading transactions with Non-AEs at 4.45%; and commission earned at 1.61%. The Tribunal also referred to the order of the TPO wherein he had referred to the Assessee’s letter dated 19 th October, 2010 in which the Assessee had bifurcated the commission earned between commission from AEs and Non-AEs; the commission from Non- AEs was declared as 2.26% on value of goods while the commission from AE transactions was computed at 1.58%. The Tribunal accepted the Assessee’s contention that the nature of indenting transactions were different from trading transactions. The trading transactions involved certain risks and finances whereas in respect of indenting transactions, the Assessee did not incur any financial obligation or carry any significant risks. The Tribunal found that the indent business of the Assessee was nothing but trade facilitation, both in form as well as in substance. It further noted that there was no material on record to regard the indent transactions as trading transaction. The Tribunal further proceeded to note and accept the Assessee’s contention that it would be appropriate to compare commission/service income earned by the Assessee in respect of transactions with AEs with the similar transactions with Non-AEs. However, the Tribunal rejected the Assessee’s claim for an appropriate adjustment on account of difference in volumes as well as the associated risks. The Tribunal held that in the facts and circumstances of the case, no adjustment as to the extent of volume was necessary as the Assessee had entered into separate contracts for each transaction and it was not the Assessee’s case that each of such separate transaction with an AE was greater in volume as compared to a similar transaction in the Non-AE segment. The Tribunal then proceeded to direct that the commission computed at the rate of 2.26% (i.e. the rate of commission in respect of transactions with Non-AEs) be taken as the benchmark for determining the ALP for commission earned in the AE segment.”

While the buy/sale activity is a different transaction than the commission activity, our economic model can be used to evaluate the appropriate gross margin for the buy/sale activity as well as the appropriate commission rate if the analysis considers the appropriate facts for each activity. Table 4 offers a numerical illustration of the potential issues based on the following assumptions:

• Turnover for the commission sector = 18 billion rupees and the commission rate = 1.65%;
• Sales for the buy/sell sector = 6 billion rupees and the gross margin = 4.8%;
• Operating expenses for the commission sector = 1.5% of turnover; and
• Operating expenses for the buy/sales sector = 3%.

Table 4: Illustration of the Financials for the Sumitomo Litigation

Under these assumptions, the overall gross margin = 2.44% and overall expenses = 1.88% of total turnover. As such, operating profits represent 0.56% of total turnover or a 30% markup over expenses.

An appropriate analysis should be performed on a segmented basis. The tax authority did not challenge the 4.8% gross margin on buy/sell activity in part because this gross margin exceeded the approximately 4.5 gross margin on third party sales. The 60% markup over operating expense also appears generous unless the buys/sale sector had a high asset to expense ratio or owned valuable intangible assets. The tax authority asserted that the Indian affiliate owned valuable intangibles but it is not clear whether the court accepted this premise.

The Indian affiliate received commissions equal to 2.25% of turnover on third party activity. The tax authority used this fact to assert that the 1.65% commission rate was too low. This position is captured by the last column of table 4, which indicates a 50% markup over operating expenses. A 50% markup over operating expenses is quite high for a commission agent unless it does own valuable intangible assets.

Another possible difference between the controlled gross margin and commission rates versus what was observed in the third party transactions might be differences in functions performed in the controlled transactions versus the third party transactions. While functional differences are a key issue in the appropriate evaluation of the arm’s-length gross margin for a distributor or the arm’s-length commission rate for commission activity, the litigation did not adequately explore such issues.

Concluding Comments

We have reviewed the use of TNMM in three Indian litigations involving the Indian affiliate of a Japanese based sogo shosha. In two of these litigations, the Indian affiliate had both buy/sale and commission operations where it would be reasonable to assert that gross margin for the former sector should be higher than the commission rate for the latter. Simply noting that the Berry ratio for the aggregate financials are within some TNMM ranges is not as informative as separately tested the transfer pricing for each segment.

As such, criticisms of an aggregate approach are well founded. The Indian tax authority often adopts an aggressive return to sales approach that ignores the fundamentals of the economic model proposed by Dr. Berry. We have argued that Dr. Berry’s model can be reliably applied if the tax payer provides certain financial information on the Indian affiliate, which includes sales or turnover for both sectors, the gross margin or commission rate for both sectors, operating expenses by sector, and the key balance sheet information for the buy/sale operation. With this information, a well constructed TNMM analysis based on the use of the capital adjusted Berry ratio would be possible.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Harold McClure has been involved in transfer pricing as an economist for 25 years.