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Persistent Loss Filter: The Sumitomo Case

Published on Tue, May 05,2015 | 17:04, Updated at Tue, May 05 at 17:04Source : 

By: Ajit Kumar Jain, Partner, BMR & Associates

“Book Loss” and not “operating loss” a relevant indicator for determining persistent loss – Mumbai Tribunal Ruling in the case of Sumitomo Chemical India Private Limited  

Transfer pricing aims at establishing the arm’s length price of the controlled transactions using the most appropriate method. The success of transfer pricing lies in identifying uncontrolled transactions that are comparable and similar to the transaction entered into by the taxpayer. In India, based on judicial trends, it is experienced that the transfer pricing issues are more concerned about determining the arm’s length price than on the applicability of transfer pricing methods. The major issue of contention among the taxpayer and the Revenue authorities are on selection of comparable companies and performing economic adjustments that amount to decisions around the measure of arm’s length price.

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2010 (“OECD Guidelines”) has prescribed certain quantitative and qualitative criterion in identifying potential comparables. In addition to the quantitative filters prescribed in the OECD Guidelines, the Revenue authorities use few other quantitative measures to establish the comparability. Some of the commonly used filters in determining the comparability analysis are persistent loss filter, employee cost filter, forex earning filter etc. These filters are not prescribed in the Indian Transfer Pricing Regulations and there isn’t any guidance on this aspect.  

One of the most commonly applied filters in identifying the comparable companies is “Persistent loss filter”. The comparable companies that have incurred losses for three consecutive years are rejected applying this filter. While the Revenue authorities and the taxpayers are in consensus in the application of persistent loss filters, it is not very clear if the book loss or operating loss that should be considered to adjudge the company as persistent loss making. Recently, the Mumbai Bench of the Income Tax Appellate Tribunal (“Tribunal”) in the case of Sumitomo Chemical India Private Limited (“taxpayer”), delivered its judgment on the relevant indicator to be considered in determining the persistent loss. A summary of the Ruling is given below:

The taxpayer is a manufacturer and trader of pesticides and insecticides.  Transactional net margin method was selected as the most appropriate method in determining the arm’s length price. During the assessment proceedings, the Transfer Pricing Officer (“TPO”) rejected the comparable company identified by the taxpayer - Super Crop Safe Limited, on account of the fact that the company had incurred persistent losses. Super Crop Safe Limited had incurred book loss for the year under consideration and operating losses for the preceding two years, basis which the TPO had rejected the company on account of persistent losses. While Super Crop Safe Limited had incurred operating losses during the preceding two years, it had made book profits for that period. The TPO further treated foreign exchange gain / loss as a non-operating item.

On appeal before the CIT(A), the taxpayer argued that Super Crop Safe Limited had incurred book losses only during the assessment year 2007-08, which was the year under consideration and for the immediate preceding two years, the company had earned book profits. The CIT(A) however rejected the taxpayers arguments and removed Super Crop Safe Limited from the list of comparables.  

On further appeal before the Tribunal, the taxpayer emphasized that the book loss is different from operating loss and that the TPO had applied persistent loss filter and not operating loss filter. The Tribunal ruled in favor of the taxpayer and held that ‘persistent loss’ is the appropriate filter to be applied in identifying comparables and rejected the ‘operating loss filter’ adopted by the TPO. The Tribunal further held that the Revenue authorities cannot deviate from applying persistent loss filter to operating loss filter and make a new case before the Tribunal.   

BMR point of view

The selection of comparable companies is litigated widely in India and there are divergent views amongst various Bench of Tribunal in establishing the comparability. While the Courts in a few cases have held that losses cannot be the sole reason for determining the comparability, the Tribunal in few other cases have held that loss making comparables can be excluded if such losses are on account of abnormal factors. Also while, there are several Rulings on acceptance or rejection of a persistent loss making companies, the Tribunal Ruling in the case of Sumitomo Chemical India Private Limited is one of its kind which discusses on the indicator to be considered in determining the persistent loss.  

This Ruling appears to be more judicious on the following counts:           

·     Persistent loss filter is a measure to establish the comparability analysis, which ought to be carried out even before determining the operating profits. The operating profits can be determined only after a company has been accepted as a comparable and not prior to that.  

·     Further. Para 3.4 of the OECD Guidelines has provided a step by step approach in determining the comparability analysis. Step 7 and 8 in para 3.4 of the OECD guidelines discuss on identifying potential comparables and making comparability adjustments and step 9 goes about to discuss on the “interpretation and use of the data collected”. The TPO in the present case has computed the operating profit of the comparables after excluding the non-operating items which amounts to “interpreting the data collected referred in step 9” and has then proceeded to conclude on the comparability analysis prescribed in step 7.    

Further, Rule 10B of the Income-Tax Rules, 1962 does not provide any guidance in the exclusion of a company solely on the basis of turnover.  The comparability should be established after taking into account the nature of transactions, assets employed, risks assumed, contractual terms and other relevant factors that delineate the transaction. The turnover criteria is one among the aforesaid criteria and the loss making comparables which satisfies the comparability analysis should not be rejected only on account of the fact that they had incurred losses. To conclude, it is the facts and circumstances in which the comparable company operates and not the financial result of the company relevant for determining the comparability analysis.  

Ajit Kumar Jain, Partner, BMR & Associates LLP represented Sumitomo Chemicals India Pvt Ltd at the Hon’ble Income-tax Appellate Tribunal, Mumbai.


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