Comparable Uncontrolled price (“CUP”) and Resale Price Method (RPM) for Transfer pricing(TP) purposes

Case Study: Cummins Car & General Limited v Commissioner of Legal Services and Board Coordination (Tax Appeal E450 of 2023) [2024] KETAT 1319 (KLR) (Civ) (6 September 2024) (Judgment)

CCG Kenya is a duly licensed company incorporated in Kenya in 2015 whose principal activity is the sale of power generators, commercial engines and spare parts for the power generators and commercial engines. These products are sourced from CMI Africa affiliates in India and the United Kingdom (UK).

On 23rd March, 2023, CCG Kenya was issued with an assessment for Kshs. 119,328,977.00 being Income tax for the period 2017 year of income

In its assessment letter, KRA stated that the basis of issuing the assessment was as follows: -

• That the use of Comparable Uncontrolled Price (CUP) method based on the prices charged by CMI Africa affiliates to CGTL prior to establishment of the joint venture under CCG Holdings in relation to purchase of products by CCG Kenya from CMI Africa affiliates for the year of income 2017 was inaccurate since the difference in the period of the two (2) transactions could have a material impact on the price as the circumstance of the transactions could have changed by virtue of passage of time;
• That CCG Kenya purchases tangible goods from CMI Africa affiliates, namely power generators, commercial engines and spare parts for the power generators and commercial engines and resells the products to third parties without physically altering the products and consequently the most appropriate transfer pricing method for this transaction is the resale price method (RPM);
• That from a review of the intercompany ledgers in relation to transactions between CCG Kenya and CGTL( Car &General Trading Limited) for the year of income 2017, there were debit and credit balances of Kshs. 2,444,508,240.00 and Kshs. 2,302,924,444.00 respectively. That the KRA treated the debit balance of Kshs. 2,444,508,240.00 as arising from invoices issued to CGTL but not declared as part of the income and consequently assessed additional income (corporate) tax on the same;
• That the services offered by CCG Kenya to CCG Holdings are part of the core activities of the group, since the core business of the CCG Group is the distribution of CMI products. That these services are therefore not low value adding and a mark-up of 5% would not be applicable; and
• ·That the commission earned on sales to Bidco Africa Limited was 15% and 18%, while the commission on sales to Safaricom was at 1%. That the KRA revised the rate of commission applied on the Safaricom income from 1% to 15% giving rise to additional taxes.

CCG Kenya objected to the notice of assessment on 28th April, 2023..

KRA vide a letter dated 26th June, 2023 partially allowed CCG Kenya’s objection.

CCG Kenya being dissatisfied with the objection decision, filed a Notice of Appeal dated 25th July, 2023 on 8th August, 2023. Among the grounds of appeal were:

• That KRA erred in law and fact in failing to find that the Comparable Uncontrolled Price (CUP)method used to price the products purchased by Cummins Car & General (Kenya) Limited (CCG Kenya)from CMI Africa Holdings B.V.(CMI Africa) was the appropriate pricing method for these products.
• ·That KRA erred in fact by failing to recognize that the 5% markup applied on the services offered by CCG Kenya to Cummins Car & General Holdings Limited (CCG Holdings) was determined based on a detailed benchmarking exercise conducted and documented in the Transfer Pricing Policy, as opposed to applying the simplified method for low value adding services.
• That KRA erred in law and fact in its assertion that CCG Kenya had under-declared incomes arising out of inter-company transactions.
• ·That KRA failed to recognize that stock transfers had been done by CCG Kenya to Car &General Trading Limited (CGTL) at cost and that receipts made by CGTL on behalf of CCG Kenya and payments made on behalf of CGTL by CCG Kenya during and shortly after the joint venture, were as a result of CGTL remaining as the key contracting party and these were not incomes chargeable to tax in the books of CCG Kenya.
• That KRA erred in law and fact in failing to recognize that a portion of the amount assessed for purposes of Corporate income tax related to contra entries, being debit entries made in the inter-company transactions ledger, but which were all reversed and booked in the correct ledgers.
• That KRA erred in law and fact in failing to recognize that the transactions between CCG Kenya and Safaricom are transactions between unrelated parties and are therefore not controlled transactions within the Income Tax Act.
• That KRA erred in law and in fact by confirming the assessment on CCG Kenya contrary to the supporting documentation provided in the notice of objection.

CCG Kenya Argued that:

• ·the 5% markup was determined based on detailed economic and functional analysis and benchmarking carried out and was not arrived at as a result of adopting the simplified method for low value addition services, the use of the lower rate of commission in relation to the Safaricom transaction was because the transaction lost value due to higher freight and clearance charges that eroded the margin and the additional costs had to be absorbed by the Company and part of the amount of Kshs. 2,444,508,240.00 that KRA has assessed tax on was
• That with regards to TP method applied, CCG Kenya sells power generator sets, commercial engines and spare parts. These products are purchased from CMI affiliates in the UK and India for resale to third parties
• That prior to the joint venture arrangement, CGTL purchased similar products from CMI affiliates to which it was not related at the time. That accordingly, CUP method was selected as the most appropriate method to determine the arm's length price applicable on purchases of the products by CCG Kenya from CMI affiliates after establishment of the joint venture which made the entities to be related parties.
• That the fact that CGTL Kenya previously purchased the products from CMI affiliates to which it was not related at the time was used as the internal comparable as it was an uncontrolled transaction in relation to similar items under similar circumstances.
• That Paragraph 2.15 of the OECD TP Guidelines provides that where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm's length principle. That an uncontrolled transaction is comparable to a controlled transaction for purposes of the CUP method if one of the two conditions is met:

i.    none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market; or

ii.     reasonably accurate adjustments can be made to eliminate the material effects of such differences

• That in applying the CUP method while comparing the two transactions, the main comparability factors taken into account in applying the CUP method in relation to the two transactions were the products involved, sales volumes and payment terms. That despite the slight difference in time of the two transactions, these factors did not change; CCG Kenya purchases similar products in the same volumes and under the same terms from CMI affiliates as did CGTL
• That the only change in relation to the transaction is that after establishing the joint venture, the prices charged by CMI affiliates to CCG Kenya are fairly lower than those previously charged due to increased efficiency arising from the new structure and a commercial decision to reduce the prices of the products in order to compete effectively in the market.
• That in addition, the functions performed by CCG Kenya in relation to the purchase and sale of the products are indeed comparable to those of CGTL prior to the joint venture. That the team and structure were also maintained. That therefore, the use of the CUP method to price the purchase of products purchased by CCG Kenya from CCG Holdings is indeed the most preferred.
• That notwithstanding the above, KRA in conducting its benchmarking analysis selected companies which do not trade in similar products as CCG Kenya. That the aforementioned benchmarking of CCG Kenya products to dissimilar products negatively affected the comparability under the analysis conducted by CCG Kenya and resulted in the erroneous profit margin of 20.35% which is way above the average market margin usually realized by CCG Kenya in its business.
• That in addition, CCG Kenya incurs significant workshop or service costs and import costs in relation to distribution of the products which costs are booked as cost of goods in the Company's financial statements. That the workshop or service costs are the costs incurred in servicing the gensets and the reason behind including the workshop costs in the cost of goods sold is to cover labour income which has no direct costs.
• That the mark-up applied in pricing the services offered by CCG Kenya to CCG Holdings was arrived at through a bench-marking analysis conducted and documented in the Transfer Pricing Policy
•  That contrary to KRA's assertion therefore, the 5% mark-up was not arrived at as a result of adopting the simplified method for low value addition services as alleged by the KRA. That the mark-up was determined based on detailed economic and functional analysis and benchmarking carried out under the Transfer Pricing Policy.

KRA argued That:

• That KRA’s assessing team was correct that the CUP method may not have taken into consideration material differences caused by the passage of time. That the more time that elapses, the more likely it is that other factors such as changes in market, in rates of exchange, in costs etc., will need to be considered in any comparison.
• That RPM is ordinarily used in situations where one entity (the reseller) purchases tangible goods from a related entity and the reseller does not physically alter the tangible goods or add substantial value to the goods and the applicability of RPM is thus limited because of differences in accounting practices affects the reliability of data applied at the gross margin level.

In its ruling on 06/09/2024, The TAT observed that:

• Paragraph 2.15 of Chapter II of the OECD TP Guidelines states that:-

“an uncontrolled transaction is comparable to a controlled transaction (i.e. it is a comparable uncontrolled transaction) for the purposes of the CUP method if one of the two conditions is met:

a)none of the differences (if any) between the transactions being compared or between enterprises undertaking those transactions could materially affect the price in the open market; or

b)reasonably accurate adjustments can be made to eliminate material effects of such difference”.

• ·CCG Kenya did not make adjustments for the timing difference under the CUP method and therefore was not justified in using the same. Further, while RPM is the more appropriate method for this transactions based on Paragraph 2.27 of the OECD TP Guidelines, KRA did not make adjustments for other costs associated with the purchase of the product. In regard to CCG Kenya’s transactions, these costs were workshop costs and service costs associated with distribution of CCG Kenya’s products.
• The Tribunal further noted that CCG Kenya and Safaricom are unrelated parties dealing at arms-length and there are no legal restrictions as to how transactions between the two parties are priced. In this regard, the Tribunal posited that KRA has no obligation to re-write contracts between parties in a bid to collect additional taxes.

Final Orders Were:

• The assessment in relation to the Transfer Pricing method applicable on the purchase of products by CCG Kenya from CMI be and was upheld. However, KRA shall only apply it by making adjustments for costs as per the Tribunal’s findings.
• The assessment in relation to commissions on Safaricom income be and is was set aside.