Transfer Pricing-Profit Split Method(PSM)

Case Study: Itochu Corporation, Kenya Branch v Commissioner of Investigation and Enforcement (Tax Appeal 557 of 2022) [2024] KETAT 709 (KLR) (9 May 2024) (Judgment)

Background

The case centered on whether the Kenya Revenue Authority (KRA) correctly assessed Itochu Kenya (a liaison office of Itochu Japan) for corporate income tax and PAYE by recharacterizing its activities as trading-related  rather than routine liaison services

Itochu lodged its objection to the said assessments on 29th October 2021.

The objection was partially allowed but the assessments on transfer pricing adjustments were confirmed on 14th April 2022 for tax liability of Kshs 2,559,875,622.00 inclusive of penalties and interests.

Itochu was dissatisfied with this decision and it lodged its Appeal to the Tax Appeal Tribunal on 13th May 2021.

Itochu’s Argument:

• Itochu Kenya acted solely as a liaison office, performing market research, communication, and support for Itochu Japan.
• It did not engage in trading, assume risks, or utilize significant assets.
• The transactional net margin method(TNMM), (benchmarked against third-party service providers) was the correct transfer pricing method.

KRA’s Argument:

• Itochu Kenya was highly integrated with Itochu Japan’s trading operations.
• Employees had quantitative performance targets (e.g., transaction volumes), indicating direct involvement in revenue generation.
• PSM was appropriate due to shared risks and contributions to profits.

Tribunal analysis:

Selection of Transfer Pricing Method

The Tribunal evaluated whether PSM or TNMM was the most appropriate method under:

• Section 18(3) of the Income Tax Act (ITA) (arm’s length principle).
• OECD Transfer Pricing Guidelines (2022).

Why PSM Was Upheld

• High Integration of Functions: Evidence showed Itochu Kenya’s employees were involved in: Business development (e.g., securing deals, negotiating prices). Sales & procurement (e.g., coordinating orders for Isuzu, CMC Motors). Customer/supplier relationship management. Work permits & appraisals indicated roles beyond mere liaison (e.g., "developing profitable business").
• Shared Risks & Unique Contributions: Employees were evaluated on transaction volume targets (40% of appraisal metrics). The Tribunal found this demonstrated assumption of market/credit risks, contrary to the Itochu’s claims.
• Lack of Reliable Comparables for TNMM: The Itochu’s benchmarking used non-comparable companies (e.g., call centers, market research firms). No independent entities performed similar highly integrated functions for a trading conglomerate.

Rejection of TNMM

• TNMM requires internal comparables or reliable external data, which the Itochu failed to provide.
• The Tribunal noted: Itochu Kenya’s 3.2% cost-plus markup was below the OECD’s 5% benchmark for low-value services. The Itochu withheld key documents (e.g., contracts, sales data), undermining its TNMM argument.

Attribution of Profits to Kenya

The Tribunal analyzed whether Itochu Kenya’s activities created a taxable presence under:

• Section 3(1) ITA (tax on income "accrued in or derived from Kenya").
• OECD Model Tax Convention (Article 5) on Permanent Establishments (PEs).

Key Findings:

• Beyond "Preparatory/Auxiliary" Activities: The Itochu argued its role was exempt under Article 5(4) OECD Model (e.g., storage, information collection). The Tribunal ruled its functions (e.g., sales support, procurement) were core to Itochu Japan’s profits, making them taxable.
• 39:61 Profit Split Justified: The KRA’s allocation was based on: Functional analysis (Itochu Kenya’s role in generating East African sales). Customs data & financial statements (due to Itochu’s lack of sales/purchase records). The Tribunal accepted this as a reasonable approximation under Section 31, Tax Procedures Act (best-judgment assessments).

Burden of Proof & Documentation Failures

• Section 30, Tax Procedures Act: The Itochu failed to prove the assessment was excessive.
• Critical Shortcomings: Withheld employee appraisals (later submitted but unsigned/unverified). Provided incomplete transaction data (only motor vehicle sales, omitted food/chemicals divisions). Relied on non-independent benchmarks (companies with >25% parent ownership).

Final Judgment:(09/05/2024)

• Appeal dismissed; KRA’s assessment upheld.
• No costs awarded (each party bore its own expenses).

.