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Vol. 11 Issue 4.2 April 2, 2015
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The Delhi High Court rules on controversy surrounding marketing
intangibles
In a landmark decision of Sony Ericsson Mobile Communications India Pvt.
Ltd. and others vs. CIT [1], the Delhi High Court (“HC”) has given its verdict and
addressed the controversies surrounding the transfer pricing (“TP”) adjustments
for advertisement, marketing and sales promotion (“AMP”) expenses, arising out
of the ruling of the Special Bench of the Income tax Appellate Tribunal in the case
of LG Electronics India Pvt. Ltd. vs. ACIT[2] (“SB Ruling”).
Firstly, the HC upheld the observation of the SB Ruling that the AMP expenditure
incurred by the taxpayers qualifies as an international transaction, however, the
taxpayer cannot be insisted to receive separate and exclusive reimbursement for
excessive AMP expenses from the owner/ licensor of the brand, particularly when
the taxpayers have been adequately compensated having regard to the
differences in intensity of their functions vis-à-vis the comparables.
Background and brief facts of the case
Taxpayers are engaged in import, distribution and marketing of products
manufactured by their foreign associated enterprises (“foreign AEs”) under
their brand(s). The intangible rights in the brand-name / trademark /
trade-name (“marketing intangible”) were owned and controlled by the foreign AE.
Taxpayers had benchmarked their international transactions of import of finished
goods for resale, by adopting transactional net margin method (“TNMM”) with
profit level indicator (“PLI”) of operating profit / total cost ratio, or resale price
method (“RPM”) with PLI of gross profit/ sales.
The Transfer Pricing Officer (“TPO”) made adjustments on account of AMP
expenditure incurred by the taxpayers. The TPO was of the view that incurrence
of substantial AMP expenses by the taxpayers, in relation to the marketing
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intangibles owned by the foreign AE, were in the nature of services for creation or
improvement of marketing intangibles and, therefore, for the benefit of respective
foreign AEs. Thus, the TPO concluded that the taxpayers should
have been compensated by the foreign AEs, at arm’s length.
To examine the sanctity of the said action, a Special Bench of the Delhi
Tribunal (“SB”) was constituted in the case of LG Electronics India Pvt. Ltd.,
(“LG India”) to examine the vexed issues of TP of marketing intangibles. The
SB, vide its order dated January 23, 2013, ruling substantially in favour of the
Revenue held:
o Incurrence of proportionately higher AMP expenses, than comparable
companies’ AMP expenses, would be treated an international transaction
of provision of service of brand building for the foreign AE.
o The quantum of AMP expenses incurred by such comparable companies
was referred to as the “Bright Line” and anything in excess of the Bright
Line was termed as “non-routine” expenses. Such, “non-routine” expenses
should have been recovered from the legal owner of the brand along with
appropriate mark-up.
o The subsidy received from foreign AEs should be reduced for computing the
arm’s length price. Further, expenses which are inextricably linked to sales,
such as trade discount, dealer commission, etc., should not be considered
a part of cost / value of international transactions.
o Summarized a set of principles for undertaking benchmarking of such
transactions (Para 17.4 of SB Ruling).
Aggrieved, the taxpayers as well as the Revenue filed appeals under section
260A of the Income-tax Act, 1961 (“Act”) before the HC.
Substantial questions of law before the HC:
Whether TPO had jurisdiction to examine the AMP expenses when no specific
reference was made to him by the Assessing Officer (“AO”).
Whether AMP expenses can be treated and categorized as an international
transaction under section 92B of the Act.
Whether TP adjustments can be made in respect of AMP expenses, and if so,
under what circumstances.
Equity, M&A in India for the year
2013 by Venture Intelligence.
Mukesh Butani, New Delhi
+91 11 3066 3010
[email protected] Rajeev Dimri, New Delhi
+91 124 669 5050 [email protected]
Gokul Chaudhri, New Delhi
+91 124 669 5040
[email protected] Bobby Parikh, Mumbai
+91 22 6135 7010
[email protected] Abhishek Goenka, Bangalore
+91 80 4032 0100 [email protected]
Sriram Seshadri, Chennai
+91 44 4298 7000
Amit Jain, Pune +91 20 668 19010
Vishal Kalra
Gaurav Gupta
Vrinda Tulshan
S Siddhant
Whether the Tribunal was right in holding that TP adjustment in respect of AMP
expenses should be computed by applying Cost Plus Method.
Whether the Tribunal was right in directing that fresh benchmarking /
comparability analysis should be undertaken by the TPO by applying parameters
laid down in paragraph 17.4 of the SB Ruling.
Whether the Tribunal was right in distinguishing and directing that selling
expenses, such as trade / volume discounts, rebates and commission, etc.,
cannot be included in AMP expenses.
Ruling of the HC:
Jurisdiction of TPO: The HC upheld the order of the SB and ruled in favour of
the Revenue. The HC held that, in view of insertion of sub-section (2B) to section
92CA by Finance Act 2012 with retrospective effect, the TPO had validly
assumed jurisdiction though no specific reference was made by the AO for
computation of the arm’s length price in relation to the AMP expenses.
International Transaction: The HC upheld the order of the SB and ruled in
favour of the Revenue by holding that incurrence of AMP expense by the
taxpayers in relation to the marketing intangible owned by the foreign AE, is an
international transaction under section 92B of the Act, subject to limits as laid
down.
Aggregation of Transactions: The HC observed that expression “class of
transaction”, “functions performed by the parties” under section 92C (1) of the
Act, illustrate that the word “transaction” includes a bundle or group of connected
transactions. Clubbing of closely linked, which include continuous transactions,
may be permissible under the Act and the taxpayer can aggregate the controlled
transactions if the transactions meet the specified common portfolio or package
parameters.
Application of TNMM for benchmarking AMP expenses: The HC further held,
if the AO / TPO adopts and accepts TNMM, AMP expenses must not be treated
as separate international transaction since AMP expenses is the cost or expense
and is not diverse, and is factored in the net profit of the inter-linked transaction.
Therefore, the HC, rejecting the Revenues plea to make separate comparison of
AMP expenses without segregation, held that it would be impermissible.
Use of RPM: The HC held that it must be tested and examined whether the
gross profit margins adequately remunerate an AE for performing marketing and
selling function. While selecting comparables, internal comparables would not be
appropriate since AMP expenses do not get factored and compared. For this
reason, external comparables, not being the legal owner of the brand name,
trade mark etc. but performing similar functions including AMP expenses should
be used to give more accurate and precise results. In other words, if a
comparable did not perform AMP functions which was performed by the tested
party, then such comparable have to be discarded.
Further, the HC observed that the AO/ TPO can make adjustments in relation to
substantial AMP expenses incurred by the tested party in comparison to the
comparables. In case, it would not be possible to make adjustments, then RPM
may not be the most appropriate method to be adopted.
Brand Building: The HC, rejecting Revenue’s plea, observed that it would be
erroneous and fallacious to treat brand building as counterpart or to
commensurate brand with advertisement expenses. The HC took the view that it
was possible to build a brand name without incurring substantial advertisement
or promotion expenses and also cases where in spite of extensive and large
scale advertisements, brand values have not been created. Brand creation and
value, depends upon various factors, such as nature and quality of goods /
services offered and also reflects the reputation which is gathered over a
passage or period of time.
Bright Line Test: The HC negated the broad-brush universal approach adopted
by the Revenue where in each case where an Indian AE incurs AMP expenses, it
should be subjected to the ‘bright line test’ and corresponding TP adjustments.
The HC observed that such an approach is neither mandated nor stipulated
under the law or any international commentaries or under universally accepted
and applied general principles of international taxation.
Para 17.4 and Para 17.6 of SB Ruling: The HC further held that the list of
parameters for ascertaining the comparables for applying bright line test in
paragraph 17.4 and, thereafter, the assertion in paragraph 17.6 that comparison
can be only made by choosing comparables of domestic cases
not using any foreign brand, is contrary to the law and Income Tax Rules, 1962
(“the Rules”).
The HC rejected the Revenue’s adoption of the Bright Line Test and, concurred
with the view adopted under the UN Model and held that an Indian taxpayer must
be compensated for the AMP expenses by the foreign AE. Further, it observed
that such compensation could be included or subsumed in low purchase price or
by not charging or charging lower royalty, or by way of payment of direct
compensation to the Indian AE.
The HC rejected Revenue’s reliance on the foreign rulings in the case of DHL
and GlaxoSmithKline by stating that these decisions do not assist the Revenue’s
stand.
Economic ownership: The HC appreciated that economic ownership of brand
and marketing intangibles is important factor for determining the pricing
mechanism of distributors, having long term distribution licenses, thereby
overturning the SB Ruling. The brand valuation would be mandated and required
if the Indian entity was deprived, denied or transfers economic ownership, upon
termination of the distribution-cum-marketing agreement or upon transfer of
economic ownership to a third party. In such a situation, the distributor / India AE
might seek compensation from the legal owner of the brand and it may require
transfer pricing assessment.
Cost Plus Method (“CPM”): The HC held that in case AMP expenses were to
be treated as a separate international transaction, CPM was an appropriate and
reliable method. The entire cost, i.e., marketing expenses or distribution and
marketing expenses, can be made subject matter and included in ‘cost’ for
determining arm’s length price (“ALP”) by applying CPM. Further, the HC, held
that if entire marketing and distribution expenses, or AMP expenses are
benchmarked under CPM, then it would be injudicious and irrational to apply any
other method to compute the ALP of larger composite international transaction,
of which the AMP expenses form only a part.
Direct Marketing Expenses: The HC uphold the SB ruling and held that
marketing or selling expenses like trade discounts, rebates, etc. offered to sub-
distributors or retailers are not in the nature and character of ‘brand promotion’
expenses, as they are not directly linked to brand building exercise, but
connected to marketing and increased volume of sales or turnover.
Markup: HC held that, as per sub-clause (ii) to Rule 10B(1)(c) of the Rules,
appropriate markup would be comparable gross profit on the cost or expenses
incurred as AMP. The mark-up has to be benchmarked with comparable
uncontrolled transactions or transactions for providing similar service / product,
and not the interest rate of Reserve Bank of India with a further mark-up.
Consequentially, the HC remanded the matter for de novo consideration to the
Tribunal holding that the legal ratio accepted and applied by the Tribunal relying
upon the SB Ruling was erroneous and unacceptable.
BMR Comments
The HC ruling is a welcome ruling and lays significant though broad
principles of law to be applied to the facts of each case. The HC
appreciated that the issue of marketing intangibles is highly factual,
depending on the FAR of each taxpayer, and common principles as laid
down in the SB Ruling, cannot be applied universally to all taxpayers.
The HC has clarified that TP law is an anti-avoidance provision, and it
should be invoked selectively and must not result in 'double taxation'. It
has also been observed that while the Act and Rules are supreme, the
OECD Transfer Pricing Guidelines and UN Transfer Pricing Manual act
as valuable guide in such situations.
The HC has decided the batch of appeals in the context of distributors
and has not specifically addressed the cases of licensed manufacturers.
Though, the HC ruling has laid important principles regarding the issue of
marketing intangibles, licensed manufacturers would need to substantiate
that its transactions with related parties, particularly those of import of
raw materials & components, and payment of royalty for technology &
brand, were at arm’s length, on stand-alone basis, as per transaction by
transaction approach; and not by applying an overall entity wide TNMM.
The judgment broadly rejects application of bright line test (segregation of
routine and non-routine expenses) as it has no statutory mandate under
the Indian statute. The Court has granted breather to the tax payers while
holding that if bundled transaction are concluded to be at arm’s length by
applying TNMM or RPM, then there is no need to bifurcate and treat AMP
as a separate transaction.
[1] ITA 16 of 2014 with CA 155 of 2014, High Court of Delhi
[2] (2013) 152 TTJ 273 (Del)
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