MARKETING INTANGIBLES –CURRENT DYNAMICS

July, 2015

CONTENTS

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• INTRODUCTION TO TAX POLICY

• STORY SO FAR

• APPROACH(ES)

• DOCUMENTATION APPROACH

• APA STRATEGY

• QUESTION & ANSWERS

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INTRODUCTION TO TAX POLICY

Per Capita GDP, PPP (Current International $)

5

5,056.0

15,507.2 12,596.7

India Brazil South Africa

Tax-GDP Ratio: Corporate Income Tax to GDP

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24.6

3.60 4.00 5.00

India Brazil South Africa

16.3

26.324.6

Non-Resident Withholding

7

Corporate tax collections

Non-residentwithholding component

9%

Transfer Pricing Adjustments

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23,237

44,531

70,016

2010-11 2011-12 2012-13FY FY FY

Transfer Pricing Adjustments (Cont.)

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2.983.23

3.56

0.08 0.15 0.23

2010-11 2011-12 2012-13

Total corporate tax revenue Potential tax effect of transfer pricing adjustments

Taxpayers Bearing the Brunt – in India

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STORY SO FAR

Story so Far

Penetration of the global brands in India, with liberalisation of the economy

Competitive Indian market – promotion of brands by publicity and advertisement

Advertisement, Marketing and Promotion (“AMP”) expenditure’ incurred for promotingIndian sales (by Indian entity)

The Revenue Authorities disallowed deduction of AMP expenditure since brandsowned by overseas Associated Enterprise (‘AE’) were promote

Courts / Tribunal allowed deduction as the expenditures were for “businesspurposes”

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The Revenue realigned their approach towards AMP expenditure

Issue entered the realm of Transfer Pricing controversy

It contended that AMP expenditure, incurred by Indian enterprise, benefits overseas AEby creation / development of their marketing intangible in India

The Revenue contended that Indian entity should be compensated for providing AMPservices by applying:

'Bright Line Test' as per decision of US Tax Court in DHL Inc.’s case

‘Mark up’ for the marketing / brand development services

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Story so Far

LG Electronics (ITAT - Special Bench) laid down:

Non-routine AMP expenditure for Brands owned by the overseas AE- ‘InternationalTransaction’

Use of Bright Line Test to determine value of transaction - upheld

The transaction, being in the nature of ‘provision of service’, requires mark-up

Sales expenses / cost not covered

14 parameters were laid down for determination of ALP

Special Bench order applied in other cases and further laid down:

Subsidy received by Indian entity – reduce while computing arm’s length price

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Aggrieved, taxpayers and Revenue filed appeals before the Delhi High Court (‘HC’)

Year 2013

Story so Far

Whether TPO has jurisdiction to benchmark AMP expenses

Whether AMP expense constitutes International Transaction

Whether adjustment can be made by TPO in respect of AMP expenses

Whether Cost Plus Method can be applied to compute adjustment

Whether fresh benchmarking should be undertaken by TPO

Whether selling expenses should be considered as part of AMP expenses

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Issues before the High Court

Story so Far

Decision of the Delhi High Court in Sony Ericsson: TPO entitled to suo-moto examination of such transaction

Upheld contention of ‘International Transaction’

Distribution and Marketing functions are inter-connected and inter-twined

Adjustment can be made in relation to ‘International Transaction’

‘Bright Line Test’ is not a method under the statute

Aggregation approach or Segregation approach can be adopted

Comparable should be functionally comparable and must not be Brand owner

Set-off is not barred / prohibited under the statute

Direct marketing and selling expenses not form part of the AMP expenses.

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Year 2015

Story so Far

Issue ITAT Special Bench HC of Delhi

AMP - International Transaction Yes Yes

Bright line test - to bifurcate routine

and non-routine expense Yes No

Whether AMP expense amounts to

brand building service

Yes

Non-routine AMP

expense constitutes

brand building service

Not Necessary

Brand building is not

equivalent or substantial

attribute of AMP

Aggregation of International

transactionsNot permissible Permissible

Set-off among various international

transactionsNot permissible Permissible

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Comparative Analysis – ITAT Special Bench vs HC of Delhi

Story so Far

Toshiba India, ITAT - Delhi :

AMP functions of the comparable should be similar to Indian entity while benchmarkingtransaction on aggregate basis

If suitable comparable not available – segregation approach followed

Matter remanded to the TPO for examination of AMP functions and determination of ALP

Ratio followed in: Zimmer

Casio

Perfetti Van Melle

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Year 2015

Story so Far

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APPROACH(ES)

AMBIGUITY IN HC’s ORDER:

AMP expenditure independent international transaction OR integrated functions of adistributor ie distribution and marketing

AMP function vs AMP expenditure

“An external comparable should perform similar AMP functions…In case acomparable does not perform AMP functions in the marketing operations, a functionwhich is performed by the tested party, the comparable may have to be discarded.…Comparable analysis of the tested party and the comparable would includereference to AMP expenses”

What are AMP functions and how to compare AMP functions - Magnitude or Nature

How can Assessee obtain information (relating to AMP functions), which is notreported

Treatment of subsidy received in relation to AMP expenditure

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APPROACH (ES)

Options

Seek directions from HC

SLP before the SC

Remand Proceeding before the AO / TPO

Formation of SB of

ITAT

APA

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APPROACH (ES)

DIRECTIONS FROM THE HC

Companies which were parties in appeal before the HC, can seek clarification /direction from the HC in relation to ambiguity arising from its order

SLP / APPEAL BEFORE THE SC

SLP / Appeal against the order of the HC can be filed before the Supreme Court(‘SC’)

Interested parties can join the proceedings before the SC

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APPROACH (ES)

APPEAL TO THE HC

Order of the ITAT is binding unless appealed

If not appealed, no further agitation in second round

Only non-compliance with earlier order can be challenged in second round

Recommendation : If order of the ITAT is contrary to the letter and spirit of its Order– Appeal to HC

FORMATION OF SB OF ITAT

Companies can approach the President of ITAT requesting him to constitute SpecialBench for adjudication on this issue which involving interest of multiple companies

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APPROACH (ES)

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DOCUMENTATION APPROACH

• SCOPE OF LAW

• BENCHMARKING APPROACHES POSTHIGH COURT ORDER

• PRACTICAL DIFFICULTIES

• COMPLIANCE DISCLOSURES

Scope of Law

Finance Act 2012 amended the definition of international transaction, by including an explanation, to include the marketing intangibles within the scope of the definition:

Intangible property transactions: Purchase, sale, transfer, lease or use of intangibleproperty, including …… copyrights, patents, trademarks, licenses, franchises, customer list,marketing channel, brand, ….

Provision of services: Provision of market research, market development, scientificresearch, legal or accounting service, etc.

Further, the Finance Act 2012 provided an explanation to define the term “intangibleproperty” for the purposes of an international transaction. It has defined the term toinclude:

“1.Marketing related intangible assets;……………..”

This amendment was effective retrospectively from the financial year 2001-02

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Post amendment, digressive views were adopted by Taxpayers

Benchmarking Approaches Post High Court Order

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Post Delhi High Court ruling, there are primarily 2 approaches under which international transaction of advertising, marketing and promotional (AMP) expenses can be benchmarked:

Aggregation approach – to be bundled with primary transaction• Resale Price Methodology (RPM)

• Transactional Net Margin Methodology (TNMM)

Segregation approach – to be benchmarked as a separate transaction• Cost plus

• Profit Split Methodology

• Any Other Method

Aggregation Approach

In case RPM is selected to benchmark the primary transaction along with AMP function:

Taxpayers to earn gross margin that commensurate’ s with the level of AMP functionsperformed

AMP expenses to be considered as a part of cost while computing profitability

Adjusted Gross Profit of Taxpayer to demonstrate the arm’s length nature of transaction

In case TNMM is selected to benchmark the primary transaction along with AMP function

A bundled approach would be adopted wherein AMP function would be aggregated andbenchmarked as one transaction

Accordingly, AMP expenses gets factored in the net profit while computing net margin

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Segregation Approach

Segregation approach in view of Delhi High Court ruling In case adjustment is not possible or comparables are not available, then, RPM or TNMM on

entity level would not be possible to benchmark AMP transaction

Accordingly, international transaction of AMP would be viewed in a de-bundled manner

In separately determining the arm’s length price of AMP expenses, the Tax authorities canchoose any other suitable method which may include cost plus method, PSM or Any othermethod

If segregation approach is adopted then a proper set off / purchase price adjustment shouldbe allowed

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Promotional expenses to be identified and reduced from advertising and marketing expenses

Practical Difficulties

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AGGREGATION APPROACH SEGREGATION APPROACH• Identification of appropriate

comparables?

• Difficulty in obtaining comparablesengaged in AMP functions similar toTaxpayer?

• Identifying brand owners?

• Difficulty in bifurcating brand buildingexpenses and sales relatedexpenses?

• Determining cost base?

• Difficulty in determining the purchaseprice adjustment?

• Basis of allocating return onintangibles under PSM?

Documentation Approach – Way Forward

Post Delhi High Court ruling, it is imperative for the Taxpayers to make appropriate disclosures of AMP expenses

To be disclosed as an international transaction

Disclosure in Form 3CEB• Disclose it as a separate transaction – Provision of brand building services?

• Aggregate it with primary transaction and disclosure by way of note or disclose it as any othertransaction in “clause 19”?

• Value of transaction to be disclosed excluding sales related expenses

Disclosure in Transfer Pricing report• Appropriate disclosure to be made in transfer pricing report – to avoid penalty exposure

• Choice of methodology?

• Stand on comparables?

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Potential penalty exposure for non-disclosures

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APA OPTION

APA – An OptionWorth Exploring?

Lack of clarity around the approach in remand proceedings

APA intended to arrive at negotiated, fact specific agreement

High Court Order stresses upon avoidance of double taxation – scope for bilateral APA

Characterization of the entity and the relevant business plans & strategy possible to be crystallized in an APA

Manufacturers and distributors to be dealt with differently: Questions for manufacturers arise around characterization and extent of international

transactions – functions (licensed manufacture or assembly), royalty/tech fee, managementfees extent of portable profits that are presently transferred

Questions for distributors are around the import pricing and if it already factors a return forthe marketing intangibles, characterization of distributor (for determination ofmethod), subsidy for AMP and treatment of promotion expenses

Persuasive value of international guidance from OECD and ATO

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Q & A