India s Delhi High Court rules on transfer pricing aspects relating to development and enhancement of marketing intangibles

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1 23 March 2015 Global Tax Alert News from Transfer Pricing EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date India s Delhi High Court rules on transfer pricing aspects relating to development and enhancement of marketing intangibles Executive summary This Tax Alert summarizes a recent ruling of India s Delhi High Court on transfer pricing aspects relating to development and enhancement of marketing intangibles. The case involved a group of litigants, with the lead case being that of Sony Ericsson Mobile Communications India Pvt. Ltd. 1 (Taxpayer) vs Commissioner of Income-tax. 2 The transfer pricing issue before the High Court was whether under arm s length principles an affiliate needs to be compensated for its promotional efforts that allegedly enhanced the value of a trademark or brand name legally owned by another member of the multinational group. The promotional efforts typically result in the marketing affiliate incurring Advertising, Marketing and Promotional (AMP) expenses. The marketing affiliate may be a trademark licensee or a distributor of trademark products, while the legal owner of the trademark is the licensor or the supplier of the trademark products. In the case of LG Electronics India Private Ltd., 3 which was decided by the Special Bench (SB) of Delhi Income-tax Appellate Tribunal in January 2013, it was held that there was a transaction between the taxpayer and its Associated Enterprise (AE) under which the taxpayer incurred AMP expenses toward promotion of the brand legally owned by the AE. The SB held that the transaction of brand building by the taxpayer for the AE is in the nature of provision of service requiring a mark-up. Further, the SB also upheld the use of the bright line test 4 in order to determine the transaction value of AMP.

2 The High Court, while holding that the AMP spend may be considered an international transaction, has concluded that the compensation for AMP expenses may be included or subsumed in the purchase price of goods imported from AEs or a lower charge for royalty. The High Court held that the arm s length nature of the arrangement may be tested by way of an aggregate or bundled analysis with other transactions relating to the distribution activity. If the Tax Authority seeks to unbundle the transactions, the Tax Authority should clarify its reasons for doing so. The High Court also rejected the application of the so called bright line test advanced by the Tax Authority for determining whether the Taxpayer needs to be compensated for its promotional efforts. The High Court has restored the matters back to the Appellate Tribunal for a final determination taking into account the principles laid down by the Court. Detailed discussion Treatment of AMP expense as an international transaction The High Court rejected the Taxpayers contentions that activities that result in AMP expense are not international transactions. The High Court has observed that in most cases the taxpayers have submitted that the declared price of the international transaction of import of goods from a foreign associated enterprise included an element or function of AMP expenses, for which they stand duly compensated in their margins or the arm s length price as computed. However, the High Court also observed that AMP is a function or expense related to distribution and under a bundled approach it would be illogical to treat AMP expense as a separate international transaction. Taxpayer had also contended that the expenses were incurred in India and that the dispute is not about the quantum of expenditure but about the adequacy of the compensation for the AMP function to suggest that AMP expense does not constitute an international transaction. The High Court disagreed with these contentions. Bundling of transactions The High Court disagreed with the SB ruling in the case of LG Electronics, which had held that the word transaction refers to a single independent transaction and not a bundle of transactions. The High Court also held that one of the primary rules of statutory construction is that singular includes plural and vice-versa and that no presumptions should be made to the contrary. The High Court further noted that use of the expression class of transaction in various provisions of the tax law and rules explicitly states that the term transaction includes a number of closely linked transactions thus makes it clear that it was never the intent of the legislature to abandon the general principle of plurality. Use of Transactional Net Margin Method (TNMM) The High Court made a detailed observation of the applicability and the strengths and weaknesses of TNMM. The Court has in particular addressed the Tax Authority s contention that distribution and marketing functions cannot be benchmarked on a composite basis in TNMM as several factors affect the net margins making the results unreliable. The High Court recognized the importance of comparable selection since net margins may be affected by multiple factors. The High Court also stated that once a composite set of transactions have been benchmarked together under the TNMM analysis it is not appropriate to segregate AMP expenses as a separate transaction without providing an appropriate set-off of the composite profits earned. According to the High Court, TNMM proceeds on the assumption that if functions, assets and risk are broadly similar, after making adjustments that may be appropriate, all other factors stand reconciled when computing the net profit margin. AMP expenses and brand building On the issue of whether incurring AMP expenses necessarily leads to enhancement or development of brand value, the High Court stated that it would be incorrect to assert that AMP is the substantial part of a brand. A brand reflects the reputation the brand owner has earned over a period of time due to the nature and quality of goods and services. Quality control is one of the most important elements that can damage or enhance the value of a brand. Thus, it would be incorrect to assert that AMP expenses are a substantial reason for brand building 2 Global Tax Alert Transfer pricing

3 or that the only reason for incurring AMP expenses is to enhance the value of the brand. Bright line test The High Court disagreed with the Tax Authority s contention that excess AMP expense benefits only the foreign affiliate and observed that increased sales also benefit the Indian taxpayer. The High Court has also observed that it is difficult to compartmentalize promotion of product or promotion of brand expenses and record them as separate from each other and thus stated that the issue is merely whether or not the taxpayer is adequately compensated by its foreign affiliate. The High Court rejected the use of the bright line test as a way of identifying an international transaction and held that the use of the bright line test on the basis of the comparability analysis outlined in the SB order is unwarranted. Economic v. legal ownership The High Court has recognized the concept of economic ownership of trade name or trade mark as intrinsic to the determination of transfer prices. The High Court has further stated that economic ownership will arise in cases of longterm contracts and where there is no stipulation of denying economic ownership. The Court has also held that the valuation of economic ownership of a brand is not done from time to time but only at the time of termination or transfer at which point a transfer pricing valuation may be undertaken. Implications One of the most challenging issues in transfer pricing is the taxation of income from intangible property (IP). A common situation where some of the complex principles relating to transfer pricing aspects of IP need to be applied arises when an enterprise associated with the legal owner of trademarks performs marketing or sales functions that benefit the legal owner of the trademark, for example through a distribution arrangement. In such cases, it is necessary to determine how the distributor should be compensated for the activities. One key issue is whether the distributor should be compensated only for providing promotion and distribution services or whether the distributor should also be compensated for enhancing the value of the trademarks and other marketing IP. The analysis of this issue requires assessment of: (1) the obligations and rights implied by the legal registrations and agreements between the parties; (2) the functions performed, assets used and risks assumed by the parties; (3) intangible value anticipated to be created through the distributor s activities; and (4) the compensation provided for the functions performed by the distributor. By stressing comparability, the High Court has affirmed the fundamental principle that the distributor s share of benefits should be determined based on what an independent distributor would receive in comparable circumstances. In a number of situations, the distributor s efforts may be enhancing the value of its own intangibles, namely its distribution rights. An independent distributor in such cases would not typically require additional remuneration from the owner of the trademark or other intangibles. Even in situations where additional remuneration may be necessary, such remuneration may take the form of higher distribution profits or a reduction in royalty rate. Taxpayers should review the implications of this ruling on their transfer pricing documentation and compliance policies and consider options for risk management. Global Tax Alert Transfer pricing 3

4 Endnotes 1. Now known as Sony India Limited. 2. TS-96-High Court-2015(DEL)-TP. 3. (2013) 152 TTJ 273 (Del). 4. The bright line test was espoused by the US Tax Court in the case of DHL Inc and Subsidiaries v Commissioner (TCM ). The Tax Authority typically applied the bright line test to the taxpayers by comparing the AMP expense as a percentage of sales of the taxpayer with that of comparable companies. For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (India), New Delhi Vijay Iyer vijay.iyer@in.ey.com Ernst & Young LLP (India), Bangalore Rajendra Nayak rajendra.nayak@in.ey.com 4 Global Tax Alert Transfer pricing

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