Sharing insights. News Alert 12 April, High Court s decision on royalty discussing criteria for allowability and taxpayer s commercial prudence

Transcription

1 Sharing insights News Alert 12 April, 2012 High Court s decision on royalty discussing criteria for allowability and taxpayer s commercial prudence In brief In a recent ruling in the case of EKL Appliances Ltd 1. (the taxpayer), the Delhi High Court (HC), while adjudicating in relation to the disallowance of a brand fee/ royalty payment made by the taxpayer to its associated enterprise (AE), ruled as follows Revenue authorities cannot either question the judgment or decisions of the taxpayer on the conduct of its business or tell the taxpayer what expense it can incur. 1 CIT v. EKL Appliances Ltd [TS-206-HC-2012(Del)] For an expense to be allowed as a deduction, the only condition is that it should have been incurred wholly and exclusively for the purpose of business. Thereafter, it is not necessary to show the necessity of the expense, and whether or not the expense resulted in profit. Rather than a wholesale disallowance of an expense, the transfer pricing officer (TPO) is expected to examine the international transaction as he actually finds the same and then make suitable adjustment, if necessary. The quantum of expense can be examined by the TPO. However, financial health (continued losses in the instant case) of a taxpayer can never be a criterion to judge allowability of an expense. 1

2 Even on merits the disallowance was not warranted because the taxpayer had demonstrated the benefit realized from the use of the intangible, and had submitted sufficient material and valid reasons, along with facts and figures to support its continuous losses. Facts Notably, in arriving at the above conclusions, the HC extensively relied on the Transfer Pricing Guidelines laid out by the Organisation for Economic Cooperation and Development (OECD Guidelines). The taxpayer is an Indian public limited company engaged in the manufacturing of refrigerators, washing machines, compressors, and spares thereof, and also in the trading of the above items, along with trading in microwave ovens, dish washers, cooking ranges, air conditioners, and spares thereof. All international transactions of the taxpayer with its AEs were accepted by the TPO to be at arm s length, except for the transaction of payment towards brand fee/royalty for Kelvinator brand, which was adjusted to NIL value by the TPO for assessment years (AYs) as well as This is the common controversy arising in both AYs. The associated facts are also the same, and the appeals for both AYs have therefore been dealt with together. Transfer pricing assessment proceedings During the transfer pricing (TP) assessment proceedings, the TPO noted that the taxpayer had been incurring huge losses year after year and hence concluded that 2 Brand fee/ royalty was paid for only 3 months during AY at the rate of 0.5% of net sales (for the period prior to that the payment had been waived on account of advertising and launch support from the AE). For AY , brand fee/ royalty was partly paid at 0.5% of net sales and partly at 1% of net sales. the payment for brand fee/royalty had not benefitted the taxpayer; i.e., had not helped the taxpayer in earning profits. To counter the TPO s position, and justify the payment towards brand fee/royalty, key contentions raised by the taxpayer were as follows: The AE had received similar brand fee/ royalty from an unrelated party in New Zealand. A firm of global repute had certified the payment of brand fee/ royalty to be lower than the uncontrolled brand fee, and therefore at arm s length from Indian TP perspective. The allowance of brand fee/ royalty does not depend on the profitability but on the utility of the brand name and technical know-how in respect of which the payment is made. Brand fee/ royalty was a legitimate business expense, and not incurring it would have hampered the availability of the brand name Kelvinator, and affected business operations. There were several internal and external factors, unrelated to royalty, which had contributed to the operating losses. It was due to the payment of brand fee/royalty that substantial increase in turnover could be achieved, and therefore losses were curtailed, despite high fixed costs. However, the TPO continued to believe that the taxpayer had failed to demonstrate benefit of using the brand name, and adjusted the value of brand fee/royalty to NIL, which the AO also considered while completing the assessment. Aggrieved, the taxpayer appealed before the Commissioner of Income-tax (Appeals) (CIT(A)). Proceedings before CIT(A) The CIT(A) was of the view that the payment towards brand fee/ royalty was genuine business expenditure and that the taxpayer could not have discontinued payment to the AE despite its financial crunch. The CIT(A) concluded that the 2

3 expense should be allowed despite continuous losses, and this conclusion was based on the following observations made by the CIT(A): The taxpayer was required to upgrade the technology on account of tough competition, which enabled it to reduce its losses to a significant extent. The payment towards brand fee/royalty had therefore benefitted the taxpayer. Based on a comparative review of a statement of costs incurred/assets acquired/loans obtained/capacity installed over a period of 3-5 years, as provided by the taxpayer, it was evident that these factors had contributed to the increase in operating losses, despite gross profits from operations. Drawing reference to the OECD Guidelines and citing the relevance of business strategies in determining the comparability of controlled and uncontrolled transactions, the CIT(A) concluded that the TPO had disregarded the business and commercial realities, and had acted in a mechanical manner ignoring the economic circumstances surrounding the transaction. The CIT(A) opined that the TPO cannot question the judgment of the taxpayer as to how it should conduct its business, or with respect to the necessity of an expense 3. It is for the taxpayer to decide who it wants to source the technology from and what needs to be done to counter competition. Tribunal s decision Aggrieved with the CIT(A) s decision, the Revenue appealed before the Tribunal. However, for AY , the Tribunal upheld the decision of the CIT(A), and for AY it followed its own decision of AY High Court ruling Aggrieved with the Tribunal s decision, the Revenue appealed before the HC, and raised the following substantial question of law, i.e., whether the Tribunal was right in confirming the order of the CIT(A) deleting the disallowance of the payment towards brand fee/royalty while determining arm s length price. The HC held as follows: Relying primarily on the OECD Guidelines 4, the HC observed that the tax administration should not disregard the actual transaction, i.e., actually undertaken and structured by AEs, or substitute other transactions for them. The OECD Guidelines discourage re-structuring of legitimate business transactions, as they could lead to double taxation. The only two exceptions to this principle would be when, - the economic substance of a transaction differs from its form and - where the form and substance of the transaction are the same but arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner. The HC added that there is no reason why the OECD Guidelines should not be taken as a valid input; it further stated that several courts have relied on OECD commentaries, though in different forms. Drawing references to various Supreme Court decisions 5, the HC held as follows: 4 Paragraphs 1.36 through 1.38, which correspond to paragraphs 1.64 through 1.66 of the Revised OECD Guidelines, July The CIT(A) drew support from the Supreme Court decision in the case of S.A. Builders Limited v. CIT [2007] 289 ITR 26 (SC). 5 Eastern Investment Ltd v. CIT [1951] 20 ITR 1 (SC), CIT v. Walchand & Co. etc [1967] 65 ITR 381 (SC), Hughes v. Bank of New Zealand [1938] 6 ITR 636 (HL), CIT v. Rajendra Prasad Moody, [1978] 115 ITR 519 (SC), Sassoon J. David & Co. Pvt. Ltd. v. CIT, [1979] 118 ITR 261 (SC). 3

4 - It is not for the Revenue Authorities to dictate to the taxpayer as to how he should conduct his business and it is not for them to tell the taxpayer as to what expense the taxpayer can incur. - For an expense to be allowed as a deduction, it is not necessary to show that it resulted in profit. - It is not necessary to show the necessity of incurring any legitimate business expenditure. - Reasonableness of the expense has to be judged from the point of view of the businessman and not of the Revenue. - The only condition is that the expense should have been incurred wholly and exclusively for the purpose of business and nothing more, and this principle finds expression in the OECD Guidelines referred to above. Rule 10B(1)(a) of the Income-tax Rules, 1962 does not authorize disallowance of any expense on the ground that it was not necessary or prudent for the taxpayer to have incurred the same; or that in view of the Revenue the expenditure was unremunerative; or that in view of the continued losses suffered by the taxpayer in his business, he could have fared better had he not incurred such expense. Whether or not to enter into a transaction is for the taxpayer to decide. The quantum of expense can be examined by the TPO. However, the TPO has no authority to disallow the expense if it is demonstrated to have been incurred for business purposes, or only on the ground that the taxpayer has suffered continuous losses. Financial health of a taxpayer can never be a criterion to judge allowability of an expense. Once again drawing reference to the OECD Guidelines, the HC adjudicated that the TPO is expected to examine the international transaction as he actually finds the same and then make suitable adjustment, if necessary. A wholesale disallowance of the expense, particularly on the grounds which have been given by the TPO in the instant case is not contemplated or authorised. Separately, apart from stating the above legal position, the HC observed that even on merits the disallowance was not warranted because the taxpayer had submitted sufficient material and valid reasons, along with facts and figures to support its continuous losses. On the other hand, the Revenue had not put forth any material to show to the contrary. Accordingly, the HC held that the Tribunal did not commit any error in confirming the CIT(A) s order. PwC observations The HC has re-established that Revenue authorities cannot question the commercial prudence of a taxpayer, i.e., it is not for the Revenue authorities to tell the taxpayer as to what expense it can incur, and the necessity of incurring an expense is also for the taxpayer to decide. However, the quantum of such expense is surely up for scrutiny by the Revenue authorities. As regards allowability of the expense, the HC has categorically stated that Revenue authorities cannot disallow it merely because the taxpayer has suffered continuous losses. In fact, in the instant case, the HC has acknowledged the taxpayer s justification for its continuing losses, and the rationale provided by the taxpayer, supported by facts and figures has been especially appreciated by the HC. Further, the HC has recognised the benefit derived from the use of the intangible (as demonstrated by the taxpayer), which helped curtail the taxpayer s losses. 4

5 This is certainly encouraging for loss making taxpayers, where the use of an intangible has resulted in actual benefit (as recognised in this case) but where the same has not converted into profits. It is vital for such taxpayers to maintain adequate back-up documentation and reasoning to demonstrate the benefit derived from the use of an intangible (as was done in this case), and to also support their financial position. The HC has further opposed a wholesale disallowance of an expense. In this regard, the HC has laid down the expectations from a TPO, i.e., the TPO is expected to suitably adjust an international transaction rather than disregard the actual transaction completely. The use of the words wholesale and disregard seem indicative of a word of caution from the HC to TPO s against mechanical and arbitrary disallowances. The explicit reliance placed by the HC on OECD Guidelines ratifies the reliance placed on these guidelines by Tribunals in the past, and thus going forward, reliance placed on these guidelines during TP assessment proceedings, may itself now find greater acceptability. Further, in light of the amendments proposed to the TP regulations by the Finance Budget 2012 such as introduction of Advance Pricing Agreements (APAs), expansion of the definition of international transactions, etc., the acceptability of OECD Guidelines would certainly prove very helpful in practical implementation and interpretation of these amendments. 5

6 Our Offices For private circulation only Ahmedabad President Plaza, 1st Floor Plot No 36 Opp Muktidham Derasar Thaltej Cross Road, SG Highway Ahmedabad, Gujarat Phone Bangalore 6th Floor, Millenia Tower 'D' 1 & 2, Murphy Road, Ulsoor, Bangalore Phone Bhubaneswar IDCOL House, Sardar Patel Bhawan Block III, Ground Floor, Unit 2 Bhubaneswar Phone / 2296 Chennai PwC Center, 2nd Floor 32, Khader Nawaz Khan Road Nungambakkam Chennai Phone Hyderabad # /82/A/113A Road no. 36, Jubilee Hills, Hyderabad , Andhra Pradesh Phone Kolkata South City Pinnacle, 4th Floor, Plot XI/1, Block EP, Sector V Salt Lake Electronic Complex Bidhan Nagar Kolkata Phone / Mumbai PwC House, Plot No. 18A, Guru Nanak Road - (Station Road), Bandra (West), Mumbai Phone Gurgaon Building No. 10, Tower - C 17th & 18th Floor, DLF Cyber City, Gurgaon Haryana Phone : Pune GF-02, Tower C, Panchshil Tech Park, Don Bosco School Road, Yerwada, Pune Phone For more information contact us at, pwctrs.knowledgemanagement@in.pwc.com The above information is a summary of recent developments and is not intended to be advice on any particular matter. PricewaterhouseCoopers expressly disclaims liability to any person in respect of anything done in reliance of the contents of these publications. Professional advice should be sought before taking action on any of the information contained in it. Without prior permission of PricewaterhouseCoopers, this Alert may not be quoted in whole or in part or otherwise referred to in any documents 2012 PricewaterhouseCoopers. All rights reserved. "PwC", a registered trademark, refers to PricewaterhouseCoopers Private Limited (a limited company in India) or, as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. 6