17 March 2015 EY Tax Alert Delhi High Court upholds bundling approach for benchmarking AMP expenses in a landmark transfer pricing judgement Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarizes a recent ruling of the Delhi High Court (DHC) involving a group of taxpayers, with the lead case being that of Sony Ericsson Mobile Communications India Pvt. Ltd. (now known as Sony India Ltd.) (Taxpayer) v. Commissioner of Income-tax on the issue of a transfer pricing (TP) adjustment for excessive advertising, marketing and promotional (AMP) expenditure incurred by the Taxpayers during the Assessment Year (AY) 2008-09. The transfer pricing issue before the DHC was whether an affiliate needs to be compensated under arm s length conditions for its promotional efforts that allegedly enhance the value of a trademark or brand name legally owned by another affiliate. The promotional efforts typically result in the marketing affiliate incurring 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. Earlier, in the case of LG Electronics, Special Bench (SB) of Delhi Income Tax Appellate Tribunal held that there is a transaction between the taxpayer and its Associated Enterprise (AE) under which the taxpayer incurred AMP expenses towards promotion of the brand which is legally owned by the AE. The SB held that 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 bright line test (BLT) in order to determine the transaction value of AMP. The SB also laid down fourteen factors which need to be considered while determining the value of the international transaction of brand/logo promotion through AMP expenses such as determining whether the Indian affiliate has received any subsidy from the foreign AE, whether the Indian AE has paid any royalty, whether the brand is an established brand etc. The DHC while holding that 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 overseas AE or lower charge of royalty paid. The DHC held that arm s length nature of the arrangement may be tested by way of an
aggregated/bundled analysis with other transactions relating to the distribution activity. In case the Tax Authority seeks to unbundle the transactions, the Tax Authority should elucidate reasons for doing so. The DHC emphasized that transfer pricing is an income allocating exercise and should not result in over or double taxation. The fourteen factor test as espoused by the SB of Delhi Tribunal earlier in the case of LG Electronics India would now have limited precedential value as the matters have been restored to the Tribunal for application of the ruling in light of the facts of each case. Ruling of the High Court International transaction The DHC has rejected the Taxpayers contentions that AMP expenses are not international transactions. The DHC has observed that, in most cases, the Taxpayers have submitted that the declared price of the international transaction of import of goods from foreign AE 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 DHC also observed that AMP is a function/expense related to distribution and under a bundled approach it would be illogical to treat AMP expense as a separate international transaction. The Taxpayers 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 propose that AMP expenses do not constitute an international transaction. The DHC has disagreed with these contentions. The DHC has also differentiated between section 37(1) and Chapter X of the Income Tax Law (ITL) to support the same. Bundling of transactions The DHC has disagreed with this interpretation of the SB ruling that the word transaction in section 92C(1) of the ITL refers to a single independent transaction and not a bundle of transactions. The DHC has 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. They have further noted that use of the expression class of transaction in section 92C(1), the wordings of section 92F and that Rule 10A explicitly states that the term transaction includes a number of closely linked transaction thus making 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 DHC has made a detailed observation of applicability and the strengths and weaknesses of TNMM. They have 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 DHC also referred to the example laid out in the SB ruling that demonstrated that even if the entity wide net margin earned by the Taxpayer was higher than that of comparables, there may be case of profit shifting through excessive AMP expenses. In response to this, the DHC has held that since the net margins may be affected by multiple factors, it is even more important that analysis undertaken to select comparables is robust. It would be inappropriate to accept comparables and apply TNMM and yet conjecturise and mistrust the arm s length price. The DHC has 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. The TNMM analysis proceeds on the assumption that once functions, assets and risk being broadly similar and any necessary adjustments have been made, all other factors stand reconciled when computing the net profit margin. Once the comparables pass the functional analysis test and the profit margin matches with the comparables, it leads to an affirmation of the transfer price as the arm s length price. After this it is not permissible to make a comparison of a particular item of costs without segregation of profits as well.
The DHC has however also observed that in a case where a taxpayer is undertaking manufacturing, distribution and marketing, it may not be appropriate to combine and benchmark all three transactions together under TNMM. In such a scenario, the appropriate approach may be to benchmark manufacturing separately and distribution and marketing separately. Connection between AMP expenses and brand building On the issue of whether incurring of AMP expenses necessarily leads to creation of a brand, the DHC has stated that it would be incorrect to assert that AMP is the substantial part of a brand. Brand reflects the reputation which the brand owner has earned over a period of time due to the nature and quality of goods and services sold or dealt with. Quality control is one of the most important elements which 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 or that the only reason for incurring AMP expenses is to enhance the value of the brand. Bright line test (BLT) The DHC has disagreed with the Tax Authority s contention that excess AMP expenses benefits only the foreign AE and observed that increased sales also benefit the Indian taxpayer. The DHC 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 Indian assesse is adequately compensated by its foreign AE. Thus, overturning the ruling of the SB, the DHC rejected the use of BLT as a way of identifying an international transaction and held that the use of BLT on the basis of the comparability analysis outlined in para 17.4 of the SB order is unwarranted. The DHC held that computing the value of the international transaction by applying a BLT is not mandated in the ITL and it amounts to writing and prescribing a mandatory procedure not stipulated in the ITL. Aggregation of transaction and setting off provisions The Taxpayers had argued that while the Tax Authority had segregated the excessive AMP expenses from the profit and loss statement of the main business activity, they had not segregated the additional profits earned due to such spend. In response, the Tax Authority had argued that the ITL [section 92(3)] prohibited them from providing any set-off. However, the DHC has rejected this argument of the Taxpayers. The Taxpayers have stated that the said provision [section 93(3)] applies where an assesse has declared more favorable results as its books of account while the application of the arm s length principle reduced the income chargeable to tax. The concept of set off or adjustments is well recognized and accepted internationally. In case the legislative intent behind the provision [section 92(3)] was to deny set off, the same would have been explicitly stated. Economic ownership vs. legal ownership The SB had held that the ITL recognizes only legal ownership of intangibles and economic ownership exists only in a commercial sense. The SB further held that in the instance of sale of brand by the foreign parent, the Taxpayer would not be entitled to a share in the total consideration towards sale of brand by virtue of it being an economic owner. Only the foreign parent will recover the entire consideration for the sale of brand and there shall be no taxability in the hands of the Indian Taxpayer for parting with its economic ownership of the brand. Contrary to the ruling of the SB, the DHC has recognized the concept of economic ownership of trade name or trade mark as intrinsic to the determination of transfer prices. The DHC has further stated that economic ownership will only arise in cases of long-term contracts and where there is no stipulation of denying economic ownership. They have 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 of time a transfer pricing valuation may be undertaken.
Miscellaneous Issues Scope of AMP expense The DHC held that direct marketing expenses like discounts, rebates and incentives as well as selling expenses cannot be considered to be incurred for the purpose of brand building and thus should not form part of the examination of AMP expenses. Whether the TPO was justified in assuming jurisdiction in absence of reference by AO The Taxpayers had argued that the AO had not specifically referred and no previous approval of the Commissioner was sought or granted for reference of an international transaction relating to AMP expenses. Thus the TPO had no jurisdiction to examine the AMP expenses of the Taxpayer. The DHC has held that in view of the insertion of section 92CA(2B) by the Legislature with retrospective effect, this argument of the Taxpayers stands negated. Applicability of Maruti Suzuki Case The decision of the DHC in the case of Maruti Suzuki India Ltd. vs. Addtl. CIT/TPO [1] on the issue of marketing intangibles, relied upon by both the Taxpayers and the Tax Authority, was not binding in nature since it was subsequently overruled by the Supreme Court ( SC ) [2]. Whether a mark-up is permissible The DHC held that prime lending rate cannot be used as a mark-up under Rule 10B(1)(c) and that the mark-up has to be benchmarked with comparable uncontrolled transactions. Comments One of the most challenging issues in TP is the taxation of income from intangible property (IP). A common situation where some of the complex principles relating to TP 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 distributors activities; and (4) the compensation provided for the functions performed by the distributor. By stressing on comparability, the DHC has affirmed the fundamental principle that the distributor s share of benefits should be determined based on what an independent [1] [(2010) 328 ITR 210 (Del)] [2] [(2011) 335 ITR 121 (SC)]
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 would need to review the implications of this ruling on the transfer pricing documentation and compliances and consider options for risk management.
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