Transfer pricing is increasingly influencing significant changes in tax legislation around the world. This 18th issue of BDO’s Transfer Pricing Newsletter focuses on recent developments in the field of transfer pricing in Australia, Israel, the Netherlands, and India. Transfer pricing is becoming increasingly important for both tax authorities and tax payers around the world, with various countries introducing new legislation and guidance with respect to transfer pricing. As you will read, various countries are also showing initiatives following the finalization of OECD’s BEPS project, which are expected to expand over the coming months.
We are very pleased to bring you this issue of BDO’s Transfer Pricing News, which we were able to produce in close co-operation with our colleagues from the above-mentioned countries. We trust that you will find it useful and informative. If you would like more information on any of the items featured, or would like to discuss their implications for your business, please contact the person named under the item(s). The material discussed in this newsletter is intended to provide general information only, and should not be acted upon without first obtaining professional advice tailored to your particular needs.
INTERNATIONAL BRAND PROMOTION – THE TRANSFER PRICING TANGLE
India has been on the global radar so far as controversies surrounding tax and transfer pricing are concerned. In the last few rounds of audit by the Revenue, Indian taxpayers promoting international brands in India have been scrutinised for the level of advertising, marketing and promotion (AMP) expenses incurred by them. This issue has largely affected MNEs in the consumer durables, distribution and automotive sectors, gaining such importance that a three-member special bench of the Tribunal was constituted to address it. The issue then escalated to the High Court and is now pending with the Indian Supreme Court. In this article we highlight the issues around AMP expenses in India, the positions taken by Indian taxpayers and the Revenue, and how this has evolved amongst the judiciary.
The AMP issue in India
Under a typical license/distributor arrangement, the Indian entity of a MNE group uses the International brand/trademark to sell the products in India. The Indian entity would pay a royalty for the use of such brand/ trademark. In order to spread awareness of products and increase/maintain the market share of the products manufactured or distributed by them in India, the Indian entity would incur expenses on advertising marketing mand promotion.
During the course of transfer pricing audits, the Revenue has consistently been taking a position that the Indian entity of the MNE group provides assistance to the overseas affiliate (legal owner of the brand/trademark) by enhancing or building the International brand/ trademark in India. According to the Revenue, AMP expenses beyond the level of expenses incurred by comparable businesses (bright line test) are non-routine, resulting in the creation of marketing intangibles for the legal owner of the brand. Transfer pricing adjustments have been made on the premise that the Indian entity ought to recover the excess costs along with an appropriate mark-up for such assistance.
How it all started
The AMP issue can be traced back to 2010, when the Delhi High Court made a ruling in the case of Maruti Suzuki3. The High Court remarked that if the level of AMP expenses (defined by a ratio of AMP expense to sales) by the Indian taxpayer is higher than what a comparable company would incur, the Indian taxpayer should be compensated at arm’s length, particularly when the use of a trademark or logo of the foreign affiliate is obligatory on the part of the Indian taxpayer. With a shot in the arm with this ruling, the Revenue made several transfer pricing adjustments in cases involving distributors, licensed manufacturers, service providers, etc. Without appreciating the difference in functional characterization, business model, or industry life-cycle of the Indian taxpayers, the Revenue painted everyone with same broad brush and made transfer pricing adjustments for excess AMP expenses.
The Revenue seems to have taken inspiration from the US Tax Court ruling in 1998 in the case of DHL4, which was subsequently reversed by the Ninth Circuit US Court of appeal5. In the case of DHL, the Tax Court asked DHL to prove that it incurred more than routine AMP expenses outside the US, in order to substantiate that DHL was the developer of the non-US trademark/brand rights. However, the Ninth Circuit Court of appeal rejected the approach of the Tax Court, holding that there was no such requirement to compare AMP expenses incurred by the taxpayer with comparable companies under the 1968 regulation.
Evolution of transfer pricing jurisprudence on AMP in India
More cases were appealed after the Delhi High Court ruling in the case of Maruti Suzuki. In these appeals, taxpayers challenged the legality of the transfer pricing adjustments. In one case, the Appellate Tribunal (second level appellate authority, lower to the High Court) deleted the transfer pricing adjustment on the technical ground that the transfer pricing officer (a specially designated tax officer to carry out transfer pricing audits) had no jurisdiction to assess any transaction which was not specifically referred by the tax officer assessing the case. The Revenue challenged this technical ground before the High Court but failed, no discussion being recorded on the merits of the transfer pricing adjustment. To overturn the defeat in 2012, the Government amended transfer pricing provisions through the Finance Act 2012 which in effect bestowed the right on transfer pricing officers to test transactions even if specifically not referred by the tax officer assessing the case. After this amendment, the Appellate Tribunals started adjudicating the issue on merit. However, the decisions differed in different cases, creating uncertainty around the transfer pricing implications of AMP expenses.
3 Maruti Suzuki India Limited Vs Addl. CIT TPO [W.P.(C) 6876/2008]  328 ITR 210.
4 DHL Corporation & Subsidiaries Vs. Commissioner of Internal Revenue (T.C. Memo. 1998-461, 30 December 1998).
5 DHL Corporation & Subsidiaries Vs. Commissioner of Internal Revenue (Ninth Circuit Court ruling, 11 April 2002).
Special Bench Ruling in the case of LG Electronics India Private Limited6 (LG India)
Considering the conflicting decisions, the importance and the complexity of the issue, in the case of LG Electronics, a three-member special bench was constituted by the Appellate Tribunal to adjudicate on the transfer pricing aspects of AMP expenses. Some other Indian taxpayers7 also affected by the issue appealed as interveners to the case. The special bench heard both sides and decided as follows:
- AMP expenses incurred by Indian taxpayers result in creating and improving marketing intangibles for the overseas affiliates
- Expenses for the promotion of sales directly lead to brand building; expenses directly in connection with sales are only sales specific
- In addition to promoting its products through advertisements, LG India simultaneously promoted the foreign brand
- The concept of economic ownership is not found in Indian tax law. It is the legal owner of the brand who benefits
- If the level of AMP expenses incurred by an Indian taxpayer is in excess of that of comparables, the excess AMP ought to be recovered by the Indian taxpayer from the overseas affiliate along with the appropriate mark up
- Selling expenses which do not lead to brand promotion do not form part of AMP expenses and hence should be excluded for the purpose of benchmarking. Most cases pending before Appellate Tribunals were referred back to the transfer pricing officers, with specific directions to follow the principles laid down by the special bench in the LG India case. This resulted in transfer pricing adjustments in many cases, barring some relief on account of exclusion of routine sales expenses from the ambit of AMP expenses. Delhi HC ruling in the case of Sony Ericsson8 Aggrieved by the order of the tax tribunals following the decision in LG India case, taxpayers (including consumer electronics and consumer durables giants like Daikin, Haier, Reebok, Canon and Sony) appealed to the High Court. In adjudicating the Sony Ericsson case, the High Court laid down the following broad principles:
- In line with the decision of the special bench in case of LG India, AMP expenses are treated as international transactions with the associated enterprise and are thus subject to transfer pricing regulations in India
- Excess AMP expenses incurred by Indian taxpayers warrant remuneration, but the bright line test is not well suited to compute this
- Distribution and marketing functions are intertwined, and should be analysed in a bundled manner from an arm’s length remuneration perspective, unless good and sufficient reasons are demonstrated for debundling them
- If under the bundled approach, the gross margin or net margin of Indian taxpayers is sufficient to cover the excess AMP expenses, then separate remuneration for such excess from the foreign affiliate is not required
- If the distribution and marketing functions are to be de-bundled, then the taxpayer should be allowed a set-off for additional remuneration in one function, with a shortfall in the other function
- In order to apply a bundled approach using an overall transactional net margin method (TNMM)/resale price method (RPM), it should be ensured that the level of the AMP functions in comparables should be similar to that of the Indian taxpayer or the tested entity
- An attempt should be made to find comparables with a similar level of AMP functions, and if such comparables cannot be found, then a proper adjustment should be made to even out the differences
- All AMP expenses may not necessarily result in brand building
- The concept of economic ownership of the intangibles is recognized.
The High Court also suggested that the Appellate Tribunals try to adjudicate the pending cases (rather than remitting them to the transfer pricing officer) following the broad principles laid down in the case above.
However, the Tax Tribunals are in fact remitting the issue back to the transfer pricing officer on the ground that the no analysis is carried out as to the comparability in the level of AMP functions.
Unresolved issues on AMP
Although the Delhi High Court has laid down broad principles and some guidelines for computation of the arm’s length price for distribution and brand promotion functions, some issues remain to be clarified when implementing the ruling in practice. The High Court has emphasized the need for comparability of AMP function between the taxpayer and comparable entities. If companies with comparable AMP functions cannot be found, then a necessary adjustment needs to be made to even out the difference in the AMP functions. However, neither the High Court nor the Appellate Tribunals have provided any guidance on computing adjustments for differences in AMP functions. With regard to the “set-off” of compensation for distribution function with the AMP function in the case of a de-bundled analysis, it is not clear whether the taxpayer’s gross or net margin should be considered as the reference point for determining the amount of the setoff. It is worth noting that the High Court ruling related to a distribution business, and it remains to be seen how the broad principles will be applied in other cases, like those of licensed manufacturers.
6 L.G. Electronics India Private Limited Vs. Asstt. Commissioner of Income Tax (ITA No. 5140/Del/2011).
7 Haier Telecom Pvt. Ltd; Goodyear India; Glaxo Smithkline Consumer India; Maruti Suzuki India; Sony India; Bausch & Lomb; Fujifilm Corporation; Canon India; Diakin India; Amadeus India; Star India; Pepsi Foods India.
8 Sony Ericsson Mobile Communication India Pvt. Ltd Vs. Commissioner of Income Tax (ITA No. 16/2014).
While the Delhi High Court ruling in the Sony Ericsson case is broadly in line with international jurisprudence on the issue, the AMP saga still seems far from over in India. A few Indian taxpayers affected by the Delhi High Court decision, i.e. Sony Ericsson, Canon India and Daikin India have filed a special leave petition before the Indian Supreme Court challenging the ruling by the Delhi High Court.
The key issue that needs consideration and deliberation is whether Indian taxpayers have incurred AMP expenses in their capacity as service providers or as an entrepreneur on their own account. The answer to this may lie in the functional analysis and conduct of the Indian taxpayer and the foreign affiliate. The issue of compensating for AMP function at arm’s length would arise only in cases where the Indian taxpayer is incurring AMP expenses in the capacity of a service provider. Furthermore, indicative facts like exclusivity, longevity of contract, premium pricing and increase in the market share, etc. could be used to demonstrate the economic ownership of the brand. Documentation by the MNE group would play a key role in helping the MNE find answers, determine a course of action and/or build an appropriate defense. Consideration also needs to be given to the mode of remunerating such services. Instead of recovering AMP expenses from the overseas affiliates, MNEs could consider remunerating the Indian taxpayers by way of a higher gross margin to cover the AMP expenses. Lastly, while MNE groups evaluate their value chains in the wake of BEPS, it may be worthwhile considering the above implications while aligning ownership of IP, compensation and related structures.
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