Devang Bhasin and Aishwarya Diwan ((Students of LawHidayatullah National Law University (H.N.L.U) Raipur)).
“The taxation of income from intangibles is perhaps the most important large case issue in the inter-company transfer pricing world today ((Monica Boos, International Transfer Pricing : The Valuation Of Intangible Assets, 1 ( 1st ed.2007).)).”
An increasing number of multinational enterprises (hereinafter “MNE’s”) have been tapping the Indian market by offering their products through local affiliates. Due to strong market competition, they have substantially increased their advertising expenditure. This has brought to fore a key transfer pricing (hereinafter “TP”) issue in intra-group transactions, related to the creation of marketing intangibles ((Marketing intangibles are those which aid in the commercial exploitation of a product or service. They are trademark and trade names.))by the Indian affiliates and the taxability of the associated income ((Rakesh Mishra, The Extra Factor of a Brand, August 11, 2013 available at http://www.thehindubusinessline.com/features/taxation-and-accounts/the-extra-factor-of-a-brand/article5010129.ece (Last visited on 5th September, 2013).)). The TP aspect of marketing intangibles has been the focus of Indian Revenue Authorities (hereinafter “IRA”) over the last couple of years. The issue has been taken up zealously and aggressively by the tax authorities; as a result, taxpayers have witnessed large TP adjustments on the basis of Advertisement, Marketing and Promotion (hereinafter “AMP”) expenditure being asserted to be outside a permissible arm’s length range. The common questions raised in all these cases are:
- Whether promotional efforts undertaken by an Indian entity (Licensee of trademark), enhance the value of a trademark which is legally owned by an Associated Enterprise (hereinafter “AE”)?
- Whether the AE should compensate the Indian entity for the excessive AMP expenditure that is attributable to the developing a trademark owned by it?
IRA have been contending that such non-routine marketing efforts of a subsidiary of the MNE’s should be categorized as “ service “ rendered to their AE and accordingly, should be compensated for the same. This non-routine expenditure is presumed to create marketing intangibles for the AE. However, the Indian Transfer Pricing Regulations (hereinafter “TPR”) do not provide any specific guidance on the arm’s length treatment of marketing intangibles, but there is some guidance in the form of rulings of tax tribunals. Recently, Special Bench (hereinafter “SB”) of Delhi Income Tax Appellate Tribunal (hereinafter “ITAT”), constituted in the case of LG Electronics India Pvt Ltd ((LG Electronics Pvt Ltd v. ACIT  29 taxmann.com 300 (Delhi) (SB).))delivered its decision on the vexed issue of transfer pricing of marketing intangibles. SB, in its ruling has ruled in favour of Tax Authorities by stating that excessive AMP expenditure constitutes an “international transaction” under section 92B of Income Tax Act, 1961 (hereinafter “Act”) and further defined the scope of AMP expenditure by providing specific guidelines to benchmark AMP expenditure. It is pertinent to note that there have been series of other ruling ((See RayBan Sun Optic India Limited v. DCIT ( ITA NO. 5933/Del/2012); Glaxo Smithkline Consumer Healthcare v. ACIT ( ITA No. 1148/ Chd /2011 and Canon India Pvt. Ltd v. DCIT ( ITA Nos.4602/Del/2010, 55993/2011 & 6086/Del/2012).))on the issue of marketing intangibles which have followed the principle laid down in LG India case with regard to sales and distribution expense.
History of Marketing Intangibles in India
The issue of marketing intangible started with “Bright Line” concept which was derived from the DHL case ((DHL Corporation & Subsidiaries v. Commissioner ( TC Memo 1998-461, ( 30 December 1998) ; The US tax court in this case espoused the “Bright Line Test” which notes that “while every licensee or distributor is expected to spend a certain amount of cost to exploit the items of intangible property to which it is provided, it is when the investment crosses the bright line of routine expenditure into the realm of non-routine that economic ownership, probably in the form of marketing intangible is created.” )). In India, issue of marketing intangibles has been raised widely and applied mechanically by IRA ((Rachesh Kotak and Ajit Jain, Marketing of Intangible – Indian Perspective, available at http://www.ifaindia.in/newsletter%5CIFA_WRC_Newsletter_July_to_September_2013.pdf (Last visited on 7th Septemeber 2013).)). The issue of marketing intangibles first came up before the Delhi High Court in the case of Maruti Suzuki India Ltd v. ACIT ((Maruti Suzuki India Pvt Ltd v. ACIT/TPO  328 ITR 210 (Del).)). In the instant case, the taxpayer Maruti Suzuki India Limited (hereinafter “MSIL”) being an Indian Company had entered into a license agreement with Suzuki Motor Corporation (hereinafter “SMC”) for the manufacture and sale of automotive vehicles. As per the terms of the agreement, MSIL agreed to pay a lump sum amount as well as royalty to SMC as consideration for technical assistance and license. MSIL started using the logo of SMC on the cars and continued using the brand name ‘Maruti’ along with the word “Suzuki” on vehicles manufactured by it. MSIL had also incurred significant AMP spends for promoting its products. In connection with AMP spends incurred by MSIL, the Delhi High Court laid down the following guidelines:
- AMP expenses incurred by domestic entity are more than what similarly situated and comparable independent domestic entity would have incurred (bright line test), the foreign AE needs to suitably compensate the domestic entity in respect of the advantage obtained by it in the form of marketing intangible development ((Rohan K Phatarphekar , AMP resulting in creation of Marketing Intangibles- emerging focus in Transfer Pricing Audits available at http://www.tp.taxsutra.com/experts/column?sid=5#content-bottom ( Last visited on 7th September 2013).)).
- In case, the domestic entity uses a foreign trademark or logo on its product manufactured or sold in India’s, no payment to the foreign entity on account of such use, is necessary, in case the use of the foreign trademark or logo is discretionary. However, the consideration for usage needs to be determined at arm’s length ((Id; Aggrieved by the decision of Delhi HC, taxpayer filed appeal with the Supreme Court. The SC observed that the High Court has not merely set aside the original show-cause notice but it has made certain observations on the merits of the case and has given directions to the Transfer Pricing Officer, which virtually concludes the matter. Accordingly SC, directed the TPO, to proceed with the matter in accordance with law uninfluenced by the observations/directions given by the High Court)).
Post the Maruti Suzuki ruling, there have been decisions, which have discussed the aspect of AMP spends and TP adjustments in respect of the AMP spends which lead to creation of marketing intangibles for the foreign AE’s who have derived benefits. However, the tribunals in most of its decisions prior to the Finance Act, 2012 have held that since the specific international transaction pertaining to AMP spends has not been referred to Transfer Pricing Officer (hereinafter “TPO”) by the Assessing Officer, the assumption of the jurisdiction by TPO in working out the Arm’s length price of the AMP transaction is not justified ((Amod Khare & Pavan Kakade , Transfer Pricing issues surrounding the Advertisement, Marketing & Promotion Expenses, August 2012, available at http://www.bmradvisors.com/upload/documents/Article_Transfer%20pricing_Amod%20and%20Pavan_Inernational%20taxation_Aug1346140194.pdf ( Last visited on 6th September 2013).)). Also taxpayers prior to the amendments brought by Finance Act, 2012 have contended that marketing intangibles per se were not covered under the meaning of the term “international transaction ((Id)).”
However, the amendments brought by Finance Act, 2012 in Indian TPR, empowers the TPO to scrutinize any international transaction which TPO deems fit ((Section 92(2B) as inserted by Finance Act, 2012 provides that “Where in respect of an international transaction, the assessee has not furnished the report under section 92E and such transaction comes to the notice of the TPO during the course of the proceeding before him, the provisions of this Chapter shall apply as if such transaction is an international transaction referred to him under sub -section (1)”.)). Further, it also expanded the meaning of the term “international transaction” to bring within its ambit provision of services relating to development of marketing intangibles ((Explanation to section 92B as inserted by the Finance Act, 2012 provides that (i) the expression “ international transaction “ shall include- (d) provision of services, including provision of market research, market development, marketing management , adminisatrion, technical service….. and (ii) the expression intangible property include- (a) marketing related intangible assets, such as trademarks, trade names, brand names, logos)).
M/s L.G. Electronics India Private Limited v. Assistant Commissioner of Income Tax
- A. Facts of the Case
In the present case ((LG India, supra note 5.)), L.G. Electronics India Pvt Ltd (hereinafter “Taxpayer”) is a subsidiary of L.G. Electronics Inc Korea (‘AE’) and is engaged in the business of manufacture and sale of consumer electronic products in India under the brand name “LG”. During the relevant previous year, the taxpayer incurred AMP expenses amounting to 3.5% of sales. As per the analysis of TPO applying Bright Line Test, the ratio of AMP expenses to sales of the taxpayer was higher than average of the similar ratio of two comparable companies namely Videocon Appliances Ltd- 0.12% & Whirlpool of India Ltd-2.66%, average AMP expense of the two comparable companies being 1.39%.The TPO held that the excess AMP expenditure incurred by the taxpayer was toward creation of brand “LG” in India which is legally owned by AE and therefore, AE should have compensated the taxpayer for the excess AMP expenditure incurred by it. The Dispute Resolution Panel upheld the order of the TPO and also directed that mark up of 13% be charged to account for the opportunity cost (10.50%) and entrepreneurial efforts (2.50%) undertaken by the taxpayer. Aggrieved, the taxpayer appealed before the Tribunal.
- B. Questions Before the Tribunal
A SB was constituted to adjudicate the following two questions:
- “Whether, on the facts and in circumstances of the case, the AO was justified in making transfer pricing adjustment in relation to AMP expenses incurred by the taxpayer”?
- “Whether, the AO was justified in holding that the taxpayer should have earned a mark up from the AE in respect of AMP expense alleged to have been incurred for and on behalf of the AE”?
- C. Taxpayer’s Contention and SB Ruling
C.1. Jurisdiction of the TPO
- The Assessee contended that section 92CA of the Income Tax Act, 1961 prevailing at the time of issuing of the TP order does not permit the TPO to assume jurisdiction over an international transaction which has not been referred to him by the AO.
- SB held that in view of section 92 CA(2B) of the Act inserted by Finance Act,2012 with retrospective effect from 1.6.2002, the TPO had the jurisdiction to make TP adjustment qua AMP expenses even if the said issue was not referred to the TPO by AO ((Id at ¶ 7.9, 7.18 & 7.23.)).
C.2 Existence of Transaction
1. The Assessee contended that there is no agreement or understanding with the foreign AE for creating or development of a marketing intangible in the nature of brand building for its foreign AE. Even if it was presumed that some part of the AMP expenses incidentally led to brand building for the foreign AE, it cannot be said that there is an international transaction with the foreign AE.
2. SB observed that an International transaction between two parties can be formal, or in writing on one hand or oral in the other. The critical test would be the conduct of the parties ((Id at ¶ 9.9)). It further observed that “where the Indian company has incurred expenditure on product advertisements including the foreign brand and the AMP expenses incurred by the taxpayer are proportionally higher than those incurred by comparable cases, the same leads to the inference of “transaction” between the taxpayer and the foreign AE for creating marketing on behalf of the latter ((Id at 9.11)).
C.3 Economic Ownership v. Legal Ownership
- The Assessee contended that it can be considered as the ‘economic owner ‘ of the brand and part of AMP expenses incurred can be construed as being incurred towards building of economic ownership of a foreign brand which vests solely with the Indian assessee.
- SB held that economic ownership of brand is a concept which exists only in commercial sense. SB stated that the taxpayer and middlemen in a supply chain can be considered as economic owner of a brand only in commercial sense as they all exploit the brand for furthering their sale. It further explains that if AE (legal owner) sold its brand, then the sale consideration would not be shared amongst such economic owners and would vest only with legal owner. So in the context of the Act, it is only legal ownership which is recognized and not economic ownership ((Id at ¶ 10.2.)).
C.4. International Transaction
- The Assessee contended that payment for AMP expenditure was made to third parties. Further, there was no consideration between the taxpayer and its AE for provision of brand-building services.
- SB observed that it was not the contention of the Revenue that payment made to third parties is an international transaction rather taxpayer was provided brand building service to AE by incurring such advertisement expenditure. SB held that there is a transaction of creating and improving marketing intangible by the taxpayers for the foreign AE, foreign AE is a non-resident; such transaction is in the nature of provision of service ((Id at ¶ 14.21.)).
C.5 Application of Bright Line Test
- The Assessee contended that Bright Line Test ((Bright Line Test’ (a concept under the U.S. legislation) is a line drawn within the overall amount of AMP expenses. The amount on one side of the bright line is the amount of AMP expenses incurred for normal business of the assessee and the remaining amount on the other side is the cost / value of the international transaction representing the amount of AMP expenses incurred for and on behalf of the foreign AE towards creating or maintaining its marketing intangible.))[hereinafter “BLT”] is not a prescribed method under the Indian TPR and hence application of the same to taxpayer’s case is invalid.
- SB observed that since the expenses incurred by the Indian taxpayer for its own business purposes and for promotion of brand of the AE, are intermingled & otherwise inseparable, BLT test is a way of finding out the cost of the international transaction ((LG India, supra note 21 at ¶ 15.6 and 15.7)). It further observed that BLT is used to only ascertain the cost of service rendered by the taxpayer to foreign AE towards creation and improvement of marketing intangibles ((Id at ¶ 16.12.)).
C.6 Application of Transactional Net Margin Method
- The Assessee contended that AMP expenses cannot be benchmarked separately when the overall profit declared by the assessee is higher than other comparable cases. The AMP expenses stood adequately compensated and the same can be inferred from the comparably high Transactional Net Margin Method (hereinafter “TNMM) margins of the entity.
- Tribunal held that merely because the net profit rate of the Indian taxpayer is better than the corresponding rate of comparable companies would not lead to conclusion that incurring of AMP expenses for the AE is at arm’s length. TNMM has to be applied on transaction to transaction basis and not on entity level basis ((Id at ¶ 21.13)).
C.7 Choice of Comparables
Tribunal mentioned various factors which have bearing on the question of determination of cost of the international transaction. These factors inter alia include characterisation of the entity, payment for technology or trademark in any form ((Id at ¶ 17.4)). Tribunal also stated that in choosing comparables, the correct way to make a meaningful comparison is to choose comparable domestic cases not using any foreign brand ((Id at ¶ 17.6)).
C.6 Nature of AMP expenses
SB held that expenditure in the nature of selling expenses would not be covered within the ambit of AMP expenses for determining the cost of the transaction ((Id at ¶ 18.6)).
C.7 Application of Maruti Suzuki’s Case
SB held that Delhi HC ruling in Maruti Suzuki India Pvt Ltd ((Maruti Suzuki India Pvt Ltd v. ACIT/TPO  328 ITR 210 [Del].))case was still very much alive and has not been diluted by the SC.
Conclusion by SB
SB concluded that TP adjustments in relation to AMP expenses incurred by the taxpayer for creating or improving the marketing intangible for and on behalf of the AE is permissible. Secondly, earning a mark up from the AE in respect of AMP expenses incurred on behalf of the AE is also allowable.
From the above ruling it can be analyzed and concluded that the issue of marketing intangibles is contentious in India and taxpayers should go in for a stronger transfer pricing analysis. There is an emerging focus of IRA on AMP spends, so it is imperative for taxpayers to stick with fundamental principles of TP. In light of the principles laid down in LG Electronics India case taxpayers should firstly evaluate the existing arrangements and nature of rights obtained, functions, cost and risk relating to marketing intangibles. Secondly, try to segregate AMP expenditure between routine and non-routine. Thirdly, evaluate whether the level of marketing activities performed by the Indian affiliate is more than that performed by comparable companies having regard to various factors and fourthly, analyse whether the Indian affiliate requires any compensation for its marketing activities. They should also consider going for Advance Pricing Agreements ((Advance Pricing Agreement is an agreement between a taxpayer and a tax authority on an appropriate transfer pricing methodology for a set of transactions over a fixed period of time in future))route as it would bring certainty on the issue of marketing intangibles.