Premium Profits represents compensation for excessive marketing activities undertaken by a Taxpayer

 

In a recent order in the case of BMW India Private Limited[1] (the “Taxpayer” or “BMW India”), the Income Tax Appellate Tribunal (“Tribunal”) has laid down an important principle on the concept of marketing intangibles holding that the premium profits earned by the Indian subsidiary of a foreign parent represents an arm’s length compensation for excessive marketing activities undertaken by the Taxpayer, and hence, no further adjustment was required.

Facts of the case

· BMW India was incorporated in 1997 as a private limited company and is a wholly owned subsidiary of BMW Holding B.V, Netherlands. The relevant year in question was the first full year of operations for BMW India.

· Taxpayer demonstrated its international transactions to be at arm’s length after application of Resale Price Method (“RPM”) corroborated by Transactional Net Margin Method (“TNMM”) as the most appropriate method. Taxpayer had earned a Gross Profit Margin (“GPM”) of 27.36 percent as compared to 13.65 percent earned by comparable companies and a Net Profit Margin (“NPM”) of 13.52 percent as compared to 2.11 percent earned by comparable companies thereby complying with the arm’s length principle as envisaged in the Indian Transfer Pricing (“TP”) legislations.

Assessment Proceedings

· The case was picked up for scrutiny by the Transfer Pricing Officer (“TPO”) post receiving reference from the Assessing Officer (“AO”). During the course of proceedings, the TPO adjudicated the primary international transactions of purchase of completely built units (“CBU”), completely knocked down (“CKD”) kits and parts & components to be at arm’s length. However, the TPO observed that BMW India had incurred advertisement, marketing and promotion (“AMP”) expenses in excess to that of comparable companies and that the same had not been compensated by its associated enterprises (“AEs”) for the brand promotion activities which resulted in creation of marketing intangibles for its AE.

· Accordingly, the TPO after excluding certain comparables of the Taxpayer came to an average AMP sales ratio representing the bright line of 0.52 percent.

· However, the Taxpayer, submitted a fresh set of comparables to the TPO which had similar “intensity of functions” performed as that of BMW India. The TPO, post adding few comparables taken by the Taxpayer in its TP documentation to this fresh comparable set, recomputed the bright line at 1.99 percent as against Taxpayers’ AMP to sales ratio of 7.09 percent. Further, the TPO added a mark-up of 15 percent to propose addition to the total income of the Taxpayer.

Dispute Resolution Panel (“DRP”) Proceedings

· Aggrieved by this, the Taxpayer filed its objections before the DRP. The DRP concurring with the findings of the TPO, nonetheless, directed the TPO to exclude amounts inextricably incurred in relation to sales from the AMP expenditure. However, the AO erroneously did not incorporate the same in the final assessment order.

Taxpayer’s Contentions before the Tribunal

· International Power House (“IPH”) is the organizational unit of BMW and as such it is responsible for marketing and development, consequently, the Taxpayer had no role to develop campaigns etc.

· AMP expenses calculation included expenditure like after-sales support costs etc. which needed to be rectified in accordance with the directions of the DRP.

· Further, the Taxpayer while trying to distinguish its case from that of LG Electronics India Private Limited (“LG India”), it was argued that since it had withdrawn its application for intervention before the Special Bench, the principles as laid down by the Special Bench are not applicable to its factual matrix.

· Taxpayer also contended that it is a routine/ entrepreneurial distributor engaged in the import and resale of CBUs. In addition to the distribution activity, the Taxpayer also carried out low
value-added assembling of CKD kits from its assembly facility in Chennai.

· Taxpayer being a routine/ entrepreneurial distributor was solely responsible for enhancing its market by undertaking sales promotion and marketing activities. Therefore, the AMP expenditure incurred resulted into a benefit to the Taxpayer by way of enhanced sales and benefit, if any accruing to the overseas AEs, was purely incidental.

· It was the first full year of operations of BMW India and given the position of automobile industry in India which faces intense competition and rising costs thereby lowering the margins, the Taxpayer necessarily had aggressively undertake sales promotion and advertisement in order to enhance its market share while performing the functions of a distributor..

· Placing reliance on the ‘Importation Agreement’ entered between Taxpayer and its AE, it was highlighted to the Tribunal that the pricing is done in such a manner that the price charged for the contract goods is adequate to ensure recovery of total cost of the contract goods supplied plus representative profits.

· Taxpayer also strongly argued that it had earned premium profits which were substantiated by the fact that the Taxpayer had earned a gross profit/ sales margin of 27.36 percent as compared to 13.65 percent of comparables. Alternatively, under the TNMM, the Taxpayer demonstrated that its net margin was 13.52 percent as compared to 2.11 percent of comparables.

· Based on the above, the Taxpayer demonstrated that even after considering the comparables accepted by the TPO, BMW India’s earning was much higher than the arms’ length return, both at gross profit and net profit level. Accordingly, placing reliance on various international commentaries including Organization for Economic Co-operation and Development (“OECD”) Transfer Pricing Guidelines, US TP Regulations (“US Regs”) and Australian Tax Office (“ATO”) Guidelines, it was submitted that the bright line test had no application in the face of high profit/ premium margin shown in RPM/ TNMM.

· It was further argued that, post incorporating the DRP directions and removing after-sales support costs and salesman bonus, the excess AMP ratio would be 3.62 percent as opposed to 7.09 calculated by the TPO. The difference between bright line considered by the TPO (1.99 percent) and the Taxpayer’s AMP remained at 1.63 percent (3.62- 1.99). The Taxpayer, thus, , as compared to its comparables has earned, 13.71 percent higher gross margin (27.36 - 13.65) and 11.41 percent higher net margin (13.52 - 2.11) whereas the actual excess AMP spend was only 1.63 percent. In absolute terms, the Taxpayer claimed that it has already been compensated to the tune of INR 106.85 crore (11.41 percent being the difference between BMW India OP/sales and Arm’s Length OP/sales) which is greater than AMP spend of INR 33.93 crore from which routine expenses are to be allowed.

· Based on the above, the Taxpayer contended that BMW India has already received the payment for the services rendered to the foreign AE and no further compensation was required to be made by the AEs as the same has already been received.

· During the course of proceedings, it was also emphasized that for exploiting the brand logo etc, no royalty has been paid by the Taxpayer to its foreign AE. Further, the Taxpayer argued that the AE has provided the Taxpayer with a loan at a rate better than the external benchmark, the average PLR as per the Taxpayer’s TP study is 13.30 percent and the BMW India’s effective Rupee cost on the loan is 7.43 percent.

Tribunal Ruling

· On the key legal grounds, the Tribunal followed the Special Bench decision in the case of LG India and held that the excess spend of AMP is an international transaction and, further, upheld the application of the bright line .

· The Tribunal agreed with the primary argument of the Taxpayer that, since it has earned premium profits vis-à-vis comparable companies, the AEs had actually more than compensated BMW India for development of marketing intangibles. The Tribunal, while placing reliance on the “Importation Agreement” wherein it was stated that the Taxpayer shall charge such a price that would ensure adequate recovery of total costs of the contract goods plus representative profits, agreed with the Taxpayer that no further compensation was required to be made by the AE as the same has already been received which is represented by premium profits earned by the Taxpayer.

· The Tribunal, further, stated that the revenue department cannot insist, in the absence of any provision under the Income-tax Act, 1961 (the “Act”), that the mode of compensation to the Taxpayer by the foreign AE necessarily has to be direct compensation and pricing adjustment should not be accepted. In the absence of any such rule or provision in the Act, the Taxpayer is free to adjust and apply any method which it finds most suitable to manage its affairs. The Tribunal also observed that had it been specifically required by the Act and the Rules that the remuneration/ compensation for the performance of non-routine functions of a distributor has to necessarily be remitted/ reimbursed separately with a cost plus, the occasion to refer and rely on the terms of the “Importation Agreement” would have not arisen.

· It was further held that the above proposition is also supported by contemporaneous international jurisprudence and even the Special Bench ruling in LG India’s case leaves the issue open while giving voice to the diverse nature of facts, business models and peculiar terms and conditions of different assessee by observing that there cannot be any ‘straight-jacket’ formula.