Wednesday 27 August 2014

India’s Delhi Tribunal rules on TP issues regarding AMP expenses, software support services and CAPM risk adjustments

We are pleased to release a Tax Alert which summarizes a recent ruling of India’s Delhi Income-tax Appellate Tribunal (Tribunal). The Taxpayer in this case is engaged in the distribution of telecom equipment mobile phones and provision of telecom services in India. The Taxpayer’s Associated Enterprise (AE) is the legal owner of the trademarks and brand name (collectively referred to as marketing Intangible Property or Marketing IP) under which the products are distributed. The Taxpayer also provides software development services and marketing and administrative support services to its AEs.

The issues before the Tribunal were the appropriateness of a transfer pricing (TP) adjustment made by the Transfer Pricing Officer (TPO) for the Financial Year (FY) 2006-07 with regard to “excessive” advertising, marketing and promotional (AMP) expense incurred by the Taxpayer in its distribution activity and the level of markup on costs for provision of software development services and administrative and market support services.

The TPO alleged that the AMP expenses incurred by the Taxpayer benefitted the AE by enhancing the value of the marketing IP belonging to the AE, for which the Taxpayer needed to be appropriately compensated under arm’s length principles. A TP adjustment of approximately INR 1.79 billion was made for this transaction. The Tribunal primarily relied on the decision of the Special Bench (SB) in the case of LG Electronics v ACIT and distinguished the Taxpayer’s case from the Delhi Tribunal ruling in the case of BMW India Pvt. Ltd v ACIT . The Tribunal thereafter restored the matter back to the TPO for deciding the issue in light of factors outlined by the Special Bench in the case of LG Electronics (supra). It may be noted that the Special Bench had indicated 14 factors that needed consideration while dealingwith the issue. In the facts of the case, the Taxpayer argued that it had been compensated by its AE as its group’s global TP policy required appropriate adjustments so that the Taxpayer earned an arm’s length return on sales. Such adjustments were affected by way of credit notes from the AE and should be considered as a form of compensation or subsidy for the “excessive” AMP expenses that Taxpayer had allegedly incurred. The Tribunal observed that while the compensation or subsidy received from the AE is a factor that needs consideration in light of the ruling in the case of LG Electronics (supra), the Taxpayer would need to specifically demonstrate a nexus between the adjustments made by way of credit notes and the AMP expense incurred by the Taxpayer and a conclusion on this matter cannot be reached by considering the overall operating profit margin of the Taxpayer.

The TP adjustment relating to provision of software development services (approximately INR 1.07 billion) and marketing and administrative services (approximately INR 78 million) primarily arose in view of a difference in selection of comparable data by the TPO. The Tribunal while restoring the matter back to the TPO for re-determination made significant observations regarding application of various quantitative and qualitative criteria for selection of comparable data. The Tribunal also recognized the need to make appropriate adjustment for risk differences between the Taxpayer and the comparable companies and acknowledged that the Capital Asset Pricing Model (CAPM) may be used for this purpose. The Tribunal proposed the appointment of independent experts by the Taxpayer as well as the TPO to determine the risk adjustment.


TP aspects relating to marketing IP have emerged as a contentious issue in TP audits in India in recent times. A common situation where the issue arises is 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 its activities, i.e., whether the distributor should be compensated only for distribution activity or whether the distributor should also be compensated for enhancing the value of marketing IP by virtue of its functions performed. The Tribunal ruling reiterates the principles stated in the case of LG Electronics (supra) need to be considered to determine this issue. The ruling also highlights the importance of a nexus between the AMP activity and expense and the form of compensation to the AE, if the same needs to be considered for evaluating its implications from a TP perspective.

The approach to selection of comparable data has been a challenging issue while dealing with TP aspects of outsourced services. In practice, both quantitative and qualitative criteria may be used to include or reject potential comparables. The choice and application of selection criteria depends on the facts and circumstances of each particular case. The process followed to identify potential comparables is one of the most critical aspects of the comparability analysis. In particular, the choice of selection criteria has a significant influence on the outcome of the analysis and should reflect the most meaningful economic characteristics of the transactions compared. While the Tribunal’s observations on the selection criteria do seem to reflect principle, it also leaves some room for subjective judgments. The Tribunal’s direction to the Tax Authority on use of independent experts while determining impact of a risk adjustment on the transfer price is welcome. It may be pertinent to note that the Central Board for Direct Taxes, India’s apex tax administration, has issued Instruction No. 5/2011 dated 5 March 2011 directing the Tax Authorities to take the opinion of technical experts in cases involving complex technical issues.

It would be useful for multinational enterprises with Indian affiliates to review the impact of the ruling on their intra-group arrangements involving distribution activities and provision of outsourced services. 

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