Wednesday, 11 June 2014

Understanding Tax impact of AMP under Indian Transfer Pricing.


Income earned from intangible property is one of the most challenging issues in Transfer Pricing (TP), more so in the context of India and its growing economy. More often than not, the transactions pertaining to intangible property are between Associated Enterprises (AEs) and hence the challenges to ensure that such transactions reflect arm’s length dealings.
In the recent round of TP audits in India, the tax payers have experienced aggressive approach by the Transfer Pricing Officers (TPO’s) where it is alleged that the AMP (Advertisment, Marketing & Promotion branding etc ) expenditure incurred by the Indian AE results in an enhancement of the value of the brand / trademark belonging to the foreign AE and therefore an appropriate compensation is required to be made to the Indian AE. Accordingly, the Indian AE ought to get an arm’s length compensation. In this context, it would be appropriate to understand the related background internationally as well as in India.
Marketing intangibles have become a hotly debated topic within the transfer pricing community in different countries. Generally, the term marketing intangibles and its value is derived from the company's levels of AMP expenses. These are created by the enterprise that invests to give market recognition or value to the brand. While the increased brand value at a local level may benefit the local entity only, it may not have the right to future perpetual intangible benefits arising from it. Hence, the tax authorities seek to identify and differentiate these spends that develop the intangible and provide enduring benefit over that of routine advertising costs. The revenue authority's contention is that the entity that has incurred significant spends to generate these non-routine intangible needs to be compensated by its affiliates in other jurisdictions, if the benefit from such intangibles is flowing to the foreign affiliates which own the intangibles.
The US regulations have tried to draw a line to separate the provision of marketing services and the development of intangible property. An important theory propounded in IRS regulations relates to 'Developer – Assister rule' and it finds application where there is no legal ownership to intangible property and one of the controlled taxpayers is considered as the developer (who bears the largest portion of direct/indirect costs of developing the intangible) and the other participating member is regarded as the assister. Allocation may be made to reflect an arm's-length consideration for assistance provided, however it does not include expenditure of a routine nature that an unrelated party dealing at arm's length would be expected to incur.
In an early interesting decision, the US courts, in the DHL case, held that no royalty would be due to DHL US from its associated entity DHL International, standing for the proposition that for items of intangible property, the party which bore the economic burden of the investment should bear the economic rewards. Here, the trial judge espoused the 'bright-line' test which notes that, while every licensee or distributor is expected to expend 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 expenditures into the realm of non-routine that economic ownership, probably in the form of a marketing intangible, is created.
While the guidelines and court precedents fundamentally revolve around dividing AMP spends into routine and non-routine or applying the bright-line test, it is not possible to apply this uniformly because companies within the same industry have different marketing philosophies, business realities/features, product launches, product dependence or interdependence and may account for their marketing spends under different accounting heads, which would create different levels of AMP and different bright lines for each entity.
However, to date the bright-line approach has been considered as more realistic to resolve the issue at hand though it is often used by tax authorities to their advantage. It would also be pertinent to note that recently the Committee on Fiscal Affairs of the OECD announced that Working Party No 6 is considering a new consultation project on the transfer pricing aspects of intangibles.
In the Indian context, the decision of the Delhi High Court in the case of Maruti Suzuki India Ltd vs. ACIT (2010-TII-01-HC-DEL-TP) has highlighted the complex issue pertaining to marketing intangibles. The High Court held that:
·         If the AMP expenses incurred by the domestic entity are more than what a 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;
·         In case the domestic entity uses a foreign trademark or logo on its product manufactured or sold in India, 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.
The Indian Revenue/TP authorities are implementing the ratio of the High Court decision and are scrutinizing existing as well as past cases (under Section 148 of the Indian Income-tax Act, 1961) where similar issues exist / arise. There are various approached being followed by the TPO’s in quantifying the benefit from the AMP spend. One approach relates to using the Profit Split Method alleging that the foreign AE as well as the Indian AE are both involved in enhancing the value of the IPR and hence there should be an apportionment of global profits to the Indian AE. The other alternate method is to treat the AMP expenses which exceed the bright-line test, to be a service by the Indian AE and adding a mark-up in the range of 10-15%. In either of the approach, the resultant adjustment in the hands of the Indian AE, more often than not, is huge. Also the recent amendment enabling the TPO to bring into scrutiny any international transactions which he deems fit is a step to empower the TPO to bring into ambit transactions like AMP spends.
Marketing intangibles are assets that may have considerable value even though they may have no book value in the enterprise’s balance sheet. However, it is important to understand that not all marketing activities result in creation of marketing intangibles. There also may be considerable risks associated with such intangibles including contract or product liability risks.
Given the emerging focus of the TP authorities on AMP spends, it is imperative for tax payers responding to tax-authority challenges and proactively:
·         Evaluate existing arrangements and the nature of rights obtained, functions, costs and risks relating to marketing activities;
·         Segregate AMP expenditure between routine and non-routine;
·         Evaluate whether the level of marketing activities performed by the Indian affiliate is more than that performed by comparable companies / competitors having regard to various factors;
·         Analyse whether the Indian affiliate requires any compensation for its marketing activities.
Further, Indian transfer pricing regulations do not have specific guidance dealing with the transfer pricing of marketing intangibles. Accordingly, in line with international practice and OECD principles, guidance should be issued to recognise certain methodologies/approaches for evaluating the arm's- length character of transactions involving marketing intangibles.
In this context, let us analyse few more recent court rulings.
·         In the case of L.G. Electronics India Pvt. Ltd v. .ACIT, 140 ITD 41/ 22 ITR 1/83 DTR 1/152 TTJ 273(SB)(Delhi)(Trib.) , it was held that the “Bright Line test” can be applied to determine whether AMP expenses incurred by assessee are excessive and for the benefit of the brand owner- Adjustment in relation to advertisement, marketing, and sale promotion expenses incurred by assessee for creating or improving, marketing intangible for and on behalf of foreign AE is permissible. Expenses in connection with sales which do not lead to brand promotion cannot be brought within ambit of ‘advertisement, marketing and promotion expenses’. Correct approach under TNMM is to consider operating profit from each international transaction in relation to total cost or sales or capital employed ,etc of such international transaction and not net profit , total costs sales , capital employed of assessee as a whole on entity level. (S. 92B , Rule 10A, 10B ). 
 
·         In A.Y. 2008-09, the assessee entered into two transactions: (i) it sold its call center business to Hutchison Whampoa and (ii) it assigned its call options to Vodafone International Holdings B.V. The said two transactions were not reported in Form 3CBEB. The AO made a reference on 25.01.2010 u/s 92CA(1) to the TPO to determine the ALP of certain other transactions entered into by the assessee with the AEs. The said two transactions were not a part of the reference. The TPO took suo motu cognizance of the said two transactions and held that though the sale of the center business was between two domestic companies, it was pursuant to the share sale agreement with Vodafone International and so was hit by s. 92-B(2). He also held that the assignment of the call options was the transfer of a capital asset giving rise to capital gains. He made an adjustment of Rs. 8,590 crore. The assessee did not raise any objection on the jurisdiction of the TPO to consider the said two un-referred transactions though it filed objections on the merits before the DRP. During the pendency of the DRP proceedings, the assessee filed a Writ Petition contending that (a) under the law laid down in CIT v. Amadeus India (P) Ltd. (2011) 203 TM 602 (Del) the TPO has no jurisdiction to go beyond the reference made by the AO, (b) s. 92CA(2A) which was inserted on 1.6.2011 to provide that the TPO can suo motu take cognizance of an un-referred international transaction is a substantive provision and cannot apply retrospectively to a reference made on 25.01.2010, (c) the rewriting of the call options was not an international transaction in view of the law laid down in Vodafone International Holdings B.V. v. UOI ( 2012) 341 ITR 1(SC). It was urged that as there was inherent lack of jurisdiction in the TPO and as the DRP did not have jurisdiction u/s 144C(8) to quash the TPO’s order, the Writ Petition was maintainable. HELD by the High Court dismissing the Petition:
(i)                 Though s. 92CA(2A) inserted w.e.f 1.6.2011 is a substantive provision and not a procedural one and confers fresh jurisdiction on the TPO, it applies to all proceedings that are pending as of 1.6.2011. Consequently, the TPO has jurisdiction to consider unreported and un-referred international transactions in proceedings that were pending before him on 1.6.2011;
(ii)               (ii) The assessee’s contention that s. 92CA (2B) inserted by FA 2012 w.r.e.f. 1.6.2002 operates only where an assessee has not furnished a report u/s 92E in Form 3CEB and thereafter an international transaction comes to the notice of the TPO is not correct. S. 92CA(2B) applies also where the assessee has filed Form 3CEB but not included certain transactions. There is no cogent reason why the Legislature would have conferred jurisdiction upon the TPO to consider an unreported international transaction in cases where a report has not been furnished at all but not in cases where a report has been furnished u/s 92E, but the report does not include a particular international transaction;  
(iii)             The department’s contention that the AO is entitled to revisit and, in effect, sit in appeal over the TPO’s report in all respects is not correct. It is not that the TPO is a valuer who merely facilitates the AO in the computation of the arm’s length price. U/s 92CA(4) the AO is bound to pass an order “in conformity” with the TPO’s order and so he is bound by the TPO’s determination and cannot sit in judgment over the same in any respect;
(iv)             The assessee’s contention that it has no alternate remedy because the DRP is not entitled u/s 144C to consider whether or not the transactions are international transactions is not correct. Though s. 144C(8) refers to the DRP’s powers to only “confirm, reduce or enhance”, its powers are wider and it can consider the question as to whether the unreported transactions are international transactions or not or even whether what the TPO considered was a transaction at all. S. 144C is an alternate to an appeal to the CIT(A) and the legislature cannot be intended to curtail the assessee’s rights;  
(v)               While in principle a Writ Petition can be entertained if the TPO lacks inherent jurisdiction to proceed in the matter u/s 92CA(2A)/(2B), that should be done only if it is invoked at the appropriate time viz. at the outset or soon thereafter. There would be no question of exercising jurisdiction after the TPO has made the order or has proceeded to a considerable extent in the determination of the arm’s length price.  On facts, as the TPO has already passed his order and as the assessee has an alternate remedy before the DRP/ ITAT, the writ petition cannot be entertained; 
(vi)             On merits, the contention that the sale of the call center business was between two domestic   companies and that it could not be regarded to be pursuant to the share sale agreement for purposes of s. 92-B(2) cannot prima facie be accepted because the sale of the call center business appears to be  foreshadowed by the shares sale agreement. The assessee does not have an ‘open and shut’ case.  Likewise, the argument that there was no transfer of the call options and that the findings of the TPO are contrary to Vodafone International Holdings B.V. v. UOI (2012) 341 ITR 1(SC) would have to be urged before the DRP especially in view of the subsequent amendment to s. 2(47)  
 Refer, Vodafone India Service Pvt. Ltd v. UOI, WP No. 488 of 2012, dt. 06/09/2013)

·         The Assessing Officer made disallowance by 10% of the expenditure on advertisement & sales promotion relatable to promotion of ‘samsung’ brand. CIT(A) deleted the addition. Tribunal held that no part of the advertisement and sales promotion expenditure can be treated as relatable to promotion expenditure of foreign brand in India. There was no allegation by the TPO that the assessee had spent proportionately higher amount of AMP expenses to draw an inference of a transaction between the assessee and its AE of promoting the foreign brand. Refer, ACIT v. Samsung India Electronics (P.) Ltd., 156 TTJ 44.
·          The focus under the TNMM is on transactions rather than operating income of the enterprise as a whole. Once in a given case, there are similar nature of transactions and functions between controlled transactions with the related party and uncontrolled transactions with unrelated party, then internal comparability will result into more appropriate result of ALP, as it will require least amount of adjustments. Since product similarity has to be seen while applying CUP method and not TNM method, rejection of internal TNM method, simply on basis of distinction between alcoholic beverages, holding whisky and non-whisky as two different products, is wholly undesirable and not sustainable. Advertisement, marketing and sales promotion expenses incurred by assessee, resulting in brand promotion of foreign AE, is an international transaction as per section 92B, triggering transfer pricing mechanism. However, sales expenses not related to brand promotion, should be excluded while determining cost of international transactions in respect of AMP expenses. Refer, Diageo India (P) Ltd. .v. DCIT, 59 SOT 150.

·         After TPO determines the AMP expenditure incurred for benefit of AE, balance is deemed to be incurred for assessee’s business & is automatically allowable u/s 37(1). [S.37(1)] The avowed object of the TP adjustment on account of AMP expenses is to first find out and attribute the amount spent by the assessee towards promotion of its foreign AE’s brand/logo etc and then make addition for such amount with appropriate mark-up. By this exercise, the total AMP expenses get segregated into two classes, viz., one benefiting the assessee’s business and two, benefiting the foreign AE by way of promotion of the brand. Whereas the first amount is deductible in full subject to the regular provisions, the second amount is added to the total income with suitable mark-up by way of the TP adjustment. Once the total amount of AMP expenses is processed through the provisions of Chapter X of the Act with the aim of making TP adjustment towards AMP expenses incurred for the foreign AE, or in other words such expenses as are not incurred for the assessee’s business, there can be no scope for again reverting to s. 37(1) qua such amount to make addition by considering the same expenditure as having not been incurred `wholly and exclusively’ for the purposes of assessee’s business. If the amount of AMP expenses is disallowed by processing under both the sections, that is 37 and 92, it will result in double addition to the extent of the original amount incurred for the promotion of the brand of the foreign AE de hors the mark-up Refer, Whirlpool of India Ltd. .v. DCIT, Delhi ITAT.

·          In an important ruling in the case of Canon India Private Limited (“Canon India”), the Delhi Divisional Bench of the Income Tax Appellate Tribunal (“Tribunal”) has laid down important principles in relation to Transfer Pricing adjustments relating to the issue of creation of marketing intangibles. In this case, the Tribunal remanded back the matter to the Transfer Pricing Officer (“TPO”) with specific instructions that Advertisement, Marketing and Promotion (‘AMP') expenditure should be benchmarked in light of guidelines laid down by the Special Bench (“SB”) in the case of LG Electronics India Limited vs. ACIT[1] (“LG India”) and Chandigarh Bench in the case of Glaxo Smithkline Consumer Healthcare Limited vs. ACIT[2] (“GSK India”). While doing so, the Tribunal has directed the TPO to exclude subsidy [received from associated enterprise (“AE”)], trade discount & volume rebates, commission and cash discount from AMP. This serves as a significant relief to majority of taxpayers facing this issue.


Brief background


For the past few years, Indian Tax Authorities have been alleging that the non-routine marketing efforts of a subsidiary company should be categorized as ‘service’ rendered to their AE and accordingly, should be compensated for the same. Such adjustments have increased tremendously over the years and no jurisprudence existed to deal with this vexed issue. Thus, SB was constituted in the case of LG India that dealt with this issue. Canon India also participated as one of the interveners in addition to several other taxpayers facing similar issue. The SB in its ruling has ruled in favor of Tax Authorities in relation to the legal concept of marketing intangible by stating that excessive AMP expenditure constitutes an international transaction. Simultaneously, SB defined the scope of AMP expenditure by providing specific guidelines to benchmark AMP expenditure.


In view of the aforesaid, Delhi Divisional Bench construed the guidance provided by SB in case of LG India and ruled in favor of Canon India by adjudicating that the amount of subsidy (received from AEs), trade discount & volume rebates, commission and cash discount should be reduced from AMP expenditure while computing the bright line. Further, in context of legal issues the Tribunal has ruled in favor of Tax Authorities, thereby acknowledging the concept of marketing intangibles.


Brief facts of Canon India


· Canon India is primarily engaged in distribution of digital imaging products that include photocopiers, multifunctional peripherals, fax-machines, printers, scanners, digital cameras and multimedia projectors.


· Canon India also receives subsidy from its AE in relation to certain AMP related costs.


· Canon India had benchmarked its international transactions by using Resale Price Method as the most appropriate method with gross profit to sales as profit level indicator.


· During the Transfer Pricing assessment proceedings, the TPO made an adjustment questioning the adequacy of AMP expenditure incurred by Canon India and alleging that it resulted in creation of marketing intangibles. Accordingly, an adjustment was made by the TPO stating that Canon India should have been compensated for provision of services. TPO further added a mark-up.


· Transfer Pricing adjustment made by the TPO was upheld by the Dispute Resolution Panel.


· Aggrieved by the order of Assessing Officer, Canon India filed an appeal with the Tribunal.


Taxpayer’s contentions


Contentions of Canon India are summarized below:


· Canon India pressed upon the legal issues before the Divisional Bench of Tribunal. These issues primarily included arguments relating to the validity of TPO’s jurisdiction, qualification as transaction/ international transaction, use of bright line approach, etc.


· With respect to the composition of AMP expenditure, Canon India argued that expenses directly related to sales such as trade discount & volume rebates, commission/ cash discount and receipt of subsidy from the AE should be excluded while computing AMP expenditure to determine the bright line.


· Further, Canon India while seeking specific directions from the Tribunal argued that the thirteen criteria’s as laid down in the case of LG India by SB should be considered by the TPO while benchmarking the AMP expenditure in light of Canon India’s facts. These criterion include analysis of contractual arrangements, business model, product life cycles, choice of comparables, payment of royalty, etc.


Revenue’s contentions


· Revenue contended that the issue of Transfer Pricing adjustments made on account of AMP expenditure stands covered against Canon India by the decision of SB in the case of LG India and GSK India and the same should be followed.


· Nature of trade discount & volume rebates, commission and cash discount may be set aside and restored back to AO / TPO to verify the nature of such expenditure.


· If subsidy is reduced from the amount of AMP expenditure, Canon India may get double deduction as some part of the subsidy may have been received in respect of trade discounts and incentives provided to dealers, which has to be reduced from AMP expenditure.


Decision of the Tribunal


In view of SB decision in the case of LG India and Chandigarh Bench decision in the case of GSK India, the Delhi Divisional Bench of Tribunal adjudicated as follows:


· The Tribunal decision reaffirms the principles laid down by the majority view of the SB in the case of LG India. While reiterating the principles articulated by the SB, the Tribunal has unequivocally held that TP adjustments in relation to AMP expenditure incurred by the taxpayer for creating the marketing intangible for and on behalf of the foreign AE is permissible.


· Tribunal has allowed exclusion of trade discount & volume rebates, commission and cash discount form AMP expenditure and restricted the scope of AMP expenditure.


· Moreover, exclusion of subsidy (received from its AE) from AMP expenditure has resulted in a move that will benefit large number of subsidiaries functioning in India and receiving special subsidies from their AEs. This will significantly reduce the quantum of expenditure classified as non-routine AMP expenditure.


· Tribunal has restored the matter back to the TPO for computation/ benchmarking of AMP expenditure, after affording a reasonable opportunity.

In an important ruling in the case of Glaxo SmithKline Consumer Healthcare (“GSK India”), the Chandigarh Bench of the Income Tax Appellate Tribunal (‘Tribunal’) has laid out important principles in relation to transfer pricing adjustments on marketing intangibles following the guidelines laid down by the SB in the case of LG India.


Brief background


Indian Revenue Authorities have been alleging Advertisement, Marketing and Promotion (‘AMP') expenses incurred by the Indian subsidiaries of MNC’s to be services rendered to their associated enterprises (‘AE’). The Revenue Authorities have held that the Indian subsidiary be compensated for such services in relation to creation of marketing intangibles. The Special Bench of the Income Tax Appellate Tribunal (‘SB’) was constituted in the case of LG Electronics India Pvt. Ltd., (‘LG India’) and had delivered its decision on the vexed issue of Transfer Pricing (‘TP’) of marketing intangibles.


The SB held, on the facts of LG India’s case, that AMP expenditure incurred by the Indian subsidiary resulted in creation or improvement of marketing intangibles of the foreign brands, which constituted an ‘international transaction’ and, accordingly, the TP adjustments were permissible. The SB also held that such compensation should not only be at cost but with a mark-up. However, the SB has restored the matter to the Transfer Pricing Officer (‘TPO’). The SB, has, provided relief to the taxpayers while holding that the amount of subsidy received from its AE should be reduced for computing ALP and expenditure inextricably linked to sales, such as trade discount, dealer commission, etc. should not be considered for determining the cost/ value of international transaction. There were several interveners before the SB, including, GSK India.


Brief facts of GSK India


· GSK India was incorporated under the laws of India and was owned 40% by Horlicks Ltd, UK, which is part of GSK Group.

· GSK India, inter alia, was engaged in manufacturing and selling of nutritional products i.e. malted milk food products and drinks under the brands ‘Horlicks’, ‘Boost’, ‘Maltova’ and ‘Viva’. In addition, GSK India also provided certain administrative support services such as marketing, sales inputs, IT support, training and accounting, etc. to its group companies.

· GSK India had benchmarked its international transactions by adopting transactional net margin method (‘TNMM’) with operating profit/ total cost ratio as profit level indicator for AY 2007-08.

· The TPO made an adjustment on account of AMP expenditure incurred by GSK India. The TPO took the view that GSK India had created marketing intangibles for the benefit of its AE by incurring excessive AMP expenditure and, accordingly, should have been compensated at arm’s length by the AE. The TPO, further, added a mark-up of 13.04% to the excess AMP Expenditure incurred by GSK India.

· The TP Adjustment was confirmed by the DRP but directed the Assessing Officer to allow expenditure incurred on R&D by GSK India as the same did not form part of the AMP expenditure.

· Aggrieved GSK India filed an appeal with the Tribunal.


Taxpayer’s contentions


· There was no international transaction as per Section 92B of the Act.

· AMP Expenditure was neither incurred at the instance or direction of the AE and nor the AE is expected to benefit from such expenditure.

· In line with the ratio laid down by the SB, AMP Expenditure needs to be re-looked by the TPO after giving an opportunity to GSK India.

· AMP Expenditure incurred by GSK India also included certain expenses not in the nature of advertising and marketing expenses such as

i) service charges paid to the selling agent,

ii) sales promotion,

iii) discount on sales,

iv) market research expenses and

v) selling and distribution expenses.

· Such expenses were in the nature of selling expenses and not brand promotion and, accordingly, the same ought to be excluded from AMP Expenditure.

· Expenses incurred for the promotion of Indian brands such as Viva, Maltova and Boost, should be excluded.


Revenue’s contentions


· The issue of TP Adjustments made on account of AMP expenditure stands covered against GSK India by the decision of SB in LG India. In view of the directions of the SB, the matter has to be restored to the file of the TPO for computation/ benchmarking purposes.


Decision of the Tribunal


· Following the SB ruling, the Tribunal held that excessive AMP expenditure incurred by GSK India does constitute an international transaction.

· In view of the directions of the SB, the matter has been restored to the TPO for computation/ benchmarking the AMP expenditure, after affording a reasonable opportunity. GSK India will have the liberty to furnish fresh set of comparables for benchmarking and computing the ALP.

· The Tribunal has also directed the TPO to consider the relative spends made on foreign brands and domestic brands while determining the ALP.

· Placing reliance on the SB ruling, the expenses inextricably incurred in connection with sales and not related to brand promotion were excluded from AMP Expenditure.

· Further, the amounts attributable to the promotion of domestic brands owned by GSK India were also excluded.


In a recent order in the case of BMW India Private Limited (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.



DCIT vs. Motorola Solutions India Pvt. Ltd (ITAT Delhi)
The AO made a transfer pricing adjustment for the AMP expenditure incurred by the assessee and raised a demand of Rs. 210 crore. The assessee filed an appeal before the Tribunal and a stay application. The Tribunal granted a stay on recovery of the demand on the condition that the assessee would not seek an adjournment of the hearing. When the matter came up for hearing, the assessee pointed out that a similar issue was pending before the Special Bench (now decided as L. G. Electronics 152 TTJ 273) and so the Bench adjourned the appeal to await the judgement of the Special Bench. The AO took the view that the assessee had sought an adjournment and violated the stay order and so he attached the bank account u/s 226(3) and recovered some part of the demand. The assessee filed an application before the Tribunal and claimed that it had not sought an adjournment and that the AO had acted in defiance of the stay order and should be directed to vacate the attachment and refund the moneys recovered. The Tribunal accepted the plea that the assessee had not sought an adjournment and directed the AO to refund the sums collected (order attached). The AO filed a MA against the order and also a Writ Petition before the High Court. In the Writ Petition, the AO did not disclose the fact that the MA had been filed. The High Court granted an interim stay (now finally decided) against the Tribunal’s order directing refund. During the pendency of the Writ petition, the AO argued in the MA that the recovery of the demand was justified and that as the appeal was “in the process of final hearing”,“judicial propriety demanded that the interim order directing a refund should not have been passed”. HELD by the Tribunal dismissing the MA:
(i) “It alarms us that unfortunately with complete impunity and disregard of the factual position, the AO repeatedly makes apparently naive misplaced, mis-guiding and factually incorrect assertions that the Tribunal was in the process of final hearing of the appeal”. These assertions indicate either a gross ignorance or ineptitude of the Department or a deliberately calculated belief that even misstatement of facts before the Tribunal could be accepted as gospel truth on a mere assertions of the government officers. Both or either of these situations are equally dangerous and fraught of dangers as vast powers have been given by the Act to the AO in order to exercise its powers and discharge the functions under the Income Tax Act;
(ii) An AO cannot claim to be in constant and perpetual ignorance nor can the officers under whom she was functioning themselves feign ignorance of this actual factual position on the issue where on the grounds of judicial propriety the Department was constantly seeking adjournments in almost all stay granted appeals on the said issue over the years;
(iii) Being ignorant of relevant facts shows a pattern which needs to be considered before such laxity becomes endemic and plays havoc with “the interest of the revenue” which the AO most vociferously seeks to uphold;
(iv) The actions of the AO, which earlier appeared to be wrongful acts of misfeasance by a public official were actually serious acts of malfeasance. In our adversarial system, one or the other side will probably be lying, if only to exaggerate their position and hence perjury is likely to be far more common place then we would choose to admit. In either case and especially in the case of the Revenue, apparently when swearing falsely or referring to wrong facts, the concerned officers may be under the belief that he or she is doing so in a good cause that is “protecting the interest of revenue.” Judges and judicial authorities are not so unrealistic that they do not recognize that a substantive portion of the population displays a lack of respect for or otherwise merely pays lip service on oath to tell the truth. But unlike in the Courts having “lay litigants”, the litigants in tax matters are invariably of a class which recognize the solemnity of the occasion and understand the consequences of swearing to an affidavit or affirmation as a serious act outside the course of their everyday lives and it is hoped that the deponents understand the sanction for breach of such oath and the seriousness with which such a breach will be normally regarded by adjudicating authorities. In the present case, the acts of malfeasance by pleading apparent ignorance or acting in a subterfuge and underhand manner in apparently trying to achieve their objectives and targets of higher tax collection are required to be understood and addressed by the appropriate authorities;
(v) The CBDT is requested to ensure that proper legal knowledge and training is imparted to the officers addressing the appropriate interpretation of orders of higher forums and instead of resorting to underhand manner in achieving the targets set. Such an exercise will go a long way in addressing identical situations where the AO may be tempted to take matters in his or her own hands with complete impunity and disregard for the laws of the land




Cadbury India Ltd vs. ACIT (ITAT Mumbai)
Transfer Pricing: ALP of royalty for trademark usage and technical know-how fee can be determined as per TNMM. Approval of RBI & Govt. means payment is as at arms length
The assessee entered into an agreement with its parent company, Cadbury Schweppes, pursuant to which it agreed to pay royalty for the use of trademarks and royalty for the use of technical know-how at 1.25% each of the net sales. This was approved by the RBI and the SIA (Government). The assessee adopted the Transaction Net Margin Method (“TNMM”) for computing the ALP of the international transactions by comparing the net margin of the company at entity level with that of companies engaged in food products, beverages and tobacco business. The TPO held that the transactions pertaining to payment of royalty for trademarks and technical know-how fee had to be separately and independently bench-marked using the Comparable Uncontrolled Prices (“CUP”) method. He held that the ALP of royalty and technical know-how fee should be computed at 1% of sales the instead of at 1.25% of the sales. This was reversed by the CIT(A) who held that the royalty and technical know-how fee paid by the assessee were at ALP. On appeal by the department to the Tribunal HELD dismissing the appeal:
The assessee has been paying royalty on technical know-how to its parent AE since 1993. Other group companies across the Globe are also paying the same royalty. Also, the payment is as per the approval given by the RBI and the SIA. Hence there cannot be any scope of doubt that the royalty payment on technical know-how is at arms length. As regards the royalty on trademark usage, the assessee is in fact paying a lesser amount if the payment is compared with the payment towards trademark usage by other group companies using the brand “Cadbury” in other parts of the world. Accordingly, the royalty payment on trademark usage is also within the arms’ length and does not call for any adjustment (Lumax Industries (ITAT Del) (attached) followed). The Department’s request for a remand to the TPO to examine the AMP expenses in the light of Maruti Suzuki 328 ITR 210 (Del) (and L. G. Electronics140 ITD 41 (Del)(SB)) rejected  

Hope the above small summary on AMP   will help you in getting some relief from the hardship from the ITD. In case you have any further clarification please mail me at taxbymanish@yahoo.com.
Income earned from intangible property is one of the most challenging issues in Transfer Pricing (TP), more so in the context of India and its growing economy. More often than not, the transactions pertaining to intangible property are between Associated Enterprises (AEs) and hence the challenges to ensure that such transactions reflect arm’s length dealings.
In the recent round of TP audits in India, the tax payers have experienced aggressive approach by the Transfer Pricing Officers (TPO’s) where it is alleged that the AMP expenditure incurred by the Indian AE results in an enhancement of the value of the brand / trademark belonging to the foreign AE and therefore an appropriate compensation is required to be made to the Indian AE. Accordingly, the Indian AE ought to get an arm’s length compensation. In this context, it would be appropriate to understand the related background internationally as well as in India.
Marketing intangibles have become a hotly debated topic within the transfer pricing community in different countries. Generally, the term marketing intangibles and its value is derived from the company's levels of AMP expenses. These are created by the enterprise that invests to give market recognition or value to the brand. While the increased brand value at a local level may benefit the local entity only, it may not have the right to future perpetual intangible benefits arising from it. Hence, the tax authorities seek to identify and differentiate these spends that develop the intangible and provide enduring benefit over that of routine advertising costs. The revenue authority's contention is that the entity that has incurred significant spends to generate these non-routine intangible needs to be compensated by its affiliates in other jurisdictions, if the benefit from such intangibles is flowing to the foreign affiliates which own the intangibles.
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The US regulations have tried to draw a line to separate the provision of marketing services and the development of intangible property. An important theory propounded in IRS regulations relates to 'Developer – Assister rule' and it finds application where there is no legal ownership to intangible property and one of the controlled taxpayers is considered as the developer (who bears the largest portion of direct/indirect costs of developing the intangible) and the other participating member is regarded as the assister. Allocation may be made to reflect an arm's-length consideration for assistance provided, however it does not include expenditure of a routine nature that an unrelated party dealing at arm's length would be expected to incur.
In an early interesting decision, the US courts, in the DHL case, held that no royalty would be due to DHL US from its associated entity DHL International, standing for the proposition that for items of intangible property, the party which bore the economic burden of the investment should bear the economic rewards. Here, the trial judge espoused the 'bright-line' test which notes that, while every licensee or distributor is expected to expend 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 expenditures into the realm of non-routine that economic ownership, probably in the form of a marketing intangible, is created.
While the guidelines and court precedents fundamentally revolve around dividing AMP spends into routine and non-routine or applying the bright-line test, it is not possible to apply this uniformly because companies within the same industry have different marketing philosophies, business realities/features, product launches, product dependence or interdependence and may account for their marketing spends under different accounting heads, which would create different levels of AMP and different bright lines for each entity.
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However, to date the bright-line approach has been considered as more realistic to resolve the issue at hand though it is often used by tax authorities to their advantage. It would also be pertinent to note that recently the Committee on Fiscal Affairs of the OECD announced that Working Party No 6 is considering a new consultation project on the transfer pricing aspects of intangibles.
In the Indian context, the decision of the Delhi High Court in the case of Maruti Suzuki India Ltd vs. ACIT (2010-TII-01-HC-DEL-TP) has highlighted the complex issue pertaining to marketing intangibles. The High Court held that:
The Indian Revenue/TP authorities are implementing the ratio of the High Court decision and are scrutinizing existing as well as past cases (under Section 148 of the Indian Income-tax Act, 1961) where similar issues exist / arise. There are various approached being followed by the TPO’s in quantifying the benefit from the AMP spend. One approach relates to using the Profit Split Method alleging that the foreign AE as well as the Indian AE are both involved in enhancing the value of the IPR and hence there should be an apportionment of global profits to the Indian AE.
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The other alternate method is to treat the AMP expenses which exceed the bright-line test, to be a service by the Indian AE and adding a mark-up in the range of 10-15%. In either of the approach, the resultant adjustment in the hands of the Indian AE, more often than not, is huge. Also the recent amendment enabling the TPO to bring into scrutiny any international transactions which he deems fit is a step to empower the TPO to bring into ambit transactions like AMP spends.
Marketing intangibles are assets that may have considerable value even though they may have no book value in the enterprise’s balance sheet. However, it is important to understand that not all marketing activities result in creation of marketing intangibles. There also may be considerable risks associated with such intangibles including contract or product liability risks.
Given the emerging focus of the TP authorities on AMP spends, it is imperative for tax payers responding to tax-authority challenges and proactively:
Further, Indian transfer pricing regulations do not have specific guidance dealing with the transfer pricing of marketing intangibles. Accordingly, in line with international practice and OECD principles, guidance should be issued to recognise certain methodologies/approaches for evaluating the arm's- length character of transactions involving marketing intangibles.
(Rohan K Phatarphekar, Partner & National Head, Global Transfer Pricing Services, KPMG India. The views expressed are personal)


 

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