The Delhi High Court has ruled that the notion of brand-building shall not be equated to advertisement and sales promotion.
The Delhi High Court has adjudicated on a host of transfer pricing adjustment cases, where the adjustment had been made by the taxman for ‘excessive’ spends on advertising, marketing and promotional expenses (AMP). The High Court’s judgment in a high-stakes transfer pricing case lends clarity on many of the questions raised about the Indian transfer pricing regime. One, does the transfer pricing office have the jurisdiction to factor in ‘excessive AMPs’? Two, is AMP an international transaction, and under what circumstances can transfer pricing adjustments be made for AMP expenses? Three, what is the process for benchmarking of AMP transactions? Four, will selling expenses, such as trade or volume discounts, be excluded for AMP expenses benchmarking?
The revenue authorities had contended that AMP expenditure is incurred for brand-building and predominantly benefits the foreign parent or associated enterprises (AEs). Hence, excessive expenses should be reimbursed with a mark-up based on the bright-line test. In the LG Electronics India case, a special bench of the Income Tax Appellate Tribunal (ITAT)—in an order dated January 23, 2013—agreed to the application of the bright-line test wherein the routine and non-routine expenses would be segregated and the non-routine ones shall be regarded as a separate international transaction and benchmarked.
The issue is complex in terms of quantifying how much benefit has accrued to the foreign parent. If it is adjudged that benefits have flowed to the parent, the question arises: Has the Indian subsidiary been adequately compensated? Such compensation could be in the form of lower purchase price, zero or reduced payment of royalty, or by way of direct payments so as to ensure that adequate profit margin is maintained. If not compensated as above, how is the mark-up on the AMP expenses to be calculated? How much should be attributed to the local spend versus brand-building? International jurisprudence has accepted AMP as a separate transfer pricing transaction to be benchmarked applying the bright-line test. AMP expenses normally comprise advertising and marketing costs. How can both be separated? Further, it needs to be examined whether, due to AMP expenses, the taxpayer received a share of excess profits related to marketing intangibles in the form of enhanced profitability or not?
The High Court stated that AMP shall be covered from June 1, 2002, as international transaction, irrespective of whether it is out of retrospective amendment or not. Now, that being the law in force, it should be followed. It was observed that chapter X of the Income-Tax Act did not artificially expand or broad-base the concept of real income. The arm’s length price (ALP) shall correct the distortion of true and correct profit which should have been accrued to the taxpayer and brought to tax.
The use of aggregation method is strongly suggested when the transactions are closely linked or are continuous transactions. The High Court clearly stated that bundling of marketing and distribution functions is the right approach and, upon testing for ALP by the Transactional Net Margin Method or the Resale Price Method, if the transaction is at ALP, then there is no need to bifurcate and look at AMP alone as a separate transaction.
The High Court disagreed with the use of the bright-line test which was used in the DHL Corp vs Commissioner case in a US court, Canada vs Glaxo Smithkline Inc in the Canada SC and the OECD/UN Manual suggesting non-routine AMP as a separate transaction. The High Court stated that if the same does not figure in the Act and rules in India, then it cannot be applied.
The High Court differentiated the concept of brand-building from that of the AMP spend. It stated that brand-building does not necessarily result out of the AMP spend. There are many reputed brands which do not go in for advertisement with the intention to build brand value, but to increase sales and earn more profits.
The High Court directed the revenue authorities to address the issue of economic ownership versus legal ownership in line with the business models and distribution function performed. When a distributor uses the brand over a period of time and sells the goods, he is deemed to be an economic owner of the brand. This is more relevant for licensed manufacturers. It needs to be examined if the intangible is exploited in the market to benefit the foreign parent. It is necessary to examine whether the distributor is involved in development of markets, like that of an entrepreneur distributor or is just a pure distributor. If it is a routine marketing or sales promotion expense which does not result in a brand-building expenditure, then the question of compensation in addition to the profits earned is not warranted. Even though the parties can use the profit-split method for such non-routine contribution of intangible property, it has not been used by any of the disputing parties. It is directed to have adequate compensation to the Indian company if there is an excessive AMP. If the compensatory model is already built-in, there is no need for further transfer pricing adjustment separately. The characterisation of the distribution function is key to use the most appropriate method—whether it is long-term distribution or distribution cum marketing agreements and short-term contractual arrangements.
The High Court has appreciated the fact that marketing intangibles is an in-depth fact-finding exercise, using the FAR profile of each taxpayer and its foreign enterprise. It cannot be held universally that there is excessive AMP spend that needs transfer pricing adjustment. Also, the notion of brand-building shall not be equated to advertisement and sales promotion. It is more relevant for a licensed manufacturer who exploits the trademark, know-how, infrastructure, etc. This being one of the landmark judgments, it will remain in force for long, for transfer pricing analysis of distribution function from AMP expenses perspective.
The author is head of taxation, General Motors India