In a significant ruling that will bring clarity and make doing business in India easier, the Delhi High Court has held that advertising, marketing and promotion transactions are “international transactions” and hence subject to transfer pricing.
But it has favoured multinational consumer goods companies Sony India and Canon India, among others, and has rejected the computational methodologies adopted by the revenue authorities while calculating tax on such spends.
While holding that the “bright line method” adopted by tax authorities to determine allowable expenses on AMP spends had no statutory mandate, it laid down important principles for benchmarking such transactions.
Clarifying the ambiguities on how the tax officials should proceed on the issue, the HC said the first step in transfer pricing is to ascertain and conduct detailed functional analysis of a distributor and marketing associated enterprise (AE), including its AMP function/expenses. Besides, it mandated ascertainment of comparables or comparable analysis. “A comparable is acceptable, if based upon comparison of conditions a controlled transaction is similar with the conditions in the transactions between independent enterprises … identification of the potential comparables is the key to the transfer pricing analysis. As a sequitur, it follows that the choice of the most appropriate method would be dependent upon availability of potential comparable keeping in mind the comparability analysis including befitting adjustments which may be required…” the HC said.
While writing the judgment, the judges agreed with the United Nations’ Manual Transfer Pricing which says that determination of arm’s length price in cases of marketing intangibles would involve functional assets analysis of the profile of both the entities. This mandates identification of the nature, types and stages of development of marketing intangibles, i.e. whether foreign parties are new entrants into the Indian market and, so, related party in India would incur substantial expenses?
According to the judgment, the domestic AEs must be compensated by the foreign AE for services—pure distribution or promotional services or services as a marketer—resulting in return attributable to marketing intangibles. Even the OECD Transfer Pricing Guidelines stipulate that the AE might obtain an additional return from the owner of the trademark, perhaps through a lower purchase price of the product or reduction in royalty rate.
Where the assessing officer/TPO accepts the comparables adopted by the assessed, with or without making adjustments, as a bundled transaction, it would be improper to treat AMP expenses as a separate international transaction, the HC said, adding the “distribution and marketing are interconnected and intertwined functions. Bunching of interconnected and continuous transactions is permissible, provided the transactions can be evaluated and adequately compared on aggregate basis. This would depend on the method adopted and comparability analysis and the most reliable means of determining arm’s length price.”
Welcoming the ruling, tax experts feel that the HC had taken into account the business realities that many transactions are bunched together and benchmarking them also needed to be done jointly. The clarifications will go a long way in settling a large number of such cases and would provide clarity to taxpayers as well as tax authorities.
“I appreciate the clarification on the complex issue which though has a good purpose to serve was being implemented arbitrarily. It will help both tax authorities and the assesses and will pave way for better transfer pricing regime,” said senior tax lawyer MS Syali.
According to Tarun Gulati, partner, PDS Legal, the HC has categorically held that AMP transactions are international transactions. “However, for purpose of benchmarking, they can be bundled and need not be segregated into routine and non-routine as suggested by the Income Tax Appellate Tribunal special bench order in the LG Electronics India case. The crucial determination required to be taken by the TPO is whether the Indian subsidiary is a pure distributor or a distributor with marketing functions. In the latter case, some form of benefit must accrue to Indian entity on account of higher sales for the foreign parent,” he said.
However, some tax lawyers feel that the HC has left certain loopholes by not considering scenarios where the foreign parent has a PE in India.
“In such cases, allocation of functions has to be undertaken between the Indian PE and Indian subsidiary,” added Gulati.
To avoid any further issues, experts feel foreign MNEs must carefully plan their supply chains in India, with each entity’s role, functions and risks clearly spelt out. Disputes of such complex nature highlight the importance of “safe harbour rules” and need certainty to curtail litigation.
As of now, the issue has been remanded to ITAT. But it is yet to be seen whether both the parties will go back to the tribunal or will file cross-appeals before the Supreme Court.