I would like to begin by wishing all the readers a very Happy New Year and a productive 2016.The year 2015 has been a good year for the industry from the direct taxes perspective with the government actively working to simplify the provisions of the Act and clarifying matters of litigation such as applicability of MAT on Foreign Institutional Investors.
One of the significant events to have occurred at the end of the year 2015 in the tax landscape was the clarity which emerged from a wave of high court rulings on the BLT tool used for transfer pricing purposes by the Indian revenue authorities. The ‘BLT’ we will be discussing in this article is not the popular items found on breakfast menus, rather we will be discussing the Bright Line Test tool, and therefore as a reader, you need not worry whether this article will increase your appetite.
The Bright Line Test (BLT) in the recent times has been used by the revenue authorities as a tool for making additions to income of Indian companies engaged in distribution business, under the brand name of their foreign associated enterprises. The addition is done by making adjustments to the advertising, marketing and promotion (AMP) spend of these companies. In this article we will be discussing the two landmark judgements of the Delhi High Court which were pronounced in March 2015 and December 2015 respectively on the matter of using BLT for making adjustment on the AMP spend of assessees under the transfer pricing provisions.:
- Sony Ericsson Mobile Communications India P. Ltd. V. CIT 374 ITR 118 and
- Maruti Suzuki India Ltd. v. CIT 595 TS 2015
As per Garner’s Dictionary of Legal Usage, Bright Line rule means “a judicial rule of decision that is simple and straightforward and that avoids or ignores the ambiguities or difficulties of the problem at hand”. The usage of the phrase dates back from the mid – 20th century,the phrase was used by Supreme Court of the United States in “Girard Trust Co vs I.R.C., 122 F.2d 108, 110(3rd Cir.1941)” case saying “A bright line between that which brings conviction to one person and its influence on the body politic cannot be drawn”.
The concept of BLT under transfer pricing for making adjustments on marketing intangibles was first used in a celebrated US Court of Appeals decision in the case of DHL in 2002. An important principle emanating from the DHL ruling is that the AMP expenditure should first be examined to determine routine and non-routine expenditure and accordingly, if at all, compensation may be sought possibly for the non-routine expenditure.
In the Indian context, the revenue authorities have used the BLT, to make transfer pricing adjustments to AMP expenses incurred by the Indian Associated Enterprise (AE) distributors of foreign brands. The case of the revenue being, the Indian AE distributors are rendering brand building services to the owner of the foreign brand by incurring the AMP expenses in India. Therefore, as per the revenue authorities this AMP expenditure is in the nature of international transaction, and the Indian company has to be separately compensated for the AMP expenditure; in the absence of the same, the Indian AE will be liable for a Transfer Pricing adjustment by way of an addition to the income.
The Indian revenue authorities used the BLT tool to determine the quantum of the international transaction liable for adjustment, the Bright Line Test being a comparison as to the percentage of AMP spend over sales incurred by Indian AE distributor to the percentage of AMP spend over sales incurred by independent Indian companies engaged in the similar lines of business. If the Indian AE distributor, say Motorola India, has incurred AMP expenditure of 5% over sales and other independent comparable companies on average have incurred AMP expenditure of 2% over sales, the excess 3% will be considered as an international transaction liable for adjustment along with a mark – up. As a result many Indian AE distributors suffered substantial additions to their income by way of transfer pricing adjustment on the excess AMP (i.e. 3% in the example presented above) spend over the Bright Line.
Before we go ahead, I would like to invite attention to the Special Bench decision of the ITAT in 2013 in the case of LG Electronics Pvt Ltd. Vs ACIT, 22 ITR (Trib) 1. This ruling on the AMP adjustment was followed in many other tribunal decisions. In the LG case (supra) the tribunal ruled that the incurring of the AMP expenses lead to the promotion of LG brand in India, which is legally owned by the foreign AE and hence it is an international transaction. The said transaction can be characterised as an international transaction within the ambit of Sec. 92 B (1) of the Act, since:
- there is a transaction of creating and improving marketing intangibles by the assessee for and on behalf of its AE;
- AE is a non – resident; and
- such transaction is in the nature of provision of service
Also the special bench of the ITAT accepted BLT to determine the cost/ value of the international transaction, in view of the fact that the assessee failed to discharge the onus by not segregating the AMP expense incurred on its own behalf vis-à-vis that incurred on behalf of the AE.
Though the Sony Ericsson and the Maruti Suzuki decisions deal with transfer pricing adjustment on AMP expenses incurred by the assessee, they differ with regard to a key point. In the Sony Ericsson decision the appellants at the first instance admitted the existence of an international transaction with reference to the AMP expenditure, whereas in the Maruti Suzuki decision the appellant challenged the very existence of an international transaction with reference to the AMP expenditure.
Sony Ericsson Mobile Communications India P. Ltd. v. CIT 374 ITR 118
In the batch of appeals heard in the Sony Ericsson case the assessees had used either the Transaction Net Margin Method (TNMM) or the Resale Price Method (RPM) to establish Arm’s Length Price (ALP).
The revenue authorities had segregated the AMP expenditure above the Bright Line as an international transaction and computed addition being the excess AMP expenditure & a mark – up on the same without giving the benefit of a set – off, except where a consideration was specifically received by the Indian AE distributor for meeting AMP expenditure specifically from the foreign brand owner. The tribunal had decided the matter in favour of the revenue following the LG Electronics ITAT decision. To give an example, suppose the assessee has a net margin of Rs.150 on revenue of Rs.1000 and has used the TNMM where the Net Margin is after including AMP expenses of say Rs.100. The assessing officer had made an adjustment of Rs.100 plus the computed mark – up say 10%, therefore making a total addition of Rs.110.
The assessees contested this order on various grounds before the High court, such as economic ownership of the brand lies with the Indian distributor itself and therefore the AMP expenses are for the benefit of the Indian entity itself and not the foreign brand owners. The assessee also contested that TNMM subsumes the AMP expenses; therefore, if as per TNMM the assessee’s margins are at ALP then there is no need for separate benchmarking of the AMP expenses. Also in case of RPM the Arm’s Length gross margin compensates for the AMP expenses incurred.
The High Court after much deliberation observed that only AMP expenses are insufficient to build a brand & brand is a function of continued efforts to deliver quality and build trust. In the final order pronounced the following points are the highlights:
- Once the AO/TPO accepted and adopted TNMM, but chooses to treat a particular expenditure like AMP as a separate international transaction without bifurcation/segregation, it would lead to unusual and incongruous results as AMP expenses was the cost or expense and was not diverse. It was factored in the net profit of the inter-linked transaction. The TNMM proceeded on the assumption that functions, assets and risks being broadly similar and once suitable adjustments have been made, all things get taken into account and stand reconciled when computing the net profit margin. Once the comparables pass the functional analysis test and adjustments have been made, then the profit margin as declared when matches with the comparables would result in affirmation of the transfer price as the ALP. Then to make a comparison of a horizontal item without segregation would be impermissible.
- The BLT was judicial legislation. By validating the BLT the Special Bench in LG Electronics Case went beyond Chapter X of the Act. Even international tax jurisprudence and commentaries do not recognise BLT for bifurcation of routine and non-routine expenses.
- Segregation of aggregated transactions requires detailed scrutiny without which there shall be no segregation of a bundled transaction. Set off of transactions segregated as a single transaction is just and equitable and not prohibited by Section 92(3). Set-off is also recognized by international tax experts and commentaries.
- The RPM loses its accuracy and reliability where the reseller adds substantially to the value of the product or the goods are further processed or incorporated into a more sophisticated product or when the product/service is transformed. RPM may require fewer adjustments on account of product differences in comparison to the CUP Method because minor product differences are less likely to have material effect on the profit margins as they do on the price.
- However, it would be wrong to assert and accept that gross profit margins would not inevitably include AMP expenses. The gross profit margins could remunerate an AE performing marketing and selling function. This has to be tested and examined without any assumption against the assessed. A finding on the said aspect would require detailed verification and ascertainment.”
Maruti Suzuki India Ltd. v. CIT 595 TS 2015
In this case law the matter which was debated is similar to the Sony Ericsson case law discussed above i.e. adjustment on AMP expenses above the Bright Line. However, a key difference between the Sony Ericsson case law and the Maruti Suzuki case law which has been pointed out earlier in the article being, in the former whereas the client accepted existence of an international transaction with reference to the AMP expenditure and only challenged the transfer pricing adjustment, in the current case the assessee challenged the very existence of an international transaction with reference to the AMP expenditure.
The assessee Maruti Suzuki India Ltd. (MSIL) contended that BLT has been used first to infer the existence of an international transaction and thereafter quantify the amount of the transfer pricing adjustment. After the judgement in Sony Ericsson, BLT cannot be used for either of the purposes. Moreover revenue has to show the existence of an agreement or an arrangement or an understanding between the assessee (MSIL) and its AE foreign brand owner (Suzuki Motor Corporation) prior to incurring of the AMP expenditure in excess of the bona fide requirements of its business in India and thereby may add to the value of the brand of the Foreign AE (Suzuki Motor Corporation). A mere incurring of the AMP expenditure could not be considered as an international transaction.
After much deliberation on various issues put forth by the department representative and the counsel for the assessee the High court has made the following key observation:
- “As regards the submission regarding the BLT having been rejected in the decision in Sony Ericsson is concerned, the Court notes that the decision in Sony Ericsson expressly negatived the use of the BLT both as forming the base and determining if there is an international transaction and secondly for the purpose of determining the ALP. Once BLT is negatived, there is no basis on which it can be said in the present case that there is an international transaction as a result of the AMP expenses incurred by MSIL. Although the Revenue seems to contend that the BLT was used only to arrive at the quantum of the TP adjustment, the order of the TPO in the present case proceeds on the basis that an international transaction can be inferred only because the AMP expenses incurred were significantly higher than what was being spent by comparable entities and it was also used for quantifying the amount of the TP adjustment. Consequently, the Court does not agree with the submission of the learned Special counsel for the Revenue that de hors the BLT, which has been rejected in the Sony Ericsson judgment, the existence of an international transaction on account of the incurring of the AMP expenses can be established”.
The two case laws discussed in this article will certainly be land mark judicial precedents on AMP expenses and marketing intangibles from the perspective of taxation in the Indian jurisdiction. Taxation of marketing intangibles has always been a difficult area to grapple with for both the assessee and the revenue authorities. The challenge has also been recognised in the OECD Transfer Pricing Guidelines. I have tried to present the gist of the matter of the case laws in the most concise manner for the benefit of the reader, as these are voluminous case laws and we are all tied for time. But I would definitely recommend these case laws as a weekend read for those who are passionate about direct taxes as they have been eloquently drafted. I would like to conclude by wishing all the readers, Happy Reading for the year ahead.