Tax Hotline December 23, 2015

No transfer pricing on promotional expenses incurred by domestic manufacturer of international brand: High Court distinguishes Sony Ericsson


  • Transfer Pricing Adjustment cannot be made on AMP expenses incurred by domestic manufacturer of an international brand.

  • Excessive AMP expenditure cannot be a basis for discerning international transaction in the absence of specific statutory provisions.

  • Sony Ericsson case is only applicable to distributors of foreign AEs and not to manufacturers.


Recently, the Delhi High Court in the case of Maruti Suzuki India Ltd. vs. Commissioner of Income Tax1 held that excessive advertisement, sales and promotion (“AMP”) expenditure incurred by domestic manufacturer using co-branded trademark of its foreign Associated Enterprise (“AE”) does not constitute as an international transaction warranting a transfer pricing adjustment. The court distinguished the decision of Delhi High Court in Sony Ericsson Mobile Communications India P. Ltd. v. CIT2 and held that it was in respect of distributors selling products produced by foreign manufacturers and not those taxpayers who were manufacturers themselves.

The High Court held that in the absence of substantive and machinery provisions in Chapter X of the Income Tax Act, 1961 (“ITA”), excessive AMP expenditure could not be used as a basis for inferring existence of an international transaction. Relying on the Sony Ericsson case, the court rejected Bright Line Test (“BLT”) as a legitimate method for determining existence of international transaction.

Facts

Maruti Suziki India Limited (“MSIL/ Taxpayer”), a subsidiary of Suzuki Motor Corporation, Japan (“SMC”) is an Indian company which manufactures passenger cars in India. MSIL has entered into various licence agreements with SMC under which SMC grants license to MSIL to manufacture SMC’s car models, provides technical know-how and right to use SMC’s patents and technical information, and also gives right to use the co-branded trademark ‘Maruti-Suzuki’ on the car models manufactured by MSIL. In return, MSIL pays SMC a bundled royalty.

The Assessing Officer (“AO”) referred the Taxpayer’s international transactions to the Transfer Pricing Officer (“TPO”) for determination of arm’s length price (“ALP”). The international transactions referred by the AO included purchase of components, consumables and spare parts, sale of vehicles, purchase of capital item, payment of royalty etc. The TPO undertook benchmarking analysis and compared the Advertisement, Sales and Promotion (“AMP”) expenses incurred by MSIL by applying the BLT. The TPO observed that the AMP expenses incurred were 1.87% of its turnover, with the mean of 0.60% being incurred by comparable companies. Thereafter, the TPO concluded that the excess was incurred for promoting the brand ‘Suzuki’ owned by SMC and hence warranted a transfer pricing adjustment on the basis of which the AO issued a draft assessment order. The Dispute Resolution Panel (“DRP”) concurred with the AO’s disallowance. On appeal for AY 2005-06 and 2006-07, the Income Tax Appellate Tribunal (“Tribunal”) through separate orders relied on the ruling of the Special Bench in LG Electronics India Pvt. Ltd. v. ACIT3 and upheld the transfer pricing adjustment. MSIL appealed against the Tribunal’s orders before the Delhi High Court.

Issue

Whether AMP Expenses incurred by MSIL in India can be characterised as an international transaction under section 92B of the ITA?

Ruling

The High Court held that the AMP expenses incurred by MSIL did not classify as international transaction under Section 92B4 of ITA and in the absence of there being an international transaction involving AMP spend with an ascertainable price, neither the machinery nor the substantive provisions relating to avoidance of tax under the ITA can be made applicable to the transfer pricing adjustment exercise. Further, the Revenue had failed to show an ‘arrangement’ or ‘understanding’ between the two AE’s under which MSIL was obliged to incur AMP expenses for SMC. The Court made the following observations in reaching to this conclusion:

  • Sony Ericsson Judgment: In Sony Ericsson, the Delhi High Court had upheld the transfer pricing adjustment made on account of AMP expense incurred by Indian distributors of international brands. The court, however, in the present case, held that since Taxpayer was a domestic manufacturer and not a distributor of international brands, the decision in the case of Sony Ericsson would not apply and therefore no international transaction existed in the present case. Moreover, none of the taxpayers in Sony Ericsson questioned the existence of an international transaction, and neither was it disputed that the incurring of AMP expenses could be made the subject matter of a transfer pricing adjustment.

  • No ‘arrangement’ or ‘understanding’: Under the ITA ‘international transaction’ means, inter alia, a transaction which is in the nature of sale, purchase etc. or “any other transaction having a bearing on the profits, incomes or losses of such enterprises” and includes a mutual agreement or arrangement” for allocation of any costs or expenses etc. Therefore, both the ‘means’ and ‘includes’ part of the definition requires existence of an ‘agreement’ or ‘arrangement’ or ‘understanding’ between MSIL and SMC whereby MSIL is obliged to incur AMP expenses of a certain level for SMC to promote the brand of SMC. The Revenue had failed to show any such ‘arrangement’ or ‘understanding’ between the two AEs. Moreover, the fact that MSIL’s AMP spending is only 1.87% of its sale compared to SMC’s global AMP of 7.5% belies the possibility of any such ‘arrangement’ or ‘understanding’.

  • BLT not applicable: The decision in Sony Ericsson expressly rejected the use of BLT both a) as forming the base and determining if there is an international transaction; and b) for the purpose of determining the ALP. Hence, it was necessary to establish the existence of international transaction de hors the BLT.

  • No substantive or machinery provision to discern international transaction on account of AMP: The court undertook a step-wise analysis of Section 92B to 92F of the ITA, and observed that the existence of international transaction is a necessary pre-condition for commencing transfer pricing exercise. This step is followed by calculating the ALP based on one of the five prescribed methods. However, in the instant case, existence of international transaction was deduced merely on the basis of excess AMP spend of MSIL after applying BLT. Placing reliance on the judgement of Delhi High Court in CIT v. EKL Appliances Ltd5, the court held that the very existence of international transaction cannot be a matter for inference or surmise. There is no machinery provision in the ITA for determining existence of international transaction involving AMP expenses. The transfer pricing provisions in the ITA envisage a substitution of the transaction price with the ALP, and not a quantitative adjustment. The quantum of AMP expenses is a business decision and it is not open to the Revenue to dictate the appropriate AMP expenses for an entity.

  • Incidental benefit to SMC: The decision in Sony Ericsson requires that the mark should belong to the foreign AE. However, the co-brand ‘Maruti-Suzuki’ does not belong to SMC and cannot be used by SMC either in India or anywhere else. The court held that the benefits accruing to SMC from the AMP expenses are merely incidental and it cannot be presumed otherwise in the absence of specific data. In the absence of statutory guidance, ascertaining the extent of benefit arising to SMC from AMP expenses incurred by MSIL would be a complex exercise. This exercise will necessarily require studies to be conducted on a scientific basis on the behaviour of market and assessment of brand value.

  • MSIL’s higher operating margins: The decision in Sony Ericsson held that if the operating margins of the Indian enterprise are much higher than the operating margins of the comparable companies, no further separate adjustment for AMP expenditure was warranted. The operating profit margin of MSIL was 11.19% as compared to 4.04% in case of comparable entities. Hence, relying on the decision in Sony Ericsson, the court held that since MSIL had a higher operating margin than that of comparables, no further adjustment on AMP expenses was warranted.

Analysis

This is a welcome judgment which has settled the controversial decisions of LG Electronics and Sony Ericsson in favour of the taxpayers. The court has rightly held that excessive AMP expenditure does not constitute an international transaction in the absence of specific statutory provisions for the same. The provisions of the ITA deal with avoidance of tax and do not contemplate a quantitative adjustment in respect of AMP expenses unlike taxing statutes of certain countries such as USA, Australia and New Zealand which have specific provisions which permit such adjustment. The court has effectively nullified the Delhi High Court’s decision in Sony Ericsson even though it purports to distinguish the same on facts. Additionally, the court has also invalidated the judgment of Delhi High Court in MSIL v. ACIT/TPO6 on an earlier writ petition filed by MSIL, which in principle had upheld characterisation of excessive AMP expenses as international transaction. The court has held that the High Court’s decision in no more binding since, in response to a Special Leave Petition field by MSIL, the Supreme Court7 directed the TPO to proceed with the matter in accordance with law uninfluenced by the observations of the High Court.

After the decision of Special Bench of Delhi Tribunal in LG Electronics, there was a growing trend in India of deeming AMP spend by domestic AEs as international transaction between the domestic and foreign AE. The court has rightly held that mere incidental benefit to the foreign brand is not reason enough to presume an “arrangement” or an “understanding” between the two AEs. The objective of transfer pricing is to make adjustments to the price of an international transaction in order to check shifting of profits from one jurisdiction to another. Hence, an assumed price cannot form the basis for making ALP adjustment. The court has recognised that quantum of AMP expenses is a business decision and the Revenue cannot decide on the propriety of AMP expenses incurred by every entity having a foreign AE.


Ameya Mithe & Ashish Sodhani

You can direct your queries or comments to the authors


1 ITA Nos. 110/2014 and 710/2015

2 (2015) 374 ITR 118

3 (2013) 24 ITR (Trib) 634 (Delhi)

4 Meaning of International Transaction

5 (2012) 345 ITR 241

6 (2010) 328 ITR 210

7 MSIL v. ACIT (2011) 335 ITR 121

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