SKP Tax Alert
25 March 2015 | Volume 7 Issue 25
Delhi High Court ruling on 'Marketing Intangible' issues

The first chapter of the widely argued marketing intangible saga has unfolded with the decision of the Delhi HC clearing many unanswered questions on this subject. It is interesting to note that the hearings on the issue were carried out by November 2014, however the HC has delivered the final verdict after quite a long time. Prima facie, it appears that the legal question of 'whether advertisement, marketing and promotion expenses (AMP) incurred is an 'international transaction'?' has been answered by the HC in Revenue's favour affirming the Special Bench (SB) ruling in the case of LG Electronics[1] on this issue. However, the HC has given due consideration to factual aspects while determining arm's length price.  The important aspects of the HC's ruling on this complex issue have been analysed in this tax alert.


The HC has dealt with seven different taxpayers engaged in the business of import, distribution and marketing of branded products manufactured by their overseas associated enterprises (AE). All the intangible rights like the brand name, trademark, etc were owned by AE. It was held by the Revenue that AMP incurred by the taxpayers above 'Bright Line'[2] creates/enhances marketing intangible owned by foreign AE. Therefore, the taxpayer should be compensated for excessive AMP along with mark-up for rendering brand building services. The SB had decided this matter largely in favour of the Revenue and therefore, this complex issue reached the HC.
Whether the Transfer Pricing Officer (TPO) can adjudicate the transactions not reported in Form 3CEB
The taxpayers had taken an argument that transaction of AMP expenses were not specifically referred by the Assessing Officer (AO) to the TPO (after taking an approval of the Commissioner) and therefore were out of the purview of assessment. The HC has held that no specific reference in respect of unreported international transaction is required pursuant to retrospective enactment of sub-section (2B) to section 92C of the Income Tax Act, 1961 (ITA).
Whether AMP expenses incurred in India constitute 'international transaction'
The primary contention of the taxpayers was that since the AMP expense is incurred in India, it is out of the purview of definition 'international transaction'. However, HC has rejected the contention of the taxpayers. The HC has differentiated the provision of Chapter X from section 37(1) of the ITA and observed that the dispute is not about the reasonableness of the AMP expense incurred in India but the adequacy of compensation to be received by the taxpayer to perform marketing and distribution functions. However, the HC has noted that under distribution activity, incurring AMP is an inherent function and therefore under a 'bundled approach', treating AMP expenses as a separate international transaction is not warranted.
Aggregation of the marketing and distribution function

The HC has held that when the distribution and marketing functions are intertwined and reliable comparable are available, arm's length price could be computed as a package. However, if the TPO concludes that it is not possible to determine arm's length price without segregating and dividing distribution and marketing or AMP functions, he can proceed to determine ALP of two functions independently. However, the onus is on the TPO to prove the necessity for the same.
Bundling of transactions and application of Transactional Net Margin Method (TNMM)

The HC has held that clubbing of closely linked, inter-connected and continuous transactions is permissible under Indian law and also enunciated under OECD Transfer Pricing Guidelines and UN Transfer Pricing Manual. The HC has observed that it is not appropriate to determine arm's length price with the preconceived notion that each transaction must be analysed separately. The HC has noted that if the tested party is engaged in a single line of business, there is no prohibition from applying the TNMM on entity level basis.
By objecting the manner in which TPO has applied TNMM, the HC held that AMP expense cannot be segregated and benchmarked separately. Therefore, once the functional comparability test is passed by the comparable (after making adjustments), and if the profit earned by the taxpayer is commensurate with that of the average of comparable companies, it results in affirmation of the transfer price as the arm's length price. Therefore, separate benchmarking of AMP expenses under such circumstances would lead to inconsistent results.
However, where the taxpayer is involved even in manufacturing apart from marketing and distribution, an entity level benchmarking would not be justifiable.
Nexus between AMP expense and brand building

Based on the contention that excessive AMP expenses lead to brand building, the Revenue has treated it as a separate international transaction. By relying on the factual matrix of taxpayers the HC has held that brand value depends upon many factors such as quality of goods and services sold or dealt with. The HC has accepted the fact that there are multiple examples where brands have been built without incurring substantial AMP expense and also cases where in spite of incurring heavy AMP expenditure brand values have not been created. Further, the HC has observed that it would be inappropriate to apply the fourteen parameters laid down by SB in the case of LG Electronics to identify AMP expense which leads to brand building. Thus, it is incorrect to hold that incurring excessive AMP is equivalent to brand building.
Bright Line Test

The Revenue has used Bright Line Test (BLT) to determine the remuneration for excessive AMP expenses incurred by taxpayers in India by bifurcating AMP expenses as routine and non-routine expenses. The HC has rejected the contention of the Revenue to bifurcate AMP expenses into routine and non-routine and has also rejected BLT approach. The HC has noted that an application of BLT would work as adding and writing words in the statue and Rules which has not been recognised and accepted in any of the international literature. Such a broad-brush universal approach in unwarranted and would amount to judicial legislation.
Is it necessary to substantiate when the taxpayer has been compensated by a lower purchase price/royalty transaction
The SB in the case of LG Electronics had observed that there is no basis for a presumption that arm's length price of one transaction, being purchase of goods was lower and this position has to be proved dehors the overall net profit rate. Relying on the OECD Transfer Pricing Guidelines the HC has agreed that when a subsidiary engaged in distribution and marketing activities incurs AMP expenses, the compensation may be in the form of lower purchase price, no or reduction in royalty or by way of direct compensation to ensure an adequate profit margin. The HC reiterating the observations of the Delhi tribunal in the case of BMW India Pvt. Ltd.[3] has held that net profit under the TNMM may be indicative, or in a given case, sufficient proof of adequate compensation. It is a matter of fact and not law whether higher net profit rate would indicate a lower/ reduced purchase price.
Ownership: Legal vs. Economic

The HC has appreciated the concept of economic ownership of intangibles, contrary to SB's observations in the case of LG Electronics which said economic ownership exists only as commercial premise. The HC noted that economic ownership would arise due to advertisement and marketing functions performed by the taxpayer under a long-term contract. Further, it was observed that the need for a transfer pricing valuation to determine an exit charge would only arise in case a long-term distribution-cum-marketing agreement is terminated resulting in the transfer of economic ownership.  
Marketing and selling expenses

Upholding the observations of SB in case of LG Electronics, the HC held that the marketing and selling expenses like trade discounts, volume discounts, etc. offered to retailers are not in the nature of brand promotion expenses.
Use of Resale Price Method

 The HC has held that it is incorrect to assert and accept that Gross Profit Margins would not inevitably include the cost of AMP expenses. If on comparable analysis, after considering AMP expenses, gross profit margins are commensurate, no separate transfer pricing adjustment is warranted. In such cases the gross profit margin would include the margin or compensation for the AMP expenses incurred. The HC has also noted that routine or non-routine AMP expenses would not materially affect the gross profit margins when the tested party and the comparable undertake similar AMP functions.
[1] LG Electronics India Pvt. Ltd. v. ACIT [2014] 52 240 (Delhi)
[2] Average AMP expenses incurred by comparable companies
[3] BMW India Pvt. Ltd. (2013)  92 DTR (Delhi Tribunal) 257
SKP's comments
The primary argument of the taxpayer has been ruled negatively by the HC, since it has held that AMP expenditure is an 'international transaction'. To this extent, it's going to be a facts specific fight for all taxpayers from here on. However, some of the HC comments will have a wide reaching impact not only on marketing intangibles cases but also on other transfer pricing litigation. Foremost, the HC has reiterated what is globally understood that transfer pricing provisions are anti-avoidance provisions and should be invoked selectively and should not result in any double taxation. The HC has also permitted aggregation of transactions where the activities/transactions are closely related and inter-twined. It has firmly rejected application of Bright Line Test. It has also concurred with the UN Model views that there could be other means to compensate subsidiary for the advertisement and marketing function and there need not always be reimbursement of AMP expenses. While it has approved reliance on OECD and UN Guidelines, it has rejected the Revenue's reliance on US Case laws of Glaxo and DHL.
It is pertinent to note that the ruling has been given from the distributor's perspective and there is no clarity in cases where the Indian subsidiary of a multinational group is functioning as a full-fledged manufacturer. The licensed manufacturers would need to substantiate that its related party transactions especially import of raw material, payment of royalty for technology and brand are at arm's length on a standalone basis and not by applying overall TNMM. Further specific consideration is required for:
  • Functional analysis relating to AMP activities
  • Selection of comparables
  • Aggregation/bundling of transactions
  • Reporting/disclosures in Form 3CEB

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