Volume 5, Issue 7

8th May, 2012

Tax Alert
Delhi High Court ruling for Royalty Payments in the case of EKL Appliances Ltd.

This tax alert summarizes a recent significant ruling pronounced by the Delhi High Court (HC) in the case of EKL Appliances Ltd.1 (EKL), wherein the HC has held that the profitability of the company can not be the determining factor for judging the arm’s length nature in respect of royalty payments.

Facts of the case:

EKL an Indian company is a subsidiary of AB Electrolux, Sweden. EKL is engaged in the business of manufacturing of refrigerators, washing machines, compressor etc. During the relevant assessment years, EKL had entered into various international transactions including the payment of royalty. Except for the brand fee/ royalty paid by EKL to its overseas associated enterprises (AE), the Transfer Pricing Officer (TPO) accepted all the other transactions to be at arm’s length. The TPO noted that EKL had been consistently incurring huge losses and consequently, the benefits received by EKL from the payment of brand fee / royalty were questioned by the TPO.

Contentions of EKL:

In support of the arm’s length nature of the royalty transaction, EKL argued as under:

  • Due to availability of the brand name, EKL was able to achieve substantial increase in its turnover. Thus, without the brand name, EKL would have incurred even more losses, as it was incurring high fixed expenses.
  • The AE had received similar brand fee from third party, and this transaction was comparable with the EKL’s transaction with the AE and thus the said transaction can be considered to be at arm’s length.
  • The brand fee payment is a legitimate expenditure. If EKL would not have incurred the said expenses, its operations would have been seriously affected.

Contentions of the TPO:

The TPO contended that:

  • The comparison of the royalty charged by AE to third party and to EKL did not prove the arm’s length nature of the price paid by EKL for the use of the brand name and the technical know how.
  • EKL failed to demonstrate the actual benefit derived by it by using the brand name.
  • The increase in the turnover has not resulted in any profit to EKL.
  • The increase in the turnover has not resulted in any profit to EKL.
  • The continuous losses showed that EKL did not benefit in any way from the brand fee payment.

Accordingly, the TPO held that the Arm’s Length Price (ALP) in respect of royalty payment should be considered to be Nil and accordingly, he proceeded to disallow the royalty expenditure.

Appeal before the CIT(A):

Aggrieved by the TPO’s order, EKL filed an appeal before the first appellate authority - CIT(A). Based on the submission made by EKL, the CIT(A) observed that:

  • Due to high competition, EKL was forced to upgrade its technology. Subsequent to the upgradation of technology and acquisition of the relevant technical know how, by payment of royalty, EKL was able to reduce the losses to a significant extent. Hence it can be inferred that EKL benefited from the payment of royalty to AE.
  • The figures furnished by EKL showed that though it was deriving gross profit from the operations, it was suffering losses due to significant increase in expenses and other factors.
  • The TPO has disregarded the business and commercial realities and strategies and has acted in a mechanical manner ignoring the economic circumstances surrounding the transaction.
  • The TPO can not dictate the terms of business to EKL. It is entirely upto EKL, to take all the necessary steps and incur all the necessary expenses to meet the competition prevalent in the market and to stave off the competitors.

Accordingly, based on the above observations, the CIT(A) deleted the adjustment made by the TPO.

Appeal before the ITAT:

Aggrieved by the relief granted by the CIT(A) to EKL, the tax department filed an appeal before the Income-tax Appellate Tribunal (ITAT). The ITAT echoed the observations made by the CIT(A) and upheld the deletion of the addition.

Appeal before the HC:

Aggrieved by the order passed by the ITAT, the tax department filed an appeal before the HC. After hearing the concerned parties, the HC observed the following:

  • The OECD Guidelines on the Transfer Pricing Regulations recognise that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions in place of the actual transaction and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the associated enterprises.
  • Principles laid down in various caselaws enumerate that, for an expense to be considered to be genuine business expense, it is only necessary for the assessee to demonstrate that the said expenses have been incurred “wholly and exclusively” for the purpose of business and nothing more.
  • The TPO has to determine the quantum of the international transactions with regards to the arm’s length principle as per the provisions of the law and the financial health of the assessee can never be a criterion to judge allowability of an expense.
  • EKL has furnished detailed justification supported by facts and figures to demonstrate that the increase in the employees cost, finance charges, administrative expenses, depreciation cost and capacity increase have contributed to the continuous losses. There is no material brought by the tax department during the course of the appellate proceedings to show that the facts and figures presented by EKL were incorrect or that the reasons for the losses are not genuine.

Accordingly, the HC upheld the royalty payment and the deletion of the adjustment made by the TPO.

Our comments:

The important principle that gets reiterated in this caselaw is the fact that the TPO can not overlook the business necessities of the taxpayer. Further, on the part of the taxpayer, it is important to demonstrate that it has received benefits in lieu of royalty payments. It is also important to demonstrate that losses (if any) are due to business / commercial reasons and not because of royalty payments. This demonstration with appropriate documentation holds the key of justifying the ALP in respect of royalty payments.

1 CIT v. EKL Appliances Ltd. (ITA Nos. 1068/2011 & ITA Nos. 1070/2011) – Taxsutra.com