Delhi High Court delivered a landmark decision on the transfer pricing implications of advertisement, marketing and sales promotion (AMP) expenses for licensed manufacturers in December 2015, in the case of Maruti Suzuki, holding that AMP expenditure does not constitute an “international transaction” and cannot be subject to transfer pricing adjustments.
The court observed that even in a case where an AMP expense is seen as an international transaction, there is no statutory machinery provision to enable the tax department to determine the compensation due to an Indian entity. Further, as neither the substantive nor the machinery provisions of Chapter X of the Income-tax Act, 1961, were applicable to AMP, the inevitable conclusion was that Chapter X of the act did not permit an adjustment in respect of AMP. The court fittingly observed that the value of a brand may be impacted by a number of factors and imponderables.
Relying on its decision in Sony Ericsson Mobile Communications, of March 2015, which held that India’s transfer pricing provisions do not mandate the use of the “Bright Line Test” (BLT), the court held that the BLT cannot be applied even to ascertain whether there is an international transaction, particularly as there is no machinery provision for this purpose. Considering the statutory provisions on transfer pricing, the court held that existence of an international transaction has to be proved within the contours of the statutory framework, and not by surmises and conjectures.
The court reiterated that it is essential to first ascertain whether an international transaction took place between the taxpayer and its associated enterprise (AE), and then to ascertain the price at which it took place. Next, the arm’s length price (ALP) has to be determined by applying one of the prescribed methodologies. Then, the transaction price is compared with the ALP and a transfer pricing adjustment is made by substituting the ALP for the contract price. It was held that no quantitative adjustment is contemplated in law rather substitution of transfer price with ALP.
The department’s case was that in incurring AMP, the taxpayer caused benefits to flow to its foreign AE, resulting in an international transaction requiring transfer pricing adjustment. Significantly, the court held that any incidental benefits to the AE on account of AMP expenses incurred by the taxpayer should not lead to an automatic inference of a service being rendered by the taxpayer to the AE that triggers the transfer pricing provisions. The court observed that AMP adjustment could not be made in respect of a full-risk manufacturer.
In the context of the facts before the court, it was held that the onus to demonstrate that the AMP expense incurred by the taxpayer constitutes an international transaction is on the tax department, and this must be established without applying the BLT, which was discarded in the Sony case. Taxpayers must also demonstrate through their inter-company arrangements, transfer pricing documentation and business conduct that there is no arrangement or implied understanding with the AE and that the decision pertaining to AMP has been independently taken for the benefit of the business.
In terms of the arrangement, the taxpayer was able to use the co-brand Maruti Suzuki, while the Suzuki brand was legally owned by the foreign AE. Since the foreign AE did not own the co-brand nor was it entitled to use it, the court held that the question of a benefit arising as a result of AMP spending did not arise, hence absence of an international transaction. The court further noted that the foreign AE’s AMP expenditure was 7.5% of sales, while the Indian taxpayer spent only 1.87% of sales on AMP!
Disregarding the department’s contention regarding benefit flowing to the foreign AE in the form of increased royalty payment, the court held that royalty transactions were separately subjected to transfer pricing assessment. The court reiterated its observation in Sony that on application of the transactional net margin method, if an Indian entity recorded operating margins higher than those of the comparable companies, no separate adjustment on account of AMP expenses is required. In the instant case, the court held that since the net operating profit margin of the taxpayer was higher than that of comparable companies, transfer pricing adjustment due to AMP expense did not arise.
Delhi High Court’s judgments in Sony and Maruti Suzuki usher in clarity and certainty as to what constitutes an international transaction in distributor and manufacturer scenarios respectively, and hopefully will resolve litigation in this field. A challenge to these judgments in the Supreme Court implies the last word is not yet out.
From a taxpayer’s standpoint, the court declared that the tax department should conclusively satisfy its burden of proof before making any transfer pricing adjustment. AMP issues are factual. They depend on functions performed, assets employed and risks assumed by each taxpayer, so the department cannot follow a common dictum and apply it to taxpayers across the board; each case will have to be examined on its facts.