Delhi High Court rules on marketing intangibles

By Ranjeet Mahtani and Darshi Shah, Economic Laws Practice
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Delhi High Court delivered a much awaited judgment on the transfer pricing implications of advertisement, marketing and sales promotion (AMP) expenses on 16 March. The judgment ushers in clarity on the issue, to resolve disputes over AMP expenditure by Indian units of multinational companies.

The judgment dealt with several appeals by Indian subsidiaries of multinationals in cases where the ruling of the Special Bench of the Income Tax Appellate Tribunal in the LG case was applied.

Ranjeet Mahtani
Ranjeet Mahtani

The court held that AMP expenses constitute an “international transaction” that falls within the ambit of transfer pricing provisions. However, the computational methodologies employed by the tax authorities were rejected. The judgment stressed that the purpose behind the arm’s length principle is to tax the actual and commercial income which could have been earned by the associated enterprise (AE) in India.

In the context of the facts before the court, it was held that since the Indian transfer pricing provisions do not mandate use of the bright line test, it cannot be applied. Its use by the tax authorities to separate non-routine from routine payments for determining AMP spending was rejected as lacking legislative prescription.

The court reiterated that it is essential to first ascertain whether an international transaction existed between the assessee and its AE, and then to ascertain the price at which that transaction has taken place. Next, the arm’s length price (ALP) has to be determined by applying one of the five prescribed methodologies, followed by comparing the transaction price with the ALP and making a transfer pricing adjustment by substituting the ALP for the contract price.

Moreover, the court held that distribution and marketing functions are interconnected and can be analysed together as a bundled transaction.

With regard to assessing the bundled transaction under either the transactional net margin method (TNMM) or resale price method (RPM), the court asserted that TNMM would be effective and reliable when applied to closely linked transactions, while RPM requires close similarity in the intensity of the functions performed by the taxpayer vis-à-vis the comparables.

Significantly, in line with international best practices and considering commercial realities, it was held that sepa-rate remuneration for AMP activities may not be required if compensation is already provided, for instance by way of lower purchase price or reduced payment of royalty. So each case will have to be examined on its own facts.

Darshi Shah
Darshi Shah

Disregarding the tax department’s interpretation that AMP was directly attributable to brand-building of the AE in India, the court went on to analyse the relevance of brand and brand-building. The court held that brand value depends on the nature and quality of goods and services sold or dealt with. Brand-building cannot be equated with advertisement and sales promotion. Day-to-day marketing or sales promotion expenses, even when excessive and exorbitant, would not amount per se to brand-building expenses. The court observed that reputed brands advertise not to increase the brand value but to increase sales and earn greater profits. Therefore, AMP expenditure cannot be directly connected to brand-building for multinational enterprises.

This decision brings some clarity and certainty on the issue of transfer pricing implications on AMP expenses, after the decision in the LG case became the beacon light, but caused much discomfort to assessees. The diversity in views in the appellate hierarchy, with the high court overturning the majority view of the tribunal on certain issues, is notable.

Importantly, the court recognized that transfer pricing is not an exact science but a method of legitimate quantification which requires exercise of judgment on the part of the tax administration and the taxpayer. It is method and formula based, and therefore rational and scientific. Moreover, the court rightly appreciated that transactions are often bunched together and can be benchmarked jointly, keeping in mind commercial realities. The judgment observes that as transfer pricing is an anti-avoidance provision, claim by the tax department of a separate reimbursement may lead to double taxation.

Crucial among the court’s findings is that the tax department cannot claim that the taxpayer-distributor has to be separately reimbursed by the AE for any excess AMP expenses, if the benefit of the distribution functions, having regard to the differences in the intensity of functions of the taxpayer-distributor vis-à-vis the comparable companies, was already built into the profit margin of the distributor through adequate pricing of the imported goods, i.e. there existed a system of adjustment for AMP.

The discussions in this judgment, on the choice of methodologies, commercial structures, and scope of brand-building and AMP, are seminal, and both assessees and the tax department will benefit from this exposition.

Ranjeet Mahtani is an associate partner and Darshi Shah is an associate manager at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.

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