“MARKETING INTANGIBLES: AN ANALYSIS UNDER THE TRANSFER PRICING REGIME IN INDIA.”
By:
Adith Narayan .V & Manasa Ananthan *^ 4th Year Students of Law from School of Law, SASTRA University, Thanjavur.
INTRODUCTION:
The Transfer Pricing (“TP”) legislation in India was introduced by the Finance Act, 2001 based on the report submitted by an ‘Expert Group on Transfer Pricing’, set up by the Central Board of Direct Taxes (CBDT) in order to protect the Indian tax base and to prevent the shifting of profits from India to other jurisdictions by multinational companies by way of misrepresentation of transaction prices. The underlying principle of the TP regulations is that the transaction(s) between two associated enterprises must be at arm’s length, i.e., in conformity to the uncontrolled transaction(s) between independent unrelated parties[1]. In the recent times ‘Marketing intangibles’ and the determination of its Arm’s Length Price (“ALP”) is the most significant controversy revolving under the transfer pricing regime in India.
The controversy is simply the determination of non-routine or excessive expenditure in relation to the Advertisement, Marketing and Promotional activities, specifically undertaken by the Indian taxpayers who use their foreign Associated Enterprise’s brand/logo, which results in promotion of its foreign Associated Enterprise’s brand. It is the contention of the Revenue that the excess of Advertisement, Marketing and Promotional expenditure incurred by the domestic entity is attributable to the promotion of the brand of its foreign Associated Enterprise and the same has to be reimbursed by the foreign Associated Enterprise.
HISTORY OF MARKETING INTANGIBLES:
The concept of marketing intangibles conceived from the landmark ruling of the US Tax court in case of DHL Corporation & Subsidiaries v. Commissioner[2]. The US tax court in this case adopted the “Bright Line Test” which notes that “while every licensee or distributor is expected to spend a certain amount of cost to exploit the items of intangible property to which it is provided, it is when the investment crosses the bright line of routine expenditure into the realm of non-routine that economic ownership, probably in the form of marketing intangible is created”.
INDIAN SCENARIO
I. MARUTI SUZUKI INDIA LTD V. ACIT
The concept of Bright Line Test was adopted in India for the first time in the case of Maruti Suzuki India Ltd v. ACIT[3], giving rise to the issue of marketing intangibles. In the instant case, the Assessee, Maruti Suzuki India Ltd. (“MSI”) being an Indian entity entered into a license agreement with Suzuki Motor Corporation (“SMC”) for the manufacture and sale of automobiles. As per the agreement, SMC was to provide technical assistance to MSI, and as a consideration MSI was to pay a lump sum amount as well as royalty to SMC.
MSI manufactured vehicles under the brand name ‘Maruti’ along with the name ‘Suzuki’ and used the logo of SMC on the manufactured vehicles. MSI incurred significant advertising and marketing expenses for promoting its products. It was the contention of the revenue that the benefit of excess Advertisement, Marketing and Promotional accrues to the foreign Associated Enterprise and thus issued a notice to the Assessee to show cause as to why adjustments to Arm’s Length Price should not be made. The Assessee in reply to this notice contended that the assumption of jurisdiction by the transfer pricing officer was not justified. As the Assessee did not receive any response to the said reply, it filed a writ petition before the Hon’ble High Court of Delhi to stay the proceedings before the Revenue department.
The Hon’ble High Court of Delhi framed the following guidelines:
1. The expenditure incurred on Advertisement, Marketing and Promotional by a domestic entity which is an Associated Enterprise of a foreign entity within the meaning of section 92-A, using a foreign trademark/logo amounts to an international transaction.
2. Where expenses incurred by domestic company are more than what a similarly situated and comparable independent domestic entity would have incurred (ALP), foreign entity needs to suitably compensate domestic entity in respect of advantage obtained by it in form of brand building and increased awareness of its brand in domestic market.
3. Bright Line Test was recognized as a method to demarcate between routine and non-routine expenditure of the said Advertisement, Marketing and Promotional expenditure.
Aggrieved by the order, an appeal was filed before the Apex Court, where the Hon’ble Supreme Court remanded the matter back to the Transfer Pricing Officer and directed him to decide the issue without taking into consideration the ruling of the High Court. It is not, therefore, clear what the precedential value of the judgment would be[4].
Subsequent to the MSI ruling, various decisions have discussed the concept of Advertisement, Marketing and Promotional expenditure and the liability of the foreign AE to reimburse the expenses incurred by the Indian entity. However, there has not been a concrete decision prior to Finance Act, 2012 as the Transfer Pricing Regulations prevailing then did not- (i) authorize the Transfer Pricing Officer to take suo moto cognizance of transactions not referred to him by the Assessing Officer and (ii) cover ‘marketing intangibles’ within the meaning of international transaction. As a result, the Assessees contended that the assumption of jurisdiction was bad in law and the Tribunals also ruled in favour of the Assessees holding that since the specific international transaction pertaining to Advertising, Marketing and Promotional spends has not been referred to Transfer Pricing Officer by the Assessing Officer, the assumption of the jurisdiction by Transfer Pricing Officer in working out the arm’s length price of the advertising and promotional activities in the transaction, was not justified[5].
The position however changed after the amendments brought out by the Finance Act, 2012. These amendments, by virtue of Sections 92CA(2A) and 92CA(2B) enlarged Transfer Pricing Officer’s jurisdiction by empowering him to take suo moto cognizance of transactions not referred to him by the Assessing Officer[6]. Further, the meaning of international transaction defined under section 92B was also expanded so as to include marketing intangibles within its scope[7].
II. LG ELECTRONICS (P.) LTD. V. ACIT
Post amendment, similar issues arose in a number of cases, most significantly in LG Electronics (P.) Ltd. v. ACIT[8]. L.G. Electronics India Pvt Ltd ( “LGI”), a subsidiary of L.G. Electronics Inc Korea (‘AE’) is engaged in the manufacture and sale of consumer electronic products in India under the brand name “LG”. LGI, in the relevant previous year incurred Advertisement, Marketing and Promotional expenses amounting to 3.5% of its sales. It was the contention of the Transfer Pricing Officer, that upon applying the Bright Line Test to determine the arm’s length price of the said transaction, it was ascertained that the ratio of LGI’s Advertisement, marketing and promotional expenses to its sales was higher than the expenses incurred by comparable companies in uncontrolled transaction. The comparable companies were Videocon Appliances Ltd and Whirlpool of India Ltd, whose average Advertisement, Marketing and Promotional expenses amounted to 1.39% of their sales. The Transfer Pricing Officer held that the excess Advertisement, Marketing and Promotional expenditure incurred by LGI was toward creation of brand “LG” in India which is legally owned by AE and that the foreign AE should have compensated the taxpayer for the excess Advertisement, Marketing and Promotional expenditure incurred. The Dispute Resolution Panel upheld the order of the Transfer Pricing Officer and effected additional adjustments to be charged for opportunity cost and entrepreneurial efforts.
Aggrieved by the order of the panel, LGI preferred an appeal. A Special Bench of the Income Tax Appellate Tribunal was constituted to decide the issues relating to Transfer Pricing adjustments of Advertisement, marketing and promotional expenses. After hearing 23 intervening taxpayers and the Revenue Authority, the Special Bench concluded that:
1. The benefit of the Advertisement, marketing and promotional expenses adds a value to the intangible asset of the Associated Enterprise, thereby having a bearing on the Associated enterprise’s intangible assets making the said transaction come under the purview of S. 92B (international transaction).
2. Bright Line Test was not only recognized as a method to demarcate between routine and non-routine expenditure but also held that it was derivative of cost-plus method. Further, it held that even when there was no express reference to any method employed for determining the Arm’s length price of international transaction; it would not be detrimental to the computation of the Arm’s length price, if in substance, one of the prescribed methods was followed.
Apart from the subject of Advertisement, Marketing and Promotional expenditure, the issue pertaining to the legal and economic ownership of the brand was also discussed. The Tribunal held that the benefit of the enhanced brand promotion of the foreign entity’s logo resulting from excessive Advertisement, Marketing and Promotional activity undertaken by the Indian entity will legally accrue only to the foreign Associated Enterprise, as such benefit would enhance market value of its brand/logo though the Indian entity would commercially benefit from the enhanced sales by the usage of foreign logo.
At this juncture, it is pertinent to state precisely what expenses create marketing intangibles. It is not the case that entire Advertisement, Marketing and Promotional activity undertaken by the Indian subsidiary directly benefits the foreign Associated Enterprise. A distinction is drawn between expenses that are incurred purely for marketing of the Indian entity’s products and those Advertisement, Marketing and Promotional expenses that would result in promotion the foreign Associated Enterprise’s brand. Such a classification, though objected by the Revenue Authority, was accepted by the Chandigarh Bench of the Tribunal in the case of Glaxo Smithkline Consumer Healthcare Limited v. ACIT[9].
In the said case, the following expenses were held to fall outside the scope of Advertisement, Marketing and Promotional expenses resulting in promotion of any brand, though they were advertisements expenses: discounts offered to selling agents; market research expenses; sales promotion expenses; and product related scientific research. The Tribunal observed that these expenses which are incurred ‘wholly and exclusively’ for the purpose of business is allowable as revenue/routine expenditure. A similar view has been taken by the Delhi Bench of the Tribunal in the case of Canon India Private Limited vs DCIT[10]. As a result, it is now well established that these expenses cannot be added while determining the Arm’s length price.
ANALYSIS
The Hon’ble High Court of Delhi and the Special Bench have relied upon the case of DHL Corpn. V. Commissioner T.C. Memo[11] which was decided by the US Court of Appeals for the Ninth circuit. On analysis of this judgment, it is pertinent to note that there existed a specific provision for ‘valuation of trademarks’ under the transfer pricing regulations of the US.[12] Further, the determination as to which member of a group of related entities is a developer and which members of the group are rendering assistance to the developer in connection with its development activities has also been provided in the US Transfer Pricing Regulations. This rule in short is known as the Developer Assistor Rule. The US court upheld the application of Bright Line Test as a method to determine the arm’s length price to demarcate the routine and non-routine expenditure between the associated entities was in context of a specific law, viz. Developer-Assister Rule, in US Transfer Pricing Regulations[13]. Thus, in absence of specific provisions relating to application of the Bright Line test in India, it is incongruous to apply such inexistent transfer pricing provisions to such marketing intangibles.
It is significant to note that the settled law is that ‘there can be no brand without product’[14], which shows that all Advertisement, Marketing and Promotional expenses even though exhibiting the foreign logo were liable to be attributed only to the advertisements of its products. Advertisements are largely undertaken to create “product recall”, “popularize products in the market”, “counter competition”, etc. Thus it should be understood that that advertisements are ‘product centric’ and not ‘brand centric’. ‘Brand’ is built only by the ‘product-satisfaction’ and is influenced by the features of the product. The life of an advertisement is not very long since the memory of purchasing market is short[15]. As a result, Advertisement, Marketing and Promotional expenses are considered to be revenue expenditure[16] and the same does not create any intangible asset of enduring nature[17]. Thus, the Advertisement, Marketing and Promotional expenses being revenue in nature, coupled with the fact that they do not create any intangible asset of enduring nature shows that the foreign Associated Enterprise could not have been directly benefitted by the Advertisement, Marketing and Promotional expenses incurred by the Indian Subsidiary. The benefit thereof had to necessarily accrue to the assessee as the main purpose of the advertisement was to augment the sale of its products[18].
Further, the Advertisement, Marketing and Promotional expenditure incurred by the assessee is for sole business purposes, and the Income Tax Department is not entitled to either presume that it has been undertaken for a different purpose[19] or to re-characterize this transaction. For this purpose, it is relevant to refer the case of CIT V. E.K.L Appliances Ltd[20] where it was held that “the Revenue was not entitled to re-characterize this transaction by splitting it into two parts- First towards advertisement expenses for the Assessee’s business and Secondly, towards the brand building for its foreign enterprise”. It is the Assessee who has to ascertain as to what level of Advertisement, Marketing and Promotional expenditure is required in its commercial exigencies[21] and the business decision of the assessee can neither be challenged by the Tax authorities[22] nor can it decide as to how much is reasonable expenditure[23]. Making such kind of a distinction, that part of the advertisement is for the product and part of the advertisement is for the corporate brand is not appropriate[24].
It is entrenched that in case of group companies, there is an incidental benefit of the Advertisement, marketing and promotional activity always derived by the group companies. However, it is a well settled principle that even as per OECD guidelines, that no compensation is required to be paid in cases where the Associated Enterprises derive some incidental benefit. This position was affirmed in the case of Sassoon J. Davit & Co. Pvt. Ltd. Vs. CIT [25]. The service would not be treated as an intra-group service when an Associated Enterprise receives some incidental benefits being a part of a group and not because of any specific activity being performed. Further, as laid down in Sassoon J. Davit & Co. Pvt. Ltd. Vs. CIT (Supra), the fact that somebody other than the assessee is also benefitted by the expenditure should not come in the way of an expenditure being allowed by way of deduction u/s 10(2)(xv) of the Act. A similar proposition finds authority in CIT V. Khambhatta Family Trust[26], where it was held that merely because some other persons are incidentally benefited from expenses incurred by Assessee; it would not change character of expenses from being wholly and exclusively for purpose of business.
CONCLUSION
To recapitulate: first: the bright line test adopted by the US Tax Courts cannot be imported wholesale into the Indian context, particularly since there appear to be some differences in the valuation of the intangibles, adopted in the Transfer Pricing Regulations in the US, and the regulations in force in India; second: the benefit of the domestic entity’s expenditure on product promotion would not necessarily result in the promotion of the brand itself, as advertisements are generally understood to be product centric and not brand centric; third, the benefit of the excess Advertisement, Marketing and Promotional expenditure would only have an incidental benefit on the value of the foreign Associated Enterprise’s intangibles; the settled position of law is that the character of the expenses incurred would not alter, merely because the some other persons are incidentally benefited from such expenses.
The concept of marketing intangibles is still evolving and is still in a nascent stage. Various guidelines provided for by OECD and the Indian Transfer Pricing Regulations do not cover the concept in its entirety. A perusal of the rulings given by various Tribunals shows the ambiguity in the interpretation of various rules that regulate the concept of marketing intangibles. The arrangements between foreign Associated Enterprise and the Indian entity for usage of the foreign partner’s logo is going to continue in the future and is likely to see considerable litigation in the coming years. The necessity of having concrete guidelines for deciding such contentious cases is, thus, imperative.
* Students of IV year B.com., LL.B. (Hons.), School of Law, SASTRA University.
^ We sincerely thank Advocate Bharath Palle, Madras High Court, for his valuable contributions and suggestions to this article.
[1] Section 92F(ii) of the Income Tax Act, 1961
[2] 76 T.C.M (CCH) 1122 (1998)
[3] (328 ITR 210) – Delhi High Court
[5] Veer Gems V. ACIT (2013) 351 ITR 35
[6] Vodafone India Services (P) Ltd. V. Union of India [2013] 262 CTR 133
[7] Explanation (ii) (a) to Section 92B was inserted by Finance Act, 2012, w.r.e.f. 1-4-2002
[8][2013] 22 ITR(T) 1 (Delhi - Trib.)
[9] 2012 51 SOT 52(Chandigarh Tribunal)
[10] 2013(24)ITR(Trib)694
[12] The 1968 Treasury Regulations7 for § 482
[14] Asian Paints Ltd. V. ACIT [2014] 41 Taxmann.com 71 (Mumbai - Trib.) -The brand name of the company is embedded in the product and the brand value of the product is also the brand value of the company, who owns the product.
[15] CIT Vs. Berger Paints [India] Ltd 254 ITR 503 (206)
[16] Bank of Cochin V. CIT 50 ITR 211
[17] Fine Jewellery (India) Ltd. V. ACIT. [2012] 19 ITR(T) 746 (Mumbai - Trib.) ; CIT v. Brilliant Tutorials (P.) Ltd. [2007] 292 ITR 399 (Mad.);
[18] Adidas India Marketing (P.) Ltd. V. AO[2011] 46 SOT 17 (Delhi)(URO)
[19] Ravi Marketing (P.) Ltd V. CIT. [2005] 198 CTR 354 (Calcutta)
[21] Sassoon J. Davit & Co. Pvt. Ltd. Vs. CIT 118 ITR 261 [SC]
[22] Hive Communication Private Ltd. Vs. CIT (ITA No. 306/2011, Delhi High Court);
[23] CIT v. Dalmia Cement (P.) Ltd. [2002] 254 ITR 377
[26] [2013] 215 Taxman 602 (Gujarat).