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Tripping On Transfer Pricing
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After eight consecutive days of rigorous appeals and cross appeals, the Delhi High Court on March 15, pronounced its path breaking judgement. It held that the money spent by Indian subsidiaries of foreign companies on advertising, marketing and promotion (AMP) of their global brands in India are international transactions and fall under the purview of transfer pricing rules. Ruling in favour of the tax authorities, the court said that expenses on AMP should be considered international transactions. It, however, discarded the bright line method for calculating tax payable by the subsidiaries adopted by the authorities in previous cases which was challenged by LG Electronics India Pvt Ltd.
'Bright line', is an international standard of spending on AMP and any expenditure over and above this limit is taxable to the global parent company. This practice had been adopted by the Indian tax authorities. The companies had opposed it saying such a methodology is inflexible. While disposing of their pleas, the court held "the bright line method has no statutory mandate and a broad-brush approach is not mandated or prescribed."
Instead, the bench laid down a number of guidelines to be adopted by the tax authority like the Transaction Net Margin Method (TNMM) or Resale Price Method (RPM) for the revenue authorities to calculate the tax payable by the Indian subsidiary for expenses incurred on AMP.
The ruling and guidelines came on the pleas of several Indian subsidiaries of MNCs including Sony Mobile Communications, Daikin Airconditioning India Pvt Ltd., Haier Appliances India Pvt Ltd, Reebok India Co. Ltd, Discovery Communications India, Canon India Co. Pvt Ltd and Casio India Co Pvt Ltd.
“Transfer Pricing provisions are anti-avoidance provisions and cannot result in double taxation. The aspect that the AMP expenses cannot be examined on a standalone basis or in a standard manner, and has to be analysed based on facts of the tax payer in line with the international norms will be of great help to the former,” says Rohan K Phatarphekar, Partner and National Head - Transfer Pricing of KPMG.
This ruling delves deep into fundamentals of Transfer Pricing and Economics which is incongruence with international concept available in Organisation of Economic Co-operation and Development (OECD) and the Australian Taxation Office (ATO) guidelines.
“The good thing is that the court accepted the concept of economic ownership of the “excess” AMP expenditure incurred by Indian entities in case it is in a long term contract with its global parent,” says Sunil Agrawal, Senior Tax Partner with law firm AZB & Partners. Like for instance, LG Electronics India, one of the official sponsors of ICC World Cup spent around Rs 100 crore in its AMP expenditure. As per the contract, LG Global will repay a portion of the total amount spent by the cricket playing nations where its subsidiary is present. This is a long term contract and a valid related party transaction which the tax authorities cannot challenge and accept it as being on“arm’s length”.
The High Court also ruled that the need for a TP valuation to determine an exit charge would arise in case a long-term distribution-cum-marketing agreement is terminated which results in transfer of economic ownership of the brands name. Cases like that of Sony India Pvt Limited, which is a wholly-owned subsidiary of Japanese electronics company, the Sony Corporation, can be taken as an example. Sony India entered into transactions with its parent company pertaining to the import and export of some goods and material. Based on these transactions, Sony computed “Arm's Length Price” (ALP) or in justifiable terms for TP purposes. But the transfer pricing officer (TPO) disagreed.
ITAT held that contractual terms of an agreement have to be recognised by the tax department along with Sony’s competitor firms, such as companies with negligible related party transactions and loss making ones. The tribunal also held that the 5 per cent relief should extend to the benefit of all taxpayers. “The revenue authorities went about carrying out artificial adjustments to deflate the operating profit of Sony and that served as a good justification to carry out a TP adjustment,” says Rajendra Nair, Tax Partner Ernst & Young that represented Sony.
Legal experts believe that the high court seems to have examined different business models for distributors (viz., normal distributor, low-risk distributor) like in the cases of Canon and Daikin India Co. who are the distributors of their Japanese based parent companies in India and that the AMP issue needs to be dealt in such arrangements, the ruling does not provide much clarity on the AMP issues in case of manufacturing arrangements.
“Yes the judgement has had a major tilt to the distributors and marketers but now the ball is in the court of ITAT to come up with a framework for the licensed manufacturers,” says Lingaraj Patnaik, V.P.(Finance) and Chief Compliance Officer at Daikin Airconditioning India Pvt. Ltd.
What Happens Now?
The HC has held that brand building is not equivalent to advertisement and sale promotion. In the context of licensed manufacturers, like a LG Electronics, Maruti Suzuki, Honda, Nestle, among others this would be relevant, as the brand value not only consists of the trademark or trade name but is also a contribution of infrastructure, know-how, ability to compete, etc. “Also, the court gave a clarity that routine or day-to-day marketing or sale promotion expenses, even when excessive and exorbitant, would not amount per se to expenses is relevant,” says Agrawal.
It laid emphasis on the relevance of intensity of the AMP function in the choice of potential competitors. “However, the HC has not provided specific guidance on how to measure the intensity of the functions while selecting competitors,” says Krishan Malhotra, Head Taxation at law firm, Amarchand & Mangaldas & Suresh A Shroff & Co.
The issue around marketing intangibles is highly factual, depending upon the FAR profile of each taxpayer, for which a common dictum could not have been laid down on merits of the issue, applying to taxpayers across the board. “The resolution on merits for licensed manufacturers is far from over, as facts pertinent to licensed manufacturers have not been dealt with by the HC,” says Malhotra. Nonetheless, taxpayers who are licensed manufacturers are advised to follow correct approach in line with fundamentals of TP, and leveraging upon relevant legal principles laid out in this ruling.
The Way Forward
India contributes more than 70 per cent of transfer pricing disputes valued at $11 billion (in number) worldwide, according to Price Waterhouse & Co LLP. Taxes paid, profit earned on a particular sales or service transaction or exporting of finished goods among others by the Indian subsidiary of multinationals to their parent company needs more approvals and comes under greater scrutiny by the tax authoriries here in India.
With the Indian government making all efforts to ease doing business in India for the foreign investors, TP issues always posed a great challenge to the government but this judgement is a relief to only one of many aspects that is a bottleneck with TP. Early this year, India and the US had finalised a framework to resolve transfer pricing cases, some of them pending for five years, in what could end tax trauma for more than 200 American MNCs such as Microsoft, IBM and Oracle by the fiscal year-end and send a strong signal to overseas investors that the Modi government is indeed committed to a non-adversarial tax regime.
“What any investor ( including an Indian investor) would look before investing in a country is its political and regulatory certainty. If we can provide certainty through guidelines and circulars, it will go a long way in boosting investor confidence. Further, tax policies should be framed keeping reciprocity in mind. In other words, what treatment we expect Indian companies to get for their overseas investment is something we can provide to foreign subsidiaries operating in India,” says Sanjay Tolia, Transfer Pricing leader at PriceWaterhouse & Co LLP who represented Colgate in a previos TP case.