In this blog post, Smita Singh, a practising Advocate and a student pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, describes the calculation of transfer pricing in india for advertising, marketing and promotional expenses.
Transfer Pricing in India
“Transfer Pricing” (TP) refers to prices of transactions between Associated Enterprises which takes place under conditions differing from those taking place between independent enterprises. It refers to the value attached to transfers of goods, services and technology between related entities or between unrelated parties which are controlled by a common entity. TP is adopted by an entity to sell goods and services to related entities at an inflated price so as to reduce profits and consequently to reduce tax liability.
Chapter X of Income Tax Act 1961 (IT Act) comprising Sections 92, 92A to 92F, incorporates anti-tax avoidance measure dealing with such tendencies of Associated Enterprises (AE) in an international transaction or a specified domestic transaction.
Arm’s Length Price
Law requires any income from international transaction to be computed as per Arm’s Length Price (ALP) which can be determined by any of the five methods mentioned therein viz.:
(a) Comparable Uncontrolled Price (CUP) Method: The CUP method compares price charged for the property or service in a controlled transaction with the price charged for comparable property or service in an uncontrolled transaction in comparable circumstances.
(b) Resale price (RP) method: In RP Method, the price paid for the product by an independent third party, i.e the resale price received by an AE is taken as the basis. The AMP is computed by a reverse exercise by determining the normal gross profit margin, i.e gross profit margin, of an unrelated enterprise. Expenses incurred are thereafter, reduced and adjustments for differences in comparables is made to arrive at the AMP.
(c) Cost plus (CP) method: CP Method requires determination of the appropriate gross profit margin which would be charged by a comparable and adding the same mark up to the expenditure/cost incurred by the AE to determine the appropriate profit in view of market conditions and functions performed.
(d) Profit split method: Profit Split Method takes the combined profit earned by two related parties from one or series of transactions and then divides those profits using economically valid defined basis and aims on replicating the division of profits which would have been anticipated in an agreement made at arm’s length. It requires working back from the profit to the price.
(e) Transactional Net Margin (TNM) method: TNM Method compares the net profit margin of a taxpayer arising from a non-arm’s length transaction with the net profit margins realized by arm’s length parties from similar transactions; and examines the net profit margin relative to an appropriate base such as costs, sales or assets.
The Central Board of Direct Taxes is empowered to prescribe the sixth method.
ALP for Advertisement, Marketing and Sale Promotion expenditure
Advertising, Marketing and Sale Promotion expenditure (AMP), benefits both the Domestic AE/ assessee and the foreign AE. The Domestic AE benefits from the increased sales which results in higher profits and more taxable income in India. ALP for AMP needs to be ascertained by finding whether the Domestic subsidiary is adequately compensated by the foreign AE for undertaking AMP functions that benefit the foreign AE. Such compensation may take the form of a) lower purchase price, b) non or reduced payment of royalty or c) direct payments to ensure adequate profit margin. If the payment is not commensurate with the benefit received by foreign AE, ALP will have to be determined.
An ‘international transaction’ means- (a) a transaction between two or more AEs, either or both of whom are non-resident; (b) the transaction is in the nature of purchase, sale or lease of tangible or intangible property or provision of service or lending or borrowing money or any other transaction having a bearing on the profits, incomes or losses of such enterprises, and (c) shall include a mutual agreement or arrangement between two or more AEs for allocation or apportionment or contribution to the any cost or expenses incurred or to be incurred in connection with the benefit, service or facility provided or to be provided to one or more of such enterprises.
Delhi High Court and ITAT Bangalore have taken a view that no TP adjustment can be made if there is no arrangement between the assessee and its foreign AE for incurring AMP expenditure. Further merely because the benefit of AMP expenditure would also enure to its foreign AE, is not sufficient to infer the existence of international transaction; the onus lies on the revenue to prove the existence of international transaction.
Delhi High Court in an earlier ruling in Sony Ericsson Mobile Communications India Pvt. Ltd. (Now known as Sony India Limited) v. Commissioner of Income Tax – III 2015 SCC OnLine Del 8083, treated AMP to be an International Transaction so as to attract TP adjustment, since the assessees concerned did not dispute the position. Said decision considered a host of related issues. This write-up mainly examines the principles emerging from the said decision on how is TP calculated for AMP.
Distributor and Marketing AE
The Domestic AE may be performing functions of a pure distributor or performing distribution and marketing functions. In case of a distributor and marketing AE, the first step in TP is to ascertain and conduct detailed functional analysis, which would include AMP function/expenses. As a second step comparables will have to be ascertained.
A purely independent distributor and one with marketing rights, are distinct. An independent distributor with a full marketing right is a person independent of the manufacturer, who purchases goods from the manufacturer for re-sale on its own accounts. Such distributor takes all economic risk of product distribution and ultimately gains or makes loss depending upon market and other conditions, which the manufacturer having no concern. On the other hand, a low or no risk distributor virtually acts as an agent of the manufacturer and the loss and gain is that of the manufacturer. He is, therefore, entitled to fixed remuneration for the self-efforts, i.e, relating to the function of distribution. A low-risk distributor with marketing functions stands on similar footing except that he should be compensated for the marketing, including AMP function. A distributor with marketing function could be normal or a high-risk distributor. Such distributors should be compensated and the quantum of compensation would be higher. Such cases have to be distinguished from cases of a pure distributor, who is in an independent business, uses his own money for purchasing at a low price and selling at a high price and accordingly shoulders the burden in case of a bad judgment. Profits or losses, therefore, correspond to the risk and market consideration. There is also functional incompatibility between a distributor and a retailer. Retailers cannot be compared with distributor also performing marketing functions.
Where domestic AE is entitled to compensation as a pure distributor, it would not be entitled to share in any return attributable to the marketing intangible, not being the legal owner. In case of a long-term contract of sole distribution rights of the trade marked products, the distributor might acquire “economic ownership”. In cases, where the distributor bears extraordinary marketing expenses, he would be entitled to additional return. However, a distinction is drawn between a ‘function’ and a ‘transaction’ to hold that every expenditure forming part of the marketing function cannot be construed as a ‘transaction’.
The principles mentioned above laid in Sony Ericsson relating to Distribution and Marketing AEs, may not apply to marketing AEs. Manufacturing AEs perform complex operations of manufacture and sale. AMP expenditure incurred by them normally cannot be inferred to have benefitted the AEs. Such entities are the economic owners of the brand and trademark and reap the benefit of their AMP in the form of increased turnover.
Delhi High Court in a case involving Domestic AE engaged in manufacturing and distribution held that there is no enabling provision in Chapter X to determine ‘fair ‘compensation’ which the Indian entity would be entitled to if it is found that there is an international transaction concerning AMP. It observed that strength of a brand, which could be product specific, may be impacted by numerous other imponderables like nature of the industry, geographical peculiarities, economic trends both international and domestic, consumption patterns, market behaviour, etc.; hence a simplistic approach using one of the modes contemplated by Section 92C may not only be legally impermissible but lead to arbitrariness. The court emphasized the need for clear statutory scheme encapsulating the legislative policy providing checks against arbitrariness while also addressing the apprehension of tax avoidance.
Bundling and Segregation of Distribution and Marketing Functions
When the distribution and marketing functions are interconnected, and reliable comparables are available, ALP could be computed as a package, if required and necessary, by making adequate adjustments.
When it is not possible to compute ALP without segregating the distribution and marketing or AMP functions, segregation is permissible by giving justification and adequate reasons. Price received or the compensation paid by the foreign AE towards distribution and marketing or AMP functions must then be ascertained. Appropriate to compute the ALP of the two independently can be applied.
Set Off When Bundled Transactions are Segregated
The object and purpose behind of ALP is to tax the actual and commercial income which could have been earned by the AE in India. Set off, when bundled transactions are segregated, is justified, as the tax is payable on the total income after TP computation in respect of international transactions. The question of set-off would only arise in case two transactions are separate and ALP should be computed separately. It would apply in cases where there are closely linked or continuous international transactions.
Disregarding Actual Transaction
Tax authorities have to examine associated parties’ transaction as actually undertaken/structured. They cannot substitute a transaction for another as per their perception, subject however to following two exceptions:
- a) Where the economic substance of transaction differs from its form. In such cases, the parties’ characterization may be disregarded to re-characterise the transaction in accordance with its substance.
- b) When form and substance of the transaction are same, but arrangements made in relation to the transaction, viewed in totality, differ from those which would have been adopted by independent enterprise behaving in a commercially rational manner. The actual structure should impede determining of appropriate transfer price.
Re-categorisation of transaction is an exercise different from aggregation or segregation of transactions. It would result in re-categorisation of the functions and the comparables. Aggregation or segregation of transactions accepts that the transactions do not require re-categorisation of transactions. However, in a given case when there is re-categorisation of transaction, as a consequence, segregation or aggregation may be required.
An independent enterprise acting in a commercially rational manner can enter into an agreement for distribution and marketing as entered into by the Indian assessee, a subsidiary of the foreign AE. It cannot be said that the transactions for distribution and marketing as a package are not executed between a foreign enterprise and an independent enterprise.
The value of tangible property may be affected by the value of intangible property, such as trademark affixed on the tangible property. Transfer of tangible property with embedded intangible property normally is not considered a transfer of such intangible, particularly when the controlled purchasers do not acquire any right to exploit the intangible property other than the right to re-sell the tangible property with embedded intangible rights.
Economic ownership of a trade name or trade mark is one of the components or aspects for determining TP. In cases of long-term contracts and where there is no negative stipulation denying economic ownership, domestic AE may have the economic ownership. The assessed can plead and prove the economic ownership.
Whether the arrangement is long-term with economic ownership or short-term, should ordinarily be determined based upon the conditions existing at the start of the arrangement, though, the assessed can prove that at the start of the arrangement it was accepted and agreed that the contract would be renewed.
Economic ownership of a brand is an intangible asset. Undifferentiated, economic ownership brand valuation is not to be done periodically. But if the assessed is deprived, denied or transfers economic ownership (e.g.,. on account of termination of the distribution-cum-marketing agreement or when economic ownership gets transferred to a third party), the TP valuation will have to be done.
Direct Marketing Expenses
Distribution and marketing exercise in case of tangibles requires transfer/sale of goods to third parties, which could be sub-distributors or retailers. The marketing or selling expenses like trade discounts, volume discounts, etc. offered to sub-distributors or retailers are not in the nature of “brand promotion” and are not directly related to “brand building” exercise, but have direct connect with marketing and increased volume of sales or turnover. Such direct marketing expenses are not incurred for publicity or advertisement and cannot be treated as “brand building” exercise, thus are not AMP expenses.
Arm’s Length Price for Royalty for Technical Know-how Paid to Foreign AE
TP provisions, recognise separate entity principle. Therefore, when AE avails the advantage of technical know-how, it should pay ALP for the right to use. Payment of royalty is a relevant consideration when ALP of the international transaction of distribution and marketing is considered. Tax treatment of royalty payments being different, the royalty transaction, may be benchmarked separately.
However, the quantum of royalty payable cannot be determined on the basis of profitability of the assessed, if know-how and technical information were provided. ALP cannot be determined on the basis that assessee had not derived any commercial benefit as technology and know-how had not resulted in any substantial profit increase. Profitability of the assessed could have been lower or varied due to various reasons and lower profitability particularly in short duration cannot lead to the conclusion that no benefits were derived or technology was unproductive. Moreover, an assessee can justify lower profits on account of factors like bad debts, high rent, increase certain costs, etc.
Selection of Method for Determining ALP
The Revenue can reject a method selected by the assessed for several reasons including want of reliability in the factual matrix or lack/non-availability of comparables. When the Revenue rejects the method adopted by the assessed, he is entitled to select the most appropriate method, and undertake comparability analysis. Selection of the method and comparables should be as per the command of IT Act and Rules and justified by giving reasons.
The ‘bright line test’ which on the basis of specified comparables provides that any excess expenditure beyond the bright line should be regarded as a separate international transaction of brand building, cannot be applied. Applying ‘bright line test’ would amount to judicial legislation by adding words in the statute.
In a subsequent decision, Delhi High Court has emphasised that only TP adjustment authorised by Chapter X is the substitution of the ALP for the transaction price. Each of the methods specified in S.92C (1) is a price discovery method. S.92C (1). The only manner of effecting a TP adjustment is to substitute the transaction price with the ALP so determined. Chapter X of the Act, does not envisage a quantitative adjustment but only a substitution of the transaction price with the ALP. It is the ‘price’ of an international transaction which is required to be adjusted. The very existence of an international transaction cannot be presumed by assigning some price to it and then deducing that since it is not an ALP, an ‘adjustment’ has to be made. Further, an AMP TP adjustment to which none of the substantive or procedural provisions of Chapter X apply is not permitted. With neither the substantive nor the machinery provisions of Chapter X being applicable to an AMP TP adjustment, Chapter X as a whole does not permit such an adjustment.
Adopting a Comparable
Economically relevant characteristics of the two transactions being compared must be comparable. The difference, between controlled and uncontrolled transaction, should not materially affect the conditions being examined given the methodology being adopted for determining the price or the margin. When this is not possible, it should be ascertained whether reasonably accurate adjustments can be made to eliminate the effect of such differences on the price or margin. Choice of the most appropriate method depends on the availability of potential comparable.
While decision in Sony Ericsson supra, is followed in subsequent decisions, in a few of the jurisdiction the decision is treated as not binding as not being the decision of the jurisdictional High Court. IT department, as well as several assesses, have not accepted the decisions of the Delhi High Court and Appeals have been filed before the Supreme Court and an authoritative pronouncement in the matter, settling the issues, so as to provide certainty to Taxpayers as well as Revenue, would be welcome.