Delhi HC: Continuous losses is not the criteria to disallow the payment for brand fees/ royalty under transfer pricing provisions

On March 29, 2012 Hon’ble High Court of Delhi pronounced a land mark judgment in case of ELK Appliances Ltd., wherein it observed that tax officer is not authorised to disallow the payment made for brand fee or royalty while determining an arm’s length price of the same.

Facts of the Case

This case relates to financial year 2001-02 and 2002-03. EKL Appliances Ltd. (‘taxpayer’), Group Company of Electrolux group, was engaged in the business of manufacturing of refrigerators, washing machines, compressor and spares thereof and also trading all these items and microwaive ovens, dish washers, cooking ranges, air conditioners and spares thereof. In respect of the assessment years 2002-03 and 2003-04, it filed returns of income declaring losses amounting to Rs. 148,23,80,117/- and  Rs. 1,14,59,660/- respectively. The Assessing Officer noticed that there were international transactions entered into by the taxpayer during the relevant previous years and accordingly invoked the provisions of Section 92CA(3) of the Act and referred the question of determination of the Arms Length Price (“ALP) to the Transfer Pricing Officer (“TPO”).

The TPO noticed that the taxpayer has been incurring huge losses year after year except for the financial year 1999-2000 and considering the perpetual losses, “the payment of royalty to the Associate Enterprise did not appear justified, as the technical knowhow/ brand fee agreements with A.E. had not benefited the taxpayer company in achieving profits from its operations”. The TPO further noted that the taxpayer itself stopped the payment from 01.10.1998 till 01.01.2002 and thus “the justification for payment of brand fee during the year under reference becomes questionable”.

He conceded that there was an increase in the turnover but observed that it has not resulted in any profit to the taxpayer. According to him, despite the payment of the brand fee for several years, the taxpayer has not been able to make a turnaround. He further held that the fact that the A.E. had charged similar brand fee from another company in New Zealand did not prove that the price paid by the taxpayer for obtaining the use of the brand name and the technical knowhow represented the ALP. He was of the view that the taxpayer had to demonstrate the actual benefit derived by it by using the brand name which it had failed to do. The continuous losses according to the TPO showed that the taxpayer did not benefit in any way from the brand fee payment. For these reasons, the TPO held that the brand fee payment made by the taxpayer to the A.E. was unjustified and the ALP of the transactions should be taken as nil.

Observations of Hon’ble High Court of Delhi

The Hon’ble High Court of Delhi ruled in favour of the taxpayer and observed,

•  It is not necessary for the taxpayer to show that any legitimate expenditure incurred by him was   also incurred out of necessity.
• In applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of business, reasonableness of the expenditure has to be judged from the point of view of the businessman and not of the Revenue.
• The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allow-ability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the taxpayer has suffered continuous losses.

Relying upon OECD guidelines, the Hon’ble High Court of Delhi also observed;

•    It is also not necessary for the taxpayer to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred “wholly and exclusively” for the purpose of business and nothing more.
•  The TPO is expected to examine the international transaction as he actually finds the same and then make suitable adjustment.

 Conclusion

This judgement should bring a good relief for other taxpayers also, as in number of cases the Revenue has disallowed payment of royalty or brand fee because of low profitability or no profitability. As the judgment suggests that profitability should not be the criteria to allow or disallow the payment, it is recommended that the taxpayer should try to benchmark transactions like payment of royalty/ brand fee or say management charges using comparable uncontrolled price method or cost plus method. Transactional Net Margin Method, considering payer of expenses as the tested party should be avoided.   

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CA Gaurav Garg

JGarg Economic Advisors Pvt. Ltd.

(M) +91 98999 94934

(E) gaurav@jgarg.com

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