Year 2013 starts with landmark judgment from Delhi Tribunal’s
Special Bench (‘Tribunal’) in case [IT
APPEAL NOS. 5140 (DELHI) OF 2011] of M/s LG Electronics India Pvt. Ltd. (‘LG
India’ or ‘taxpayer’).The Tribunal analysed various issues including higher
expenditure on advertisement, marketing & promotion (‘AMP’) incurred by subsidiary
company on brand owned by foreign associated enterprise.
Below is the synopsis and observations made by the tribunal
in the captioned case relating to the transfer pricing;
A.
Jurisdiction of the Transfer Pricing Officer
(‘TPO’) – Section 92CA
B.
Meaning of Transaction
C.
Economic vis-à-vis legal ownership of brand
D.
Meaning of International Transaction
E.
Cost of the Transaction and Bright line test
F.
Scope of Transactional Net Margin Method
G.
Choice of the Transfer Pricing Method under
section 92C
Facts of the Case
The
factual matrix of the case is that L.G. Electronics Inc. (‘LGK’), is a Korean
based company, engaged in the business of manufacture, sale and distribution of
electronic products and electrical appliances. LG India was incorporated in 1997
as a wholly owned subsidiary of LGK.
An
agreement was entered between LGK and LG India in March 1997, as per which both
entered into a mutual foreign collaboration agreement. Thereafter a technical
assistance and royalty agreement was entered into between these two entities on
1-7-2001 by which LG India, in the capacity of a licensee, obtained a right to
use the technical information, designs, drawings and industrial property rights
for the manufacture, marketing, sale and services of the agreed products from
the LGK i.e. the licensor. As per the agreement, the taxpayer agreed to pay
royalty to LGK at the rate of 1% as a consideration for the use of industrial
property rights, designs and technical knowhow, for the manufacture and sale of
the greed products.
LGK also
allowed LG India to use its brand name and trade marks to products manufactured
in India during the validity period of the agreement, which in the instant case
is “without any restriction”. The
agreement also provided that “In case at any stage in future the Licensor
demands any royalty payment on this account, the Licensee will take steps to get
the Government of India‘s approval for payment of such royalty payment".
The
Assessing Officer (‘AO‘) referred the international transactions reported by
the taxpayer to the TPO. One of such transactions included in the taxpayer‘s
audit report was “Contribution towards Global Cricket Sponsorship”. The TPO
observed that the taxpayer had received contribution from its associated
enterprise (`AE‘) for the expenditure incurred on sponsorship of Global Cricket
events. The quantum of contribution received was considered as a part
contribution for the brand promotion carried out by the taxpayer on behalf of
its foreign AE.
The
TPO observed that the taxpayer‘s expenses on AMP including trade discount and
volume rebate, were 3.85% of its sales at Rs.6,553.36 crore. He computed
similar percentage in the case of Videocon Appliances Ltd. (0.12%) and
Whirlpool of India Ltd (2.66%) with their arithmetic mean at 1.39%. It was
opined that the taxpayer was promoting LG brand owned by its foreign AE and
hence should have been adequately compensated by the foreign AE. Applying the
Bright Line Test, the TPO held that the expenses up to 1.39% of the sales
should be considered as having been incurred for the taxpayer‘s own business
and the remaining part which is in excess of such percentage, at 2.46% (3.85% -
1.39%) on brand promotion of the foreign AE. Such excess at Rs.161.21 crores
was proposed as a transfer pricing adjustment on account of AMP expenses for
brand building.
Before
the Dispute Resolution Panel (hereinafter called `the DRP‘), it was contended
on behalf of the taxpayer that the total AMP expenses so incurred helped in
increasing its sales activity and hence no part of the same could be considered
as unrelated to its business, being in the nature of brand building for the
foreign AE. It was also put forth that the LG brand was in existence globally
even before the taxpayer started its operations in India. Thus it was pleaded
that the taxpayer did not have any occasion to create this brand in India. The taxpayer
also claimed that brand name was available to it without paying any brand
royalty, which was an important factor to be kept in mind. Even if such
expenses resulted in creation of a brand in India, the taxpayer contended that
no further amount was attributable to such brand creation on account of its
higher profitability and nonpayment of brand royalty.
The
DRP found that the taxpayer incurred extraordinary AMP expenses for the
promotion and development of LG brand in India. The taxpayer‘s contention that
the incurring of such expenses did not lead to the promotion of brand in India,
was found to be not tenable. The DRP concurred with the view taken by the AO in
the draft order prepared by the AO u/s 144C in making adjustment of `161.21
crore. It was further observed by the DRP that TPO had not charged markup on
such AMP expenses. The same was found warranted as the taxpayer ‘s activity
required not only the deployment of its funds but also entrepreneur‘s efforts
including the use of its infrastructure. Opportunity cost was finalized at
10.50%, being the interest rate charged by the banks; and compensation for the taxpayer‘s
entrepreneurial efforts was taken at 2.5% . Thus, the DRP came to hold that the
mark-up of 13% should have been applied on the amount proposed for adjustment.
At the same time, the DRP agreed with the taxpayer‘s contention that no
opportunity cost of 10.5% should be charged on the expenses for which
reimbursement was received immediately after the same were incurred. Pursuant
to directions given by the DRP, the ld. AO passed order u/s 143(3) read with
sec. 144C making additions, inter alia, of Rs.182.71 crore (inclusive of
mark-up @ 13%) towards AMP expenses on brand building incurred for and on
behalf of its AE.
Aggrieved
by the same, the Taxpayer appealed in the Tribunal, wherein Tribunal observed
on various transfer pricing issues discussed below in detail.
A.
Jurisdiction of the Transfer Pricing Officer
(‘TPO’) – Section 92CA
Contention
of the Taxpayer
In
the current case, it was contented by the Taxpayer that AO did not refer the
international transaction of marketing intangibles to the TPO and as such the
latter was precluded from determining the arm‘s length price in respect of such
transaction.
Relevant
Provisions of the Act
Section
92CA of the Income Tax Act (‘the Act’) defines the jurisdiction of the TPO in
determination of the arm’s length price in case of international transactions
entered between the taxpayer and its associated enterprise during the
assessment year under audit.
As
per section 92CA(1) the Act, the AO can refer the transactions to the TPO for
the purposes of computation of arm’s length price if he considers the same
necessary or expedient after taking
prior approval from the Commissioner.
Once
reference is made to the TPO, TPO is competent to exercise all powers that are
available to the AO under sub-section (3) of Section 92C of the Act for
determination of ALP and consequent adjustment.
Section
92CA(2A) of the Act was added through Finance Act 2011 (w.e.f 1-6-2011), wherein it was specifically provided that in case
if the TPO notice any other transaction, transactions other than the
transactions referred by the AO under section 92(1), he may compute the arm’s
length price of the same after giving proper opportunity of the Assessee in
additions to the transactions referred to him by the AO under section 92(1) of
the Act.
Further,
it was realized by the law making body that as per section 92E of the Act there
is reporting requirement on the taxpayer and the taxpayer is under obligation
to file an audit report in prescribed form before the AO containing details of all
international transactions undertaken by the taxpayer during the year. However,
wherein in a case the transaction has not be disclosed in the Form 3CEB, AO may
not be able to refer the same to the TPO and TPO may not be able to compute the
arm’s length price of such international transactions. Accordingly, to avoid any litigation or
disputes section 92CA(2B) of the Act (w.e.f
1-6-2002) was introduced to empower TPO to compute arm’s length price of an
international transaction noticed by him in the course of proceedings before
him, even if the said transaction was not referred to him by the Assessing
Officer, provided that such international transaction was not reported by the
taxpayer as per the requirement cast upon him under section 92E of the Act.
Observation
of the Tribunal
7.7…….A
conjoint reading of sub-secs (1) & (2) of section 92CA makes it manifest
that the TPO can determine ALP of an
international transaction only when a valid reference is made to him by the AO
and not otherwise……
7.8…..It thus becomes apparent that with the insertion of sub-sec. (2A), the
TPO can compute ALP in respect of any transaction other than those referred to
him by the AO. However, it is pertinent to note that sub-sec. (2A) has been
inserted w.e.f. 1-6-2011. Thus, the
mandate of sub-sec. (2A) cannot apply to a period anterior to this cut-off
date. As the TPO passed the order in the instant case on 29-10-2010 which
is obviously prior to 1-6-2011, sub-section (2A) cannot be of any help to save
his action.
7.18 Realizing that sub-sec. (2A) did not
serve the purpose in entirety to validate the action of the TPO in determining
ALP in respect of transactions not referred to by the AO, the legislature came out with sub-sec. (2B) with retrospective effect
from 1-6-2002. As per this sub-section, any international transaction in
respect of which the assessee has not furnished report u/s 92E can be
considered by the TPO for determining ALP. Thus, sub-sec. (2B) has the
effect of validating the action of the TPO with effect from 1.6.2002, thereby covering
even the period prior to 1-6-2011, being the date of insertion of sub-sec. (2A)
of sec. 92CA. The contention that sub-sec. (2B) of sec. 92CA cannot be invoked
to regularize the otherwise invalid action of the TPO, in our considered
opinion, is farfetched……
7.20…….. The jurisdiction of the TPO is activated only when the AO makes
reference to him under sub-section (1) for determining ALP in respect of
certain transactions. Sub-secs. (2A) and (2B) come into play only when sub-sec.
(1) has already been set into motion. Thus, it is only when the AO makes a
reference to the TPO in terms of sub-sec. (1) for determination of ALP in
respect of the referred international transactions, that the TPO gets power
under subsections (2A) and (2B) to determine ALP in respect of non-referred international
transactions as well. In the absence of any such reference under sub-section
(1), the TPO cannot suo motu undertake the determination of ALP in respect of
other international transactions not referred to him…..
7.21… There
is no requirement of previous approval of the Commissioner in respect of the
international transactions which come to the notice of the TPO during the
course of proceedings before him. The prerequisite of seeking approval of
the Commissioner is incorporated in sub-sec. (1) alone and the same cannot be
read into sub-secs. (2A) and (2B) by the doctrine of incorporation. Our view is
fortified by the judgment of the Hon‘ble Supreme Court in the case of CIT Vs.
Pawan Kumar Laddha [(2010) 324 ITR 324 (SC)].
B.
Meaning of Transaction
Contention
of the Taxpayer & Tax Department
The
whole argument between the tax payer and the tax department was around intent
for incurring the expenditure, wherein the taxpayer was arguing that the very
intent for incurring the expenditure is to promote India Business and there is
no formal or written understanding between the taxpayer and its associated
enterprises. Whereas contention of the tax department was as the expenditure
incurred by the tax payer is more than the normal AMP spend by similar
companies and in certain instances AMP spend was only in respect of Logo and
Brand name of foreign associated enterprises, it can very well be deduced that
the taxpayer was involved in brand promotion activity of the foreign
enterprises and accordingly the same is in the nature of services.
Relevant
Provisions of the Act
Transfer
pricing provisions are applicable on international transactions and accordingly
it is important to analyse the meaning of “transaction”. Definition of the
transaction is given under section 92F(v) of the Act and it includes an
arrangement, understanding or action in concert whether or not it is formal or
in writing or intended to be enforceable by legal proceedings.
Observation
of the Tribunal
9.9…so
long as there exists some sort of understanding between two AEs on a particular
point, the same shall have to be considered as a transaction, whether or not it
has been reduced to writing….
9.10. We do not find any force in the
contention of the ld. DR that the mere fact of the assessee having spent
proportionately higher amount on advertisement in comparison with similarly
placed independent entities be considered as conclusive to infer that some part
of the advertisement expenses were incurred towards brand promotion for the
foreign AE. Every businessman knows his interest best. It is for the assessee
to decide that how much is to be incurred to carry on his business smoothly.
9.12….What is relevant to consider is as to
whether an independent enterprise behaving in a commercially rational manner
would incur the expenses to the extent the assessee has incurred. If the answer
to this question is in affirmative, then the transaction cannot be recharacterized.
If, however, the answer is in negative, then the transaction needs to be probed
further for determining as to whether its recharacterization is required….
9.12…….Once by making such a comparison, the
result follows that the Indian AE, prominently displaying brand of its Foreign
AE in its advertisements, has incurred expenses proportionately more than that
incurred by independent enterprises behaving in a commercial rational manner, then
it becomes eminent to recharacterize the transaction of total AMP expenses with
a view to separate the transaction of brand building for the foreign AE. Even
the United Nations Transfer Pricing Manual, which has only a persuasive value,
provides for the allocation of such cost between the MNE and its subsidiaries.
We, therefore, hold that in the facts and circumstances of the present case, there
is a transaction between the assessee and the foreign AE under which the
assessee incurred AMP expenses towards promotion of brand which is legally
owned by the foreign entity.
C.
Economic vis-à-vis legal ownership of brand
Contention
of the Taxpayer
Taxpayer
claimed that Indian entity is the economic owner of the brand in India and
accordingly no adjustments should be made.
Observation
of the Tribunal
10.2.
We do not find any weight in the contention put forth about the economic
ownership and legal ownership of a brand. It is not denied that there can be no
economic ownership of a brand, but that exists only in a commercial sense. When
it comes in the context of the Act, it is only the legal ownership of the brand
that is recognized…….Suppose the foreign company, who is legal owner of the
brand, sells its brand to a third party for a particular consideration, can it
be said that the Indian assessee or for that purpose the wholesalers or
retailers should also get share in the total consideration towards the sale of
brand because they were also economic owners of such brand to some extent? The
answer is obviously in negative. It is only the foreign enterprise who will
recover the entire sale consideration for the sale of brand and will be
subjected to tax as per the relevant taxing provisions. There can be no tax
liability in the hands of the Indian AE or the wholesalers or the retailers for
parting with the economic ownership of such brand under the Act. In that view
of the matter we are of the considered opinion that the concept of economic
ownership of a brand, albeit relevant in commercial sense, is not recognized
for the purposes of the Act. The above discussion leads us to irresistible
conclusion that the advertisement done by the assessee also carrying the
brand/logo of its foreign AE coupled with the fact that it spent
proportionately higher amount on AMP expenses, gives clear inference of a
`transaction‘ between the assessee and its AE of building and promoting the
foreign brand.
D.
Meaning of International Transaction
Meaning
of international transaction is given in section 92B of the Act, according to
which "international transaction" means a transaction between two or
more associated enterprises, either or both of whom are non-residents, in the
nature of purchase, sale or lease of tangible or intangible property, or
provision of services, or lending or borrowing money, or any other transaction
having a bearing on the profits, income, losses or assets of such enterprises,
and shall include a mutual agreement or arrangement between two or more
associated enterprises for the allocation or apportionment of, or any
contribution to, any cost or expense incurred or to be incurred in connection
with a benefit, service or facility provided or to be provided to any one or
more of such enterprises.
Observation
of the Tribunal
14.14 When we read sec. 92B(1) it comes to
fore that in order to be characterized as an international transaction, the
following salient features must be present : - (1) There should be a
`transaction‘ (2) Such `transaction‘ should be between two or more AEs and
either or both of whom should be non-residents. (3) Such transaction should be
of the nature as referred to in section 92B.
14.18.2. We do not find any force in this
submission advanced on behalf of the assessee for the reason that the language
of section 92B simply mandates the “provision of services” by one AE to
another. It is not qualified by any words to restrict its scope only to such
services as are provided by the assessee in its regular course of business.
What is significant in this regard is the factum of rendition of service, which
is an international transaction. Source of service is inconsequential. It can
be produced by the AE as primarily engaged in the business of rendering such
service or it can be produced by the Indian AE otherwise than by being
primarily engaged in such business or it can be outsourced. The fact that the
Indian entity is rendering any service to the foreign AE, which is not its main
business, would not convert the otherwise international transaction into a
non-international transaction.
14.21. Thus it is palpable that all the
three necessary ingredients as culled out from a bare reading of section 92B
are fully satisfied in the present case. There is a transaction of creating and
improving marketing intangibles by the assessee for and on behalf of its
foreign AE ; the foreign AE is non-resident ; such transaction is in the nature
of provision of service. Resultantly, we hold that the Revenue authorities were
fully justified in treating the transaction of brand building as an
international transaction in the facts and circumstances of the present case.
E.
Cost
of the Transaction & Bright Line Test
For
the purposes of computing arm’s length price of the transaction in the nature
of services it is important to identify cost of the service provider. After
identification of cost price is determined by adding arm’s length mark-up to
such cost of services.
In
the captioned case Bright Line test was used to identify the cost of services.
Observation
of the Tribunal
15.7.…..Bright
line is a line drawn within the overall amount of AMP expense. The amount on
one side of the bright line is the amount of AMP expense incurred for normal
business of the assessee and the remaining amount on the other side is the
cost/value of the international transaction representing the amount of AMP
expense incurred for and on behalf of the foreign AE towards creating or maintaining
its marketing intangible…..
15.8. In the present case, the assessee did
not declare any cost/value of the international transaction in the nature of
brand building. As such, it fell upon the TPO to find out such amount out of the
total AMP expenses incurred by the assessee. In the absence of any assistance
from the assessee in determining such cost/value, logically it could have been
by first identifying comparable independent domestic cases ; ascertaining the
amount of advertisement, marketing and promotion expenses incurred by them and
percentage of such AMP expenses to their respective sales ; noting the total
AMP expenses incurred by the assessee ; discovering the amount of AMP expenses
incurred by the Indian entity for its business purpose, by applying the above
percentage of comparable cases to assessee‘s sales. The excess of total AMP
expenses over such amount as determined as per the immediately preceding step
ought to have been and has been rightly taken as a measure to determine the amount
of AMP expenses incurred by the assessee for the brand promotion of foreign AE.
In other words, the amount coming up as per the last step is the cost/value of
such international transaction.
17.2. We find that the first step in making
comparability analysis, is to find out some comparable uncontrolled cases. It
goes without saying that a comparison can be made with the cases which are
really comparable. A case is said to be comparable when it is from the same genus
of products and also other relevant factors, such as, type of products, market
share, assets employed, functions performed and risks assumed, are also
similar. Once proper comparable cases are chosen, then the next step is to
neutralize the effect of the differences in relevant facts of the case to be
compared and the assessee‘s case, by making suitable plus or minus adjustments.
17.6. …. We find that choosing cases using
the foreign brand ex facie cannot be accepted. It is but natural that the AMP
expenses of such cases will also include contribution towards brand building of
their respective foreign AEs. In such a situation the comparison would become
meaningless as their total AMP expenses will stand on the same footing as that
of the assessee before the exclusion of expenses in relation to brand building
for the foreign AE. The correct way to make a meaningful comparison is to
choose comparable domestic cases not using any foreign brand. Of course when
effect will be given to the relevant factors as discussed above, it will
correctly reflect the cost/value of international transaction.
18.3. Having heard the rival submissions on
this issue, we find that the AMP expenses refer only to advertisement,
marketing and publicity expenses. A divider needs to be placed between the expenses
for the promotion of sales on one hand and expenses in connection with the
sales on the other. Both these expenses are required to be kept in different
compartments. While expenses for the promotion of sales directly lead to brand
building, the expenses directly in connection with sales are only sales
specific.
18.6….. We, therefore, hold that the
expenses in connection with the sales which do not lead to brand promotion
cannot be brought within the ambit of “advertisement,
marketing and promotion” expenses for determining
the cost/value of the international transaction.
F.
Scope
of Transactional Net Margin Method (‘TNMM’)
The
basic rule of transfer pricing suggests that the transaction should be
benchmarked on standalone basis and the aggregation should be only done if they
are inter-related. In the captioned case, as the Tribunal observed that the
taxpayer is involved in providing brand promotion services to its AEs, would it
be correct to aggregate all the transactions for the purposes of justification
of arm’s length price under TNMM. Otherwise also, if the taxpayer has various
types of transactions, how correct it would be justify the profitability at
entity level was the question in front of the Tribunal.
Observation
of the Tribunal
21.4….This
method (TNMM) provides for benchmarking of `an‘ international transaction by
considering the operating profit from the concerned international transaction
vis-à-vis certain basis as given in Rule 10B(1)(e), being total cost, sales,
capital employed etc. Here it is significant to note the meaning of the term
`transaction‘ as given in rule 10A(d). It provides that: `transaction includes
a number of closely linked transactions‘. Plural of transactions becomes
singular when the transactions are closely linked to each other or are
identical. These closely linked transactions can be processed as one
transaction under any of the prescribed methods. If an Indian enterprise has
made sale of similar goods to its foreign AE through several invoices and has
also incurred some expenses or paid interest to it, it would mean that all the
transactions of sales are closely linked and these can be processed as one
unit. However the transactions of payment of interest or incurring of any other
expense would be required to be separately scrutinized under Chapter-X because
these are of a different nature vis-a-vis the transactions of sales.
21.5. ….The correct approach under the TNMM
is to consider the operating profit from each international transaction in
relation to the total cost or sales or capital employed etc. of such
international transaction and not the net profit, total costs, sales, capital
employed of the assessee as a whole on entity level……Thus it is clear that the
sanction is for applying the TNMM only on a transactional level and not on
entity level. Of course, the TNMM can be correctly applied on entity level if
all the international transactions are of sale by the assessee to its foreign
AE and there is no other transaction of sale to any outsider and also there is
no other international transaction. But if there are several unrelated
international transactions, as is the case before us and the assessee or the
TPO has applied the TNMM in a wrong manner on entity level for testing any of
such transactions, then the remedy lies in correcting such mistake rather than
drawing legally unsustainable conclusions by taking such mistake as a correct
legal position.
21.8. … Earning an overall higher profit
rate in comparison with other comparable cases cannot be considered as a licence
to the assessee to record other expenses in international transactions without
considering the benefit, service or facility out of such expenses at arm‘s
length. All the transactions are to be separately viewed…
21.10…The fact that the assessee has a better
net profit rate in comparison with other comparable entities is not decisive in
itself of the assessee having purchased the goods at a concessional rate from
its foreign AE as a compensation for its incurring AMP expenses towards the
promotion of their brand.
21.12..There is no provision which permits
set off of negative adjustment with the positive adjustment to the income on
account of different international transactions. The outcome of both the
transactions has to be given effect distinctly. It, therefore, divulges that
two or more international transactions are required to be separately processed
under the TP provisions….
G.
Choice
of the Transfer Pricing Method under section 92C
For
the purposes of computation of the arm’s length price 5 methods are prescribed
in section 92C of the Act. The law mandates the use of the any of the method,
out of those 5 methods, being the most appropriate method.
Observation
of the Tribunal
22.9….When we read sub-section (1) of
section 92C in entirety along with Rule 10B(1), there remains no doubt that the
arm‘s length price is required to be determined by any single method out of the
five prescribed methods…… In our considered opinion the general and a non case
specific argument advanced by the ld. DR that there can also be a combination
of the one or more of the five methods for determining the ALP, is not correct.
22.10. As regards the contention that
methods are tools for determining the ALP, we find that there is no dispute
that the main purpose of Chapter X is to determine the ALP of an international
transaction, but such determination can be done only by way of the methods
specified by the statute….
My Comments
When
in para 10.2 the Tribunal agrees to the concept of “economic ownership” in
commercial sense but deny the same from tax perspective or more precisely from
transfer pricing perspective it raises doubt on very mechanism of transfer
pricing as understood. We need to be clear that transfer pricing is first a
commercial concept and then a tax concept.
To validate the transaction price including terms & conditions of
the commercial transaction between two associated enterprises it is required
under the tax law to identify another commercial transaction between two
independent enterprises and then deduce price including terms & condition
from the same i.e. arm’s length price. Accordingly, the Tribunal instead of
rejecting the “economic ownership” concept from transfer pricing perspective could
have reviewed or analysed whether any direct return would accrue to legal owner
because of economic value that is being generated by AMP spend in India. Assuming
capital gain on sale of brand by foreign company seems to be far-fetched and
based on assumption.
The
observation of the Hon’ble Tribunal that the taxpayer was displaying brand of
its Foreign AE in its advertisements, has incurred expenses proportionately more
than that incurred by independent enterprises behaving in a commercial rational
manner and accordingly it is a transaction in the nature of services needs
review. The prime objective of the advertisement and marketing is to
communicate, is to reach potential or prospective customers and influence their
awareness, attitudes and buying behavior. Such communication might happen by
displaying full ad or just by displaying logo or brand name, till such ad is
communicating about the taxpayer in India to its potential customer it should
not be of much relevance that someone else is the legal owner of the brand
name. The question which needs an answer in this case if logo of “LG” is
displayed in India, the Indian customer will go to Korea or some local market
in India for buying a product.
Trust the same would find you useful.
For assistance on transfer pricing and tax issues, please feel free to call us.
Best Regards
CA Gaurav Garg
JGarg Economic Advisors
(M) +91 9899994934
(E) gaurav@jgarg.com
