[Shannon Khalkho is a IV year B.A. LL.B. (Hons.) student at the National Law School of India University, Bangalore]
Introduction
The issue of advertisement, marketing and promotion (AMP) expenses incurred by a domestic entity for its foreign associate entity (foreign AE) has been mired in controversy since its entry into the realm of transfer pricing, essentially because of a lack of statutory machinery and the varying nature of businesses and contractual mechanisms employed. Tax tribunals and High Courts have been grappling with the treatment of AMP expenses for a few years now, with a marked change in their approach over this period.
One of the first cases to have dealt with this issue was Maruti Suzuki India Ltd. v Additional Commissioner of Income Tax [(2010) 328 ITR 210] in which the Delhi High Court held that AMP expenses incurred would qualify as an international transaction if it exceeded the expenses incurred by similarly situated and comparable independent domestic entities. Similarly, in LG Electronics India Pvt. Ltd. v Assistant Commissioner of Income Tax [(2013) 140 ITD 41 (Delhi) (SB)], the existence of an international transaction was deduced from proportionately higher AMP expenses. The Delhi High Court departed from this rationale in Sony Ericsson Mobile Communications India Pvt. Ltd. v Commissioner of Income Tax [(2015) 374 ITR 118], and overruled the aforementioned judgments to the extent that they dealt with the question of when AMP expenses would constitute an international transaction.
The Revenue’s attempts to bring in AMP expenses within the ambit of transfer pricing stems from an understanding that incurring such expenses necessarily entails a benefit to the foreign AE in terms of enhancement of brand value. The need for making a transfer pricing adjustment arises because of the absence of an adequate compensation in exchange for the benefit. Thus, the Revenue zealously takes on the task of attributing an arms’ length price (ALP) to the perceived ‘transaction’ of brand-building. The most frequently used method for the same is the ‘bright line test’, which was expounded in detail in LG Electronics. It continues to be employed time and again by the Revenue in different forms, despite its validity being struck down in Sony Ericsson.
In this post, I will trace the shifts in judiciary’s approach to the transfer pricing problem in case of AMP expenses, focusing on the Court’s decision and rationale in Sony Ericsson. I will also study its impact and implications through an analysis of decisions applying the principles laid down in Sony Ericsson.
A Tale of Two Extremes – from LG Electronics to Sony Ericsson
In LG Electronics, the Revenue was irked by the substantial amount of money spent by LG India, the licensed manufacturer of LG Electronics Inc., in promotional and marketing activities. It was observed that the quantum of LG India’s AMP expenses was significantly higher than its comparables.[1] This, coupled with the fact that LG India’s products used its foreign AE’s brand name and logo, formed the basis for the Revenue’s contention that high AMP expenses constituted an international transaction. The Court upheld the Revenue’s argument, inferring the existence of an international transaction without there being an express agreement to that effect. The existence of a ‘tacit understanding’ between the assessee and its foreign AE was deduced merely on the basis of proportionately higher AMP expenses.[2] In essence, the Court looked at the ‘bright line’ – a line drawn within the total amount of AMP expenses indicating the average AMP spending of comparables. Any amount exceeding the bright line was considered to be an international transaction, representing the expenses incurred for and on behalf of the foreign AE towards maintaining and enhancing its brand value.[3] This treatment of AMP expenses was brought up for appraisal in Sony Ericsson, wherein the incompatibility of the bright line test with the statutory framework was elucidated.
In Sony Ericsson, the assessees were subsidiaries engaged in the distribution and marketing of products manufactured by their foreign AEs. The Court did not struggle with the determination of an international transaction, as the parties’ primary submission was that the international transactions between them and their foreign AEs included the value of AMP functions.[4] However, the Revenue and the Transfer Pricing Officer (TPO) had relied heavily on LG Electronics to justify their use of the bright line test in ascertaining the portion of AMP expenses which would constitute an international transaction. The Court rejected their contentions, holding that the use of the bright line test had no statutory backing. Consequently, the Court overruled the decision in LG Electronics insofar as it upheld the bright line test, asserting that such an approach would amount to judicial legislation.
Sony Ericsson – A Step in the Right Direction?
Following the decision in Sony Ericsson, there has been a noticeable shift in the judiciary’s approach. Maruti Suzuki India Ltd. v Commissioner of Income Tax[5] [(2016) 381 ITR 117 (Delhi)] highlights the crucial developments in the post-Sony Ericsson scenario. As a discussion on the meaning of international transaction had not been warranted in Sony Ericsson, it lent no guidance to subsequent cases which struggled with the same. The judiciary has since then grappled with the problem of determining standards for conclusively showing the existence of an international transaction.
Determining the existence of an international transaction
The statutory framework concerning the commencement of a transfer pricing exercise is fairly clear – first, the existence of an ‘international transaction’ has to be shown; second, the price of the transaction has to be determined; and third, an ALP has to be fixed using one of the methods specified in section 92C of the Income Tax Act, 1961 (ITA).[6] The final transfer pricing adjustment can be made only on the completion of each of these steps. The existence of an international transaction is thus the sine qua non of a transfer pricing exercise. The statute has also clearly defined the terms ‘international transaction’[7] and ‘transaction’[8]. While the international element was not in dispute in either LG Electronics, Sony Ericsson, or Maruti Suzuki, what formed the bone of contention was the meaning of transaction itself. The statutory definition of transaction includes an agreement, understanding or an action in concert, which need not be formal or in writing. In LG Electronics, higher AMP spending vis-à-vis comparables was considered as an objective standard to determine the existence of a ‘tacit understanding’. Essentially, an international transaction was determined through inference using the bright line test. Such an objective standard would be invalid in the light of Sony Ericsson.
In the post-Sony Ericsson scenario, the judicial approach has been to juxtapose the Court’s ruling in Sony Ericsson with the statutory framework, which has given way to some interesting results. In Maruti Suzuki, the assessee was a licensed manufacturer of passenger cars, using the co-branded trademark ‘Maruti-Suzuki’ on its vehicles.[9] A substantial AMP spending caught the attention of the Revenue, who contended that the use of the foreign AE’s name and logo coupled with high AMP expenses would amount to an international transaction. The assessee vehemently rejected these contentions, asserting that there was no international transaction. In this case, unlike in Sony Ericsson, the Court had to tackle the fundamental question of the existence of an international transaction. Crystallising the principles laid down in Sony Ericsson, the Court asserted that the very existence of an international transaction cannot be a matter of inference.[10] In this case too, the Revenue’s modus operandi was akin to the bright line test – the excessive nature of AMP spending was treated as the basis for coming to a positive conclusion as to the existence of an international transaction. The Court affirmed that such an approach has no statutory sanction. What the Revenue ought to do, is to first show the existence of an international transaction independently of the quantum of AMP expenses. However, in making this assertion, the Court did not delve into the issue of how an international transaction could be proved in the specific case of AMP expenses.
A path fraught with difficulties – absence of an express agreement
The impact of the assertion that an international transaction needs to be determined factually is noteworthy. Subsequent cases have shown tendencies of being fixated on written agreements. For instance, in BMW India (P) Ltd. v Deputy Commissioner of Income Tax [(2017) 190 TTJ 717 (Delhi) at paras 6–8, 19] the Court concluded positively as to the existence of an international transaction only because there were specific clauses in the agreement between the assessee and its foreign AE which mandated the performance of AMP functions. Further, in Yum Restaurants (India) (P.) Ltd. v Income Tax Officer [(2016) 380 ITR 637 (Delhi) at para 26] it was opined that the operating agreement between the assessee and its foreign AE needs to be carefully examined in order to establish an international transaction. While such an approach is congruous with the Sony Ericsson ratio rejecting the Bright Line Test, it risks being repugnant to the statutory provision itself.[11]
In a majority of cases, the Revenue’s attempts to show the existence of an international transaction seem to draw from the bright line test. Most decisions come to a negative finding as to the factum of an international transaction too, save for those rare instances when an express agreement between the assessee and its foreign AE exists. Such complications stem from the absence of a ‘machinery provision’ in the ITA, which was emphasized in Maruti Suzuki. Without a machinery provision, and without any assistance from the bright line method, the Revenue is forced to assess the taxpayer’s subjective intentions in the absence of an express agreement. The Revenue tried to infer such subjective intentions from the ‘benefit’ that foreign AEs receive from the performance of AMP functions. However, such an argument was also rejected in Maruti Suzuki. This quandary finds no recourse in the ITA, which gives no clarity as to whether a subjective assessment of parties’ intentions can be made at all, and if they can be made, what standards the Revenue would need to conform to.
The varied nature of businesses, business environment and contractual mechanisms employed by related parties pose yet another challenge to the Revenue. In the event of lack of an express agreement, a functional analysis of several factors has to be undertaken – the Indian entity may be a licensed manufacturer, a distributor, a manufacturer-cum-distributor or simply a marketing agent,[12] the contract may be long-term or short-term, with parties assuming high or low risk,[13] or the foreign AE may be a new entrant into the Indian market or a brand with considerable customer loyalty.[14] Thus, a simplistic approach such as the one taken by the Revenue in a majority of cases, will most definitely lend itself to arbitrariness. This also implies that there can be no set standard or straight-jacket formula for determining the existence of an international transaction involving AMP expenses, unless a clear statutory scheme accounting for different factors and encapsulating all checks against arbitrariness is framed.[15]
Conclusion
The legislative framework governing transfer pricing is fairly clear and straightforward. However, its inadequacy comes to light in case of AMP expenses, for it offers no guidance in situations where an express agreement does not exist. Sony Ericsson is definitely a step in the right direction, so far as it overruled the bright line test. The bright line test is fraught with difficulties and arbitrariness, both in terms of compatibility with the statute and commercial considerations. While the former has been explicated at length in Sony Ericsson, the latter has been given due consideration in Maruti Suzuki.
Sony Ericsson lays down various principles for the determination of the price of the transaction and the ALP, which are respectively the second and the third steps in a transfer pricing exercise. It does not, however, prescribe any guidelines for the determination of the existence of an international transaction, which is the first threshold to be satisfied. The Court categorically states what the Revenue should not do, but gives no clarity on what it should do. Thus, the current position with regard to the treatment of AMP expenses is clear to the extent that the bright line test cannot be employed in any manner or form; but confusion abounds in the manner of determining the existence of an international transaction.
Now that the issue of AMP expenses has reached the Supreme Court, a final word on the same is awaited. However, the extent to which the resolution of this issue falls within the appropriate role of the judiciary is uncertain. Unless a clear statutory scheme is prescribed, any effort by the Court to resolve the issue might run the risk of judicial legislation.
– Shannon Khalkho
[1] An entity would be a 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.” – LG Electronics, para 17.2.
[2] LG Electronics, para 9.10.
[3] LG Electronics, para 15.7.
[4] Sony Ericsson, para 52.
[5] Maruti Suzuki India Ltd. v Commissioner of Income Tax (2016) 381 ITR 117 (Delhi).
[6] The statutory framework is such that each of the steps must be satisfied in the order that they are enumerated.
[7] The Income Tax Act 1961, section 92B.
[8] The Income Tax Act 1961, section 92F(v).
[9] Maruti Suzuki, para 4–5.
[10] Maruti Suzuki, para 64.
[11] Section 92F makes it amply clear that the agreement, understanding or action in concert need not be formal nor in writing.
[12] Sony Ericsson, at para 115.
[13] Sony Ericsson, at paras 123–124.
[14] Sony Ericsson, at para 126.
[15] Maruti Suzuki, at para 75.
