Month: January

Introduced by Finance Act, 2012 and effective from 1st April, 2013, Section 56(2)(viib) of the Income Tax Act, 1961, provides for a specific category of income that shall be chargeable to tax under the head “Income from other sources”.

The article gives an in-depth analysis of the said section and Rule 11UA that prescribes certain modes of valuation. The author suggests that a literal interpretation of the provision may result in it failing to achieve its objective. Section 56(2)(viib) { introduced by Finance Act 2012 w.e.f 01-04-2013 } r.w.s. 2(24)(xvi), of the Income tax Act (‘the Act’) provides that where a closely held company issues shares to a resident, for an amount received in excess of the fair market value of the shares, then the said excess portion will be regarded as income of the Company and charged to tax under the head ‘Income from other sources’. The said fair market value is defined as higher of the value arrived at on the basis of the method prescribed under Rule 11UA of the Income-tax Rules, 1962 (‘the Rules’) or the value as substantiated by the Company to the satisfaction of the Assessing Officer under Explanation to section 56(2)(viib). The Company can substantiate the fair market value based on the value of the tangible and intangible assets and various types of commercial rights as stated in the section. The fair market value which may be determined under Rule 11UA and the determination of date of fair market value for the purpose of valuation is discussed separately in the ensuing paragraphs below. However, this provision will not apply to amounts received by a venture capital undertaking from a venture capital fund or a venture capital company, which terms have been defined in section 10(23FB) . Further, this provision will also not apply to amount received for issue of shares from a non-resident, a foreign company or from a class of persons as may be notified by the Government.

A better understanding of the aforesaid provisions a reference should be made to the Budget Speechby the Hon’ble Finance Minister and Notes on Clauses and Memorandum Explaining the provisions. which are reproduced at Annexure 1 separately. For section 56(2)(viib) to apply, the following conditions will have to be fulfilled:

• Recipient of consideration for issue of shares should be a closely held company i.e. a company in which the public are not substantially interested, referred to u/s. 2(18) of the Act;

 • Consideration received for issue of shares should be only from a person, who is resident and the consideration so received should exceed the face value of shares issued;

• Recipient must ‘receive’ income i.e. consideration in excess of fair market value for issue of shares in the previous year [i.e. relevant financial year]; and

• The share premium received (i.e. consideration received for value of shares issued which exceeds the fair market value of the shares), is charged as income and subjected to tax accordingly; Section 56(2)(viib) is one of the charging sections under the Act. The sections which provide for levy or charge should be strictly construed. The rule of construction of a charging section is that before taxing any person, it must be shown that he falls within the ambit of the charging section by clear words in the section. No one can be taxed by implication. Further, the word ‘receives’ as referred to in section 56(2)(viib) has been interpreted to mean: “The words ‘receives’ implies two persons – the person who receives and the person from whom he receives.”

However, it is equally true that mere receipt of money is not sufficient to attract tax. It is only on receipt of ‘income’ which would attract tax. Every receipt is not necessarily income. So, until the Company receives income as referred to in section 56(2) (viib) r.w.s. 2(24)(xvi), it cannot be taxed. In addition to above, it would be necessary to highlight the following exceptions and certain limitations, :

1. As regard to determination of the date as on which fair market value of the shares issued needs to be determined, the provisions of section 56(2)(viib) and Rule 11UA provide as under: Three modes of valuation are prescribed for determination of fair market value of shares for section 56(2)(viib), with each of them providing for different valuation dates i.e. the dates as on which the fair market value of the shares needs to be decided. While two modes of valuation are prescribed under Rule 11UA, one mode of valuation, which is generally subjective in nature, is prescribed under Explanation to section 56(2)(viib) of the Act: a. The subjective mode of valuation as prescribed under Explanation to section 56(2)(viib), provides for determination of fair market value of shares on the date of issue of shares. The said mode of valuation provides for applicability of any method to determine the fair market value of shares, as may be relevant, however it categorically requires satisfaction of the Assessing Officer to said determination of fair market value of shares; or b. Rule 11UA as mentioned above provides for two modes of valuation to determine fair market value of shares issued by the closely held company as on the valuation date. Recently, Rule 11UA(2) has been inserted and the term ‘valuation date’ was amended vide Notification No. 52 under Income-tax (Fifteenth Amendment) Rules, 2012 w.e.f. from 29th November 2012, which provides for the present two modes of valuation.

The term ‘valuation date’ is now defined under Rule 11U(j) as the date on which the consideration is received by the assessee for issue of shares. Rule 11UA(2) is specifically inserted to provide for determination of fair market value of shares u/s. 56(2)(viib) of the Act. Prior to the aforesaid amendment, Rule 11UA only provided for one method of valuation and the term ‘valuation date’ was also not defined to provide for cases covered u/s. 56(2) (viib). Further, Rule 11UA(2) provides for option to the Company to select for either mode of valuation as provided under Rule 11UA(2)(a) or Rule 11UA(2) (b) of the Rules. The said modes of valuation are explained in brief below and for better understanding :

(a) The said mode of valuation is generally based on the book value of the shares as on the latest audited balance sheet of the Company, subject to adjustments as provided for assets and liabilities of the Company. In other words, the fair market value (‘FMV’) of the shares of the Company are defined as under: FMV of unquoted equity shares = (Assets – Liabilities) x PV PE The term ‘assets’ and ‘liabilities’ as required to be considered with necessary adjustments are defined under the Rules, while PV stands for Paid up value of such equity shares and PE stands for total amount of paid up equity share capital of the Company as shown in the latest Audited balance sheet of the Company. So, the FMV of the shares under this method which is to be determined as on the valuation date, provides for consideration of values as on the latest Audited Balance sheet of the Company;

(b)    The second mode of valuation provides for FMV of the shares to be undertaken by Merchant banker or Fellow Chartered Accountant of ICAI as per the Discounted Free Cash Flow method. The second method is silent as regard to values based on which FMV needs to be computed. However, considering FMV of the shares needs to be computed as on the valua- tion date, therefore, Discounted Free Cash Flow Method will have to be determined as on valuation date i.e. date on which consideration is received by the Company for issue of shares.

So, in the light of the above discussions, it appears that the Legislature has provided for selection of either modes of valuation under Rule 11UA and selection of the highest FMV on comparison with the mode of valuation prescribed under Explanation to section 56(2)(VIib), based on which FMV of the shares issued by the Company are to be determined. However, the modes of valuation so prescribed are subject to various limitations and subjectiveness, some of which are referred above.

2.    Secondly, one finds that the taxable event of the income under discussion is based on receipt of consideration for issue of shares in the given financial year. So, it is imperative to understand the terms ‘consideration’ and ‘issue of shares’ as referred to in the section. However, the said terms are not defined under the Act.

The concept of ‘issue of shares’ could be better understood under the Indian Companies Act, 1956 (‘the 1956 Act’) with the help of the legal precedents under the 1956 Act which are referred in ensuing paragraphs who have explained the concept of ‘issue of shares’ in context of ‘allotment of shares’ as under:

“Under the Act [author’s note – i.e. Companies Act], a company having share capital is required to state in its memorandum the amount of capital and the division thereof into shares of a fixed amount. see Section 13(4). This is what is called the authorised share capital of the company. Then the Company proceeds to issue the shares depending on the condition of the market. That only means inviting applications for these shares. When the applications are received, it accepts them and this is what is generally called allotment…..

……The words ‘creation’, ‘issue’ and ‘allot- ment’ are used with the three different meanings familiar to business people as well as to lawyers. There are three steps with regard to new capital, firstly it is created, till it is created the capital does not exist. When it is created it may remain unissued for years, as indeed it was here, the market did not allow of favourable opportunity of placing it. When it is issued it may be issued on such terms as appear for moment expedient. Next comes allotment…

…Allotment means the appropriation out of the previously unappropriated capital of a company, of a certain number of shares to a person. Till such allotment, the shares do not exist as such. It is on allotment in this sense that the shares come into existence.”

The aforesaid legal proposition explaining the different stages of share capital of the Company are approved in the following legal precedents:
•    Florence Land and Public Works Company (1885)
L.R. 29 Ch.D. 421;

•    Mosely vs. Koffyfontain Mines Limited (1911) I.L.R. Ch. 73.84.;

•    Sri Gopal Jalan and Company vs. Calcutta Stock Exchange Association Ltd. (AIR 1964 SC 250); and

•    Shree Gopal Paper Mills Ltd vs. CIT (77 ITR 543) (SC);

Further, the Income tax Act, 1961 has been using the terms ‘issue of shares’ and ‘allotment of shares’ independently in different provisions at different points in time. So, the Legislature is aware of the differences between ‘issue of shares’ vis-a-vis ‘allotment of shares’ and their meanings and respective stages thereof in the share capital of the Company.

The word ‘consideration’, is defined under the Indian Contract Act, 1872 (‘the 1872 Act’) and could be considered for the purpose of understanding the meaning of the term, on account of absence of specific definition for under the Act. The word ‘consideration’ is defined u/s. 2(D) of 1872 Act as under:

“When at the desire of the promisor, the promise or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or to abstain from doing, something, such act or abstinence or promise is called a consideration of the promise.”

So, existence of promisor-promisee relationship is sine qua non for ‘consideration’ under the 1872 Act. In context of share transactions relating to the companies particularly on issue of shares, the determination of promisor-promisee relationship could be explained as under:

A share is a right to a specified amount of the share capital of a company with it certain rights and liabilities, while the company is a going concern and in the winding up. The promisor- promisee relationship shall not come into existence until the offer and acceptance of offer thereof in completed in a contract. So, in context of contract of shares of the Company with the proposed shareholders, the following steps take place:

•    Step 1: Initially, the Company makes an invitation of offer to the public in general for subscription of shares at a given price for the share and other relevant conditions. This stage is referred to as ‘issue of shares’ under the legal precedents above;

•    Step 2: Out of the said invitation of offer to public, the proposed shareholders upon having accepted the terms of conditions of issue of shares of the Company makes an offer to the Company for al- lotment of shares on payment of price referred in step 1; and

•    Step 3: The Company through its Board of Directors on receipt of offer from the proposed share- holders decide in their meeting for acceptance of said offers and thereby pass resolution and undertake other compliances viz. filing of return of allotment in favour of shareholders, who are selected from the list of proposed shareholders. This stage is referred to as ‘allotment of shares’ and it is at this stage, the relationship of promisor-promisee comes into existence and simultaneously definition of ‘consideration’ under the 1872 Act is satisfied.

So, at the time of issue of shares, the receipt of money from the proposed shareholders by the Company cannot partake the nature of consid- eration, since no promisor-promisee relationship exists between the proposed shareholders and the Company. The promisor-promisee relationship comes into existence at the time of ‘allotment of shares’ by the Company; which is a stage anterior to ‘issue of shares’.

In light of above averments, it may be possible to urge that the charging provisions of section 56(2) (viib) of the Act may fail to satisfy the taxable event provided therein at the time of ‘issue of shares’, because the receipt of money at the time of ‘issue of share’ fails to satisfy the definition of ‘consideration’ under the 1872 Act. Further, the condition of ‘consideration’ is satisfied only at the time of allotment of shares because the shares also come into existence at the said stage of share capital and accordingly the incidence of share premium [which is sought to be taxed u/s. 56(2)(Viib)] is also established at that stage and not at ‘issue of shares’.

Alternatively, one may want to debate that in light of the intention of the Legislature to tax the share premium received at the time of issue of share above the fair market value, the averments as referred in above paras may require reconsideration. One may want to dispute the above understanding of the ‘issue of shares’ and distinguish it for want of relevance restricted to Companies Act, 1956 and thereby giving the term ‘issue of shares’ as a general meaning instead. In light of said understanding, one may argue that charging provisions of section 56(2)(VIIB) are satisfied and share premium shall be taxed accordingly in the hands of the Company at the time of issue of shares.

So, until the Courts of India decide upon the issue and/or clarification on the above contrary interpretation of the provision is given by the Legislature, it would be difficult to reach to any conclusions. As a way forward until any clarity is received, on a conservative basis, one may want to suggest that advance tax and/or self assessment tax, as the case may be, be paid considering the alternative interpretation as discussed later [i.e. in the immediately preceding para above] for the income under consideration be taxed u/s. 56(2)(VIIB) and at the time of filing the return of income, one may take an aggressive position of not subjecting the income under consideration to tax and a suitable note substantiating the said position be disclosed in the return of income. With this there may be limited chances of penalty and interest provisions being attracted to the transaction at the time of assessment of the company in the income-tax proceedings.

Annexure 1

Relevant extracts of Budget Speech of Finance Bill, 2012

“Para 155.    I propose a series of mea- sures to deter the generation and use of unaccounted money. To this end, I propose:

(i)    ……,

(ii)    ……,

(iii)    Increasing the onus of proof on closely held companies for funds received from sharehold- ers as well as taxing share premium in excess of fair market value.”

Relevant extracts of Budget Speech while moving in amendments to Finance Bill, 2012 “It has been proposed in the Finance Bill, 2012 that any consideration received by closely held company in excess of fair market value would be taxable. Exemption is provided to angel investors who invest in start-up company”

Memorandum explaining the provisions of Finance Bill, 2012

“Share premium in excess of the fair market value to be treated as income…….Section 56(2) provides for the specific category of incomes that shall be chargeable to income- tax  under  the  head  “Income  from  other sources”…. The new clause will apply where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares. This amendment will take effect from 1st April 2013 and will accordingly apply in relation to AY 2013-14 and subsequent AYs”

Supplementary Circular explaining the amendments to the provisions of Finance Bill, 2012

“Company which receives any consideration for issue of shares and the consideration for issue of such shares exceed the fair market value of the share then the aggregate consideration received for such shares as exceeds the fair market value of the share shall be chargeable to tax”

Notes on Clauses to Finance Bill, 2012 “….Company receiving the consideration for issue of shares shall be provided an opportunity to substantiate its claim regarding the fair market value of shares”.

Transfer Pricing Litigation concerning Advertising marketing and sales promotion (AMP Expenses) and creation of Marketing Intangibles for the Foreign Associated Enterprise, has come to the fore in recent years. In the absence of statutory law on the subject, the law is getting developed purely through judicial pronouncements and the same is still at a very nascent stage.

 1. Overview

In a typical MNC business model, the Indian subsidiary acts as a distributor/provider of goods/services and incurs AMP expenses for the promotion of its products or services. The Assessees have contended that the AMP expense is incurred necessarily for the purpose of selling its products/services in the Indian market. In the past, there have been instances of the Tax Department not allowing a tax deduction for such expenses on the basis that the expenses promote the brand of the foreign Associated Enterprise (‘AE’) in India and resultantly since the expenses benefit the foreign AE such expenses should not be allowed as a tax deduction in the determination of taxable income of the Indian AE. Various judicial pronouncements have held that where the expenditure has been incurred for the purposes of business of the Indian company, the payment should be allowed as a deduction. Resultantly, the issue (incurring of AMP expenses and creation of Marketing Intangibles) has now entered the realm of transfer pricing controversy. The contention of the Tax Department has been that since the Indian company incurs expenses which benefit the foreign AE, the Indian company should be reimbursed for such expenses. In fact, the proposition has been that by promoting the brand in India, the Indian subsidiary is providing a service to the foreign AE, for which it should receive due compensation (which could be the recovery of expenses incurred plus an appropriate mark-up over and above such expenses). It is contended by the Tax Department that such advertisement and brand promotion expenses resulted in creation of marketing intangibles which belong to the AE and appropriate compensation for such advertisement and brand promotion expenses was required to be made by the Foreign AE. Accordingly, the Transfer Pricing Officers (“TPOs”) in India, applying the ‘Bright Line Test’ as laid down in the decision of US Tax Court in DHL Inc.’s case, have held that the expenditure on advertisement and brand promotion expenses which exceed the average of AMP expenses incurred by the comparable companies in India, is required to be reimbursed/ compensated by the overseas associated enterprise. The principle followed by the Tax Department is that the excess AMP expenditure incurred by the Indian AE contributes towards the development and enhancement of the brand owned by the parent of the multinational group (the foreign AE). This perceived enhancement in the value of the brand is commonly referred to as ‘marketing intangibles’. The issue for consideration here is that where an Indian AE is engaged in distributing branded products of its foreign AE, and the Indian AE incurs AMP expenditure for selling the products, whether such expenses have been incurred for marketing of the product or for building the brand of the foreign AE in India. The Tax Department ought to appreciate the difference between product promotion and brand promotion. Product promotion primarily targets an increase in the demand for a particular product whereas Brand Promotion results in creation of Marketing Intangibles. There have been many decisions (mainly Tribunal Decisions) which have discussed the aspect of AMP expenditure and TP adjustments in respect thereof which lead to creation of marketing intangibles for the foreign AEs who have derived benefits. However, the Tribunals in the decisions pronounced prior to the retrospective amendments made by the Finance Act, 2012, in this regard, have held that since the specific international transactions pertaining to AMP expenses have not been referred to the TPO by the Assessing Officer (‘AO’) the assumption of the jurisdiction by the TPO in working out the ALP of the AMP transaction is not justified. Furthermore, assessees, prior to the amendments introduced by Finance Act, 2012, have contended that marketing intangibles per se were not covered under the meaning of the term “international transaction”. However, the amendments brought by Finance Act, 2012 in the Indian Transfer Pricing Regulations empower the TPO to scrutinise any international transactions which the TPO deems fit and additionally, the definition of the term international transaction has been broadened to bring within its ambit provision of services related to the development of marketing intangibles.

2 Concept of Marketing Intangibles

Para 6.2 of Chapter VI of the OECD Transfer Pricing Guidelines 2010 (‘OECD TP Guidelines’) defines the term “intangible property” as “intangible property includes rights to use industrial assets such as patents, trademarks, trade names, designs or models. It also includes literary and artistic property rights, and intellectual property such as know-how and trade secrets.

Marketing Intangibles : Marketing intangibles generally refers to the benefits like brand name, customer lists, unique symbols, logos, distribution/dealership network etc. which are not normally measured or recognised in the books of account. Marketing intangibles are created over a period of time through brand building, large-scale marketing of product, distribution network etc.

3. TP Issues surrounding Marketing Intangibles/ AMP Expenses

The Transfer Pricing Issues surrounding Marketing Intangibles/AMP Expenses may be crystallized as follows:

i)    Whether when the assessee has incurred AMP expenses for promotion of brand belonging to its holding company, the Tax Department can make an addition against the assessee on account of royalty or brand development fee, computed on sales turnover and on excess AMP expenditure determined on the arm’s length principle?

ii)    Whether when the assessee has incurred AMP expenses for promotion of brand belonging to its holding company, the Tax Department is justified to apply the Bright Line Test for determination of Arms Length Price (ALP) of AMP?

iii)    Whether the Bright Line Test applied by the Tax Department for determination of ALP of AMP fit is an appropriate method?

4.    Origin of Dispute in USA – DHL Case

To understand the issue better, it would be relevant to look at the genesis of the transfer pricing con- troversy around marketing intangibles. This issue first came up for consideration in the case of DHL before the US Tax Court. This was primarily on ac- count of the 1968 US Regulations which propounded an important theory relating to ‘Developer-Assister rules’. As per the rules the developer being the person incurring the AMP spends (though not being the legal owner of the brand) was treated as an economic owner of the brand and the assister (being the legal owner of the brand), would not be required to be compensated for the use or exploitation of the brand by the developer. The rules lay down four factors to be considered:

• the relative costs and risks borne by each controlled entity
•  the location of the development activity
•  the capabilities of members to conduct the activity independently
•  the degree of control exercised by each entity.

The principal focus of these regulations appears to be equitable ownership based on economic expenditures and risk. Legal ownership is not identified as a factor to be considered in determining which party is the developer of the intangible property, although its exclusion is not specific. However, the developer-assister rule were amended in 1994, to include, among other things, consideration of ‘legal’ ownership within its gamut, for determining the developer/owner of the intangible property, and provide that if the intangible property is not legally protected then the developer of the intangible will be considered the owner.

However, the US TPR recognise that there is a distinction between ‘routine’ and ‘non-routine’ expenditure and this difference is important to examine the controversy surrounding remuneration to be received by the domestic AE for marketing intangibles.

In the context of the above regulations, the Tax Court in the case of DHL coined the concept of a ‘Bright Line Test’ (‘BLT’) by differentiating the routine expenses and non-routine expenses. In brief, it provided that for the determination of the economic ownership of an intangible, there must be a determination of the non-routine (i.e. brand building) expenses as opposed to the routine expenses normally incurred by a distributor in promoting its product.

An important principle emanating from the DHL ruling is that the AMP expenditure should first be examined to determine routine and non-routine expenditure and accordingly, if at all, compensation may be sought possibly for the non-routine expenditure.

5.  Origin of Dispute in India – Maruti Suzuki’s Case

It is pertinent to note that the Indian TPR does not specifically contain provisions for benchmarking of marketing intangibles created by incurring non-routine AMP spends. In the Indian context, the issue in respect of marketing intangibles was dealt extensively by the Delhi High Court in the case of Maruti Suzuki India Ltd vs. ACIT (2010-TII-01-HC-DEL-TP). In this case, the assessee, Maruti Suzuki India Limited (‘MSIL’), an Indian company had entered into a license agreement with Suzuki Motor Corporation (‘SMC’) for the manufacture and sale of automotive vehicles including certain new models. As per the terms of the agreement, MSIL agreed to pay a lump sum amount as well as running royalty to SMC as consideration for technical assistance and license. MSIL started using the logo of SMC on the cars and continued using the brand name ‘Maruti’ along-with the word ‘Suzuki’ on the vehicles manufactured by it. MSIL had also incurred significant AMP spends for promoting its products.

In connection with the AMP spends incurred by MSIL, the Delhi High Court laid down the following guidance:

•  If the AMP spends are at a level comparable to similar third party companies, then the foreign entity i.e. SMC would not be required to compensate MSIL.

•  However, if the AMP spends are significantly higher than third party companies, the use of SMC’s logo is mandatory and the benefits derived by SMC are not incidental, then SMC would be required to compensate MSIL.

However, it is important to note that the Supreme Court has directed the TPO to examine the matter in accordance with law, without being influenced by the observations or directions given by the Delhi High Court.

6.    Concept of Bright Line Test

6.1)    As discussed above, the US Tax Court in the case of DHL Inc., propounded the ‘Bright Line Test’ for distinguishing between the routine and non-routine expenditure incurred on advertisement and brand promotion. The US Tax Court in that case laid down that AMP expenses, to the extent incurred by uncontrolled comparable distributors is to be regarded within the ‘Bright Line limit’ of the routine expenses and AMP expenses incurred by the distributors beyond such ‘Bright Line limit’ constituted non routine expenditure, resulting in creation of economic ownership in the form of market intangibles which belong to the owner of the brand.

It may be noted that the aforesaid decision in case of DHL, sought to be relied upon by the Revenue for making adjustment on account of AMP expenses, applying Bright Line Test, was rendered in the con- text of a specific law, viz. Developer-Assister Rule, in US TPR (US Reg. 482-4). Similar provision for benchmarking of marketing intangibles allegedly created by incurring non-routine AMP expenses is not provided in the Transfer Pricing Regulations in India.

6.2 OECD’s  Position:

Paragraph 6.38 of the OECD Guidelines on Transfer Pricing read as follows:

“6.38 Where the distributor actually bears the cost of its marketing activities (i.e., there is no arrangement for the owner to reimburse the expenditures), the issue is the extent to which the distributor is able to share in potential benefits from those activities. In general, the arm’s length dealings the ability of a party that is not the legal owner of a marketing intangible to obtain the future benefits of marketing activities that increase the value of that intangible will depend principally on the substance of the rights of the party. For example, a distributor may have the ability to obtain benefits from its investments in developing the value of a trademark from its turnover and market share where it has a long term contract of sole distribution rights/or the trademarked product. In such cases, a distributor may bear extraordinary marketing expenditures beyond what an independent distributor in such a case might obtain an additional return from the owner of a trademark, perhaps through a decrease in the purchase price of the product or a reduction in royalty rate.”

The Transfer Pricing regulations in India being, by and large, based on OECD Transfer Pricing guidelines, the said guidelines are usually referred to in explaining and interpreting the Transfer Pricing provisions under the Income-tax Act to the extent that they are pari materia with the OECD guidelines. However, the recommendations of the OECD guidelines could not be applied in absence of a specific enabling provision or method provided under the Transfer Pricing Regulations in India to deal with such extraordinary marketing expenditure.

7.    Special Bench Decision in the case of L.G. Electronics: (2013) 29 taxmann.com.300

The Special Bench of the Income Tax Appellate Tribunal, Delhi (“the Tribunal”) held by majority that the advertising, marketing and promotion (“AMP”) expenses incurred by a assessee constitute an “in- ternational transaction” and that bright line test is acceptable for determining the arm’s length price (“ALP”) of such transactions. It further held that while expenses incurred directly on promotion of sales, leads to brand building, the expenses in connection with sales are only sales specific and are not a part of AMP expenses.

Facts:
•    L.G. Electronics India Private Limited (“the assessee”) is a subsidiary of L.G. Electronics Inc., Korea (“the AE”). Pursuant to Technical Assistance and Royalty agreement, the assessee obtained a right from the AE to use technical information, designs, drawings and industrial property rights for the manufacture, marketing, sale and services of agreed products, for which it agreed to pay royalty @ 1 per cent. The AE allowed the assessee to use its brand name and trademarks to products manufactured in India “without any restriction”.

•    The Transfer Pricing Officer (“TPO”) concluded that the assessee was promoting LG brand as it had incurred expenses on AMP to the tune of 3.85% of sales vis-à-vis 1.39% incurred by a comparable. Accordingly, TPO held that the assessee should have been compensated for the difference.

•    Applying the Bright Line Test, the TPO held that the expenses in excess of 1.39 % of the sales are towards brand promotion of the AE and proposed a transfer pricing adjustment.

•    The Dispute Resolution Panel (“DRP”) not only confirmed the approach of the TPO, but also directed to charge a mark-up of 13 % on such AMP expenses towards opportunity cost and entrepreneurial efforts.

Issues:
•    Whether transfer pricing adjustment can be made in relation to advertisement, marketing and sales promotion expenses incurred by the assessee?

•    Whether the assessee ought to have been compensated by the AE in respect of such AMP expenses alleged to have been incurred for and on behalf of the AE?”

Observations & Ruling

The Tribunal has held as follows:

•    Confirmed validity of jurisdiction of the TPO by observing that the assessee’s case is covered u/s. 92CA(2B) of the Income Tax Act, 1961 (‘the Act’) which deals with international transactions in respect of which the assessee has not furnished report, whether or not these are international transactions as per the assessee.

•    The incurring of AMP expenses leads to promotion of LG brand in India, which is legally owned by the foreign AE and hence is a transaction. The said transaction can be characterised as an inter- national transaction within the ambit of Section 92B(1) of the Act, since (i) there is a transaction of creating and improving marketing intangibles by the assessee for and on behalf of its AE; (ii) the AE is non-resident; and (iii) such transaction is in the nature of provision of service.

•    Accepted Bright Line Test to determine the cost/value of the international transaction, in view of the fact that the assessee failed to discharge the onus by not segregating the AMP expense incurred on its own behalf vis-à-vis that incurred on behalf of the AE.

•    The transfer pricing provisions being special pro- visions, override the general provisions such as section 37(1) / 40A(2) of the Act.

•    For determining the cost/value of international transaction, selection of domestic comparable companies not using any foreign brand was relevant in addition to other factors.

•    The Supreme Court of India in Maruti Suzuki’s case examined the issue of AMP expenses where it directed the TPO for a de novo determination of ALP of the transaction. The direction by the Supreme Court recognises the fact of brand building for the foreign AE, which is an international transaction and the TPO has the jurisdiction to determine the ALP of the transaction.

•    The expenses incurred “in connection with sales” are only sales specific. However, the expenses “for promotion of sales” leads to brand building of the foreign AE, for which the Indian entity needs to be compensated on an arm’s length basis by applying the Bright Line Test.

•    With regard to the DRP’s approach, of applying a mark-up on cost for determining the ALP of the international transaction, on the ground that the same has sanction of law under Rule 10B(1)(c)(vi) of the Income Tax Rules, 1962 WAS accepted.

•    The case was set aside and the matter was restored to the file of the TPO for selection of appropriate comparable companies, examining effect of various relevant factors laid down in the decision and for the determination of the correct mark-up.

8.    Chennai ITAT decision in the case of Ford India Pvt. Ltd (2013-TII-118-ITAT-MAD-TP)

The Chennai Bench of the Tribunal, in the case of Ford India Private Limited, followed the Special Bench ruling in the case of LG Electronics India Pvt. Ltd (supra) in applying Bright-Line Test (BLT) to arrive at the adjustment towards excess AMP expenditure. Further, the Tribunal ruled that the expenditure directly in connection with sales had to be excluded in computing the AMP adjustment. The Tribunal deleted the hypothetical brand development fee adjustment computed at 1 % of sales made by the TPO, and provided relief upto 50 % with respect to adjustment made by the TPO for Product Develop- ment (PD) expenditure held as recoverable from the parent company.

Though the Tribunal has relied on the Special Bench decision in the case of LG Electronics India Pvt. Ltd on issues of principle, the distinguishing facts between the assessee and LG Electronics India Pvt. Ltd were analysed thoroughly and the Tribunal has passed a speaking order.

On selection of comparables, the Tribunal has agreed with the assessee’s contentions that the comparables selected by the TPO were not comparable to the assessee, and has stated that such comparables selected (same as in the Maruti ruling – Tata Motors, Mahindra and Hindustan Motors) were not appropriate. Interestingly, the Tribunal has further stated that even the same comparables provided in the Maruti ruling can be considered, with proper adjustments carried out on the figures for making good the deficiencies noted in such comparables.

The Tribunal has disregarded the concept of add on brand value on normal sales and add on brand value on additional sales brought by the tax department to justify two additions in relation to brand building, and deleted the brand development fees computed at 1 % of sales. However, in relation to adjustment towards product development expenditure, the Tribunal has not provided the rationale behind the 50 % adjustment in the hands of the assessee.

9.    Delhi ITAT decision in the case of BMW Motors India Pvt. Ltd. (2013-TII-168-ITAT-DEL-TP)

In a recent decision in the case of BMW Motors India Pvt. Ltd., the Delhi Bench of Tribunal has distinguished the Special Bench Ruling in case of LG Electronics India Private Limited vs. ACIT (2013) 29 taxmann.com.300 (‘SB Ruling’) with regard to issue of marketing intangibles in the context of a distributor. The Tribunal adjudged that if the distributor was sufficiently compensated by the foreign principal through the pricing of products, i.e. through higher gross margins, the same would have catered to extra AMP expenses, if any, spent by the distributor as compared to the comparables. Accordingly, no separate compensation in the form of reimbursement of excess AMP expenses was required from the principal when the assessee was already earning premium profits as compared to comparables with similar intensity of functions.

The Tribunal acknowledged that in absence of a specific provision in Income – tax Act, the Tax Department could not insist that the mode of compensation for AMP expenses by foreign principal to Indian assessee (who is a distributor) necessarily be direct reimbursement and not pricing adjustment. The said remuneration for extra AMP could well be received through the pricing of imported products, namely through a commensurately higher gross margin.

After a spate of negative rulings on the issue of marketing intangibles following the SB Ruling in the case of LG Electronics (supra), this is the first favour- able ruling on marketing intangibles at the Tribunal level. In terms of key takeaways, the following points which have been acknowledged by the Tribunal in the instant ruling are worth a mention:

•    In the first ruling of its kind, the Tribunal has upheld the contention that no separate compensation is needed for excessive AMP expenditure, when the distributor receives sufficient profits/ rewards as part of the pricing of goods imported from its foreign principal.

•    The Tribunal has upheld the contention that a judgement or a decision considered as a binding precedent necessarily has to be read as a whole. To decide the applicability of any section, rule or principle underlying the decision or judgement which would be binding as a precedent in a case, an appraisal of the facts of the case in which the decision was rendered is necessary. The scope and authority of a precedent should not be expanded unnecessarily beyond the needs of a given situation.

•    The Tribunal acknowledged that transfer pricing litigation and adjudication is a fact-intensive exercise which necessarily requires due consideration of the assessee’s business model, contractual terms entered into with the AEs and a detailed FAR analysis, so as to appropriately characterise the transactions and the business model. The Tribunal has also supported the fact that there can be no straitjacket to decide a transfer pricing matter.

•    The Tribunal has dwelt on this aspect and categorically acknowledged existence of a fine line of distinction between the FAR profiles of a manufacturer vis-à-vis that of a distributor. Consequently, the remuneration model and the transfer pricing analysis for one could vary from the other.

•    The Tribunal also affirmed that in the absence of suitable aids or guidelines in the Indian tax laws or jurisprudence, there is no bar/prohibition to refer to international jurisprudence/guidelines.

The Tribunal has made an important distinction on the AMP issue for a distributor from that of a licensed manufacturer. While drawing the distinction in the facts of the assessee with that of the LG India’s case, the Tribunal has provided commendable clarification on how the typical AMP issue for distributors is to be analysed.

The Tribunal’s ruling that premium profits earned by the assessee, a distributor, compensates for the excessive AMP expenditure is distinguished from the contrary findings in the case of LG India, wherein the SB held that entity level profits do not benchmark all the international transactions of LG India and that a robust profit margin at entity level would not rule out AMP expense adjustment.

The findings of the Tribunal in this case is a greater acceptance of the well accepted international practice incorporated in the OECD Transfer Pricing Guidelines, the ATO’s Guidelines (Australian Tax Office) related to Marketing Intangibles and the OECD Discussion Draft on Intangibles. Transfer pricing litigation and adjudication being fact based, necessarily requires consideration of the business model of the assessee and the contractual terms with AEs, along with a detailed FAR analysis to characterise the transactions. The Tribunal’s consideration of and reliance on the same for distinguishing this case from the LG India’s case, underscore the importance of an extensive FAR analysis, inter-alia, for the AMP issue.

The Tribunal made an important observation that the orders and judgments of co-ordinate division benches or special benches of the Tribunal, or the High Court and Supreme Court, particularly in transfer pricing adjudication cannot necessarily always be taken as a binding precedence ‘unless facts and circumstances are in pari material in a case cited before the court’.

It is worth noting that in a later decision in the case Casio India Co. Pvt. Ltd. [TS-340-ITAT-2013(DEL)-TP] a distributor of Watches and Consumer Information and other other related products of Casio Japan, in India, the Delhi Tribunal has expressly dissented from the coordinate bench’s decision in the case of BMW India Pvt. Ltd. and has followed SB decision in the case of LG Electronics. In Casio’s case, the Tribunal observed that the special bench decision in the case of L.G. Electronics is applicable with full force on all the classes of the assessees, whether they are licensed manufacturers or distributors, whether bearing full or minimal risk; that special bench order has more force and binding effect on the division bench order in BMW India’s case on the same issue.

10.    Scope of/exclusions from, AMP Expenses

In Canon India vs. DCIT (2013-TII-96-ITAT-DEL-TP),
the Delhi Tribunal relying on Special Bench Ruling in case of L.G. Electronics (supra) and Chandigarh Tribunal’s Ruling in the case of Glaxo Smithkline Consumer Healthcare Ltd. [TS-72-ITAT-2013 (CHANDI)-TP/2013-TII-71-ITAT-CHD-TP] held that, while computing TP Adjustment for marketing intangibles, expenses on Commission, Cash Discount, Volume Rebate, Trade Discount etc. and AMP Subsidy received by the assessee from the Parent Company should be excluded from the total AMP Expenses. In Glaxo’s case, the Chandigarh Tribunal also held that the Con- sumer Market Research Expenses and AMP Expenses attributable to various domestic brands owned by the assessee should be excluded from the ambit of AMP Expenses and no adjustment is required to be made in respect of the same. Similarly, in Maruti Suzuki India Limited (2013-TII-163-ITAT-DEL-TP), the Delhi Tribunal held that the expenditure in connection with sales cannot be brought within the ambit of AMP Expenses.

In order to avoid unnecessary confusion and consequent litigation, the assessees should be very careful in properly accounting for various sales related expenses and adequately documenting and distinguishing the same from various AMP Expenses, which are subject matter of TP Adjustments.

11.    Conclusion

One of the most challenging issues in transfer pricing is the taxation of income from intangible property. The OECD Transfer Pricing Guidelines recognise that difficult TP problems can arise when marketing activities are undertaken by enterprises that do not own the trademarks they are promoting. According to the Guidelines, the analysis requires an assessment of the obligations and rights between the parties. The United Nations Practical Manual on Transfer Pricing for Developing Countries – released in 2013 (UNTPM) also states that marketing related activities may result in the creation of marketing intangibles depending on the facts and circumstances of each case. The Chapter of the UNTPM dealing with Emerging TP Challenges in India however is more explicit when it states that an Indian AE needs to be compensated for intangibles created through excessive AMP expenses and for bearing risks and performing functions beyond what an independent distributor with similar profile would incur or perform.

While the SB ruling in case of L.G. Electronics does not seem to have specifically dealt with the issue in light of the above principles, some of the concepts articulated by the OECD Guidelines and the UNTPM may be implicit in the factors identified by the SB for undertaking a comparability analysis. These principles may also be inferred by the Delhi High Court decision in the case of Maruti Suzuki. The SB does not seem to have discussed the key issue of who benefits from the AMP spend incurred by the Assessee, even assuming it is excessive – i.e., the Assessee or the foreign AE. The SB has also not ad- dressed the issue of whether the benefit, if any, to the foreign AE may largely be incidental. However, by recognising that the Delhi High Court ruling in the case of Maruti Suzuki is still relevant, it would appear that these principles that were enunciated by the High Court would also need to be given due consideration while examining the issue.

It is important to note that the SB has also rejected a mechanical application of the bright line test by a mere comparison of the AMP to sales ratios. It may be noted that the level and nature of AMP spending can be affected by a variety of business factors, such as management policies, market share, market characteristics, and the timing of product launches.

The benefits of the AMP spend may also be realised over a period of time, even though from an account- ing perspective the amounts are expensed in the year in which they are incurred. Further, the ‘bright-line’ between routine and non-routine AMP expenses could vary for each industry and even within the same industry it could be quite company specific.

The SB’s ruling relies extensively on the facts particularly relevant to the Assessee in this case and therefore its impact on other assessees may need to be examined based on their specific facts. The applicability of a transfer pricing adjustment for AMP expenses may arise where there is influence of an AE in advertising and marketing function of the Indian affiliate. Further, the quantification of excessive AMP expenditures may also not necessarily be based on a bright line test if assessees are able to provide information related to brand promotion.

Transfer pricing aspects of marketing intangibles has been the focus of the Indian tax authority for the last few years. In light of the above, it would be useful for multinational enterprises with Indian affiliates to review their intra-group arrangements relating to sales and marketing and use of trademarks/ brand names in light of the judicial pronouncements.

In the interest of reducing avoidable, time consuming and costly litigation which benefits nobody and for providing certainty to foreign investors and encouraging inflow of much needed FDI, the Finance Ministry should issue necessary detailed fair, reasonable and equitable/balanced guidelines with suitable illustrations and examples on the lines of Australian Tax Office’s Guidelines or bring in necessary statutory amendments in Indian Transfer Pricing Regulations. The Guidelines/Statutory Amendments should be framed keeping in mind the business realities which Foreign Businessmen have to face in India; particularly the fact that, in view of accelerating changes in technology, the shelf life of a product or service is very short, such that an Electronic Product (Smart- phone, Tablet, Laptop etc.) tends to get outdated within 6-9 months of its launch. This necessitates recoupment of expenditure on product research and development by garnering significant level of market share, in a very short time by means of aggressive expenditure on advertisement, marketing and sales promotion, leaving the competition well behind.