A Special Bench of the Income Tax Appellate Tribunal ('ITAT') has ruled on several crucial issues in L.G. Electronics India Private Limited v. Assistant Commissioner of Income Tax1 which are likely to have tremendous bearing on commercial transactions between an Indian Taxpayer and a foreign Associated Enterprise ('AE') or even an unrelated third party in an international transaction as per the Income Tax Act, 1961 ('IT Act'). The majority opinion2 ('ITAT Ruling') has laid down tests regarding the degree and extent of enquiry in ascertaining the extent of influence of an AE over the Taxpayer, test to be applied to ascertain whether a transaction is an international transaction, valuation for the purpose of transfer pricing, questions to be determined for determination of cost or value of international transaction of brand/logo promotion through advertising, marketing and promotion expenses ('AMP expenses') and application of the various methods of computation. The questions of law before the ITAT were:
"1. Whether, the Assessing Officer was justified in making transfer pricing adjustment in relation to advertisement, marketing and sales promotion expenses incurred by the assessee?
2. Whether the Assessing Officer was justified in holding that the assessee should have earned a mark-up from the Associated Enterprise in respect of AMP expenses alleged to have been incurred for and on behalf of the AE?"
The ITAT Ruling broadly charts out the scope of enquiry to be undertaken in respect of AMP Expenses and upholds the line of enquiry adopted by the Income Tax Department ('Department') and remands the matter to the Transfer Pricing Officer ('TPO') to complete his enquiry in line with the principles identified in the ITAT Ruling. The incurrence of AMP expenses which includes advertisement expenses that can be attributed to brand / logo of the AE have far reaching consequences in the context of transfer pricing transaction and could potentially lead to disallowance, if such expenses also do not meet the test of being reasonable expenditure incurred under arms-length valuation.
L.G. Electronics India Private Limited ('LGI / Taxpayer'), a wholly owned subsidiary of L.G. Electronics Inc. ('LGK') a Korea based company, engaged in the manufacture, sale and distribution of electronic products and electrical appliances had entered into a mutual foreign collaboration agreement in 1997 and technical assistance and royalty agreement in 2001. Through these agreements LGI as licensee obtained rights to use 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 subject to a royalty of 1% as consideration. Although use of LGK's brand name and trademark was without the payment of royalty, a clause provided for payment of royalty at the desire of LGK at any future date.
The AO referred the transaction to the TPO who held that LGI had received contribution from LGK for expenses incurred by LGI in connection with the expenditure incurred on sponsorship of Global Cricket events. The quantum of contribution was considered as a part of contribution for the brand promotion carried by LGI on behalf of LGK. The TPO computed the AMP expenses at 3.85% of its sales which was above the mean percentage of 1.39% spent by firms engaged in similar activities.3 Applying the 'bright line'test as laid down by the United States Court of Appeal in DHL Corporation & Subsidiaries v. Commissioner of Internal Revenue4, the TPO held that the expenses above 1.39% was incurred for promotion of LGK's brand and consequently, warranted transfer pricing adjustment. In the appeal before the DRP, the DRP concurred with the AO's disallowance and calculated a mark-up of 13% on expenses. LGI thereafter appealed to the ITAT which disposed of the appeal by answering the questions framed above in favor of the Department and remanding the matter for fresh consideration by the TPO.
Issues before the ITAT
In terms of the submissions made by the parties before the ITAT several issues, including jurisdiction of the TPO, scope of inquiry, definition of 'international transaction', scope of inquiry for valuation among other issues arose for consideration.
1. Meaning of 'Transaction'
The Taxpayer contended that to invoke the provisions of transfer pricing there should be 'transaction' between LGI and LGK. The Taxpayer argued that with regard to the incurring of AMP expenditure there was no formal or written understanding between them and the expenditure was purely for promoting its business in India. Further, LGI had contended that the AMP expenses were paid to third parties who were not AE and hence the transaction was not an international transaction. It was contended that these transactions were undertaken by LGI at its sole discretion and on a commercial basis. The Department argued that the AMP expenses incurred by the Taxpayer was more than the normal standards and to the extent of the additional expenses incurred by the Taxpayer was to promote the brand and logo of the foreign AE which in effect amounted to provision of services. The ITAT held that the definition of 'transaction'5 includes an arrangement, understanding or action in concert, whether or not it is formal or in writing; or intended to be enforceable by legal proceeding. It further held that while the Taxpayer could decide how much expense was to be incurred to carry on his business smoothly, it had to be determined whether there was any arrangement and for that purpose to ascertain whether an independent enterprise behaving in a commercially rational manner would incur expenses to the extent the taxpayer has incurred. Based on the facts of the case, the ITAT concluded that the Taxpayer had incurred expenses proportionately more than that incurred by independent enterprises behaving in a commercially rational manner which therefore resulted in promotion of the brand legally owned by the foreign AE and therefore, there was a 'transaction' between the Taxpayer and the foreign AE.
The ITAT Ruling notes that while the separate legal identity of the taxpayer and the AE cannot be ignored the degree of influence of one entity over the dealings of the other will have to be ascertained at a transactional level while applying ALP.6
Further, the ITAT held that re-characterization of the transaction was permissible7 (a) where the economic substance of a transaction differs from its form and (b) where the form and substance of the transaction are the same but the arrangements made in relation to the transaction viewed in their totality differ from those which would have been adopted by the individual enterprise behaving in a commercially rational manner and towards this end, independence of the taxpayer in relation to its transactions with its AE would have to be ascertained.
However, the ITAT declined to accept the argument of the Department that the mere fact of the taxpayer incurring proportionately higher amount on advertisement than its comparables, conclusively established that some of the advertisement expense was incurred towards brand promotion for the foreign AE.
2. Scope of International Transaction
In the context of AMP expenses, the Taxpayer contended that expenses incurred on brand promotion could provide certain benefit to an AE and that such incidental benefit that accrued to an AE ought not to entail classification of the transaction as an international transaction.8 Further, the taxpayer contended that the expenses were admittedly paid to third parties who were not AE and consequently the same could not be international transaction.
The ITAT Ruling held that there are three requisites for international transaction:
- There must be a transaction,
- The transaction must be between two or more AEs, either of who must be non-residents, and,
- The transaction must be of the nature specified in section 92B of the IT Act.
The ITAT held that brand building by a taxpayer is a transaction for the purpose of section 92B of the IT Act.9 The ITAT held that incurring additional expense for the foreign AE for brand building is 'provision of service' and it is not necessary that the transaction for provision of service should be entered in the regular course of business.
3. Relation between section 37, section 40A (2) and section 92
It was argued by the Taxpayer that any sum disallowed under section 92 should be allowed as a deduction under section 3710 as the Department could not interfere with reasonable business expenses. The Taxpayers also sought to contend that payments which were 'wholly' and 'exclusively' for the purpose of business could not be disallowed under section 40A(2).11 Section 40A(2) provides for disallowance of excess deductions claimed in respect of payments made to certain related parties. However this contention was rejected on the basis that the scope of section 40A(2) and section 92 were completely different and were held to be operational in their respective fields of operation. Section 92 being a special provision was applicable to international transactions whereas section 40A (2) was general in nature. It was further held that disallowance under section 37 was premised on whether an item of expense was for the business of the taxpayer or not – however what was considered in the present case was that expenses incurred by taxpayer were for benefit of its AE and hence were to be disallowed.
Reliance was placed on a Department Circular12 to reason that the onus was on the taxpayer to determine the ALP and substantiate the same with documents. If a taxpayer is able to discharge such onus, there will be no intervention by the Department. Thus, the ITAT Ruling concludes that section 40A(2) determines reasonableness of expenditure while section 92 questions the very admissibility of the expenditure. Section 37 would also not provide relief since the expenses in question are disallowed on the ground that the same are not for the business of the taxpayer.
4. Relevant factors for determining cost/value of international transaction of AMP expenses
The submissions of LGI regarding identifying comparable cases was accepted by the ITAT and it was held that it was necessary to first choose proper comparable cases before engaging in the exercise of making comparison of AMP expenses and then to remove the effect of difference on account of various factors identified as between the case of the comparable case and the taxpayer by making appropriate adjustments.13 The ITAT held that if a taxpayer had not declared any cost or value of the international transaction in the nature of brand building and in the absence of any assistance from the taxpayer in determining such cost or value, the Department was justified in finding out such AMP expenses incurred by the taxpayer. The ITAT laid down the following method in determining such cost or value:
- Logically 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 taxpayer
- Discovering the amount of AMP expenses incurred by the taxpayer for its business purpose by applying the above percentage of comparable cases to taxpayer's sales
The amount coming up as per the last step is the cost or value of such international transaction. The ITAT explained Bright Line Test as the amount on one side of the bright line is the amount of the AMP expense incurred in the normal course of business and the remaining amount is for and on behalf of the foreign AE towards creating or maintaining its marketing intangible. In the present case, the ITAT held that the TPO had not properly considered the facts of comparable cases and relevant factors for determining cost/value of international transaction.
Although the Department contended that expenses for the promotion of sales and expenses in connection with sales were the same, the ITAT Ruling clarified that AMP expenses would not include selling expenses and expenses incurred in connection with sale.
The ITAT Ruling noted that there could be circumstances were a taxpayer incurred expenses on behalf of its AE and in such cases the onus was on the taxpayer to demonstrate that expenses were for its own benefit and not for benefit of its AE. Since a difficulty would arise where there was no separation, the ITAT Ruling notes that the absence of an express agreement between the AE and a taxpayer would not preclude the Department from separating expenses incurred by the taxpayer. The ITAT Ruling acknowledges the importance of a mechanism to separate such expenses and notes that the reliance placed by the Department on the bright line test laid down in DHL Corporation & Subsidiaries, was liable to be rejected as not being per se applicable under the IT Act. However, since the Taxpayer did not provide a mechanism for separation of such costs, the onus fell on the Department. The ITAT Ruling notes that in substance the TPO sought to ascertain the cost/value of the international transaction and as such the nomenclature of test applied would not make a difference. Consequently, it was held that even if bright line test was applied to ascertain the cost/value of the international transaction, the same could be permissible. Therefore, where the taxpayer fails to provide a basis for separating costs incurred in connection with AMP expenses, the onus would be on the TPO to ascertain value of such transaction on a rational basis.
The ITAT explained that the Transactional Net Margin Method ('TNMM') provides for benchmarking of 'an international transaction' by considering the operating profit from the concerned international transaction vis-ŕ-vis certain base such as total cost, sales, capital employed, etc. The term 'transaction' includes a number of closely linked transactions. 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 taxpayer as a whole on entity level. In short, the ITAT encouraged a segment-wise analysis of each international transaction of the comparables before applying to the taxpayer's transaction. Further, the ITAT held that only one of the five methods could be used to determine the ALP as prescribed in the statute and rejected Department's contention that one or more of the five methods could be used to determine the ALP.
The ITAT Ruling also noted that section 92(3) contemplated ALP in respect of 'a transaction' and hence the transfer pricing mechanism was to operate at the transactional level and not at the level of the entity.
6. Permissibility of mark-up
The DRP had applied mark-up of 13% to the cost/value of international transaction. The ITAT Ruling holds that this was essentially an application of the cost plus method of valuation.14 The ITAT Ruling notes that the matter has been remanded back to the TPO for determination in the case of LGI regarding appropriate factors for consideration and the correct ALP, however, there was nothing in law that prevented the Department from applying a particular mark-up.
The ITAT Ruling seeks to draw a balance between two enterprises and protecting the interest of Revenue under the IT Act. The ITAT Ruling has attempted to set out extensively the extent of review that can be undertaken by an AO and the consequential computational adjustment to be made. Broadly, the onus is on the taxpayer to show that the transaction undertaken is at arm's length and if the taxpayer is unable to satisfy the queries of the AO, the AO will have the right to make necessary computations. The ITAT Ruling rightly gives the taxpayer the prerogative of deciding how much expenditure is required for a particular activity and that the Department cannot second guess such expenses. By identifying clear and unambiguous factors to establish relation/ influence between a taxpayer and its AE, the ITAT Ruling has ensured that there is clarity in the application of the IT Act. The identification of preliminary burden of proof and the principles on which the onus shifts from the taxpayer to the AO would ensure that a taxpayer can accordingly prepare documents while entering in cross-border transactions and putting its case before the Department.
However, the ITAT Ruling may be faulted for its analysis regarding the benefit that accrues to a taxpayer on account of expenditure in relation to brand/promotion expenses of an AE. The analysis by the ITAT in the case related to LGI is conjectural as there is no correlation between the expenses incurred by the Taxpayer and benefit accrued to LGK. The requirement for separation of expenses on the basis that they are incurred for the taxpayer or are attributable to an AE ignores the fact that there is no way of establishing that AMP expenses are not beneficial for a taxpayer. The ITAT Ruling requires a taxpayer to prove the negative which is factually not possible. This conclusion also ignores the fact that under intellectual property regime in India, it is essential for multi-national corporations to have their trademark displayed along with the trademark of the Indian entity.
However, substantially, the ITAT Ruling would be beneficial for taxpayers as there is clarity in the manner of application of the provisions of the IT Act and further, guidelines with respect to exercise of discretion by the Department. These observations in the ITAT Ruling will help taxpayers plan accordingly and present their case better before the Department.
1 ITA No. 5140/Del/2011, Assessment Year 2007 – 2008
2 The dissenting opinion of Hari Om Mehta, Ld. Judicial Member, differs in reasoning and conclusion answering both questions framed above in favor of the Taxpayer and against the Income Tax Department.
3 Videocon and Whirlpool were considered similarly placed. However, in para 17.6, the ITAT Ruling rejects the comparative analysis of the Department and accepts the Taxpayer's contention about the necessity of choosing properly comparable cases.
4 76 T.C.M. (CCH) 1122.
5 Section 92F(v).
6 Pertinently, in the case of LGI the ITAT Ruling notes, at para 12.4 and para 12.6 that LGI was following brand and advertising strategies broadly conceived by LGK and importantly, advertising the products of LGI and LGK.
7 CIT v. EKL Appliances Ltd. (2012) 345 ITR 241 (Del.).
8 Para 9.3 of the ITAT Ruling.
9 Para 9.10 of the ITAT Ruling.
10 Section 37 of the IT Act provides for deduction of expenses incurred by the taxpayer which are wholly and exclusively for the purpose of business.
11 CIT v. Nestle India Limited (2011) 337 ITR 103 (Bom.).
12 Circular No. 214 of 2001, para 15.12.
13 The ITAT identified possible questions to determine the cost / value of brand/promotion through AMP expenses:
Whether the taxpayer is a distributor or licenced manufacturer for its AE?
Whether the taxpayer is selling the goods purchased from the foreign AE as such or making value addition to such goods?
Whether the brand logo of the AE is used on goods sold by the taxpayer?
Whether the goods sold bear logo only of foreign AE or of taxpayer as well?
Whether the taxpayer is paying any as consideration for the use of the brand/logo of its AE?
Whether the royalty payment to the AE is comparable with payments by other domestic entities to independent foreign parties.
Where the taxpayer is a licenced manufacturer, whether it is also using any technology or technical input or technical knowhow acquired from its AE for manufacturing?
Where the taxpayer is using technical know-how and is paying any amount to the foreign AE, whether the payment is only towards fees for technical services or includes royalty part for the use of brand name or brand logo also?
Whether the foreign AE is compensating the taxpayer for promotion of its brand directly or indirectly?
Where such compensation is made by foreign AE, whether it is commensurate with the expenses incurred by taxpayer on promotion of brand for foreign AE?
Whether the foreign AE has its presence in India only in one field or different fields and relation of taxpayer to AE with respect to other fields?
The number of years of operation of taxpayer in India and number of years it has been engaged in the relevant transaction with its AE.
Whether new products were launched in India during the relevant period or is it continuation of the business with the existing range of products?
How the brand will be dealt with after the termination of agreement between AEs?
14 Rule 10B(1)(c)(iv).
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