India: SKP Transfer Pricing 360˚ Volume 4 Issue 1 | Apr-Jun 2017

Last Updated: 11 August 2017
Article by SKP  

Evolving outlook of tax authorities towards marketing intangibles

The issue on excessive advertisement and marketing has gradually evolved over the last decade in India and gained prominence due to India's unique market specific characteristics, viz location advantage, huge market base, etc.

The Indian subcontinent has witnessed substantial Advertising, Marketing and Promotional (AMP) activities being undertaken by the Indian subsidiaries of MNE groups. Over the years, Transfer Pricing Officers (TPOs) have made adjustments on such excess AMP spend, on the premise that such expenses were being incurred by Indian taxpayers on behalf of foreign Associated Enterprises (AE), for promoting the brands/trademarks legally owned by foreign AEs and for creating/developing marketing intangibles. Generally, the tax authorities over these years have been taking a position that:

  • The taxpayers spend significant amount on AMP benefitting the AE, thereby creating marketing intangibles without receiving corresponding compensation/ reimbursement for the same.
  • Expense to sales ratio for taxpayer is in excess of other comparable companies (bright Line test), highlighting that contribution by the taxpayer is towards strengthening the brands owned by the AE and not for distribution or sales in India. This excess expenditure needs to be reimbursed to the Indian company with an appropriate markup. Alternatively, Profit Split Method (PSM) can be used by allocating global profits attributable to AMP spend in the ratio of Indian AMP to Global AMP.

This aggressive stand and varied methodology adopted by tax authorities has resulted in the transfer pricing adjustments reaching astronomical numbers. In the initial phase, the tax authorities' position was vindicated when the Delhi Special Bench of Tax Tribunal, in case of LG Electronics, allowed the concept of Bright Line test and adjustment for such excessive AMP. Though the above Income Tax Appellate Tribunal (ITAT) ruling was negated last year by the Delhi High Court in several cases – primarily in the cases of Maruti Suzuki India Pvt Ltd and Sony Ericsson Mobile Communications India Pvt Ltd. In case of Maruti Suzuki, the very fundamental question of whether incurring excessive AMP expenditure itself is an international transaction was questioned and was held in favour of the taxpayer. While the tax authorities have appealed before the Supreme Court and the last word on this matter is yet to be heard, the tax authorities felt that they would need to evolve and invent new approaches if they need to be successful on taxing this.

The Luxottica India Eyewear Pvt Ltd (Luxottica India) case – new approach to AMP expenses

We have witnessed this new approach recently in case of Luxottica India [ITA No. 344/2017]. The facts of the case, approach of the TPO and the findings of ITAT are discussed below.

The taxpayer is a part of a multinational group engaged in manufacturing and distribution of sunglasses and frames. The taxpayer benchmarked its purchase of finished goods transaction by applying Resale Price Method (RPM) and compared its gross margins (25%) with that of comparable companies (23%). The Transfer Pricing Officer (TPO) observed that the taxpayer had incurred significant AMP expenditure in proportion to its sales revenue. This excessive expense was viewed as an additional marketing function/ promotional efforts carried out by the taxpayer on behalf of its AE that enhanced the value of the AE's brand in India. In addition, the TPO also observed that the comparable companies identified by the taxpayer had low or negligible marketing functions as compared to the taxpayer. However, the TPO did not consider AMP as a separate international transaction, instead proposed an innovative AMP intensity adjustment. The TPO made an upward revision to the net margins of the comparables on account of AMP intensity adjustment and used Transactional Net Margin Method (TNMM) to benchmark the import transaction of the taxpayer. The ITAT in its order reaffirmed the approach adopted by the TPO of treating AMP as a function and making the AMP intensity adjustment. The ITAT also heavily relied on similar observations made by the Delhi High Court in case of Bausch & Lomb Eyecare India Pvt Ltd1.

Thus, this new approach from Revenue authorities on analysing the intensity of functions, an alternative to applying the Bright Line test, has now got judicial blessings and is also in line with the OECD BEPS Action Plan 8-10. However, the fundamental aspect of selection of proper comparables for undertaking comparability analysis still would be the key to any economic analysis.

AMP expenses – what can taxpayers expect?

Considering the learnings from the principles laid down in five landmark decisions2 on AMP in India, the government has circulated an internal note to the TPOs for the purpose of bringing about further clarity and achieving consistency in scrutinising the transaction pertaining to AMP. The guidance, which extensively relies on the BEPS Action Plan 8-10, and also on United Nations Transfer Pricing (UNTP) manual and India's chapter in the UNTP manual.

The guidance also relies heavily on the US and Australian Guidelines and starts with encouraging the TPOs to do more detailed fact finding exercises and not presume the existence of AMP as a separate transaction by default. It lays down following principles:

  • The existence of an international transaction in relation to any service or benefit will have to be established before determining compensation.
  • The mere fact of unusual or excessive AMP expenditure cannot establish the existence of such a transaction.
  • Once such a transaction is established, it is possible to benchmark it separately and it need not always be aggregated with other international transactions.

One can now expect the following approaches being adopted by the TPO depending on the facts and circumstances of the case.

In line with the UNTP manual on Marketing Intangibles, the need for compensating Indian taxpayers for the functions carried out (in the nature of Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE)) flow from a two- fold benefit received by the AEs:

  • Direct benefit by way of increased revenue on account of sale/royalty/ FTS; and
  • Indirect benefit on account of market development efforts made by Indian taxpayers and enhancement of brand/exit value owing to change in ownership.

Delineating the international transaction and benefit to foreign AE

Based on this guidance, we can expect the TPOs to have more robust checklist for collecting appropriate and relevant information as well as on classification of marketing expenses. The guidance stresses on the need for TPOs to examine whether the actual conduct of the parties conform to the terms of the agreement. The TPOs would now have more detailed understanding of the Functions, Assets and Risks (FAR), scrutinising the DEMPE functions in relation to the risk profile of the entities, examining dependency of the AE on the DEMPE functions carried out by the taxpayer and thereafter selection of the most appropriate method to benchmark the transaction.

In straight forward cases, where there are evidences to the effect that the taxpayer is discharging marketing functions which include market development, thereby creating and adding value to the existing intangibles owned by the AE as well as other marketing intangibles, one can expect an adjustment on the account of such marketing functions. Of course, there will be through scrutiny of the DEMPE functions performed by the taxpayer and the benefits derived by the AEs from such DEMPE functions.

With regard to the classification of marketing expenses, it would be important for TPOs to maintain consistency in the classification of marketing expenses being considered both for the taxpayer and comparables while undertaking the economic analysis. This would assume more importance since there is no guidance on accounting and nomenclature of such expenses in the Indian Accounting Standards or other accounting standards.


Limited Risk Distributor: In case of a limited risk distributor, the TPO shall analyse whether the taxpayer is compensated by way of reduction in price of goods purchased from the AE or by a separate compensation in case the margin falls below the assured return.

For a full fledged distributor where the taxpayer claims to incur AMP expenditure on its own account; the TPOs would tend to benchmark the primary transaction of import of goods using TNMM and test the net margins of the taxpayer. This would pose some challenges where the taxpayer has used RPM/gross margin analysis to benchmark the import transaction.

There would be also through examination of the DEMPE functions of the taxpayer and one can expect the AMP intensity adjustment to be in line with Luxottica India ruling.

In situations where the foreign AE directly sells to Indian customers and where the distributor provides marketing support services only on a cost plus markup basis, the TPOs will analyse the conduct of parties where the taxpayer receives no compensation for the marketing functions performed and the foreign AE gets direct benefit from the DEMPE functions performed by taxpayer.

Licensed Manufacturer:

The BEPS report does not provide guidance with respect to manufacturing companies performing DEMPE functions that benefit the AE. Issue of AMP warranting separate compensation may arise only in few cases, wherein:

  1. The Indian licensed manufacturer also undertakes the distribution function of the AEs products. In such cases, the TPOs will examine in detail that no DEMPE functions are carried out on behalf of the AE and the marketing expense (if any) incurred is for the sale of goods manufactured by the taxpayer.
  2. Indian taxpayer being a licensed manufacturer, utilises the technical knowhow and license provided by the AE's for the purpose of manufacturing and makes payment toward royalty. In such a case, where the marketing expense incurred is duly compensated on a cost plus basis, a separate AMP adjustment is not warranted. However, in such cases, the TPOs would definitely analyse other inter- company transactions, viz purchase, royalty, etc. and ensure that the same are benchmarked separately. We can also expect that in such cases, the TPO may disallow/reduce the payment towards royalty. Furthermore, the compensation at the time of restructuring/cessation/ transfer of business may be determined after analysing the brand value of the AE.

All in all, we will see more intense and robust scrutiny of AMP functions and expenses going forward. The tax authorities will call for information spanning 5 to 10 years for understanding the business model, global transfer pricing policy, competitor information, marketing strategy of the taxpayer and involvement of AE, basis of setting brand royalty rate, patent/trademark registration details, budgeting process, brand valuation and group restructuring, comparing similar arrangements existing in the group, etc. As is the case currently, the onus would be on the taxpayer to justify the manner in which compensation is provided by the AE.

Thus, it is crucial for the taxpayers to evaluate their marketing functions/ expenses in light of the recent developments. With so much said and done on the issue over the past six or seven rounds of transfer pricing audits, only the apex Court can really decide the fate of the current battle between MNEs and tax authorities. However, each case may have varied facts, and even if the apex Court rules on any taxpayer, the applicability on other disputed MNEs could still be a question.

To view the full article click here


1 Bausch & Lomb Eyecare (India) Pvt Ltd [ITA Nos. 643,675-77/2014 and 165, 166/2015]

2 Maruti Suzuki India Ltd [W.P.(C) 6876/2008], LG Electronics India Pvt. Ltd [ITA No. 5140/ Del/ 2011] (Special bench), Sony Ericsson Mobile Communications India Pvt. Ltd. & Ors [ITA No. 16/2014], Maruti Suzuki India Ltd. [ITA No. 110/2014 & 710/2015], Whirlpool India Ltd [ITA No. 610/2014 & 288/2015]

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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