L.G.Electronics India Pvt. Ltd vs. ACIT (ITAT Delhi Special Bench)

Transfer Pricing: The “Bright Line test” can be applied to determine whether AMP expenses incurred by assessee are excessive & for the benefit of the brand owner

L.G. Electronics Inc, a Korean company, set up a wholly owned subsidiary in India (the assessee) to which it provided technical assistance. The assessee agreed to pay royalty at the rate of 1% as consideration for the use of technical know how etc. The Korean company also permitted the assessee to use its brand name and trade marks to products manufactured in India on a royalty-free basis. The AO, TPO & DRP held that as the Advertising, Marketing and Promotion (“AMP expenses”) expenses incurred by the assessee were 3.85% of its sales and such percentage was higher than the expenses incurred by comparable companies (Videocon & Whirlpool), the assessee was promoting the LG brand owned by its foreign AE and hence should have been adequately compensated by the foreign AE. Applying the Bright Line Test, it was held that the expenses up to 1.39% of the sales should be considered as having been incurred for the assessee‘s own business and the remaining part which is in excess of such percentage on brand promotion of the foreign AE. The excess, after adding a markup of 13%, was computed at Rs. 182 crores. On appeal by the assessee, the Special Bench had to consider the following issues: (i) whether the TPO had jurisdiction to process an international transaction in the absence of any reference made to him by the AO? (ii) whether in the absence of any verbal or written agreement between the assessee and the AE for promoting the brand, there can be said to be a “transaction“? (iii) whether a distinction can be made between the “economic ownership” and “legal ownership” of a brand and the expenses for the former cannot be treated as being for the benefit of the owner? (iv) whether such a “transaction“, if any, can be treated as an “international transaction“? (v) whether the “Bright Line Test” which is a part of U. S. legislation can be applied for making the transfer pricing adjustment? (vi) whether as the entire AMP expenses were deductible u/s 37(1) despite benefit to the brand owner, a transfer pricing adjustment so as to disallow the said expenditure could be made? (vii) what are the factors to be considered while choosing the comparable cases & determining the cost/value of the international transaction of AMP expenses? (viii) whether, if as per TNMM, the assessee’s profit is found to be as good as the comparables, a separate adjustment for AMP expenses can still be made? (ix) whether the verdict in Maruti Suzuki 328 ITR 210 (Del) has been over-ruled/ merged into the order of the Supreme Court so as to cease to have binding effect?

By the Majority (Hari Om Marathe, JM, dissenting)

(i) Though s. 92CA (2A), inserted w.e.f. 1.6.2011, which permits the AO to consider international transactions not specifically referred to him does not apply as the TPO’s order was passed before that date, sub-sec (2B) to s. 92CA inserted by the Finance Act 2012 w.r.e.f. 1.6.2002 (which provides that the TPO can consider an international transaction if the assessee has not furnished the s. 92E report) cures the defect in the otherwise invalid jurisdiction at the time of its original exercise. The assessee’s argument that jurisdiction has to be tested on the basis of the law existing at the time of assuming jurisdiction and that s. 92CA (2B) cannot regularize the otherwise invalid action of the TPO is farfetched and not acceptable because it will render s. 92CA(2B) redundant. The argument that s. 92CA(2B) should be confined only to such transactions which the assessee perceives as international transactions but fails to report is also not acceptable;

(ii) The assessee’s contention that in the absence of any mutual agreement between the assessee and its foreign AE, there is no “transaction” is not acceptable in view of the definition of that term in s. 92F(v) which includes an “arrangement or understanding“. An informal or oral agreement, which is latent, can be inferred from the attending facts and circumstances and the conduct of the parties. As long as there exists some sort of understanding between two AEs on a particular point, the same shall have to be considered as a “transaction“, whether or not it has been reduced to writing. However, the department’s contention that the mere fact that the assessee spent proportionately higher amount on advertisement in comparison with other entities shows an understanding is also not acceptable. On facts, as it was seen that the assessee not only promoted its name and products through advertisements, but also the foreign brand simultaneously, and the fact that the assessee‘s AMP expenses were proportionately much higher than those incurred by other comparable cases, lent due credence to the inference of the transaction between the assessee and the foreign AE for creating marketing intangible on behalf of the latter;

(iii) The assessee’s contention that a distinction should be made between the “economic ownership” of a brand and its “legal ownership” and that AMP expenses towards the “economic ownership” of the brand, which are routine in nature, cannot be allocated as being for the benefit of the brand owner is not acceptable as it will lead to incongruous results. While the concept of economic ownership of a brand is relevant in a commercial sense, it is not recognized for the purposes of the Act;

(iv) The assessee’s argument that there is no “international transaction” is not acceptable because the definition of that term in s. 92B(1) is inclusive. Under clause (i) of the Explanation to s. 92B, a transaction of brand building is in the nature of “provision of service” by the assessee to the AE. Clause (ii) of the Explanation defines “intangible property” to include “marketing related intangible assets, such as, trademarks, trade names, brand names, logos“. Consequently, brand building is a “provision of service”. The fact that no consideration is paid by the foreign AE is irrelevant;

(v) While a provision from a foreign legislation cannot be imported into the Indian legislation, there is an inherent fallacy in the assessee’s argument that the bright line test cannot be adopted to determine the ALP of the international transaction as it is not one of the recognized methods u/s 92C. The bright line test is a way of finding out the cost/value of the international transaction, which is the first variable under the TP provisions and not the second variable, being the ALP of the international transaction. Bright line is a line drawn within the overall amount of AMP expense. The amount on one side of the bright line is the amount of AMP expense incurred for normal business of the assessee and the remaining amount on the other side is the cost/value of the international transaction representing the amount of AMP expense incurred for and on behalf of the foreign AE towards creating or maintaining its marketing intangible. If the assessee fails to give any basis for drawing this line by not supplying the cost/value of the international transaction, and further by not showing any other more cogent way of determining the cost/value of such international transaction, then the onus comes upon the TPO to find out the cost/value of such international transaction in some rational manner. On facts, the cost/value of the international transaction was determined at Rs. 161.21 crore while its ALP (after the 13% markup) was Rs. 182.71 crore. The assessee was not entitled to claim a deduction for Rs. 161.21 crore and it was liable to be taxed on the markup of Rs. 21.50 crore;

(vi) The assessee’s contention that once the entire AMP expense is found to be deductible u/s 37(1), then, no part of it can be attributed to the brand building for the foreign AE notwithstanding the fact that the foreign AE also got benefited out of such expense is not acceptable because the whole purpose of transfer pricing is to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India in the case of multinational enterprises. The TP provisions prevail over the general provisions. The exercise of separating the amount spent by the assessee in relation to international transaction of building brand for its foreign AE for separately processing as per s. 92 cannot be considered as a case of disallowance of AMP expenses u/s 37(1)/ 40A(2). s. 37(1)/40A(2) & s. 92 operate in different fields;

(vii) In principle, it is necessary that properly comparable cases should be chosen before making comparison of the AMP expenses incurred by them. However, the argument that only such comparable cases should be chosen as are using the foreign brand is not acceptable. The correct way to make a meaningful comparison is to choose comparable domestic cases not using any foreign brand. Also, several factors have to be considered for determining the cost/value of the international transaction of brand/logo promotion through AMP expenses (14 illustrative issues set out). On facts, the TPO restricted the comparable cases to only two without discussing as to how other cases cited by the assessee were not comparable. Also, a bald comparison with the ratio of AMP expenses to sales of the comparable cases without giving effect to the relevant factors cannot produce correct result (matter remanded);

(viii) There is a basic fallacy in the assessee’s contention that if the TNMM is adopted and the net profit is at ALP, there is no scope for making an adjustment for AMP expenses. TNMM is applied only on a transactional level and not on entity level though it can be correctly applied on entity level if all the international transactions are of sale by the assessee to its foreign AE and there is no other transaction of sale to any outsider and also there is no other international transaction. Where there are unrelated international transactions, it is wrong to apply TNMM at an entity level. Further, even assuming that in applying the TNMM on entity level for the transaction of import of raw material the overall net profit is better than other comparables, an adjustment can still be made by subjecting the AMP expenses to the TP provisions. There is no bar on the power of the TPO in processing all international transactions under the TP provisions even when the overall net profit earned by the assessee is better than others. Earning an overall higher profit rate in comparison with other comparable cases cannot be considered as a licence to the assessee to record other expenses in international transactions without considering the benefit, service or facility out of such expenses at arm‘s length. All the transactions are to be separately viewed. Also, the contention fails if any of the other methods (CUP etc) are adopted instead of TNMM;

(ix) Maruti Suzuki 328 ITR 210 (Del) lays down the law that (a) brand promotion expenses are an “international transaction”, (b) AMP expenses incurred by a domestic entity which is an AE of a foreign entity are required to be compensated by the foreign entity in respect of the brand building advantage obtained by it & (c) the factors required to be considered by the TPO. This verdict has not be overruled by the Supreme Court except to the extent that directions were given to the TPO to proceed in a particular manner. The verdict has also not merged into that of the Supreme Court because the principles of law laid down by the High Court have not at all been considered and decided by the Supreme Court. Consequently, the law laid down therein continues to have binding force.

Per Hari Om Maratha, JM (dissenting):

(i) Before making any transfer pricing adjustments, it is a pre-condition that there must exist an ‘international transaction’ between the assessee and its foreign AE. The Department has proceeded on a presumption that because the AMP expenses are supposedly higher than that incurred by other entities, there is an ‘international transaction’ discernible and a part of these expenses have to be treated towards building of the LG Brand owned by the foreign AE. It is not permissible to proceed on such presumption in the absence of a written agreement or evidence to suggest any oral agreement between the parties;

(ii) Further, the assessee had not paid any ‘brand-royalty’ to the foreign AE though it got the benefit of the brand and earned revenue there from which has been taxed. The AMP expenses have been paid to an unrelated entity in India which has in turn paid tax thereon. As there is no shifting of income to a different jurisdiction, neither Chapter X not the bright line method has any application;

(iii) Also, the concept of commercial ownership of a brand is a reality in modern global business realm and it is as good as a legal ownership in so far as its effects on sale of products in India is concerned. Any advertisement which is product-centric and even entirely brand-centric will only enhance the sales of the products of that brand in India. In no way is the brand owner benefited. Consequently, the AMP expenses is not a case of brand-building/ promotion and no ‘covert transaction’ between the Indian entity and its foreign AE can be presumed or inferred. The Revenue has no power to re-characterize the AMP expenditure as routine and non-routine expenditure;

(iv) Maruti Suziki India Ltd 328 ITR 210 (Del) cannot be regarded as a binding precedent after the verdict of the Supreme Court in 335 ITR 121 (SC). The fact that a reference was made to the Special Bench itself shows that because a covered issue cannot be referred to a Special Bench.