There are many ways in which multinationals would like to take away profit from a country in which they are doing business, particularly if it is a relatively high tax country. The easiest way to do so is through intra company dealings. In the absence of Transfer Pricing (TP) legislation in India, till the year 2001, not much attention has been paid to these aspects. The attitude of the court/ tribunals that the assessee best knows its business also helped. However, with the passing of the TP legislation in India, many such transactions are coming to the notice of the tax department. In TP legislation, the standard is the arm's length. So, the question that always needs to be asked is whether two independent parties would have entered into the particular transaction.

Profit can be taken away from a country through myriad ways. Payment for purchases of goods and services is one obvious choice. Similar will be less than adequate compensation to the Indian company for sales or provision of services. Transfer pricing legislation normally should be capable of tackling such cases. Payment of inflated interest and royalties is another way. Again transfer pricing legislation along with thin cap rule, if any, should be able to take care of such situations. However, there are quite a few other ways which are not very obvious that have come to the knowledge of the Indian tax department in the course of the administration of the TP legislation. Some of these often become controversial since others had not taken the approach of the Indian revenue before. One such issue is the exaggerated advertisement spends by the Indian subsidiaries of foreign MNCs although it must be admitted that the path has been shown in this respect by the US IRS in the celebrated Glaxo case. The advertisement and brand building expenses of MNCs in India has been on the rise. If these inure for the exclusive benefit of the Indian company, no one can have any quarrel with such spends which are normally tax deductible. However, when it is not clear who is reaping the benefit of these expenses, disputes are bound to arise.

The India chapter of the UN TP Manual gives the country experience with TP legislation. It has been mentioned therein that that the experience of the tax administration is that Indian subsidiaries claim to be no risk and limited risk bearing distributors by the parent MNE in order to justify low cost plus return but they incur very large expenditures on the development of marketing intangibles. The tax administration believes that the Indian entity should be compensated for its efforts and adopts the concept of a “ bright line ” test on the premise that a no risk or limited risk distributor will bear the cost of only routine expenditure on advertisement, marketing and sale promotion (AMP).

This practice of the Revenue came up for examination before the Special Bench (SB) of the Tribunal in the case of LG Electronics (2013-TII-15-ITAT-DEL-SB-TP) some months back. In a major victory for the tax department, the SB of the Tribunal has laid down in the LG Electronics case the principles for making the arm's length determination for the Advertising, Marketing and promotion spends of Indian subsidiaries of multinational companies. The SB was constituted since there were conflicting decisions of various benches of the Tribunal over the issue. It may be noted that although the main case was filed by LG, there were many interveners. In this case, these interveners represented different spectrums of the industry- some of them were manufacturers, some were limited risk distributors and some full risk distributors. The principles laid down by the SB however apply to the entire gamut of cases.

The SB by a majority view held that the AMP spends did represent ‘international transaction' which could be subject matter of transfer pricing analysis. The Tribunal also approved the ‘bright line test' and for calculating the ALP in such cases laid down a list of 14 criteria – whether the Indian entity is a simple distributor or holding licence to manufacture; whether the goods sold by the Indian AE bear the same brand name etc. It may be noted that these tests have been laid down by the SB for determination of the cost/value of the brand/logo promotion through AMP expenses incurred by the Indian AE for its foreign entity.

Following this order of the special Bench, other the Division Benches (DB) of the Tribunal in the case of Ford India (Pvt Ltd) (2013-TII-118-ITAT-MAD-TP), Canon India Pvt Ltd (2013-TII-96-ITAT-DEL-TP), Glaxo Smith Kline Consumer Health Care Ltd (2013-TII-71-ITAT-CHD-TP) etc., also upheld the application of the principles laid down by the SB. However, recently, the Delhi Bench of the Tribunal, while not openly differing from the views of the special Bench, has apparently taken a view which, prima-facie does not seem to be in conformity with the principles laid down by the SB.

It may be mentioned that BMW had initially been an intervener in the LG case. It seems that certain arguments were also presented. However, it withdrew thereafter and pressed its case before the Delhi Tribunal. BMW argued that the principles laid down by the SB should not apply to it.

Apart from challenging the existence of ‘international transaction' as also the applicability of the bright line test resorted to by the Revenue, BMW tried to differentiate its case on facts and the Bench seems to have got persuaded by its arguments. It may be noted that the Tribunal even in the BMW case (2013-TII-168-ITAT-DEL-TP) has in no uncertain terms upheld the applicability of transfer pricing provisions in respect of the AMP spends. To quote from the judgement itself:

“…the arguments (sic) that the incurring of AMP expenses though a function of a distributor, is not an international transaction is not accepted in view of the precedent value of the order of the Special Bench which is binding on the issue as such is decided against the assessee. The argument that the assessee was not required to show it as a separate transaction as it was a function within the bundle of functions performed as a distributor which includes costs of warehousing etc. also is not agreed with in view of the binding precedential value of the decision of the Special Bench in L.G. Electronics case…”

About the applicability of the brightline test again the Tribunal agreed with special Bench and held as follows: “…it is seen that the use of bright-line as a tool for calculating the non-routine AMP spend has been upheld by the L.G. Electronics decision and even if the assessee was not an intervener before the Special Bench, the said principle is binding and as opposed to applying arbitrary estimation is a well accepted methodology in Transfer pricing and is an accepted tool for calculating non-routine expenditure for marketing intangibles where the brand ownership rests with the foreign AE…”

As for the vital issue as to whether any brand building was done in the present case, again the Tribunal held as follows: “… we conclude that services over and above the routine services as a distributor have been rendered by the assessee which has resulted in brand building for the AE for which compensation has to be computed …” Thus there was admittedly brand building by BMW and its ALP was to be determined by applying the bright-line test.

The main contention of BMW was that it had been allowed to earn more profits as compared to comparables which were not challenged by the Revenue and therefore, it had to be assumed that BMW India was compensated by the AE for its efforts. The subsidiary argument was that the TP rules do not lay down how the Indian company should be compensated for its efforts and that the same need not be direct compensation. The Tribunal examined the importation agreement of BMW (India) with its AE and found that it was stipulated therein that the Indian company shall pay such a price that would ensure adequate recovery of total costs of the contract goods and a representative profit. Based on such stipulation in the agreement and the fact that there is no specific method of compensation prescribed in the rules for the Indian AE, the Tribunal held that no further compensation was required to be made by the AE as the same has already been received which is represented by premium profits earned by the BMW(India).

Although prima-facie appealing , on a proper reading of the LG case, the conclusion of the Division Bench seems to be at odds with the SB decision. This is for the reason that there was a specific argument before the SB by the various interveners that no disallowance can be made out of AMP expenses by benchmarking them separately when the overall net profit rate declared by the assessee is higher than other comparable cases. And this is precisely the argument that seems to have prevailed with the DB. The SB had pointed out the fallacy of such an argument through an example:

“Suppose an Indian entity is engaged in manufacturing of some products and all the sales are to its foreign AE. In such international transaction, it earns actual profit of, say, Rs 120/-. Further suppose the arm's length profit on total sales earned in comparable uncontrolled transactions is Rs 100. In such a case, there can be no question of making any addition on account of arm's length profit from such international transaction of sale to foreign AE because the actual overall profit is more than the arm's length profit. It may also be possible that the actual profit of the Indian AE was Rs 140/- but the AMP expenses have been so claimed as deduction so as to include a part representing branding building for the foreign AE to the tune of Rs 20/-. In such a case, notwithstanding the fact that the assessee's overall profit at Rs 120/- is more than the arm's length profit earned by comparable cases at Rs 100/-, still there will be a requirement for making adjustment of Rs 20/-on account of advertisement expenses incurred by the assessee towards the brand-building on behalf of the foreign AE. If we accept the assessee's contention that since Rs 120/-, being the profit declared by the assessee from the international transaction is more than the arm's length profit of Rs 100/- and hence no further adjustment on account of AMP expenses should be made, then the assessee's income would stand reduced to Rs 120/-as against the actual income of Rs 140/…”

Dealing specifically with the argument, that once the Indian entity has shown more than normal profit at the entity level, there is no question of any adjustment in respect of the transaction relating to brand building, the Special Bench in paragraph 21.10 of its order held as follows:

“21.10. It was also contended on behalf of the assessee that if the overall profit of the Indian entity is more than the comparable cases then it should be presumed that the foreign enterprise supplied goods at relatively low price to make up for the AMP expenses incurred in India towards brand promotion. In our considered opinion there are no roots for such a presumption . In order to take benefit of such a contention the assessee is required to directly prove the fact of cheap purchases de hors the overall higher net profit rate. This fact can be established by demonstrating that the foreign AE charged a specially low price from the assessee in comparison with that charged for the similar goods supplied to other independent entities dealing with it in India or in case there is no other independent entity in India, then the price charged for similar goods from other foreign parties. It can also be proved by showing that goods with identical features are available in the Indian market at a higher price. The fact that the assessee has a better net profit rate in comparison with other comparable entities is not decisive in itself of the assessee having purchased the goods at a concessional rate from its foreign AE as a compensation for its incurring AMP expenses towards the promotion of their brand. “ (Emphasis added)

The SB has thus in clear terms laid down that there is no presumption that better profit margin of the Indian subsidiary is indicative of the fact that it has been compensated for the ad spends. The logic of the same is obvious. Profit margin depends on various factors- someone's cost of sales might be lower, someone might be able to get a higher selling price, someone is more efficient and might have the advantage of the economy of scale etc. Therefore, higher profit in a particular case can be the result of different factors and not necessarily because of cheaper cost of goods. Therefore, the SB has laid down that the taxpayer must adduce direct evidence that the foreign AE supplied goods to it at specifically low price as compared to others and the same was compensation for the AMP expenses.

In this case, there is nothing in the order of the DB to indicate that BMW India could demonstrate that as a matter of fact it had received a reduction in price as a compensation for AMP incurred in India. It is thus obvious that the DB has fallen into the error of raising a presumption of reduction in prices being solely influenced by a higher net profit. This is exactly contrary to what has been laid down by the SB in Para 21.10 quoted above.

Thus, applying the ratio of the decision of the SB, there is no presumption that merely because the overall profit margin of the Indian entity is better than the comparables, it has been adequately compensated for the ad spends. In terms of the SB decision, the burden lies on the taxpayer and the taxpayer has to show by direct evidence that the foreign AE had sold goods to it at a lower rate than to comparable companies. In this case, it has not been shown that BMW has sold cars to BMW India at a lower rate than it sells to anyone else either in the Indian market or elsewhere.

In this case, it was also argued that unlike in the LG case, the assessee was a distributor and not a licensed manufacturer. But the LG case is not limited to licensed manufacturers alone. Out of the many interveners, there were many distributors as well. Since as per the DB itself, there was brad building by BMW India, even if it is not a licensed manufacturer, all that changes is that the bright line will change according to the nature of the activities. It does not mean that no adjustment can be made in such cases.

The DB in Para 5.2.1 berates the TPO (and rightly so) for not following the directions of the DRP which is a higher forum: “… If such an attitude is allowed to be continued then what to talk of judicial discipline the justice dispensing system would lose its sanctity and purpose…” In the circumstances, not applying the various criteria laid down by the SB and placing reliance on a reasoning which has been specifically discarded by the SB seems very ironic indeed.