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https://www.bcasonline.org/articles/artin.asp?1122

Transfer Pricing the concept of Bright Line Test

Subject : Income Tax Law

Month-Year : Jan 2014

Author/s : Tarunkumar G. Singhal Chartered Accountant

Topic : Transfer Pricing the concept of Bright Line Test

Article Details :

Synopsis

Transfer Pricing Litigation concerning Advertising marketing and sales promotion (AMP Expenses) andcreation of Marketing Intangibles for the Foreign Associated Enterprise, has come to the fore in recentyears. 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.

The purpose of this Article is to acquaint the reader with the basic concepts, the issues involved and

broad thrust of judicial pronouncements. To gain an in-depth understanding of the concepts, issuesinvolved, rival contentions and judicial thought process, the reader would be well advised to criticallystudy and analyse relevant judicial pronouncements. As the stakes involved are very high, the matterwould be settled only at the Apex Court level.

1. Overview

In a typical MNC business model, the Indian subsidiary acts as a distributor/provider of goods/servicesand incurs AMP expenses for the promotion of its products or services. The Assessees have contendedthat the AMP expense is incurred necessarily for the purpose of selling its products/services in the Indianmarket.

In the past, there have been instances of the Tax Department not allowing a tax deduction for suchexpenses 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 atax deduction in the determination of taxable income of the Indian AE. Various judicial pronouncementshave held that where the expenditure has been incurred for the purposes of business of the Indiancompany, the payment should be allowed as a deduction.

Resultantly, the issue (incurring of AMP expenses and creation of Marketing Intangibles) has nowentered the realm of transfer pricing controversy. The contention of the Tax Department has been thatsince the Indian company incurs expenses which benefit the foreign AE, the Indian company should bereimbursed 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 duecompensation (which could be the recovery of expenses incurred plus an appropriate mark-up over andabove such expenses). It is contended by the Tax Department that such advertisement and brandpromotion 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 theForeign AE.

Accordingly, the Transfer Pricing Officers (TPOs) in India, applying the 'Bright Line Test' as laid down inthe decision of US Tax Court in DHL Inc.s case, have held that the expenditure on advertisement andbrand promotion expenses which exceed the average of AMP expenses incurred by the comparablecompanies 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 IndianAE contributes towards the development and enhancement of the brand owned by the parent of themultinational group (the foreign AE). This perceived enhancement in the value of the brand is commonlyreferred 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 suchexpenses have been incurred for marketing of the product or for building the brand of the foreign AE in

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India.

The Tax Department ought to appreciate the difference between product promotion and brandpromotion. Product promotion primarily targets an increase in the demand for a particular productwhereas Brand Promotion results in creation of Marketing Intangibles.

There have been many decisions (mainly Tribunal Decisions) which have discussed the aspect of AMPexpenditure 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 tothe retrospective amendments made by the Finance Act, 2012, in this regard, have held that since thespecific international transactions pertaining to AMP expenses have not been referred to the TPO by the

Assessing Officer (AO) the assumptionof the jurisdiction by the TPO in working out the ALP of the AMPtransaction 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 theterm international transaction.

However, the amendments brought by Finance Act, 2012 in the Indian Transfer Pricing Regulationsempower 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 provisionof services related to the development of marketing intangibles.

2 Concept of Marketing IntangiblesIntangible Property : Para 6.2 of Chapter VI of the OECD Transfer Pricing Guidelines 2010 (OECD TPGuidelines) defines the term intangible property as intangible property includes rights to use industrialassets such as patents, trademarks, trade names, designs or models. It also includes literary and artisticproperty rights, and intellectual property such as know-how and trade secrets.

Commercial Intangibles : OECD TP Guidelines defines the term commercial intangibles asCommercial intangibles include patents, know-how, designs, and models that are used for theproduction of a good or the provision of a service, as well as intangible rights that are themselvesbusiness assets transferred to customers or used in the operation of business (e.g. computer software).

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 timethrough brand building, large-scale marketing of product, distribution network etc.

OECD TP Guidelines on Marketing Intangibles : Para 6.3 and 6.4 of Chapter VI of the OECD TPGuidelines defines the term marketing intangibles as a special type of commercial intangibles whichinclude trademarks and trade names that aid in the commercial exploitation of a product or service,customer lists, distribution channels, and unique names, symbols, or pictures that have an importantpromotional value for the product concerned. Some marketing intangibles (e.g. trademarks) may beprotected by the law of the country concerned and used only with the owners permission for therelevant product or services.

The value of marketing intangibles depends upon many factors, including the reputation and credibilityof the trade name or the trademark, quality of the goods and services provided under the name or the

mark in the past, the degree of quality control and ongoing R&D, distribution network and availability ofthe goods or services being marketed, the extent and success of the promotional expenditures incurredfor familiarising potential customers with the goods or services.

3. TP Issues surrounding Marketing Intangibles/

AMP Expenses

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

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

ii) Whether when the assessee has incurred AMP expenses for promotion of brand belonging to its

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holding company, the Tax Department is justified to apply the Bright Line Test for determination of ArmsLength Price (ALP) of AMP?

iii) Whether the Bright Line Test applied by the Tax Department for determination of ALP of AMP fit is anappropriate 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 pricingcontroversy around marketing intangibles. This issue first came up for consideration in the case of DHLbefore the US Tax Court. This was primarily on account of the 1968 US Regulations which propoundedan important theory relating to 'Developer-Assister rules'. As per the rules the developer being theperson incurring the AMP spends (though not being the legal owner of the brand) was treated as aneconomic owner of the brand and the assister (being the legal owner of the brand), would not berequired to be compensated for the use or exploitation of the brand by the developer. The rules laydown 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 economicexpenditures and risk. Legal ownership is not identified as a factor to be considered in determining whichparty is the developer of the intangible property, although its exclusion is not specific. However, thedeveloper-assister rule were amended in 1994, to include, among other things, consideration of legalownership within its gamut, for determining the developer/owner of the intangible property, and providethat if the intangible property is not legally protected then the developer of the intangible will beconsidered the owner.

However, the US TPR recognise that there is a distinction between routine and non-routine expenditureand this difference is important to examine the controversy surrounding remuneration to be received bythe 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 BrightLine Test (BLT) by differentiating the routine expenses and non-routine expenses. In brief, it providedthat for the determination of the economic ownership of an intangible, there must be a determination ofthe non-routine (i.e. brand building) expenses as opposed to the routine expenses normally incurred by adistributor in promoting its product.

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

5. Origin of Dispute in India - Maruti Suzukis 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 inrespect of marketing intangibles was dealt extensively by the Delhi High Court in the case of MarutiSuzuki India Ltd vs. ACIT(2010TII01HCDELTP). In this case, the assessee, Maruti Suzuki India Limited(SIL, an Indian company had entered into a license agreement with Suzuki Motor Corporation (MC forthe manufacture and sale of automotive vehicles including certain new models. As per the terms of theagreement, MSIL agreed to pay a lump sum amount as well as running royalty to SMC as considerationfor technical assistance and license. MSIL started using the logo of SMC on the cars and continued usingthe brand name arutialong-with the word uzukion the vehicles manufactured by it. MSIL had alsoincurred significant AMP spends for promoting its products.

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

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.

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The Transfer Pricing Officer (TPO) concluded that the assessee was promoting LG brand as it hadincurred expenses on AMP to the tune of 3.85% of sales vis--vis1.39% incurred by a comparable.

Accordingly, TPO held that the assessee should have been compensated for the difference.

Applying the Bright Line Test, theTPO held that the expenses in excess of 1.39 % of the sales aretowards 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 salespromotion expenses incurred by the assessee?

Whether the assessee ought to have been compensated by the AE in respect of such AMP expensesalleged 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 assessees case is covered u/s.

92CA(2B) of the Income Tax Act, 1961 (the Act) which deals with international transactions in respectof which the assessee has not furnished report, whether or not these are international transactions asper the assessee.

The incurring of AMP expenses leads to promotion of LG brand in India, which is legally owned by theforeign AE and hence is a transaction. The said transaction can be characterised as an internationaltransaction within the ambit of Section 92B(1) of the Act, since (i) there is a transaction of creating andimproving 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.

AcceptedBright Line Test to determine the cost/ value of the international transaction, in view of thefact that the assessee failed to discharge the onus by not segregating the AMP expense incurred on itsown behalf vis--vis that incurred on behalf of the AE.

The transfer pricing provisions being special provisions, override the general provisions such as section37(1) / 40A(2) of the Act.

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

The Supreme Court of India in Maruti Suzukis case examined the issue of AMP expenses where itdirected the TPO for a de novo determination of ALP of the transaction. The direction by the SupremeCourt recognises the fact of brand building for the foreign AE, which is an international transaction andthe 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 forpromotion of sales leads to brand building of the foreign AE, for which the Indian entity needs to becompensated on an arms length basis by applying the Bright Line Test.

With regard to the DRPs approach, of applying a mark-up on cost for determining the ALP of theinternational transaction, on the ground that the same has sanction of law under Rule 10B(1)(c)(vi) ofthe Income Tax Rules, 1962 was accepted.

The case wasset aside and the matter was restored to the file of the TPO for selection of appropriatecomparable companies, examining effect of various relevant factors laid down in the decision and for thedetermination 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 Benchruling in the case of LG Electronics India Pvt. Ltd (supra) in applying Bright-Line Test (BLT) to arrive atthe adjustment towards excess AMP expenditure.

Further, the Tribunal ruled that the expenditure directly in connection with sales had to be excluded incomputing the AMP adjustment. The Tribunal deleted the hypothetical brand development fee

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jurisprudence, there is no bar/prohibition to refer to international jurisprudence/guidelines. The Tribunalhas made an important distinction on the AMP issue for a distributor from that of a licensedmanufacturer. While drawing the distinction in the facts of the assessee with that of the LG Indias case,the Tribunal has provided commendable clarification on how the typical AMP issue for distributors is tobe analysed.

The Tribunals 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, whereinthe SB held that entity level profits do not benchmark all the international transactions of LG India andthat 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 internationalpractice incorporated in the OECD Transfer Pricing Guidelines, the ATOs Guidelines (Australian TaxOffice) related to Marketing Intangibles and the OECD Discussion Draft on Intangibles.

Transfer pricing litigation and adjudication being fact based, necessarily requires consideration of thebusiness model of the assessee and the contractual terms with AEs, along with a detailed FAR analysis tocharacterise the transactions. The Tribunals consideration of and reliance on the same for distinguishingthis case from the LG Indias case, underscore the importance of an extensive FAR analysis, inter-alia, forthe AMP issue.

The Tribunal made an important observation that the orders and judgments of co-ordinate divisionbenches or special benches of the Tribunal, or the High Court and Supreme Court, particularly in transferpricing adjudication cannot necessarily always be taken as a binding precedence unless facts andcircumstances 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 benchs decision in the case ofBMW India Pvt. Ltd. and has followed SB decision in the case of LG Electronics. In Casios case, theTribunal observed that the special bench decision in the case of L.G. Electronics is applicable with fullforce 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 thedivision bench order in BMW Indias 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 Rulingin case of L.G. Electronics (supra) and Chandigarh Tribunals Ruling in the case of Glaxo SmithklineConsumer Healthcare Ltd. [TS-72-ITAT-2013 (CHANDI)-TP /2013-TII-71-ITAT-CHD-TP] held that, whilecomputing TP Adjustment for marketing intangibles, expenses on Commission, Cash Discount, VolumeRebate, Trade Discount etc. and AMP Subsidy received by the assessee from the Parent Company shouldbe excluded from the total AMP Expenses. In Glaxos case, the Chandigarh Tribunal also held that theConsumer Market Research Expenses and AMP Expenses attributable to various domestic brands ownedby the assessee should be excluded from the ambit of AMP Expenses and no adjustment is required tobe 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 carefulin properly accounting for various sales related expenses and adequately documenting and distinguishingthe 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 marketingactivities are undertaken by enterprises that do not own the trademarks they are promoting. Accordingto 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 withEmerging TP Challenges in India however is more explicit when it states that an Indian AE needs to be

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compensated for intangibles created through excessive AMP expenses and for bearing risks andperforming 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 inlight of the above principles, some of the concepts articulated by the OECD Guidelines and the UNTPMmay be implicit in the factors identified by the SB for undertaking a comparability analysis. Theseprinciples 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 theAssessee, even assuming it is excessive - i.e., the Assessee or the foreign AE. The SB has also notaddressed the issue of whether the benefit, if any, tothe 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 wouldappear that these principles that were enunciated by the High Court would also need to be given dueconsideration while examining the issue.

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

The benefits of the AMP spend may also be realised over a period of time, even though from anaccounting 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 withinthe same industry it could be quite company specific.

The SBs ruling relies extensively on the facts particularly relevant to the Assessee in this case andtherefore its impact on other assessees may need to be examined based on their specific facts. Theapplicability 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 excessiveAMP expenditures may also not necessarily be based on a bright line test if assessees are able to provideinformation related to brand promotion.

Transfer pricing aspects of marketing intangibles has been the focus of the Indian tax authority for thelast few years. In light of the above, it would be useful for multinational enterprises with Indian affiliatesto 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 forproviding certainty to foreign investors and encouraging inflow of much needed FDI, the Finance Ministryshould issue necessary detailed fair, reasonable and equitable/balanced guidelines with suitableillustrations and examples on the lines of Australian Tax Offices Guidelines or bring in necessarystatutory amendments in Indian Transfer Pricing Regulations. The Guidelines/Statutory Amendmentsshould be framed keeping in mind the business realities which Foreign Businessmen have to face inIndia; particularly the fact that, in view of accelerating changes in technology, the shelf life of a productor service is very short, such that an Electronic Product (Smartphone, Tablet, Laptop etc.) tends to getoutdated within 6-9 months of its launch. This necessitates recoupment of expenditure on productresearch and development by garnering significant level of market share, in a very short time by meansof aggressive expenditure on advertisement, marketing and sales promotion, leaving the competition

well behind.