Transfer Pricing issues surrounding the Advertisement, Marketing and Promotion expenses Source: International Taxation, Volume7 August, 2012

Transcription

1 Transfer Pricing issues surrounding the Advertisement, Marketing and Promotion expenses Source: International Taxation, Volume7 August, 2012 Author: Amod Khare and Pavan Kakade The Indian Transfer Pricing Regulations ( TPR ) were introduced over 10 years ago. During this period, the Indian Revenue Authorities ( IRA ) have concluded transfer pricing audits for 7 years. Interpretations applied to transfer pricing provisions have changed, new thoughts have evolved, a plethora of decisions have been delivered by the Indian Courts and consequential amendments to the law including retrospective amendments have been introduced to negate some of the judicial precedents. Implementation of the TPR continues to remain uncertain and multinationals operating in India have over the years, suffered substantial adjustments to the reported values of their international transactions. This fact is evident from the quantum of TP adjustments which have increased from INR 12,200 million (approximately USD 220 million) to INR 445,310 million (approximately USD 8 billion) 1 in a span of only 7 years of audit. With the experience gained through undertaking detailed audits, the trend of transfer pricing audits has been that every few years, the IRA have made enquiries into new issues. Transfer pricing audits completed in the initial years did not usually deal with issues such as the need to charge guarantee commissions, additions on account of the working capital cycle, etc. In line with this trend, an emerging area of transfer pricing controversy has been the treatment of expenditure incurred for Advertising, Marketing and Publicity ( AMP ). In a typical MNC construct, the Indian subsidiary acts as a distributor / provider of goods / services and incurs AMP expenses for the promotion of its products or services. Tax payers have contended that the AMP expense is incurred necessarily for the purpose of selling its products / services in the Indian market. In the past, there have been instances of the IRA not allowing a tax deduction for such expenses 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 a tax deduction in the determination of taxable income of the Indian AE. Judicial precedents have held that where the expenditure has been incurred for the purposes of business of the Indian company, the payment should be allowed as a deduction. However, a court ruling suggested that if the transaction (the incurring of AMP expenses by the Indian AE) was not challenged by the transfer pricing officer, it cannot now be questioned by the assessing officer undertaking the corporate tax assessment. Resultantly, the issue (incurring of AMP expenses) has now entered the realm of transfer pricing controversy. The contention of the IRA has been that since the Indian company incurs expenses which benefit the foreign AE, the Indian company should be reimbursed for its expenses. In fact, 1 Press Release, dated Government's white paper on black money

2 the proposition has been that by promoting the brand in India, the Indian AE is providing a service to the foreign AE, for which it should receive due compensation (which could be the recovery of expenses incurred and an appropriate mark-up over and above such expenses). In order to appreciate the manner in which the transfer pricing adjustment has been made, one needs to consider the manner in which Indian companies suffering such adjustments would undertake their transfer pricing benchmarking. For the purpose of simplicity, let us assume that the Indian AE acts as a distributor of products. Let us assume that these products are imported from a foreign AE. These products would normally be sold under the global brand relevant to the product since these would typically be branded products. Let us assume that the Indian company has defended its distributor s margin (the international transaction here would be the import of foreign products) by comparing itself to other distributors. Typically, the method for benchmarking the transaction would be the Transaction Net Margin Method ( TNMM ). TNMM is typically selected due to the lack of data available for comparable companies that undertake the same line of business ie same product or the same functions in the same industry and on account of the fact that the comparison of the net margin evens out the differences between the tested part and the comparable companies, if any. However, the disadvantage of using companies which undertake similar and not the same line of business is that the comparable companies would typically undertake operations in different industries and possibly with some differences in their operating model TNMM is normally forgiving of such differences when it comes to the determination of the remuneration for a given set of functions. The IRA have determined the due compensation for this service (the AMP expenses incurred by the Indian AE) by making a comparison between the level of AMP expenses incurred by the Indian AE with the level of AMP expenses incurred by other Indian companies that form part of the set of comparables identified by the Indian AE. As mentioned earlier, these comparable companies would typically be ones which undertake a similar line of activity but not the same activity as the Indian AE. This comparison, penalises the Indian company if it incurs AMP expenditure in excess of the expenditure incurred by the companies engaged in the similar (and not the same) line of business since the IRA would make a TP adjustment in the assessment of the Indian AE holding that the Indian AE should have recovered the AMP expenses along with an appropriate mark-up from the foreign AE. The principle followed by the IRA is that the excess AMP expenditure incurred by the Indian AE contributes towards the development and enhancement of the brand owned by the parent of the multinational group (the foreign AE). This perceived enhancement in the value of the brand is commonly referred to as marketing intangibles. The moot point to consider 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 such expenses have been incurred for marketing of the product or for building the brand of the foreign AE in India. At times, the IRA have not appreciated the difference between product promotion and brand promotion. Product promotion primarily targets an increase in the demand for a particular product. Such product promotion expenditure may support brand building however such rub on effect would need to be analysed on a case to case basis and not by comparing the same with the other companies identified for the purpose of determining the remuneration that the Indian AE should have earned from the sale of the product.

3 To better understand the issue, it would be relevant to look at the genesis of the transfer pricing controversy around marketing intangibles. This issue first came up for consideration in the case of DHL before the US tax court. This was primarily on account of the 1968 US Regulations which propounded an important theory relating to 'Developer-Assister rules'. As per the rules the developer being the person incurring the AMP spends (though not being the legal owner of the brand) was treated as an economic owner of the brand and the assister (being the legal owner of the brand), would not be required to be compensated for the use or exploitation of the brand by the developer. The rules lay down 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 economic expenditures and risk. Legal ownership is not identified as a factor to be considered in determining which party is the developer of the intangible property, although its exclusion is not specific. However, the developer-assister rule were amended in 1994, to include, among other things, consideration of legal ownership within its gamut, for determining the developer/owner of the intangible property, and provide that if the intangible property is not legally protected then the developer of the intangible will be considered the owner. However, the US TPR recognises that there is a distinction between routine and non-routine expenditure and this difference in important to examine the controversy surrounding remuneration to be received by the domestic AE for marketing intangibles. In context of the above regulations, the Tax Court in the case of DHL coined the concept of a Bright-line test ( BLT ) by differentiating the routine expenses and non-routine expenses. The case was ultimately reviewed by the 9 th Circuit Court of Appeals. In brief, it provided that for the determination of the economic ownership of an intangible, there must be a determination of the non routine (i.e. brand building) expenses as opposed to the routine expenses normally incurred by a distributor in promoting its product. An important principle emanating from the DHL ruling is that the AMP expenditure should first be examined to determine routine and non-routine expenditure and accordingly, if at all, compensation may be sought possibly for the non-routine expenditure. At this stage, 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. Also, the international jurisprudence (ie decision in the case of DHL), may have persuasive value for interpreting the Indian TPR s which is pari materia to the statute in the context of which the decision(s) sought to be applied has been rendered. In the Indian context, the issue in respect of marketing intangibles was dealt extensively by the Delhi High Court in the case of Maruti Suzuki India Ltd vs. ACIT 2. In the instant case, the taxpayer, Maruti Suzuki India Limited ( MSIL ) being an Indian company had entered into a license agreement with Suzuki Motor Corporation ( SMC ) for the manufacture and sale of automotive vehicles including certain new models. As per the terms of the agreement, MSIL agreed to pay a lump sum amount as well as running royalty to SMC as consideration for TII 01 HC DEL TP

4 technical assistance and license. MSIL started using the logo of SMC on the cars and continued using the brand name Maruti along-with the word Suzuki on the vehicles manufactured by it. MSIL had also incurred significant AMP spends for promoting its products. In connection with the AMP spends incurred by MSIL, the Delhi High Court laid down the following guidance: If the AMP spends are at a level comparable to similar third party companies, then the foreign entity ie SMC would not be required to compensate MSIL. However, if the AMP spends are significantly higher than third party companies, the use of SMC s logo is mandatory and the benefits derived by SMC are not incidental, then SMC would be required to compensate MSIL. However, it is important to note that the Supreme Court has directed the TPO to examine the matter in accordance with law, without being influenced by the observations or directions given by the Delhi High Court. Pursuant to above decision, there have been decisions, which have discussed the aspect of AMP spends and TP adjustments in respect of the AMP spends which lead to creation of marketing intangibles for the foreign AEs who have derived benefits. However, the Tribunals in the decisions pronounced prior to Finance Act 2012 have held that since the specific international transaction pertaining to AMP spends has not been referred to the TPO by the Assessing Officer ( AO ) the assumption of the jurisdiction by the TPO in working out the ALP of the AMP transaction is not justified. Furthermore, taxpayers, prior to the amendments introduced by Finance Act, 2012, have contended that marketing intangibles per se were not covered under the meaning of the term international transaction. However, the amendments brought by Finance Act, 2012 in the Indian TPR s empower the TPO to scrutinize any international transactions which the TPO deems fit and additionally, the definition of the term international transaction has been broadened to possibly bring within its ambit provision of services related to the development of marketing intangibles. In order to make a determination of whether the Indian AE should be compensated by the foreign AE for the AMP spends, the following factors should be considered: Routine vs non-routine expenses The AMP spends should be analysed to form a determination of whether these spends are routine in nature ie are these spends which would have been incurred by a third party distributor. One basis of determining routine spends would be a comparison with spends by comparable companies. However, as mentioned earlier, it is usually difficult to obtain direct comparables, and a comparison with companies undertaking similar functions is unlikely to provide an accurate result. It should be pointed out that even in the case of Maruti Suzuki, the Delhi High Court held that entities operating in the automobiles sector may not be the right comparable given that they were not engaged in the passenger car segment. Expenses ought to be analysed from the perspective of whether these are routine expenses which a third party would have incurred for selling the product. For examples, advertisements in the media that provide details of the product should be considered as routine expenses. However, expenses incurred for a promotional activity (being in the nature of brand building activity) that focuses on the brand rather than the product may be regarded as brand building expenses and accordingly potentially non-routine in nature eg a promotion party commemorating an anniversary of the brand or the success of the Group in India may be regarded as non-routine expenditure.

5 AMP vs Selling expenditure The main purpose of AMP spend is to create awareness of the product with potential customers. AMP spends typically aim to convey the strengths, features, price, etc of the product in order to get the customer interested in the product. Selling expenditure normally would not focus on the brand. Selling expenses ought to be identifiable on the basis of the marketing strategy / budget that has been approved by the company. These details would need to be reviewed to identify this type of expense. It should be pointed out that a Group does not stand to benefit from a substantial amount of AMP spends if the product is not sellable. Distribution expenses are not in the nature of AMP spends Distribution expenses are clearly identifiable as product related selling expenditure. Product placement expenses are an example of distribution expenses which may be get classified as AMP spends in the books of accounts for grouping purposes. However, these expenses are clearly distinguishable from AMP spends and cannot be regarded as being in the nature of advertising, marketing or publicity expenses since these expenses are incurred for increasing the sale of the product and not to create awareness of the either the brand or the product. Appropriateness of the margin of the Indian AE Examination of AMP spends in isolation could result in an inaccurate conclusion. The remuneration of the Indian AE takes into account the functions undertaken, the risks borne and the assets employed by the Indian AE. The functions to be undertaken by the Indian AE under its contract with the foreign AE could include undertaking of appropriate marketing and promotion of the products, which would inevitably require promotion of brand in some form or the other, since these would invariably include branded products. When the remuneration of the Indian AE is decided, these factors are taken into account to determine the appropriate compensation to be paid to the Indian AE. Normally one would find that even after taking into account the AMP spends, the Indian AE earns a margin which is commensurate with companies undertaking similar functions. This is a clear indication of the fact that the Indian AE has been adequately remunerated. In such a scenario, forcing the Indian AE to recover the AMP spends with a mark-up in addition to the arms length margin that it has earned would be unreasonable. Infact, this approach would lead to double taxation in the hands of the Indian AE in a situation where the IRA proposes an adjustment on account of inadequacy of the net margin and further makes an adjustment on account of non recovery of the AMP expenses. This is on account of the fact that the adjusted net margin in any case takes into account the AMP expenditure incurred by the Indian AE. Incidental benefit As mentioned above, typically, the products sold in the Indian market would be branded products. Accordingly, when the product is advertised, it is natural that the brand is advertised. Would it be possible for an electronics company to advertise television sets solely on the basis of a product number and without the use of the brand name and expect its target customers to be able to identify which product is being advertised? Advertising for a product, to a certain extent, is likely to benefit the brand over a long term. However, the fact remains, this benefit to the brand is purely incidental which is nothing but a rub-off effect of

6 the AMP expenditure. In a third party scenario, can a distributor expect compensation for incidental benefit derived by its principal from the activities of the distributor? A company would not gain any commercial advantage by marketing only its brand, it is the product that is important there are examples of companies (for example in the case of e- commerce space) which despite incurring heavy AMP expenses did not succeed because the product being sold did not match up to the customer s needs or expectations. To hold that all AMP expenses benefit the brand and ought to be recouped by the Indian AE under a cost plus arrangement would show a lack of analysis of the nature of the expenses and the reasons why industry would incur such expenses. At the same time, to insist that all AMP expense are incurred purely for product advertising and none of the AMP spends are incurred for brand building exercise would be presenting an incomplete picture. As part of its marketing strategy, one expects that companies would need to undertake brand building or brand promotion exercises. These expenses could be regarded as being non-routine in nature a third party distributor is unlikely to agree to promote the brand of its principal out of its own remuneration. Further, an aspect related to marketing intangibles which has not found due consideration is the issue around the right to use the brand. Typically, the Indian AE is licensed the right to use the brand. In normal situations, the brand is licensed to the Indian AE to enable it to sell the products. The brand could be licensed with or without a charge (the brand could be licenses without a charge if the Indian AE is unable to undertake its selling function without the use of the brand). Let us assume that an adjustment for AMP expenses is thrust on the Indian AE whereby the IRA hold that the Indian AE should recover AMP expenses with a mark up from the foreign AE. In a third party scenario, if a foreign principal incurs expenses for the promotion of a brand, which is licensed to the Indian distributor, the foreign principal would recover these expenses from the Indian distributor. Accordingly, making a TP adjustment for AMP expenses in the assessment of the Indian AE should result in the foreign AE correcting its future transfer pricing with the Indian AE by recovering this cost from the Indian AE, possibly with an appropriate mark up. Would the IRA hold this charge to be arms length? Determination of the need for a recovery of AMP spends from the foreign AE without examining the relationship between the two AEs on the use of the brand would be reaching a conclusion without considering all facts. In conclusion, a standard approach cannot be adopted for the determination of the transfer pricing treatment of marketing intangibles. While a formula driven approach of comparing the AMP spends with companies engaged in similar functions would not produce a fair result, it cannot be denied that AMP spend does have a rub-off effect on the brand. A reasonable result cannot be obtained without examining in detail the nature of the expenses (whether the expenses were necessarily incurred for the sale of the product) and without gaining an in depth understanding of the industry and also the economic scenario under which these expenses are incurred. For example, a launch of a new product in a country may obviously require incurring of higher AMP expense as against an existing product but that does not mean that the differential in on account of promotion of brand. Often, transfer pricing involves a comparison with averages, but the treatment of AMP spends cannot be determined through averages since at the end of the day, the objective of incurring greater AMP spends would generally be driven by a need to achieve greater market penetration in order to achieve better sales, which would ultimately produce the greater profit. In the market place, usually, without appropriate levels of AMP spends, customer acquisition is a difficult task and each company would implement marketing strategy to promote its products and not necessarily on the basis of a relative comparison to the marketing undertaken by its competitors. A straight jacketed approach of comparison through averages leads to a suggestion that all

7 companies should incur a similar level of expense for earning profits, and resultantly should have the same level of profitability, which in a competitive economy is not possible. In order to deal with the controversy, tax payers should carefully examine their AMP spend to determine expenses which are routine in nature and those that are non-routine on which compensation may need to be