Introduction:
Indian subsidiaries of foreign entities may carry out certain activities as part of their business in India. Generally, they may undertake manufacturing, advertising, or promotion activities and the costs incurred are known as advertising, marketing, promotion expenditure (‘AMP expenditure’).
The inclusion of AMP expenditure by an associated company in transfer pricing analysis has been a point of contention in India for quite a few years. While these costs are undertaken to promote the brand in India, it also contributes to the growth of the global brand, which transfer pricing officers allege means that it is an ‘international transaction’.
While this has continued to be a contested matter, there have also been several tribunal rulings in India on this matter. Tribunals recently have been holding that such expenses cannot be held as an ‘international transaction’.
Is AMP expenditure covered by transfer pricing?
Transfer pricing is the testing of pricing of international transactions between associated enterprises to ensure that the price is at arm’s length price. ‘International transaction’ has been defined in the Income Tax Act to mean a transaction between two associated enterprises where at least one is a non-resident Indian. The transaction may be a purchase, sale, or lease of tangible or intangible assets, provision of services, borrowing or lending of money, or any other transaction which has some effect on the profit or income or loss or assets of the enterprises.
In the process of transfer pricing study, international transactions have to be demarcated between associated enterprises to determine if it was made at arm’s length i.e. at pricing comparable to transactions between unrelated independent parties. When demarcating such transactions, the assessing officer will have to consider which transactions are thus relevant, and for advertising, marketing, and promotion-related transactions there has been a contention for the last few years on whether they can be included as part of international transactions.
The contentions emerge as assessing officers allege that these expenses result in the creation of intangibles like brand identity and image which are part of the intellectual property rights of the foreign entity. And in general, these costs are in excess of the costs that would be incurred by unrelated parties. Hence, they argue that it should come under ‘international transaction’ and should be included in the transfer pricing study. However, Indian subsidiaries contend that such expenditure is carried out for their own purposes to build the business in India and is not meant to contribute to the global business.
Bright Line Test:
Indian authorities have also adopted the “bright-line test” to determine whether such transactions can be included in the transfer pricing. This test was laid down by the United States Courts. The test states that the AMP expenditure which is in excess of the expenses incurred by comparable companies in a controlled transaction has to be compensated to the overseas enterprise. The Indian authorities consider this excessive expenditure as an enhancement of the global branch and a step towards creating marketing intangibles. The legality of the test has also been reviewed by the tribunals recently.
Jurisprudence on the Issue:
This matter has been heavily contended for years and initially, tribunals were holding that such expenditure would amount to international transactions. However, more recently there have quite a few rulings where the tax tribunals have been holding in favour of the associated enterprises, and have been trying to settle the matter.
In 2010, in the case of Maruti Suzuki, the Delhi High Court had held that that the AMP expenditure amounted to an international transaction. This judgment was subsequently overruled by the Supreme Court. A similar matter was then again heard by the Delhi High Court in the LG Electronics Case, where they held that the bright-line test can be used to determine if the AMP expenditure is an international transaction.
This decision was partially overruled by the Delhi High court in a later judgment by disregarding the application of the bright-line test, but still holding that the AMP expenditure is an international transaction. At the same time, several other decisions were also upheld by the Delhi High Court where they held that excess AMP expenditure could not amount to an international transaction and that there is no method to determine whether AMP expenditure is such a transaction. The second Maruti Suzuki case at the Delhi High Court also held that there should be an understanding between the domestic company and the associated enterprises for incurring AMP expenditure for it to be considered an international transaction.
Hence, there has been a lack of consistency in the application of the bright-line test and there was no conclusive decision for the determination of AMP expenditure.
Recent Tribunal Rulings:
In September 2020, the ITAT at Delhi held in the Haeir Appliances case that the bright-line test should not be used to determine whether the AMP expenditure is an international transaction or not. They relied on a previous Delhi High Court judgment that had found the bright-line test to be an unreliable method for determining whether AMP was an international transaction as well as for computation of ALP.
Subsequently, in November 2020, the Bangalore ITAT held in the case of Himalaya Drug Company that the excess AMP expenditure should be deleted from the transfer pricing adjustment. The important points held by the tribunal are as follows:
- That the bright-line test has proved to be unreliable in demarcating international transactions for transfer pricing. Hence, transactions should be considered outside of the scope of the test.
- In the absence of any prior arrangement between the Indian associated enterprise and its foreign entity in regard to AMP expenditure, transfer pricing adjustment cannot be made for such expenses.
- Simply because the foreign entity also benefits from AMP expenses conducted by the domestic enterprise does not mean that marketing intangibles have been created for the foreign entity.
- The transfer pricing analysis of AMP expenditure should be considered as follows: the AMP expenses have to be added to the overall price while computing ALP, to determine whether it is in excess of what it would be in an uncontrolled transaction.
The Bangalore tribunal conclusively holds that the bright line test is inapplicable in such situations and moreover points out a method of computation for the AMP costs.
Similarly, in December 2020, the Delhi ITAT held in the case of Nikon Pvt. Ltd that the excess advertising, marketing, and promoting expenditure (AMP) incurred by an associated enterprise would not amount to an international transaction for transfer pricing analysis. The tribunal held that the expenses incurred by Nikon India were clearly for the development of the brand in the domestic territory and hence could not be considered an international transaction. The Delhi tribunal like the Bangalore tribunal also held that the Sony Ericson decision of the Delhi High Court that excess AMP expenditure is always an international transaction is not a reliable judgment.
The Delhi ITAT held in the Ray Bans Case in January 2021, that the AMP expenditure had to be deleted from the transfer pricing study as there was no evidence to indicate it was an international transaction. The tribunal held that mere existence of excess AMP expenditure being conducted by the domestic enterprise for its associated foreign enterprise does not constitute an international transaction. The Transfer pricing officer has to watch for other indicators that there exists an international transaction such as subsidies or grants or existing contractual agreements. Once this has been gathered then the AMP expenditure may be included in the determination of arm’s length price.
Conclusion:
While the matters have only found some consistency with the latest ITAT rulings, there is still a case pending before the Supreme Court on the determination of AMP expenditure. Until this case is decided there might still continue to be some inconsistency, however, the trend of the tribunals and High courts is clear:
- Bright-line test alone cannot be considered an indicator that the AMP expenditure constitutes an international transaction under the Income Tax Act.
- Even if the foreign entity is to gain by the AMP services carried out by the domestic entity, that will not be proof of an international transaction if the services were carried out specifically for the development of the domestic entity in India.
- Transfer pricing officers must look for further evidence such as subsidies, grants, or contractual arrangements between the associated enterprises to prove that such expenses were a part of an international transaction.
- If the AMP is shown to be an international transaction, then it must be added as part of the computation of the arm’s length price.
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