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Marketing Intangibles: An Indian Saga By T.P. Ostwal

The Indian Transfer Pricing Regulations (‘TPR’) were introduced over 13 years ago. During this period, the Indian Revenue Authorities (‘IRA’) have concluded transfer pricing audits for 10 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 700,000 million (approximately USD 11.66 billion) in a span of only 11 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. 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, the issue has been taken up zealously and aggressively by the tax authorities; as a result, taxpayers have witnessed large TP adjustments on the basis of Advertisement, Marketing and Promotion (hereinafter “AMP”) expenditure being asserted to be outside a permissible arm’s length range. The common questions raised in all these cases are: Whether promotional efforts undertaken by an Indian entity (Licensee of trademark), enhance the value of a trademark which is legally owned by an Associated Enterprise (hereinafter “AE”)? Whether the AE should compensate the Indian entity for the excessive AMP expenditure that is attributable to the developing a trademark owned by it? IRA have been contending that such non-routine marketing efforts of a subsidiary of the MNE’s should be categorized as “ service “ rendered to their AE and accordingly, should be compensated for the same. This nonroutine expenditure is presumed to create marketing intangibles for the 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. Evolution of Marketing Intangible Concept Globally The issue of marketing intangible started with “Bright Line” concept which was derived from the DHL case in the US. 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. History of Marketing Intangibles in India Round 1 of Marketing Intangible Saga In India, issue of marketing intangibles has been raised widely and applied mechanically by IRA. The issue of marketing intangibles first came up before the Delhi High Court in the case of Maruti Suzuki India Ltd [2010] 328 ITR 210. In the instant case, the taxpayer Maruti Suzuki India Limited (hereinafter “MSIL”) being an Indian Company had entered into a license agreement with Suzuki Motor Corporation (hereinafter “SMC”) for the manufacture and sale of automotive vehicles. As per the terms of the agreement, MSIL agreed to pay a lump sum amount as well as royalty to SMC as consideration for 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 vehicles manufactured by it. MSIL had also incurred significant AMP spends for promoting its products. In connection with AMP spends incurred by MSIL, the Delhi High Court laid down that the AMP expenses incurred by domestic entity are more than what similarly situated and comparable independent domestic entity would have incurred (bright line test), the foreign AE needs to suitably compensate the domestic entity in respect of the advantage obtained by it in the form of marketing intangible development. In case, the domestic entity uses a foreign trademark or logo on its product manufactured or sold in India’s, no payment to the foreign entity on account of such use, is necessary, in case the use of the foreign trademark or logo is discretionary. However, the consideration for usage needs to be determined at arm’s length. OECD Position on Marketing Intangibles Paragraph 6.38 of the OECD Guidelines provides that in arm’s length dealings the ability of a party who is not the legal owner of marketing intangible to obtain future benefit of marketing activities that increases value of that intangible will depend principally on the substance of the rights of party. The OECD Guidelines further clarifies that a distributor may have ability to obtain benefit from its investment in developing the value of trade mark from its turnover and market share where it is a long term contract of sale distribution right or the trade mark product. It is provided in such case a distributor may bear extraordinary marketing expenditure beyond what an independent distributor in such a case might incur to obtain an additional return from owner of a trade mark, e.g., through a decrease in the purchase price of the product and reduction in royalty rate. Paragraph 6.38 of the OECD Guidelines on Transfer Pricing read as follows: “6.38 Where the distributor actually bears the cost of its marketing activities (i.e., there is no arrangement for the owner to reimburse the expenditures), the issue is the extent to which the distributor is able to share in potential benefits from those activities. In general, the arm’s length dealings the ability of a party that is not the legal owner of a marketing intangible to obtain the future benefits of a marketing activities that increase the value of that intangible will depend principally on the substance of the rights of the party. For example, a distributor may have the ability to obtain benefits from its investments in developing the value of a trademark from its turnover and market share where it has along term contract of sole distribution rights/or the trademarked product. In such cases, a distributor may bear extraordinary marketing expenditures beyond what an independent distributor in

such a case might obtain an additional return from the owner of a trademark, perhaps through a decrease in the purchase price of the product or a reduction in royalty rate.” (emphasis supplied)” The Transfer Pricing regulations in India being, by and large, based on OECD Transfer Pricing guidelines, the said guidelines are usually referred to in explaining and interpreting the Transfer Pricing provisions under the Act to the extent that they are pari materia with the OECD guidelines. However, the recommendations of the OECD guidelines could not be applied in absence of a specific enabling provision or method provided under the Transfer Pricing regulations in India to deal with such extraordinary marketing expenditure. Position in UN Transfer Pricing Manual United Nations Transfer Pricing Manual provides for the allocation of such cost of market penetration, marketing expansion and market maintenance strategies between a MNE and its subsidiaries under the Transfer Pricing Regulations. Para 5.3.2.5 provides that the allocation of the cost of these strategies between a MNE and its subsidiaries is an important issue in transfer pricing and will depend on the facts and circumstances of each case. It is important to examine various factors in order to address this issue of cost allocation between parties to the transactions. It is also essential to know which entity or entities have the legal ownership of the intangibles. Note that in some cases an enterprise which does not have legal ownership of an intangible may nevertheless be entitled to a share of the returns from its exploitation. Some countries refer to this notion as “economic ownership”. For instance, where a MNE parent has legal ownership of a product trademark or trade name it may have to be determined, depending on the facts and circumstances of the case, whether the subsidiary has “economic ownership” of the associated marketing intangibles that are created, based on the subsidiary’s contribution to a strategy to enhance market share. Round 2 of Marketing Intangible Saga & Finance Act 2012 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 AE’s who have derived benefits. However, the tribunals in most of its decisions prior to the Finance Act, 2012 have held that since the specific international transaction pertaining to AMP spends has not been referred to Transfer Pricing Officer (hereinafter “TPO”) by the Assessing Officer, the assumption of the jurisdiction by TPO in working out the Arm’s length price of the AMP transaction is not justified. Also taxpayers prior to the amendments brought 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 Indian TPR, empowers the TPO to scrutinize any international transaction which TPO deems fit. Further, it also expanded the meaning of the term “international transaction” to bring within its ambit provision of services relating to development of marketing intangibles. In the year 2012, Delhi Special Bench Tribunal delivered a ruling on this issue in case of L.G. Electronics India Pvt Ltd [(2013) 152 TTJ 273]. This decision of the special bench is much more conclusive and decisive than the decision of Delhi High Court in the case of Maruti-Suzuki Vs ACIT. It settled preliminary issues like whether the TPO has jurisdiction u/s 92 of Indian Income Tax Act (hereinafter “the Act”), whether there exists a transaction u/s 92 of the Act and whether there was an international transaction u/s 92 of Act. Also, it agreed with the view of Delhi High Court that the AMP expenditure in excess of the arm’s length range helps to promotes the brand of the foreign AE and that the Indian AE should necessarily be compensated by the foreign AE. Thirdly, it also dissented with the developer-assister rule and economic ownership of the brand concept on the ground that nobody can become an owner of a brand by merely splurging money to promote a brand that did not legally belong to him. However, even this elaborate decision could not put a full stop to the brand promotion band issue. In fact, this decision laid a platform for more confusion through ‘The 14 Factors’ in selecting the comparables and making adjustments. Each of the 14 factors recommended by the Special Bench will be put under a scanner in the near future and there will be more and more bargain from both the sides (i.e., from the taxpayer as well as from the department) with respect to the adjustments to be made in the comparable companies profits to be comparable with the tested party. The irony in the case is that the special bench held that even an implied arrangement (without any documentary evidence) is enough for the TPO to take cognizance of brand promotion, but it is up to

the taxpayer to prove beyond doubt (with as many supporting documents as possible) to make any adjustment in the arm’s length range fixed by the TPO. Following the decision of Delhi Tribunal in the case of L.G.Electronics, the various Tax Tribunals in India have remanded back many of the pending cases relating to AMP expenditure to the file of TPO with specific directions to follow and apply the principles laid down by the Delhi Tribunal. Round 3: New Twist in the Marketing Intangible Saga in 2015 In a reprieve to multinational companies (MNCs) and their subsidiaries operating out of India, the Delhi High Court [ITA No.16/2014] has laid out broad principles and a computational mechanism to resolve disputes relating to transfer pricing for marketing intangibles. The case involved a spectrum of consumer durables and consumer electronics companies, including Daikin Airconditioning, Haier Appliances, Reebok India, Canon India and Sony Mobile Communications. The court said the tax department had the jurisdiction to treat advertising, marketing and promotional expenses by an Indian subsidiary of an MNC as international transactions, under section 92B of the Income-Tax (I-T) Act, 1961. It, however, noted while treating such transactions under transfer pricing rules, “the exercise undertaken should not result in over- or double-taxation”. The dispute related to whether a portion of the amount spent by multinational companies in the country on advertisement and marketing expenses should be borne by the Indian subsidiaries or their parent companies abroad. The income tax department had applied transfer pricing rules on such transactions, citing notional benefits to the parent company. The court said for any “excess” expenditure established, the Indian subsidiary must be compensated by the parent group. The High Court disagreed with the use of the bright-line test which was used in the DHL Corp vs Commissioner case in a US court, Canada vs Glaxo Smithkline Inc in the Canada SC and the OECD/UN Manual suggesting nonroutine AMP as a separate transaction. The High Court stated that if the same does not figure in the Act and rules in India, then it cannot be applied. The High Court further held that various legal ratios accepted and applied by the Tribunals relying upon the decision of Delhi Tribunal in case of LG Electronics as erroneous and unacceptable. Also, the court disagreed with the tax department’s practice of de-bundling inter-connected transactions such as distribution, marketing, advertising and promotional spends to arrive at tax liabilities of Indian subsidiaries. It ruled distribution and marketing were intertwined and could be analysed together. The court said tax authorities should give “good and sufficient reasons” for de-bundling such inter-connected transactions. The High Court differentiated the concept of brand-building from that of the AMP spend. It stated that brandbuilding does not necessarily result out of the AMP spend. There are many reputed brands which do not go in for advertisement with the intention to build brand value, but to increase sales and earn more profits. The High Court directed the revenue authorities to address the issue of economic ownership versus legal ownership in line with the business models and distribution function performed. When a distributor uses the brand over a period of time and sells the goods, he is deemed to be an economic owner of the brand. This is more relevant for licensed manufacturers. It needs to be examined if the intangible is exploited in the market to benefit the foreign parent. It is necessary to examine whether the distributor is involved in development of markets, like that of an entrepreneur distributor or is just a pure distributor. If it is a routine marketing or sales promotion expense which does not result in a brand-building expenditure, then the question of compensation in addition to the profits earned is not warranted. Even though the parties can use the profit-split method for such non-routine contribution of intangible property, it has not been used by any of the disputing parties. It is directed to have adequate compensation to the Indian company if there is an excessive AMP. If the compensatory model is already built-in, there is no need for further transfer pricing adjustment separately. The characterisation of the distribution function is key to use the most appropriate method—whether it is long-term distribution or distribution cum marketing agreements and short-term contractual arrangements. The High Court appreciated the fact that marketing intangibles is an in-depth fact-finding exercise, using the FAR profile of each taxpayer and its foreign enterprise. It cannot be held universally that there is excessive AMP spend that needs transfer pricing adjustment. Also, the notion of brand-building shall not be equated to advertisement and sales promotion. It is more relevant for a licensed manufacturer who exploits the trademark, know-how,

infrastructure, etc. The landmark judgement has created many safeguards for companies. This decision will have a far reaching impact on ongoing disputes on this issue. Conclusion As can be gathered from above, one of the most challenging issues in transfer pricing is the taxation of marketing intangibles. 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. 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 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. The analysis of this issue requires assessment of: (1) the obligations and rights implied by the legal registrations and agreements between the parties; (2) the functions performed, assets used and risks assumed by the parties; (3) intangible value anticipated to be created through the distributor’s activities; and (4) the compensation provided for the functions performed by the distributor. As a proactive approach to attain upfront tax certainty on this complex issue, the option of APA should be evaluated by taxpayers. With inputs from Shreyash Shah © 2015 Kluwer International Tax Blog. All Rights Reserved.