2015 (3) TMI 580 - HC - Income Tax

Transfer pricing: AMP expenses treated as international transactions; retrospective s.92CA(2B) validates procedure, factual issues remitted

HC held that the Transfer Pricing Officer could validly treat Advertising/Marketing & Promotion (AMP) expenses as part of international transactions and ... Advertising, Marketing and Promotion expenditure (AMP) as an international transaction - Transfer Pricing Officer's jurisdiction under Section 92CA(2B) - Application and limits of the bright line test to segregate AMP - Transactional Net Margin Method (TNMM) - scope, bases and limitations - Cost Plus Method (CPM) as an acceptable method for AMP adjustments - Resale Price Method (RPM) - comparability and treatment of AMP - Set-off and apportionment on de-bundling/segregation of bundled transactions - Distinction between Section 37(1) deductibility and Chapter X arm's length adjustments - Selection and comparability criteria for benchmarking (functional analysis and PLI) - Economic ownership versus legal ownership of brand/logo in transfer pricing analysisTransfer Pricing Officer's jurisdiction under Section 92CA(2B) - Whether the TPO could examine and make adjustments in respect of AMP transactions not specifically referred under Section 92CA(1). - HELD THAT: - The Court held that retrospective insertion of sub section (2B) to Section 92CA (w.e.f. 1 6 2002) permits a TPO, to whom a reference under s.92CA(1) has been made, to examine international transactions in respect of which the assessee has not furnished a report under s.92E, provided the conditions for jurisdiction under s.92CA(1) are satisfied and the TPO records requisite satisfaction. The provision cures the need for a specific prior reference for undeclared international transactions and is to be given full retrospective effect; challenges based on absence of a specific reference are negatived. The Court therefore answered this question in favour of the Revenue. [Paras 43, 44, 45, 46, 49]TPO has jurisdiction under Section 92CA(2B) to examine undeclared AMP international transactions once a valid reference under Section 92CA(1) exists; question answered for Revenue.Advertising, Marketing and Promotion expenditure (AMP) as an international transaction - Selection and comparability criteria for benchmarking (functional analysis and PLI) - Whether AMP expenses incurred by an Indian AE can be treated/categorised as an international transaction under Section 92B. - HELD THAT: - The Court held that AMP expenses can fall within the definition of 'international transaction' because s.92B and related provisions contemplate transactions (including arrangements for allocation/apportionment of costs) between associated enterprises having a bearing on profits. The fact that AMP is expended in India and paid to independent third parties does not preclude characterisation as an international transaction where the economic substance shows a contribution to the foreign AE's marketing intangible or benefits that are compensable between AEs. The Court emphasised that Section 37(1) deductibility is a distinct inquiry and does not prevent Chapter X valuation for arm's length pricing. [Paras 53, 54, 55, 56, 57]AMP expenses may be treated as an international transaction under Section 92B; question answered for Revenue.Application and limits of the bright line test to segregate AMP - Set-off and apportionment on de-bundling/segregation of bundled transactions - Selection and comparability criteria for benchmarking (functional analysis and PLI) - Whether the TPO/Tribunal may segregate AMP into routine and non routine parts (apply bright line test), and the legal status of the Special Bench parameters (paragraph 17.4) for selecting comparables. - HELD THAT: - The Court held that while a TPO may, for good and sufficient reasons, de bundle or segregate interconnected/bundled transactions (including AMP) if the bundled transactions cannot be reliably valued on an aggregate basis, there is no statutory mandate that AMP must always be subjected to the 'bright line' test or that the Special Bench's paragraph 17.4 parameters are binding in every case. Paragraph 17.4/17.6 from the L.G. Electronics majority cannot be elevated to a mandatory universal test; comparability and method selection must follow the Act and Rules, with detailed functional analysis. Where segregation is undertaken, apportionment and set off must be examined and given effect so as to avoid irrational or double adjustments. Because the Tribunal's approach and application of the bright line/benchmarks in the impugned orders required factual reassessment in light of these legal constraints, the Court remitted the matters for fresh consideration. [Paras 120, 121, 136, 142, 144]TPO may segregate AMP in appropriate cases but the bright line parameters are not universally binding; remand for factual re examination and correct application of comparability, apportionment and set off.Transactional Net Margin Method (TNMM) - scope, bases and limitations - Selection and comparability criteria for benchmarking (functional analysis and PLI) - Whether TNMM may be applied at entity level and whether AMP segregation is compatible with TNMM. - HELD THAT: - The Court explained TNMM's mechanics and emphasised that TNMM can be applied at entity level where the tested party is functionally homogeneous (e.g., a single line 'plain vanilla' distributor) and comparables exist. However, TNMM is vulnerable where operating expenses (such as AMP) materially differ because net margins may be affected by items unrelated to the international transaction; in such cases TNMM may be inappropriate unless reliable adjustments or suitable comparables exist. Importantly, if the assessor accepts comparables for TNMM (with or without adjustments) on the bundled transaction, it is illogical thereafter to treat AMP as a separate international transaction without proper justification. The Court directed factual re examination consistent with these principles. [Paras 90, 91, 93, 101, 111]TNMM may be used where appropriate comparables exist and functions are comparable; where TNMM is accepted for a bundled transaction, segregation of AMP cannot be mechanically applied - remand for factual application.Cost Plus Method (CPM) as an acceptable method for AMP adjustments - Whether CPM is an appropriate method to compute arm's length price for AMP when AMP is treated as a separate international transaction. - HELD THAT: - The Court acknowledged CPM as a recognised method under s.92C/Rule 10B(1)(c) and accepted that CPM can be applied to AMP when AMP is segregated as a distinct international transaction, provided CPM is demonstrably the 'most appropriate method' after functional comparability and reliable benchmarking of mark ups. The Court cautioned that once AMP costs are benchmarked under CPM they should not be re included in another bundled arm's length computation (to avoid double/non rational taxation). Because the Tribunal had not completed appropriate comparability and mark up selection analysis, the matter was remitted for fresh computation if CPM is to be invoked. [Paras 169, 170, 171, 173, 174]CPM may be applied to segregated AMP only if it is the most appropriate method after proper comparability and mark up benchmarking; remand for factual and quantification exercise.Resale Price Method (RPM) - comparability and treatment of AMP - Whether RPM applied by an assessee can be maintained where AMP functions/expenditure materially affect comparability. - HELD THAT: - The Court explained RPM mechanics and held that RPM remains an acceptable method where comparables perform similar functions and AMP is either functionally comparable or can be reliably adjusted for. Where the tested party performs substantial AMP/marketing activities not reflected in the internal comparables, internal comparables may be unreliable and external comparables performing similar AMP functions should be sought; if reliable adjustments are not feasible RPM may be inappropriate. The Tribunal's reliance on CP/bright line in cases where RPM/TNMM had been adopted required remand for factual re examination. [Paras 157, 158, 162, 163, 165]RPM may be appropriate only if comparables reflect similar AMP functions or reliable adjustments can be made; remand directed where comparability was not satisfactorily established.Distinction between Section 37(1) deductibility and Chapter X arm's length adjustments - Whether allowability under Section 37(1) prevents Chapter X transfer pricing adjustments in respect of AMP. - HELD THAT: - The Court held that Section 37(1) (revenue deductibility) and Chapter X (arm's length determination) operate in separate spheres: allowability of an expense for tax purposes does not preclude the TPO from determining arm's length price of an international transaction under Chapter X. Thus AMP may be deductible under s.37(1) yet still be scrutinised for arm's length valuation and adjustment under Chapter X. The Court recorded that Chapter X's operation cannot be curtailed by s.37(1). [Paras 54, 55, 56]Section 37(1) deductibility does not oust TPO's power under Chapter X to determine and adjust arm's length price; decision for Revenue on separability of inquiries.Set-off and apportionment on de-bundling/segregation of bundled transactions - Whether Section 92(3) prohibits set off/adjustment when a bundled transaction is de bundled and AMP treated separately. - HELD THAT: - The Court rejected the proposition that s.92(3) bars set off. It interpreted s.92(3) as preventing transfer pricing rules from being used to reduce the taxpayer's income reported in books (i.e., it prevents transfer pricing producing a lower taxable income than books show), not as a prohibition on apportionment between components of a bundled transaction. The Court held that where segregation is justified, apportionment and set off must be realistically and fairly carried out to avoid double or irrational taxation; legislative intent needed to be explicit to deny set off and it is not present. [Paras 136, 139, 140, 144]Section 92(3) does not prohibit set off; where de bundling occurs, TPO must examine apportionment and allow appropriate set offs to avoid anomalous results.Direct selling expenses (trade/volume discounts, rebates, commissions) excluded from AMP - Whether selling expenses like trade/volume discounts, rebates and commissions constitute AMP for arm's length purposes. - HELD THAT: - The Court accepted the Tribunal's and Special Bench's conclusion that direct selling/distribution costs (trade/volume discounts, dealer commissions, cash discounts, etc.) are selling expenses linked immediately to price/consideration for goods and are not to be treated as AMP for brand building international transaction valuation. Such items have a live link to pricing and turnover and, when AMP is de bundled, should be examined and excluded from AMP comparison; TPO must verify quantification but cannot treat routine selling discounts as brand building AMP. [Paras 15, 21, 175, 176]Direct selling expenses are not part of AMP for brand building adjustments; issue answered in favour of assessee.Royalty paid to Associated Enterprise - arm's length determination under CUP - Selection and comparability criteria for benchmarking (functional analysis and PLI) - Whether the Tribunal was right in setting aside the TPO's determination that royalty paid by Reebok India was NIL. - HELD THAT: - On the royalty claim, the Court agreed with the Tribunal that where bona fide know how/technology/licence was provided under the licence agreement and comparables supported a positive royalty rate, the TPO's conclusion that royalty was NIL (based principally on profitability metrics) was unsustainable. Profitability alone is not decisive; if technology/know how benefiting the Indian AE was provided and comparables show arm's length royalty rates, the royalty payment cannot be treated as NIL. The Tribunal's allowance of the assessee's appeal on this point was upheld and the matter was answered in favour of the assessee. [Paras 180, 181, 182, 183, 186]Tribunal rightly set aside the NIL royalty finding; royalty upheld as an arm's length compensable transaction.Final Conclusion: The Court held that (i) Sub section 92CA(2B) confers jurisdiction on the TPO to examine undeclared international transactions including AMP where a valid reference under s.92CA(1) exists; (ii) AMP can constitute an international transaction under Chapter X; (iii) TPOs may segregate AMP into routine and non routine parts and apply methods like CPM where justified, but the Special Bench 'bright line' parameters are not universally binding and cannot be mechanically applied; (iv) selection of method and comparables must follow detailed functional analysis and Rule 10B/10C principles, with appropriate apportionment and set offs on de bundling to avoid anomalous taxation; (v) direct selling expenses (trade/volume discounts, rebates, commissions) are not to be treated as AMP for brand building adjustments; and (vi) the Tribunal was correct in overturning the TPO's NIL royalty finding for Reebok. Several matters of quantification and comparability were remitted to the Tribunal/TPO for fresh factual determination in accordance with the legal principles laid down. Issues Involved:1. Jurisdiction of Transfer Pricing Officer (TPO) regarding AMP expenses.2. Categorization of AMP expenses as an international transaction.3. Conditions for transfer pricing adjustment of AMP expenses.4. Application of Cost Plus Method for AMP expenses.5. Directions for fresh benchmarking/comparability analysis.Issue-wise Analysis:1. Jurisdiction of Transfer Pricing Officer (TPO) regarding AMP expenses:The court held that the TPO has jurisdiction to examine and apply transfer pricing provisions to transactions, which come to his notice, even if the assessee has not furnished a report under Section 92E of the Income Tax Act. This is in line with the retrospective amendment to Section 92CA by the Finance Act, 2012. The TPO can evaluate transfer prices of undeclared international transactions if it is established that there was an international transaction for which a report was not furnished.2. Categorization of AMP expenses as an international transaction:The court rejected the contention that AMP expenses are not international transactions. It clarified that the arm's length determination pertains to adequate compensation to the Indian AE for incurring and performing functions, including AMP expenses. The expenses incurred by the Indian assessee for AMP purposes are recognized as international transactions under Section 92B of the Income Tax Act.3. Conditions for transfer pricing adjustment of AMP expenses:The court emphasized that AMP expenses should be adequately compensated by the foreign AE. This compensation can be included in the purchase price, lower royalty, or direct payments. The method selected and comparability analysis should appropriately include AMP functions and costs. The court also noted that the TPO can segregate AMP expenses as an independent international transaction if justified by grounds and reasons, ensuring no over or double taxation.4. Application of Cost Plus Method for AMP expenses:The court held that the Cost Plus Method (CP Method) is recognized under Indian transfer pricing regulations and can be applied if AMP expenses are treated as a separate international transaction. However, the adoption of CP Method must be justified, and the gross profit of the comparable must be reliable. The court also stated that if the entire marketing and distribution expenses are benchmarked under CP Method, it would be irrational to apply another method for the composite international transaction.5. Directions for fresh benchmarking/comparability analysis:The court disagreed with the Tribunal's reliance on the majority decision in L.G. Electronics India Pvt. Ltd. (supra) and the application of the 'bright line test' for AMP expenses. The court directed that the Tribunal should re-examine the factual matrix and apply the legal standards and ratios enunciated in this decision. The Tribunal should ensure that the gross/net profit margin accounts for AMP expenses and, if necessary, remand the case to the Assessing Officer/TPO for re-examination.Separate Judgment on Royalty Payment by Reebok India Company Ltd.:The court upheld the Tribunal's decision that the royalty payment was justified and should not be disallowed based on profitability alone. The royalty payment was benchmarked using the CUP Method, and the Tribunal found that the technology and know-how were provided under the licence agreement, justifying the royalty payment. The court emphasized that the financial health of the assessee should not determine the appropriateness of the transfer price paid for royalty.