Tax dispute intensifies over marketing and ad expenses of MNC subsidiaries

The tax authorities argue that these AMP expenses incurred by MNC subsidiaries enhance the value of trademarks or brands owned by the foreign parent entities

On May 20, the Delhi High Court, in a matter about taxing PepsiCo India’s advertising, marketing, and promotion (AMP) expenses, said the bright line test (BLT) was not a valid methodology. Earlier, too, in a case involving Sony Ericsson, the Court held that BLT was not a valid method under India’s transfer pricing rules and lacked statutory mandate.

However, in a case involving LG Electronics India, a special bench of the Delhi-based income tax appellate tribunal (ITAT) accepted BLT as a tool to determine the arm’s length nature of the AMP expenditure, while contending that part of it was an international transaction. 

In a case involving Maruti Suzuki India, the Delhi high court has held that the AMP expenses are not an international transaction.

By this point, if you have begun to lose your way, that is understandable. So, let’s get to the point. But first, here are some definitions. 

TP, AMP, BLT, arm’s length

Transfer pricing, or TP, refers to the prices of goods and services exchanged between companies under common control. For example, if a subsidiary sells goods or renders services to its holding company or a sister company, the price charged is referred to as the transfer price. In nutshell, transfer pricing rules prescribe how expenses incurred by related parties are to be taxed.

These are taxed according to the arm's length principle, which states that the price agreed upon in a transaction between two related parties must be the same as the price agreed upon in a comparable transaction between two unrelated parties.

There are six methods under India’s transfer pricing rules to compute the arm's length price. One of the six methods adopted by the tax authorities is the BLT, about which the haziness can be seen from the accompanying box.

Under BLT, AMP expenses are compared with the industry average, and the excess expenses by Indian subsidiaries are taken as brand building expenses of the foreign parent, which are to be taxed as international expenses.

However, due to the lack of specific guidelines on AMP expenses and BLT, this matter has become a contested issue between companies and the tax authorities. 

Tax authorities argue that AMP expenses incurred by subsidiaries of multinational companies enhance the value of trademarks, or brands, owned by the foreign parent. As such, the local subsidiaries should be compensated by the brand owners and those expenses must be taxed under the transfer pricing rules in India. 

Tarun Arora, Partner at Deloitte India, says taxpayers, in view of the ongoing uncertainty, need to strategize their litigation approach methodically, supported by robust factual evidence. 

No one size fits all

So far, limited clarity is available on this issue by way of a few judgements by courts and tribunals in recent years. The most recent judgement was of the Delhi high court on May 20, which rejected BLT as a valid method to substantiate the arm's length price.

Both companies as well as tax authorities have lodged petitions in the Supreme Court against most of the judgements passed by the high courts and tribunals and are waiting for the verdict. For instance, Maruti Suzuki and Sony Ericsson have both approached the Supreme Court against the Delhi high court rulings.

Though a Supreme Court ruling can put the AMP controversy to rest on the limited facts applicable to the petitions filed, it is unlikely that the court can find a “one size fits all” solution, given the unique peculiarities involved in every case.

Two pertinent questions are waiting to be addressed by the Supreme Court: One, whether the AMP expenses constitute an international transaction, and, if yes, what is the correct methodology to compute the arm’s length price for an AMP transaction.

The best one can expect is that the Supreme Court may lay out parameters that might provide a broad framework on how to proceed in cases of AMP expenses, says Manish Garg, head of transfer pricing and litigation practice at tax and consulting firm AKM Global.

There are two possible scenarios from the Supreme Court ruling, he says. “First if the Supreme Court holds that AMP expenses are not international transactions. In this case, the question of BLT or any other transfer pricing methodology will be put to rest forever.”

However, if the Supreme Court holds that AMP expenses are international transactions, the biggest challenge would be to determine the methodology for computing compensation for Indian distributors and manufacturers.

“The BLT does not take into account the uniqueness of functions performed, assets employed, and risks undertaken by different companies, and it attempts to measure all the companies using a single yardstick. Hence, BLT does not appear to be a fair tool,” Garg says.

He says a single, broad-brush approach is unlikely to be helpful in determining compensation for advertising, marketing and promotion activities, as these expenses vary by industry, and sometimes by product.

Dispute on the use of BLT stems from the fact that it is not mentioned in the five methods to compute arm's length price. But there is a sixth. 

The sixth method

Eric Mehta, partner at Price Waterhouse & Co LLP, says a sixth method —“the other method” — was introduced a few years back under the transfer pricing rules to substantiate the arm’s length relationship. This method provides flexibility to the transfer pricing authorities in choosing the basis for substantiating the arm’s length relationship, based, of course, on facts.

Though there are court rulings that suggest BLT is not one of the specified methods, the transfer pricing authorities are now justifying the use of BLT to make AMP adjustment by suggesting that it is a computation falling under the “other method”, Mehta explains.

The issue is whether AMP spend by the Indian taxpayer is enhancing the brand value of the marketing intellectual property (IP), such as brands, trademarks, etc, owned by foreign associated enterprises, and so suggestive of a service, or it is leading to economic ownership of the marketing IP itself by the Indian taxpayer.

To add to it, India’s transfer pricing authorities are adding sales and distribution expenses while computing the amount of AMP adjustment, which Mehta questions. He adds that some of the questions can persist unless the Supreme Court puts the matter to rest for good.

To BLT or not to BLT

LG Electronics India case

A special bench of the Delhi-based income tax appellate tribunal accepts BLT as a tool to determine the arm’s length nature of AMP expenditure, while contending that part of it was an international transaction.

Sony Ericsson Mobile Communications India and others

The Delhi High Court holds that the AMP expenses constituted an international transaction. However, it rejects BLT as a valid tool to determine the arm’s length price for AMP transactions. The court finds the ITAT special bench ruling in the LG case was erroneous and unacceptable, and rules that BLT lacks a statutory mandate.

Maruti Suzuki India Ltd case

The Delhi High Court holds that AMP expenses by the company are not an international transaction. The Court observes that the decision in the Sony Ericsson case rejects the use of BLT. Consequently, without BLT, there is no basis to assert that Maruti Suzuki's AMP expenses constituted an international transaction.

PepsiCo India case

The Delhi High Court holds that BLT is not a valid methodology, cites HC judgement in Sony Ericsson case.