Over the past few years issue of Advertisement, Marketing and Promotion (‘AMP’) expenses has become very prominent in Transfer Pricing Assessments in India, wherein Indian subsidiaries which are engaged in business activities using brand name of global multi-national enterprises (‘MNEs’). Indian Revenue Authorities (IRA) argues that AMP expenses involving brand promotion service by the taxpayer for its AE results into creation of marketing intangibles for the brand owner which is Foreign AE of the taxpayer, hence covered under transfer pricing regulations and requires adjustments according to arm length principle. This article discusses the guiding principles to determine whether a TP adjustment is required for AMP expenditure and the prominent approaches to determine arm’s length price and related judicial developments on the issue. Read on.
The very first step towards determining exposure of AMP adjustment is to determine whether the AMP expenditure can be construed as “international transaction” as per section 92B of the Income tax Act, 1961 “Act”. For this a proper study of relationship between associate enterprise is to be undertaken i.e. whether AMP expenditure has been made from any contractual obligation between associates, along with FAR analyses of associates to determine the rationale for incurring expenses. Other guiding aspects to consider are as below:
1. Whether AMP expenses actually leads to brand building or is it a mere functional requirement in the business of taxpayer. If it is a functional requirement then how much of such expenditure can be determined as routine expenditure & how much is non-routine expenditure.
2. Target customers / market for such AMP expenditure.
3. Whether AMP should be identifiable to the Indian operations i.e. direct nexus with Indian operations.
4. Whether any approvals are required in incurring AMP expenses and the duties and functions performed by approving personnel.
5. Any inter group company agreement mandating de-minimis quantum of AMP expense by taxpayer. If yes, what are the benefits endowing to its associate and how taxpayer is rewarded for AMP expense incurred.
6. Which taxpayer is the primarily economic beneficiary of such AMP expense i.e. whether AMP spend by taxpayer is intended to benefit its own business in terms of higher sales or higher market share and whether any benefit endowed to associate is purely incidental.
7. Whether taxpayer has exclusive right to the use of trademark or Brand in its market.
Prominent approaches followed for determining arm’s length price:
Bright Line Test (BLT): Expenditure incurred by taxpayer exceeding the average AMP expenditure of comparable companies can be considered for AMP adjustment. Further such AMP adjustment should be topped up with mark-up of average profit margin earned by the entities rendering market support services. Refer illustration below:
|Particulars||Taxpayer (INR)||Average of Comparables (INR)|
|Excess AMP by Taxpayer||100 x (10-5.83)% = 4.17|
|Avg Mark up of MSS entities||11%|
|TP Adjustment||4.17 x(1.11)=4.63|
Intensity Based Approach: AMP expenditure of the taxpayer in percentage of sale can be construed as Intensity of AMP expenditure. Similar average intensity of comparable companies shall be identified and excess expenditure on AMP incurred by taxpayer can be computed by comparing the average intensity of comparable companies. Thereafter revised average operating margins of the comparables is computed after adjusting the excess of AMP intensity to the operating cost and enhanced revenue along with mark-up of average profit margin earned by the entities rendering market support services. Refer illustration below:
|Particular||Taxpayer (INR)||Average of Comparables (INR)|
|Cost of goods sold||70||80|
|GP/Turnover (%)||30 / 100 = 30%||40/120= 33.33%|
|Other Operating cost||10||10|
|Operating Profit||30-10 = 20||40-10 = 30|
|OP/ Turnover (%)||20 / 100 = 20||30 / 120 = 25|
|AMP/ Turnover (Intensity) %||10 /100 = 10||8 / 120 = 6.67|
|Difference of Intensity (%)||10 – 6.67 = 3.33|
|Difference in Cost||120 x 3.33 = 4|
|Adjusted cost of comparable||(80 + 10) + 4 = 94|
|Adjustment in sales of comparable in the ratio of differential cost||4x (1.2) = 4.8|
|Adjusted sales||120 + 4.8 = 124.80|
|Adjusted profits||124.80 – 94 = 30.80|
|Adjusted operating margin of comparable (%)||30.80 / 124.80 = 24.68|
|Arm’s length profit||24.68|
|Difference b/w arm’s length profit and reported operating profit (TP adjustment)||24.68- 20 = 4.68|
Residual Profit Split Method: AMP expenditure incurred by the Indian taxpayer equivalent to the amount of comparable companies is considered a routine and excess expenditure is considered as non-routine. Operating profit on sales percentage of the comparable companies and taxpayer (excluding non-routine AMP expenditure) is computed and difference is determined as ‘Residual Profit’. Further based on FAR analysis AEs share in the residual profit is derived and is reduced from non-routine expenditure to make an adjustment. Refer illustration below:
|Particular||Taxpayer (INR)||Average of Comparables (INR)|
|Operating Profit||100-80 = 20||120-90 = 30|
|OP/ Turnover (%)||20 / 100 = 20||30 / 120 = 25|
|AMP/ Turnover (%)||10||6.67|
|Routine expenses||100 x 6.67%= 6.67|
|Non-routine expense||10-6.67 = 3.33|
|Adjusted Operating Cost||80-3.33 = 76.67|
|Adjusted Operating Profit||23.33|
|Residual profit over comparable||23.33-25 = -1.67|
|Profit to be split to AE on the basis of FAR (assumed 25%)||-1.67 x 25% = -0.42|
|Non- routine expense||3.33|
|TP Adjustment||3.33 – (-0.42) = 3.75|
The selection of the most appropriate transfer pricing method should be based on a functional analysis that provides a clear understanding of the MNE’s global business processes and how the transferred intangibles interact with other functions, assets and risks that comprise the global business. The functional analysis should identify all factors that contribute to value creation, which may include risks borne, specific market characteristics, location, business strategies, and MNE group synergies among others. The transfer pricing method selected, and any adjustments incorporated in that method based on the comparability analysis and should take into account all of the relevant factors materially contributing to the creation of value, not only intangibles and routine functions.
JUDICIAL DEVELOPMENTS RELATED TO AMP
One of the earliest decision on the AMP issue was reported in the case of Maruti Suzuki India Ltd. (MSIL) v. Addl. CIT, TPO  328 ITR 210 (Delhi),(1st Maruti judgment) a case of license manufacture, wherein the AMP was held as international transaction under section 92B of the Income Tax Act, 1961(“Act”). It was further held that the Indian Entities merely uses the brand of their foreign partners for its business. The matter was then remanded, however, this judgment was challenged before the Hon’ble Supreme Court and was overruled in Maruti Suzuki India Ltd. v. Addl. CIT  335 ITR 121 (SC).
Thereafter the matter was again reported to Delhi Bench of ITAT in LG Electronics India (P.) Ltd. v. Asstt. CIT  140 ITD 41 (Delhi) (SB) where it was held that the Assessing Officer (‘AO’) was entitled to make a transfer pricing adjustment under Chapter X of the Act on the basis of BLT in respect of the AMP expenditure incurred by Indian Entity as the same is an international transaction. This decision results in a batch of appeals including the cases of Sony, Reebok, Canon etc., who are distributor of foreign company, before the Hon’ble Delhi High Court, which came to be decided by a decision in Sony Ericsson Mobile Communications India (P.) Ltd. v. CIT  374 ITR 118 (Del).
In this case the Hon’ble The Court did not struggle with the determination of an international transaction, as the parties’ primary submission was that the international transactions between them and their foreign AEs included the value of AMP functions. However, the Revenue and the Transfer Pricing Officer (TPO) had relied heavily on LG Electronics to justify their use of the bright line test in ascertaining the portion of AMP expenses which would constitute an international transaction. The Court rejected their contentions, holding that the use of the bright line test had no statutory backing. Consequently, the Court overruled the decision in LG Electronics insofar as it upheld the bright line test, asserting that such an approach would amount to judicial legislation. The matter was remanded back for determination of ALP after doing the functional analysis and determination of valid comparable. It was further held that even if an expense is wholly and exclusively spent for the purpose of business and allowable under section 37 of the Act, still, the same can be a subject matter to transfer pricing adjustment under chapter X of the Act in so far as it is excessive.
In the meanwhile, the fact that the benefit of such AMP expenses would also enure to the AE is itself sufficient to infer the existence of an international transaction has been rejected by the Hon’ble Delhi High Court in Maruti Suzuki India Ltd. v. CIT  381 ITR 117 (Delhi) (2nd Maruti judgment). Also, there are various other decisions of the Hon’ble Delhi High Court including Bausch & Lomb Eyecare (India) (P.) Ltd. v. Addl. CIT  381 ITR 227 (Delhi) which has similarly held that AMP expense is not an international transaction and further there is no machinery provision for computation of AMP expense adjustment.
Recently, the Delhi Bench of Income tax Appellate Tribunal in the case of M/s Sony Mobile Communications [India] Pvt. Ltd v. The Addl. C.I.T (ITA No. 6410/Del/2012) has in remand proceedings (pursuant to Sony Ericsson (Supra) judgment) held that the AMP expense incurred by the taxpayer company could not have added any value to the brand Sony Ericsson owned by its Associated Enterprise and since this was the first year of business in India, the taxpayer had to advertise aggressively but could not be considered as expenditure incurred for brand building. At the most, the same can be considered as having been incurred for brand maintenance. Further, the taxpayer earned margin of 2.5% after considering AMP expenditure which is much higher than the mean margin of comparable companies, which is at 0.4%. Hence, any addition on account of ALP is uncalled for.
The aforesaid judgment of Delhi High Court including the Sony Ericsson (Supra) and 2ndMaruti judgment are pending before the Hon’ble Apex Court (Civil Appeal No. 132 of 2016), therefore, a final view on the issue may be taken once the same are disposed by the Apex Court.
It is expected that Supreme Court of India may lay out certain parameters which might provide a broad framework on this issue. However, considering the complexity involved, it is unlikely that Supreme Court of India judgement would be able to provide a final position equally applicable for each such tax payer or even a category.
As can be gathered from above, until the transfer pricing legislation would not be amended with respect to a method to determine the ratio or quantum of AMP expenditure eligible for TP adjustment, a standard set of procedures or methods comparing the AMP expenditure with comparable companies would not produce a fair result.
A reasonable results can only be obtained only after examining in detail the necessity of expenditure considering the industry comparable along with FAR analysis of AEs.