The Delhi High Court (HC), in a writ petition filed by Maruti Suzuki India Ltd. (Taxpayer) [WP.(C) No. 6876/2008] against the order of the Tax Authority, has ruled on transfer pricing (TP) aspects of marketing intangibles in respect of a licensing arrangement between the Taxpayer and its associated enterprise (AE), Suzuki Motor Corporation, Japan (Suzuki).
In its ruling, the HC, besides reiterating a number of key TP principles, has provided guidance on the circumstances under which a legal owner of a marketing intangible, such as a trademark or a brand name, should compensate a licensed affiliate for its promotional efforts that has the effect of enhancing the value of the intangible. The HC held that if the advertising, marketing and promotion (AMP) expenses, incurred by the licensed affiliate using the trademark/brand name, are more than what a similarly situated and comparable enterprise would have incurred, the owner of the intangible needs to suitably compensate the licensed affiliate for the advantage obtained by it in the form of brand building and increased awareness of the intangible. In such a situation the arm’s length price (ALP) for the arrangement would need to be determined taking into consideration all the rights obtained and obligations incurred by the AEs. Furthermore, to determine whether the AMP expenses incurred are more than what a similarly situated and comparable enterprise would have incurred, it would be necessary to identify appropriate comparables for the purpose of comparison.
It would be useful for multi-national enterprises with Indian affiliates to assess the impact of the ruling on their intra-group arrangements relating to use of trademarks/brand names in India.
Background and facts
- The Taxpayer, a joint venture company of Suzuki, is engaged in the business of manufacture and sale of automobiles, besides trading in spares and components of automotive vehicles. The trade mark/ logo ‘M’ is the registered trade mark of the Taxpayer.
- The Taxpayer entered into a License Agreement (Agreement) with Suzuki in the year 1992 for the manufacture and sale of certain models of Suzuki four wheel motor vehicles. As per the terms of the Agreement, Suzuki agreed to provide technical collaboration and license, necessary to the engineering, design and development, manufacture, assembly, testing, quality control, sale and after-sale service of the Suzuki products and parts. Suzuki also granted exclusive right to use licensed information and licensed trademarks ‘Suzuki’. The Taxpayer was required to pay a recurring royalty besides a one time lump sum payment for the licensed information and the use of the licensed trademarks provided by Suzuki.
- Prior to 1993, the Taxpayer was using the logo ‘M’ on the front of the cars manufactured and sold by it. From 1993 on wards, it started using the logo ‘S’, which is the logo of Suzuki, in the front of new models of the cars manufactured and sold by it, though it continued to use the trademark ‘Maruti’ along with the word ‘Suzuki’ on the rear side of the vehicles manufactured and sold by it.
- During the audit proceedings for the tax year 2004- 05 to determine the ALP of the international transactions between the Taxpayer and Suzuki, a notice was issued by the Tax Authority to the Taxpayer. The initial approach of the Tax Authority was that there was a ‘deemed transfer’ of ‘Maruti’ brand name to Suzuki for which the Taxpayer should receive an arm’s length consideration based on the fair market value of the brand (‘deemed transfer theory’).
- In the final order, the Tax Authority abandoned the ‘deemed transfer theory’ and proposed to make an adjustment under the ‘assister in development theory’. Under this approach, the Tax Authority disallowed the royalty paid to Suzuki for use of trademark and the AMP expenses incurred in promoting ‘Suzuki’ intangibles. According to the Tax Authority, the responsibility to develop markets and promote the trademarks was on the Taxpayer. In order to develop a market for the vehicles, which included promotion of the trademark ‘Suzuki’, the Taxpayer incurred huge AMP expenditure. Hence, Suzuki should have compensated the Taxpayer for the assistance provided in developing the marketing intangibles. Accordingly, non-routine AMP expenditure was adjusted as being the value of the marketing intangibles accruing to the benefit of Suzuki.
- The Tax Authority relied on the OECD TP Guidelines relating to Intangible Property in support of the above theory. The Tax Authority also referred to the US case law in the case of DHL Inc. and Subsidiaries vs. Commissioner [TCM 1998-461] in its order and the so called ‘bright-line’ test espoused by the court in this ruling. According to this test, while every licensee or distributor is expected to spend a certain amount of costs to exploit the items of intangible property to which it is provided, it is when the investment crosses the ‘bright-line’ of routine expenditure into the realm of non-routine that the economic ownership, likely in the form of marketing intangible, is created.
- The Taxpayer challenged the notice issued by the Tax Authority by way of a writ petition in the HC.
Remedy of writ petition
- The Tax Authority raised an objection that the merits of a TP order cannot be examined in a writ since an alternative remedy was available by way of appeal to the first appellate authority. The Tax Authority was also of the view that the matter could be remanded back to the Tax Authority for passing a fresh order. The Taxpayer, on the other hand, requested that the proceedings initiated be quashed.
- The HC observed that the remedy of writ petition is not against the decision of the subordinate court, tribunal or authority. The remedy of writ petition is against the decision making process, if the court, tribunal, or authority deciding the case has ignored vital evidence or misconstrued the provisions of the relevant Indian Tax Laws (ITL) and arrived at an erroneous conclusion, leading to gross injustice. Accordingly, the HC held that it would be appropriate to examine the order passed by the Tax Authority in order to determine whether to quash the proceedings or to remand the matter back to the Tax Authority for a fresh decision.
- The HC also stated that since the TP provisions being new to the tax regime in India, it was appropriate to clarify various aspects pertaining to TP provisions including the procedure and approach to be adopted in such cases.
Procedure and approach to be followed in TP cases
- During a TP proceeding, the onus is on a taxpayer to satisfy the Tax Authority that the ALP is computed in consonance with the provisions of the ITL. The Tax Authority can reject the price computed by the taxpayer and determine it only where it finds that the taxpayer has not discharged the onus placed on it or it finds that the data used by the taxpayer is unreliable, incorrect or inappropriate or it finds certain evidence, which discredits the data used and/or the methodology applied by the taxpayer.
- As the Tax Authority had abandoned the ‘deemed transfer theory’, originally proposed in the notice in favor of the ‘assister in development theory’, in the final order, it was obligatory for the Tax Authority to issue a fresh notice for the change in approach for making the proposed adjustment.
Royalty payments by the Taxpayer to Suzuki
- If a domestic entity, irrespective of whether it is an independent entity or an AE of a foreign entity, feels that the use of a foreign brand name and/ or its logo is likely to be beneficial to it, there can be no dispute about the business decision to use the foreign brand or logo on payment of a royalty. However, in the case of AEs, such royalty should satisfy the arm’s length test.
- There were valid business reasons for the Taxpayer to enter into an agreement with Suzuki in order to meet the increased competition from foreign players. In such a case, the benefit from the association of a reputed name and logo may outweigh the loss, if any, in the value of the domestic brand. The test is to determine what a comparable entity, placed in the position of the Taxpayer, would have done. Only then can it be determined whether Suzuki had given any subsidy to the Taxpayer in the payment of royalty or it got more than what it ought to have.
- The Tax Authority had not tried to find out what royalty, if any, a comparable independent entity would have paid for the benefits derived by the Taxpayer under the Agreement.
Payments by Suzuki to the Taxpayer for use of co-branded trademark
- There is no justification for the Tax Authority insisting on a payment by Suzuki to the Taxpayer merely on account of the use of the trade name or logo as it is the Taxpayer which felt the necessity to use Suzuki’s brand and logo.
- If a domestic entity, at its discretion, uses a foreign trademark and/or logo or a trademark, which is a combination of its domestic brand name and the brand name of a foreign entity, that by itself would not necessarily entail any payment from the foreign entity to the Indian entity, so long as benefit of such a joint brand name accrues to the Indian entity alone. In such cases, the benefit, if any, accruing to the foreign entity is only incidental for which no payment is warranted.
- However, under the Agreement, the Taxpayer was under a contractual obligation to use the joint trademark. If a domestic entity is mandatorily required to use the trademark/logo of its foreign AE, appropriate payment in this regard should be made by the foreign AE on account of the benefit it derives in the form of brand building in the domestic market by its display and use on the product, as well as its packaging. The Tax Authority has to determine the ALP of the benefits obtained and obligations incurred by both parties under the Agreement by determining the payment, if any, a comparable independent domestic entity would have made in respect of an agreement of this nature.
- The AMP expenditure incurred by a domestic entity on advertising, promotion and marketing its products, using a foreign trademark/logo, does not require a compensation by the owner of the trademark since the benefits of the expenditure accrue to the domestic entity only. The benefit which the owner of the foreign brand/logo gets in the form of the increased awareness and goodwill of its brand in the domestic market, is purely incidental. Compensation for the AMP costs incurred by a domestic entity becomes relevant only where such a payment is agreed by the foreign entity and/or the expenses incurred by the domestic entity on AMP exceed normal expenses, which an independent entity would incur in this regard.
- The HC held that Tax Authority failed to appreciate that it would have been difficult for the Taxpayer to compete with automotive giants who were making an entry into India and achieve further growth without incurring adequate expenditure on advertising promotion and marketing its products. In the present case, the benefits from the AMP expenditure incurred by the Taxpayer would accrue only to it, since the products promoted and advertised were being manufactured and sold solely by it and Suzuki had no right to sell any product under the joint trademark.
- The Tax Authority failed to arrive at the AMP expenditure which an independent comparable entity, placed in the position of the Taxpayer, would have incurred. The com parables chosen and the method adopted by the Tax Authority were faulty and unjustified. If the Tax Authority was unable to find domestic com parables, he could have looked at foreign com parables. But unless the Tax Authority is able to find appropriate com parables, it is not justified to conclude that the AMP expenditure incurred by the Taxpayer exceeded the ‘bright-line’ limit. Even if it is found that the AMP expenditure incurred by the Taxpayer was more than that of a comparable independent entity, it would not automatically entail a payment to Suzuki if it is established that the Taxpayer has obtained some concession or subsidy from Suzuki, which can offset the extra expenditure incurred by the Taxpayer.
The HC set aside the order passed and directed the Tax Authority to determine the appropriate ALP in light of the following observations:
- Where an enterprise uses a trademark/ brand name of its foreign AE and the use is discretionary for the enterprise, the foreign AE is not required to pay the user. However, the consideration for usage needs to be determined at arm’s length.
- Where an enterprise is mandatorily required to use the trademark/ brand name of its foreign AE, appropriate payment should be made by the foreign AE to the domestic affiliate on account of the benefit it derives.
- The AMP expenditure incurred by a domestic enterprise using a brand name/ trademark of its foreign AE does not require any payment or compensation by the owner, so long as the AMP expenses do not exceed the expenses which a similarly situated and comparable uncontrolled enterprise would have incurred.
- If the expenses incurred are more, the foreign AE needs to suitably compensate the domestic enterprise in respect of the advantage obtained by it in the form of marketing intangible development.
- The ALP determination should take into consideration all rights obtained and obligations incurred, including the value of the intangibles obtained by the foreign AE. It would also be necessary to identify appropriate com parables for the purpose of comparison. Suitable adjustments will have to be made considering the facts and circumstances.
One of the most challenging issues in TP is the taxation of income from intangible property. The issues may arise in several contexts, such as the appropriate royalty to be charged to a licensee of intangibles or the appropriate inter-company transfer price for goods manufactured and sold to a controlled distributor when the manufacturer owns the trademark for the finished goods in the distributor’s jurisdiction. The OECD has also recently announced that it is considering starting a new project on the TP aspects of intangibles that could result in a revision to the existing guidelines.
An issue that could typically arise is when the promotional efforts of a marketing affiliate enhance the value of a trademark or brand name that is legally owned by another affiliate. A fundamental issue that is posed is how income should be allocated under arm’s length principles between the ‘legal owner’ of the trademark and the marketing affiliate that undertook the promotional efforts to develop the trademark in the local market.
The TP aspects of marketing intangibles have been the focus of the Indian Tax Authority over the last couple of years. The Tax Authority has applied the so called ‘bright-line test’ in case of many taxpayers to contend that their AMP expenditure is excessive and, therefore, the foreign AE should compensate the Indian affiliate under an arm’s length situation.
In light of the present ruling, it would be useful for multi-national enterprises with Indian affiliates to review their intra- group arrangements for India relating to trademarks/brand names. The key matters that would need to be examined include:
- The contractual arrangements between the trademark/brand name owner and the Indian affiliate– in particular, the duration of the agreement, nature of the rights obtained and who bears the costs and risks of the marketing activities.
- Whether the level of marketing activities performed by the Indian affiliate exceeds that performed by comparable uncontrolled enterprises, having regard to factors such as increase in market share, extent of competition etc.
- The extent to which the marketing activities would be expected to benefit the owner of the trademark/ brand name and/ or the Indian affiliate
- Whether the Indian affiliate is properly compensated for its marketing activities. The compensation may be by way of reimbursement of ‘excess AMP’ expenses or a reduced purchase price or a lower royalty rate.
As TP issues are fact-sensitive, the present ruling may have limited precedent value where the factual matrix varies. However, affirmation of general principles is welcome and can be expected to have some persuasive value for taxpayers.