CA Deepak Mantri
Introduction
Royalty means payment of any kind received as consideration for the use of or right to use any intangible property like patent, copyright, design or model, secret formula or process, trademark, trade name or for information concerning industrial, commercial or scientific experience. The essence of ‘royalty’ is that owner of intangible property possessing domain knowledge continues to retain the intangible property and only permits the use or allows the right to use such intangible property. Royalties thus reflect usage-based payments made by one party to another for ongoing use of intangible or tangible assets.
Ownership of intangible can be legal or economic. Where intangible property is legally protected the legal ownership test applies for transfer of rights in property. But when owner of intangible asset is economic owner the nature of rights enjoyed would depend upon the provisions in domestic law. Although concept of economic ownership is commercial reality it is not recognized in India in the Act or Rules. Royalty contracts are normally made through licensing agreements. The consideration of Royalties can be determined as a percentage of gross or net sales derived from use of the asset or a fixed price per unit sold. Further, there also exist other modes and metrics of compensation.
Transfer pricing regulations provide that the arm’s length character of international transactions involving payment of royalties should be determined by comparing the results or conditions of controlled transactions to the results realized or conditions present in comparable uncontrolled transactions.
Issues
The cross border transactions have given rise to tax controversies, which are pending adjudications before the Tribunals and Courts in India. The payment of royalty for the use of intellectual property such as trademarks, know-how, brand names etc. is now a significant focus area of the tax authorities. In many cases, the authorities have rejected the taxpayer’s analysis and disallowed payments for use / transfer of intellectual property.
Many incremental TP adjustments are seen in this area. Often revenue authorities ask taxpayers to demonstrate description of intangibles and the benefit it accrues, Whether royalty is embedded in import / sales price, Owner of intangibles (details of foreign enterprise) , Challenging the commercial need for the arrangement, At the same time determining arm’s length royalty payment for transfer of intangible property can be challenging exercise. Where ordinary or routine intangible is transferred to the licensee, there is some protection, though not complete, available to the licensee from the competitors. But if a super intangible is granted the licensee gets a monopoly or near monopoly over the market. Thus identification of licenses and rights associated with the grant of license can be important consideration for determining arm’s length royalty.
Perspective of OECD and UN
OECD Transfer Pricing Guidelines2, 2010, outlines various factors that require special consideration to apply arm’s length standard of controlled transactions involving royalty payments. These factors include, the comparability of transactions; expected benefits from intangible property; limitations of the geographic area in which the rights may be exercised; capital investment; start up expenses; development work required; possibility of sub-licensing; distribution network of the licensee and right of participation in further developments by the licensor.
Court Rulings
Taxpayer may apply comparable uncontrolled price (CUP) method to determine arm’s length royalty rate if owner of intangible asset has granted similar licensing rights to independent parties. But when internal comparables are not available, the royalty rate can be imputed by comparing the transaction under consideration with other transactions involving similar licenses and making appropriate adjustments for differences in conditions and terms of contracts. The cost plus method may also be used in some cases if proper comparables are available. However, when traditional transaction methods cannot be applied the taxpayer can rely on profit methods. The TNMM is most common method applied in such situation. When net margins of comparable entities at transactional level are not available the taxpayer may have no choice except to apply TNMM at entity level and then account for differences in transactions making appropriate adjustments. Similarly when intangible property is of unique nature or of high value for which comparables are not available, the profit split or TNMM can be applied.
CUP
The Mumbai tribunal in Dow Agro science ruling [1]Held that Where TPO having found that royalty paid by assessee to its AE was higher as compared to similar payment made by another AE, added certain amount to assessee’s ALP, in view of fact that assessee had paid royalty on net sales of product whereas other AE made payment on gross sales receipts, there being difference in mode of computation of royalty, impugned addition was to be set aside. Similarly held in Kansai Nerolac Paint [2] by Mumbai tribunal. The Hyderabad tribunal in RAK Ceramics [3]held that Where TPO had not even brought a single comparable to justify arm’s length percentage of royalty either under CUP or TNMM , approach of TPO in estimating royalty at 2 per cent as against 3 per cent as claimed by assessee being in complete violation of TP provisions had to be struck down.
TNMM applicable
The Hyderabad tribunal in Air Liquid[4] held that once TNMM has been applied to the assessee company’s transaction, it covers under its ambit the Royalty transactions in question too and hence separate analysis and consequent deletion of the Royalty payments by the TPO in the instant case seems erroneous. It followed Mumbai ITAT decision in Cadbury India Ltd. v. Addl. CIT [2013] 40 taxmann.com 529 wherein the Hon’ble ITAT upheld the use of TNMM for Royalty.
Benefit Test
Benefit test indicates the measure of benefits derived by an associated enterprise from use of intangible property.
Revenue has been disallowing royalty payments in entirety or in part on the ground that the taxpayer has failed to convincingly demonstrate- the need for availing the Intellectual Property (IP); evidentiary documents to support that IP actually received was proprietary in nature and therefore, not available to the taxpayer from any cheaper third party source and the taxpayer did not have the necessary capabilities or expertise to undertake the required research and development activity in-house ; the taxpayer received commensurate economic and commercial benefits (that are tangible as well as quantifiable) from the receipt of IP. The Rulings on Business and Commercial Expediency are as under.
The Hyderabad tribunal in Air Liquid [5]Ruled that In transfer pricing proceedings, TPO could not sit in judgment on business and commercial expediency of assessee company so as to conclude that payment of royalty made by assesse to its AE was unreasonable and, thus, ALP of said payment was to be taken as nil. The Delhi High court ruling in EKL Appliances [6]on the subject is leading judgment on the subject and followed in many other decisions. The position emerging from the above decisions is that it is not necessary for the assessee to show that any legitimate expenditure incurred by him was also incurred out of necessity. It is also not necessary for the assessee to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred “wholly and exclusively” for the purpose of business and nothing more. The Delhi Tribunal in the case of Ericsson India (P.) Ltd. v. Dy. CIT [2012] 25 taxmann.com 472 (Delhi), too, following the law laid down by the Hon’ble Delhi High Court, held that It would be wrong to hold that the expenditure should be disallowed only on the ground that these expenses were not required to be incurred by the assessee”. There are various other rulings which favour above position.[7]
RBI Approval/ FIPB Approval
Royalty, payouts is commonly benchmark for adopting the aggregated approach and further substantiated with external benchmarking by use of limits specified by the RBI. There are contradictory rulings on the subject. The arguments advance by the tax authority is that the limit specifies by the RBI or in the context of regulating the outflow or foreign exchange from India and therefore they cannot be leave for benchmarking. The Delhi high court in the case of CIT V/s Nestle India ltd. 2011 337 ITR 103 as held that the approval granted by the RBI to the tax payer is from prospective of regulation of foreign exchange the RBI at the time of granting such approval does not keep in mind the provision of the IT Act.
The Mumbai bench of the tribunal in the case of SKOL Braveries V/s SEIT 2013 29 Taxmann.com111 has held that the press note issued regarding FDI policy and prescribing the percentage of royalty to the sales allowed under automatic rule cannot substitute ALP to be determine under the provisions of IT Act. In contradiction to this the Mumbai bench of the tribunal in the case of Thysenkruvp industries India Pvt. Ltd. v/s SEIT held that if the royalty payment has been approved are being to have been approved by RBI then such payment is to be considered as ALP. Similarly in Rebok India company ITA No. 5857/DEL/2012 held that the approval of royalty payment by the government has to be given due consideration while considering the ALP.
It is also noted that various Tribunals such as Dy. CIT v. Sona Okegawa Precision Forgings Ltd. [2012] 49 SOT 520/17 taxmann.com 98 (Delhi), Hero Motocorp Ltd. v. Addl CIT (IT Appeal No. 5130/Del/2010), ThyssenKrupp Industries India Ltd. v. Addl. CIT (IT Appeal No 6460/Mum/2012), Abhishek Auto Industries Ltd. v. CIT [2011] 9 taxmann.com 27 (Delhi) have taken a view that RBI approval of the Royalty rates itself implies that the payments are at Arm’s Length and hence no further adjustment needs to be made viewed from this angle too.; SGS India (P.) Ltd. v. ACIT (IT Appeal No. 2406(Mum.) of 2006) ; Reebok India Co. v. ACIT (IT Appeal No. 5130(Delhi) of 2010) ; Hero Moto Corp Ltd. v. ACIT (IT Appeal No. 5857(Delhi) of 2012) ; [2014] 41 taxmann.com 463 (Mumbai – Trib.) SGS India (P.) Ltd.v.ACIT ; [2014] 51 taxmann.com 276 (Hyderabad – Trib.) , DCIT v. Owens Corning Industries (India) (P.) Ltd.
Conclusions
Applying arm’s length principle is critical issue for all countries to determine arm’s length price of international transactions involving intangibles. Given the unique nature of intangibles which provide a competitive advantage to the user it is extremely difficult to find comparable uncontrolled transactions to compute arm’s length prices. Traditional transaction methods may not always work as similar internal or external transactions are not easy to find to in respect of intangible property. The various court ruling discussed above provides some guidelines. The contemporous documentary evidence / analysis to substantiate the royalty payout can help the assesse. This may be by maintaining Copies of license agreement, benefits received by tax payer, quantification of the benefit, rights of the taxpayer to receive upgrades, comparative profits before/ after royalty, rates at which the royalty is paid for use of similar intangibles by any other concern / subsidiary of the AE / Group.
In the absence of suitable comparables taxpayers invariably rely on profit methods especially transaction net margin method for comparing results. Due to practical difficulties faced by taxpayers and tax administration to satisfy the arm’s length test the Government should issue guidelines to apply prescribed methods. There is also need to introduce royalty valuation rules in the statute or in income tax rules. Alternatively safe harbour rules should be provided or rules to deal with such cases.
[1] [2014] 43 taxmann.com 63 (Mumbai – Trib.) Assistant Commissioner of Income-tax -10(2)v. Dow Agro sciences India (P.) Ltd.
[2] 2013] 32 taxmann.com 60 (Mumbai – Trib.) Kansai Nerolac Paints Ltd. v.DCIT
[3] 2015] 55 taxmann.com 15 (Hyderabad – Trib.) R.A.K. Ceramics India (P.) Ltd.v.DCIT
[4] [2014] 43 taxmann.com 299 DCIT v. Air Liquide Engineering India (P.) Ltd
[5] 2014] 43 taxmann.com 299 DCIT v. Air Liquidee Engineering India (P.) Ltd.
[6] CIT v. EKL Appliances Ltd. [2012] 345 ITR 241/209 Taxman 200/24 taxmann.com 199 (Delhi)
[7] Dresser Rand India (P.) Ltd. v. Addl. CIT [2011] 47 SOT 423/13 taxman.com 82 , LG Polymers India (P.) Ltd. v. Addl. CIT [2011] 48 SOT 269/15 taxmann.com 79, KHS Machinery (P) Ltd. v. ITO [2012] 53 SOT 100 (URO)/20 taxmann.com 44, SC Enviro Agro India Ltd. v. Dy. CIT [2013] 143 ITD 195/34 taxmann.com 127 ; AWB India (P.) Ltd. v. Addl. CIT [IT Appeal No 4454 (Delhi) of 2011) ; Dy. CIT v. Owens Corning Industries India (P.) Ltd. [2015] 67 SOT 61/[2014] 51 taxmann.com 276 (Hyd. – Trib.) ; Kirby Building Systems India Ltd. v. Addl. CIT [2014] 48 taxmann.com 326 (Hyd. – Trib.) ; Toyota Kirloskar Motor (P.) Ltd. v. Asstt. CIT [2014] 48 taxmann com 380 (Bang. – Trib.); Lumax Industries Ltd. v. Addl. CIT [2013] 157 TTJ 412 (Delhi) ; Castrol India Ltd., v. Addl. CIT [2014] 151 ITD 76/45 taxmann.com 330 (Mum. – Trib.)
Dear Sir,
An excellent Article on Transfer Pricing issues arising out of royalty payments.
However I have one query. I was told that post liberalisation, there is no ceiling on the rates of royalty payments to be made . So in that case RBI approval does not help mreally.
I this case I would like to have your views and I would be much obliges if you can clarify this.
Regards
CA Sushant C. Bidaye