Court: Delhi Income-tax Appellate Tribunal
Citation: McDonald’s (India) Pvt Ltd. Vs. ACIT [ITA No. 3890 (Del) of 2004]
Brief: Advertisement expenditure incurred by a resident entity on behalf of another resident entity does not invoke the provisions of section 92 of the Income-tax Act, 1961
In a recent ruling’ , the Delhi Income-tax Appellate Tribunal (“the Tribunal”) in the case of McDonald’s (India) Pvt Ltd v. ACIT [ITA No. 3890 (Del) of 2004], has held, on evaluation of available facts, that the old provision of section 92 of the Income Tax Act, 1961 (“the Act”) does not apply in case of advertisement expenditure incurred by the resident assessee on behalf of other resident entity.
It is pertinent to note that this ruling dealt with the old provisions under section 92 of the Act as was applicable prior to the introduction of the Indian transfer pricing regulations. The old provisions of section 92 provided for computation of income from transactions with non-resident by the assessing officer (“AO”) in certain cases. This provision was applicable when it appeared to the AO that due to close connection between resident and the non-resident, the business between them was so arranged that it resulted in either no profit or less than ordinary profit for the resident entity.
- The appellant was a wholly owned subsidiary of McDonald’s Corporation, USA (“MC”).
- The appellant acquired a non exclusive license from MC to adopt and use the McDonald’s system in restaurants in India under a Master License Agreement (“MC-License Agreement”). As a consideration, the appellant was required to pay a royalty at the rate of 5 percent of gross sales and an initial franchise fee at the rate of USD 45,000 for each new restaurant opened. The appellant was also required to incur a minimum of 5 percent of gross turnover for advertisement.
- MC also entered into a Service agreement (“MC-Service Agreement”) with the appellant. The appellant was required to render specified budgeted services to MC under the Service Agreement. As a consideration, MC agreed to compensate the appellant for all the authorized expenditure incurred on the budgeted services with a mark-up of 10 percent.
- The appellant formed two joint venture companies in India and entered into a Franchise Agreement with these joint venture companies (“Franchisee”). The Franchisees were granted a license to adopt and use McDonald’s system in the restaurants operated under the agreement.
- The Franchisees were required to pay a royalty equal to 5.04 percent of the gross sales and an initial franchise fee at the rate of USD 45,000 for each new restaurant opened during the year. The Franchisees had to also incur a minimum of 5 percent of gross sales towards advertisement.
- The appellant also entered into a Marketing Support Agreement with the Franchisees. As per this agreement, the appellant was required to contribute some part of the advertisement expenditure which was required to be borne by the Franchisees.
- For the relevant year, the appellant computed the service fee at Rs. 20,363,270 i.e. 110 percent of expenses of Rs. 18,512,063 as against the total expenditure of Rs. 27,822,721 debited to the Profit and Loss A/c (excluding royalty payment).
- The AO found that expenses reimbursed by the appellant to the Franchisee for advertisement were not included in the total expenses for computing the service fee. Accordingly, the AO applied the percentage of 110 percent to the entire expenditure of Rs. 27,822,721 for computing the service fee and made the resultant adjustment of Rs. 10,241,723 to the income of the appellant.
- The rationale for incurring advertisement expenditure by the appellant was that the Franchisees were in the infancy of their business and were not able to spend the prescribed amount on advertisement.
- The appellant was entitled to reimbursement of ‘authorised expenditure’ incurred on budgeted services with a mark-up of 10 percent from MC. Advertisement expenses incurred by the appellant was neither a part of the ‘authorised expenditure’ nor the advertisement activity was a part of ‘budgeted services’.
- Section 92 of the Act was not applicable as these expenses were incurred under the Marketing Support Agreements entered into by the appellant with its Franchisees, which were resident in India. Such expenditure was never intended to be incurred by MC. It was always required to be incurred by the assessee or its Franchisees.
- It was not correct to say that the benefit of the advertisement went only to MC. The benefit accrued to the Franchisees in terms of increased sales and resultant increased profits. The appellant got benefited in terms of increase in the return on investment as well as increase in the net worth of the investment made in the Franchisee company
- No such addition was made in all the earlier years and in the subsequent years on identical facts.
- The activities of the appellant were for the benefit of MC. The appellant could not undertake any other work and also could not be a Franchisee of other products of different companies.
- The expenses incurred on advertisement were also for promoting the business of MC as it led to royalty income, etc. for MC. Non-reimbursement of aforesaid expenses by MC resulted in lesser profit for the appellant.
- the Tribunal examined the Marketing Support Agreement between the appellant and the Franchisee. The Tribunal observed that the appellant had incurred such expenditure as it would eventually result in increase in the return on investments as well as increase in the net worth of the investment for the appellant.
- The Tribunal noted that the appellant is not earning any corresponding royalty income. Further, the benefit of incurring the advertisement expenditure would be in the form of earning exempt dividend income on the investment in Franchisees. Thus, the AO could have examined the allowability of such advertisement expenditure borne by the appellant which were otherwise required to be borne by the Franchisees. The Tribunal only made the above noting and did not adjudicate on this issue since this issue was not in appeal before the Tribunal.
- The Tribunal held that section 92 of the Act was not applicable in the instant case. The advertisement expenditure partly borne by the appellant had no impact on the income of the MC. MC would get the same amount of royalty irrespective of whether the advertisement expenditure was borne by the appellant or by the Franchisees. Thus, it cannot be said that there was any arrangement between the appellant and MC (a non-resident) which has resulted in lesser profit to the appellant.
- The Tribunal also observed that as per the MC-Service Agreement, the specified services did not include advertisement on behalf of MC. Also, MC had to pay service fees to the appellant at the rate of 110 percent of only the authorised expenditure. The advertisement expenditure was not incurred for providing the specified services. Accordingly, the terms of the MC-Service agreement cannot be applied to such advertisement expenditure.
- The Tribunal also noted that as per none of the three agreements viz. MC-,License agreement, Franchisee Agreement and the Marketing Support Agreement, advertisement expenditure was to be incurred by MC. Thus, it cannot be said that the appellant had incurred expenditure which was otherwise required to be incurred by MC.
- Considering the above, the Tribunal held that section 92 was not applicable in the instant case and hence, deleted the addition made by the AO.
Though the aforesaid ruling is on the old provision of section 92 of the Act, it can be inferred from the observations made by the Tribunal that the advertisement expenditure incurred by the licensee for its own business does not necessarily lead to an inference that the licensor should reimburse a part of such expenditure on the premise that the licensor derives benefit in terms of royalty income. The observations of the Tribunal were based on the facts of the instant case. Thus, it is critical that the facts and circumstances of each case must be evaluated before applying the aforesaid inference.
This ruling further emphasizes on the importance of documenting the terms and conditions of the arrangement between the transacting entities. The Tribunal, in the instant case, evaluated the terms of various agreements between the parties while arriving at a particular conclusion. Thus, it is critical that the terms and conditions are well documented by way of an agreement which serves as an important tool of defense before the revenue/ appellate authorities.