Global Tax Alert (News from Transfer Pricing) | 9 August 2013
Delhi Tribunal rules in Maruti Suzuki Ltd royalty payment case
This Tax Alert summarizes a recent ruling of the Delhi Income-tax Appellate Tribunal (ITAT) in the case of Maruti Suzuki Ltd [TS-212-ITAT-2013(DEL)-TP]. The issue was the appropriateness of a transfer pricing adjustment relating to the disallowing of a royalty paid by Maruti Suzuki Ltd (the Taxpayer) to its Associated Enterprise (AE) for use of Intangible Property (IP) in the nature of trademark/brandname legally owned by the AE and for “excessive” advertising, marketing and promotional (AMP) expenditure, which the Taxpayer is alleged to have incurred for the benefit of its AE. The adjustments relate to the Financial Year (FY) 2004-05.
The Taxpayer is a licensed manufacturer of passenger cars in India. The Taxpayer had entered into a licensing arrangement with Suzuki Motor Corporation of Japan (Suzuki), its AE, under which it paid a bundled royalty for the use of technology and for use of the brandname. During the course of transfer pricing audit proceedings, the Transfer Pricing Officer (TPO) made a bifurcation of the royalty between the technology and brandname based on the proportion of R&D expenses and advertising expenses incurred by the Taxpayer. The TPO then disallowed the royalty attributed to the use of the brandname.
According to the TPO, co-branding of the manufactured products as “Maruti Suzuki” and the piggybacking of the “Suzuki” brandname on the “Maruti” brandname resulted in the impairment of “Maruti” brand value. Therefore the Taxpayer was not required to pay a royalty for use of the “Suzuki” brandname. With regard to the AMP expenses incurred by the Taxpayer, the TPO disallowed the same on grounds that the expenses enhanced the value of the “Suzuki” brandname that was legally owned by the AE.
The ITAT rejected the TPO's bifurcation of the royalty payment between technology and brandname. The ITAT also rejected the adjustment disallowing the royalty that was allegedly attributable to the use “Suzuki” brandname. With regard to the adjustment relating to AMP expenses, the ITAT remanded the matter back to the TPO for further determination in light of principles laid down by the Special Bench of the ITAT in the case of LG Electronics [TS-11-ITAT-2013(DEL)-TP].
Background and facts
- • The Taxpayer, a joint venture company of Suzuki, is engaged in the business of manufacture and sale of automobiles, as well as trading in spare parts and components of automobiles. The trade mark/logo 'M' is the registered trade mark of the Taxpayer.
- • The Taxpayer entered into a License Agreement (Agreement) with Suzuki in 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 for engineering, design and development, manufacture, assembly, testing, quality control, sale and after-sale service of the Suzuki products and parts. Suzuki also granted the taxpayer, exclusive right to use licensed information and the ”Suzuki” trademark. 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 onwards, it started using the logo ”S” (which is the logo of Suzuki), on the front of new models of the cars manufactured and sold by it, although it continued to use the trademark ”Maruti” along with the word ”Suzuki” on the rear side of the vehicles manufactured and sold by it.
- • The Taxpayer during the year on appeal had entered into various international transactions with its AEs and had adopted the Transactional Net Margin Method (TNMM) using the combined transaction approach for testing the arm's length nature of the transactions.
- • During the audit proceedings for the FY 2004-05, the TPO observed that the taxpayer had incurred huge AMP expenditure towards promotion of the trademark ”Suzuki” and held that Suzuki should have compensated the taxpayer for assistance provided in developing the trademark. Accordingly, non-routine AMP expenditure was adjusted using a ”bright-line” test, as being the value of the marketing intangibles accruing to the benefit of Suzuki.
- • The Taxpayer challenged the order by way of writ petition1 in the Delhi High Court (HC). The HC held that mere use of brand/logo of AE, in advertising, marketing and promotion need not by itself entail payment by the owner of such brand/logo. The HC further observed that apportionment of the AMP expenditure was not justified where use of a joint trademark was discretionary and where such expenses did not exceed those incurred by comparable companies. Thus, the HC set aside the order of TPO and directed him to re-determine the arm's length price of the transactions in line with the HC's directions.2 However, the Supreme Court3 directed the TPO to decide the issue uninfluenced by the observations/directions given by the HC.
- • During the audit proceedings after the order of the SC, the TPO made certain adjustments with regard to the royalty paid by the Taxpayer to Suzuki on the following grounds:
- • The license agreement covers the use of technical assistance in the form of license information and also the use of the licensed trade mark for the technological development and sales of products and parts within the territory and outside the territory. However, the agreement did not provide a bifurcation of payment for technical assistance and licensed trade mark. Also, the TPO noted that the Taxpayer had paid a royalty even though it had incurred expenditures for research and development and marketing/brand promotion. Further, the tax authority contended that no independent entity would enter into an agreement of this nature and make composite payments without ascertaining the individual split towards royalty attributable to technical assistance and use of the brand name.
- • Consequently, the TPO bifurcated the royalty pay-outs in proportion to the research & development (R&D) and brand promotion expenses (reduced by sales promotion and sales incentive expenses) as per the consolidated financials of Suzuki and determined the arm's length price (ALP) of the royalty pertaining to the brand name as NIL.
- • The TPO justified the position by stating that the Suzuki brand was a lesser known brand in India and hence had piggybacked on the established brand name of Maruti, thereby not warranting any royalty pay-outs for the use of the Suzuki brand name. To further strengthen this claim, the TPO referred to an extract of the interview with an employee of the Taxpayer which indicated that the Taxpayer had carried out a brand asset evaluation exercise wherein Maruti was determined to be a slightly stronger brand than Suzuki.
- • Further, the TPO also made an adjustment for non-routine AMP expenditures incurred by the Taxpayer using the ”bright-line” test.
- • The Dispute Resolution Panel (DRP) affirmed the above actions of the TPO. Aggrieved with the directions of the DRP, the Taxpayer filed an appeal with the ITAT.
Contentions of the taxpayer before the ITAT
The decision to use the co-branded trademark of “Maruti-Suzuki” was an independent decision of the Taxpayer
The royalty paid by the Taxpayer during the subject year was agreed in 1982 when the taxpayer was a wholly-owned government company and therefore, the two parties were unrelated. Suzuki was in a position to influence the decision-making of the Taxpayer only after it acquired a controlling stake in the Taxpayer's share capital in 2003. As a result, the said license agreement entered earlier could be considered to be an uncontrolled license agreement and could be used as a Comparable Uncontrolled Price (CUP) to benchmark the royalty paid during subject year. It was also pertinent to note that the license agreement entered into between the Government of India and Suzuki specifically provided for the use of co-branded tradename or logo. The decision to use the co-branded logo was in the best commercial interest of the Taxpayer since Suzuki was an established international brand while Maruti was unknown.
None of the prescribed methods was applied by the TPO
The Taxpayer contended that the tax law provides only five methods4 for determining the arm's length price of an “international transaction.” Hence, the mandate of the TPO is limited to application of any of the five prescribed methods as the most appropriate method to determine the ALP of an international transaction. However, the TPO had not applied any of the prescribed methods while computing the ALP of royalty pay-outs made by the Taxpayer. The Taxpayer also relied on various ITAT judgments that support this proposition.
The agreement is a single/inseverable license for manufacture and sale of products
The Taxpayer contended that the royalty paid constituted a single/unseverable/indivisible contract/package, which provided the Taxpayer the exclusive right and license to manufacture and sell the licensed product for a specified duration. All other rights vested in the license agreement, including technology, technical know-how and trademark are linked to the core right of manufacture and sale of licensed products. Consequently, the bifurcation done by the TPO was arbitrary and without any basis. The Central Government while approving the royalty payment has also directed the Taxpayer to pay R&D cess (payable for import of technology) on the entire amount and has not differentiated between payment for technology and payment for trademark.
The Taxpayer also argued that re-writing of transactions (i.e., splitting up the royalty pay-outs) undertaken by the Taxpayer is not only inconsistent with the factual reality of the case but is also contrary to various judicial pronouncements.
Further, it was submitted that the brand “Suzuki” and the technology which it represented were interlinked and interdependent; and hence it would be inappropriate separately to evaluate the royalty pay-outs for use of the technology and use of the brand name.
Erroneous conclusion by TPO that Suzuki brand was weak
The TPO failed to appreciate that Suzuki had global stature, standing and reputation in the small car segment and its brand/logo/trademark was well established. The Taxpayer accordingly contended that the association of the “Suzuki” trademark with that of the Taxpayer not only brought an international flavor to the “Maruti” brand, but also helped the Taxpayer in projecting itself as a company which is associated with a global automotive giant.
Further, it was submitted that the joint venture (JV) partner was chosen by the Government of India and hence it is incongruous for the Government of India to choose a JV partner with zero brand value.
The Taxpayer also submitted that the TPO had not placed any empirical evidence or material on record to show that there has been any impairment of the Maruti brand or that there was any benefit accruing to Suzuki from the use of Suzuki's name conjointly with that of Maruti in India.
The effective royalty rate was lower than the permissible limit and thus heavily subsidized
The Taxpayer had conducted a search for arriving at comparable uncontrolled royalty rates in relation to the licensing of similar technology and accordingly concluded that the effective rate of royalty pay-out by the taxpayer was significantly lower than the comparable royalty rate. Therefore, the taxpayer claimed that it had received a concession on the royalty rates and this was substantiated by the fact that overall margins of the Taxpayer were significantly higher than the margins of comparable companies in India.
The License agreements were approved by the Government
The Taxpayer contended that the license agreements were approved by the Government and once an approval is granted by the Government authorities, it is not appropriate for another Department of the Central Government to contend that the royalty pay-outs were non-bonafide.
Other key contentions of the Taxpayer included the following:
- • Suzuki does not have a four-wheel business in India and hence the question of promoting the brand of Suzuki at the expense of Maruti does not arise.
- • Benefits are irrelevant for ALP determination if the expenses are incurred wholly and exclusively for the purposes of business.
- • Even for purposes of bifurcating the royalty pay-outs, the tax authority should have relied upon the standalone financials of Suzuki rather than the consolidated financials which included the data of all subsidiaries including the taxpayer, thereby distorting the comparison.
Ruling of the ITAT
The ITAT ruled in favor of the Taxpayer and deleted the adjustment with regard to the royalty. Further, the ITAT observed the following while adjudicating in favor of the Taxpayer:
- • The co-branded trademark Maruti-Suzuki has been used since inception of the company. At the time of entering into the agreement, the Taxpayer was an independent 100 percent Government of India entity and the decision to use the trademark of Suzuki was carried forward to the license agreements, including the 1992 agreement. Hence, the decision to continue the joint trademark was taken in the Company's business interests and was not influenced by the need to manipulate or erode the Indian tax base.
- • Since, the same agreement is in place during the subject year and earlier years, the tax authorities could not take a different view without any change in facts and circumstances.
- • The act of re-writing the transaction by the TPO was erroneous, as the primary intent of the licence is the transfer of technology and not trademark usage. However, all other rights vested in the license agreement including technology, technical know-how and trademark are linked to the core right of manufacture and sale of licensed products. Thus, the royalty paid by the Taxpayer constituted a single/unseverable/indivisible contract/package and the TPO has arbitrarily divided the license agreement.
- • Imputing an adjustment for AMP expenditure contradicted the TPO's position that Suzuki was a weak brand, which when reinforced on Maruti's brand, has resulted in impairment in the value of the latter.
- • In respect of the AMP adjustment, the ITAT followed the Special Bench ruling in the case of LG Electronics India Limited5 and remanded the issue back to the TPO to quantify the adjustment based on the observations made by the Special Bench in the aforementioned ruling.
One of the most challenging issues in transfer pricing is the taxation of income from intangible property. In this case, the TPO attempted to disallow a royalty payment by the Taxpayer that was licensed to use the intangible property under the theory that an inferior “Suzuki” brandname was “piggybacking” on a superior “Maruti” brandname.
This concept of “piggybacking” is not present in the OECD Transfer Pricing Guidelines. Under the Guidelines, the question is the amount that the transferee would be willing to pay the transferor for use of the intangible property, i.e., what a party should pay for the use of intangible property to the extent that the party does not own or did not develop it. The ITAT ruling affirms this principle.
The ruling also recognizes that a taxing authority should not substitute its judgment for a taxpayer's sound or reasonable judgment. This concept is also embedded in the OECD Guidelines (Para 4.9), which recognize that transfer pricing examinations should consider the taxpayers' judgment in conducting their business affairs. The judgment also recognizes commercial realities and emphasizes the importance of strong documentation supporting the inter-company arrangements.
1. WP (C) 6876/2008.
2. Please refer to the EY Tax Alert dated 5 July 2010, titled Delhi High Court ruling on transfer pricing aspects of marketing intangibles.
3. Civil Appeal No.8457 Of 2010.
4. Sixth Method under Rule 10AB was introduced only with effect from 1 April 2011.
5. ITA No. 5140/Del/2011. Also, please refer the EY Tax Alert dated 23 January 2013, titled Ruling by SB of Tribunal on TP aspects of marketing intangibles.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India), Bangalore
- • Rajendra Nayak
+91 80 4027 5454
Ernst & Young LLP (India), New Delhi
- • Vijay Iyer
+91 11 6623 324
Ernst & Young LLP (India), Noida
- • Anuj Khorana
+91 120 671 7150
EYG no. CM3720