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Royalty Payment: Holistic View Appreciated By Tax Tribunal

Published on Mon, Dec 02,2013 | 15:55, Updated at Mon, Dec 02 at 15:55Source : 

By: S P Singh, Deloitte Haskins & Sells

Royalty payment has been a matter of intensive discussion in India as well as internationally. Recently, the Organisation for Economic Cooperation and Development (OECD) published discussion paper on Base Erosion and Profit Shifting (BEPS) in which it is suggested that they are looking at developing “rules to prevent BEPS by moving intangibles among group companies. This will involve: (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii) developing transfer pricing rules or special measures for transfer of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements.” Obviously, identification of intangibles and payments therefore has assumed very high importance in the area of transfer pricing and international taxation. The OECD defines the term “intangible” as “something which is not a physical asset or a financial asset, and which is capable of being owned or controlled for use in commercial activities”. This term remained undefined under the Indian tax laws for a long time. By an amendment introduced in 2012 the term “intangible property” was defined in the Income-tax Act, which is quite broad in scope.

Royalty is payment for the use of or right to use an intangible. Normally, an intangible is crucial for a group when it attempts to be ahead of its competitors. Protecting it becomes a top priority. Due to this, most of the time it is given to entities within the group. The burden to establish the genuineness of the payment and the arm’s length price of the same is much heavier than many other transactions.

In order to determine arm’s length conditions for the use or transfer of intangibles it is important to consider as part of the comparability and functional analysis: (i) the identification of specific intangibles; (ii) the identification of the party(ies) that should be entitled to retain the return derived from the use or transfer of the intangibles; (iii) the nature of the controlled transactions and whether they involve the use of intangibles and/or lead to the transfer of intangibles between the parties; and (iv) the remuneration that would be paid between independent parties for the use or transfer of such intangibles (1).

In India payment of royalty has been one of the most litigated issues under transfer pricing. There have been several decisions by the Income Tax Appellate Tribunal (ITAT). The last on this issue is by the Mumbai ITAT in the case of M/S Cadbury India Ltd (2) . The issue was whether payment of royalty for Trademark at 1% and Technical Knowhow at 1.25% was justified or not. It was contended by the company that the payment was approved by the Reserve Bank of India (RBI) and was within limits prescribed by the Press Note No. 9 of GOI, Ministry of Commerce and Industry, Department of Industrial Policy & Promotion. The assessee had used Transactional Net Margin Method (TNMM) at entity level to benchmark royalty payments. In other words, the stand of the company was that as its profitability was better than comparable companies the intra-group transactions were at arm’s length.
During transfer pricing proceedings, the Transfer Pricing Officer (TPO) rejected application of TNMM on the ground that the total of the payment against royalty was very small compared to the turnover of the company and could not have any impact on the profitability. Consequently, he held that Comparable Uncontrolled Price (CUP) Method was the most appropriate method for benchmarking the royalty payments. The TPO observed that the assessee had paid royalty between 1-2.5% and the average would come to 2.32%, as against 2% royalty paid by other group companies. Relying on the OECD Guidelines, the TPO held that transactions between AEs can be used as comparable as last resort when there is sufficient data available to demonstrate their reliability and such data is the most reliable data available to determine arm’s length price. The TPO held that most FMCG companies in India are part of MNE and therefore, it was difficult to find a company without controlled transactions. Thus, the TPO clubbed two royalty payments together and compared the royalty rate with 2% payment made by the Group companies.

Before the Commissioner of Income Tax (Appeals) [CIT (A)] the assessee argued that overseas AE was intellectual property owner and without access to the trademark, the assessee was unable to exploit it in the Indian market. Further, the assessee argued that it's contribution to total sales of the group was meagre 1% over the years 2001-2008. Hence, the assessee could not be treated as economic owner of the 'Cadbury' brand. But, the assessee was able to capture 75% of the market share in India due to use of the brand. Further that the Cadbury brand was in existence even before it was introduced in India. It was argued that the group companies and the third parties to whom license was granted were legally obliged to incur marketing/advertising expenditure while paying royalty to the licensor and none of these partners’ had faced any TP adjustment on the issue of royalty payment to the overseas AE, while undergoing TP audits. The CIT (A) accepted the argument that marketing expenditure in itself is insufficient for a claim to economic ownership of an intangible. He appreciated the fact that the profit margin of Cadbury was much higher than that of comparables and inferred that there is a direct correlation between the Cadbury’s intangible capital and its performance.

The CIT (A) agreed with the taxpayer and deleted the addition. Aggrieved, the Revenue went in appeal before the ITAT. The ITAT held that the assessee was making payment of royalty since 1993 and similar payments were made by other group companies across the globe. Further, the TPO had accepted that the royalty payment had not affected taxpayer’s profitability. The payment was duly approved by the RBI and Secretariat for Industrial Assistance (SIA), Government of India. Hence, there was no scope of doubt as to payment being not at arm's length in respect of royalty for technical know-how. Regarding trademark royalty, ITAT held that payment was less as compared to payment made by the other group companies using brand 'Cadbury'.
The decision of the ITAT underlines the need to justify payment as royalty both on the befit basis as well as on the arm’s length principle. It accepts that transactions with group companies can be taken as comparable, particularly when third party comparables are not available. However, the most important message that comes out of the views expressed by the CIT (A) and the ITAT is that for determining the arm’s length price of royalty a holistic view should be taken. The contribution of intangibles to the profitability of a company is an important parameter to judge whether the intangible is beneficial to the company. In order to justify the arm’s length nature of royalty, companies must have proper documentation establishing benefit test and pricing mechanism.

 1) For Intangibles In Chapter VI Of The OECD Transfer Pricing Guidelines     And Related Provisions 6 June To 14 September 2012 OECD Discussion Draft     Revision Of The Special Considerations

 2) ITA No. 7408/MUM/2010 dated 13th November 2013.


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