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Reebok's Royalty Payment: Cost-Benefit Analysis

Published on Fri, Jun 28,2013 | 16:14, Updated at Sat, Jun 29 at 13:26Source : 

By: Karishma Phatarphekar, Partner-Transfer Pricing, Grant Thornton India

The recent case of Reebok India Co. has discussed various royalty payment issues with an emphasis on the new issue of cost benefit analysis.

Recently, the Delhi Tribunal in the case of Reebok India Co. (“the taxpayer” or “Reebok India”) held that royalty paid to an associated enterprise for use of technology is fully justified in view of the benefit derived through growth in revenue and the economic circumstances faced by the taxpayer. Further, necessity of any expenditure should be looked from the perspective of business and not profitability.

Reebok India, engaged in manufacturing of footwear and apparel, obtained a license from its group company to use technical know-how and designs at 5% rate of royalty.
During the proceedings for AY 2008-09, the transfer pricing officer (‘TPO’) rejected the CUP analysis performed by the taxpayer by considering that approval given by the Government for payment of royalty is not conclusive and questioned the commercial expediency of the transaction. He also requested Reebok India to furnish the cost benefit analysis in respect of royalty paid to its associated enterprises.

The TPO compared year on year profitability of Reebok India to conclude that no substantial benefit was derived and thus royalty payment was not according to arm’s length principle. He also noted that no independent enterprise would make payment for royalty which is not contributing to its profitability. The taxpayer, during the proceedings before the TPO and DRP, had referred to a government website to identify comparable royalty rates and had also submitted additional comparable instances to support the validity of use of CUP method.

Aggrieved with the decision of the TPO, Reebok India filed an appeal with the Tribunal against the order.  Among various grounds of appeal, Reebok India affirmed that commensurate benefits had been derived from payment of royalty and the expenditure was wholly and exclusively incurred for business purpose. In this regards, Reebok India brought the Tribunal’s attention to the following facts:

• Reebok India operates in a highly competitive industry wherein use of technology is essential to survive and grow
• Reebok India does not perform any research and development and thus depends wholly on its group company for use of new technology
• All research and development undertaken by the group company is patented and thus requires a license to use such technology
• Reebok India submitted a description of various technologies provided during the year
• Reebok India highlighted benefits in the form of growth in the revenue and that low profits were on account of other reasons.
The Tribunal ruled in favour of the taxpayer affirming that the cost benefit test was justified in terms economic circumstances like severe market competition faced by Reebok India, its dependence on use of patented technology owned by the group company and the need to use latest technology to survive market competition.  The Tribunal accepted that year on year growth in sales is sufficient to substantiate the benefit test rather than considering profitability which may be affected due to other extraordinary business reasons. It also accepted that similar royalty payment was held bonafide for earlier years.

While passing the above ruling, the Tribunal rejected TPO’s approach by also stating that due importance should be given to the government approval, even though it is not a conclusive proof and arm’s length price shall be determined by one of the methods mentioned in the statute which was rightly done by the taxpayer through furnishing of comparable instances.

It also upheld that the taxpayer is free to conduct its business in its own prudent manner and commercial and business expediency of expenditure should be seen from taxpayer’s point of view.  

This ruling of the Delhi Tribunal is analogous to judgment given by the Delhi High Court in the case of EKL Appliances wherein the payment of royalty even under persistent loss making situation was justified since it was a legitimate business expenditure which was not only fostering the future growth of the company but also helping it to survive the market competition. The taxpayer in this case had submitted elaborate reasoning’s to prove the benefit test.

While delivering the judgment, the Delhi High court also considered commercial expediency of an expenditure which is to be looked at from the taxpayer’s point of view. It held that as long as the expenditure is incurred wholly and exclusively for the purpose of business, it is irrelevant as to whether such expenditure actually results in profit or not. In this regard, reliance was placed on numerous Supreme Court decisions. Some of them are Eastern Investment Ltd, Walchand& Co. and Rajendra Prasad Moody.

It is also worth noting that even the OECD guidelines advocate the view taken by the Delhi High Court on commercial expediency of business expenditure.

The above ruling of the Delhi Tribunal lays down different aspects regarding determination of arm’s length nature of royalty payment. Till now, controversy regarding royalty payment revolved around determination of rate of royalty charged, correct application of CUP method and issues relating to commercial and business expediency of expenditure.

With this ruling, the Delhi Tribunal has introduced a new aspect relating to cost benefit analysis of royalty payment which until now was limited to intra-group payments between multinationals. Further, the Delhi High Court judgment also supports royalty payment in a persistent loss making scenario which will help a sleuth of manufacturing companies during their initial years wherein benchmarking of royalty under a loss scenario is a daunting task.

In the light of this ruling, it is certainly evident that the taxpayer needs to be more vigilant to support their business expenditures through strong business rationale and appropriate supporting documentation.

(The views expressed are personal. Aparna Shaligram, AM, Grant Thornton also contributed to this article.)


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