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Reebok Case: Benefit Test v/s Business Expediency

Published on Tue, Aug 13,2013 | 14:16, Updated at Wed, Aug 14 at 13:36Source : 

By: Rohan K Phatarphekar, Head – Transfer Pricing, KPMG India

While Transfer Pricing (TP) litigation in India is at its peak; estimates based on various sources have revealed transfer pricing additions to income have crossed USD 14 billion during the recently completed eight round of TP audits.

In a scenario like this some Tribunal decisions have been giving some hope to the Multinational Companies (MNCs). One of the most common and recent TP controversies revolve around allowability of Royalty expense and Advertisement spent (leading to creation of marketing intangible) of a company.  Reebok India (taxpayer) has been relieved by the recent order of the Delhi Income-tax Appellate Tribunal (Tribunal) in its case. The Tribunal asserted that merely based on the fact that there is a fall in the profitability of the taxpayer, the Transfer Pricing Officer (TPO) cannot make a bizarre conclusion that the taxpayer was not deriving commercial and commensurate benefit from the payment of royalty to the overseas associated enterprise (AE)

However in the same case, the adjustment made by the TPO on account of disallowance of Advertising, marketing and promotion (AMP) expense alleging creation of marketing intangible, was sustained by the Tribunal

Royalty expenses

This case pertains to year 2008. Reebok India had entered into Technology License Agreement in October 2002 with Reebok UK, whereby the UK Company would provide data, documentation, drawings and specifications relating to inventions, designs, formulae, process and similar property, referred to as know how to the Indian Company. Further the UK Company, which was an AE of Reebok India, had granted a non exclusive, non transferrable right to utilize the technology in the manufacture and distribution of Reebok products in India. Reebok India manufactured goods on the basis of technical know–how and designs provided by the AE.

In consideration of all of the above Reebok India was paying a royalty of 5% to its AE and was applying Comparable Uncontrolled Price (CUP) method to justify the payment of royalty.

Reebok India had argued that the Royalty expense was arms length as it was able to furnish not only government approvals but also independent third party comparable contracts (taken from the website of  the Secretariat of Industrial Assistance (SIA) under Ministry of Industry and Commerce).Further Reebok India had produced material to prove that its entire business was dependent upon the technology provided by the AE and without the Technology license; it  would not be able to continue its business.

The TPO had however rejected Reebok India’s arguments stating that Government approval does not automatically determine the arms length nature of Royalty payment (such stance has been taken by various Tribunals in cases like Coca Cola India, Perot Systems and Cabot India).
Further the TPO alleged that the taxpayer did not get any tangible commercial benefit from royalty payment on the ground that margin earned by the taxpayer in the current year was much lesser than the margin earned in the previous year.

The Tribunal's decision was undoubtedly in favor of the taxpayer – It appreciated that:

*The industry (i.e. premium sports apparel and footwear industry) in which taxpayer operates is highly competitive and to survive and grow it is imperative to continuously launch new and improved products. Taxpayer does not undertake any significant research and development activity on its own and survival of the taxpayer in the industry depends upon the technology & know how provided by the AE. The aforesaid technology being patented by the AE cannot have been used without the permission of the AE.

*The growth in the taxpayer’s revenue demonstrates the benefits derived. Profitability can be lower due to various business reasons and lower profitability in the current year as compared to previous year does not conclude that no benefits were derived.

*Taxpayer is free to conduct business in the manner it deems fit and the commercial and business expediency of incurring any expenditure is to be seen from the businessman’s point of view.

*Though it is not conclusive proof, the approval of the Government has to be given due consideration.

*Taxpayer has rightly considered the CUP method. The conclusion of the TPO that the arms length royalty payment should be Nil without specifying any cogent reason is not sustainable. The TPO did not provide any basis for determining royalty rate at Nil, whereas the taxpayer provided third party agreements wherein royalty rates ranged between 5%-12%.

AMP Expenses

In case of AMP expense the TPO had alleged that Reebok India was creating a marketing intangible for its AE and therefore undertook benchmarking analysis by applying bright line test

– the 'Bright Line Test', is a concept laid down in the decision of US Tax Court in the case of DHL incorporated and its subsidiary. It was held that the expenditure on advertisement and brand promotion expenses which exceeded the average of AMP expenses incurred by the comparable companies was required to be reimbursed by the overseas AE.

The TPO relied on the decision of Special Bench constituted in case of LG Electronics India Pvt. Ltd.   and enhanced the income of Reebok India by such  excessive expenditure on AMP along with a markup of 15%. The Dispute Resolution Panel further confirmed the adjustment of the TPO however reduced the mark up to 12.50%.

The Tribunal also affirmed the action of the TPO and based on the ruling of the special bench in case of LG electronics, where even Reebok India had intervened before the bench with several others, remitted the matter back to the TPO to be adjudicated on similar lines.

LG Electronics has been recently followed in various cases like Canon India (Delhi Tribunal) and GlaxoSmithKline Consumer Healthcare India (Chandigarh Tribunal) where the Tribunals have instructed the Assessing officers to exclude selling expenses like trade discount, volume rebate, cash discount, sales promotion expenses etc., appreciating that they do not lead to brand promotion, from the calculation of AMP expenses to be recovered from the AE. The Tribunals have also directed the TPO’s to add a markup on AMP expense to be recovered, thereby characterizing this as a service activity.


The Tribunal has followed the Delhi High Court’s decision in the case of EKL Appliances , wherein the High Court upheld the payment of royalty to AEs and concluded that royalty expenditure need not be linked with profit/income resulting there from.  The High Court also held that Tax department cannot dictate to the taxpayer whether or not to incur expenditure.

This is a welcome step as far as Royalty payment is concerned, as the tax authorities are now giving due importance to commercial and business expediency and are holding themselves back from stepping into the shoes of the businessman.

It is important to note that since the TPO had totally disallowed the royalty on the premise that there was no benefit to the business of the assessee, the Tribunal has not discussed the quantum of royalty. However, this reinforces the necessity to substantiate such payments with robust TP documentation. Further, the delinking of profitability from royalty payments would provide a breather to a lot of startup companies with less or no profits in the initial years or even companies with genuine business reasons for incurring losses. The ruling reiterates and highlights the need for the TPO’s to carefully examine and consider the business and commercial realities of transactions and not merely consider profits and/or losses as the key basis for evaluating arm’s length nature of royalty payments.

(The views and opinions expressed herein are those of the author and do not necessarily represent the views of KPMG in India.)

  1.  LG Electronics India Private Limited vs. ACIT (ITA No. 5140/ Del/2011)
  2. CIT v. EKL Appliances Ltd. (ITA Nos. 1068/2011 & ITA Nos. 1070/2011)

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