Saturday, July 31, 2010

Delhi High Court clarifies Transfer Pricing law

In a fillip to the increasing global ambitions of Indian industries, the Delhi High Court, in Maruti-Suzuki India Ltd. v. ACIT, clarified the application of transfer pricing provisions to the use of foreign trademarks in India. The issue arose out of the Maruti-Suzuki collaboration all of us are well aware of, and was a good example of judicial intervention to stifle the parochial approach of the Income-tax department to international transactions.

In 1992, Suzuki and Maruti entered into a License Agreement with the approval of the Government of India. Under this Agreement, Suzuki agreed to provide technical assistance to Maruti. Also, the Agreement also provided for the use of the logo ‘Maruti-Suzuki’ on all products and parts manufactured, assembled and sold in India pursuant to the agreement, and on the containers, packages and wrappings used in connection with these products and parts. A combined royalty for both, the technical assistance and the use of the trademark was to be paid by Maruti. In addition to these conditions in the Agreement, Maruti also replaced the ‘M’ on its products with ‘S’. Since Suzuki was a majority shareholder in Maruti, the assessing officer referred the transaction to the transfer pricing officer [“TPO”], under section 92(CA)(1).

Based on these facts, the TPO drew some highly far-fetched conclusions. For starters, the showcause notice suggested that by changing its brand name from Maruti to Suzuki, and by using the ‘S’ on its products instead of the ‘M’, Maruti had transferred its brand name to Suzuki. Since no consideration was paid by Suzuki to Maruti, the TPO concluded that the transaction was not conducted at arm’s length. In the actual order however, the TPO dropped this line of reasoning, and observed that by the use of the joint logo of ‘Maruti-Suzuki’, Suzuki was ‘piggybacking’ on Maruti’s reputation in India. In his opinion, since Maruti was a big brand in India, and Suzuki did not have an Indian presence, this transaction benefited Suzuki, for which consideration should flow from Suzuki to Maruti. Further, it asked for a breakup of the consideration paid by Maruti into two parts- for the technical assistance and the use of the trademark, concluding that 50% would have to be attributed to the trademark use. Finally, the order also observed that the advertisement expenditure incurred by Maruti to further the ‘Maruti-Suzuki’ brand name in fact benefited Suzuki, and would hence have to be accompanied by consideration paid by Suzuki to Maruti. On this basis, the TPO concluded that since consideration which would have been paid by an independent entity, had not been paid by Suzuki, the transaction was not conducted at arm’s length.

In a writ petition against this order, Maruti challenged this order contending that the transaction was at arm’s length and that no consideration can be required to flow from Suzuki to Maruti for any part of the transaction (the procedural reasons why a writ petition was maintained as opposed to an appeal are discussed in the first 28 paragraphs of the decision, but are not relevant for the present discussion). The Delhi High Court, in a detailed decision intended to assist Assessing Officers to “appreciate the scope of their powers under Transfer Pricing Provisions of the Act”, substantially upheld Maruti’s claim, and remanded the matter back. Recognising the commercial necessity of collaborating with foreign companies in order to face international competition in the domestic market, the Court pointed out that the order of the TPO, if upheld, would actively discourage foreign companies from Indian collaborations. The TPO order would have lead to the absurd conclusion that any foreign company allowing an Indian company to use its trademark would be required to pay for such use. Dismissing this interpretation as incorrect, the Court observed that even though Maruti was an established brand in India in 1992, the use of Suzuki’s mark was commercially necessary for it to compete with the other international car-makers entering the Indian market. Interestingly, the Court relied on the Government approval of the Agreement to verify this commercial necessity. On this basis, it held that an Indian company using the trademark of a foreign company, could not be expected to receive consideration for such use. However, for this, the use would have to be voluntary. In the License Agreement under consideration, the use of the ‘Maruti-Suzuki’ brand name was mandatory. The Court concluded that such a mandatory use could only serve the purpose of furthering Suzuki’s image in India, for which consideration would have to flow to Maruti. Further, with regard to the advertising expense, it again observed that the expenditure incurred benefitted Maruti’s market in India. Unless it was shown that the expenditure incurred was in excess of that which would have been incurred by an independent party, it could not be brought to tax.

That then gave rise to the important question of how this comparable price for an independent party was to be computed, and whether the different parts of the transaction could be considered separately. The Court rightly held that breaking up such a composite agreement would be erroneous. All the rights and obligations incurred by the parties would have to be considered, and the comparable price for such a composite transaction would have to be determined. However, while this is a welcome clarification, there is one part of the dictum that is left unclear. In ¶ 82 of the decision, the Court observes that in making this determination, the composite agreement itself, and any other arrangement entered between the parties which has a bearing on the respective rights and obligations of the parties, must be considered. However, in clause (vi) of ¶ 84, where the Court summarises its conclusions, the Court only mentions rights and obligations incurred by the parties “under the international transaction in question”. It is submitted that the former of these views seems preferable, but the decision itself is silent on which of the two views it adopts. (But for this disparity, the conclusions of the Court in ¶ 84 serve as a useful summary of the decision).

Thus, this decision in Maruti-Suzuki, together with the AAR’s recent pronouncement in In Re The Timken, provide two instances where Indian tribunals have exhibited an appreciation of the commercial imperatives of international transactions.

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