The Corporate & Commercial Law Society Blog, HNLU

Category: Income Tax Act

  • Taxing the Non-existent: Transfer Pricing of AMP Expenses

    Taxing the Non-existent: Transfer Pricing of AMP Expenses

    BY YARABHAM AKSHIT REDDY, THIRD- YEAR STUDENT AT HNLU, RAIPUR
    Introduction

    The treatment of Advertising, Marketing and Promotion (‘AMP‘) expenditure has been a contentious issue under the Transfer Pricing (TP) Regulations as outlined in sections 92 to 92F of the Income Tax Act, 1961 (‘ITA‘). The debate centers on whether such expenses constitute transactions between Associated Enterprises (AEs) requiring compensation or qualify as ordinary business expenses. Recently, in the case of PCIT v Beam Global Spirits & Wine (India) Pvt Ltd, the Delhi High Court ruled that the existence of an International Transaction must be established before proceeding with the benchmarking analysis of AMP expenses and rejected the application of Bright Line Test (‘BLT‘) for inferring the International Transaction. As per section 92B (1) of ITA, an International Transaction is “a transaction entered into between two or more AE where at least one of them is a non-resident by way of agreement, arrangement or action – whether formalized in writing or otherwise. Since, there is no statutory framework governing the AMP expenses, the concept has evolved through a series of judicial pronouncements. This ruling came as a relief to the taxpayers who are engaged in marketing intangibles and could claim deductions for such expenses under section 37 of ITA.

    In light of the above, the article critically analyzes the judgement in two prongs, viz, firstly, by understanding the concept of the BLT for determining the existence of International Transactions, and Secondly, through exploring the alternatives in determining the TP adjustments of AMP expenses and prevent unfair tax assessments by revenue authorities.

    Behind the Judgement: Key Legal Takeaways

    In the present case, the assessee (Beam India Holding Ltd) is one of the companies of Beam Global Group which is engaged in the manufacture, sale, marketing and trading of Indian Made Foreign Liquor (‘IMFL‘). This IMFL is sold under the brand name and license given by Fortune Brands which is stated to be the ultimate parent company. The core issue before the Transfer Pricing Officer (‘TPO‘) was whether AMP expenses incurred by the assessee constitute an International Transaction as per section 92B of ITA.

    The TPO applied the BLT and determined that the excessive expenditure constitutes an International Transaction as the same has benefited the legal owner as a result of brand building and commenced benchmarking analysis. As a result, the assessee filed an appeal before the Income Tax Appellate Tribunal (‘ITAT‘) which ruled in his favour by establishing that before initiating a TP Adjustment, the TPO must establish the presence of an International Transaction with tangible and concrete evidence. Aggrieved by the same, the revenue authorities challenged the decision before the Delhi High Court (HC).

    The Delhi HC upheld the decision given by ITAT by stating that a mere relationship between two AEs cannot be satisfactory evidence for the presence of an International Transaction and relied on Maruti Suzuki India Pvt Ltd v. CIT, which established that mere rendering of service by one party to another would not constitute a transaction unless the same is based on mutual arrangement or agreement as per Section 92B (1) of ITA. Further, the court relied on Sony Ericsson Mobile Communication India Private Limited v. CIT (‘Sony Ericsson‘) and rejected the BLT as an objective criterion for establishing AMP expenses as International Transactions.

    From Acceptance to Rejection: Tracing the path of BLT

    The concept of BLT originated in the case of DHL Corporation & Subsidiaries v. Commissioner of Internal Revenue before the US Tax Court. According to this test, if a subsidiary AE incurs significant costs in the exploitation of an intangible brand name and that expenses exceed the bright line limit of routine expenditure (costs incurred by the other comparable entities), then such entity is deemed to have economic ownership over that brand name. It then becomes an obligation for the parent AE to reimburse the subsidiary AE for non-routine expenditures incurred in brand building. In the absence of any statutory provision to compensate the subsidiary AE for the benefits drawn by foreign AE, the need for transfer pricing adjustment arises. The revenue authorities apply this test in determining the arms’ length price of this perceived transaction.

    In the Indian Context, the test was first applied in the case of Maruti Suzuki India Ltd v ACIT wherein the Delhi HC determined that AMP Expenses would constitute an International Transaction if they exceed the expenses incurred by comparable independent entities placed in similar circumstances. Further, in LG Electronics India Private Limited vs. ACIT (‘LG Electronics‘), the ITAT ruled that proportionately higher expenses incurred in the creation of marketing intangibles would constitute an International Transaction.

    Subsequently, LG Electronics was overruled to the extent that excessive AMP expenses incurred by domestic AEs would constitute an International Transaction in Sony Ericsson case. The court held that BLT would not be an appropriate method as it lacks statutory mandate and was not envisioned in ITA or Income Tax Rules. Moreover, the Supreme Court has dismissed the Special Leave Petition challenging the Delhi HC judgment in CIT v. Whirlpool of India Ltd which invalidated the BLT test, thereby establishing it as a binding precedent.

    It is contended that the application of the BLT method would risk undermining statutory framework of ITA. Such an approach would introduce a novel concept that lacks any formal recognition, thereby creating interpretative inconsistencies and potential conflicts with the established methodologies. section 92C of ITA outlines an exhaustive list of methods for the computation of AMP and must not lay down any other guidelines. The existence of International Transactions must be established based on actual or concrete evidence and such a qualitative determination cannot serve as the basis for their recognition. Despite subsequent High Court rulings rejecting BLT, Revenue Authorities are increasingly relying on BLT for a regressive analysis of AMP expenses to determine an International Transaction.

    Critical Analysis
    • Prima Facie establishment of International Transaction:

    The judgement is a step in the right direction as it places the burden of proof on the revenue authorities to prove the existence of International Transactions based on tangible or concrete evidence between the domestic AE and its foreign AE. This position has been affirmed in CIT v EKL Appliance Enterprise Ltd, wherein the TPO has been directed to “examine the International Transaction as he finds it and not to make its existence a matter of surmises.” This would reduce arbitrary assessments faced by Indian AEs and force the Revenue authorities to reassess their approach towards transfer pricing of AMP Expenses.

    • BLT cannot be an appropriate method for AMP Expenses:

    The level and nature of AMP spending depend on a variety of business factors like market share, market environment, contractual mechanisms, management policies, etc. It varies across industries and also differs within the same industry as it could be company-specific. In the absence of a clear statutory scheme, reliance cannot be placed on BLT to decide AMP expenses by mere comparison with other similarly situated entities. Such fact-specific cases necessitate careful consideration of multiple factors- whether the AE operates a licensed manufacturer, distributor or marketing agent, the duration of contracts whether long-term or short-term, extent of risk undertaken. The Delhi ITAT in BMW Motors India Pvt. Ltd v. DCIT, established that there is no straightjacket formula to determine transfer pricing matters of AMP expenses and such a fact-extensive exercise requires a detailed Functional Analysis to characterize transactions appropriately and understand the business models.

    Avoiding TP Adjustment of AMP Expenses: Assessing the Possible Alternatives

    Until the legislature lays down clear guidelines for determining International Transactions or the Supreme Court resolves the ambiguity, BLT cannot be used as it is inherently susceptible to arbitrariness and operational challenges. In due time, revenue authorities must mandate Indian entities and their foreign AEs to maintain detailed documentation of Functions performed, assets employed and risk undertaken (‘FAR Analysis’) while performing AMP functions. This would help in keeping track of purposes for which expenditure is undertaken, reasons for excessive expenses and the existence of any implicit arrangement or agreement.

    OECD and the Australian Tax Office (‘ATO’) also lay down guidelines for preventing profit shifting due to excessive AMP expenditure. It prescribes that any assessment undertaken by the revenue authorities must look for reduced product/service prices or lower royalty rates paid by domestic AE to foreign AE, profit splitting agreements between them and any provision for compensation for excessive AMP by foreign AE. Since, these guidelines concern distributors or marketers, any legislature enacting these rules must also lay down for licensed manufacturers.

    Another alternative would be Advance Pricing Agreements (‘APAs’). These are pre-negotiated agreements between revenue authorities and the assessee, providing for fixed methods of transfer pricing over a specific period and decides the ALP. These APAs will determine what kind of transactions will be covered by them and what methods would be used for TP Adjustments. AMP Expenses could be covered under these APAs which would help in reducing tax litigations and boost foreign investments in India. Since this issue requires a thorough analysis of fact-specific cases, it must be carried out with a fixed/standardized methods for a fair and accurate determination.

    Conclusion

    This judgement reinforces that excessive AMP expenses incurred by the assessee could not qualify as International Transaction as the creation of marketing intangibles increases his own sales and benefits his business. The burden of proof is on revenue authorities to prove the presence of International Transactions with tangible or concrete evidence. Rejection of BLT emphasizes the need for a more objective/ standardized methods to ensure fair TP Assessments, thereby protecting companies from arbitrary and unwarranted tax adjustments. Until legislative clarity is provided in this regard, proper and detailed documentation, APAs and FAR Analysis could bring clarity and consistency in handling AMP-related TP issues. Such a fair and balanced approach will go a long way in reducing litigations and create a predictable tax environment in India.

  • Redefining Derivatives: India’s Speculative Turn on Futures And Options Taxation

    Redefining Derivatives: India’s Speculative Turn on Futures And Options Taxation

    BY TAPAS JOSEPH AND ADITYA S. NAIR, FOURTH-YEAR STUDENTS AT NUALS, KOCHI

    Introduction

    Up until the early 2000s, derivatives revolutionized spot and futures markets, disrupting natural market relationships and attracting regulatory scrutiny due to potential negative effects. This increased leverage made futures leading indicators. Derivative markets, employing futures and options, became pivotal for trading stock risks, with legally binding contracts specifying asset transactions. Future contracts involves buyer and seller being legally bound to the purchase and sale of a specific asset at a specific price by a certain time. On the other hand, options contracts involve the buyer being given a right but not a responsibility to buy or sell a specific asset at a specified price before a given time, where the seller is also bound to fulfil the buyer’s right if they choose to exercise it. The income derived out of futures and options (‘F&O’) trading has always been classified in the realm of non-speculative business income for levying tax. However, due to recent increase in the retail participant trade activity, there is a plan to move the F&O income to speculative business income under the Income Tax Act, 1961 (‘Income Tax Act’). This reclassification would put F&O transactions under deterrent tax laws and tax deducted at source (‘TDS’) which will harm the traders to one extent or the other by implementing a niggardly tax system.

    The Indian government’s proposed reclassification of F&O trading reflects growing concerns over unprecedented retail investor participation in derivatives. This regulatory shift aims to address potential systemic risks from unchecked retail F&O trading. Regulators worry that a major market correction could cause significant losses for retail investors, leading to widespread financial distress at the household level. This could have profound implications for market sentiment and economic stability. To mitigate these risks and ensure long-term market health, the government is considering reclassifying F&O trading income as speculative.

    What is Speculative Transaction?

    A speculative transaction is a transaction of purchase or sale of a commodity, being stocks and shares, and includes (section 43(5) of the Income Tax Act) a transaction that is not completed by the actual delivery of or by the transfer of the commodity.

    Section 43(5) defines ‘Speculative Transaction’ as a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scripts. For example, intra-day trading in shares could be one such kind of trade that comes under the head of speculative transaction.

    Understanding F&O Contracts in Financial Markets

    F&O are types of financial derivatives that enable traders to speculate on the price movements of an underlying asset without owning it. A futures contract binds the buyer to purchase and the seller to deliver the asset at a set price and future date. Conversely, an options contract grants the buyer the right, but not the obligation, to buy or sell the asset at a specified price by a certain date, while the seller is required to fulfil the contract if the buyer opts to exercise their right.

    Fiscal Implications for F&O Transactions

    An eligible transaction in respect of trading in derivatives referred to in Clause (ac) of section 2 of the Securities Contracts (Regulation) Act 1956 carried out in a recognized stock exchange is not a speculative transaction.

    Related to this, the Income Tax Act under section 43 (5) classifies F&O transactions as business income. This condition provides an exemption for trading in derivatives under clause (d). The section also includes subsection 5, which has clauses (a) to (e), and it specifically excludes speculative transactions. These include:

    • Hedging contract with respect to raw materials or merchandise.
    • Hedging contract with respect to stocks and shares.
    • Forward contract.
    • Trading in derivatives.
    • Trading in commodity derivatives.

    This makes trading under derivatives like F&O fall under the ambit of non-speculative business income, which is taxed under tax slabs based on the trader’s annual turnover.

    In essence, the profits from F&O trading are taxed like other business income, allowing taxpayers to claim deductions for expenses incurred, such as telephone bills, electricity bills, internet bills, etc.

    Prior to the addition of Clause (d) to the proviso of sub-section 5 of section 43, the Bombay High Court in Commissioner of Income Tax v. Bharat R. Ruia, determined that exchange-traded derivative transactions carried out by the assessee before January 24, 2006, were deemed speculative transactions. With the insertion of Clause (d) in section 43(5), an explanation was also introduced to define the term ‘Eligible Transaction’ as used in Clause (d). According to this explanation, only specific types of derivative trading transactions conducted on recognized stock exchanges are classified as non-speculative transactions. This was formalized by Notification No. S.O. 89(e) dated January 25, 2006. In this regard, from the date of Securities and Exchange Board of India (‘SEBI’), both Bombay Stock Exchange (‘BSE’) and National Stock Exchange (‘NSE’) were officially accorded recognition only for this particular purpose. Therefore, any derivative trades that were carried out in those exchanges and any others that may be entered in the future under the provision of this section are, in effect, non-speculative if they meet the conditions in the explanation of section 43 (5). These classifications apply to each of the transactions that satisfy the above conditions after January 25, 2006. The fact that for eligible derivative trades, there is a change of status from speculative to non-speculative is a major overhaul in tax and regulation.

    Analytical Assessment of Derivatives Taxation Reclassification: Implications for Market Participants

    F&O trading is considered a non-speculative business, and loss from its trading is allowed to be set against income from any other resource except salary income. This has been vividly described under section 71(2A) of the Income Tax Act.

    Unadjusted losses can be offset against income from other sources, except salary. Any remaining loss can be carried forward for up to eight years. In these subsequent years, the carried forward loss can only be offset against income under “Profit and Gains of Business and Profession.”

    Under section 73A, if a taxpayer incurs a loss from a speculative business transaction, they can only set off this loss against profits earned from other speculative business transactions. This means that a taxpayer cannot use a speculative business loss to offset gains earned from non-speculative business transactions, such as income from salaries, rent, or interest.

    In case a taxpayer is unable to set off the entire speculative business loss against profits earned from other speculative business transactions in the same financial year, they can carry forward the unabsorbed loss to the subsequent year. The unabsorbed loss from speculative business can only offset profits from similar transactions and be carried forward for four assessment years, as per section 73. This differs from non-speculative business losses, which can be carried forward for eight years.

    Examination of the Potential Impact on Market Behaviour and Investor Sentiment.

    The imposition of increased taxes on F&O trading could potentially reduce liquidity and trading volumes in these markets by dissuading active traders. While there are numerous drawbacks associated with such changes, they may also serve to influence market participants. For instance, the growing presence of retail investors in derivatives markets raises concerns about their vulnerability to significant losses during market corrections. Reclassifying F&O transactions as speculative could function as a deterrent, aiming to mitigate these risks and dissuade retail investors from exposure to substantial losses.

    However, there is also a risk that heightened taxes could redirect retail investors towards unregulated and potentially riskier investment alternatives. While these alternative channels offer the potential for greater profits, they operate outside the regulatory framework of traditional markets. This lack of oversight may expose retail investors to increased risks, potentially compromising their financial security. Institutional investors, who constitute a substantial segment of the F&O market, may reassess their strategies in response to these developments. The increased tax burden might influence their assessments of risk versus reward, altering market dynamics and potentially increasing volatility. Moreover, smaller market participants could face heightened operational costs and complexities as a result of these changes.

    Conclusion and a Way Forward

    The proposed reclassification of F&O transactions from ‘business income’ to ‘speculative income’ in India aims to protect retail investors but risks driving them to unregulated alternatives. To balance investor protection with market vitality, we propose:

    1) A tiered tax structure with lower rates for small investors and higher rates for large traders, curbing speculation while maintaining liquidity;

    2) Partial reclassification to a hybrid category, retaining some non-speculative tax benefits while introducing restrictions;

    3) Extending the loss carry-forward period beyond four years for speculative transactions. These amendments could foster a stable yet dynamic F&O market, ensuring fairness without unduly burdening traders. A robust regulatory framework remains crucial for maintaining transparency and investor confidence.