DISCOVERY COMMUNICATIONS INDIA,NEW DELHI vs. DCIT, NEW DELHI

This appeal by the assessee is directed against the final assessment order passed by the Assessing Officer (AO) on 27.2.2015 u/s 143 (3)

The first issue raised in this appeal is against the addition of Rs.20,33,78,769/- made on account of transfer pricing adjustment due to difference in the arm’s length price of the international transaction of incurring of advertisement, marketing and promotion (AMP) expenses relating to creation of marketing intangibles.

Briefly stated, the facts of the case are that the assessee is a subsidiary of Discovery Channel (Mauritius) Pvt. Ltd. with Discovery Communication Inc., USA as the parent company of this group. The assessee is engaged in the distribution of Discovery Channel, Discovery Travel and Living Channel and Animal Planet Channel in India region and also sale of advertisement inventory on the channels. The assessee reported six international transactions which have been enlisted on page 2 of the order passed by the Transfer Pricing Officer (TPO). The assessee employed Transactional Net Margin Method (TNMM) as the most appropriate method for demonstrating that its first three international transactions were at arm’s length price (ALP). The remaining three were `At cost’ only. On a reference made by the AO for determining the ALP of the international transactions, the TPO accepted the reported international transactions at ALP. He, however, observed that the assessee incurred AMP expenses to the tune of Rs.29,60,08,795/- which was not reported. For determining the ALP of the international transaction of AMP expenses, he chose certain companies as comparables. By applying the bright line test, he worked out non-routine expenses incurred for developing intangibles in excess of bright line at Rs.22,85,49,990/-. Adding the mark up of 14.48%, he worked out a transfer pricing adjustment of Rs.26,25,58,229/-. In addition to that he noticed that the assessee had not charged any `Interest on receivables’ from its AE. After entertaining objections from the assessee, the TPO worked out TP adjustment of interest on receivable to the tune of Rs.1,16,33,235/-, thereby proposing total TP adjustments amounting to Rs.27,41,91,464/-. The AO, inter alia, made these two additions on account of transfer pricing adjustments. The assessee challenged the additions so proposed in the draft order amounting to 3 Rs.27.41 crore and odd before the DRP. Vide its Direction dated 15.12.2014, the DRP gave some directions on the computation of ALP of AMP expenses. However, the TP adjustment of `Interest on receivables’ was not altered. The TPO passed consequential order in conformity with the direction of the DRP on 26.2.2015 revising the amount of total adjustment to Rs.21,50,12,004 instead of the order amount of Rs.27,41,91,464 inclusive of adjustment on account of Interest on receivables. In the final order passed, the AO made addition for a sum of Rs.21.50 crore and odd, comprising of Rs.20,33,78,769/- towards AMP and Rs.1,16,33,235/- towards interest on receivables. No argument has been advanced before us on account of addition on account of TP adjustment of `Interest on receivable’. The assessment order to that extent is, therefore, approved.

We have heard the rival submissions and perused the relevant material on record qua the addition on account of transfer pricing adjustment of AMP expenses. In this regard, it is imperative to note that Special Bench of the Tribunal in the case of LG Electronics India Pvt. Ltd. Vs. ACIT (2013) 152 TTJ (Del) 273 (SB), by its majority decision held, inter alia, that AMP is a transaction and also an international transaction within the meaning of section 92B of the Act and that the TPO has jurisdiction to compute the ALP of this international transaction despite the same not having been specifically referred to by the AO. On the question of determination of the ALP of this international transaction, the Special bench approved the application of bright line test for working out the amount of non-routine AMP expenses and held that the ALP of AMP expenses should be determined on Cost plus method by treating AMP transaction as a separate and distinct from other international transactions. It was further held that the selling expenses directly incurred in connection with the sales do not lead to brand promotion and hence should not be brought within the ambit of AMP expenses. The Special bench laid down certain parameters to be taken into consideration for determining the ALP of AMP expenses. In the ultimate analysis, the matter was sent back to the TPO for undertaking the exercise afresh in the light of its directions.

Following the said order, benches of the Tribunal decided several cases involving AMP expenses, restoring the matter to the file of AO/TPO for deciding this issue in conformity with the directions given by the Special Bench in LG Electronics (supra). Several assessees as well as the Revenue preferred their respective appeals before the Hon’ble High Courts against the tribunal orders following the Special bench order. A batch of such appeals, also including the case of the assessee for the year under consideration, led by Sony Ericson Mobile Communications India Pvt. Ltd. Vs. CIT (2015) 374 ITR 118 (Del) has been disposed of by Their Lordships of the Hon’ble Delhi High Court, upholding the majority view of Special Bench in LG Electronics (supra) treating AMP as an international transaction and also conferring jurisdiction in the TPO to determine the ALP of the international transaction of AMP expenses. The Hon’ble High Court has held, inter alia, that the international transaction of AMP expenses should be bundled or aggregated with other international transaction carried out by the assessee as a Distributor, who either simply acts an agent of manufacturer or purchases goods from the manufacturer for resale at his 6 own account. However, in the case of a Manufacturer, the import of raw material has been held to be an independent transaction of marketing and distribution. In the case of a Distributor, the Hon’ble High Court held that where TNMM has been applied as the most appropriate method, which method has not been disturbed by the TPO, then, the international transactions of AMP and Distribution activities should be clubbed. It further held that for determining the ALP of such transactions under a combined approach, only such comparables should be chosen which conform to the AMP functions and other distribution functions conducted by the assessee. If there is some difference in the functions under these international transactions, including that of AMP, between the assessee and the comparables, then, suitable adjustment should be made to bring both the transactions at par. If probable comparables are not performing similar functions as done by the assessee and no adjustment is possible for bringing the international transactions of the assessee in an aggregate manner at par with those undertaken by the comparables, then, segregation should be done and the international transaction of AMP spend should be separately processed under the 7 transfer pricing provisions for the purposes of determining its ALP separately. In such determination of ALP of AMP expenses in a segregated manner, proper set off on account of excess purchase price adjustment should be allowed. The view taken by the Tribunal in segregating routine and non-routine expenses on the basis of bright line test has been set aside by the Hon’ble High Court. The view taken by the Special Bench that the expenses concerned with the sales, such as, rebates and discounts etc., should be excluded from the ambit of AMP expenses, has been upheld.

We can summarize the relevant position emanating from the judgment of the Hon’ble High Court, as under : -

With the above background of the ratio decidendi of the judgment of the Hon’ble jurisdictional High Court, let us examine the contention put forth by the ld. AR in support of the deletion of addition.

The ld. AR initially contended that the assessee is a service company and hence cannot be considered either as a Distributor or a Manufacturer. It was however admitted that considering the totality of the nature of business, the assessee is more akin to that of a Distributor rather than a Manufacturer. The Hon’ble High Court has dealt with the case of the assessee in a group of cases who are either distributors or manufacturers. There is no separate discussion qua the assessee in the judgment on the determination of the ALP of AMP expenses. This shows that the assessee has not been considered by the Hon’ble High Court as belonging to a separate class other than a Distributor or a Manufacturer. Since the ld. AR has admitted that out of these two options, it is more close to a `Distributor’, we are proceeding accordingly by classifying it as a Distributor.

The ld. AR submitted that the assessee applied TNMM as the most appropriate method. Since the profit margin declared by the assessee was favourably comparable with the average margin of the comparables, which fact has not been disputed by the TPO, then, no adjustment should be made on account of AMP expenses because such expenses stand subsumed in the overall operating profit. This was countered by the ld. DR with reference to certain paras of the judgment in Sony Ericsson (supra) not permitting the acceptance of such a wide proposition.

We are unable to accept the argument advanced on behalf of the assessee for deletion of the addition towards AMP expenses on the plain logic of the assessee’s profit margin matching with those of comparables. There is a basic fallacy in the argument of the ld. AR. It is pertinent to note that the TPO examined and got satisfied with the assessee’s profit margin vis-à-vis the comparables only qua the international transactions of Distribution function. He initially determined the ALP of AMP expenses by applying bright line test, which mechanism was altered due to the directions given by the DRP and in doing so, he simply compared the quantitative figures of AMP expenses incurred by the assessee and comparables for working out the non-routine expenses. He did not examine the AMP functions carried out by the assessee and the comparables. As the bright line test and the method suggested by the DRP primarily concentrate on the quantitative aspects of the AMP expenses alone, it overlooks the examination of the AMP functions carried out by the assessee on one hand and the comparables on the other. Now, the Hon’ble High Court in Sony Ericson Mobile (supra) has held that AMP expense is a separate international transaction and also bright line test is not applicable for determining the ALP of AMP expenses. The manner for the determination of the ALP of the Distribution activity and AMP activity has also been set out by the Hon’ble High Court to be conducted, firstly, in a bundled manner by considering the distribution and AMP functions performed by the assessee as well as the probable comparables, and if probable comparables having performed both the functions are not available, then to determine the ALP of AMP expenses in a segregated manner. As such, it becomes immensely important to separately examine 13 the Distribution and AMP functions undertaken by the assessee as well as probable comparables. It is vital to highlight the difference between the AMP expenses and AMP functions. Whereas the AMP functions are the means by which the AMP activity is performed, the AMP expenses are the amount spent on the performance of such means (functions). To put it simply, an examination of AMP functions carried out by the assessee and the probable comparables is sine qua non in the process of determination of the ALP of the international transaction of AMP spend, either in a segregate or an aggregate manner. What Their Lordships have held is to bundle the Distribution activity with the AMP activity, being two separate but connected international transactions, for the purposes of determination of the ALP of both these international transactions in a combined manner. The argument of the ld. AR, if taken to a logical conclusion, will make the AMP spend as a non-international transaction, which, in our considered opinion, is not appropriate. Once AMP expense has been held to be an international transaction, it is, but, natural that the functions performed by the assessee under such a transaction need to be compared with similar functions performed by a 14 comparable case. If AMP functions performed by the assessee turn out to be different from those performed by a probable comparable company, then, an adjustment is required to be made so as to bring the AMP functions performed by the assessee as well as the comparable, at the same pedestal. If we concur with the contention of the ld. AR that the addition on account transfer pricing adjustment of AMP expenses be deleted without any examination of the AMP functions carried out by the assessee as well as comparables, this will amount to snatching away the tag of international transaction from AMP expenses, assigned by the Hon’ble High Court. What Their Lordships have held in the judgment is that the Distribution activity and AMP expenses are two separate but related international transactions. It is only for the purposes of determining their ALP that these two should be aggregated. The process of such aggregation does not take away the separate character of the AMP transaction, albeit related. An analysis and examination of the Distribution and AMP functions carried out by the assessee must be necessarily done in the first instance, which should be then compared with similar functions performed by some probable comparables. If the 15 Distribution and AMP functions performed by the assessee turn out to be different from those performed by probable comparables, then, a suitable adjustment should be made to the profits of the comparable so as to balance the effect of such differences. If however differences exist in such functions, but no adjustment can be made, then, such probable comparable should be dropped from the list of comparables. If, in doing this exercise, there remains no company doing comparable distribution and AMP functions, then, both the international transactions are required to be segregated and then examined on individual basis by finding out probable comparables doing such separate functions similarly. For the international transaction of AMP spend, this can be done by, firstly, seeing the AMP functions actually performed by the assessee and then comparing it with the AMP functions performed by a probable comparable. If both are found out to be similar, then the matter ends and a comparable is found and one can go ahead with determining the ALP of such a transaction. If the AMP functions performed by the two entities are found to be different, then adjustment is required to be made in the case of a probable comparable, so as to make it uniform with the 16 assessee. The assessee may have possibly done, say, four different AMP functions as against the probable comparable having done, say, only three. In such a scenario, again the adjustment will be warranted. In another situation, the AMP functions performed by the assessee and probable comparable may be similar but with varying standards, which will also call for an adjustment. Crux of the matter is that the AMP functions performed by the assessee must be similar to those done by the comparable, in the same manner as such functions are compared in any other international transaction. However, in computing ALP of AMP spend, the adjustment or set off, if any, available from the Distribution function, should be made. The essence of the judgment in the case of Sony Ericson Mobile (supra) is that the two international transactions of Distribution and AMP should be examined on the touchstone of transfer pricing provisions, but on an aggregate basis. Determining the ALP of two transactions in an aggregate manner postulates making a comparison of both the functions of Distribution and AMP carried out by the assessee with the comparables, so that surplus from the distribution activity could be adjusted against the deficit in the AMP activity. The 17 Hon’ble High Court has no where laid down that the AMP functions performed by the assessee should not be compared with those performed by the comparable parties. On the contrary, it turned down the contention raised by the ld. AR urging for not treating AMP as a separate function, which is apparent from the extraction from para 165 of the judgment : `On behalf of the assessee, it was initially argued that the TPO cannot account for or treat AMP as a function. This argument on behalf of the assessee is flawed and fallacious for several reasons.

Adverting to the facts of the instant case, we find that the TPO accepted TNMM as the most appropriate method and did not make any TP adjustment on account of the reported international transactions carried out by the assessee during the course of its business. He, however, espoused the AMP expense as a separate and distinct item apart from `Interest on receivables’, which is not in dispute. Treating the AMP spend as a separate international transaction and after giving effect to the direction of the DRP, he applied the Cost plus method and proposed the extant adjustment. It is obvious that in the entire exercise carried out by the TPO, he proceeded on an altogether different line in examining the quantum of AMP expense for determining the value of the international transaction of AMP, without looking at the AMP functions carried out by the assessee and the comparables. Distinct examination of AMP functions does not find place in this method of computing the value or the ALP of AMP spend. Now, when we look at the ratio laid down by the Hon’ble jurisdictional High Court, it becomes crystal clear that the approach adopted by the TPO for determining ALP of AMP expenses has been rendered incorrect. However, the fact remains that as per the verdict of the Hon’ble High Court, the AMP spend is an international transaction, which is required to be processed under Chapter X of the Act by taking into account the AMP functions performed by the assessee and then comparing such functions with those performed by comparable entities, though, firstly in a combined manner with the Distribution functions. We find no reference to the AMP functions carried out by the assessee in the order of the TPO. As such, there can be no question of making any comparison of the assessee’s AMP functions with those of the comparables. Going by the ratio in the case of Sony Ericson Mobile (supra), it is mandatory to make a comparison of the AMP functions performed by the assessee and comparables and then making an adjustment, if any, due to differences between the two, so that the AMP functions performed by the assessee and comparable are brought to a similar platform. In fact, this is also the prescription of Rule 10B(1)(e), which provides as under :-

A perusal of the sub-clause (iii) of this Rule divulges that net profit margin under a comparable uncontrolled transaction as determined under sub-clause (ii) should be: “adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions.” It is only such adjusted net profit margin in sub-clause (iii) of Rule 10B(1)(e) which is compared with the net profit margin realized by the assessee as per the mandate of sub-clause (iv) of Rule 10B(1)(e).

Sub-rule (2) of Rule 10B provides that ‘for the purposes of sub- rule (1)’, the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely — (a) the specific characteristics of the property transferred or services provided in either transaction ; (b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions ; (c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions ; (d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail. Sub-rule (3) of Rule 10B stipulates that an uncontrolled transaction shall be comparable to an international transaction if (i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market ; or (ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences.

On a comparative reading of sub-rules (1), (2) and (3) of Rule 10B, it becomes palpable that the international transaction and the uncontrolled transaction with which comparison is sought to be made for determining the ALP, in the first instance, must have overall similar characteristics. It is vivid that if the goods/services are different, then no effective comparison can be made. Once the goods/services under both the transactions are broadly similar but there is a difference in them because of certain specific characteristics; and/or the products/services in both the transactions are identical, but still there are certain differences due to the contractual terms or the geographical location, etc., then, a reasonably accurate adjustment should be made for eliminating the material effects of such differences so as to bring the international transaction and the comparable uncontrolled transaction on the same podium. If due to one reason or the other, no reasonable accurate adjustment can be made due to such differences, then, such uncontrolled transaction should not be considered as a comparable transaction.

It is discernible that the prescription of Rule 10B is in complete harmony with the ratio of the judgment in the case of Sony Ericson Mobile (supra), to the effect that the AMP functions carried out by the assessee are required to be necessarily compared with the AMP functions carried out by a comparable entity in determining the AMP of ALP expenses. Difference between the functions, if capable of adjustment, should be given effect to in the profit rate of the comparable and if such difference cannot be given effect to, then, the probable comparable should be eliminated from the list of comparables. Going further, if no proper comparable survives, then the TNMM should be discarded and an alternative method, may be, Cost plus or any other suitable method be applied for determining the ALP of AMP expenses.

At the cost of repetition, we summarize that the Distribution and AMP functions are two separate international activities, which need to be compared with uncontrolled transactions. Because of their inter- twinning, it is only for the purpose of determining their ALP that both these transactions can be aggregated in the first instance, so that the surplus from one could be adjusted against the deficit from the other in an overall approach. It does not mean that because of aggregation, the AMP expense transaction sheds its character of a separate international transaction and hence the AMP functions should not be matched with the AMP functions carried out by probable comparables. If suitable comparables can be found having performed both Distribution and AMP functions, then, their ALP should be determined on aggregate basis. If, however, there is some difference in the Distribution or AMP functions performed by the assessee vis-à-vis the probable comparables, then an attempt should first be made to iron out such difference by making a suitable adjustment to the profit margin of comparables. If such an adjustment is not possible, then such probable comparable should be eliminated. If, by making a comparative analysis of the Distribution and AMP functions jointly, there remains no comparable case performing such distribution and AMP functions, then, the international transaction of AMP should be segregated and its ALP be determined separately by applying a suitable method. However, in so determining the ALP of such an international transaction of AMP expenses on separate basis, a proper set off, if any, available from the distribution activity, should be allowed.

Coming back to the facts of the instant case, we find that no detail of the AMP functions performed by the assessee is available on record.

Another corporate tax issue raised in this appeal is against the disallowance of proportionate advertisement expenses of Rs.3,17,71,475/- out of total advertisement expenses amounting to Rs.8,51,90,351/- incurred by the assessee. The facts apropos this issue are that the assessee showed `Advertising sale commission’ @ 20% of total advertisement income received on behalf of its AE. Remaining 80% was transferred to the parent company with whom the assessee entered into advertising sale agreement. The AO segregated total advertisement expenses as per Profit & Loss Account to the tune of Rs.8,51,90,351/- into two parts, viz, advertisement expenses allocable to total income from advertisement sales commission; and advertisement expenses allocable to advertisement revenues not offered to tax. The later amount of Rs.3,17,71,475/- was added to the total income, against which the assessee has come up in appeal before us.

At the outset, the ld. AR submitted that this issue has been decided by the Tribunal in assessee’s favour for the AYs 2002-03, 2003-04 and 2004-05 and the view taken by the Tribunal has been upheld by the Hon’ble Delhi High Court. A copy of the judgment of the Hon’ble Delhi High Court dated 24.11.2014 and the Tribunal orders for the above referred three years were placed on record. The ld. DR resisted the contention raised on behalf of the assessee by submitting that the view taken by the Tribunal for the AYs 2002-03 to 2004-05, as affirmed by the Hon’ble Delhi High Court, cannot be directly and blindly applied to the facts of the instant case inasmuch as no AMP expenses were incurred for promoting marketing intangibles of the assessee’s AE in such earlier years, in contrast to such expenses having been actually incurred for the year under consideration for which TP adjustment of AMP expenses has been made and is subject matter of this appeal. It was submitted that there is a common pool of AMP expenses incurred both for the business of the assessee and the promotion of the brand of its AE.

We have heard the rival submissions and perused the relevant material on record. It is observed from the judgment of the Hon’ble Delhi High Court rendered in assessee’s own case for the AYs 2002-03 to 2004-05 that it was engaged in the business of distribution of television channels and under the Agreement, there was obligation and the duty of the assessee to advertise and promote the channels of its AEs in lieu of 15% of gross receipts as commission. The Hon’ble High Court found expenditure incurred on advertisement on promoting channels as clearly relatable and laid out for the purpose of business of the assessee and, hence, deductible in full. That is how, the addition was deleted. On a specific query from the Bench, the ld. AR stated that in the current year, the assessee received 20% of the total subscription fees in lieu of advertising and promoting the channels of its AEs and candidly admitted that the expenses incurred on advertisement and promotion of channels are common and form part of total AMP expenses considered by the TPO for recommending TP adjustment towards promotion of marketing intangibles. As the total AMP expenses incurred by the assessee are on account of its own business and also relatable to the creation of marketing intangibles for its AE, the entire expenditure, which also includes advertisement expenses for promotion of channels of its AEs, for which the assessee received 20% of gross receipts, cannot be considered as exclusively relatable to advertisement of channels of its AEs and hence deductible in full. The facts of the current year are thus clearly distinguishable from those of the A.Ys. 2002-03 onwards because in such years the entire amount of advertisement expenses was for earning income and no part was attributable to the creation or promotion of the brand of its AE. The Hon’ble High Court in assessee’s 31 own case for the A.Y. 2008-09 has restored the computation of the transfer pricing adjustment on account of AMP expenses for marketing intangibles to the tribunal, which has been dealt with by us in a separate order. In disposing of the appeal of the assessee against the transfer pricing adjustment towards AMP expenses for the said A.Y. 2008-09, we have restored the matter to the file of TPO/AO for deciding it in conformity with our directions as deduced from the judgment of the Hon’ble Delhi High Court in the case of Sony Ericson Mobile Communication India (P) Ltd. (supra). As admittedly the AMP expenses are one composite amount and there is no separately identifiable advertisement expenses relatable to promotion of TV channels of its AEs, the acceptance of the view point of the ld. AR in treating the entire amount of AMP expenses as deductible u/s 37(1), would amount to considering the entire AMP spend for business purpose, thereby leaving nothing for the promotion of brand of its AE, which will be contrary to the judgment of the Hon’ble High Court in assessee’s own case for the A.Y. 2008-09. Under such circumstances, we set aside the impugned order on this issue also and send it to the file 32 of AO/TPO for deciding it afresh after hearing the assessee. Needless to say, the AO, while disposing of this issue, will keep into consideration the context and the ratio of the decision rendered by the Hon’ble High Court in the assessee’s own case for AYs 2002-03 to 2004-05.

In the result, the appeal is partly allowed for statistical purposes.