India Issues Ruling on Transfer Pricing Aspect of Royalty Payments

The Delhi High Court, in its ruling on the case of Commissioner Income Tax vs. EKL Appliances Limited (Taxpayer), has given its decision on the transfer pricing aspects of a royalty payment by the Taxpayer to its associated enterprise. In its judgment, the High Court ruled that royalty payments cannot be prohibited on instances of continuous loss where the spending was proven to be incurred “wholly and exclusively” for the purpose of the business of the Taxpayer.

The honorable High Court said that it is not for the tax authorities to inquire into the commercial feasibility of a transaction. While ruling in favor of the EKL Appliances, the honorable High Court observed that it is suitable to rely on the OECD Transfer Pricing Guidelines to evaluate the situation adopted by the Tax Authority, since these guidelines have been recognized in the tax jurisprudence of India.

Relying on the OECD Transfer Pricing Guidelines, the honorable High Court stated that re-characterization of lawful business transactions by the tax authorities is not allowed.

Background of the case
EKL is a subsidiary of AB Electrolux Sweden involved in the business of manufacturing refrigerators, washing machines, compressors and spares thereof, and dealt in all these items as well as microwave ovens, dishwashers, cooking ranges, and air conditioners. During the applicable evaluation years, EKL had entered into a range of worldwide transactions including the payment of royalty. Except for the brand fee/royalty paid by EKL to its out of country associated enterprises, the transfer pricing officer (TPO) acknowledged all the other transactions to be at arm’s length. The TPO illustrated that EKL had been again and again incurring huge losses and, as a result, the benefits received by EKL from the payment of brand fee/royalty were inquired by the TPO.

Reasons of loss
The honorable High Court held that even on the merits of the case, the disallowance was not acceptable as the Taxpayer had provided numerous substance and valid reasons as to why it was suffering losses. The honorable High Court also stated that full explanation supported by facts and figures were given by the Taxpayer to reveal that the increase in employee costs, finance charges, administrative expenses, depreciation costs and capacity increases had contributed to the continuous losses.

The taxpayers have been facing a tough time to state that the losses are commercial in nature and not the result of transfer pricing. In few cases, the tax authorities need taxpayers to show the economic and commercial benefits resulting from the use of intangible property owned by the associated enterprises. There is repeatedly a propensity to gauge the advantage having regard to the profitability of the intangible property user.

The ruling also emphasizes the significance of maintaining credentials that outline the non-transfer pricing issues such as start-up or market access strategies, downturns in the business cycle, the materialization of more competition or new technologies in the market, or unfavorable economic conditions that have contributed to losses.

The honorable High Court’s position to the OECD Transfer Pricing Guidelines and the court’s acknowledgement of the significance of the guidelines has also been received in a positive way in light of the new account that the Indian government has expressed its difference with the use of the OECD Transfer Pricing Guidelines by the United Nations as it does not take into account the issues of developing nations.

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