The Delhi High Court (HC) issued a decision on 11 July 2024 in which it rejected a transfer pricing adjustment made by the Indian tax authorities in a case involving royalty payments made by an Indian subsidiary to its Korean parent company. The court noted that the royalty payments were made on arm’s length terms and concluded that the subsidiary operates as a licensed manufacturer rather than a contract manufacturer. The HC upheld the decision of the Income Tax Appellate Tribunal (ITAT) to reverse the tax authorities’ disallowance of a royalty deduction.
India’s tax authorities took the position that Samsung India was a contract manufacturer as it was undertaking production based on the parent company’s instructions and directives and thus, a royalty payment on sales to group entities was not on arm’s length terms because it effectively resulted in a royalty on sales to itself. The authorities disallowed the entire royalty payment and treated it as income of the Indian company.
Samsung India appealed the tax authorities’ decision to the ITAT, which held as follows:
Simply because two entities are part of the same multinational group does not automatically colour the lens when evaluating the genuineness of an arrangement. A blanket approach cannot be used to establish the veracity of related party transactions—a thorough analysis must be made on a case-to-case basis.
Lalit Attal
Pranav Thakker
Prateik Sachdev
BDO in India
Background and facts of the case
Samsung India, a wholly owned subsidiary of Samsung Korea, is engaged in the business of manufacturing and selling mobile phones in India and overseas. Pursuant to a Technology License Agreement that enabled Samsung India to manufacture mobile phones by utilising Samsung Korea’s intellectual property (i.e., design, technical know-how, etc.), the Indian subsidiary was required to pay technical assistance fees and royalties. The subsidiary paid a royalty of 8% on total sales to Samsung Korea and to other associated parties.India’s tax authorities took the position that Samsung India was a contract manufacturer as it was undertaking production based on the parent company’s instructions and directives and thus, a royalty payment on sales to group entities was not on arm’s length terms because it effectively resulted in a royalty on sales to itself. The authorities disallowed the entire royalty payment and treated it as income of the Indian company.
Samsung India appealed the tax authorities’ decision to the ITAT, which held as follows:
- Samsung India operates as a proprietor and is fully responsible for its own business decisions (i.e., it is a full-fledged licensed manufacturer).
- Contract manufacturing involves extensive instructions from a principal entity regarding the nature, quality and quantity of manufacturing, along with an assurance that the entire production would be purchased.
- Even though Samsung Korea kept a close watch on the quality of raw materials and production processes, there was no assurance that Samsung India’s entire production would be purchased.
- In the proceedings on the same issue for the preceding year, a decision was issued in favour of Samsung India; all relevant facts remained unchanged for the current year.
HC decision
In issuing its decision to annul the transfer pricing adjustment imposed by the tax authorities, the Delhi HC made several important observations, specifically citing the appellate tribunal’s ruling:- Although Samsung India cannot carry out its manufacturing activities under the Samsung brand without access to Samsung Korea’s technological know-how, the Indian subsidiary undertook the manufacturing activities on its own accord and no evidence was produced to refute this.
- Contract manufacturing is not defined in India’s Income Tax Act but the Commentary to the OECD transfer pricing guidelines provides that contract manufacturing will exist where a manufacturer receives “extensive instruction about what to produce, in what quantity and of what quality,” bears low risks and may be assured that its entire output will be purchased if quality requirements are met. In the case before the HC, although Samsung Korea closely monitors the quality of Samsung India’s raw materials and production process, it does not determine the quantity of production or the terms of sales of the products. Further, no assurances were given to the Indian subsidiary that its production would be purchased. In these circumstances and based on the Commentary to the OECD guidelines, Samsung India is operating as a full-fledged licensed manufacturing company and cannot be considered a contract manufacturer.
- There was no evidence that any of Samsung India’s revenue was repatriated to Samsung Korea with an intention to shift profits.
Comments
The Delhi HC emphasised the transfer pricing principle that it is necessary to understand the substance of a business arrangement rather than its form to determine whether transactions between related parties are on arm’s length terms or are undertaken with a view to derive undue tax benefits and/or to shift profits. The HC also indicated that the tax authorities do not have the right to step into the shoes of the taxpayer and question the commercial expediency or genuineness of the need for a transaction. The tax authorities have the power to examine the appropriateness of the method adopted for determining the arm’s length price in light of the transfer pricing law and guidance.Simply because two entities are part of the same multinational group does not automatically colour the lens when evaluating the genuineness of an arrangement. A blanket approach cannot be used to establish the veracity of related party transactions—a thorough analysis must be made on a case-to-case basis.
Lalit Attal
Pranav Thakker
Prateik Sachdev
BDO in India