United States

Delhi court: Intercompany royalties are pass-through costs

Indian Appellate Tribunal ruling echoes OECD guidelines and U.S. rules

TAX ALERT  | 

The Delhi Income Tax Appellate Tribunal ruled in favor of a taxpayer’s treatment of intercompany franchise royalties as pass-through costs for transfer pricing purposes. This pass-through treatment reduced the amount of profit taxable in India. The case, McDonald’s India (P) Ltd. v. DCIT (April 12, 2006, ITA 961/Del/2010), presents support for pass-through treatment of certain, nonvalue added services at cost from an Indian perspective—similar to the approach taken by the Organisation for Economic Co-operation and Development (OECD) guidelines and U.S. transfer pricing regulations.

McDonald’s Indian subsidiary provided two primary functions for its U.S. parent:

  1. It operated as a nonexclusive licensee of the company’s marketing and operational intangible property, which it sublicensed to joint venture franchisees for the development of McDonald’s restaurants
  2. It provided consulting services to the U.S. parent for the company’s operations in India

The company tested the pricing of the former function by applying the comparable uncontrolled price (CUP) method and the latter function by applying the transactional net margin method (TNMM). After establishing pricing for the license relationship consistent with the CUP method analysis (namely a franchise fee, a 5 percent royalty on sales, and a commitment of 5 percent of gross sales to marketing spend), the taxpayer tested the overall profit earned by the entity using the TNMM. McDonald’s did not, however, include the costs related to the license transactions in its overall profit calculation, arguing that McDonald’s India assumed no risk and performed limited functions related to the transactions. The exclusion of these costs resulted in reduced taxable profit in India.

Upon audit, the Indian Transfer Pricing Officer (TPO) argued McDonald’s India assumed risk related to cancellation of the franchisee agreements and subsequent default of royalty payments. Relying on several cases, including the tribunal decision from Cheil Communications India Pft. Ltd. (ITA 712/de/2010), the High Court ruling in Johnson Matthey India Pvt. Ltd. v. DCIT, and the tribunal decision in McDonald’s U.S. (2001-2002), the tribunal ruled against the TPO, determining McDonald’s India did not assume risk, did not add value to the transactions, and did not gain profit or suffer loss related to the transactions. Hence, the tribunal determined costs related to the franchise should not be applied to the TNMM application.

The tribunal decision also relied on paragraph 2.93 of the OECD transfer pricing guidelines regarding the pass-through of certain intercompany activities at cost. This application of the pass-through language of the OECD guideline is significant as it supports the approach taken by McDonald’s and suggests that the Indian courts will look to the OECD guidelines in their decision making process. This treatment is also consistent with the services cost method (SCM) described in U.S. transfer pricing regulations, under which the expenses related to certain activities can be passed through at cost if the activities do not contribute to the core competencies or key competitive advantages of the taxpayer.

The decision should be considered by any company in India in similar situations involving intercompany royalty fees and franchising activities. It should also be considered by any company with similar, nonvalue added activities within the country.

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