LG Electronics India: The Marketing Intangibles Concept Forges Ahead

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         LG Electronics India: The Marketing Intangibles Concept Forges Ahead, Journal of International Taxation

Marketing Intangibles

LG Electronics India: The Marketing Intangibles Concept Forges Ahead

       For all the detail in the court's decision, the lack of insight regarding the nature of LG India's AMP spend and its impact
       within the market, as well as the comparables, creates a large void in its analysis.

Author: MARC M. LEVEY AND PHILIP CARMICHAEL

       MARC M. LEVEY is a Principal of Baker & McKenzie LLP and is located in the firm's New York office. He is a
       frequent contributor to the Journal and a member of its Board of Advisers. PHILIP CARMICHAEL is a Principal
       Economist of Baker & McKenzie Consulting, LLC, also in the New York office.

The marketing intangibles concept has been on a rapid rise. In the United States, it is a staple in most U.S. tax audits. From
countless anecdotal stories of how the concept has been interpreted and applied during these audits, the judicial understandings of
the DHL case, 1 the Indian decision in Maruti-Suzuki, 2 the recent decision of the ITAT New Delhi Bench decision in LG Electronics
India, 3 and guidance from the OECD discussion draft on intangibles 4 and the U.N. Transfer Pricing Manual for Developing Countries, 5
many have grappled with the concept, and significant tax dollars have been placed in controversy, with minimal practical guidance on
its application.

Background

In Maruti-Suzuki, Suzuki Motor Corporation (“Suzuki”), a Japanese company, owned more than 50% of Maruti-Suzuki, Ltd. (Maruti), an
Indian company. Maruti licensed from Suzuki the right to use the Suzuki brand and certain technical know-how for the sale of its
automobiles in India. For this intellectual property, Maruti paid Suzuki a royalty. However, the transfer pricing officer (TPO) asserted
that Suzuki should have compensated Maruti for the marketing intangibles regarding use of the Maruti name on the sale of Suzuki
automobiles in India. Here, the TPO generally asserted that (1) the use of the Suzuki brand name on Maruti automobiles effectively
constituted a sale of the Maruti brand name to Suzuki because of Maruti's superior market position in India which allowed for greater
market penetration; and (2) Maruti was owed an arm's-length royalty for Suzuki “piggybacking” on Maruti's brand on the co-branded
trademark “Maruti-Suzuki.”

The TPO relied on the “bright-line” test to assess when the investment crossed from routine to non-routine expenditures such that
economic ownership likely in the form of a marketing intangible is created. The TPO assumed that the investment is reflected in the
AMP (advertising, marketing, promotion) expenses that the distributor incurred and that its AMP expenditures in total were non-routine
or -brand-building expenses. The TPO analyzed the AMP expenses in light of comparable companies, noting that Maruti-Suzuki's
royalty-to-sales ratios were much lower than those of other companies and further contending that its growth rate was lower than that
of the comparable companies. The TPO believed without factual basis that these comparable companies applied substantially similar
marketing and branding policies, occupied similar market positions, and, among other things, accounted for AMP expenses similarly.

Maruti-Suzuki raised numerous questions. First, how should a marketing intangible be defined? Second, what constitutes non-routine
investment in the brand? The Supreme Court of India reviewed the opinion of the Delhi High Court and neither rejected nor accepted its
opinion or analysis. Rather, it remanded the matter to the TPO (1) to consider an economic analysis of ratios of selling, general, and
administrative (SGA) expenses to gross receipts within the industry to determine the extent to which AMP expenses were brand-
building expenses; and (2) to seek comparable company data using a ratio of AMP expenses to gross receipts as a screening
criterion for the marketing intangibles. Thus, little guidance has come from the Supreme Court's review and many tax audits ensued

still following the views of the Delhi High Court.

In a new Indian case, LG Electronics India (“Maruti-Suzuki II”), the Income Tax Appellate Tribunal (ITAT), New Delhi Bench, advanced
the jurisprudence of the marketing intangible concept to the next level.

LG Electronics India—Facts

LG Electronics India, a wholly owned subsidiary of LG Electronics, Inc. (a Korean company, “LG Korea”), was manufacturing and
selling LG products in India. LG Korea charged LG India a 1% royalty for the use of industrial property rights, designs, and technical
know-how to manufacture the LG Products. LG Korea also provided LG India with certain marketing subsidies, such as funds toward
sponsorship of a global cricket event, to assist it with this presumably global branding event. There were no intercompany agreements
for these subsidies or any provisions for brand-building expenses. Otherwise, LG India was to market and exploit LG products in the
Indian market. LG India was quite profitable, and considered more so than its perceived comparable companies, notwithstanding that it
incurred significant AMP expenses. For the years in issue, its AMP expenses were 3.85% of its gross sales.

During the audit, the TPO questioned this level of AMP expense, specifically whether LG India was incurring significant expenses that
directly added to the brand value of the trademark owned by LG Korea. The TPO asserted that two comparables, Videon Appliances
Ltd. and Whirlpool of India, had ratios of AMP expenses to gross sales of .12% and 2.66%, respectively, or an arithmetic mean of
1.39%. Accordingly, the TPO applied the “bright-line” test of DHL 6 and asserted that 1.39% of these AMP expenses were routine and,
therefore, deductible expenses, and the balance of 2.46% (3.85% - 1.39%) of these expenses were brand-building, nondeductible
expenses that LG India incurred on behalf of LG Korea. In short, the TPO applied these percentages to gross sales to arrive at the
cost base for his purported marketing service fee as an “international transaction” under Indian tax law.

The TPO determined that a service fee was appropriate in the international transaction between LG Korea and LG India. On the cost
base of the 2.46% ratio of gross sales to AMP expenses, the TPO calculated a profit mark-up of 13% (LG India's opportunity cost of
10.5%, based on bank interest rates, plus 2.5% as compensation for LG India's entrepreneurial effort). The TPO provided no more
detail for these calculations.

The issues before the court were:

 ●   Whether, on the facts and circumstances of the case, the Assessing Officer (AO), who referred the international transaction to the
     TPO, was justified in making a transfer pricing adjustment in relation to AMP promotion expenses that LG India incurred
 ●   Whether the AO was justified in holding that LG India should have earned a 13% mark-up on the AMP expenses alleged to have
     been incurred for and on behalf of LG Korea.

Court's Analysis

In its detailed analysis, the ITAT New Delhi Branch essentially ruled in favor of the government, holding that the transfer pricing
adjustment and mark-up were appropriate, but remanded the case to the TPO for a more detailed comparability analysis. Although
remanded, the court's analysis provided more guidance than in the seminal case of Maruti-Suzuki, yet still seemed to circumvent
certain critical issues.

Most important was the court's finding that the arrangement or understanding between LG India and LG Korea regarding the AMP
expenses was an “international transaction” under section 92B of the Indian Income Tax Act. Given that a “transaction” under Indian
law is an “arrangement, understanding or action in concert, whether formal or in writing or whether enforceable or not by legal
proceedings,” the court's view was that the AMP expenses that LG India incurred on behalf of LG Korea to build its brand were more
than what independent third-party entities would incur proportionately in a similar “transaction.”

The court was not persuaded by the lack of a formal agreement for incurring these expenses Rather, it inferred this intent and
agreement from the facts and circumstances and, more significantly, from the parties' conduct. Here, the court seemed to believe that
the parties' common objective and purpose were controlling as to the economic substance of the transaction, but it never spelled out
what were the compelling facts for “acting in concert.” One can only guess that as related parties, the “action in concert” was implied.

The bright-line test came under scrutiny in the cost analysis. Here, the court rejected the parties' various arguments that the bright-line

test was not a sanctioned transfer pricing method, but rather merely saw the test as a tool in the cost allocation analysis to determine
routine versus non-routine brand-building expenses. Presumably, the court found this tool necessary because the parties failed to
specifically earmark the non-routine portion of its own AMP expenses. However, while the court upheld the concept of the bright-line
test, it was uncomfortable with the TPO offering just two firms as the comparability measure and remanded this issue to the TPO for
consideration.

The court identified 14 factors that “have considerable bearing on the question of determination of the cost/value of the international
transaction of brand/logo promotion through AMP expenses incurred by the Indian AE [associated enterprise] for its foreign entity.”
See Exhibit 1.

In determining the actual cost base, the court also determined the scope of the AMP expenses. Noting that a portion of the AMP
expenses were perceived as brand-building expenses, the court went to great lengths to find that a “bald comparison of the ratio of
AMP expenses to sales” can lead to an incorrect result. Here, the court focused on selling expenses and correctly noted that they
should not be considered AMP expenses. Further, the court said that any and all subsidies to LG India should be given true effect,
i.e., reducing the cost base for non-routine intangibles. Indeed, this is a message to the TPO to consider on remand.

Next, the court focused on the arm's-length price for the assessed non-routine brand-building expenses. The court considered this a
marketing service by LG India on behalf of LG Korea and agreed that the cost-plus method was appropriate. As noted above, the TPO
calculated a mark-up of 13% over those costs. The court rejected the taxpayer's argument that LG India's operating profit was higher
than that of the comparable firms and that any additional profit from a marketing service fee was, therefore, unnecessary and
duplicative. The court stated that each transaction must be considered separately notwithstanding the overall level of profitability.
Hence, that LG India's operating profit exceeded that of the comparable firms was irrelevant. The court also rejected the 13% mark-up
simply for lack of a reasonable if not robust comparability analysis and remanded that issue to the TPO.

Finally, the court considered Maruti Suzuki and noted that the principles observed in that case are still held to be correct: (1) brand
promotion expenses are an “international transaction”; (2) AMP expenses incurred on behalf of a foreign enterprise should be
compensated at arm's length; and (3) identification of the factors required to be considered for determining an arm's-length price.

Comment

The court in LG Electronics India thoughtfully considered all issues relevant to the transaction. Its analysis that “transaction” and
“international transaction” are embedded in the economic substance versus form doctrine, and its adoption of concepts like acting with
a “common objective,” are applied in other tax jurisdictions.

How did the court come to this decision? Was it merely intuitive? Was it simply inferred by the volume of AMP expenses and the two
comparable transactions? The court's decision suggests that its own examination may have lacked the in-depth financial and
economic analysis required to not only quantify and support application of the bright-line test, but also to assess the relevance and
impact of the 14 factors cited in the decision (see Exhibit 1). For example, did the court actually identify and review the specific
expenses recorded in the Indian AE's accounting records to determine the expenses associated with AMP activities, how those
expenses were incurred, and for what purpose? Brand-building expenditures presumably are investments that allow an enterprise to
earn premium profits beyond the period in which the expenditures were made. Therefore, it would be important to know the extent to
which the Indian AE's AMP expenditures were part of a consistent and ongoing investment pattern and created lasting value. If LG
India ceased its AMP investments, how quickly would it lose the competitive advantages that were created by the AMP spend?

A more fundamental element of the required analysis is whether the AMP spend is qualitatively and quantitatively consistent with the
industry standard—understanding that the "industry" must be defined carefully and culled from the available comparables. In other
words, the potential comparables should be marketing similar products with similar profit potential while making similar AMP
investments of similar magnitude. And because all LG India sales were intra-India and not cross-border, why were the Indian AE's
transactions with the foreign AE considered an “international transaction?”

While the determination appears to be based on LG India's investment in AMP to build the brand, analysis of the impact of the AMP
spend on markets beyond India is crucial. Again, there is no indication that the necessary analysis was undertaken to establish that
the products of the Indian AE's AMP spend were adapted or used by its foreign AEs in foreign markets or whether promotional efforts
within India had a spillover effect in foreign markets through, for example, global media advertising of India-specific events.

Similarly, it would be necessary to understand whether LG India's AMP represented support of global marketing campaigns, directly or
indirectly, by sharing with foreign AEs AMP tools and methods developed in India. Conversely, it would be important to understand the
extent to which LG India may benefit from AMP investments made by its foreign AEs. As can easily be deduced, a careful
examination of how LG India's AMP investments were implemented and benefits conferred on AEs outside of India should be
undertaken to support the argument that LG India in fact is engaging in an international transaction.

For all the detail in the court's decision, the lack of insight regarding the nature of LG India's AMP spend and its impact within the
market, as well as the comparables, creates a large void in its analysis. It is absolutely correct to find that the bright-line test was not
a sanctioned transfer pricing method but merely a tool to draw the “line” between routine and non-routine expenses. But was the tool
used appropriately and will the TPO find any value on remand in the available comparable data presented? Or was the tool used
because LG India itself did not establish the portion of AMP expenses that were brand-building?

For the first point, to determine whether the bright-line tool was used appropriately for routine versus non-routine AMP expenses, it is
first necessary to address LG India's specific activities because every business markets and builds its brand differently, even among
competitors within the same industry. Further, firms within the same industry may operate at different levels of the market, which may
limit the comparability of their branding activities.

The importance of analyzing LG India, its place in the local market, and its branding practices is implicit in the court's 14-factor test
including level of the marketplace, nature of the product, position with other products in the product line, launch periods, product
cycles, branding policies, and competition. Hence, as noted above, how one company decides to develop and build a brand may be
quite different from its direct competitors.

Further, advertising alone is rarely considered a brand-builder capable of creating lasting economic value, but rather a routine
maintenance effort. This might explain in part why advertising is accounted for as a current deductible item rather than a capital
expenditure.

Accordingly, by not analyzing the broader context of LG India's business and branding activities, it is not possible to derive a real
commercial and practical result. Here, the ITAT was correct in noting that a bald ratio of gross sales to AMP expenses produces an
incorrect result. Its instructions to the TPO on remand lacked the specificity to get to these facts, however, and instead focused on
what a comparable firm may do.

The second point, whether there is there any value in the comparable data, presents challenges that similarly require careful analysis.
It is difficult at best to identify comparable firms that meet the standards in the 14-factor list and still produce a commercial and
practical result. Even among direct competitors, it is difficult to find comparables that can meet these standards. Assuming, however,
that it were possible to identify appropriate comparables, extracting useful and reliable data from their accounting records may be
difficult if not impossible. First, the available accounting records may not provide the necessary specificity to isolate and compare
AMP expenses, much less whether the expenses are routine or non-routine. In some cases, there may be additional information
available in footnotes to the financial records or other public sources that may help in understanding a firm's AMP expenses. Second,
it is common knowledge that not all firms account for AMP expenses similarly. AMP expenses may be commingled with, for example,
selling expenses or general and administrative expenses. Similarly, one firm may identify as AMP particular expenses that another
firm may consider something else.

Thus, even if one could identify from the available financial information expenses labeled as AMP, the comparison across firms may be
like apples and oranges. Accordingly, the comparison may be faulty from the beginning.

This does not necessarily mean that comparables are useless in the context of the bright-line tool. While the TPO's use of only two
comparables in LG India likely exemplifies and perhaps even magnifies the problems discussed herein, examination of a broader set of
comparables may provide additional insights about company-specific and industry-wide AMP practices and long-term trends that
reasonably solve some or most of these problems. An acceptable answer to identifying non-routine AMP expenditures may be found,
for instance, by evaluating companies with AMP investments greater than the "industry average" established by a larger set of
comparables. Or perhaps a statistical method such as regression analysis could provide credible insight into the link between AMP
expenditures and profitability over a multiple-year period. None of these approaches is likely to produce a silver bullet, but they may
provide a broader and more informed context for using comparables to address the issue. Was the court taking an initial step in this
direction (i.e., more careful analysis of AMP expenses both for the Indian AE and the comparables) and implying that companies
should identify these expenses on their own when it observed that the bright-line test was applied because LG India did not? That

implicitly may mean this is what the court expects.

Remanding these issues to the TPO after enunciating the general principles of the marketing intangibles concept, but without real
guidance, does not truly allow for a workable platform for this issue. There appears to be some misguided belief that magic is to be
found in the comparable data. This is not so, and good economic modeling cannot be done without a solid foundation in the facts.
Indeed, using a ratio of gross receipts to operating expenses or AMP expenses, if ascertainable, can be a starting point to identify
possible comparable firms, but it is not the end answer by any means, for all reasons stated above.

In short, the ITAT court provided a thorough analysis of the marketing intangible concept and well understood the bright-line test, but
the decision lacks the understanding in application and detail of these issues that is so needed to advance the process.

Exhibit 1. Factors in Cost/Value of Brand/Logo Promotion Through AMP Expenses

       (1) Whether the Indian AE is simply a distributor or is holding a manufacturing license from its foreign AE.
       (2) Where the Indian AE is not a full-fledged manufacturer, is it selling the goods purchased from the foreign AE or is it making
       some value addition to the goods purchased from its foreign AE before selling them to customers?
       (3) Whether the goods sold by the Indian AE bear the same brand name or logo, which is that of its foreign AE.
       (4) Whether the goods sold bear the logo only of the foreign AE or the Indian AE, or is it a joint logo of both the Indian entity and
       its foreign counterpart?
       (5) Whether the Indian AE, a manufacturer, is paying any royalty or similar amount to its foreign AE as consideration for use of
       the brand/logo of the foreign AE?
       (6) Whether the payment made as royalty to the foreign AE is comparable to what other domestic entities pay to independent
       foreign parties in a similar situation.
       (7) Where the Indian AE has a manufacturing license from the foreign AE, is it also using any technology or technical input or
       technical know-how acquired from the foreign AE for purposes of manufacturing the goods?
       (8) Where the Indian AE is using technical know-how received from the foreign AE and paying any amount to the foreign AE,
       whether the payment is only toward fees for technical services or also includes a royalty for use of a brand name or logo.
       (9) Whether the foreign AE is compensating the Indian entity for the promotion of its brand in any form, such as a subsidy on the
       goods sold by the Indian AE.
       (10) Where a subsidy is allowed by the foreign AE, whether the amount of the subsidy is commensurate with the expenses that
       the Indian entity incurred in promotion of the brand for the foreign AE.
       (11) Whether the foreign AE has its presence in India in only one field or different fields. If different fields, is there only one Indian
       entity looking after all of the fields or there are different Indian AEs for different fields? If there are different entities in India, what is
       the pattern of AMP expenses in the other Indian entities?
       (12) Whether the year under consideration is the entry level of the foreign AE in India or is it an established brand in India?
       (13) Whether any new products are launched in India during the relevant period or is it continuation of the business with the
       existing range of products?
       (14) How will the brand be handled after termination of agreement between AEs?

1

    DHL Corporation, TC Memo 1998-461, RIA TC Memo ¶98461, 76 CCH TCM 1122 , aff'd in part, rev'd in part 89 AFTR 2d 2002-1978,
285 F3d 1210, 2002-1 USTC ¶50354 (CA 9, 2002). See Levey, Shapiro, Cunningham, Lemein, and Garofalo, “DHL: Ninth Circuit Sheds
Very Little Light on Bright-Line Test,” 13 JOIT 10 (October 2002).

2

    Maruti Suzuki India Ltd. v. Additional Commissioner of Income Tax Transfer Pricing Officer of New Delhi, W.P. (C) 68 76/2008 (High
Court of Delhi, 2010). See Levey and Arthur, “Indian Supreme Court Sets Aside High Court Ruling in Maruti-Suzuki—What's Next for
Marketing Intangibles?,” 22 JOIT 24 (January 2011); Levey and Arthur, “India High Court Applies U.S. and OECD Concepts in
Marketing Intangibles Case,” 21 JOIT 22 (October 2010).

3

    LG Electronic India Pvt. Ltd. v. Assistant Commissioner of Income Tax, ITAT New Delhi Bench (Special Bench), January 23, 2013,
itatonline.org/archives/?dl_id=938.

4

    Discussion Draft—Revision of the Special Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and
Related Provisions, June 6-September 14, 1012, www.OECD.org/ctp/transfer pricing /50526258.pdf.

5

    U.N. Practical Transfer Pricing Manual for Developing Countries (October 2012), www.un.org/esa/ffd/tax/documents/bgrd_tp.htm; see
McClure, “Indian Transfer Pricing Cases: Good News for Well-Articulated TNMM Approaches,” 23 JOIT 34 (March 2013).

6

    See Levey et al., “Tax Court Sends a Message to Taxpayers in DHL,” 482 PLI/Tax 775, 786, (2000) cited in DHL Corporation, 89
AFTR 2d 2002-1978, 285 F3d 1210, 2002-1 USTC ¶50354 (CA-9, 2002) at 1223.

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