ITAT Delhi Strikes Down Rs 5.02 Crore Royalty TP Adjustment and Upholds ESOP Deductions for ELCA Cosmetics
The Income Tax Appellate Tribunal (ITAT), Delhi Bench “I”, recently delivered a comprehensive ruling in the case of ELCA Cosmetics Pvt. Ltd Vs DCIT (ITAT Delhi) for the Assessment Year (AY) 2016-17. The tribunal adjudicated on multiple complex tax disputes, primarily focusing on Transfer Pricing (TP) adjustments related to royalty payments, the allowability of Employee Stock Option Plan (ESOP) expenses, information technology support charges, and advertisement expenditures.
The assessee challenged the final assessment order dated 29 April 2021, wherein the assessing authorities had determined the business income at Rs. 12,95,10,035, a stark contrast to the returned income of Rs. 1,43,27,495. This assessment resulted in aggregate additions and disallowances amounting to Rs. 11,51,82,540. The most prominent addition was a transfer pricing adjustment of Rs. 5,02,84,262 concerning the payment of royalty to an Associated Enterprise (AE).
Factual Matrix of the Business Operations
The assessee operates as a wholesale distributor of premium branded cosmetics in India. The business model involves purchasing cosmetic products from its global group entities (Associated Enterprises) and subsequently supplying these products to domestic retailers. The portfolio of brands distributed by the assessee includes globally recognized names such as MAC, Clinique, and Bobbi Brown. The retailers, in turn, sell these products to the end consumers.
To facilitate this business, the assessee entered into two distinct agreements with its AE, Estee Lauder International Inc.:
- Trademark License Agreement: Effective from 1 April 2012, this agreement required the assessee to pay a royalty of 3% on net sales for the right to use and sub-license the trademarks of the respective brands.
- Marketing Knowhow License Agreement: Effective from 1 April 2010, this agreement mandated an additional royalty of 3% on net sales. This payment was for accessing marketing knowhow, which ensured that the retail spaces maintained the global brand image, store design, and standardized customer experience.
The assessee passed on the right to use these trademarks and marketing knowhow to the Indian retailers without charging any separate consideration. The core argument of the assessee was that the purchase of the cosmetic products and the payment of royalties were inextricably linked. A retailer could not successfully sell a premium product like MAC without the dedicated, globally standardized retail space and the brand name.
The Transfer Pricing Dispute: Aggregation vs. Segregation
The Assessee's Approach
In its transfer pricing documentation, the assessee adopted an aggregation approach. It bundled the transaction of purchasing products from the AE with the transaction of paying royalties, arguing that the two were inseparable components of its distribution business. To benchmark these aggregated transactions, the assessee selected the Resale Price Method (RPM) as the Most Appropriate Method (MAM).
The financial data revealed that the assessee earned a gross profit of Rs. 55,06,79,414, translating to a gross profit margin of 37.97%. In comparison, the average gross profit margin of the selected comparable companies stood at 32.28%. Since the assessee's margin was higher, it concluded that the royalty payments were at arm's length. Furthermore, the assessee highlighted that the transfer pricing officer of the AE (Estee Lauder International Inc.) had accepted the receipt of this royalty at arm's length in an order dated 25 March 2019, utilizing the RPM method.