Why did the court allow ESPN to club its two distinct revenue streams for Arms Length Pricing Calculation purposes?

Case Name:

Commissioner of Income Tax (LTU) vs. M/S ESPN Software India Ltd.(High Court of Delhi)

Key Takeaways:

1. The ITAT upheld the Appellate Commissioner’s findings that the transactions in question ought to be analyzed in conjunction, i.e., after aggregation for arm’s length purposes.

2. The rejection of the RBI guidelines and the TPO’s omission given due weight to the downlinking guidelines were relevant factors considered by the lower authorities.

3. The appeals were dismissed, and the decision of the ITAT was upheld.

Case Synopsis:

The case “COMMISSIONER OF INCOME TAX (LTU) v. M/S ESPN SOFTWARE INDIA LTD.” was heard in the High Court of Delhi at New Delhi, and the decision was made on November 7, 2017.

The case involved the clubbing of two distinct revenue streams, namely the sale of airtime with distribution business, advertisements, and sale business.

The Revenue contended that the ITAT (Income Tax Appellate Tribunal) erred in clubbing these two revenue streams for Arm’s Length Price (ALP) determination, as they were of the opinion that both sets of businesses were separate and distinct and could not have been clubbed. However, the CIT (A) (Commissioner of Income Tax - Appeals) and the ITAT upheld the assessee’s decision to aggregate the sets of transactions for the purpose of ALP determination and worked out an operating profit margin of 7.82% .

The CIT (A) was of the opinion that both segments were appropriately clubbed for the purposes of benchmarking international transactions and cited two reasons.

• Firstly, that they were closely related and that the popularity of a channel had a bearing on the subscription as well as the sale of airtime for advertisement. It was felt that both businesses mutually reinforced each other.
• The second element which persuaded the CIT (A) to accept the assessee’s contention was that both segments employed the same set of assets and that separately benchmarking them would take it away from reality.

Furthermore, the ITAT felt that it was not possible to merge comparables for profits having regard to these practical considerations, the CIT upheld the assessee’s decision to aggregation of the sets of transactions for the purpose of ALP determination and worked out an operating profit margin of 7.82% .

In appeal, the Revenue emphasized that in earlier years,

= the advertisement sales segment had reflected a profit but that in the year under consideration the assessee had recorded losses. This was used as evidence to say that clubbing of the two transactions or rather their aggregation, distorted the picture.

- The other argument made was that the assessee overstated the purchase price of advertisement inventory which had been clearly added by the AO as the assessee had adjusted the losses incurred against profit distribution.

Thus apparently, deliberately merging two audited separate business segment, i.e., distribution business segment and sale of airtime advertisement sale segment.

The ITAT rejected the Revenue’s submissions.

The findings of the ITAT pertinently are as follows:

- In the present case, it is noticed that activities of distribution of channels and advertisement air time inventory allotment are inter-related because higher the subscriber base of channel, the greater are chances of the aired advertisement being viewed by a large target audience because the advertisers want the widest possible coverage to their messages and both the activities i.e. subscription and advertisement air time drive towards the same end of promotion of channels.

- As regards to the objection of the TPO/AO that there was a loss in the advertisement air time inventory business in the year under consideration while in the earlier year there was profit, the ld. Counsel for the assessee explained that in the earlier years the assessee was acting only as a commission agent for its AE and solicited advertisements in the Indian market for its AE for that purpose the assessee was getting a fixed percentage of commission while for the year under consideration and in the succeeding years, the assessee shifted to the distribution model in pursuant to the change in the foreign exchange regulations of the RBI vide Circular No. 76 which relaxed the condition of export earnings by advertisers in Foreign Television Channels and the assessee, without prior approval from RBI, could have brought air time on a bulk basis and allot the same directly to third parties i.e. advertisement agencies etc.

It is also noticed that Ministry of Information and Broadcasting formulated several guidelines vide Downlinking Guidelines Number 13/2/2002-BP&L/BC-IV dated 11.11.2005. The said guidelines were as under:

1.3 The applicant company must either own the channel it wants downlinked for public viewing, or must enjoy, for the territory of India, exclusive marketing/distribution rights for the same, inclusive of the rights to the advertising and subscription revenues for the channel and must submit adequate proof at the time of application.

1.4 In case the applicant company has exclusive marketing / distribution rights, it should also have the authority to conclude contracts on behalf of the channel for advertisements, subscription and programme content.

In view of the aforesaid guidelines, if the assessee decided to relinquish advertisement air time inventory rights on account of losses, it would also have to relinquish the subscription rights to the channel which have resulted in profits. Therefore, the assessee was required to aggregate both the activities i.e. channel subscription and air time sale segment.

Accordingly, the assessee aggregated both the activities for the purpose of arm’s length analysis.

It is also noticed that the advertisement air time revenue earned by the assessee has a direct correlation with the number of cricket events which is evident from the chart furnished by the assessee, reproduced in the former part of this order. On perusal of the said chart, it would be clear that when the cricket events were more in the FYs 2007-08 and 2009-10. The OP/sales ratio jumped to 9.18% and 6.85% respectively from the negative ratio of 0.78% in the FY 2004-05 when the cricket events were less. In the present case, by changing the business model, the assessee was getting more control over the distribution of function and it was a part of the business strategy of the assessee.

It is also noticed that OECD guidelines clearly states that closely linked transaction should have been aggregated and evaluated together in this regard.

It is relevant to refer OECD guidelines which read as under:

‘Ideally, in order to arrive at the most precise approximation of arm’s length conditions, the arm’s length principle should be applied on a transaction-by-transaction basis. However, there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis.’

On the basis of the above observations and after taking due note of the OECD Transfer Pricing Guidelines – as well as the US Transfer Pricing Regulations, the ITAT upheld the Appellate Commissioner’s findings that the transactions in question ought to be analyzed in conjunction i.e. after aggregation for arm’s length purposes.

The ITAT also found that the assessee had structured itself in a manner that its profit was maximized as a whole rather than independently as regards these two activities”.

The Court, after considering the submissions of the Revenue, upheld the ITAT’s decision, stating that the reasons which impelled the lower authorities to uphold the assessee’s plea with regard to aggregation for ALP purposes were reasonable and cannot be interfered with.

The Court also noted that whether to segregate or not segregate two transactions is entirely a fact-dependent exercise that cannot per se be treated as a question of law.

The appeals were dismissed.

In conclusion, the High Court of Delhi at New Delhi dismissed the appeals and upheld the decision of the ITAT to aggregate the two revenue streams for the purpose of Arm’s Length Price (ALP) determination, as it was found to be reasonable and fact-dependent

FAQ

Q1: What was the main issue in the case?

A1: The main issue in the case was the clubbing of two distinct revenue streams, i.e., the sale of airtime with distribution business, advertisements, and sale business, for Arm’s Length Price (ALP) determination.

Q2: What was the decision of the High Court?

A2: The High Court dismissed the appeals, upholding the decision of the ITAT to analyze the transactions in conjunction, i.e., after aggregation for arm’s length purposes.

Q3: What were the reasons for upholding the aggregation of transactions?

A3: The lower authorities considered the rejection of the RBI guidelines and the TPO’s omission given due weight to the downlinking guidelines as relevant factors to uphold the aggregation for arm’s length purposes.

1. The question of law urged by the Revenue is that the ITAT fell into error in clubbing of two distinct revenue streams i.e. sale of air time with distribution business, advertisements, sale business, etc. The TPO was of the opinion that both sets of businesses were separate and distinct and could not have been clubbed. The assessee had urged that the clubbing of these transactions for Arm’s Length Price (ALP) determination had been permitted in the past. It relied upon common features to contend that whereas in sale of airtime, it was bulk sale of the product/service to the concerned customer, i.e. the air time user, distribution too involves sale through a network. The TPO’s rejection of the aggregation, for ALP determination was appealed against.

2. The CIT (A) was of the opinion that both segments were appropriately clubbed for the purposes of benchmarking international transactions and cited two reasons. Firstly, that were closely related and that popularity of a channel had bearing on the subscription as well as sale of airtime for advertisement. It was felt that both businesses mutually reinforced each other. If the channel fails to air popular sporting activities, the advertisement sale would correspondingly be impacted adversely. The second element which persuaded the CIT (A) to accept the assessee’s contention was that both segments employed the same set of assets and that separately benchmarking them would take it away from reality. Furthermore, the ITAT felt that it was not possible to merge comparables for profits having regard to these practical considerations, the CIT upheld the assessee’s decision to aggregation of the sets of transactions for the purpose of ALP determination and worked out an operating profit margin of 7.82%.

3. In appeal, the Revenue emphasized that in earlier years the advertisement sales segment had reflected a profit but that in the year under consideration the assessee had recorded losses. This was used as evidence to say that clubbing of the two transactions or rather their aggregation, distorted the picture. The other argument made was that the assessee overstated the purchase price of advertisement inventory which had been clearly added by the AO as the assessee had adjusted the losses incurred against profit distribution. Thus apparently, deliberately merging two audited separate business segment, i.e., distribution business segment and sale of air time advertisement sale segment. The ITAT rejected the Revenue’s submissions. The findings of the ITAT pertinently are as follows:

“20. In the present case, it is noticed that activities of distribution of channels and advertisement air time inventory allotment are inter-related because higher the subscriber base of channel, the greater are chances of the aired advertisement being viewed by a large target audience because the advertisers want the widest possible coverage to their messages and both the activities i.e. subscription and advertisement air time drive towards the same end of promotion of channels. As regards to the objection of the TPO/AO that there was a loss in the advertisement air time inventory business in the year under consideration while in the earlier year there was profit, the ld. Counsel for the assessee explained that in the earlier years the assessee was acting only as a commission agent for its AE and solicited advertisements in the Indian market for its AE for that purpose the assessee was getting a fixed percentage of commission while for the year under consideration and in the succeeding years, the assessee shifted to the distribution model in pursuant to the change in the foreign exchange regulations of the RBI vide Circular No. 76 which relaxed the condition of export earnings by advertisers in Foreign Television Channels and the assessee, without prior approval from RBI, could have brought air time on a bulk basis and allot the same directly to third parties i.e. advertisement agencies etc. It is also noticed that Ministry of Information and Broadcasting formulated several guidelines vide Downlinking Guidelines Number 13/2/2002-BP&L/BC-IV dated 11.11.2005. The said guidelines were as under:

“1.3 The applicant company must either own the channel it wants downlinked for public viewing, or must enjoy, for the territory of India, exclusive marketing/distribution rights for the same, inclusive of the rights to the advertising and subscription revenues for the channel and must submit adequate proof at the time of application.

1.4 In case the applicant company has exclusive marketing / distribution rights, it should also have the authority to conclude contracts on behalf of the channel for advertisements, subscription and programme content.”

21. In view of the aforesaid guidelines, if the assessee decided to relinquish advertisement air time inventory rights on account of losses, it would also have to relinquish the subscription rights to the channel which have resulted in profits. Therefore, the assessee was required to aggregate both the activities i.e. channel subscription and air time sale segment. Accordingly, the assessee aggregated both the activities for the purpose of arm’s length analysis. It is also noticed that the advertisement air time revenue earned by the assessee has a direct correlation with the number of cricket events which is evident from the chart furnished by the assessee, reproduced in the former part of this order. On perusal of the said chart, it would be clear that when the cricket events were more in the FYs 2007-08 and 2009-10. The OP/sales ratio jumped to 9.18% and 6.85% respectively from the negative ratio of 0.78% in the FY 2004-05 when the cricket events were less. In the present case, by changing the business model, the assessee was getting more control over the distribution of function and it was a part of the business strategy of the assessee. It is also noticed that OECD guidelines clearly states that closely linked transaction should have been aggregated and evaluated together in this regard. It is relevant to refer OECD guidelines which read as under:

“Ideally, in order to arrive at the most precise approximation of arm’s length conditions, the arm’s length principle should be applied on a transaction-by-transaction basis. However, there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis.”

4. On the basis of the above observations and after taking due note of the OECD Transfer Pricing Guidelines – as well as the US Transfer Pricing Regulations, the ITAT upheld the Appellate Commissioner’s findings that the transactions in question ought to be analyzed in conjunction i.e. after aggregation for arm’s length purposes.

The ITAT also found that the assessee had structured itself in a manner that its profit was maximized as a whole rather than independently as regards these two activities.

5. This Court has considered the submissions of the Revenue – which largely reiterated what was urged before the Tribunal.

6. The Court is of the opinion that the ITAT’s decision cannot be faulted. The rejection of the RBI guidelines and the TPO’s omission given due weight to the down linking guidelines were a relevant factor, which in our opinion, the CIT(A) and the ITAT correctly noted to reverse the original findings. It is a settled proposition that whether to segregate or not segregate two transactions, is entirely a fact dependent exercise that cannot per se be treated as a question of law.

In the present case, the reasons which impelled the lower authorities i.e. the CIT (A) and the ITAT to uphold the assessee’s plea with regard to aggregation for ALP purposes, are reasonable and cannot be interfered with.

The appeals are therefore dismissed.

S. RAVINDRA BHAT, J

SANJEEV SACHDEVA, J

NOVEMBER 07, 2017