Netflix India Transfer Pricing Ruling Boosts Investor Confidence

The Indian Income Tax Appellate Tribunal recently quashed a four-billion Indian rupee ($44.9 million) transfer pricing adjustment against Netflix Entertainment Services India LLP. The tribunal held that Netflix India’s role was limited to that of a distributor of the Netflix platform/subscription and it was not acting as a content entrepreneur.

Netflix India was only entitled to a fixed return, which resellers of similar services are entitled to, instead of a higher entrepreneurial return.

The tribunal focused on the contribution made to intangibles, as well as the activities carried out by Netflix India, to arrive at this conclusion.

This judgment is expected to boost investor confidence in the Indian market. It will play a critical role in shaping transfer pricing litigation, but its application may vary depending on the facts of each case.

The main factor to consider is how much the Indian entity contributes to developing and exploiting intangibles like technology and brand. The more significant its role in these areas, the higher the return it can be expected to earn.

The ruling also provides much-needed clarity that merely hosting infrastructure, such as caching servers, or having a user base in India, doesn’t by itself constitute economic ownership of intellectual property or justify attribution of significant profits to the local entity.

Decoding the Ruling

Netflix Inc., a US-based company, has invested extensively in its content, technology, infrastructure, and intellectual property. Netflix India was appointed as a non-exclusive distributor of the Netflix platform, with no transfer of ownership or intellectual property.

Under this arrangement, Netflix India undertook functions such as soliciting and promoting subscriptions, entering terms of use directly with Indian subscribers, invoicing and collecting fees, arranging customer support, liaising with internet service providers, and handling local compliance and permits. Netflix India was also responsible for procuring and transferring open connect appliances, or OCAs—specialized cache devices used to reduce network congestion for internet service providers.

For providing these services, Netflix India earned a fixed markup on sales, which was appropriately benchmarked using the transactional net margin method, or TNMM.

The Indian tax authorities argued that Netflix India’s role was much more than distributing access to the Netflix service. In their view, Netflix India was licensing content and technology and qualified as a content entrepreneur, thereby entitling it to a higher return. The tax authorities contended that the content stored on the OCAs formed the backbone of the Netflix platform, exposing Netflix India to investment risk.

Based on a review of the agreement and factual analysis, the tribunal concluded that Netflix India performed routine distribution and marketing support functions under the supervision of its associated enterprise. Netflix US, on the other hand, was responsible for undertaking key development, enhancement, maintenance, protection, and exploitation, or DEMPE, functions of the platform. These included developing and maintaining the platform, protecting IP, such as trademark registration and copyright enforcement, and exploiting the platform through global licensing arrangements.

The tribunal noted that OCAs employed by Netflix India serve as mirror caches, similar to logistical warehouses, merely enhancing delivery efficiency rather than creating value. Based on this reasoning, the tribunal held that Netflix India was the least complex entity, acting as a distributor of the Netflix service, and was therefore entitled to a limited return by applying the TNMM.

Analyzing the Issues

Under transfer pricing principles, economic ownership of IP, rather than legal ownership, is considered the relevant factor in assessing which entities should be entitled to returns on it.

Economic ownership depends on which entity performs DEMPE functions for the intangible. Entities within a multinational group that make decisions on budgeting, strategizing, financing, and risk-bearing opportunities can be said to perform DEMPE functions.

Additionally, if risk relating to IP materializes, the entity that takes decisions to mitigate or control the risk can also be considered to perform DEMPE functions.

In this case, the tribunal undertook a DEMPE analysis to assess ownership of the Netflix platform. It concluded that ownership and residual returns should rest with Netflix US as it undertook key functions for developing, maintaining, and protecting the platform.

The tribunal didn’t extensively deliberate on the contribution to marketing intangibles in India.

In cases where an Indian entity incurs advertising expenses to develop the Indian market, the tax authorities may argue that the entity deserves a higher return from the group. This argument is based on the premise that incurring such expenses qualifies as a contribution to the development of the group’s marketing intangibles.

In such situations, it is important for the Indian limited-risk distributor to demonstrate that its advertising activities are routine in nature: Any third-party distributor typically incurs similar expenses to boost sales. These sales promotion efforts must be distinguished from cases involving long-term brand-building expenditures.
Documentation supporting the nature of these expenses will play a critical role.

Another important aspect is that Netflix US was paying the equalization levy in India. The object of the equalization levy was to recover taxes from nonresident businesses operating digitally and catering to the Indian market without constituting a permanent establishment in India.

India, as the market jurisdiction, thus recovered its fair share of taxes through the equalization levy. It would have been a double whammy if Netflix India was also made to pay additional tax for marketing functions by invoking transfer pricing provisions.

The tribunal ruling is significant for the media entertainment industry, SaaS providers, and e-commerce businesses operating under a limited-risk reseller or support service model in India. The fear of a limited distributor being characterized as an entrepreneurial reseller or service provider should be alleviated to some extent by the judgment.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

S. Vasudevan is executive partner, and leads the firm’s direct tax and economic offenses/white collar crime practices in New Delhi, bringing over 20 years of experience across diverse tax and non-tax verticals.

Harshit Khurana is associate partner in direct tax, a chartered accountant and lawyer advising on international tax, transfer pricing, and domestic tax, and representing clients before appellate forums.

Khushi Manchanda is an associate in the firm’s direct tax practice, focusing on matters related to international taxation and transfer pricing, and contributing to research and analysis on complex cross-border tax issues.

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