Reclassifying Discounts As Capex: Flipkart Challenges Income Tax Dept

In response to the Income Tax panel's refusal to stay the $17.2 Mn (INR 110 Cr) tax penalty on Flipkart for FY15-16, the homegrown ecommerce major has once again challenged the IT department's decision over the reclassification of marketing expenditure and discounts as capital expenditure (capex).

In its argument, Flipkart has reportedly informed the Income Tax Appellate Tribunal (ITAT) that tax cannot be levied on “fictional income”.

“Nothing in the IT Act mandates that a product has to be sold at a particular price, and revenue not earned (by virtue of giving discounts) cannot be treated as capital expenditure,” said Percy Pardiwala, a senior advocate representing Flipkart during the hearing.

Capital expenditure versus revenue expense has been a bone of contention between ecommerce companies and the Income Tax department for quite some time now. The issue primarily revolves around the money spent by these firms on marketing through deep discounts.

Flipkart, Amazon India, and other ecommerce companies have been classifying these discounts as marketing expenses and deducting the amount from their revenue, thus leading them to post losses. This is, in turn, enabling them to avail tax deductions on the aforementioned expenditure.

Flipkart reported losses of over $1.3 Bn (INR 8,771 Cr) in FY17, which translated to an increase of 68% from the $814 Mn loss it registered in the fiscal before that. As indicated in the financial reports of Flipkart, a five-fold increase in finance costs to $671 Mn (INR 4,308 Cr) contributed to the losses in FY17.

Despite raising massive funding of more than $4 Bn in 2017 alone from investment behemoths like SoftBank, Tencent, and Microsoft, among others, Flipkart's cash burn rate has continued to surge as a result of deep discounting. Same is the case with Amazon.

However, as per the IT officials, these discounts and marketing costs are part of a brand building exercise. The department believes that discounts and large marketing costs of ecommerce firms should be classified as capital expenditure, which is taxable.

During the hearing, Revenue Counsel C.H. Sundar Rao said that Flipkart's actions are driven by the motive to gain a stronghold by creating marketing-related intangible assets in terms of customer base, trademarks and brands. This, in turn, has resulted in the company's high valuation.

Calling it “predatory pricing”, Rao added, “Flipkart received an enduring benefit by incurring losses because of aggressive discounts (cash discounts to the extent of 3% of the turnover).”

In response, however, Pardiwala stated that the ecommerce company's aim was to earn profits in the long-run, for which discounts are an essential part of its marketing strategy.

As part of the hearing, the revenue counsel also raised the issue of transfer pricing. It basically refers to the price at which different divisions of a company transact with each other, such as the trade of supplies or labour between departments.

According to Rao, the discounts offered by Flipkart India actually benefited another entity, Flipkart Internet. Interestingly, both Flipkart's brand and Internet platform were transferred to this entity from Flipkart India.

Flipkart Vs The Income Tax Dept: What The Fiasco Is All About

At present, ecommerce companies in the country classify marketing costs and discounts as revenue expenditure, which essentially refers to the expenses that produce benefits across one single time period such as the costs to acquire products intended for sale and to run the operations to sell those same products.

Capital expenditures, on the other hand, are expenditures that produce benefits over the course of a period, leading to the creation of long-term assets. The problem arises from that fact that revenue expenditure is eligible for tax deductions, while capital expenditure is not.

While the matter has been ongoing for quite some time now, it came into the limelight only recently. Here's a brief overview of the past developments on the matter:

Breaking down the points raised by the tax department on this issue, Amar Gahlot, Consultant – Tax, Economic Offences at Lakshmikumaran and Sridharan Attorneys told Inc42, “The ruling simply says that ecommerce companies that are spending a huge sum per year on marketing in order to build a brand, will not be allowed to deduct this amount from their income. The rationale behind this is that capital expenditure is something that gives rise to a capital asset, which essentially is something that will give you benefits over the years.”

This is a kind of capital asset that should not be allowed to be deducted, according to the department.

According to Ashok Shah, CA and Partner at NA Shah Associates, “If you incur an expenditure which gives you benefits of enduring nature, there could be a case for disallowance of an expenditure. But when it comes to brand building, there is no expenditure of an enduring nature because it does not go towards the creation of a capital asset. It is a day-to-day expenditure incurred by the companies.”

With Flipkart now challenging the Income Tax panel's move, whether the department will alter its decision over the reclassification of marketing expenditure and discounts as capital expenditure and how it would affect the startup ecosystem in India remains to be seen.

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