Giving discounts on sale of products – purportedly with a view to lure customers and boost sales – has been an age-old phenomenon. Most of the companies operating under competitive market environments take recourse to this practice.
With the advent of e-commerce however, and players in this segment [especially those with deep pockets either of their own or supported by MNCs in case of domestic players] in a hurry to capture a good chunk of the retail market in shortest possible time frame, are offering substantial discounts which in some cases could be 50% of the maximum retail price [MRP] or even more.
Until hitherto, these were allowed to be deducted as business expenses leading to corresponding reduction in the tax liability of concerned companies. Of late, the income tax authorities have taken a view that these expenses are capital in nature and hence, these need to be capitalized. This means that these cannot be claimed as business expenses leading to increase in taxable profits.
The decision of Income Tax [I-T] department over the reclassification of discounting as capital expenditure was challenged before the Income Tax Appellate Tribunal [ITAT] which upheld the position taken by the department. This will have far reaching repercussions by way of huge tax liability running in thousands of crore [including for the past period] on both online and offline companies.
The issue has become a bone of contention between the industry and the department primarily because the IT Act [1961] does not specifically mention whether discounts can be allowed as business expense. This leaves scope for varying interpretations resulting in the matter reaching the judicial bodies. The subject matter will eventually be decided by the Supreme Court [SC].
Meanwhile, it is necessary to analyze the substance of the argument made by IT authorities in support of their stance vis-à-vis the position taken by the industry.
At the outset, it is important to look at the fundamental difference between revenue and capital expenditure. Whereas, the former is in the nature of payments made every year for goods/materials, services, utilities etc needed to make and deliver a product to consumers, latter is normally one time investment in plant/machinery/equipment [besides land and buildings] which enables the company carry on with production/supplies over a period of time.
Where does discount fit in? The companies normally tend to club it with advertisement and therefore an integral part of marketing expenses which in turn, passes muster as expenditure of revenue nature. But, moot question is whether it can be put at par with advertisement which is considered crucial for creating awareness about a product, its strength and quality etc. The answer is a categorical ‘no’.
The industry argues that discounts need to be given to build brand. It is difficult to comprehend this logic. A brand is built by demonstrating to the consumers the uniqueness of a product – in terms of its unique characteristics and distinct advantages over similar products already available in market – besides educational and promotional campaign undertaken to make them aware about these.
Relying solely on discount cannot by any stretch of imagination be termed as a measure aimed at building brand. It is an unethical practice – bordering on predatory pricing – whose sole intent is to garner access to the market by displacing others. Many players in the e-commerce segment in particular, have used foreign funds [brought in as equity] to give huge discounts. Then, to expect the taxman also to help them by reducing tax liability makes it even worse.
The companies argue that the strategy does not result in enduring benefit. This is anomalous. If, an entity were not to derive enduring gains, why would it spend so much money on discounts to a point of completely eroding gross margin and even incurring loss? Yet, if it remains in denial mode, this is done with the sole aim of saving on tax by treating it as revenue expenditure in the books.
A further argument that the discount does not result in creation of a physical asset and therefore, cannot be treated as capital expenditure is untenable. For an expense to be treated as one of capital type, it is not necessary that it should result in creation of physical/tangible asset. For instance, creation of intellectual property [IP] entails lot of investment in research and development besides testing/trials to demonstrate efficacy and safety of the product. We don’t see this asset in physical form yet, it is treated as capital expenditure.
The industry has also opined that IT department is not justified in determining as to how a particular expense needs to be categorized; that this is entirely a business decision and the prerogative of the company management. This is a fallacious argument. On an issue which has a bearing on the taxable income [in turn, revenue collection], the department has every right to apply relevant test as per Section 37(1) of I-T Act and arrive at a rational decision.
The e-commerce companies have pointed to the international practice of admitting discounts as deductible against business income in support of their contention. The decisions on tax policy – including on deductibility of expenses – can only be taken in the context of domestic laws; global practices can at best be used as feed/inputs but cannot form the basis for arriving at policy decisions.
The industry has also contended that the stance of I-T department will have a debilitating effect on the ‘start-ups’ which are a priority area for the present government with its overarching focus on innovation and employment. Is discount or burning cash even if it comes free [read: equity infusion by foreign investors] is the best way of giving them a boost? They need to introspect.
From the above, it is clear that allowing discounts [albeit steep] as deductible business expense is illogical and untenable. The ITAT has done right by upholding the stance taken by I-T department as letting this happen would have meant abetting this unethical practice. The industry will do well to shun it and instead, adopt more constructive ways for brand building and promoting sales.