Homegrown Ecommerce Unicorn Flipkart Recently Lost The Appeal Against IT Panel's $17 Mn Tax Demand
Homegrown ecommerce player Flipkart recently lost an appeal against the Income Tax (IT) department over the reclassification of marketing expenditure and discounts as capital expenditure (capex), which involves substantial tax liabilities.
Despite repeated appeals, the IT panel has refused to stay the $17.2 Mn (INR 110 Cr) tax penalty on Flipkart as part of the tax assessed for FY15-16. And gave it a deadline of February 28, 2018, to deposit $8.5 Mn as tax and $8.5 Mn as bank guarantee.
As per the latest ruling, the IT department wants ecommerce companies to reclassify discounts not as a cost but a capital expenditure, meaning that it should not be deducted from revenue and should, therefore, be taxable.
“These discounts along with huge marketing and advertising expenses are creating market intangibles for the company. This means these are not costs but capital for the company,” averred an IT official close to the development.
While both Flipkart and its toughest competitor Amazon have largely remained silent on the matter, angel investor and former CFO of Infosys, Mohandas Pai, recently voiced his concerns, stating, “Discount is an event which does not create enduring value or a capital asset. Hence, tax authorities are wrong in asking ecommerce giants (Flipkart and Amazon) and startups to reclassify discounts as capital expenditure. This is a tax and accounting issue.”
According to Pai, if discounts are withdrawn, the entire ecommerce business would disappear as people primarily shop online for the discounts on sales.
He added. “This is another case of misinterpretation by the tax authorities. The government should stop such harassment of businesses and such tendencies of misinterpretation by tax authorities.”
Sharing Pai’s views, Manoranjan Mohanty, FCA and Partner at Brahmananda & Co told Inc42, “As a matter of fact, startups as their name suggests need to promote their products and acquire more customers. This expenditure is recurring in nature and incurred every year.”
He further added that, if the ruling is passed, the tax burden will increase on the startups, which will, in turn, adversely affect the entrepreneurs. He went on to state that, without these expenditures, startups have no options but to shut shop, more particularly those companies that are operating in the ecommerce and FMCG sectors.
So, before we delve deeper into its potential impact on the Indian startups, let us look at the points raised by the tax department about disallowing deductions on ecommerce discounts and just how justified they are in the current tax structure.
What’s The Fuss All About?
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.
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:
- August 2017: Both Flipkart and Amazon approached the Commissioner of Income Tax (Appeals), Bengaluru, seeking clarification.
- December 2017: As part of the hearing on the Flipkart case, the CIT (Appeals) ruled in favour of the IT department, stating that Flipkart must reclassify its discounts and marketing expenses as capex.
- February 2018: Income Tax panel refused to stay the $17.2 Mn (INR 110 Cr) tax penalty on Flipkart as part of the tax assessed for FY15-16. According to IT officials, Flipkart generated a profit of $63.52 Mn (INR 408 Cr) for FY15-16, while the company originally reported a loss of $124 Mn (INR 796 Cr) for the said financial year.
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.
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 means it has to be spread over a period of four to ten years.
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. “However, a brand is something that you can’t go to the market and buy. You never know how much expenditure will go into building a brand,” Gahlot explained.
According to Ashok Shah, CA and Partner at NA Shah Associates, under the Income Tax Act, any expenditure that is revenue in nature is allowable as an expense. On the other hand, Section 37 of the Act says that only expenditure which is not allowed as cost falls under capital expenditure or personal expenses. In case of ecommerce companies, the problem arises when they spend money on discounts, advertising or sales promotion. This brings forth the question of whether these expenses are capital or revenue in nature.
“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,” Shah added.
Flipkart, Amazon and other ecommerce companies are incurring huge losses consciously with the view of offering good customer experience.
Earlier in February 2017, Inc42 reported that Amazon had suffered losses worth over $487 Mn in its international business for the quarter ending in December 2016, as it doubled down on its commitment towards the Indian market.
Interestingly, Amazon Worldwide Consumer CEO Jeff Wilke said last year in November 2017 that Amazon is not bothered by the huge losses the US-headquartered company is making in international markets, including India.
Flipkart, on the other hand, 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.
Because these expenditures are habit-forming, aimed at acquiring repeat customers, the Income Tax department wants to categorise them as capital expenditure.
Suppose, a company has spent $15.7 Mn (INR 100 Cr) in discounts and marketing and has classified this amount as an expense in their profit and loss accounts in the same year. This, in turn, results in huge losses, which is the case with Flipkart and Amazon.
Shedding more light on the concept of capital expenditure, Abhishek Gupta, CA and Starters CFO founder stated, “Capitalisation means that this $15.7 Mn (INR 100 Cr) will stand in the balance sheet as cost and every year, these companies will be allowed some part of deduction. So in this case, their losses will be lowered or they may even turn up profits which are taxable.”
So, Are Flipkart And Amazon Actually Profitable?
If the IT department’s ruling goes through, ecommerce firms that incur substantial marketing costs could be deemed as being profitable and therefore liable to pay 30% tax. Could it mean that companies like Flipkart and Amazon are actually profitable and are only reporting losses to avail tax deductions?
Calling the Income Tax department’s argument completely unfounded, Ashok said, “The company’s records are readily available for the tax department to scrutinise. If these companies are making any profit on a transaction, and at the same time incurring losses because of these discounts and additional spending, the entity is the same. Unless and until, the income tax officials can prove that the accounts are wrong, they are not entitled to make adjustments.”
Does it imply that Indian ecommerce companies will continue on the deep discounting path and consequently, incur larger losses? Abhishek believes that the problem has more to do with the fact that the Indian startup ecosystem is still relatively young compared to China and the US.
He added, “I believe that once the ecosystem matures, this strategy of deep discounting will stop. Once there is a change in the consumer habits and more and more customers shop online, that will give them economies of scale. These companies also have a variety of other revenue streams.”
Is The Income Tax Department Justified?
On the matter of whether the latest ruling is justified, Gahlot said, “I think the ruling is absolutely absurd. If that were a good law, every single company that gives discounts or indulges in marketing will be affected by it.”
He further referred to Section 37 and said that any expenditure will be allowed as a deduction as long as it is wholly for the business. “In the past, there has been a number of disputes, where the tax department has argued that these kinds of expenditures have benefitted third parties,” he said.
So, the tax department went to the court with the argument that the entire amount should not be deductible. However, the court vehemently turned it down, Amar added. The court stated that such benefits which so arise are incidental.
He explained, “In this case, the expenditure on marketing and discounts by ecommerce companies is essential to the day-to-day running of the business. Incidentally, along the way, if the brand acquires some value, that should not be the reason to disallow it from tax deductions.”
Speaking on similar lines, Ashok Shah of NA Shah Associates averred that the department will not be able to uphold their stand at the appellate proceeding stage. He said, “When you are talking about expenses of an enduring nature, you must be able to assess how many years your business will be getting the benefit. It has to be for the long term. In my opinion, as the law stands today, the ruling will be negated in the appellate proceedings.”
Will Offline Retailers Offering Discounts Get Affected?
According to Abhishek, there are some basic differences in the business model between ecommerce firms and offline retailers like Big Bazaar, HyperCity, Spencer’s Retail and Reliance Trends. On the one hand, online marketplaces like Flipkart, Amazon and Snapdeal have raised millions of dollars in funding from both domestic and foreign investors. So, essentially, they are giving discounts from their own pockets.
In terms of unit metrics, per transaction, these companies are incurring losses. On the other hand, offline stores like Big Bazaar make use of economies of scale. They buy huge quantities of an item at very less price and therefore, manage to offer discounts without incurring losses. In fact, these companies make profits per transaction.
This, in turn, makes them less of a suspect in the eyes of income tax officials than ecommerce startups, which inherently run on investor capital and incur monumental losses.
Interestingly, the tug of war between offline retailers and ecommerce companies is an ongoing tale. In the past, offline retail companies pitched to the Competition Commission of India (CCI) for a level playing field, terming discounts offered by ecommerce platforms as “unfair practices”.
Back in 2014, a number of ecommerce companies in the country – including Flipkart, Amazon, Jasper Infotech (Snapdeal) Xerion Retail and Victor Ecommerce, among others – came under the scanner of the CCI for allegedly offering massive discounts and predatory pricing to acquire new customers.
Later on, in May 2015, the fair trade regulator rejected all these allegations of unfair business practices on the part of ecommerce firms. After analysing the companies’ revenue model, the organisation ruled that these entities had not violated any sort of competition norms by indulging in cartelisation or by abusing their dominant position.
How The IT Dept’s Ruling Could Impact The Startup Ecosystem
“One thing that is going to happen is, because of the huge losses, it is doubtful whether there would be a tax liability. Irrespective of whether these kinds of expenses are classified as revenue or capital expenditure, I do not believe it will be translated to a tax demand,” stated Ashok Shah.
What it will do is create a litigation between the tax department and the ecommerce companies which, according to him, are fruitless litigations as they would not result in a revenue gain.
For instance, suppose your company has raked $157 Mn (INR 1,000 Cr) in losses, of which the Income Tax department disallows $125.7 Mn (INR 800 Cr) from deductions. According to Shah, if these expenses are to be considered as capital expenditure, the IT department has to allow depreciation on the ground that it is intangible.
More importantly, Shah added, the tax department cannot dictate how an entrepreneur runs his/her business. Once discounts and marketing expenses are classified as revenue expenditure, the IT department has no authority to categorise these costs as capital expenditure and thereby, levy tax on them.
As to what consequences the latest development could have on ecommerce startups, Amar Gahlot believes that there’s an upside and a downside.
He stated, “The upside is that till now, this is an absolutely bogus claim by the tax department. I am sure that this will not be repeated in other jurisdictions like Mumbai. Also, currently, there is no instruction or circular.”
“But the downside of this whole thing is that given that it has already happened in Bengaluru, the tax department has something called consistency,” Gahlot added.
So considering the case of the same taxpayer (Flipkart), if one tax officer has done this, repeatedly for the subsequent years, the department will keep doing the same. In fact, they might be doing the same thing in case of other ecommerce startups as well.
Added Tax Burden On Already Struggling Startups
The IT department’s move to ask ecommerce giant Flipkart to reclassify discounts as marketing expenditure is yet another case of how the department seems to be dictating the way startups and entrepreneurs should conduct their business.
On the one side, the Indian government is talking about its efforts to reduce tax liabilities for the startups and on the other, the tax authorities are bringing new laws to impose the tax burden on these companies.
It was also seen recently that startups are getting harassed by income tax officials for raising capital, threatening to consider it as income. The heavy taxation currently being levied on capital gains of angel investors has, in turn, resulted in a 53% drop in angel funding during the first half of 2017, according to a report by NASSCOM.
Furthermore, the number of new startups incorporated in 2017 dropped by almost 80% as compared to 2016. Recently, this led to a number of Indian startups and members of the startup community coming forward to start an online petition, seeking a revision of the angel tax structure.
Speaking on the matter of revenue expenditure vs capital expenditure, Abhishek Gupta of Starters’ CFO told Inc42, “This will be an additional tax burden for all ecommerce companies. Firstly, they are incurring losses. Secondly, the Income Tax department is trying to levy tax on profits which these companies have not earned to begin with. The department is also after startups to tax the investments they raise through angel funding.”
Gupta went to say, “So, there is clearly a disparity in the government’s treatment of startups. On the one hand, they are promoting ease of doing business and Startup India initiatives, on the other, they are increasing the tax burden of already asset-light startups.”
As per the 2017 edition of the NASSCOM-Zinnov report, the Indian startup ecosystem is currently the third largest ecosystem in the world, home to around 5,000 to 5,200 tech startups. As per Inc42 Datalabs, since 2014, Indian tech startups have raised over $32.2 Bn across 3,048 deals. In 2017 alone, startups in the country secured more than $13.5 Bn funding in approximately 885 deals.
As stated by PM Narendra Modi during last year’s Independence Day speech, startups contribute greatly to the country’s economic growth through job creation. While, on the one hand, the government has been proactively working to facilitate the emergence of startups through initiatives like Startup India, on the other, it has been making survival more difficult for fledgling startups by exponentially increasing their tax burden.
To successfully usher in the next phase of evolution of the Indian startup ecosystem, the Income Tax department should, therefore, re-evaluate the above-mentioned issues of angel tax and discounts as capital expenditure.
Urging the government to take a concrete stand on the matter, Abhishek Gupta said, “At present, there are no defined laws which say that discounts and marketing expenses are capital expenditure. So, the government should offer clarity on this issue. Doing so will help in enhancing ease of doing business.”