Income Tax rule on treating discounts as capital expense will hit small e-tailers the most

E-tail giant Flipkart has lost an appeal against the Income Tax (IT) department for reclassifying marketing expenses and discounts as capital expenditure. According to news reports, IT department contends that e-commerce companies should restructure their marketing expenses and discounts as capital expenditure and not as revenue expenditure.

The IT department is of the view that the money spent on discounting and marketing is a cost incurred to increase the company's brand value. This is different from a brick and mortar retailer giving discounts because companies like Flipkart and Amazon spend big bucks and offer discounts not just to increase sales but change customer behavior, that is, get customers to start shopping online rather than go to retail stores. This increases their goodwill, number of customers and also the revenue per customer, which further improves the intangible assets of these companies, such as valuation and brand recall whose benefits will spill over to the next few years.

Currently companies treat it as revenue expenditure, part of their day to day operations, which gets treated as an expense in the P&L account and reduces the net income of the company. The result is increase in losses on sale and thus, their non-liability to pay taxes.

Historically, in various cases, marketing and advertising expenditure has been considered as revenue expense. The judgment in the three cases - Spice Retail Ltd, Fine Jewellery (India) Ltd and Mahindra & Mahindra Ltd - held that expenditure from marketing, discounts and from the peripherals of a sale (a box or a handbag with company's branding) was revenue expenditure and not incurred to increase the company's value, says Pranav Jain, Partner at Mumbai-based law firm MDP & Partners.

Jain adds that, if passed, this ruling will cover all sectors whether it is FMCG or retail and the likes but it will not impact every company that gives discounts. It will affect those that use discounting as a strategy to increase their valuation. "Big companies like Flipkart and Amazon may still escape this because of their complex organizational structure with multiple subsidiaries but the smaller ones with simple company framework will face most of the brunt," says Jain.

It is one of the cases where there is a very thin line on categorization of the two terms. The Income Tax Act was formed in 1962 and has to catch up with the new business models, until then organizations will take advantage of any loophole in the Income Tax laws to decrease their taxable income, says Vishal Gandhi, founder of law firm Gandhi & Associates.