Discounting e-commerce: Taxing online discounts is illogical

The income-tax tribunal’s decision to deny domestic e-commerce player Flipkart’s appeal against the tax authorities reclassifying marketing expenditure on discounts as capital expenditure betrays a misunderstanding of the basics of business. At the centre of the dispute is the treatment of discounts. Globally, companies treat discounts as revenue expenditure, which are deducted from sales revenue before computing taxable profits. The rationale is that discounts constitute marketing expenditure, incurred to build market share or a brand. For Flipkart, the income-tax department has argued that the discounts are creating huge intangible assets for the company, and, as such, are not costs but capital for the company.

 
It says Flipkart’s discounts are often greater than the gross margin of the underlying product. It is possible to extend the argument somewhat by suggesting that e-commerce players raise huge amounts of capital from venture capitalists and private equity investors and they are essentially poured into discount wars. One leg of the argument is that companies like Flipkart and Amazon are incurring losses on the profit and loss account owing to their discounting policies. So if part of these discounts were taken as a balance sheet cost, the losses may be lower or the company may even show a profit, which would then make it liable for income tax. But tax experts say this argument can hold only if the company’s accounts reveal irregularities.

 
The income-tax department’s observations ignore the point that a discount is a discretionary decision that companies take in response to market challenges. For fledgling start-ups that operate on wafer-thin margins in a crowded competitive paradigm, discounts are a critical tool in gaining market share and improving valuation. It is unusual for the tax authorities to decide whether these expenses are reasonable for building a business, and so far, the judicial precedent does not support its claims. Part of the problem is a grey area in Section 37 (1) of the Income Tax Act, which says any expenditure deducted against business income has to be incurred exclusively for the purpose of the business of the taxpayer. This gives discretion to the income-tax authorities to decide the nature of the expenditure, and the Section urgently demands clarification. Even earlier, Supreme Court rulings have held that even if the benefit is of enduring nature, it can be classified as revenue expenditure.

 
The stand of the income-tax authorities bodes ill for India’s fragile start-up universe. Indeed, in upholding the income-tax department’s ruling and directing Flipkart to pay Rs 1.10 billion, the tax regime may have done considerable damage to and, ironically, weakened Start-Up India, one of Prime Minister Narendra Modi’s signature schemes to create employment. The ruling also raises the question of similar discounts offered by offline retailers or even the kind of free packages that telecom players offer to build or defend market share. As with the anti-profiteering clause under the goods and services tax and the Budget announcement that the stock market regulator decides rules for large companies to raise money from the bond market, this ruling will add one more layer of uncertainty to the business climate in India. In the long run, high jumps in the World Bank’s Doing Business rankings will not be able to leaven such extreme levels of government interventions in how companies run their business.