India, your e-commerce discounts are safe

Ten years ago, my mother severed her years-long allegiance with her local shopkeepers and started buying products online. It felt like a historical moment. All her friends and their friends gradually followed suit too.

The material force driving this transformation in India's consumer landscape - that kicked off with Flipkart in 2007 deciding to sell books - was discounts.

Since then, this trail mix of coupons, deals and sales has generated its own feeding frenzy and has become a crucial component on every online retailer's entry strategy in India.

Apart from being the major driver of sales, discounts have made annual bumper selloffs a staple Indian tradition. Flipkart’s Big Billion Days and Amazon’s Great Indian Festival are important for customers, big businesses and small businesses. Millions of products are sold. After Flipkart’s festive sales last year, the gross merchandise value for the industry reached Rs. 9000 crore - approximately $1.3 billion.

While a BCG report released last year proclaimed that the price-conscious Indian consumer now prefers convenience over discounts when buying products online, e-commerce firms are still competing in a proverbial race to the bottom. Everyone wants to offer the lowest prices.

And what's more, the government has now legitimised this discounting model.

The Income Tax Appellate Tribunal, on April 25th, allowed Flipkart to continue recording discounts on its products as marketing and advertising expenses, thereby allowing the e-commerce firm to claim tax deductions on them. Flipkart was appealing a ruling from the Income Tax Department, which said it owed ₹1.1 billion in unpaid taxes for the year ended March 2016.

The move will allow India’s e-commerce firms to a sigh of relief while encouraging their loss-leading impulses. On the other hand, it will also ensure that price-conscious consumers keep getting the benefits of heavy discounts on online shopping.

The economics of discounts

However, there is more to discount policies than meets the eye.

The IT Dept, last year, had sought to make e-commerce firms classify these as a “capital expenditure”, which is taxed over a period of 4 to 10 years, as opposed to “revenue expenditure”, which refers to daily expenses that are deductible in the period they are incurred.

When Flipkart offers customers discounts, the company absorbs these costs. Its sellers are usually paid in full or charged lower commissions, even though customers don’t pay full amounts for products. Under the IT Department’s proposed classification, Flipkart would not have been allowed to deduct the full value of these costs from its bottom line, which in turn would have increased its tax liability.

The IT Dept’s rationale was that since discounts allowed companies to build their brands and retain customers for the long haul, they should be classified as a capital asset - essentially, an asset that provides returns over an extended period of time. However, brand value is largely an intangible cost and hence, it is a subject of confusion.

Why it pays to report a loss

Flipkart said that it needed to offer discounts on its products in order to achieve greater sales and increase its market share, making these discounts tax-deductible marketing expenses. Under the Income Tax Act, the government does not have the authority to levy taxes on such expenses, which fall under "revenue expenditure".

This is precisely why e-commerce firms like Flipkart and Amazon India are reporting losses in the first place - to avoid taxes. These firms offer discounts to consumers in order achieve high sales, and write off these discounts as marketing expenses - leading to a net loss - so that they aren’t liable to pay tax on them.

For the year ended March 2017, Flipkart’s net loss reportedly widened by 68% to ₹87.71 billion while sales rose 29% to nearly ₹200 billion. Despite reporting losses, the sales machine keeps on chugging because these firms draw up on the sizeable investments of backers like Softbank Corp, or in Amazon’s case - cash reserves, in order to finance these discounts.

If discounts were to be classified as capital expenditure, e-commerce firms would have no reason to offer them and without the discounts, customer demand would plummet,.

Under the scanner

E-commerce firms have been under the IT Dept’s scanner for a while for availing tax deductions on discounts while reporting high sales. In order to set a precedent for the rest of the industry, India’s income tax authorities had asked Flipkart and Amazon to reclassify their discounts as capital expenses in August 2017. The following December, the IT Dept ordered Flipkart to pay up ₹1.1 billion. Flipkart unsuccessfully appealed the decision in February 2018, explaining that it couldn’t pay taxes on “fictional” assets, before lodging a renewed appeal with the Income Tax Appellate Tribunal.

Flipkart, Amazon and their competitors in the online retail space aren’t only causing headaches for income tax authorities. Physical retailers like the Future Group, Shoppers Stop and members of the Indian Cellular Association (ICA) are finding it hard to navigate India’s retail industry as more and more consumers scour deals online.

Earlier this month, the Retailers Association of India (RAI), an industry body that includes Future Group and Reliance Retail, wrote a letter to the Suresh Prabhu, the Union Minister for Commerce and Industry, alleging that online retailer were violating India’s FDI rules by by lowering prices of products on their websites and illegally funding “abnormal discounts.”

Under India’s foreign investment regulations, retailers can only be foreign-owned if they function as marketplaces to connect vendors and buyers, without actually influencing prices.

A similar letter was sent by the ICA explaining that e-commerce firms were driving down prices for mobile handsets with direct and indirect discounts, resulting in the closure of mobile retail outlets.

The commerce and industry responded by passing the buck on to the Reserve Bank of India and the Enforcement Directorate. A decision is awaited.

How long can the party continue?

India’s e-commerce industry is relatively young, and growing fast (it is expected to touch US$188bn by 2025) as more and more consumers get access to the internet and change their buying habits. As a result, e-commerce firms are not focussing on profitability for now. Their overarching purpose is to increase their market share by driving up sales and the number of active monthly customers. However, as opposed to selling everything for cheap, they’re focusing their discounting approach on popular segments like electronics and clothing.

Much like the telecoms industry, where Jio has sparked a price war wherein everyone is trying to undercut each other to hold onto the market, once a number of competitors are forced to leave after burning too much cash, the victor will be in a position to raise prices for everyone.

Snapdeal has already become a casualty of the discount war. Now, with Walmart set to purchase a majority stake in Flipkart to take on Amazon, India’s consumers could benefit from lower prices for at least the medium term. Both these entities have a lot of money to spare and are comfortable playing the long game. However, in the event that the Walmart deal doesn’t go through and Amazon ends up joining forces with Flipkart, then the combined company will have a monopoly over the online retail segment- spelling doom for price-conscious consumers.

The Indian government is currently in the process of formulating a policy framework for the e-commerce sector. It’s goals, however, are conflicting. On one hand, it will try to level the playing field between e-commerce firms and brick-and-mortar retailers and also increase the tax liabilities for online retailers. On the other, it does not want to disincentivise companies from entering the e-commerce space and reduce the industry’s overall competitiveness. It will be a tricky balancing act.