ITAT allows Losses due to selling goods at less than cost by Flipkart

JCIT Vs Flipkart India Pvt. Ltd. (ITAT Bangalore)

Conclusion: AO was not justified in holding that losses incurred by assessee due to selling goods at less than cost price to e-commerce operators  was to create marketing intangibles assets and therefore the loss to the extent it was created due to predatory pricing should be regarded as capital expenditure incurred by assessee and should be disallowed because where a trader transferred his goods to another trader at a price less than the market price and the transaction was a bonafide one, the taxing authority could not take into account the market price of those goods, ignoring the books results of assessee and resorting to a process of estimating total income of assessee in the manner in which he did, what could be taxed was only income that accrues or arises as laid down in Sec.5, nothing beyond Sec.5 could be brought to tax.

Held: Assessee was a wholesale dealer and acquired goods from various persons and immediately selling the goods to retail sellers and others, who subsequently would sell those goods as sellers on internet platform under the name ‘Flipkart.Com’. AO was of the view that the action of assessee in selling goods at less than cost price was not a normal business practice. AO thereafter concluded that the losses incurred by assessee was to create marketing intangibles assets and therefore the loss to the extent it was created due to predatory pricing should be regarded as capital expenditure incurred by assessee and should be disallowed. AO was however gracious in holding that the value of marketing intangibles should be considered as an asset used for the purpose of business for which assessee should be eligible to claim depreciation at 25%. Assessee replied that no part of purchases by an enterprise carrying on trading business could be considered as capital expenditure and expenses incurred did not create any asset of an enduring advantage. It was held where a trader transfers his goods to another trader at a price less than the market price and the transaction is a bonafide one, the taxing authority cannot take into account the market price of those goods, ignoring the real price fetched to ascertain the profit from the transaction” and “income which has accrued or arisen can only be subject matter of total income and not income which could have been earned but not earned”. AO was not right in proceeding to ignore the books results of assessee and resorting to a process of estimating total income of assessee in the manner in which he did, what could be taxed was only income that accrues or arises as laid down in Sec.5. Nothing beyond Sec.5 could be brought to tax”. There was no expenditure which was incurred by the Assessee and one cannot proceed on the basis of a presumption that profit forgone was expenditure incurred and further that expenditure incurred was for acquiring intangible assets like brand, goodwill etc. Accordingly, the loss declared by assessee in the return of income should be accepted by AO and the action of disallowing the expenses was without any basis.

FULL TEXT OF THE ITAT JUDGEMENT

These are appeals by the Revenue against three orders dated 23.7.2018, 7.8.2018 & 7.8.2018, all by CIT(Appeals)-3, Bengaluru, relating to assessment years 2012-13, 2013-14 & 2014-15.

2. The Assessee is a company. During the relevant previous years relevant to AYs 2012-13 to 2014-15, it was engaged in the business of wholesale trader/distributor of books, mobiles, computers and related accessories. It filed a return of income for AYs 2012-13, 2013-14 & 2014-15 declaring loss of Rs.107,35,11,463, Rs.270,39,22,480/- and Rs.358,81,84,343/- respectively.

3. The AO noticed that the Assessee was a wholesale dealer and acquired goods from various persons and immediately selling the goods to retail sellers like M/S.WS Retail Services Pvt. Ltd. and others, who subsequently would sell those goods as sellers on internet platform under the name ‘Flipkart.Com’. The AO further noticed that the Assessee has been purchasing goods at say Rs.100/- and selling them to the resellers at Rs.80/-. The purchases during the relevant previous years relevant to AY 2012-13 to 1014-15 after excluding closing stock of unsold goods, the purchase and sales figure were as follows:-

4. The loss in terms of percentage was 10%, 15% & 8.80% for AY 2012-13 to 2014-15 respectively. The AO was of the view that the action of the Assessee in selling goods at less than cost price was not a normal business practice. He therefore called upon the Assessee to explain the purpose of selling goods at less than cost price.

5. The Assessee explained that sale through electronic form (e-commerce) as against the traditional sale through retail outlets had just begun in 2012. Since e-commerce was in its nascent stage, it was very difficult to create trust and awareness of sale through e-commerce. The volume of sales was very low. One of the ways to increase volume of sales and attract buyers through e-commerce is to offer discounted prices. Higher volume of sales will lead to economies of scale.

6. On the above submission the AO observed that the volume of sales of the Assessee was Rs.199.75 Crores in AY 2012-13 and increased to Rs.9351.75 Crores in AY 2015-16. He observed that the volume of increase in sales was 45 times over a period of 3 years. He was therefore of the view that the plea of the Assessee that sale at discounted price to retailers was to increase volume of sales cannot be accepted.

7. The AO examined the Senior Vice-President and Finance Controller of the Flipkart Group Sri.Rajnish Baweja, by issuing summons to him by virtue of his power to summon witness u/s.131 of the Income Tax Act, 1961 (Act). The sum and substance of the statement of the Vice-President according to the AO was that the strategy of selling at a price lower (predatory pricing) than the cost price is to capture market share and to earn profits in the long run. According to the AO the benefit to the online buyer in the short run in the form of lower price is to create indirect benefit to the Assessee in the long run.

8. The AO thereafter concluded that the strategy of selling goods at lower than cost price was to establish customer goodwill and brand value in the long run and reap benefits in the later years. The AO in this regard referred to the fact that the Assessee during the previous year relevant to AY 2015-16 sold its shares at a huge premium (Equity shares of face value of Re.1/- was sold at a premium of Rs.18,999/- per equity shares) based on the valuation of those shares under the Discounted Cash Flow method (DCF Method). The DCF Method estimates the cash flows in future and uses appropriate discounting factors to arrive at the current enterprise value. This was one reason for the AO to conclude that the strategy of incurring loss in the present was to reap benefit of such loss in future by capturing E-Commerce market.

9. The AO thereafter concluded that the losses incurred by the Assessee was to create marketing intangibles assets and therefore the loss to the extent it is created due to predatory pricing should be regarded as capital expenditure incurred by the Assessee and should be disallowed. The AO was however gracious in holding that the value of marketing intangibles should be considered as an asset used for the purpose of business for which the Assessee should be eligible to claim depreciation at 25%.

10. The AO called upon the Assessee to explain why the difference between higher purchases and lower sales should not be inferred as a pricing strategy leading to enduring benefits; and hence leading to generation of capital asset. The Assessee replied that no part of purchases by an enterprise carrying on trading business can be considered as capital expenditure. The Assessee submitted that expenses incurred does not create any asset of an enduring advantage.

11. The AO held that the business of the Assessee is different from traditional way of understanding the business. He was of the view that in traditional business if an enterprise incurs loss no investor will come forward to invest in such business but in spite of huge losses international expert investors are investing in capital at high premium with the Assessee. Hence the entire way of viewing this new business has to have a different approach in accounting and taxing principles. The Assessee contended before the AO that selling at a price below cost price does not lead to generation of any “identifiable asset”. The AO however held that intangible assets are assets without physical presence and the fact that the Assessee followed predatory pricing in order to create marketing intangibles and brand. According to him the enhanced valuations at which venture capitalists invest in the Assessee is not valuation of any tangible asset or profitability, but that valuation is mostly based on intangibles generated by Assessee. Hence, selling at a price below prices is not an irrational economic behavior. It is a clearly thought strategy to establish a monopoly in market by brand building by generating consumer goodwill. This strategy naturally leads to generation of intangible assets and enduring benefits that assessee has failed to acknowledge and recognize.

12. The AO thereafter embarked upon method of valuation of intangibles. The first observation of the AO was that E-commerce business does not follow the traditional methods for earning income and hence assessment of income in the case of E-commerce business also cannot be done by following traditional methods. The AO referred to three approaches of valuation of intangibles prescribed by OECD in its convention of Base Erosion and Profit Shifting (BEPS) viz., cost approach, income approach and market approach. The AO adopted cost approach in which a reasonable profit margin is attributed to the cost of purchases and to the extent the profit is foregone by the Assessee was to be considered as the value of intangible.

13. For the above purpose there was a need to find out average gross margin on cost for other wholesalers in the market. The AO took the database for wholesalers dealing in consumer and electronic goods. He took the average profit margins of companies engaged in wholesale business in consumer electronic goods and compared the said profit margin with Assessee’s profit margin of loss.

14. On the basis of the above, the AO arrived at an addition to the total income for AY 2012-13 to 2014-15, as follows:-

AY 2012-13

“3.19. The market average of gross profit margin for wholesalers is 19.90%. On perusal of the comparables, it is seen that none of them has an abnormally negative gross profit margin. It can be concluded that these comparable wholesalers follow a profit-based business model. In any case, averaging irons out the differences in these market comparables. Had assessee not followed a predatory pricing policy, its (market-average) sale price would have been Rs. 221,62,54,482/- plus 19.90% of Rs. 221,62,54,482/-, i.e. Rs. 265,72,89,124/-. Assessee’s real sales is Rs. 199,75,27,876/-. The reduction in sales due to following assessee’s strategy of cost cutting on an estimation, is Rs. 65,97,61,248/-. This is the value of expenses incurred by assessee towards cost of marketing intangibles in the year.

3.20. Assessee has cross-subsidized its marketing intangible and trademark value creation with reduction in sale price. However, as already stated in great detail, marketing intangibles and trademark are ‘assets. Any expense/cost incurred due to it is capital expenditure and has to be capitalized. Hence addition to the extent of Rs. 65,97,61,248/- is made on account of intangibles. Assessee’s operation has commenced (after takeover of business from the concern Flipkart Online Services Pvt Ltd) after 30th of September, 2011. Hence depreciation on intangibles is allowed @ 12.5% of this amount, i.e. 8,24,70,156/- and the balance is added back to the returned income.

Addition: Rs. 65,97,61,248 – Rs. 8,24,70,156/- = Rs. 57,72,91,092/-”

AY 2013-14

“3.19. The market average of gross profit margin for wholesalers is 19.36%. On perusal of the comparables, it is seen that none of them has an abnormally negative gross profit margin. It can be concluded that these comparable wholesalers follow a profit-based business model. In any case, averaging irons out the differences in these market comparables. Had assessee not followed a predatory pricing policy, its (market-average) sale price would have been Rs. 1232,99,50,807/- plus 19.36% of Rs. 1232,99,50,807/-, i.e. Rs. 1471,70,29,283/-. Assessee’s real sales is Rs. 1150,65,79,357/-. The reduction in sales due to following assessee’s strategy of cost cutting on an estimation, is Rs. 321,04,49,926/-. This is the value of expenses incurred by assessee towards cost of marketing intangibles in the year.

3.20. Assessee had cross-subsidized its marketing intangible and trademark value creation with reduction in sale price. However, as already stated in great detail, marketing intangibles and trademark are assets. Any expense/cost incurred due to it is capital expenditure and has to be capitalized. Hence addition to the extent of Rs. 321,04,49,926/- is made on account of intangibles. Hence depreciation on intangibles is allowed @ 25% of this amount, i.e. Rs. 80,26,12,481/- and the balance is added back to the returned income.

Addition: Rs. 321,04,49,926— Rs. 80,26,12,481/- = Rs. 240,78,37,445/-”

AY 2014-15

“3.20. The market average of gross profit margin for wholesalers is 16.95%. On perusal of the comparables it is seen that none of comparable has an abnormally negative gross profit margin. It can be included that these comparable wholesalers follow a profit-based business model. In any case, averaging irons out the differences in these market comparables. Had assessee not followed a predatory pricing policy, its (market average) sale price would have been Rs. 3051,55,64,608 + (16.95% of Rs. 3051,55,64,608 i.e. Rs. 3568,79,52,809. Assessee’s real sales is Rs. 2804,94,67,845. The reduction in sales due to following assessee’s strategy of selling at a price lower than cost, the difference of Rs. 763,84,84,964 between the price at which the assessee is selling and the price the normal wholesaler would have sold is the value of expenses incurred by assessee towards cost of marketing intangibles in the year.

3.21. Assesses had cross-subsidized its marketing intangible and brand value with reduction in sale price. However, as already stated in great detail, marketing intangibles and brand value are assets. Any expense/cost incurred due on creation of the same is capital expenditure and has to be capitalized. Hence addition to the extent of Rs.763,84,84,964 is made on account of intangibles. Hence depreciation on intangibles is allowed 25 % of this amount, i.e. Rs. 190,96,21,241 and the balance is add the returned income. Hence the addition is Rs. (763,84,84,964— Rs. 190,96,21,241) Rs.  572,88,63,723.”

15. Aggrieved by the order of the AO, the Assessee preferred appeal before CIT(A). The CIT(A) noticed that on identical addition made in AY 2015-16, the ITAT Bangalore Bench in Assessee’s own case reported in [2018] 92 com387 (Bangalore – Trib.) Fliipkart India (P.) Ltd. Vs. Assistant Commissioner of Income-tax, Circle-3 (1) (1), Bangalore IT APPEAL NOS. 202 & 693 (BANG.) OF 2018 for ASSESSMENT YEAR 2015-16 order dated APRIL 25, 2018 deleted the addition made by the revenue authorities holding that where a trader transfers his goods to another trader at a price less than market price and transaction is a bona fide one, taxing authority cannot take into account market price of those goods, ignoring real price fetched to ascertain profit from transaction. The Tribunal further held that even otherwise, since assessee had not incurred any expenditure to acquire marketing intangibles or for creation of goodwill, the order passed by Assessing Officer was not sustainable. Following the aforesaid order of the Tribunal, the CIT(A) deleted the addition made by the AO.

16. Aggrieved by the orders of the CIT(A), the Revenue has preferred the present appeals before the Tribunal. The grounds of appeal in AY 2012-13 reads thus:-

“1 The order of the learned CIT(A) is opposed to law and facts of the case.

2. On the facts and in the circumstances of the case the learned CIT(A) erred in placing reliance on the order of the Tribunal which has recorded a finding that the loss claimed by the Assessee cannot be disallowed, as the same was not claimed as an expenditure. However the assessee has accepted/admitted that the goods were sold at lower than the cost price in order to attract customers to purchase goods through e-commerce(Flipkart Portal) which would be in the nature of acquiring/creating intangible asset in the form of goodwill/Brand value and loss in capital in nature.

3. The attention of the ITAT was not drawn to the fact that the Assessee and the Retailer WS Retail Pvt Ltd were controlled by the assessee company itself where in fact during the A.Y.2012-13, the founders of Flipkart were the Directors of the company and deciding the operations of the WS Retail Pvt Ltd.

4. The factual aspect that Assessee as a wholesaler supplied 94.5% of the total goods sold on portal Flipkart to its only retailer WS retail Pvt Ltd and the rest 4.5% to its other related company M/s Flipkart Online Services Pvt Ltd as mentioned in the order itself is bound to have an effect on the judgement of the Tribunal on which reliance has been placed once the matter is highlighted before the Tribunal.

4. For these and other grounds that may be urged at the time of hearing, it is prayed that the order of the CIT(A) in so far as it relates to the above grounds may be reversed and that of the Assessing Officer may be restored.

5. The appellant craves leave to add, alter, amend and / or delete any of the grounds mentioned above.”

17. The grounds of appeal for AY 2013-14 & 2014-15 are identical but these grounds are slightly different from AY 2012-13. The grounds of appeal for AY 2013-14, reads thus:-

“1. The Order of the learned CIT(A) is opposed to law and facts of the case.

2. The CIT (A) has placed reliance on the Order of the Tribunal which has recorded a finding that the loss claimed by the Assessee cannot be disallowed, as the same was not claimed as an expenditure. However the Assessee has accepted/admitted that the goods were sold at lower than the cost price in order to attract customers to purchase goods through e-commerce (Flipkart portal) which would be in the nature of acquiring/creating intangible asset in the form of goodwill/brand value and loss is capital in nature.

3. The Attention of the ITAT was not drawn to the fact that the Assessee and the Retailer WS Retail Pvt. Ltd were associated and controlled by the Assessee company itself wherein earlier and during current AY 2013-14, the founders of Flipkart were the Directors of the Company and thereby deciding the operations of the WS Retail Pvt Ltd.

4. The factual aspect that Assessee as a wholesaler supplied majority of the total goods sold on its portal Flipkart to its own retail arm WS Retail Pvt Ltd as mentioned in the Order as well is bound to have an effect on the judgement of the Tribunal on which reliance has been placed once the matter is highlighted before the Tribunal.

5. The terms of the Agreement between the Assessee and the Retailer, WS Retail bringing forth the fact that the transaction between Assessee and the WS Retail was not an independent transaction as the supply agreement and license and service agreement between the parties, prohibits / controls the WS Retail either to purchase / procure goods from any person other than the Assessee and also to sell the said goods other than, to the customers placing orders in the Flipkart portal, would only lead to analogy that entire transaction is an colorable device to claim the cost of creating intangible asset as business loss and the same is bound to have an effect on the judgement of the Tribunal on which reliance has been placed once the matter is highlighted before the Tribunal.

6. For these and other grounds that may be urged at the time of hearing, it is prayed that the order of the CIT(A) in so far as it relates to the above grounds may be reversed and that of the Assessing Officer may be restored.

7. The appellant craves leave to add, alter, amend and/ or delete any of the grounds mentioned above.”

18. We have heard the submission of the learned DR, who relied on the order of the AO. The learned counsel for the Assessee while relying on the order of the CIT(A), further submitted that ground No.3 & 4 raised by the revenue in the appeal for AY 2012-13, the ground with regard to the Assessee having control over WS Retail Pvt.Ltd., was not the basis of assessment and there is no factual basis for the revenue to raise such a ground. With regard to Gr.No.3 to 5 in AY 2013-14 & 2014-15 with regard to allegation that transaction between WS retail Pvt.Ltd., and the Assessee being not between unrelated parties, is also without any basis. The revenue has not brought on record any material to substantiate its case in the aforesaid grounds and therefore the decision rendered by the Tribunal in Assessee’s own case for AY 2015-16, was rightly followed by the CIT(A) in deleting the addition made by the AO.

19. We have given a careful consideration to the rival submissions. On identical addition made in AY 2015-16, this Tribunal held that the starting point for computing income from business is the profit or loss as per the profit and loss account of the Assessee, which cannot be disregarded unless certain provisions [Section 145(3)] of the IT Act are invoked. Since the AO has not invoked such provisions, the AO is not empowered to go beyond the book results. It was held that it is settled law that “where a trader transfers his goods to another trader at a price less than the market price and the transaction is a bonafide one, the taxing authority cannot take into account the market price of those goods, ignoring the real price fetched to ascertain the profit from the transaction” and “income which has accrued or arisen can only be subject matter of total income and not income which could have been earned but not earned”. It was held that “the AO was not right in proceeding to ignore the books results of the Assessee and resorting to a process of estimating total income of the Assessee in the manner in which he did, what can be taxed is only income that accrues or arises as laid down in Sec.5 of the Act. Nothing beyond Sec.5 of the Act can be brought to tax”. It was held that there is no provision to disregard the loss declared by the Assessee and also there is no provision by which the Revenue can ignore the sale price declared by an Assessee and proceed to enhance the sale price without any material before him to show that the Assessee has in fact realized higher sale price. In fact, whenever, the Legislature intended to tax income not earned, they have made a provision to this effect. It was held that there was no expenditure which was incurred by the Assessee and one cannot proceed on the basis of a presumption that profit forgone is expenditure incurred and further that expenditure incurred was for acquiring intangible assets like brand, goodwill etc. It was also held the valuation of intangibles is academic since it rejected the basic position adopted by the Revenue and held that the Assessing Officer should accept the loss declared by the Assessee. The Tribunal concluded that the action of the Revenue in disregarding the books results cannot be sustained and the further conclusion that the action of the Revenue in presuming that the Assessee had incurred expenditure for creating intangible assets/brand or goodwill is without any basis. Accordingly, the loss declared by the Assessee in the return of income should be accepted by the AO and the action of disallowing the expenses in without any basis.

20. We are of the view that the aforesaid conclusion of the Tribunal will equally apply to AY 2012-13 to 2014-15 also as the basis of making the addition in these AYs are also the same as it was made in AY 2015-16. The allegation of the revenue regarding the Assessee and M/S.WS Retail Pvt.Ltd., being related parties does not emanate from the order of assessment. The revenue cannot be permitted to take a stand which was not the factual basis on which addition was made by the AO. Even otherwise, there is no basis for the stand taken by the revenue in the grounds of appeal. We therefore find no merit in these appeals by the revenue. Respectfully following the order of the Tribunal in Assessee’s own case for AY 2015-16, we uphold the orders of the CIT(A) and dismiss, these appeals by the revenue.

21. In the result, appeals by the revenue are dismissed.

Pronounced in the open court on this 14^th day of June, 2019.