In today's Finshots, we tell you why advertising spends of multinational corporations like PepsiCo have caused a bit of a stir.

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The Story

Here’s an interesting headline. A couple days ago the Delhi High Court ruled in favour of PepsiCo, dismissing Income Tax Department’s appeal on ₹2,800 crore AMP expenses.

And we know, this probably doesn’t make any sense to you. But bear with us for a minute while we break down that headline.

AMP expenses mean advertising, marketing and promotional expenses. And authorities have been trying to get PepsiCo India to pay taxes on some of these advertising spends. This may look trivial to most people. However, there’s a big problem here. If you understand the basics of tax laws, you know that expenses are usually tax deductible. If you spend on marketing, you don’t have to pay a tax on these spends. Instead, you deduct the marketing expenses from your total revenue and only pay a tax on the profits.

This is what PepsiCo India has been doing so far.

So why on earth are tax authorities trying to get them to pay an additional tax on some of these marketing expenses? Can’t a business advertise legally? And if they do, aren’t they entitled to deduct this sum from the total revenue before calculating the net tax payable?

Well, there is a catch.

Even though your marketing expenses are usually tax-deductible, the situation gets more complicated when dealing with parent companies across the border. For instance, take the case of PepsiCo India Holdings Pvt. Ltd. Sure, it’s an Indian company. But it regularly deals with its parent (or associated companies) abroad. And you could argue that some of the branding and awareness campaigns of PepsiCo India benefit these associated entities.

For instance, PepsiCo India has routinely paid for substantial advertising and marketing to promote products with brands and trademarks owned by their associated entities in countries like Bangladesh, Nepal, Bhutan and Sri Lanka.

So these marketing expenses aren’t done solely for the benefit of the Indian entity but also for the benefit of other foreign entities. And therefore, you could argue that the associated entities should adequately compensate PepsiCo India for its work. And if they were compensated, that would boost the company's income, and the additional income would be taxable.

That’s what the taxman is after. They don’t want to tax all AMP expenses. Just the ones done to benefit associated entities abroad. They believe these are international transactions (governed by separate tax rules) and over the years they’ve raised demands of hundreds of crores based on this interpretation.

How did they arrive at this number, you ask?

Well, tax authorities have often relied on a test called the BLT test (or the BrightLine test).

In simple words, it tries to identify any excessive spending that disproportionately benefits the parent company or associated enterprises. So in PepsiCo’s case, the test would compare PepsiCo India’s AMP expenses to similar companies in India. If the advertising expense (expressed as a percentage of sales) for PepsiCo India is disproportionately higher than Coca-Cola India for instance, then it suggests that the excess may represent a service to the parent company. This spending is beyond a threshold (or a bright line). And the tax demands are raised accordingly. Hence the name — BrightLine Test.

Now at this point, you’re probably thinking — Well, that’s reasonable. If in fact, there's a service being rendered for the benefit of someone outside India, without being taxed appropriately, then that is a disservice to the nation. Surely PepsiCo India should be made to pay up.

Well, not so fast. Despite the demands from the taxman, courts have routinely sided with companies like PepsiCo. And to understand why, you have to look at the other side of the coin.

Just because the associated entity stands to gain from the branding and awareness campaign you cannot claim that these spends were done solely for their benefit. PepsiCo India is just trying to boost domestic sales. Any additional benefit accrued to the associated companies could be purely incidental.

Besides how can tax authorities decide what spends benefit the parent entity and what doesn't?

The real impact of AMP expenses on brand value is complex to ascertain. Factors like customer loyalty, market dynamics, and competitive actions also influence brand value. And if you really think about it, PepsiCo India outspending its rivals may not really mean much. Each company has its own strategic objective. Maybe PepsiCo India sees merit in building its brand by spending aggressively. And it should be allowed to do so without fearing frivolous tax implications from the Income Tax Department.

This is precisely why courts have refused to acknowledge the BrightLine test. They want tax authorities to show actual contracts and agreements that prove that the Indian entity was spending large sums of money to benefit the parent entity. Not just arbitrary comparisons and calculations. In the absence of such agreements, they’ve refused to intervene.

And yet, the IT department continues to try its luck.

Perhaps this latest ruling will finally set the record straight. Or perhaps this will force the government to relook at its tax laws. In the absence of clear-cut legislation on how to tax such expenses, you will likely continue to see frivolous litigation.

Until then…

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