Bengaluru: In an unprecedented move, the Bangalore income tax authority have disallowed expenses for surrogate advertisements claimed by world’s second largest alcohol maker---United Spirits--- in its tax sheet for the assessment year 2015-’16.

Promotion of a dummy product or a brand when promoting alcoholic products is prohibited amounts to surrogate advertising. The tax authority in its recent order in December claimed United Spirit’s expenditure on advertisement is a scheme to subvert the intent of law. “By the fundamental matching principle, a company cannot claim deduction on expenses not related to its business sales,” said the order. A total of Rs 323.72 crore spent on surrogate advertisement by United Sprits would be disallowed, resulting in an increase in tax liability of about Rs 100 crore.

The department has slapped notice that requires United Spirits to pay up Rs 672.08 crore in revised taxes for the AY 2015-’16. United Spirits is likely to challenge the order in a higher tribunal.

Experts say that if the order sustains judicial scrutiny, it would have a larger impact on the brewery and tobacco industry, which spends millions on surrogate advertising of their brands. India’s breweries industry is the third largest in the world with a value of $35 billion, while India’s tobacco industry is worth about $11 billion.

The company has made sales of Rs. 18,593.06 crore in 2015-’16. While, the total tax liability imposed on the company is Rs. 672.08 crore, inclusive of the expenditure on advertisement, as per the income tax report.

B S Venkatesh, a Bengaluru-based chartered accountant, says that the income tax department is not only bothered about the ‘legal aspects’ of a company’s activities but is also concerned with the nature of the expenditure.

“What they really look at is if it is a revenue expenditure or a capital expenditure and if it is related to the business. If at all, it considers the legal aspects, it will scrutinize an expenditure which is prohibited by law,” he says. This expenditure which is prohibited by law, will not be considered as ‘deductible’ while computing the taxable income, he adds.

In this particular case, the income tax report stated that United Spirits has spent around Rs. 179.81 crore on marketing water, soda, sparkling water, music CDs, experiences, and get-togethers despite not selling any of these products or services. After having given the licensing rights to third parties who sell McDowell’s No.1 water and soda, USL charges a royalty of Rs 4 crore for lending its brand name.

The IT department observed that the company does not receive any royalty on the sale of music CDs, experiences and get-togethers. It found this “peculiar”, because there is no clarity on where the revenue to promote such activities is coming from, what kind of activity it is and how is it related to the business of USL? The department hints that this is a practice of surrogate advertising, where companies selling products like tobacco or alcohol, which are prohibited from marketing under state excise laws and Cable Television Network Rules (1994), try to keep the brand alive by promoting proxy products.

In addition to this, USL has contended that it has made sponsorship payments of Rs 164.46 crores (344.21 cr total), which must also be considered as revenue expenditure. But, these kinds of payments can only be considered as revenue payments when the company does not receive any benefits in return.

The company is claiming this as revenue expense which might be deducted from their gross income as it would bring down the payable income tax. However, tax authorities have said that since the company is not selling its own products, expenses incurred for advertisements are ‘non-allowable’.

Alok Prasanna, senior resident fellow at Vidhi Centre for Legal Policy who is an advocate adept with taxation law, says that the IT department is sufficiently justified by law to say that this kind of expenditure is a capital and not a revenue expenditure. “Because, if you own a liquor company, you cannot advertise it as per the law,” he adds.

In India, surrogate advertising emerged after the ban on advertisement of alcohol, liquor, wine, cigarettes, tobacco products or other intoxicants with the implementation of Cable Television Networks (Regulation) Act, 1995, which stated that advertisements must not make any direct or indirect reference to products mentioned above. This act was amended in September 2000, making it easier for companies, especially in the liquor and tobacco industry, to promote and advertise their products through the surrogate method.

A government notification was issued on February 25, 2008, which stated that surrogate advertising by liquor companies in any form of media would be banned. But, the Ministry of Information and Broadcasting issued a notification almost a year later amending the law. It was clear that there on, any product with a shared name and logo with that of liquor or tobacco company can be advertised as long as it is not depictive of the proscribed product. Even the  state excise laws, for instance the Karnataka Prohibition Act 1961, mention certain prohibitions in Section 14 and 15.

‘Tax terrorism’ to some

Arjun MB, chartered accountant and partner at Arjun Ravi & Co, says Income Tax department’s refusal to add back the advertisement and sponsorship expenses while taxing the company is “called ‘tax terrorism’ in the CA world”.

Arjun believes that law does not prohibit a company from advertising soda water, sparkling water, CDs etc. “Once I franchise (my) brand name, anything that is sold in the market is mine. It does not matter whether I as a company manufacture it, or someone else is manufacturing it, because the product is sold in my name.”

Since, it is under USL’s brand name that the water is being sold, they have the right to spend money on advertising the soda water, sparkling water etc. and this must be considered as a revenue expenditure, he says.

Cases objecting to surrogate advertising by liquor companies have reached the court earlier too. In 2017, the Supreme Court refused to admit that a soda advertisement could influence people to drink more while hearing a plea filed a law student.

In this case, USL stated that their “advertisement campaigns for non-alcoholic products and activities are not driven by any consideration of alcohol consumers”.

Sri Sridhar B, chief digital officer of the company claimed in a statement that liquor consumers are not targeted when they design these ad campaigns. The same has been emphasised upon by Abhishek Shahbadi, the VP of the company. The department asserted that if this is the case, these expenses are definitely not allowable.

The Income Tax department also discussed in length the different kinds of Advertisement, Marketing and Promotional activities (AMP) in the context of what can be taxed and what can be disallowed. They state that AMP expenses can only be considered as revenue expenses as long as they are relatable to sales. This is something which is referred to as the ‘matching principle’ in accounting terms. The income that USL receives cannot be matched with the AMP activity and has been described as ‘passive income’ by the department.

The Assessing Officer, in this case, rejects the company’s claim on several grounds. The company is prohibited from selling its products in the open and they claim that they have not indulged in any ‘above the line’ (term for advertisement outside liquor stores) advertisement of liquor products.

But, the department asserts that USL have themselves admitted that the sponsorship expenditure is to enhance their brand value. The department highlighted that ‘brand’ is a part of intangible assets that a company owns that has a useful life of 10 to 20 years. Therefore, this qualifies as a capital expense, which is “purely for promotion of brand”, said the report.

USL VP, Shahbadi stated that he devotes 50 percent of his time on developing ad campaigns for these non-alcoholic products that they don’t really sell. The department further observes that Shahbadi’s VP’s bonus and incentive is linked to the increase in sales of the liquor products and not the non-alcoholic products, for which there aren’t even any measurable targets.

Affirming his argument in favour of disallowing of USL’s ad expenditure, Prasanna says, “When you are promoting something which is not even a part of your business but carries your brand name or logo, what you are trying to do is to develop a long term brand value.”

He adds that capital expenditure is decided on the basis of what your actual business is and what you are spending money on.

The report also states that the Income Tax department sought details on the revenue that USL is earning from ‘experiences’ and ‘get togethers’, but the company did not furnish any.

Prasanna says that it is of utmost importance for companies to be transparent when presenting facts and figures. “If all the information is not provided, the IT department will ask for more information, and it is the obligation of the company to furnish these details under the law,” he says.

Implications of the judgement

In case USL decides to appeal against the order, the implications would have an impact on all players who manufacture alcohol and operate in the same space.

Arjun says that before approaching the High Court, USL will have to move through the Commissioner of Appeals and the Income Tax Appellate Tribunal (ITAT); if they cannot stand their ground at these two levels, only then can they approach the HC. In case they lose in the High Court, the department will start sending notices and issuing orders based on this judgement to all the other companies manufacturing alcohol and advertising otherwise, he says.

Other alcohol companies will not be able to approach the HC on this issue in future as they will be asked to refer to the judgment already passed in a similar case, says Arjun.

With a CAGR of 8.8%, India has become one of the fastest growing alcohol markets in the world. Keeping this in mind, it would be extremely difficult for alcohol companies in the country to evade scrutiny from tax and legal authorities. USL is currently valued at Rs. 36,873 cr (a week ago).