Selling Price < Cost Price means Taxman's Eyes Wide Open

We have all heard the term “loss leader”, and we have all heard someone say, “We’ll make it up on volume.” Most people don’t think about it much, even when we see advertisements indicating a company is selling below cost.

Are we allowed to charge whatever price we like?
Usually, enterprises are free to charge whatever price you wish to compete in the market. However, one must not use pricing in an anti-competitive manner. For example: predatory pricing, deliberate underpricing will be regarded as offence under the Competition laws, if the objective of the pricing of the product is only to drive competitors out of business and discourage new competitors. It is illegal for competing businesses to get together and agree to fix their prices (or to agree to charge certain fees). Price fixing agreements don’t need to be in writing – a verbal agreement or an informal understanding is sufficient.

While selling goods at a below-cost price is usually okay, it may be illegal if it is done for the purpose of eliminating or substantially damaging a competitor. This is known as predatory pricing. Whether the law has been broken will depend on a number of factors, such as how long the goods were sold below cost and how much market power the seller has.

Why is there a need to sell at prices lower than cost?

Pricing is a decision of and a measure of commercial expediency. Commercial expediency is an expense that a businessman incurs for the purpose of business given the facts and circumstances of the transaction. Commercial expediency is a sole discretion of the businessman.

Selling below cost is a practice whereby a firm sells products at less than costs of manufacture or purchase. This may be done in order to (i) drive out competitors, (ii) to increase market share, (iii) to clear the slow-moving stocks, (iv) to gain profits through cross-subsidization, among others. A question also arises as to whether selling a product below costs is economically feasible over a long period of time since the firm may incur high costs in the form of loss of potential profits. This is however a question of commercial expediency.

When Selling Below Cost, a number of measurement issues arise as to what constitutes costs but generally the practice would arise if price is below marginal cost or average variable cost. A question also arises as to whether selling a product below costs is economically feasible over a long period of time since the firm may incur high costs in the form of loss of potential profits.

There are at least five possible reasons to do this.
1. If you’re a new entrant, to quickly establish a market share by competing on price. Market share gives you credibility and customer references, which help you get more sales.
2. To put profitability pressure on your competitors; if you have deeper pockets than they do, then they can only match your price for so long before they lose too much money and go out of business. If you have “market power” then doing this is generally considered to be “predatory pricing” and anti-competitive and is illegal in many countries.
3. If you believe that you can quickly reduce your own costs to the point where that price point is no longer below your cost, it might be advantageous to start at the lower cost.
4. There are many examples of business models where one product is sold at a loss so that another can be sold at a profit.
5. To liquidate existing inventory of a product in anticipation of a newer version being released soon.

Why is the taxman concerned when sales price < cost price?

Cost Price and Selling Price gives the basis for deduction of expense and allocation of taxable profit to any enterprise. Selling price is the basis for the recovery of consumption taxes i.e. VAT and Excise. Any influence in Sales Price is also directly proportional to the taxable profits. No wonder tax authorities look closely into how the sales price has been determined.

Generally, tax authorities view that when the selling prices are set at prices lower than the cost price, i.e. the loss-making price, then the difference is the gain realized in the form of intangibles (like market strength, market share, product penetration and recognition) etc. that are generally viewed as extra commercial consideration. So, tax authorities are hard set to tax the differences as gains. Instead of the consideration of money value flowing, directly or indirectly, from the buyer to the seller, the setting of lower sales prices are viewed as an compensation otherwise agreed between the buyer and the seller, in the view of tax authorities. This view of the authorities stems from the idea that the selling at a price below the cost 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 benefit. So, in taxman’s view this should be taxable in the form of regular income of the sales. Although some of these practices may be questionable from the Competition Laws perspective, should there be different view regarding the taxation of such considerations?

The actions that are questionable from competition laws perspective should be recharacterized at normal sales price from tax point as well? Could this be a midpoint for a common understanding? Or should tax laws should altogether disregard whether or not the pricing mechanism is whether anti-competitive or not. Tax Authorities will naturally be in pressure to recharacterize such anti-competitive selling prices as both direct and indirect tax collection is largely affected by such pricing practices. 

What is the real sales price?

The real ‘price’ of a product is what the market fetches it; it need not always be fixed by the manufacturer. In some cases, this may be below the cost of production, as many companies sell products at marginal cost without recovering the fixed expenses. These are ‘normal prices’, as they are fixed by the market. Selling below cost may be done in order to (i) drive out competitors, (ii) to increase market share, (iii) to clear the slow-moving stocks, (iv) to gain profits through cross-subsidization, among others. Among these, the first two cases i.e. (i) drive out competitors, (ii) to increase market share are subject, there may be indication that the actual selling price may not actually be the price that the market fetches at the normal demand supply curve. Tax authorities in such case view the arrangement as receiving extra commercial consideration in forms of compensation other than in the form of sales price.

How do the tax authorities view such situations? How are such extra commercial considerations characterized? The argument is that such extra commercial considerations relate to the creation of intangible within an institution if form of goodwill like market strength, market share, product penetration and recognition, among others. But just as it is impossible to pinpoint when goodwill  came into existence, so it is equally impossible to pinpoint the moment at  which goodwill waxed or increased or it waned or decreased, for, the process is imperceptible: and just as in the case of a newly started business  it is not possible to ascertain in terms of money the cost of acquisition of  goodwill: it is equally impossible to ascertain in terms of money the cost of  addition or alteration to the quality of goodwill which led to the increase  in its value. So, in such cases although philosophically correct assessing officers are tied in a sense that they cannot neglect the accrual of income and disregard the loss declared by the assessee in the return of income filed without the basis to show that the accruals of compensation in other forms within the enterprise.

Let’s say, someone with deep pocket advantage were intending to (i) drive out competitors or (ii) to increase market share, then, as there are not any genuine commercial purpose for the reduced selling price other than to influence the market. In such case how will the perfect market treat such situations? An enterprise with high financial leverage or other resources gives a deep pocket advantage bringing an unfair advantage over competitors particularly if the practice of selling at prices below costs imposes losses and drives out competing firms. Others argue that firms using “deep pockets” to finance anticompetitive actions impose a cost on themselves because those funds could be more profitably employed elsewhere. Moreover, if capital markets work reasonably well, target firms should have no trouble obtaining financing to sustain themselves through the anticompetitive action.

So, can sales price be lower than the cost price?

Selling below cost could be defined as a commercial practice whereby a company sells products at a price below the production cost so that the sale would make the company lose money. A priori, a company would have no interest in losing money with a sale, however, this practice can be used for commercial or economies of scale related purposes, so that such practice would be within the framework of the market economy and free pricing.

In general, unless otherwise provided by laws or regulations, pricing is free. However, the sale below cost or the sale made at a price lower than the purchase price will be considered unfair in the following cases:

  1. When it is likely to mislead consumers about the price of other products or services offered in the same establishment.
  2. When such practice has the effect of discrediting the image of another product or establishment.
  3. When it is part of a strategy aimed at eliminating a competitor or group of competitors in the market. 

Therefore, selling a product below cost is not unlawful unless one of these three cases occurs, that is, a misleading, denigrating, or predatory sale below cost. In conclusion, one must note that not always the sale of a product below its cost is illegal, but, on the contrary, the pricing is a priori totally free. Exceptionally, the sale below cost will be considered unlawful when it entails or consist of an “act against competition” with the aim of getting a dominant position in the market; or in case of distorting free competition with damage to public interest. This we will discuss in line with the Competition Laws of Nepal.

Competition Laws in Nepal

Competition Promotion and Market Protection Act, 2063 (2007) (“Competition Law”) of Nepal was introduced to make national economy more open, liberal, market-oriented and competitive by maintaining fair competition between or among the persons or enterprises producing or distributing goods or services, to enhance national productivity by developing the business capacity of producers or distributors by way of competition, to protect markets against undesirable interference, to encourage to make the produced goods and services available to the consumers at a competitive price by enhancing the quality of goods or services by way of controlling monopoly and restrictive trade practices, and to maintain the economic interests and decency of the general public by doing away with possible unfair competition in trade practices.

Competition Law prevents a person from producing or distributing any goods or services, set prices, limit production distribution marketing technical development and advancement, limit the retain consumption quantity/quality, restrain the sale and distribution of the goods, among others with an intention to limit or control competition. Competition Law also prevents an enterprise holding dominant position to abuse such position with intent to control competition in the production and distribution of any goods by that enterprise or through its affiliation. Also prohibits the merger or amalgamation with intent to control competition. It also prevents the anti-competitive activities like bid rigging, exclusive dealing, market restriction on production or distribution of goods/services, tied selling, misleading advertisement, in general.

Relevant Case Laws

A rational business decision is always to generate a desirable level of profits over the cost incurred. Sometimes for pricing strategy, marketing strategy or cross-subsidization strategy, selling price may be lower than the cost as well which may be a viable commercial/financial/economic decision considering the profits, revenues and market shares that is expected to be earned in future. This has somewhat been addressed in the case of Mainawati Steel Industries v/s LTO

Revenue authorities expect the taxpayer to clarify the rationale behind such strategy as the decision to sale the goods at price lower than cost is not a conventional business decision. Taxpayers are expected to illustrate their strategy, substantiate the decision with cost-sheet analysis and where taxpayers are not able to demonstrate such reasoning, authorities will naturally examine such difference and may add back the difference between cost price and sales price and impose additional interest and fines. Similar interpretations have been provided in IRD v/s Shah Udhyog Pvt. Ltd, Decision#8265.

As we discussed above in “What is the real sales price?”, the allocation and attribution of the goodwill as a form of extra commercial consideration is really a challenging issue for assessment for the authorities. So, in such cases although philosophically correct assessing officers are tied in a sense that they cannot neglect the accrual of income and disregard the loss declared by the assessee in the return of income filed without the basis to show that the accruals of compensation in other forms within the enterprise. Similar interpretations have been provided in Colgate Pamoliv v/s LTO.