Tax matters in retail operations
Given the investment focus in the organised retail sector in the country, the article focuses on the tax considerations for a corporate retail chain and how it should be managed for the effective tax charge of their distribution channel... Retail is commonly (rather conventionally) understood as the sale of goods or commodities in small quantities to consumers. A retailer buys goods or products in large quantities from manufacturers or importers, either directly or through a wholesaler, and then sells individual items or small quantities to the general public or end user customers, usually in a shop or showroom, also called store. However, retailing has evolved over the years and it may not be appropriate to refer to retail as a mere store for the sale of goods. Today, with the focus on the end-consumer satisfaction businesses work hard to develop a niche brand for their products. Further, with the advent of retailing in the services space, innovative formats of retailing are evolving. Accordingly, it would be more appropriate to refer to retailing as that set of business activities, which adds value to the products or services sold to consumers for their personal or family use. A retail chain snapshot A corporate retail chain would ideally use an operating structure with a combination of various channel relationships to reach the end consumer. The effective tax charge for a corporate retail chain is highly dependent upon the transaction and the channel partner structures. The 'transaction structure' means the flow of goods or services through the distribution channel and the 'channel partner structure' as the choice of business relationship to exploit the distribution channel. It should be understood that the transaction and channel partner structures are not mutually exclusive and would need to integrate for the effective working of the distribution channel and determination of the effective tax charge. Goods retailing: Key tax considerations Transaction structure The taxes affecting the 'Transaction structure' in the flow of goods include state specific levies on the entry of goods (entry tax) and the sale of goods Value Added Tax (VAT) and the Central Sale Tax (CST). In order to design a tax efficient transaction structure, the following factors need careful consideration: Identifying the potential points of transaction tax incidence within each state or union territory through which the goods need to flow before it reaches the end consumer: While entry tax is mostly levied on mere receipt of goods, VAT/ CST would apply only when there is a transfer of title. Generally, the entry tax is leviable on receipt of goods into the local areas of each state for the purposes of use, consumption or for subsequent sale within such local area. It is pertinent to note that certain states follow a system of dual levy of entry tax, one for having caused the entry of goods into the local area and two for having received the goods from another State. The availability of input tax credits/refunds: It emphasises that besides understanding the availability of the input tax credits, it is important to factor the procedures, the time-lines and cost of compliances for obtaining the same. At this stage it should also be noted that the warehousing requirements and inventory policies of the organisations play a vital role in determining the inventory management cost and would also influence the timing of tax credits and consequentially the working capital requirements. Most states which have implemented VAT only allow a partial credit of input tax when goods manufactured within the state are stock transferred to other states for subsequent sale therein. In such circumstances, the disallowance of input tax credit is immediately upon transferring such goods to the other state. It is inferred that in most cases, such goods are held in stock, for a defined period based on the inventory policies before they are ultimately sold to the end users. From a mere economic perspective, what is pertinent is the loss on account of time value of money for the period during which such goods are held in stock. Depending on the nature of goods and the class of buyers, it may be quite possible to structure such transactions in a tax efficient manner. With this in mind, one would really have to evaluate the cost of holding inventory (including the time value of money on disallowance of partial input tax credit) with the possibility of structuring an inter-state sale. Choice of channel partners Having touched upon the tax considerations for the transaction structure, the next step would be the choice of channel partners. The choice of channel partners would ideally be interplay of: The levels in the distribution channel at which the partner is required: wholesale or retail stage of the distribution channel, and The type of partner: internal outlet (manufacturer's own outlet) or external partner outlet (wholesaler or consignee agent or franchisee). Further a key factor influencing the choice would also include the points of incidence of tax identified in the transaction structure. A simplistic depiction of the interplay of transaction structure and channel partner structure is provided below: Transaction variable choice of channel relationship Stock transfer Internal outlet of the transferor Consignment external partner outlet Sale external partner outlet The key tax considerations affecting the channel partner structure include the following: Service tax: In case of an external partner, the payment of commission or a franchisee fee could attract the incidence of Service Tax. However, it is pertinent to note that in the case of a consignment agency model, the service tax is levied on the commission charged by the consignee to the consignor. While in the case of a franchising arrangement, the service tax is levied on the franchisee fee charged by the franchisor to the franchisee. This distinction is relevant for a choice of channel partner structure. It may well have to be analysed whether it is possible to create a franchisee relationship with the characteristics of a consignment agent. Income tax: Typically in the midst of transaction taxes, the effect of income tax costs could be undermined. Stakeholders typically look at the profit after tax as a measure of their returns and so it is pertinent to factor the same while developing a channel partner structure. We refer to stakeholders as all the parties in the transaction. From an income tax perspective some of the decision variables could include: Deductibility: Deductibility of the costs in the hands of the stakeholders e.g. a fee paid for a franchisee right may not be fully deductible in certain situations and may be required to be capitalized as an Intangible Asset. Wherein only a part of the entire amount would be deductible every year. Depreciation: Depreciation leverage for a capital expenditure required at the channel partner level e.g. if there is a capital investment in the showrooms, the depreciation leverage may be a factor of consideration to decide on which party should own the capital assets. Fringe benefit tax: With the, select expenses such as entertainment, cost of provision of hospitality of every kind by the employer, cost related to organizing employee conferences, select sales promotion expenses, conveyance tour and travel expenses, etc are liable to FBT. Accordingly in case of a high dominance of internal channel partners (i.e. employee manned outlets), the effective tax charge should consider the FBT impact. One would have to explore the possibility of optimizing the effective cost of FBT while developing a channel partner structure. Key tax considerations: Retailing of services The retailing of services is a very different concept from a tax perspective at least. While in tangible goods the flow of goods can be traced through the distribution channel, the same would not arise in the case of service retailing. Based on recent trends, we believe that the similarity between the retailing of pure services vis-à-vis goods is that the end consumer looks at either of them as a commodity received for a definitive value. However from a tax perspective there is a key distinction in the two formats which is the continuity in flow of the commodity (goods or services) and the need to maintain an inventory. The need for the flow of commodity through the supply chain would ideally not arise in the case of services due to their implicit intangible nature (eg. brands, business formats, etc.). The channel partners in the distribution channel would obtain a right to exploit the same for the provision of the commodity to the end consumer. For example a branded beauty salon would like to open several retail outlets for its services. While the retail outlet would provide the services to the end consumer the channel partners in the chain (typically a master franchisee or franchisee) would have only received a right to use the brand and the business format (methodology, training, etc). Such a franchising arrangement would not require any flow of goods from the franchisor to the franchisee. While the distinction between the transaction structure and the channel partner relationship in case of retailing of tangible goods is very coherent, it would not be so in the case of intangibles/services. However, this does not mean that there would not be a levy of transaction taxes on retailing of services. In certain states, it is understood that there is a school of interpretation in terms of which, the right to use a brand name/trade marks is considered to be transfer of a goods and thus make it liable to VAT. Unlike the apparent distinctions in the case of transaction structuring for retailing of goods vis-à-vis services, the tax considerations on account of channel partner relationships for services would be similar to as detailed in the case of retailing of goods. A look beyond As may be discerned from the above discussion the development of a tax efficient operating structure for a corporate retail chain has several 'tax points'. Further, it is an accepted business principle that good brand ambassadors are the ones who generate incremental volumes of business. Thus, it would be equally important for a corporate retail chain to consider the effective return for his external partner (whether a consignee agent or franchisee) to attract and retain good brand ambassadors. In all this, by reducing the tax cost at different levels in the supply chain, one would only stand to gain either by reducing the effective tax incidence of the channel partner structure, or by beating the competition in terms of reduced price of the goods sold to the ultimate consumer. The mix of business models (retailing of goods and services) and interplay of transaction structures with channel partner relationships provide multiple avenues for tax optimisation strategies. In conclusion, while designing an operating structure for retail, tax matters! The authors specialises in tax consulting. The views expressed herein are necessarily of the authors.
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