On May 11, 2019, the Second Section of the Superior Chamber of the Federal Tax Court issued two isolated rulings in relation to the strict indispensability of different expenses related to the existence of a non-exclusive license agreement linked to the payment of royalties.
The first ruling relates to the deductibility of "marketing expenses," which are considered a strictly indispensable expense for taxpayers whose principal activity relates to the sale or purchase of goods or products under brands whose use and exploitation were given through a non-exclusive license agreement.
On the other hand, the second decision relates to the nondeductibility of the "promotion and advertising expenses," since they are not strictly indispensable or essential for taxpayers, whose principal activity relates to the sale or purchase of goods or products under brands whose use and exploitation were granted through a non-exclusive license agreement.
Both decisions derived from the analysis issued by the Federal Tax Court on the strict indispensability of (i) marketing expenses and (ii) promotion and advertising expenses. Below you will find our analysis regarding both rules.
i. Marketing Expenses deduction.
The Second Section of the Superior Chamber of the Federal Tax Court considered that "marketing" expenses are strictly indispensable for taxpayers merchandising goods or products and, therefore, it is considered that they meet the deduction requirements.
The aforementioned, considering that said expenses generate for the taxpayers the conditions and distribution routes necessary for the development of the merchandising activity, being irrelevant for deduction matters, whether the taxpayer is the brand owner under which the products are sold or not.
In other words, the merchandising expenses will be considered as strictly indispensable for taxpayers whose principal activity relates to goods or products distribution, regardless of any royalty payment incurred for brand use.
ii. Promotion and Advertising expenses deductibility.
The Second Section of the Superior Chamber of the Federal Tax Court considered that "promotion and advertising expenses" do not meet the strictly indispensable requirement for the development of merchandising activities, because they are not directly related to said merchandising activities.
The above-mentioned considers that the "promotion and advertising" expenses have the objective of publicizing a product or an article in order to attract customers through different media used to disclose or extend the notice of things or facts.
Consequently, the Chamber found that the aforementioned expenses are not directly related with the article or product nor with the merchandising activities of the taxpayer. Instead, those expenses are linked directly to the brand positioning in the market in order to make the product known among customers, acknowledging that these expenses increase the value of the brand to the exclusive benefit of the brand owner.
It worth noting that to the extent that the taxpayer engaged in goods and products distribution and merchandising activities, also conducting payments of royalties for the use and exploitation of brands under a non-exclusive license agreement, the deduction for "promotion and advertising expenses" incurred will not be deductible.
We estimate that the position adopted by the Chamber will affect those taxpayers who pay royalties for brand use and exploitation and invest in promotion and advertising, since aforementioned expenses will not be considered by the tax authority as strictly indispensable, and therefore not deductible for income tax purposes, even considering that the Chamber's decisions are not mandatory or binding.
The Chambers position regarding promotion and advertising expenses is absolute, meaning that these expenses will always be related to the increase of a brand's value and, therefore, those expenses can only be considered as strictly indispensable expenses for the brand owner.
It is important to note that, although the controversy resulted from a case that could have been argued under a Mexican tax base erosion approach from a transaction conducted between related parties (royalties), which could also be resolved under a transfer pricing adjustment. The Chamber narrowed down its analysis exclusively to the strict indispensability of the expenses and concluded that the promotion and advertising expenses are non-deductible.
The above-mentioned resulted in absolute rules regarding the promotion and advertising expenses that do not admit exceptions. In other words, those expenses in no case can be considered as strictly indispensable for conducting merchandising activities, even in the case where they have a direct impact on sales for a goods or products distributor, despite the brand's ownership.
Finally, as we mentioned, even though these isolated rulings are non-mandatory or binding for jurisdictional courts, they do established the criteria that the Chambers of the Federal Tax Court will follow and apply.