“Advertising expenses: To deduct or not to deduct?” by Aaron C. Escartin (May 23, 2011)

SUITS THE C-SUITE By Aaron C. Escartin
Business World (05/23/2011)

Companies have always relied on advertising as a means of raising product awareness to generate sales and increase market share. Given the high level of competitiveness in today’s businesses, particularly for fast-moving consumer goods, media advertising has become equally competitive.

Of course, effective advertising comes at a significant expense — one that can reach billions of pesos. In fact, a Nielsen report released last month showed that Philippine advertising spending for television for the first quarter of 2011 reached P43.43 billion. This excludes the total ad spending for radio, print and other media, including the Internet.

Since advertising expenditures can be significant, it is important to determine how they can be translated in a company’s financial report, and eventually in the tax return. Should these be recognized as incurred, or should they match the projected revenues?

For financial accounting purposes, advertising and promotional expenses should be recognized and claimed as deductions in the period when they are incurred.

However, for income tax purposes, this is not always the case. The deductibility of these expenses hinges on the facts surrounding the incurrence of these expenses, and if these meet the criteria specified by the tax rules for deductibility, including whether the purpose of the advertising is for current or future benefit. Once determined to be deductible, advertising costs may be expensed or capitalized.

Generally speaking, the Tax Code provides that for expenses to be deductible, these should be: (a) ordinary and necessary; (b) paid or incurred within the taxable year; (c) paid or incurred in carrying on the trade or business; and (d) supported by pertinent documentation.

Ordinary expenses generally include expenses which are directly connected with, and proximately resulting from, carrying on the business and must be shown to be appropriate and helpful in the development of the taxpayer’s business in the acquisition or pursuit of income or profit.

In Collector of Internal Revenue vs. The Philippine Education Co., Inc. (G.R. No. L-8505 dated May 30, 1956), the Supreme Court held that the term ‘ordinary’ as used in the statutes does not require that the payments be habitual or normal in the sense that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particular taxpayer affected. As it relates to advertising expenses, ‘ordinary’ means that the amount incurred should be reasonable and should not be considered as a capital outlay to create “goodwill” for the product or the company itself.

Advertising expenses should be qualified as to the specifics in which these were incurred, to determine when these should be claimed as income tax deduction. Normally, advertising expenses which are incurred to stimulate current sales are considered as business expenses. As such, these could be claimed as income tax deduction in the period when they are actually incurred.

However, if these are incurred to stimulate future sales and the amount involved is inordinately large, these would be considered as a capital expenditure to be spread over a reasonable period of time. This was the Supreme Court’s holding in Commissioner of Internal Revenue vs. General Foods (Phils.), Inc. (G.R. No. 143672 dated April 24, 2003). If these are incurred to stimulate future sales, it connotes expenditures to create or maintain some form of goodwill or protection of the brand franchise.

Also, inordinately large expenses are not considered ordinary expenses since it will appear that these are not normally incurred every year. In the General Foods case, the Supreme Court held that the amount of media advertising expense spent for the promotion of a single product, which accounts for one-half of the petitioner’s entire claim for marketing expenses for the year under review, is unreasonable based on the circumstance. Though the Court decision provided that these advertising expenses are considered as capital expenditures, it did not specifically rule on how long these expenses should be amortized. Still, the reasonable period of time may appear to be the number of years when the company will benefit from the expense.

One area of concern is that there are no clear-cut criteria or fixed tests to determine the reasonableness of an advertising expense. Since there is no hard and fast rule on the matter, the Supreme Court provided guidance in the General Foods case that the right to a deduction depends on a number of factors such as but not limited to: the type and size of business in which the taxpayer is engaged; the volume and amount of its net earnings; the nature of the expenditure itself; the intention of the taxpayer and the general economic conditions. It is the interplay of these, among other factors, and properly weighed, that will yield a proper evaluation.

The challenge may lie in advertising campaigns that involve stimulating current sales as well as building the brand to generate future sales. Arguably, any type of advertising contributes incrementally to the brand experience and reputation, and thus, future sales. Moreover, since the tax treatment may differ from the accounting treatment, differences in values may arise. It is likewise important that any resulting reconciling item between books be properly accounted for. After all, beyond just consumer-related advertising, having a reputation as a company that is meticulous and practices financial prudence is also another form of long-term brand-building.

(Aaron C. Escartin is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.