CAVINKARE PRIVATE LIMITED,CHENNAI vs. DCIT CENTRAL CIRCLE 2 (1), CHENNAI

:-3-: 1597 & 1598/Chny/2018 7. For that the Commissioner of Income Tax (Appeals) erred in disallowing 5% of exempt income u/s. 14A of the Income Tax Act towards expenditure incurred in earning the exempt income.

The brief facts of the case are that the assessee is engaged 3. in the business of manufacturing and trading of cosmetics and food products, filed its return of income for assessment years 2005-06 and 2006-07 on 31.10.2005 and 30.11.2006 declaring loss of Rs. 8,65,58,890/- for assessment year 2005-06 and total income of Rs. 2,99,54,993/- for assessment year 2006-07. The assessment for the impugned assessment years was completed u/s. 143(3) of the IT Act, 1961 (hereinafter the ‘Act’) on 20.12.2007 for assessment year 2005-06 and on 31.12.2008 for assessment year 2006-07, where the AO has made additions towards disallowance of depreciation on non-compete fees, additions towards disallowance of depreciation on vehicles u/s. 35 of the Act, disallowance of expenses relatable to exempt income u/s. 14A of the Act and additions towards deemed dividend u/s. 2(22)(e) of the Act. The assessee carried the matter in appeal before the CIT(A). The CIT(A) for the reasons stated in appellate order dated 28.12.2017 partly allowed appeals filed by the assessee, where he has sustained additions towards disallowance

:-4-: 1597 & 1598/Chny/2018 of depreciation on non-compete fees, disallowance of weighted deduction claimed u/s. 35 towards vehicles used for R&D facility, disallowance of expenses relatable to exempt income u/s. 14A of the Act and additions towards deemed dividend u/s. 2(22)(e) of the Act. Aggrieved by the CIT(A) order, the assessee is on appeal before us.

:-5-: 1597 & 1598/Chny/2018 consideration paid for acquiring patents, copyrights, know-how/ formulation and non-compete fees and as per said agreement a sum of Rs. 3 crores has been assigned for non-compete trade agreement. In pursuance to above two MoUs’ the assessee entered into a non-compete agreement dated 26.05.2004 and as per said agreement, the seller of Ruchi trademark was prevented from doing any business for a period of 10 years for which a consideration of Rs. 3 crores has been paid. The assessee has treated consideration paid in terms of non-compete agreement as an intangible asset falls under ‘any other business or commercial rights of similar nature’ as envisaged u/s. 32(1)(ii) of Act and claimed depreciation @ 25%. The AO has disallowed depreciation claimed on non-compete fee u/s. 32(1)(ii) of the Act on the ground that non-compete fees paid does not confer upon the assessee any right which would be used for the business, but it only restrains other person from carrying on his business in competition with the assessee business. Therefore, he observed that non-compete agreement between the parties restraining the other party in engaging in a competing business, does not in anyway result in any right which could be treated as an asset. The intangible asset defined in the depreciation table

:-6-: 1597 & 1598/Chny/2018 contemplates only rights acquired and capable of being exercised by the owner. Therefore, consideration paid for non-compete agreement is neither asset whether it is tangible or intangible which could be used for the business of the assessee and hence disallowed depreciation claimed on non-compete fees and added back to the total income of the assessee.

:-8-: 1597 & 1598/Chny/2018 right cannot be construed either as the license or as a commercial right to be eligible for deduction u/s. 32(1)(ii) of the Act, 1961. She further referring to decision of the Hon’ble Delhi High Court in the case of Sharp Business System vs CIT in ITA No. 492/12 dated 05.11.2012 submitted that intangibles spelt out in section 32(1)(ii) i.e., know-how, patents, copyright, trademark license/franchise as any other right of a similar kind it confers business or commercial or any other business or commercial right of a similar nature has to be intangible asset. The nature of this rights mentioned clearly spell out an element of exclusivity which ensures to the assessee as a sequel to the ownership. However, in the case of non-compete agreement, the advantage is a restricted one, in point of time and it does not necessarily confer any exclusive right to carry on the primary business activity. Therefore, said negative right cannot be construed as any other business or commercial right of similar nature which qualifies for depreciation u/s. 32(1)(ii) of the Act.

:-9-: 1597 & 1598/Chny/2018 parties. Admittedly, the assessee has paid non-compete fees in terms of an agreement which is carved out from main MoU between the parties for transfer of trademark called ‘Ruchi’. The assessee has entered into an agreement for acquiring trademark ‘Ruchi’ along with other bundle of rights and as per said MoU, the parties have entered into a non-compete agreement and restricted the seller of trademark not to have any kind of right in the business activity for a period of 10 years for which the assessee has paid consideration of Rs. 3 crores. The assessee has treated said consideration as intangible asset, being any other business or commercial right of similar nature and claimed depreciation u/s. 32(1)(ii) of the Act. The AO has disallowed depreciation claimed on non-compete fee on the ground that non- compete fee paid by the assessee neither gives rise to any kind of asset whether tangible or intangible which could be owned and transferable to third party. Therefore, he opined that non- compete fee paid by the assessee for restricting other party to restrain from doing similar kind of business activity for a particular period is nothing but a negative right which cannot be treated as intangible asset, know-how, patent, copy rights, trademark, license, franchise or any other business of the :-10-: 1597 & 1598/Chny/2018 commercial right of similar nature. The AO has given his own reasons for denying depreciation claimed on non-compete fees and, according to him non-compete fee paid does not confer upon the assessee any right which would be used for the business. However, it only restrain the other person from carrying on his business in competition with the assessee’s business. Therefore, he opined that definition of intangible u/s. 32(1)(ii), i.e., any other business or commercial rights of similar nature speaks about a kind of right which could be owned and transferable to the third party, but not to a negative rights called non-compete fee paid for restraining the other party from doing business.

7.1 We have given our thoughtful consideration to the reasons given by the AO in light of arguments of the assessee and we ourselves do not subscribe to reasons given by the AO, for the simple reason that non-compete fee is generally paid to a person who is in an advantageous position, because the payee is in a position where he can, if he so desires, create a hostile environment for the payer’s business either starting a competing business in the same field or by helping the growth of the payer’s competitor to ensure that such person does not indulge in such :-11-: 1597 & 1598/Chny/2018 competing behavior, and to ensuring that the payer can carry on business without bothering about the competition. Further, non- compete agreement are generally for specific periods and after an expiry of the period, the advantage in the non-compete agreement disappears since the payee is no longer bound by it. Hence, we are of the considered view that non-compete fee paid in pursuant to any agreement for transfer of patents, know-how, copy rights or trademark is in the nature of any other business or commercial rights of similar nature, being intangible asset, which is eligible for depreciation u/s. 32(1)(ii) of the Act. The fact that non-compete fee has not been specifically mentioned in section 32(1)(ii) would not result in a negative right inference that depreciation is not allowable on non-compete fee, because of the presence of the phrase “or any other business of commercial rights of similar nature which shows that the legislature intended clause (ii) of section 32(1) to be an inclusive clause and not an exhaustive once restricted to the assets specifically mentioned therein. Therefore, we are of the considered view that there is a merit in the argument of the assessee that non-compete fee paid for restraining the other party from doing competitive business for a specific period in pursuant to a trademark agreement is :-12-: 1597 & 1598/Chny/2018 intangible in the nature of any other business or commercial rights of similar nature which qualifies with depreciation u/s. 32(1)(ii) of the Act. This legal position if fortified by the decision of the Hon’ble Madras High Court in the case of Pentasoft Technologies Ltd vs DCIT, supra, where the Hon’ble Madras High Court considered relevant fact by following the decision of Supreme Court in the case of Techno Shares and Stocks Ltd vs CIT 327 ITR 323 held that non-compete fee paid by an assessee is in the nature of any other business or commercial right which is eligible for depreciation u/s. 32(1)(ii) of the Act. The Hon’ble High Court while deciding the issue, has laid down the ratio and held that under non-compete agreement the transferor had transferred all its rights in respect of the trademark and such right strengthen those rights under the said non-composite agreement which includes a non-compete clause by virtue of which, the transferor restrains from using the same trademark, copyrights etc. Therefore, the Hon’ble High Court held that non- compete clause under the agreement should be a supporting clause to the transferor of the copy rights and patents rather to strengthen the commercial right, which was transferred in favour of the assessee. A similar view has been taken by a Hon’ble

:-13-: 1597 & 1598/Chny/2018 Bombay High Court in the PCIT vs Ferromatic Milacron India Pvt Ltd, 2018, 99 Taxmann.com 154, where it has considered identical issue and held that non-compete fee is in the nature of any other business or commercial right of similar nature used in explanation to section 32(1)(ii) of the Act and thus, eligible for depreciation. As regard the case laws cited by the Ld. DR in the case of Sharp Business System s CIT 492/2012, although, the Hon’ble Delhi High Court taken a different view and held that non-compete fees is a kind of negative right which does not give rise to any kind of right which could be owned or transfer to third person similar to rights of any other kind of similar nature as mentioned in section 32(1)(ii). Although divergent views are expressed by two different High Courts, but because the Hob’ble Jurisdictional High Court of Madras has taken a view in favour of the assessee in the case of Pentasoft Technologies Ltd vs DCIT, we prefer to follow the Jurisdictional High Court decision which is binding in nature.

7.2 In this view of the matter and considering the ratio of various case laws, we are of the considered view that non- compete fee paid by the assessee in terms of Memorandum of :-14-: 1597 & 1598/Chny/2018 Understanding for acquiring trademark is nothing but an intangible asset in the nature of any other business or commercial rights of similar nature which qualifies for depreciation u/s. 32(1)(ii) of the Act. Hence, we direct the AO to delete the additions made towards disallowance of depreciation claimed on non-compete fee.

8.1 The ld.AR for the assessee submitted that the ld.CIT(A) has erred in sustaining additions towards disallowance of deduction claimed u/s.35 of the Act, in respect of two motor vehicles given to staff of the assessee who are working for &D unit without

:-15-: 1597 & 1598/Chny/2018 appreciating the fact that once cars are given to staff, the purpose of use of such vehicle is immaterial.

8.2 The ld.DR on the other hand supporting order of the ld.CIT(A) submitted that in order to claim deduction for any expenditure u/s.35 of the Act, it is a precondition that such expenditure should be exclusively incurred for R&D purpose. Since, the assessee has failed to file necessary evidences to prove use of car for R&D purpose, the AO has rightly denied deduction u/s.35 of the Act.

8.3 We have heard both the parties, perused materials available on record and gone through orders of the authorities below. The admitted fact was that the assessee had given cars to two staff who are working for R&D unit. In fact, the AO has not disputed claim of the assessee that cars were given to staff who are working at R&D unit. The only reason for denial of deduction is that the assessee has not furnished log book maintained by the R&D division to prove that vehicle has been exclusively utilized for R&D purpose. We have gone through reasons given by the AO, but could not subscribe to reasons given by the AO for the :-16-: 1597 & 1598/Chny/2018 simple reason that, once having accepted the fact that cars were given to staff who are working for R&D unit, then the AO is erred in denial of deduction only for the reason that log book was not filed to prove use of vehicle exclusively for R&D purpose, because it is irrelevant whether vehicles are exclusively used for R&D purpose or other than R&D purpose, but as long as the staff are working for R&D unit, then it is as good as expenditure was incurred for R&D purpose. Therefore, we are of the considered view that the AO as well as the ld.CIT(A) were erred in denying deduction claimed u/s.35 of the Act, towards motor cars provided to staff and hence, we direct the AO to delete addition made towards disallowance of depreciation.

:-17-: 1597 & 1598/Chny/2018 9.1 The ld.AR for the assessee submitted that the ld.CIT(A) has erred in sustaining addition made towards deemed dividend u/s.2(22)(e) of the Act, without appreciating fact that loan received from sister concern was in pursuant to commercial expediency because subsequent to the date of loan, the assessee and sister concern were merged by an order of High Court and thus, loan received from sister concern becomes money of the assessee, which was not intended to repay. Therefore, once amount received from sister concern looses the character of loan, then same cannot be considered as deemed dividend u/s.2(22)(e) of the Act.

9.2 The ld.DR on the other hand supporting order of the ld.CIT(A) submitted that there is no dispute with regard to the fact that loan received from sister concern and conditions prescribed for invoking provisions of section 2(22)(e) of the Act. Therefore, there is no error in the reasons given by the CIT(A) to sustain addition made by the AO and hence, his finding should be upheld.

:-18-: 1597 & 1598/Chny/2018 9.3 We have heard both the parties, perused materials available on record and gone through orders of the authorities below. There is no dispute with regard to the fact that the assessee has received loan from sister concern and further, M/s. Cavin Plastics & Chemicals P. Ltd., was having reserves & surplus in excess of loans given to the assessee. The conditions precedent for invoking provisions of section 2(22)(e) of the Act, are that if any payment is made by a company by way of advance or loan to a shareholder or to any concern in which shareholder is a member and the second condition is, the company should have accumulated profits over and above the amount of loan. In this case, admittedly two conditions prescribed for invoking provisions of section 2(22)(e) of the Act are satisfied. The only explanation of the assessee is that the purported loan availed from sister concern was not intended to repay because, two companies were subsequently amalgamated by an order of Hon’ble High Court and thus, amount received from sister concern looses the character of loan. We do not agree with arguments taken by the ld.AR for the assessee, for the simple reason that subsistence of loan or advance is immaterial but what is relevant is whether loan is outstanding at the last date of previous year relevant to the :-19-: 1597 & 1598/Chny/2018 assessment year. In other words, even if loan or advance ceased to be outstanding in the end of the financial year, it can still be deemed as ‘dividend’ if the other conditions factually exist to the extent of accumulated profits possessed by the company. This legal position is supported by the decision of Hon’ble Supreme Court in the case of Miss. P. Sarada vs. CIT, [1998] 96 Taxman 11. In this case, loan was subsistence at the end of the financial year and further, the sister company’s accumulated profits was over and above the amount of loan given to the assessee. Therefore, we are of the considered view that amount received by the assessee from sister concern clearly falls within the provision of section 2(22)(e) of the Act and thus, we are inclined to uphold the findings of ld.CIT(A) and reject ground taken by the assessee.

:-20-: 1597 & 1598/Chny/2018 income by disallowing 5% of exempt income as expenditure relatable to exempt income.

10.1 The ld.AR for the assessee submitted that the ld.CIT(A) has erred in sustaining addition made by the AO towards disallowance of expenditure relatable to exempt income u/s.14A of the Act, @ 5% of exempt income without appreciating the fact that disallowance made by the AO is excessive. In this regard, he relied upon the decision of ITAT, Chennai in the case of TIL Healthcare Pvt. Ltd., vs. DCIT, ITA No.1808/Mds/2014.

10.2 The ld.DR on the other hand supporting order of the ld.CIT(A) submitted that when assessee is not maintaining separate books of accounts for investment activity, the AO has to determine expenditure relatable to exempt income on estimation basis and thus, there is no error in disallowance computed by the AO.

10.3 We have heard both the parties, perused materials available on record and gone through orders of the authorities below. Admittedly, prior to assessment year 2008-09, the provisions of :-21-: 1597 & 1598/Chny/2018 Rule 8D was not applicable for determining disallowance of expenditure u/s.14A of the Act. It is also an admitted fact that prior to assessment year 2008-09, various Courts and Tribunals have directed the AO to estimate 2 - 3% of exempt income towards expenditure relatable to exempt income u/s.14A of the Act, depending upon facts of each case. The ITAT, Chennai in the case of TIL Healthcare Pvt. Ltd., supra, has considered an identical issue and restricted disallowance to the extent of 2% of exempt income instead of 5% as computed by the AO. Therefore, considering facts and circumstances of this case and also consistent with view taken by the Co-ordinate Bench in the case of TIL Healthcare Pvt. Ltd., we direct the AO to restrict disallowance of expenditure relatable to exempt income u/s.14A of the Act, to the extent of 2% of exempt income earned for the year.

:-23-: 1597 & 1598/Chny/2018 14. The next issue that came up for our consideration from Ground Nos.6 to 10 of assessee appeal is disallowance of expenditure relatable to exempt income u/s.14A of the Act. We find that an identical issue had been considered by us in ITA No.1597/Chny/2018 for assessment year 2005-06. The reasons given by us in preceding para No.10.3, in ITA No.1597/Chny/2018, for assessment year 2005-06 shall clearly apply to this appeal as well. Therefore, for similar reasons we direct the AO to restrict disallowance of expenditure relatable to exempt income @ 2% of exempt income earned for the year.

Order pronounced in the court on 8th October, 2021 at Chennai.