ECO AXIS SYSTEMS P.LTD,MUMBAI vs. DCIT RG 2(1), MUMBAI

O R D E R Per Rajesh Kumar, Accountant Member

This appeal by assessee arises out of the order of the CIT(A) – 4 , Mumbai, dated 08.11.2011, which in turn has arisen out of the order passed by the Assessing Officer u/s. 143(3) of the Income Tax Act, 1961 (hereinafter referred to as “the Act”) relating to A.Y. 2008-09.

“1. Learned Commissioner of Income Tax (Appeals) [CIT(A)] has erred in confirming the action of the Assessing Officer (AO) in holding that receipt on sale of 3 Alygn Machines of Rs. 59,20,849/- and rent of Rs. 64,200/- is a revenue receipt liable to tax. On the facts and in the circumstances of the case, the Ld. CIT(A) ought to have directed the AO to reduce the aforesaid amounts from the Capital Work in Progress (Product Development Expenditure (RCS)).

Eco Axis Systems Private Limited

2. Without prejudice to Ground 1, the Ld CIT(A) has erred in confirming the action of the AO in not allowing deduction of indirect expenses of Rs.44,21,635/- while treating the receipt on sale of 3 Alygn Machines as revenue receipt. The Ld. CIT(A) has further erred in holding that indirect expenses are overhead expenses and they are not directly connected or identifiable with the machines sold. On the facts and circumstances of the case, indirect expenses of Rs. 44,21,635/-, which are debited to Capital Work in Progress, ought to be allowed as deduction in taxing the receipt on sale of 3 Alygn Machines as revenue receipt.

4. Ld. CIT(A) has erred in confirming the disallowance of expenses of Rs. 51,15,880/- made by the AO by treating these expenses as relatable to Capital Work in Progress (CWIP) and thus, capitalising the same to CWIP. On the facts and circumstances of the case and in law, the said expenses ought to be allowed as revenue expenditure.” 3. The issue raised in ground no.1 is against the confirmation of the action of the Assessing Officer in holding the receipt on sale of 3 Alygn Machines for ` 59,20,849/- and rent of ` 64,200/- as revenue in nature and liable to taxed.

According to the assessee the same were capital in nature as the said sale was made of trial/demo machines and the rent was received when the project was in the development stage and the expenditure incurred in connection there with were debited to the capital Work-in-progress account (Product development Expenditure (RCS)). The facts in brief are that the assessee is engaged in the business of providing integrated solutions, Machine-to-machine technology (M2M), a concept wherein the performance of industrial equipment is remotely monitored, analyzed and corrected to improve machine and process reliability. During the assessment

Eco Axis Systems Private Limited proceedings, the Assessing Officer noticed that the assessee has closing work-in- progress at ` 5,67,66,927/-, which is comprised of following:

` 91,33,547/- Capital WIP (Software) Product Development expenses (RCS) ` 1,87,33,460/- Product Development expenses (RMD) ` 2,88,99,921/- Total ` 5,67,66,927/- The Assessing Officer further observed that the assessee has credited income totaling to ` 59,20,849/- from the sale proceeds of 3 Alygn Machine to M/s. Raja Biscuits, M/s. Cole and M/s. Esdee and rent income of ` 64,200/- to Capital Work-in- progress account. Accordingly, the assessee was asked to explain as to why the same should not be treated as sale for the year under consideration, to which, the assessee vide letter dated 06.08.2010 submitted that the assessee company is developing M2M and RCS product which is under development stage and all the expenses incurred/income received in connection there to were debited/credited under the head product development expenditure. The assessee submitted before the Assessing Officer that the sale realization of ` 59,20,846/- were from trial/demo products/machines and, therefore, credited to Product Development Expenditure as it was the during the development period of the product. The assessee has relied on couple of decisions viz. CIT vs. Bokaro Steel Ltd. (SC) 236 ITR 315; Indian Oil Panipat Power Consortium Ltd. vs. ITO 315 ITR 255 (Del) to defend its case. The submissions of the assessee did not find favour with the Assessing Officer and the Assessing Officer treated the sale as sale of fully developed machines as per the alterations required to suit the buyer. The Assessing Officer also distinguished the Eco Axis Systems Private Limited case laws relied upon by the assessee and thus, after allowing expenses of ` 14,75,553/- made net addition of ` 45,09,496/-.

“5. I have considered the facts of the case and submissions of the assessee. Product development is a continuous process of the assessee and it keeps on going, whereas, A.O. has rightly observed that the machine sold must have been either complete and required no further development or they must have been at a stage which could be commercially or industrially used by the buyer and, therefore, sale of the machine should be treated as income of the assessee and need not be reduced from cost of the products. The claim of the assessee that it has given a different treatment in the books of account will have no impact on the taxability of any such receipt because assessee can give any treatment as it likes or as may be recommended by accounting bodies but for income-tax purposes it is not necessary that the same view is followed. The sale consideration is clearly taxable. The case law cited by the assessee have already been dealt by the A.O. and I fully agree with the A.O. on this issue that the facts of the assessee's case are different from the facts of the case laws cited by the assessee. Therefore, the sale consideration on sale of the three machines is taxable in the year under consideration and similarly rental income is also taxable in the year under consideration because product development

6. The assessee has also claimed that while treating the sale of three machines and rental income as income pertaining to this year and taxable, A.O. has only allowed the direct expenses and indirect expenses have not been allowed. Whereas, indirect expenses are overhead expenses and they are not directly connected or identifiable with the three machines sold by the assessee. There is no reason or basis for allocation of any indirect expenses to the machine sold. In any case, it is not that these expenses are not allowed to the assessee. They are allowed to be capitalized as cost of the other major products and, therefore, this claim of the assessee is also rejected.

7. The assessee has also claimed that the purchase cost has been wrongly allowed and it should have been higher amount, whereas, A.O. has properly considered and allowed the purchase cost. If there is any Eco Axis Systems Private Limited

such mistake then the assessee could have applied for rectification u/s. 154 but assessee does not appear to have applied for rectification because no such evidence has been filed and, therefore, the claim of the assessee is rejected. In result, the grounds of appeal of the assessee are dismissed.”

Eco Axis Systems Private Limited and entail huge financial loss. The learned AR also brought to the notice of the Bench the classification of the said expenses as Capital Work-in-progress including Product Development Expenses shown under the head ‘Fixed Assets’ and the amount during the year was ` 5,67,66,727/- viz-a-viz ` 2,09,38,494/- in the corresponding previous year. While referring to page 257 of the paper-book, the learned counsel submitted that the said fact was duly disclosed by the assessee by way of note under the Schedule 18 “Notes to account”, stating that Capital Work-in- progress represents Project Development Expenses incurred in developing company’s products and after completion of the project i.e. available for commercial sale, the expenses will be amortized based on economic useful life as estimated by the management and similarly goodwill (included as intangible asset under fixed asset) will also be amortized from the period the project development expenses are capitalized. It was also stated in the said note that company had sold trial/demo machines during the year, which were regarded as projects under development and pending the completion of project, sales amounting to ` 59,20,849/- were reduced from the Project Development Expenses. The learned AR further argued that the department has not doubted the fact that the projects were under development during the year in as much as the revenue has not disputed the capitalization of the expenses. He further pointed out that in the next year the assessee has capitalized the expenses by referring to the tax audit report, which was placed before the Bench, wherein the assessee has capitalized the amount to the tune of ` 2,78,61,279/- under the head intangible assets sub head Alygn Register Control System. Thus, the learned counsel argued that the approach of the department is Eco Axis Systems Private Limited wrong and inconsistent in view of the fact that the department has allowed the expenses to be capitalized during the trial without disputing the same whereas disputed the receipts from sale of demo/trial products and rent recoveries as capital in nature. The learned AR further brought to the notice of the Bench the Guidance Note on Treatment of Expenditure during the construction period and submitted that the said guidance note specifically provided in para 11.4 that whatever income is earned during the trial run through sale of the merchandise produce or manufactured products, the same should be set off against the indirect expenditure incurred during the period of development /test runs. He further referred to other paras of the Guidance Note viz. 15.2 and 17.11 to reinforce his arguments. Finally, the learned AR submitted that the order of the CIT(A) is bad in law in view of the fact that the sale of demo/trial products were treated as normal sale and, thus, denied the assessee set off against the revenue expenditure incurred on product development, which was in progress during the year. While relying on the decisions of the Tribunal in the case of International Seaports (Haldia) Pvt. Ltd. in for A.Y. 2004-05 and Gujarat State Fertilizers & Chemicals Ltd. in ITA No. 3228 & 3358/Ahd/2003 for A.Y 1999-2000, the learned AR pleaded that the order of the CIT(A) may be set aside and the Assessing Officer be directed to reduce the amount of sale of Alygn machines from the three parties as also the rental receipts from the Project Develop Expenses account as has been claimed by the assessee.

6. The learned DR, on the other hand, heavily relied on the orders of the authorities below and submitted that the sale of three machines to three different

Eco Axis Systems Private Limited parties represented regular sales and not sale of trial/demo products during the Product Development as the assessee has fully developed the machines and the same were altered and tuned to the requirements of the respective buyers. The learned DR also distinguished the decisions relied upon by the learned AR by submitted that the facts of these cases are different and, therefore, the same are not applicable to the case of the assessee.

During the year the assessee sold three Alygn machines to three different parties in order to test the reliability and suitability when the project was not finalized and still in the development stage. According to the assessee it was sale of demo/trial products and, therefore the same was credited to the Product Development expenses account to the tune of ` 59,20,849/-. Similarly, recovery of rent from contractors who were doing contract at the factory premises were credited to the tune of` 64,200/-. Now the issue before us is whether the said revenue by way of sale and rental income constitutes revenue income or a capital receipt during the year.

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8. Having considered the facts of the case in totality, we find that the Revenue has not doubted the development of products by the assessee and allowed capitalization of expenses but at the same time the Revenue has chosen to treat the sale of demo machines to the tune of ` 59,20,849/- and recovery of rent amounting to ` 64,200 as revenue receipt and added the same to the income of the assessee after allowing the expenses of ` 14,75,553/-. The case of the assessee also finds support from the Guidance Notes issued by the Institute of Chartered Accountants of India on treatment of expenditure during construction period, which provides that if any revenue is realized during the trial run or product development stage, the same should be set off against the expenditure incurred in connection with the said project/products. The case of the assessee is also squarely covered by the decisions relied upon by the learned AR. In the case of International Seaports (Haldia) P Ltd.vs. ITO (supra), the co-ordinate Bench has held as under:

the facts of the case since it was done at the behest of the Holdia Dock Complex authorities in order to establish the stability of the berth. It is an admitted fact that even during a period of test runs and experimentation, a plant may be engaged in actual production, but until the test runs are completed and the plant is properly adjusted on the basis thereof, it cannot be said to be ready for “commercial production”. The expression “Commercial Production” refers to production in commercially feasible quantities and in a commercially practicable manner. Further, it is a correct and accepted procedure to capitalize all expenses incurred during construction period and in connection with the process of start-up and commissioning of the plant. In fact, such expenses would be incurred in order to bring the plant up to the stage at which it can commence commercial production. Thus, it is correct to capitalize the expenditure incurred on start-up and commissioning of the plant. The expenditure so incurred, therefore, should be capitalized in the same way as other indirect construction expenditure. In the present context, therefore the expenditure incurred during trial run contributes to construction of the facilities at Berth No. 4A of Haldia Dock Complex as trial run activity is regarded as an activity which is necessary to prepare the asset for its intended use. This is because flaws in the facilities at Berth noticed during trial run operation are rectified to bring the Berth to its intended use. Therefore, the expenditure incurred during trial run towards building/constructing the Berth should also be capitalized as per the requirements of Accounting Standard 166. It is also an undisputed fact that operation of cargo / vessel during trial run was directly linked with the building up of facilities in the Berth No. 4A of Haldia Dock Complex. Hence, any income earned on such operation during trial run was incidental to the building of assets for setting up the Berth. Therefore, income earned during preoperative stage was a capital receipt, which would go to reduce the cost of asset and it is settled that the deposit of money was directly linked with the purchase of plant and machinery. Hence, any income earned on such deposits was incidental to the acquisition of assessee for setting up the plant and machinery. Thus, the interest was a capital receipt which would go to reduce the cost of the asset and Ld AR relied on the decision of Hon’ble Supreme Court in the case of CIT v. Karnal Co-operative Sugar Mills Ltd. (2000) 243 ITR 2 (SC) and C.I.T. Vs. Bokaro Steel Limited.(1999) 236 ITR 315 (SC)

9. From the aforesaid discussion, we find that the assessee has made some income during the period of trial run and the same was adjusted against the pre-operative expenses. The AO rejected the working of assessee and held that the income generated during the trial run income period cannot be adjusted against the preoperative expenses and the same was confirmed by the Ld. CIT(A). However, we observe that it was the condition in the agreement that the trial run has to be Eco Axis Systems Private Limited

carried out before the beginning of commercial operation. The ld. AR drew our attention on pages 17,18,19,20,21 of the Paper Book where the requirement for the trial run was requested before the beginning of actual operation. The purpose of the trial run was to check whether there is any flaw in the system or not so that remedial action can be taken well in time in the event of any flaw in the system. So it is clear that the purpose of the trial run was to check the flaw in the system and not to begin the commercial operations. In the instant case the trial run was successfully completed on dated 13/1/2004 without any flaw in the system. Therefore the commercial operation began immediately thereafter on dated 15/1/2004. Now the question here arises that in case of any flaw caught during the trial run then in that event certainly the commercial operation shall only begin after the removal of the flaw. In view of this the income generated during trial run shall certainly be adjusted against the pre-operative expenses. Having said this we are inclined to reverse the order of the ld. CIT(A) and direct the lower authorities to adjust the trial run income from preoperative expenses of the assessee. We are relying on the judgment of the Delhi High Court in the case of Commissioner of Income Tax Vs.Nestor Pharmaceuticals Limited 322 ITR 631 where it was held that :

“The assessee was in the business of manufacture of pharmaceutical formulation in bulk drugs and supplying drugs to the Government hospitals, institutions besides selling the product in domestic and foreign markets. It claimed the benefit under section 80-IA/80-IB of the Income-tax Act, 1961. It carried out trial production from March 20, 1998. On that basis the Assessing Officer treated the assessment year 1998-99 as the initial year for the benefit claimed and since this benefit was allowable for five years, according to the Assessing Officer, this benefit was admissible from the assessment year 1998-99 to the assessment year 2002-03. The assessee on the other hand claimed the benefit from the assessment years 1999-2000 to 2003 -04. The plea of the assessee was that trial production did not amount to manufacture of its products. It was only when commercial production commenced, which, according to the assessee, commenced only in the assessment year 1999-2000 that production commenced. The Commissioner (Appeals) confirmed the order of the Assessing Officer but the Tribunal reversed that order holding that section 80-IA/80-IB of the Act being beneficial legislation, the benefit should be extended to the assessee. It further held that as on March 20,1998, only trial production started which was different from commercial production and the benefit of that section should be allowed in the year in which commercial production started, i.e. in the assessment year 1999-

Eco Axis Systems Private Limited

2000 and, therefore, would be extendable up to the assessment year 2003-04. On appeal :

Held, that the initial assessment year, for the purpose of section 80-IA, was the assessment year relevant to the previous year in which the “industrial undertaking begins to manufacture or produce articles or things”. The trial production began on March 20, 1998, as per the details given in the audit report furnished by the assessee along with its returns of income for the assessment years 2003-04 and 2004-05. There was no dispute that the first sale was made on April 23,1998, which would be the period relevant to the assessment year 1999-2000. Merely because some closing stock was shown as on March 31, 1998, that would not lead to the conclusion that there was commercial production as well. Even for the purpose of trial production material would be needed and there would be production which would result in stock of finished goods. The evidence produced by the assessee was accepted by the tribunal as well, from which it was clear that there was only a trial production in the assessment year 1998-99 and commercial and full-fledged production commenced only in the year 1999-2000. The order of the Tribunal allowing the benefit of deduction under section 80-IA/80IB of the Act from the assessment year 1999-2000 treating it as the initial year of production to the assessment year 2003-04 was correct in law.

The Tribunal held that the assessee had not only produced the goods for trial purposes but there was, in fact, sale of one water cooler and air-conditioner in the assessment year 1998-99 relevant to the previous year/financial year 1997-98. The explanation of the assessee was that this was done to file the registration under the Excise Act as well as the Sales tax Act. The Tribunal held that the sale of one water cooler and one air- conditioner as on March 31, 1998, for the purpose of obtaining registration of excise and sales tax was manufacture within the meaning of section 80-IA. On appeal :

Held, that the assessee had sold one water cooler and one air- conditioner before April, 1998. Thus, the stage of trial production had been crossed and the assessee had come out with the final saleable product which was in fact sold as well. The quantum of commercial sale would be immaterial. With sale of those articles marketable quality was established, more particularly when the assessee failed to show that the dealer returned those goods on the ground that there was any defect in the water cooler or air- conditioner produced and sold by the assessee to the dealer. The Eco Axis Systems Private Limited

Tribunal, in the circumstances, was right that the two types of conditions stipulated in section 80-IA were fulfilled with the commercial sale of the two items in that assessment year. Whether the purpose of that sale was to obtain registration of excise or sales tax would be immaterial.”

The Bombay High Court has also decided the similar issue in favour of assessee in the case of CIT Vs. Hindustan Antibiotics Ltd.(1974) 93 ITR 548 (Bom) and relevant extract of the order is reproduced below :

“The word “articles” used in the expression “has begun or begins to manufacture or produce articles “in section 15C(2)(ii) must be interpreted regard being had to the object for which the section was enacted. The provision was enacted with a view to encouraging the establishment of new industrial undertakings and the object was sought to be achieved by granting exemption from tax on profits derived from such undertakings during the first five years. The object of the section presupposes that profits are capable of being earned. Hence, until an assessee reaches a stage where it is in a position to decide that a final product which can be ultimately sold in the market can be manufactured it cannot be said to have started manufacture of the articles. If it becomes necessary for an assessee to produce a trial product at an earlier stage to verify whether it can be used ultimately in the manufacture of the final article, the commencement of operation for the manufacture of the trial product would not constitute commencement of manufacture of articles for the purposes of section 15C.

The assessee-company undertook a project for the manufacture of penicillin. It started actual operations for the manufacture of crude penicillin in December 1954. The first samples of crude penicillin were required to be sent to U.S.A. and U.K. for obtaining certificates as to their qualities. The certificates were obtained in June, 1955, and the assessee started regular production of sterile penicillin, the only product that could be sold in the market, in August, 1955. On the question when the manufacture of sterile penicillin had started and whether the assessee was entitled to the exemption under section 15C for the assessment year 1960-61 :

Held, on the facts, that production of articles by the assessee had begun only in August, 1955. The benefit of the exemption under section 15C arose to the assessee for the first time in the assessment year 1956-57 and, therefore, it was entitled to the Eco Axis Systems Private Limited exemption under section 15C for the assessment year 1960-61 also.”

Similarly, in the case of Gujarat State Fertilizers & Chemicals Ltd. (supra), the co - ordinate Bench has held as under:

guidelines of the ICAI, we are in agreement with the Id. CIT(A) that any attempt to tax the production, which is already accounted for as input for the fertilizer plant and the captive inputs of other units utilized in Ammonia IV Plant, if not allowed to be set off against the production of the plant, would lead to a distorted picture of the accounts of M/s. GSFC. In these circumstances, especially when Revenue have not placed before us any material contrary to the aforesaid findings of the Ld. CIT(A) in so far as addition of Rs. 10,99,25 ,676 is concerned nor pointed out any contrary decision, we have no hesitation in upholding the findings of the Id. CIT(A) while relying upon the decision of the Hon'ble Apex Court in Bokaro Steel Ltd.. Therefore, ground no.1 in the appeal of the Revenue is dismissed.

Besides, the assessee has also capitalized out of the Capital Work-in progress account in the next year as is apparent from the tax audit report filed by the assessee before us. Under these circumstances, we are not in agreement with the conclusion drawn by the CIT(A) that the receipts from sale of 3 Alygn Machines amounting to ` 59,20,849/- and rent of ` 64,200/- received during the trial/demo run is revenue in nature. Accordingly, we set aside the order of the CIT(A) and direct the Assessing Officer to allow deduction of the said receipts by way sale of machines and rent from the Product Development Expenditure Account. We order accordingly.

10. The next issue in Ground no.4 is with regard to confirmation of disallowance of ` 51,15,880/- by the CIT(A) as made by the Assessing Officer by treating the expenses as relatable to Capital Work-in-progress. The facts in brief are that during the course of assessment proceedings it was observed that the assessee allocated

Eco Axis Systems Private Limited expenses incurred during the year to the Project Development Expenses being capital work in progress for the products being developed by the assessee and part of the said expenditure was treated as expenses attributable to earning of revenue receipts during the year. The assessee has apportioned 90% of the expenses which are common in nature to Product Development Expenses and 10% have been apportioned to the income received during the year whereas in some other expenses charged to profit and loss account the same ratio has not been followed by the assessee, details whereof is appended in para 6 of the assessment order.

The Assessing Officer came to the conclusion that the assessee has debited to the profit and loss account the expenses without justification and accordingly, the assessee was show caused as to why the same ratio of 10:90 should not be applied to other expenses also. Thereafter, the assessee replied to the show cause notice, which did not find favour with the Assessing Officer and he worked out the disallowance of ` 51,15,880/- and added it to the total income of the assessee, the details thereof is given in para 6.3 of the assessment order.

“I have considered the facts of the case and submissions of the assessee. If common expenses have been apportioned by the assessee itself in the ratio of 9:1 between product development expenses and the income received during the year then logically the other expenses should have also been incurred in the same ratio and, therefore, I agree with the A.O. Hence, this ground of appeal is rejected.”

Eco Axis Systems Private Limited

Eco Axis Systems Private Limited appellate authority was highly subjective and, therefore, the order of the CIT(A) should be upheld.

Order pronounced in the open court on this day of 10th August 2018.