D.C.I.T. 8(3), MUMBAI vs. SANOFI SYNTHEABO (INDIA) LIMITED, MUMBAI

The first issue in for the A.Y. 2004-05 is as regards to the order of CIT(A) deleting the addition by treating pre-mature termination compensation as Revenue expenditure. For this Revenue has raised following two grounds:-

Briefly stated facts are that the AO during the course of assessment proceedings required the assessee to explain pre-mature termination compensation claimed as Revenue expenditure. The AO also issued show-cause as to why the payment of compensation be not treated as capital expenditure. The assessee replied that it has decided in May 2003 that instead of manufacturing products for which it has manufacturing license under toll arrangement, it was advantageous to have contract manufacturing arrangement. The assessee company having manufacturing license for Cordarone, Valparine, Fortagesic, Jumex, Ladogal, Tyklid but having no manufacturing facility and accordingly it entered into a toll manufacturing arrangement with Torrent Pharmaceuticals ltd. vide agreement entered on 12-09-1996 and which was subsequently amended on 14-02-2002. This amended agreement provided validity of two years from the date of amendment and it also provided that in case of per-termination of agreement not due to fault of Torrent, the company would pay compensation as per clause 3(b) of the amended agreement. The assessee filed copy of amended agreement dated 14-02-2002 before the AO. But AO was of the view that by paying this amount the assessee has got enduring benefit by way of reduction in manufacturing cost of coming years. Hence, he observed that, had onetime payment not been made by assessee, the assessee would have lost recurring income. Accordingly, he treated the termination charges as capital in nature. Aggrieved, assessee preferred appeal before CIT (A), who allowed the claimed of the assessee by observing in Para 2.8 as under:-

We have heard the rival contentions and gone through the facts and circumstances of the case. Before us, the learned Counsel for the assessee Shri J D Mistry, Senior Advocate referred to loan license agreement dated 12-09-1996, amended loan license agreement dated 14-02-2002 and termination agreement dated 07-06-2003. It was argued that the amended agreement provided for the validity of the main agreement for two years from the date of amendment and it has also provided that in case of termination of agreement not due to any breach or fault or negligence of Torrent, the assessee Co. would pay compensation as per Clause 3(b) of the amended agreement. On perusal of the loan License Agreement, we find that the said agreement was made for the period of total 7 years and this is clear from Article 9.1 of the agreement. The consideration (as per Article 7) agreed upon was a fee corresponding ID ten percent (10%) of the net sales of the products manufactured and processed by Torrent. The ‘net sales’ was defined to provide for certain deductions from the sales invoices and it was agreed that from the invoice value the deduction was to be made as under:- i) freight and insurance included in the price; We further find that the above terms were amended vide the amendment dated 14.02. 2002 that the consideration was revised from 10% to 16% at the net sales of the products and the definition of 'net sales' was revised. As per the revision of this definition reasonable rebates allowed to the customers were no longer deductible from net sales. The term of the license Agreement was reduced to two years effective from the date of the amendment i.e. up to 13-03-2004. Even in original agreement, in the event of termination of the agreement on account of Government discontinuing issuing/renewing FDA loan License allowing to perform the agreement, it was provided that the parties would discuss the possible remedies. Further, in the amendment agreement it was specified that in the event of termination, the company would pay to Torrent 6% of Net Sales calculated for the remaining period of the Agreement on the average of Net Sales of the past 6 months of the discontinuation of the agreement. This agreement was subsequently terminated vide dated 07-06-2003 with Torrent and terminate the loan license agreement effective as of 30-06-2003 and the compensation for early termination was also agreed upon as is specified in articles 2 & 3 of this agreement. The compensation of Rs.98.65 lacs was paid as per this agreement.

On the basis of the above facts, the deduction of compensation paid for early termination of Toll Manufacturing Agreement was claimed by assessee and AO disallowed the claim on the ground that the assessee got enduring benefit by way of reduction in the manufacturing cost in coming years. According to him the expenditure was capital in nature because the assessee had made onetime payment of compensation to Torrent Pharmaceuticals Ltd., for termination agreement to avoid any loss of recurring nature in the future by way of payments under the toll manufacturing agreement. But we are of the view that onetime payment was not conclusive test of enduring benefit. For this Ld. Counsel relied on the decision of the Hon’ble Supreme court in the case of Alembic Chemical Works Co. Ltd., Vs. CIT (1989) 177 ITR 377 (SC). For this, we are of the view that since the early termination compensation was paid with view to reduce the 5 ITA No. 6755 & 7592/ Mum/2011 cost of manufacturing, it was related to carrying on/conduct of the business of the assessee and thus it was to be regarded as an integral part of the profit earning process and not for acquisition of an asset or a right of a permanent character or the possession of which is a condition of the carrying on of the business and hence the expenditure was allowable as revenue expenditure. For this view of ours, we are placing reliance on the decision of the Hon’ble Supreme court in the case of Alembic Chemical Works Co. Ltd. (supra), wherein it is held as under: - “The improvisation in the process and technology in some areas of the enterprise was supplemental to the existing business and there was no material to hold that it amounted to a new or fresh venture The further circumstance that the agreement pertained to a product already in the line of the assessee’s established business and not to a new product indicates that what was stipulated was an improvement in the operations of the existing business and its efficiency and profitability not removed from the area of the day-to-day business of the assessee’s established enterprise. It appears to us that the answer to the questions referred should be on the basis that the financial outlay under the agreement was for the better conduct and improvement of the existing business and should, therefore Be held to the revenue expenditure Reference may also be made to the observations of this court in CIT Vs Ciba of India Ltd [1968] 69 ITR 69. There is also no single definitive criterion which by itself, is determinative as to whether a particular outlay is capital or revenue The ‘once for all’ payment test is also inconclusive What is relevant is the purpose of the outlay and its intended object and effect, considered in a common sense way having regard to the business realities In a given case, the test of ‘enduring benefit’ might break down In CIT Vs Associated Cement Companies Ltd [1988] 172 ITR 257 (SC) at p 262, this court said: As observed by the Supreme Court in the decision in Empire Jute Co Ltd Vs CIT [1980] 124 ITR 1 (SC) that there may be cases where expenditure, even if incurred for obtaining an advantage of enduring benefit, may, none the less, be on revenue account and the test of enduring benefit may break down It is not every advantage of enduring nature acquired by an assessee that brings the case within the principles laid down in this test What is material to consider is the nature of the advantage in a commercial sense and it is only where the advantage is in the capital field that the expenditure would be disallowable on an application of this test.”

Form the above ratio of Hon’ble Supreme Court in the case of Alembic Chemical Works Co. Ltd and the facts of the present case that the assessee Co. decided that instead of manufacturing the products, for which it had manufacturing licenses under toll arrangements, it was advantageous to have contract manufacturing arrangements. Accordingly, the assessee terminated 6 ITA No. 6755 & 7592/ Mum/2011 pre-maturely the agreement with the Torrent Pharmaceuticals Ltd. and paid compensation as per the terms of agreement, as discussed above in detail. The compensation paid for pre-mature termination of agreement to reduce the cost and increase profitability is a business decision and assessee is already in the product of line of the business and not a new product is developed by the assessee by virtue of payment of this compensation. Accordingly, we are of the view that this is a revenue expenditure and allowable as deduction. We find no infirmity in the order of CIT(A) and hence the same is confirmed. This issue of Revenue’s appeal is dismissed.

The next ground in this appeal of Revenue in for the A.Y. 2004-05 is against the order of CIT(A) deleting the disallowance made by AO on account of product development expenses u/s 37(1) r. w. s 35(1) of the Act. For this Revenue has raised following ground:-

Brief facts leading to the above issues are that the AO during the course of assessment proceedings noticed from the accounts of the assessee Schedule 40 that it has debited a sum of Rs. 92.98 lacs as product development charges. The AO required the assessee to explain and justify its claim. The AO after going through the details noted that these expenses are in the nature wherein a new product has been created or developed and a new source of income is generated by the assessee. Hence, the AO disallowed the claim of deduction. But, CIT(A) allowed the claim of the assessee by observing as under: - 3.9 I have considered the submissions made by the AR as well as the documents submitted to support the appellant company’s claim for product development expenditure u/s 35(1) and u/s 37 of the Act. I am accepting all the fresh documents submitted by the appellant during the appeal proceedings as the AO has not furnished any reason for not taking them on record in two remand reports submitted by him. Upon perusing the service agreements and the dossier submitted, I am of the view that the services rendered by MJ Bio Pharma Pvt. Ltd and Medreich Sterilab Ltd would be in 7 ITA No. 6755 & 7592/ Mum/2011 the nature of scientific research covered u/s 35(1) finds support in Hon’ble ITAT Delhi decision in the case of Escorts Ltd. Vs. ACIT reported in (2006) 102 TTJ (Del) 522. The Hon’ble ITAT concluded that the question whether the expenditure is revenue or capital, loses its significance while considering its deductibility because the nature of expenditure is on account of R&D and is admissible u//s 35(1)(iv). It is also noted that the Hon’ble Bombay HC in the case of CIT Vs. National Rayon Corp. Ltd, reported in (1983) 140 ITR 143 (Bom) has held that for claiming deduction u/s 35(1), it is not necessary that the research must carried on by the assessee himself. It can be claimed even if the research must carried on by the assessee himself. It can be claimed even if the research is carried on by some other person on behalf of the assessee. Thus the appellant company’s claim that product development expenses paid to two parties and not incurred in their own in- house research centre is fully supported by this Hon’ble Bombay HC’s decision. Further, it is noted that the appellant is in the business of Pharmaceutical products. The product development expenses are incurred for introducing new products in the same business line and therefore could not be considered as capital expenditure as such expenditure is incurred to increase the efficiency of the business. This conclusion finds support in Hon’ble ITAT Chandigarh Bench in the case of Glaxo Smith Kline Consumer. Healthcare Ltd. Vs. ACIT, reported in (2007) 112 TTJ (Chd) 94. The Hon’ble ITAT has decided this case by relying on apex court’s decision in the case of Empire Jute Co. Ltd. It has held that mere development and introduction of new varieties of products do not result in creation of a new line of business. It has observed by the Bench that prior to development and introduction of the new productions and post development and introduction of new products, the business of the assessee remains the same. Relying on this decision, the appellant company’s claim is well supported. Therefore, in my considered view, the addition of Rs. 92,98,000/- made in the assessment cannot be sustained. Accordingly, I direct the AO to delete the same from the assessed income. Aggrieved, now Revenue is in second appeal before Tribunal.

We have heard the rival contentions and gone through the facts and circumstances of the case. The facts of the case are that the assessee is a pharmaceutical company. The pharmaceutical products are marketed by the assessee but before that they are required to be subjected to number of tests/trials etc. so that they conform to the acceptable quality/standards. For the same the assessee carry out activities in the nature of research and development and this fact have also been recorded by the AO. The specimen agreements were self- evident of the fact that the activities were in the nature of research and product 8 ITA No. 6755 & 7592/ Mum/2011 development expenses. In case, of a pharmaceutical company these expenses are necessarily incurred for the purpose of business. The assessee company is in the business of production, sales of pharmacy products and even if it incurs expenditure for development of new products, it is expenditure on the activities of the existing business and thus it cannot be treated as an expenditure incurred on acquiring new source of business as has been erroneously held by the AO. Needless to say all pharmaceutical companies have to incur product development expenses either in its in-house R&D facilities or through others as has been done by the assessee. We are of the view that the expressions “Scientific research and Scientific research related to business" are defined in section 43(4) of the Act. Reference is being made to the definition at 43(4) (iii) which reads as under :-

We find from the decision of the Hon’ble Bombay High Court in the case of CIT Vs. National Rayon Corporation Ltd.(1983) 140 ITR 143 (Born), wherein the High Court has held that research need not be carried on by the assessee himself but can be done throughout her party on its behalf. The High Court further held that the narrow approach viz., that the present activity alone are to be considered as acceptable even then the research undertaken must be properly regarded as related to the business of the company. To take any other view must be regarded as impractical and contrary to commonsense. In the present case, we mention that assessee’s company expenditure on product development has to be regarded as the expenditure covered u/s 35(1) of the Act as held by Bombay High Court in the case referred to hereinbefore. The findings of revenue that the product development expenditure resulted in the creation of new source of income is also not justified since in the definition of the research related to business such expenditure is covered and the decision of the Bombay High Court only supports the claim of the assessee. We are of the view that the product development expense is a necessity for running of fast moving goods because of competition and continuing changes in consumer choices. This expenditure is a 9 ITA No. 6755 & 7592/ Mum/2011 recurring expenditure and need not be incurred only once for all. This expenditure merely results in enabling the assessee to carry on the business in a more efficient profitable manner being responsive to the needs of consumers but did not lead to creation of any fixed asset. Alternatively also, we have to point out that in the case of CIT Vs. Ciba of India Ltd. (1968) 69 ITR 692 (SC) and in several other High Court decisions it is held to the effect that where the expenditure on research was carried on for and on behalf of the assessee, the expenditure laid out or expended was expenditure on research related to business. The Supreme Court has also observed that nonetheless, the expenditure so incurred could be allowed as deduction u/s 37 of the Act. Even otherwise, it cannot be overlooked that u/s 35(1)(iv) of the Act is capital expenditure and is also allowable. In view of the facts of the case and case law cited above, we are of the view that CIT(A) has rightly allowed the claim of assessee and we confirm the same. This issue of revenue’s appeal is dismissed.

The next issue in A.Y. 2005-06 is as regards to the order of CIT(A) in deleting the disallowance of product development expenses of Rs.15.35 lacs and project registration expenses of Rs.12.43 lacs, thereby the total addition of Rs. 27.77 lacs. For this Revenue has raised following ground:-

As regards the issue of product development expenses, we have already allowed the issue in favour of assessee while adjudicating the appeal in for the A.Y. 2004-05 in Para 10 of this order. Taking a consistent view, we allow this issue in favour of assessee and this issue of Revenue’s appeal is dismissed.

As regards to project registration expenses the facts of the case are that these expenses amounting to Rs.12.43 lacs was disallowed by the AO by holding that they too have resulted in enduring benefit and/or creation/acquisition of intangible asset. The assessee submitted the detail of project registration 10 ITA No. 6755 & 7592/ Mum/2011 expenses i.e. an amount of Rs.5,67,215/- incurred towards cost of reference standards purchased/imported, Rs.2,79,540/- towards drug registration fees/expenses, Rs.137,565/- towards site registration fees/expenses, Rs.16,000/- towards expenses for regulatory documents and other expenses of Rs.2,41,900/-. The AO disallowed the same. The CIT(A) allowed the claim of the assessee by observing in Para 2.6 as under: - “I have considered the submissions made by the AR as well as the documents submitted to support the appellant company's claim for product registration being allowable expenditure. u/s 37 of the Act, upon pursuing the nature of expenses, submissions made, I am of the view that the product registration expenses are in the nature of revenue expenses. The appellant company's claim u/s 37 finds support in Hon'ble ITAT Chandigarh case of Glaxo Smith Kline Consumer Healthcare Ltd. Vs ACIT, reported in (2007) 112 TN (CM) 94. The Hon'ble ITAT has decided this case by relying on apex court's decision in the case of Empire Jute Co. Ltd. It has held that mere development and introduction of new varieties of products do not result in creation of a new line of business. It is observed by the Bench that prior to development and introduction of the new products and post development and introduction of new products, the business of the assessee remains the same. Relying on this decision, the appellant company's claim is well supported. Therefore, in my considered view, the addition of Rs.12.42 lacs made in the assessment cannot be sustained. Accordingly, I direct the AO to delete the net addition of Rs. 11.51 lacs from the assessed income.” Aggrieved, now revenue came in second appeal before Tribunal against the order of CIT(A).

We find that this issue is now covered by the decision of co-ordinate bench in the case of ITAT Chandigarh bench in the case of Glaxo Smith Kline Consumer Health Care Ltd. Vs ACIT (2007) 112 TTJ 94 (CHD), wherein the Tribunal has clearly held that mere development and introduction of new varieties of product and consequent registration charges do not create any new line of business or fixed asset and hence these type of expenses are to be held as Revenue expenditure. We confirmed the findings of CIT(A) and this issue of Revenue appeal is also dismissed.

The next issue in this appeal of Revenue in A.Y. 2005-06 is as regards to exclusion of provision of leave encashment and gratuity amounting to Rs.36.61 lacs and provision for date expire of stock of Rs. “On the facts and in the circumstances of the case and in law, the CIT (A) erred in directing the AO to exclude provision for leave encashment and gratuity of Rs.36,61,000/- and provision for date expired stock of Rs. 47,000/- for computing Book Profit u/s 115JB.”

We have heard rival contentions and gone through the facts and circumstances of the case. We find that the AO added the following sums in the assessment order while computing book profit u/s 115 JB of the Act but he has not considered the explanation (1)(c) of Section 115 JB (2) of the Act wherein, the book profit as per net profit is required to be increased by the amount or amounts of provision made for meeting liabilities other than ascertained provision as under:- “provision for leave encashment Rs.31,61,000 Provision for stock-expiry Rs. 47,000 Rs.32,08,000”

The next two issues in ITA No.7592/Mum/2011 for the A.Y. 2006-07 of Revenue’s appeal is as regards to the order of CIT(A) deleting the addition of product development expenditure and product registration expenditure. For this Revenue has raised following grounds: - “

The next issue in this appeal of Revenue in for the A.Y. 2006-07 is as regards to the order of CIT(A) deleting the disallowance of operating and other expenses. For this Revenue has raised following ground: -

The next issue in this appeal in for the A.Y. 2006-07 is as regards the order of CIT(A) deleting the disallowance made by AO u/s 43B of the Act on account of service tax outstanding. For this Revenue has raised following ground: - “

In the result, all the three appeals of Revenue are dismissed. Order pronounced in the open court on 22-11-2016.