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IN THE HIGH COURT OF KARNATAKA AT BANGALORE Dated this the 25th day of August, 2014 PRESENT
THE HON’BLE MR. JUSTICE N KUMAR AND
THE HON’BLE MRS. JUSTICE RATHNAKALA
ITA No.1073 of 2008 c/w ITA No.72 of 2011 ITA No.813 of 2007
ITA No.1073 of 2008 BETWEEN:
The Commissioner of Income Tax
C.R. Building
Queens Road
Bangalore
The Assistant Commissioner of Income Tax
Circle-12(3)
C.R. Building
Queens Road
Bangalore
…Appellants
(By Sri K. V. Aravind, Advocate) AND:
M/s. Tejas Networks India (P) Ltd., No.58, 1st Main Road
J.P. Nagar, 3rd Phase Bangalore -560 078
…Respondent
(By Sri Suryanarayana T. Advocate for M/s. King & Partridge, Advocates)
This ITA is filed under Section 260-A of I.T. Act, 1961 arising out of order dated 18-07-2008 passed in ITA No.1228/BNG/2007, for the assessment year 2003-2004, praying to (i) formulate the substantial questions of law stated therein, (ii) allow the appeal and set aside the order passed by the ITAT Bangalore in ITA No.1228/BNG/2007, dated 18-07-2008 confirming the order of the Appellate Commissioner and Assistant Commissioner of Income Tax, Circle 12(3), Bangalore.
ITA No.72 of 2011 BETWEEN:
The Commissioner of Income Tax-II
Central Revenue Building
Queens Road
Bangalore
The Deputy Commissioner of Income Tax
Circle-12(4)
C.R. Building
Bangalore
…Appellants
(By Sri E. Sanmathi, Advocate)
AND:
M/s. Tejas Networks Ltd., No.58, 1st Main Road J.P. Nagar, 3rd Phase Bangalore -560 078
…Respondent
(By Sri Suryanarayana T. Advocate for M/s. King & Partridge, Advocates)
This ITA is filed under Section 260-A of I.T. Act, 1961 arising out of order dated 14-10-2010 passed in ITA No.719/BNG/2010, for the assessment year 2004-2005, praying to (i) formulate the substantial questions of law stated therein, (ii) set aside the appellate order dated 14-10- 2010 passed by the ITAT, ‘B’ Bench, Bangalore in appeal proceedings ITA No.719/Bang/2010 as sought for in this appeal.
ITA No.813 of 2007 BETWEEN:
The Commissioner of Income tax
Central Circle C.R. Building
Queens Road
Bangalore
The Assistant Commissioner of Income Tax
Circle-12(3)
C.R. Building
Queens Road
Bangalore
…Appellants
(By Sri K. V. Aravind, Advocate)
AND:
M/s. Tejas Networks India Ltd., No.58, 1st Main Road J.P. Nagar, 3rd Phase Bangalore -560 078
…Respondent
(By Sri Suryanarayana T. Advocate for M/s. King & Partridge, Advocates)
This ITA is filed under Section 260-A of I.T. Act, 1961 arising out of order dated 08-06-2007 passed in ITA No.470/BNG/2006, for the assessment year 2002-2003, praying to (i) formulate the substantial questions of law stated therein, (ii) allow the appeal and set aside the order passed by the ITAT Bangalore in ITA No.470/BNG/2006, dated 08-06-2007 confirming the order of the Appellate Commissioner and Assistant Commissioner of Income Tax, Circle 12(3), Bangalore.
These ITAs coming on for hearing this day, N. KUMAR J delivered the following:
J U D G M E N T
These three appeals are preferred by the revenue challenging the finding recorded by the Tribunal that the expenditure on prototype development is to be treated as revenue expenditure and not as a capital expenditure.
The assessee develops and sells leading edge optical networking products for worldwide customers. It has developed software differentiated, next generation products that enable telecommunication carriers to build converged networks that support traditional voice based services as
well as new data dominated services. Their product line is marketed under the brand name TJ100.
In the return of income filed for the year 2003- 04, the assessee has claimed a sum of Rs.6,00,68,512/- as product development expenses. The break up of this figure is: Engineering charges: Rs. 27,66,645/- Employee Cost:
Rs. 3,27,47,936/- Material Cost: Rs. 2,45,53,931/-
All the expenses incurred by the assessee have been towards the development of a single product line, the TJ100 series. The assessee has spent the sums on the import of hardware components for developing prototypes, towards engineering cost of these prototypes and for employee costs involved therein. The assessee also claimed that the hardware used was not reusable and hence was being scrapped on completion of activity. The components imported have been used for manufacturing Printed Circuit Boards required for the equipment. Relying on the submission made by the
employees to the effect that these PCBs are lying in the office and the imported components used on the PCBs are available in the labs in the Company, all these components are retained by the Company for use in Product Development of other TJ100 products such as TJ100MC, the assessing authority came to the conclusion that all these products enable the assessee Company to develop and manufacture a particular product which is the mainstay of the Company’s turnover in the future years. Even after the product is successfully developed and marketed, the hardware purchased and the software developed are still used. They are used to solve any problems that may come up with the product when being used by the customer. Therefore, the assessing authority was of the view that the assessee has gained an enduring benefit by means of the product development expenditure. The expenditure is not merely to facilitate the assessee’s business but expenses is used for development which earned him substantial revenues in the later years. Therefore, treating it as a capital expenditure,
the said expenditure was added back to the income of the assessee, of course he held that the assessee can claim depreciation.
Aggrieved by the same, the assessee preferred an appeal to the Commissioner of Income Tax (Appeals). The Appellate Authority proceeded on the basis that as per its own admission, the assessee has derived an enduring benefit from the prototypes so developed as the same have not been scrapped and are still used and, therefore, it upheld the assessing authority’s action of treating the expenditure as capital.
Aggrieved by the same, the assessee preferred an appeal before the Tribunal. The Tribunal on reconsideration of the entire material on record, taking note of the various judgments on which reliance was placed by both the parties, by a detailed order came to the conclusion that the technology in telecommunication is developing at a very fast speed and new products are to be developed in case one has
to remain in the business. The product developed is marketed for one year only, as the next product will come before the end of first year of the introduction of an earlier product. A number of prototypes are developed but all such prototypes are not used as model for the new product. The prototypes, which are not finally approved for commercial production, are rejected and such prototypes are of no use. Only those prototypes are retained, for which, the Company manufactures the product. Such prototype is kept for four to five years, so that the assessee Company is able to redress the complaint of any customer in case any complaint is received. Such prototype is model of the product, which is marketed and, therefore, it was of the view that the benefit is not derived for a period of more than five years, the benefit is not of enduring nature and expenses cannot be treated as capital and, therefore, ultimately it recorded a finding that the expenditure on prototype development is to be treated as revenue and not as capital. It also held that the expenditure in the alternative as allowable under Section 35 (1) (iv) of the
Act without any discussion. Aggrieved by the said order, the revenue has filed these appeals.
ITA No. 813/2007 and ITA No. 72/2011 was admitted to consider the following substantial questions of law:- 1. Whether the Tribunal was right in holding that a sum of Rs.6,00,68,512/- incurred for developing a product TJ-100 having a utility value for a period of 5 years cannot be considered as a capital expenditure and depreciation allowed by the Assessing Officer confirmed by the Appellate Commissioner treating as a revenue expenditure?
Whether the Tribunal was right in alternatively holding that the assessee’s claim regarding expenditure is allowable under Section 36 (i) (iv) of the Income Tax Act even if the expenditure is held to be capital in nature?
Similar questions are framed in ITA No. 1073/2008 which are as under:- 1. Whether the Tribunal was correct in holding that a sum of Rs.5,82,21,211/- incurred for developing a product TJ-100 having a utility value for period of 5 years cannot be treated as a capital expenditure and depreciation allowed as held by the Assessing officer and confirmed by the Appellate Commissioner but should be allowed as a revenue expenditure?
Whether the Tribunal was correct in holding that the expenditure allowable should be alternatively allowed u/s.35(1)(iv) of the Act, as the same had been incurred on scientific research related to the business carried on by the assessee?
We have heard the learned counsel appearing for the parties.
Learned counsel for the revenue relying on the statements of the officials as set out in the order of the
assessing authority contended that, the components are retained by the Company for use by the Company in Product Development of other products, they are lying in the office, they are not scrapped as contended by the assessee and, therefore, the expenses incurred towards these components is of enduring nature and it is in the nature of capital expenditure and the Tribunal was in error in holding it otherwise.
Per contra, the learned counsel for the assessee submitted that, the expenses are incurred for upgrading their product every year. It is in the nature of product development expenses and, therefore, it cannot be treated as a revenue expenditure. The Tribunal was right in treating it as a revenue expenditure.
In the light of the aforesaid facts and the rival contentions, it is clear that the assessee is in the business of developing and selling leading edge optical networking products for worldwide customers. It has developed software
differentiated, next generation products that enable telecommunication carriers to build converged networks. The life span of this product is hardly a year. Because of competition in the market, the assessee has to come out with new features every year if they want to be in the field. Therefore, there is a constant upgradation of the original product. It is in that context substantial amount is spent towards employees cost and the upgradation also includes use of components purchased every year. In fact, those components are used for manufacturing Printed Circuit Boards. Every year these Circuit Boards under go modification, changes. Therefore, the expenses incurred in this regard is in the nature of revenue expenditure.
The Apex Court in the case of EMPIRE JUTE COMPANY LIMITED vs COMMISSIONER OF INCOME TAX [1980 VOL. 124 PAGE 1] has held that, the decided cases have, from time to time, evolved various tests for distinguishing between capital and revenue expenditure but no test is paramount or conclusive. There is no all embracing
formula which can provide a ready solution to the problem; no touchstone has been devised. Every case has to be decided on its own facts, keeping in mind the broad picture of the whole operation in respect of which the expenditure has been incurred. Further they held that, there may be cases where expenditure, even if incurred for obtaining 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 makes it a capital expenditure. What is material to consider is the nature of the advantage in a commercial sense. If the advantage consists merely in facilitating the assessee’s trading operations or enabling the management and conduct of the assessee’s business to be carried on more efficiently or more profitably while leaving the fixed capital untouched, the expenditure would be on revenue account, even though the advantage may endure for an indefinite future. The test of enduring benefit is, therefore, not a certain or conclusive test and it cannot be applied blindly and mechanically without
regard to the particular facts and circumstances of a given case.
In fact, the Apex Court in the case of ALEMBIC CHEMICAL WORKS CO. LTD., vs COMMISSIONER OF INCOME TAX, GUJARAT [1989 VOL. 177 PAGE 377] held that, it would be unrealistic to ignore the rapid advances in research in antibiotic medical microbiology and to attribute a degree of endurability and permanence to the technical know- how at any particular stage in this fast-changing area of medical science. The state of the art in some of these areas of high priority research is constantly updated so that the know- how cannot be said to be the element of the requisite degree of durability and nonephemerality to share the requirements and qualifications of an enduring capital asset. The rapid strides in science and technology in the field should make us a little slow and circumspect in too readily pigeon-holing an outlay such as this as capital. …. 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.
We are of the view the aforesaid statement of law equally holds good in the area of telecommunication, may be with more force. Having regard to the facts of this case, the expenditure that is claimed is for upgrading the existing product. Therefore, the product so upgraded goes on changing as time progresses, keeping in mind the requirement and the competition in the market. The Tribunal rightly held that the expenditure is not in the nature of capital expenditure but is revenue expenditure. Therefore, the first substantial question of law is answered in favour of the assessee and against the revenue.
In so far as the second substantial question of law is concerned, in fact the Tribunal has not given any reasons and as the assessee succeeds on the first substantial question of law, we are not going into the said question and that question is left open to be agitated at an appropriate time in an appropriate forum. On the ground that no reasons are given, we set aside the said finding.
Sd/- JUDGE
Sd/- JUDGE
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