2011 (3) TMI 1613 - HC - Income Tax

Deduction of Royalty Payment Upheld as Business Expense

The Tribunal justified the deduction of royalty payment under section 37(1) of the Income-tax Act, allowing the payment disallowed by the AO. The Tribunal ... Disallowance u/s 92 read with Section 37(1) - Royalty paid to Holding Co. for duplicating and Sub-Licencing of Software - AO's Jurisdiction to determine amount of Profits - AO disallowed royalty paid by the assessee to its holding company beyond 30% of the sub-licensing fees earned by the assessee - As per Tribunal, assessee would be entitled to get the deduction in respect of entire amount paid by way of royalty. Also, Section 92 would have no application to the facts of this case. HELD THAT:- If the conditions mentioned in provision of Sec. 92 are satisfied, the section empowers the AO to determine the amount of profits which is reasonably deemed to have been derived from there. The first two conditions mentioned in provision of section 92 i.e. Business is carried between a resident and a non-resident and Close connection between resident and a non-resident are undoubtedly satisfied. It is, thus, to be examined as to whether it is a case where the transaction between the assessee and its parent company has resulted in no profit or less than the ordinary profits which might be expected to arise in the business. As assessee declared a certain amount of income, it is not a case of 'no profits'. Next question regarding, how to determine whether the profits are less than the ordinary profits which might be expected to arise in the business? This can be found only when exercise is undertaken comparing the income of the assessee with other comparable business enterprises in India. However, the AO did not do this exercise at all. Definitely, onus in this behalf u/s 92 lays on the AO. This pertinent aspect coupled with the fact that price fixed is acceptable as Arm's Length Price by the TPO u/s 92 itself is sufficient to clinch the issue in favour of the assessee. In this backdrop, we have to examine whether such an expenditure could still be disallowed and the opinion of the AO was correct that the payment made cannot be treated to be wholly and exclusively for business purpose of the assessee to enable it to cover the same u/s 37(1). Once it is held that the payment of royalty by the assessee to its parent company is not hit by the provisions of section 92 and the price fixed is ALP as determined by the TPO himself, there is no reason to hold that the expenses would not be allowed u/s 37(1) It is, thus, clear that what is to be seen is that the expenditure was incurred by the assessee in the course of business and had nexus with the business of the assessee. It could not be disputed that the payment of royalty is a business expenditure, which was expended wholly and exclusively for the purpose of business of the assessee. The nature of the expenses is also not such which would fall in any of the exceptions carved out under sections 30 and 36. Once these conditions are satisfied, the expense is to be allowed in toto as business expenditure, and the Revenue cannot sit in the arm's chair of the assessee and decide as to how affairs of the business are to be run and wasteful or excessive expenditure is to be curtailed. The question of commercial expediency is to be judged by the assessee and not by the AO. It is well-settled that it is not open to the Department to adopt a subjective standard of reasonableness and disallow a part of business expenditure as being unreasonably large, or decide what type of expenditure the assessee should incur and in what circumstances. This was so held by the Supreme Court in the case of COMMISSIONER OF INCOME-TAX, BOMBAY VERSUS WALCHAND AND COMPANY PVT. LIMITED. [1967 (3) TMI 2 - SUPREME COURT], which principle has thereafter been often repeated and remains the bedrock of section 37 of the Act till date. Thus, the jurisdiction of the AO is only confined to deicide 'Profits and gains of business or profession', i.e., whether the expenditure claimed was actually and factually expended or not and whether it was wholly and exclusive for the purposes of business. Reasonableness of the expenditure can be considered only from this limited angle for the purpose of determining whether in fact amount was spent or not. Ld. Senior Counsel was right in his submission that AO committed serious error in mixing the provisions of section 92 and section 37. Thus, Tribunal was justified in law in allowing the deduction disallowed by the AO. Issues Involved:1. Justification of royalty deduction under section 37(1) of the Income-tax Act.2. Applicability of section 92 of the Income-tax Act regarding the payment of royalty.3. Determination of Arm's Length Price (ALP) for royalty payments.4. Assessment of whether the expenses incurred were wholly and exclusively for business purposes.Detailed Analysis:1. Justification of Royalty Deduction under Section 37(1):The primary issue was whether the Tribunal was justified in allowing the deduction of Rs. 17,10,24,600 disallowed by the AO under section 92 read with section 37(1) of the Act, being royalty paid by the assessee to its holding company beyond 30% of the sub-licensing fees earned. The AO disallowed the royalty payment exceeding Rs. 17.90 Crores, arguing it was not wholly and exclusively for business purposes. The Tribunal, however, concluded that the payment was indeed for business purposes, and thus, allowable under section 37(1).2. Applicability of Section 92:The AO invoked section 92, arguing that the business arrangement between the assessee and its parent company resulted in lesser ordinary profits. The Tribunal held that the pre-condition for invoking section 92, i.e., no profit or less than ordinary profit accruing to the resident assessee due to the business connection, was not established. The Tribunal emphasized that the AO did not bring any comparable cases to prove that the profits were less than ordinary in this type of business.3. Determination of Arm's Length Price (ALP):The Tribunal noted that the price fixed as per the agreement was accepted as Arm's Length Price by the Transfer Pricing Officer (TPO). The Tribunal pointed out that the TPO had accepted the international transactions' ALP for the relevant assessment years. This acceptance by the TPO was crucial in determining that the royalty payments were at arm's length and thus justified.4. Assessment of Business Purpose:The Tribunal and the High Court emphasized that the payment of royalty was a business expenditure, expended wholly and exclusively for business purposes. The AO's argument that the royalty payment on IPP rather than actual sales was superfluous was rejected. The High Court reiterated that the reasonableness of the expenditure should be judged by the assessee, not the AO, and the expenditure must be allowed if it was incurred for business purposes and had a nexus with the business.Conclusion:The Tribunal was justified in allowing the deduction of the royalty payment under section 37(1) of the Act. The AO's invocation of section 92 was not substantiated with comparable cases, and the royalty payment was determined to be at Arm's Length Price by the TPO. The High Court upheld the Tribunal's decision, concluding that the expenses were wholly and exclusively for business purposes, dismissing the appeals.