Capital subsidy and transfer pricing royalty disallowance: incentive for setting up a unit is capital, and ad hoc addition fails without proper ALP adjustment.

Sales tax and purchase tax subsidy under the Maharashtra incentive scheme was treated as capital receipt because the scheme was aimed at inducing establishment of units in notified backward areas, so the benefit was linked to setting up the unit rather than routine business operations. The ad hoc disallowance of royalty was deleted because no separate transfer pricing adjustment was made by the TPO, and the Assessing Officer could not sustain an addition merely on the basis of a show-cause notice. The royalty claim was also supported on merits, as the rate was within the approved range and no contrary material for a later year was shown.

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Issues: (i) Whether sales tax and purchase tax subsidy received under the Government of Maharashtra incentive scheme was capital receipt or revenue receipt; (ii) Whether the ad hoc disallowance of royalty payment was sustainable when no transfer pricing adjustment on royalty was made by the TPO.

Issue (i): Whether sales tax and purchase tax subsidy received under the Government of Maharashtra incentive scheme was capital receipt or revenue receipt.

Analysis: The subsidy was granted under the 1993 Package Scheme of Incentives for units set up in notified backward areas. The object of the scheme was to induce setting up of units in such areas, and the benefit was linked to the location and establishment of the unit, not to assist the routine conduct of business. The same issue had already been decided in the assessee's own case for earlier years, and the reasoning was consistent with the view that assistance intended to promote setting up of a unit is capital in nature.

Conclusion: The subsidy was capital receipt and not taxable as revenue receipt.

Issue (ii): Whether the ad hoc disallowance of royalty payment was sustainable when no transfer pricing adjustment on royalty was made by the TPO.

Analysis: The statutory mechanism for determining arm's length price requires the TPO to apply the prescribed transfer pricing provisions and determine an actual adjustment, if warranted. Here, the TPO did not make any separate adjustment on royalty, and the Assessing Officer could not make an ad hoc addition merely because a show-cause notice had been issued. The disallowance was also unsupported on merits, since the royalty rate was within the approved range and no material difference in the succeeding year was shown.

Conclusion: The ad hoc disallowance of royalty was not sustainable and was deleted.

Final Conclusion: The appeal succeeded on both substantive controversies, with relief granted on the subsidy issue and the royalty disallowance, resulting in only partial success overall because the remaining grounds were not pressed.

Ratio Decidendi: A subsidy granted to induce establishment of an industrial unit in a backward area is capital receipt, and a transfer pricing disallowance cannot be made on an ad hoc basis unless the prescribed statutory mechanism is followed and a proper arm's length determination is made.

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