2014 (10) TMI 364 - HC - Income Tax

High Court rules prototype development costs as revenue expenditure, not capital. Impact on telecom industry

The High Court of Karnataka affirmed the Tribunal's ruling that expenditure on prototype development for optical networking products constituted revenue ... Expenses on prototype development expenses u/s 36(1)(iv) - Revenue or Capital expenses - Whether the Tribunal was right in holding that a sum 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 AO confirmed by the Appellate Commissioner treating as a revenue expenditure - Held 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 - those components are used for manufacturing Printed Circuit Boards - Every year these Circuit Boards undergo modification, changes - the expenses incurred in this regard is in the nature of revenue expenditure. Relying upon EMPIRE JUTE COMPANY LIMITED vs COMMISSIONER OF INCOME TAX [1980 (5) TMI 1 - SUPREME Court] - 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 - The test of enduring benefit is not a certain or conclusive test and it cannot be applied blindly and mechanically – the statement of law equally holds good in the area of telecommunication, may be with more force - the expenditure that is claimed is for upgrading the existing product - 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 –Decided against revenue. Issues:1. Whether expenditure on prototype development is to be treated as revenue or capital expenditure.2. Whether the expenditure incurred for developing a product with a utility value for five years can be considered capital expenditure.3. Whether the expenditure is allowable under Section 35(1)(iv) of the Income Tax Act.Issue 1: Expenditure on Prototype DevelopmentThe case involves three appeals by the revenue challenging the Tribunal's finding that expenditure on prototype development should be treated as revenue expenditure, not capital expenditure. The assessee developed optical networking products and claimed expenses for product development. The assessing authority treated the expenditure as capital, considering it provided enduring benefits. The Appellate Authority and Tribunal disagreed, stating that the prototypes developed were not used for more than five years and did not provide enduring benefits. The Tribunal concluded that the expenditure was revenue in nature, not capital. The High Court agreed, citing the need for constant product development in a competitive market and the evolving nature of technology in the telecommunication sector. The Court relied on legal precedents to support its decision, emphasizing that the expenditure was for upgrading existing products, making it revenue expenditure.Issue 2: Capital Expenditure for Five-Year Utility ValueThe substantial question of law raised was whether the expenditure incurred for developing a product with a utility value for five years should be considered capital expenditure. The Tribunal held that such expenditure was revenue in nature, not capital, as the benefits were not enduring beyond five years. The High Court concurred with this finding, emphasizing the evolving nature of technology and the need for continuous product upgrades in the telecommunication sector. The Court referenced legal precedents to support its decision, highlighting that the expenditure was for improving existing products, making it revenue expenditure.Issue 3: Allowability under Section 35(1)(iv) of the Income Tax ActThe Tribunal also considered whether the expenditure could be allowable under Section 35(1)(iv) of the Income Tax Act. However, the High Court did not delve into this issue as the assessee succeeded on the first substantial question of law. The Court set aside the finding on this issue due to the lack of reasons provided by the Tribunal, leaving it open for future consideration in an appropriate forum.In conclusion, the High Court of Karnataka upheld the Tribunal's decision that the expenditure on prototype development was revenue expenditure, not capital, due to the evolving nature of technology and the need for continuous product upgrades in the telecommunication sector. The Court emphasized the importance of legal precedents in determining the nature of expenditure and set aside a finding related to the allowance under Section 35(1)(iv) of the Income Tax Act for further consideration in the future.