2009 (4) TMI 1 - HC - Income Tax

Marketing expenses disallowed under Section 37(1) for lack of commercial expediency and post-year scheme formation

The HC upheld the disallowance of accrued marketing expenditure claimed by the assessee-company, which incentivized franchisees through a scheme ... Disallowance of accrued marketing expenditure - incentive paid by the assessee-company to its franchisee calculated at 2% of the sales made by the franchisee - HELD THAT:- Assessee-company has created an intermediary in the form of a wholly owned subsidiary, that is, YRMPL to carry on a 'co-operative advertising' on the behalf of its franchisees and franchisees of the assessee-company, based on a contributions received from the franchisees which is equivalent to 5% of the gross sale under the tripartite agreement. This tripartite agreement was, as indicated above, executed between the assessee-company, YRMPL and its franchisees in September, 2000. Thereafter the assessee-company in order to incentivise in development of Pizza Hut brand in India at an accelerated pace formulated a scheme in April, 2001, whereby it offered to reimburse contributions made towards advertisement to the extent of 2% of the sales of the franchisees outlets for the period 01.12.2000 to 30.11.2001 provided they commenced construction or operations/business at or from three additional outlets by 30.11.2001. In this background it is quite clear that the incentive scheme came to the knowledge of the franchisees only in April, 2001, therefore, the assessee's claim with respect to accrued marketing expenditure amount in our view, was not sustainable in the financial year ending on 31.03.2001. The assessee-company could not have in the assessment year under consideration predicted the liability on this account when the scheme came to be formulated only in April, 2001. Claim of expense towards APM activities an amount which could not have been directly claimed, by setting up an intermediary in the form of YRMPL - What the assessee-company in law could not have claimed directly, that is, by making a provision for advertising expenditure could it then be allowed to claim an amount as an expense merely on account of the fact that it had set up an intermediary in the form of a wholly owned subsidiary. In our opinion as rightly held by the authorities below, it cannot be so. For any expenditure to be permitted as deduction under Section 37(1) of the Act the twin conditions which are required to be fulfilled are that the expenditure in issue should not be of a capital nature, and that, it should have been expended wholly for the purposes of business. It is well-settled that the expression 'for the purposes of business' in Section 37 of the Act has been held to mean an expenditure which is voluntary in nature and commercially expedient. In the present case the Tribunal has returned a finding of fact that the assessee-company has not been able to prove that the contributions to the subsidiary were made in the course of business or on account of commercial expediency. 1. ISSUES PRESENTED and CONSIDERED 1.1 Whether the accrued marketing expenditure amounting to Rs 27,61,882/- claimed as an incentive payable to franchisees for the period December 2000 to March 2001 is allowable as a business expense in the assessment year 2001-02. 1.2 Whether the disallowance of Rs 44,44,002/- out of the total contribution made by the assessee-company to its wholly owned subsidiary towards advertising, marketing, and promotional (APM) activities is justified, considering the nature of the contributions and the expenditure incurred by the subsidiary. 2. ISSUE-WISE DETAILED ANALYSIS Issue 1: Allowability of accrued marketing expenditure (incentive) of Rs 27,61,882/- for the period December 2000 to March 2001 Relevant Legal Framework and Principles: - Under the Income Tax Act, 1961, expenses are deductible if they are incurred wholly and exclusively for the purpose of business in the relevant assessment year. - Accrual of liability and the principle of matching expenses to the relevant accounting period are critical in determining deductibility. Court's Interpretation and Reasoning: - The incentive scheme offering reimbursement of advertising contributions at 2% of sales was formulated and communicated only on 04.04.2001, i.e., after the end of the relevant financial year (31.03.2001). - The liability to pay such incentive could arise only upon the franchisees meeting the condition of commencing construction or operation of three additional outlets by 30.11.2001, which was a future contingency not ascertainable as of 31.03.2001. Key Evidence and Findings: - The tripartite agreement and the incentive letter clearly show the timeline and conditions for the incentive. - The Assessing Officer and Tribunal found that the liability had not crystallized during the year under consideration. Application of Law to Facts: - Since the contingency determining the liability was not fulfilled within the financial year ending 31.03.2001, the accrued marketing expenditure could not be considered an expense of that year. Treatment of Competing Arguments: - The assessee-company argued for the allowance of the accrued expenditure as a legitimate business expense. - The Revenue contended that the liability was contingent and not crystallized in the relevant year. Conclusions: - The Court upheld the disallowance of the accrued marketing expenditure for the assessment year 2001-02, holding that the liability did not arise in that year and hence the expense was not allowable. Issue 2: Disallowance of Rs 44,44,002/- contribution towards APM activities paid to wholly owned subsidiary Relevant Legal Framework and Precedents: - Section 37(1) of the Income Tax Act allows deduction of expenditure not being capital in nature and incurred wholly and exclusively for business purposes. - The expression 'for the purposes of business' requires the expenditure to be voluntary and commercially expedient. - Precedents establish that mere creation of a provision or payment to an intermediary does not automatically qualify for deduction unless linked to business expediency. Court's Interpretation and Reasoning: - The tripartite agreement, particularly clause 4.1, clearly states that the assessee-company had no obligation to contribute to the subsidiary; contributions were at its sole discretion. - The subsidiary (YRMPL) received total contributions of Rs 2.64 crores, of which Rs 2.19 crores were spent, leaving Rs 44.44 lacs unspent and shown as current liabilities. - The Assessing Officer and Tribunal found that the assessee-company failed to demonstrate that the contributions were made in the course of business or were commercially expedient. - The arrangement was viewed as an attempt to claim as expense amounts which could not be directly claimed, by routing payments through a wholly owned subsidiary. Key Evidence and Findings: - The tripartite agreement's clauses 4.1, 8.4, and 8.5 were critical in determining the voluntary nature of contributions and the non-profit character of the subsidiary. - The subsidiary's accounts showing unspent contributions supported the view that the entire amount was not utilized for business purposes. Application of Law to Facts: - The Court applied the twin conditions under Section 37(1): the expenditure must not be capital in nature and must be incurred wholly and exclusively for business. - The voluntary nature of contributions without demonstrable commercial expediency or obligation led to disallowance. Treatment of Competing Arguments: - The assessee-company contended that it was within its business discretion to contribute and that the contributions were towards cooperative advertising benefiting its business. - Reliance was placed on Supreme Court judgments emphasizing business discretion and commercial expediency. - The Revenue emphasized the absence of obligation, the unspent balances, and lack of proof of commercial expediency. Conclusions: - The Court upheld the disallowance of Rs 44,44,002/-, holding that the contributions were voluntary, not obligatory, and not shown to be commercially expedient or wholly for business purposes. - The setting up of an intermediary subsidiary did not entitle the assessee-company to claim as expense amounts which otherwise would not qualify. 3. CROSS-ISSUE OBSERVATIONS - Both issues revolve around the fundamental principle of matching expenses to the relevant accounting period and the requirement of commercial expediency and business purpose for deductibility. - The Court emphasized that contingent liabilities cannot be accrued as expenses prior to crystallization of obligation. - The use of a wholly owned subsidiary as an intermediary does not alter the nature of the expenditure or create a business obligation where none exists. - The principle of mutuality and non-profit character of the subsidiary further supports the non-deductibility of unspent contributions. 4. FINAL CONCLUSIONS - The accrued marketing expenditure claimed as incentive for the period December 2000 to March 2001 was rightly disallowed as the liability was contingent and arose post the relevant financial year. - The disallowance of Rs 44,44,002/- contribution to the wholly owned subsidiary towards APM activities was justified due to the voluntary nature of the payments, lack of commercial expediency, and unspent balances. - No substantial question of law arises; the findings are factual and based on application of settled legal principles.