2025 (10) TMI 1064 - HC - Income Tax

Appeals dismissed: percentage-based license fee deemed goodwill consideration, not revenue-sharing; 5% travel/entertainment disallowance deletion upheld under Advocate Act

HC dismissed the appeals. It held the license fee tied to a percentage of firm revenue was a measurement basis for consideration for use of goodwill, not ... License fee paid for use of goodwill by the assessee - nature of expenditure - scope of provisions in the Bar Council Rules and the Advocate's Act, 1961 - Did the ITAT overlook the effect of first Explanation to Section 37 of the Income Tax Act, 1961, in the circumstances of the case? HELD THAT:- Issue which arises for consideration in all these appeals is covered against the Revenue/appellant in terms of the judgment of M/S Remfry & Sagar [2025 (2) TMI 194 - DELHI HIGH COURT] find that the reference to a percentage of the revenue earned by the law practise was intended to principally provide for a basis to compute the consideration liable to be paid for use of goodwill and the utilisation of the name. The primary purpose of referring to the total billing of the law firm was to provide a firm, definite and fixed basis to compute the consideration liable to be paid for use of goodwill. The consideration so paid is thus clearly not liable to be characterised as a sharing of revenue derived from the practise but fundamentally for the exercise of the right to exploit and derive advantage from goodwill. The linking of the consideration for the aforesaid purpose to the revenue earned by the firm only constituted a basis and a measure to determine the consideration that was to be paid. The arrangement was clearly not driven by a motive to share revenues earned by the legal firm. It was purely consideration paid for use of the goodwill attached to the name “Remfry & Sagar”. We thus find ourselves unable to accept the argument of the appellant that the Bar Council of India Rules were violated. The sheet anchor of the submissions advanced by Mr. Rai was the judgment of the Supreme Court in Apex Laboratories [2022 (2) TMI 1114 - SUPREME COURT] and where the “freebies” provided to legal practitioners was found to be an expenditure incurred for a purpose prohibited by law. In our considered opinion, the reliance placed on Apex Laboratories is clearly misplaced since the said judgment turned upon Regulation 6.8 of the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 and which clearly prohibited a medical practitioner from receiving gifts, travel expenses, hospitality as well as cash or other monetary grants. It was that prohibition in law which was found to have been violated. In view of all of the above, we find ourselves unconvinced of the challenge that stands raised in these appeals. As no substantial question of law arises, the appeals are dismissed. Disallowance of 5 per cent of the total travelling and entertainment expenses - CIT(A) deleted the disallowance - ITAT held AO without disputing the expenses claimed by the assessee on account of travelling expenses and entertainment expenses made ad hoc disallowance of 5% merely on the basis of assumptions and surmises by introducing some personal element in the claimed expenditure - HELD THAT:- Noting the conclusion drawn by the CIT(A) with which the ITAT has agreed, we find that the justification given by the CIT(A) is correct and we do not find any substantial question of law which arises for consideration on this particular issue and as such this appeal is also dismissed. ISSUES PRESENTED AND CONSIDERED 1. Whether expenditure by way of licence fee paid for use of a law-firm name/goodwill is disallowable under Explanation 1 to Section 37 as an expenditure incurred for the commission of an offence or for a purpose prohibited by law, having regard to the Bar Council of India Rules and the Advocate's Act, 1961. 2. Whether the 'purpose test' (i.e., whether the expenditure was incurred for a purpose prohibited by law) or other tests (capital v. revenue character tests) govern the assessment of disallowance under Explanation 1 to Section 37 in the context of licence fees paid for use of goodwill. 3. Whether reference to a percentage of revenue in a licence agreement amounts to 'sharing of remuneration' prohibited by the Bar Council Rules and therefore renders the licence fee a payment for a purpose prohibited by law. 4. Whether reliance on a precedent concerning prohibition on receipt of 'freebies' by professionals (medical regulator context) is applicable to licence-fee payments for use of goodwill by a legal practice. 5. Whether the Assessing Officer could disallow an ad hoc 5% of travelling and entertainment expenses on the basis of auditors' caution in Form 3CD and on conjecture/surmise where no specific evidence of personal element was identified. ISSUE-WISE DETAILED ANALYSIS Issue 1 & 2 (Grouped): Applicability of Explanation 1 to Section 37; the 'purpose test' and characterisation of licence fee for use of goodwill Legal framework: Explanation 1 to Section 37 disallows expenditure 'incurred for any purpose which is an offence or which is prohibited by law.' The assessment of whether an expenditure falls within this Explanation depends on the purpose for which it was incurred. Separately, tests distinguishing capital and revenue expenditure (benchmarks: initiation/extension of business; acquisition of an enduring asset or advantage; purpose/aim and object of expenditure) remain relevant to characterisation. Precedent treatment: The Court relied on established decisions articulating the 'purpose test' and on authorities that set out the broad tests for distinguishing capital from revenue expenditure (enduring benefit test, fixed v. circulating capital, and aim/object of expenditure). Prior departmental and judicial pronouncements applying the purpose test to determine disallowance under Section 37 were followed. Interpretation and reasoning: The Court emphasised that Explanation 1 targets expenditure genuinely incurred to commit an offence or for a purpose prohibited by law; the expression 'prohibited by law' is coupled with 'commission of an offence,' and therefore the object of the expenditure must be to pursue a legally prohibited purpose. A mere contravention of professional conduct rules which do not constitute an offence at law is not ipso facto an expenditure 'for a purpose prohibited by law.' The primary, indeed sole, purpose of the licence payments was held to be the purchase/use of an asset-like advantage (the goodwill and the right to use the name), not the sharing of professional fees or a design to flout statutory prohibition. The Court analysed the nature of goodwill as a transferable asset that can be monetised and held that payments to exploit that goodwill are consideration for use of an asset conferring enduring benefit, thus falling outside Explanation 1. The Court rejected attempts to treat the underlying gift/transferor's motive as determinative of the licence-fee question, as motive behind a gift was not germane to whether the licence fee itself was expended for a prohibited purpose. Ratio vs. Obiter: Ratio - The decisive proposition is that Explanation 1 applies only where the expenditure is incurred for the commission of an offence or for a purpose prohibited by law as such; expenditure genuinely paid for use of goodwill (a transferable asset) is not caught by Explanation 1 merely because professional conduct rules proscribe sharing of fees. Obiter - Observations on the irrelevance of questioning the validity/motive of the antecedent gift deed are ancillary to the main finding. Conclusions: Expenditure by way of licence fee to use the law-firm name/goodwill was not disallowable under Explanation 1 to Section 37. The 'purpose test' governs; the dominant purpose was exploitation of goodwill (a lawful, transferable asset) and not commission of an offence or a purpose prohibited by law. Appeals challenging allowance on this ground were dismissed. Issue 3: Whether percentage linkage to revenue in licence agreement amounts to proscribed 'sharing of remuneration' Legal framework: Bar Council Rules prohibit sharing of remuneration/fees of a lawyer with a non-lawyer (i.e., splitting of fees/revenue). The question is whether a contractual formula linking licence consideration to firm revenue converts a licence payment into prohibited sharing of remuneration. Precedent treatment: The Court examined the Bar Council Rule's language and scope, and applied settled principles requiring analysis of substance over form and the primary purpose of an arrangement. Interpretation and reasoning: The Court construed the Bar Council Rule as addressing arrangements that effectuate a split/share of fees or remuneration earned from practice. By contrast, where a contractual reference to firm billing merely provides a measurable, objective basis to compute consideration for the use of goodwill, it does not equate to sharing of revenue. The linkage to revenue was characterized as a method of fixing consideration (a metric), not as a mechanism for transferring a portion of fees earned by lawyers to non-lawyers. Thus, the arrangement was not aimed at sharing remuneration but at remunerating the right to exploit goodwill. Ratio vs. Obiter: Ratio - A revenue-linked formula for computing licence consideration does not, without more, convert the payment into prohibited sharing of remuneration under bar-council rules. Obiter - Discussion of alternative formulations or hypotheticals where linkage might amount to sharing was unnecessary to the decision. Conclusions: The percentage linkage to revenue constituted a basis to compute consideration for goodwill and did not amount to a proscribed sharing of remuneration; the Bar Council Rules were not violated for purposes of Explanation 1 disallowance. Issue 4: Applicability of precedent concerning 'freebies' (medical regulator case) to the facts Legal framework and precedent treatment: A prior decision holding that gifts/freebies were prohibited by medical regulation was cited by the Revenue. That precedent turned on an express statutory/regulatory prohibition against receipt of gifts, hospitality, monetary grants by medical practitioners. Interpretation and reasoning: The Court distinguished the medical regulation precedent on its facts and regulatory scope. The medical regulation contained an express prohibition in law against receiving certain benefits; by contrast, the Bar Council Rules regulate sharing of fees but do not create an offence in the same manner and do not categorically prohibit monetisation of goodwill or licence arrangements that remunerate the right to use a name. Therefore the medical-context precedent was inapposite. Ratio vs. Obiter: Ratio - Precedents premised on express statutory/regulatory prohibitions (leading to disallowance under Explanation 1) cannot be extended to arrangements which are lawful monetisation of goodwill absent a comparable prohibition. Obiter - Observations distinguishing policy rationales of medical regulation were ancillary. Conclusions: Reliance on the medical 'freebies' precedent was misplaced; that authority is distinguishable and does not warrant disallowance under Explanation 1 in the present factual and regulatory matrix. Issue 5: Disallowance of 5% of travelling and entertainment expenses on ad hoc basis in light of auditors' Form 3CD caution Legal framework: Assessing Officer may disallow expenditure only on evidence demonstrating that portion is not incurred wholly and exclusively for business; conjecture and surmise without specific material is impermissible. Auditors' Form 3CD containing a caution that auditors did not examine nature of certain expenses is a relevant fact but does not substitute for concrete evidence of personal expenditure. Precedent treatment: The Tribunal and appellate authorities followed earlier appellate orders for identical issues in preceding assessment years, applying the principle that ad hoc disallowance cannot be sustained on mere assumptions. Interpretation and reasoning: The Court accepted the view that the AO made an ad hoc 5% deduction merely on assumptions and surmises and that the CIT(A) correctly followed a prior year decision deleting such disallowance where AO had not pointed to any discrepancy in books or produced evidence of personal use. The auditors' caution in Form 3CD that the auditors had not examined the nature of expenses did not amount to evidence that a specific part of expenses was personal; absent positive material, disallowance on conjecture was not tenable. Ratio vs. Obiter: Ratio - Disallowance cannot be sustained purely on conjecture; auditors' general caveat does not justify ad hoc percentage disallowance without concrete evidence of personal expenditure. Obiter - None material beyond affirmation of following precedent. Conclusions: The 5% ad hoc disallowance of travelling and entertainment expenses on the basis of conjecture and auditors' caution was not sustainable. No substantial question of law arose from the Tribunal's affirmance of the appellate deletion; the appeal was dismissed.