1. This appeal is by the assessee against the order of the Commissioner under Section 263 of the Income-tax Act, 1961 ('the Act') disallowing expenditure of Rs. 12,67,514 towards capital expenditure on scientific research. The IAC, who made the assessment, had allowed deduction of Rs. 96,59,085 being expenditure incurred in respect of research and development under Section 35(1)(iv) read with Section 35(2)(i) of the Act. It is not disputed that out of the above, a sum of Rs. 12,67,514 had been met by the Government of India. The Commissioner, after issuing a show cause notice under Section 263 and hearing the assessee, held that the expenditure has been incurred out of the grant-in-aid and not out of the profits of the assessee and, thus, the assessee was not entitled to deduction under Section 35(1)(iv) to the extent of Rs. 12,67,514. He, accordingly, modified the order of the IAC. The assessee is in appeal.
2. At the outset, the assessee raised a preliminary objection that the Commissioner was not entitled to revise an order of assessment passed by the IAC under Section 263. He submitted that the Commissioner can invoke his powers under Section 263 only against the orders passed by the ITO and not against orders passed by an IAC, The learned departmental representative referred to the decision of the Karnataka High Court in writ petition No. 19196 of 1981 dated 9-12-1981 where it was held that once the assessment powers are conferred upon an IAC under Section 125A(1) of the Act, he is to be treated as an ITO for all practical purposes. In the light of this decision he submitted that the Commissioner had powers to revise the order of the IAC.3. In the case before the Karnataka High Court the IAC had been made the assessing authority. He had impounded and retained certain books of account and other papers under Section 131(3) of the Act. The assessee's request for return of the impounded books was rejected. The assessee contended before the High Court that the books had been impounded contrary to the proviso to Sub-section (3) of Section 131 which prescribed that he could not retain in his custody books or documents for a period exceeding 15 days without obtaining the approval of the Commissioner. The argument on behalf of the revenue was that the proviso applied to the ITOs only who had impounded the books of account and not to the IACs. The High Court referred to Section 125A(4) and agreed with the assessee that the said section created a legal fiction for the purpose of the Act that the IAC should be deemed to be the ITO and where the ITO has to obtain any approval from the Commissioner, the IAC, who had stepped into his shoes, should, likewise, take the approval of the Commissioner. The Court, accordingly, held that the IAC should have obtained the permission of the Commissioner for retaining the impugned books of account for a period beyond 15 days.
From the above, it follows that when an IAC is asked to perform the functions of the ITO by an order under Section 125A(1), he becomes an ITO for all practical purposes. Therefore, the Commissioner will have power to revise his orders which may be erroneous insofar as they are prejudicial to the revenue. This proposition flows directly from the decision of the Karnataka High Court, which is binding on us. We, accordingly, reject the legal contention raised by the assessee.
4. Coming to the merits, it was argued by the learned counsel for the assessee that the Commissioner was wrong in holding that the assessee had to incur expenditure on scientific research out of its profits. He also submitted that although technically the capital assets obtained by spending the grant given by the Government of India would remain the property of the Government, the assessee was the beneficial owner thereof. There was no condition that the assessee should actually own the assets acquired for scientific research The only condition was that an expenditure should be incurred which is of a capital nature and once such expenditure is incurred as specified in Section 35(1)(iv) the deduction enumerated in Section 35(2) will be available to the assessee. The learned departmental representative. on the other hand, dealt at length on the concept of expenditure. He submitted that the expenditure was the one incurred by the assessee out of its own resources. It must also result in acquisition of an asset belonging to the assessee. Capital expenditure incurred out of funds provided by a third party could not be considered as an expenditure incurred by the assessee particularly in view of the fact that the assets did not belong to the assessee. He pleaded that the order of the Commissioner should be upheld.5. We have heard the rival submissions. The relevant portions of Section 35(1) are reproduced below : 35. Expenditure on scientific research.-(1) In respect of expenditure on scientific research, the following deductions shall be allowed- (iv) in respect of any expenditure of a capital nature on scientific research related to the business carried on by the assessee, such deduction as may be admissible under the provisions of Sub-section (2).
(a) The income-tax taxes income. The deduction to be allowed is for expenditure which are debited to the profit and loss account.
Normally deductions of revenue expenditure alone are allowed. One of the exceptions is Section 35(1)(iv). We have, therefore, to consider whether the capital expenditure referred to in Section 35(1)(iv) should be met out of the revenue resources of the assessee or not in order to qualify for deduction.
(b) Apparently, there does not appear to be any support for the proposition that in order to qualify for deduction an expenditure should be incurred out of the circulating capital. For example, certain revenue payments like salary, may have to be made by an assessee out of borrowed funds like bank overdrafts, etc. The payment in this example is by an assessee who is not a banking institution where money constitutes stock-in-trade. The assessee cannot claim deduction of the borrowed funds themselves but only the interest on the loan and any other payments of a revenue nature which the assessee has to make. The salary payment will not be disallowed on the ground that the payment is not out of profits of the assessee. Applying the same criterion, it appears to us that the expenditure on scientific research coming under Section 35(1)(iv) need not be out of the profits. All that the section says is that in respect of any expenditure of a capital nature on scientific research related to the business carried on by the assessee, such deduction as will be admissible under the provisions of Sub-section (2) shall be allowed. Sub-section (2) merely states the manner in which it has to be allowed, the basis has changed from year to year.
It is admitted that the assessee has set up research laboratory at the Indian Telephone Industries, Bangalore, regarding thick thin film hybrid microcircuits. It is also admitted that the research laboratory is in connection with the business of the assessee.
Therefore, the conditions stated in Section 35(1)(iv) are satisfied and the deduction is permissible.
6. We have now to examine two more aspects of the issue : (i) whether the expenditure should have been incurred out of the assessee's own resources and (ii) whether the assessee should be the owner of the capital asset acquired by incurring expenditure.
Apparently there does not appear to be anything in the Act requiring the assessee to spend the moneys out of his own resources. Let us take the case of an assessee who receives a gift. The money is introduced in the business and out of that some payments of a revenue nature are made. In computing the income of the assessee the payments are not disallowed on the ground that the disbursements were not made out of the assessee's own resources or resources generated in the business. In fact, the capital of the business itself might be out of gifts received. But outgoings of revenue nature made out of capital resources, owned or borrowed or obtained otherwise, cannot be disallowed. In this view of the matter, we hold that apparently the receipt of a grant-in-aid by the assessee will not debar the assessee from claiming deduction under Section 35(1)(iv). When the grant-in-aid is received it merges with the funds of the assessee. Thereafter, disbursements are made. It is not the case of the revenue that the Government has directly paid for some capital equipment on behalf of the assessee. In such a case, there would be some difference in our appreciation of the problem. Obviously, the expenditure has been incurred by the assessee out of a grant received from the Government and, thus, the condition for grant of deduction under Section 35(1)(iv) is satisfied. The conditions under which the grant has been made are as follows : (i) The grant has been made for the specific project mentioned above and shall be subject to the implied conditions : (a) the grant shall be spent on the project within a reasonable time and (b) any portion of the grant which is not ultimately required for expenditure for the approved purposes shall be duly surrendered to Government.
(ii) The ITI, Bangalore, shall maintain an audited record in the form of a register in the prescribed proforma for equipment and store both capital and consumable purchased, permanent, semi-permanent assets required solely or mainly out of the Government grant.
(iii) The assets referred to in (ii) above acquired out of the Government grant will be the property of the Government and should not without prior sanction of the Government be disposed of, or encumbered or utilised for purposes other than those for which the grant has been sanctioned. An undertaking shall be given by the ITI, Bangalore, that they agree to be governed by these conditions.
(iv) At the conclusion of the project, the Government will be free to sell or otherwise dispose of the assets which are the property of the Government and ITI, Bangalore, shall render to the Government the necessary facilities for facilitating the sale of these assets.
(v) The ITI, Bangalore, shall send to the Department of Electronics at the end of each financial year as well as at the time of seeking further instalments of the grant a list of assets referred to in (ii) above which have been purchased from out of the grant.
(vi) Should at any time ITI, Bangalore, cease to exist, such assets, etc., shall revert to the Government of India.
This would indicate that the assets would remain the property of the Government of India.
We have now to see whether it is a necessary condition that the assessee should be the owner of the asset. Here also there is no express condition that the asset should be owned by the assessee as in Section 32 of the Act. Section 35(2)(ii) provides for terminal depreciation allowance. Obviously this will not be allowable to the assessee as the capital asset does not belong to it. In fact, Section 35(2)(ii), (iii), (iv) and (v) would apply only to assets which remain the property of the assessee. There is no such condition for a claim under Section 35(1)(iv) read with Section 35(2)(i) The language of the section being plain and unambiguous, the assessee is entitled to claim deduction of capital expenditure under Section 35(1)(iv) read with Section 35(2)(i) even where such expenditure does not result in the vesting of the assessee's ownership over the assets.
7. We find that the Commissioner has not met all the points made by the assessee at the time of hearing under Section 263. He has confined himself to the single fact that the expenditure was not incurred out of the profits of the assessee. But the contentions raised by the assessee were of a far reaching nature which were not set by him. After having considered all the submissions, we hold that the Commissioner was not right in reversing the order of the ITO. His order is set aside and that of the ITO restored.