1. These appeals by the Revenue and the assessees for asst. yrs.
1997-98, 1998-99 and 1999-2000 involve common points and, therefore, these were heard together and are being disposed of through this consolidated order, for the sake of convenience.
Grounds raised by the Revenue in their appeal for asst. yr. 1998-99 are as follows : "1. The learned CIT(A) in the facts and circumstances has erred in deleting the disallowance of royalty under Section 35A or 40A(2) amounting to Rs. 5,27,35,429.
2. The learned CIT(A) in the facts and circumstances has erred in deleting the disallowance of Rs. 1,73,440 on account of deferred revenue expenditure." "1. That on the facts and in the circumstances of the case and in law, the disallowance of Rs. 3,19,553 on account of prior period expenses is unjustified, illegal and unwarranted. The expenses debited to the P&L a/c pertain to the. relevant previous year only.
Therefore, the addition of Rs. 3,19,553 deserves to be deleted in total.
2. That on the facts and in the circumstances of the case and in law, the disallowance of Rs. 91,320 on account of repair and maintenance is illegal, unwarranted and unjustified. The expenditure incurred on levelling of factory land, etc., is revenue in nature and is allowable in full.
Therefore, on the grounds taken and basis adopted and in law, the disallowance of Rs. 91,320 is fully unjustified and deserves to be deleted in total." "On the facts and in the circumstances of the case, the learned CIT(A) erred in deleting the addition of Rs. 1,73,440 made on account of deferred revenue expenditure." "That the disallowance of royalty amounting to Rs. 79,77,572 is totally wrong, illegal and unjustified. During the year under consideration, the appellant has paid royalty to Shaw Wallace & Co.
Ltd. for various services rendered by them. The payment of royalty is wholly and exclusively for the purpose of carrying out business activities only. These expenses are clearly in the nature of revenue expenditure and, therefore, are fully allowable. The treatment of above expenses as of capital expenditure and covering them under Section 35A of IT Act, 1961, is totally wrong, unjustified and unwarranted as no brands have been acquired. The addition on account of payment of royalty deserves to be deleted in full." "1. That on the facts and in the circumstances of the case, the impugned order is based upon irrelevant considerations, incorrect application of law, bad in law and void ab initio.
1.1 That the impugned assessment order passed under Section 143(3)/-148 of the IT Act (the Act) and the notice of demand issued in the name of a non-existent entity is illegal, bad in law and void ab initio.
2. That the learned CIT(A) erred on facts and in law, in confirming the disallowance of royalty to the extent of Rs. 9,97,78,120 out of gross royalty of Rs. 10,74,53,360 paid by the appellant to M/s Shaw Wallace & Co. Ltd. (SWC).
2.1 That the CIT(A) erred on facts and in law, in confirming the action of the AO in disallowing 13/14th of the royalty paid to SWC under Section 35A of the Act without appreciating that the provisions of the said section are not applicable to the royalty paid by the appellant.
2.2 Without prejudice, that the CIT(A) erred on facts and in law in confirming the action of the AO in computing the royalty to be disallowed under Section 35A of the Act with reference to gross amount paid amounting to Rs. 10,74,53,360 without appreciating that the disallowance, if at all, should have been computed with reference to net royalty of Rs. 2,30,20,005 (being the excess of gross amount paid over rebates/discounts/incentives given to customers and allocated charges paid to SWC).
2.3 That the CIT(A) erred on facts and in law, in observing, inter alia, that the royalty paid by the appellant to SWC was excessive and unreasonable.
2.4 That the CIT(A) erred on facts and in law, in further observing that the appellant and SWC were related persons as defined in Clause (b) of Section 40A(2) of the Act.
2.5 That CIT(A) erred in confirming the disallowance drawing baseless, irrelevant and untenable conclusions without judiciously appreciating the facts of the case and the position of law." 2. The assessee, M/s Shaw Wallace Distilleries Ltd., is the successor of erstwhile assessee, M/s VRV Breweries & Bottling Industries Ltd., consequent to the merger of the latter with the former company.
3. M/s VRV Breweries & Bottling Industries Ltd. was a public limited company incorporated under the Companies Act, 1956. It entered into an agreement with the Shaw Wallace on 6th July, 1996, for manufacture of Indian made foreign liquor (IMFL) products of brands owned by Shaw Wallace and their associate. The aforesaid agreement was entered into as there was lack of demand of products manufactured by VRV Breweries and to open new and prospective channel for future of the company. In terms of the above agreement VRV Breweries agreed to manufacture and sell IMFL products of various brands owned by Shaw Wallace & Co. Ltd. (SWC). SWC agreed to provide various support services including controlling quality of spirit, purchase of raw material and packing material, quality control, obtaining of import permit, etc. In addition to said support services, Shaw Wallace allowed/permitted VRV a nonexclusive right and licence for use of various trademarks/brands owned by Shaw Wallace for the purpose of bottling and sale of IMFL.
4. Under the agreement, IMFL products manufactured by VRV were either sold/supplied to SWC or to other permit holders/purchasers as per the instructions of SWC. In the former case the sale price of IMFL was determined at the rates mentioned in Clause 1 of Appen. 'D' to the agreement. In that case, VRV was not required to pay any royalty to SWC. In the latter case, VRV was required to pay royalty to SWC which included royalty and service charges for rendering various services by SWC.5. The agreement provided responsibility of SWC to sell and arrange for collection of sale proceeds on behalf of VRV. The agreement further provided that SWC shall in order to boost sales and increase market presence, grant rebates and discounts to the various customers on the basis of quality of products purchased on behalf of VRV.6. The question of deduction of royalty was taken up first in asst. yr.
1997-98. The AO found that on total sale of Rs. 2,43,80,045 the assessee debited gross royalty of Rs. 84,01,160 as payment to SWC. In response to AO's query to justify deduction of the royalty, the assessee explained its case as per letters dt. 24th Jan., 2000 and 10th March, 2000.
7. The assessee relied upon the agreement with SWC dt. 6th July, 1996, for manufacture of IMFL products of brands owned by SWC or their associates on terms and conditions which opened new and prospective channels for the assessee. The agreement was claimed to be necessitated by the lack of demand of the products manufactured by the assessee under brands owned by it. It was explained that production made between April to September, 1996, of its own brand remained unsold and to large extent was reflected in the closing stock. In these circumstances, it became compulsory for the assessee-company to enter into an agreement with SWC for manufacture of products under their brands. After the agreement, company started producing and selling branded goods successfully since the brands owned by SWC were accepted in the market.
The success of the arrangement, according to the assessee, was reflected in production of 61,634 cases of IMFL as against 621 cases in the previous year. Thus, SWC under the agreement provided its brand names, samples, formula in the manufacture of IMFL, process of manufacture, provision of brand labels, arrangement for supply of raw material and sales through its chain of customers without which the assessee could not have remained in the business. Thus, royalty was paid for all the services rendered by SWC and was calculated on the basis of formula specified in the agreement.
8. The assessee argued that without the agreement with SWC, assessee could not have survived. It was accordingly claimed that royalty was wholly and exclusively expended for the purpose of business and had direct nexus to the business needs of the assessee. Complete details of working of royalty payable to the said SWC were placed on record. A photocopy of a similar agreement entered into by SWC with Balbir Distilleries Ltd. was also placed on record for a ready reference. The AO disallowed 13/14th of the deduction of royalty with the following observations : "3.1 The contention of the assesses cannot be accepted. Market practice can only be established if payment of royalty is made to a company where majority shareholders of that company are not group companies of Shaw Wallace & Co. Ltd. The case of Balbir Distilleries Ltd. of Solan will also be of no use as majority share holding must have been acquired by the group company of Shaw Wallace prior to or at the time of agreement between Balbir Distilleries Ltd. and Shaw Wallace & Co. Ltd. Further, the argument of the Authorised Representative that after the agreement, the company started producing and selling branded and patented goods of Shaw Wallace successfully holds no water as prior to agreement only, majority shareholding was acquired by the Shaw Wallace group company and as a result of this all the brand names and marketing network of Shaw Wallace group was at their command in any way ' just like any other group concern. The agreement has been entered to make a device to transfer profits. They have tried to create a separate entity so that transfer of income can take place and all types of expenditure can be debited in these dummy companies so that they are not scrutinised in its proper perspective in the main group cases and it does affect their financial ratios. As can be seen from the above, these steps are pre-planned and there cannot be any justification for such a high royalty payment. The day-to-day management is also in the control of Shaw Wallace Group. The expenditure in the form of purchases of raw material, packing material, etc. are likely to be inflated from the market rates. It is also surprising that this fact that majority shareholding had been acquired by Shaw Wallace Group does not find mention in audit report or notes on accounts or tax audit report and this fact has emerged only on persistent query by this office. It has been held by the apex Court in the case of Prakash/Bharat Beedies (P) Ltd. v. CIT (1993) 201 ITR 1063, 1070 (SC) that royalty payment made by the assessee-company for use of trade name of the firm is liable to be scrutinised under Section 40A(2). No justification has been given by the assessee with respect to market practice from independent parties. Assessee has also not bifurcated as to how much amount is towards use of brand name/labels and how much is towards marketing services. The other services provided by SWC had also not been specified. Also, assessee has not been able to point out as to why for similar work, M/s Balbir Distilleries was getting bottling charges @ Rs. 40 per case in 1995 as against Rs. 15 per case bottling charges receivable by the assessee-company in 1996. This further proves that intention is transfer of profit. It is obvious from the above that royalty payment is highly excessive and unjustified.
3.2 The copy of agreement dt. 6th July, 1996, has been perused. The assessee has acquired the right to manufacture and sell the brands of Shaw Wallace group. It has got the right to use the trademark, brand names, design and the get-up of Shaw Wallace products. By paying these consideration which are capital in nature, Shaw Wallace has authorised assessee under a separate agreement to manufacture, process, package and sell the IMFL products of various brands of Shaw Wallace. Inspite of repeated asking, the Authorised Representative has not produced a copy of the agreement mentioned in para 6.3 and also in Appen. 'C'. It is also important to mention here that assessee had pressed for claim under Section 37. However, Section 37 only deals with those expenditures which are not of the nature described in Sections 32 to 36 and also not in the nature of capital expenditure. In this case, the know-how, recent formula not being disclosed by the assessee as discussed above, designs and specifications are undoubtedly patent rights of M/s Shaw Wallace group. The expenditure under the head royalty in this case is of capital nature. Capital expenditure does not necessarily mean to be one time payment. The assessee was never manufacturing these brands which were patented trademark of Shaw Wallace group. Patent rights acquired by the assessee are used for the purpose of its business.
Therefore, condition of Section 35A is also satisfied.
3.3 As discussed in para 3.1, the payment of royalty is excessive and a part of which is to be disallowed. In the absence of agreement mentioned above, in Annex. 'C' and in absence of figures in the agreement, and also the absence of basis of charging of Rs. 15 or Rs. 40 per case and details of every other service provided by Shaw Wallace and co-relation between expenditure incurred by Shaw Wallace and corresponding element of royalty, and considering that restricting reasonable payment, 13/14 of Rs. 84,01,160 = Rs. 78,01,077 is disallowed.
4. As per the notes to accounts, interest on ICD amounting to Rs. 2.66 lakhs has not been considered in the computation of income. The assessee is following mercantile system of accounting. The disallowance under Section 143(1)(a) has been confirmed by the CIT(A). The same is brought to tax under Section 143(3) also." 9. In asst. yr. 1998-99, assessee claimed a similar deduction of royalty at Rs. 5,67,92,000. In the next asst. yr. 1999-2000, the net royalty of Rs. 2,30,20,005 as paid to SWC after deducting rebates and discounts (Rs. 7,82,80,256 and allocated charges Rs. 61,53,099) was permissible deduction. In the P&L a/c, VRV debited the gross royalty without charging rebate and discount and other expenses since quantum of rebate discount offered by SWC on behalf of the assessee was not precisely available at the time of making of accounts. Similar disallowance was made by the AO in the subsequent years.
10. The assessee impugned addition/disallowance in all the appeals before the CIT(A). The appeals were taken up by different CIT(A). The issue in asst. yr. 1997-98 was decided against the assessee whereas in asst. yr. 1998-99, the claim of the assessee was accepted. The learned CIT(A) gave following main reasons for taking the view against the assessee in asst. yr. 1997-98 : (1) Under Section 40A(2) of IT Act where the assessee ensures any expenditure in respect of which payment has been made to any person referred to in Clause (b) of this sub-section and the AO is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of goods, services or facilities or the legitimate needs of the business or profession of the assessee, or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction. Assessee's case was taken to be covered under Clause (iv) of Sub-section (b) where a company having a substantial interest in the business or profession of the assessee is covered for this purpose. AO had already pointed out that majority share holding is by the Shaw Wallace which was not controverted before him. The employees of the Shaw Wallace were having controlling share holding. It was accordingly held that payment of royalty made to Shaw Wallace was covered under Section 40A(2) of IT Act.
(2) In this connection, reference was made to a similar agreement with another company M/s Balbir Distilleries, the bottling charges were paid at Rs. 40 per case. It was further observed that although assessee-company said that it was manufacturing IMFL but in fact it was only engaged in bottling of IMFL. It pays royalty on sale of liquor but is not engaged in marketing of liquor. All activities relating to manufacture of liquor and its marketing are done by parent group company but for accounting purposes, sales are shown by the subsidiary company. In other words, on sale of Rs. 100 worth of liquor M/s Balbir Distillery would pay royalty of Rs. 60. Balance amount of Rs. 40 termed as bottling charges is received by it. On the same analogy, assessee pays Rs. 85 by way of royalty and receives only Rs. 15 which is termed as bottling charges. The onus was on the assessee to explain the reasons for paying royalty by excess amount of Rs. 25. The assessee has neither explained nor brought on record any comparable case to escape provision of Section 40A(2) of IT Act. The explanation of the assessee that Balbir Distillery was located at different place was not convincing.
Accordingly, it was held that payment of Rs. 25 out of Rs. 85 paid by way of royalty was considered excessive and disallowed".
Accordingly, out of total amount of royalty of Rs. 84,01,160, a sum of Rs. 24,70,929 was disallowed under Section 40A(2) of IT Act.
(3) The balance amount of royalty of Rs. 59,30,231 was held to be covered under Section 35A of IT Act. 1/14th of above amount, i.e., Rs. 4,23,588 could be allowed to the assessee.
11. The disallowance of royalty was held to be unjustified by the learned CIT(A) in appeals for asst. yr. 1998-99. He held that both provisions of Section 40A(2) and Section 35A were not applicable. The disallowance was deleted.
12. The successor CIT(A) in his order for asst. yr. 1999-2000 did not agree with the order of CIT(A) for asst. yr. 1998-99 and reproduced the following observations from the aforesaid order at p. 7 of the impugned order : "This issue was again decided in asst. yr. 1998-99. For the asst.
yr. 1998-99, the CIT(A)-XX has held that : "Therefore, the case is covered by the decision of Supreme Court in the case of CIT v. Ciba of India Ltd. (1968) 69 ITR 692 (SC) and the decision of Hon'ble Delhi High Court in the case of Triveni Engineering Works Ltd. v. CIT (1982) 136 ITR 340 (Del). The ratio of decisions of other Courts relied upon by the appellant is also applicable in the facts and circumstances of the case. Further, the expenditure has been incurred not only for use of trademark but also providing various other services like support for control quality of spirit, purchase of raw materials, packing materials, quality control, obtaining of import permits, obtaining verification certificate from excise authorities, financial and technical support, sale and marketing support, collection of sales proceeds, support for packing credits and payment of sales-tax, etc. Since expenditure has been incurred for the purpose of business and is revenue in character, the provisions of Section 35A will not be applicable. I respectfully defer with the findings of my learned colleague that the provisions of Section 35A are applicable to the case of appellant." In asst. yr. 1998-99, the CIT(A)-XX was of the opinion that the order of CIT(A)-IV was based on the finding that M/s VRV Breweries and M/s Shaw Wallace were group concerns. He held that : "I would like to mention here that the CIT(A)-XIV, New Delhi, had made reference to finding of the AO that the majority share holding is by the Shaw Wallace which has not been controverted. However, the appellant for the asst. yr. 1998-99 has controverted this fact. The shares are neither held by the Shaw Wallace nor by the employees of Shaw Wallace as also the payment of royalty was not made to the employees of Shaw Wallace. Further, payment was not made to Shri Surajn P. Gupta who was holding more than 20 per cent shares.
Therefore, the provisions of Section 40A(2) will not be applicable to the facts of the instant case. The AO has not brought any material on record to justify his conclusion as to how provisions of Section 40A(2) will be applicable. The reliance placed by the AO on the decision of Hon'ble Supreme Court in the case of Prakash/Bharat Beedi Works (P) Ltd. v. CIT (supra) is misplaced. In this case the Hon'ble Supreme Court had an occasion to deal with the disallowance under Section 40(c) of the Act. The payments made to the directors for use of brand name were disallowed under Section 40(c) of the Act. It was observed that so long as the agreement whereunder the said payments made is not held to be a mere device or a mere screen, the said payment cannot be treated as payments made to the directors (qua directors). The payments were made by way of consideration for allowing the assessee to use a valuable right belonging to them, viz., the brand name. Such payments may be liable to be scrutinised under Sub-section (2) of Section 40A. In the instant case the payment has not been made to the specified persons under Section 40A(2)(b) and, therefore, provisions of Section 40A(2) are not applicable. Since provisions of Section 40A(2)(b) are not applicable, the question for estimating excessive amount of expenditure does not arise though the appellant has given explanation for differential rate of payment of bottling charges to the Balbir Industries." For the aforesaid reasons, the learned CIT(A) in his order for asst.
yr. 1999-2000 did not agree with the view taken by his predecessor in asst. yr. 1998-99. He noted the shareholder of assessee-company at p. 8 of the impugned order. All the shareholding companies were held to be part of SWC as these had close business commercial and equity connection with each other. Therefore, these were held to be covered by provisions of Section 40A(2) of IT Act. He further observed that though Shaw Wallace may not themselves hold shares in the assessee-company, it cannot be denied that in case the group of companies of Shaw Wallace is a member have close business and commercial links, such a connection establishes a close business nexus between the parties.
13. The AO had also held that assessee had adopted a device to transfer profit and there was no commercial expediency or necessity for paying royalty to SWC. However, on appeal, the learned CIT(A) in order for asst. yr. 1998-99, held that shares are neither held by Shaw Wallace nor by the employees of Shaw Wallace and payment was not made to employees of Shaw Wallace. It was accordingly held that provisions of Section 40A(2) were not applicable.
14. The learned CIT(A) deciding the appeal of the assessee for asst.
yr. 1999-2000 did not agree with above view. He referred to letter dt.
11th June, 2002, of the assessee wherein the assessee-company had informed that it stood transferred and merged with Maharashtra Distillery Ltd., w.e.f. 1st July, 2000, which was having business connection with M/s Shaw Wallace. The merger scheme of above company was approved by Hon'ble High Court of Bombay vide their order dt. 26th March, 2003. Thus, entire undertaking along with properties and assets and liabilities have been transferred to the holding company w.e.f. 1st Nov., 2002. Subsequent to the amalgamation, the name of the assessee-company has changed to Shaw Wallace Distilleries Ltd. vide certificate of incorporation dt. 12th May, 2003. The learned CIT(A) also took into account decision of the Supreme Court in the case of Prakash/Bhaiat Beedies (P) Ltd. v. CIT (supra). In the said case a company was formed to take business of firm called K.M. Ananda Prabhu & Sons. As per agreement between the parties, the company was to pay royalty for use of trade name to the vendor. The royalty was to be worked out on the basis of sales of the period mentioned in the agreement. The partners of the vendor firm were also directors in the assessee-company. The Revenue authorities disallowed part of payments under Section 40(c) of IT Act. On appeal, it was held that payments made to erstwhile partners may be hit by provisions of Sub-section (2) of Section 40A, but did not fall within the four corners of Section 40(c). The question referred was answered in favour of the assessee and against the Revenue.
15. The learned CIT(A) also referred to the decision of Supreme Court in the case of Shahzada Nand and Sons v. CIT (1977) 108 ITR 358 (SC), wherein their Lordships held that question of commercial expediency must be tested in the context of current socio-economic thinking and not in the light of 19th century laissez faire doctrine which regarded man as an economic being concerned only to protect and advance his self interest.
16. In the light of above circumstances and case law, the learned CIT(A) saw no rationale in payment of Rs. 85 for each sale of Rs. 100 by the assessee when M/s Balbir Distilleries was sharing profit in 40 : 60, the arrangement between the parties being same and identical.
Accordingly, the learned CIT(A) agreed with the view taken by his predecessor in asst. yr. 1997-98: He held that AO was right in taking and allowing l/14th of expenditure under Section 35A. The disallowance of Rs. 9,97,78,120 was confirmed.
17. The other disallowance of Rs. 1,73,440 made on account of deferred revenue expenditure was also confirmed. In doing so, the learned CIT(A) followed the decision of the predecessor for the asst. yr. 1997-98.
18. Both the Revenue and the assessee have come up in appeal challenging that portion of decisions of learned CIT(A) which went against them. We have heard submissions of both the parties. The learned counsel for the assessee has drawn our attention to the agreement between the parties, i.e., assessee and Shaw Wallace & Co. He argued that Section 40A(2)(b) had no application in this case. The AO loosely described two companies as group companies without stating what he means by group companies. It is also not stated as to where does the concept of group company figure in the IT Act.
19. In the instant case only Clauses (iv) to (vi) of Section 40A(2) of the Act may, if at all apply since Clauses (i) to (iii) deal with payments made by an individual assessee or payment made to an individual (as discussed infra).
20. Insofar as payment to a company is concerned, the relevant portions of Clauses (iv) to (vi) of Section 40A(2) of the Act read as under : "(b) The persons referred to in Clause (a) are the following, namely : (iv) a company..............having a substantial interest in the business or profession of the assessee or...........; (v) a company.............of which a director..............has a substantial interest in the business or profession of the assessee; or.........
(B) where the assessee being a company................ or any director of such company..............or any relative of such director..........has a substantial interest in the business or profession of that person.
Explanation : For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if, (a) in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; and (b) in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business." In terms of the aforesaid provision, only the following payments by a company to another company fall under Section 40A(2) of the Act : --Any payment made to a company having a substantial interest in the business or profession of the assessee [Section 40A(2)(b)(iv)]; In the present case since SWC does not have substantial interest in the appellant, Clause (iv) of Section 40A(2) is not attracted (refer shareholding pattern of VRV--Annex. 3).
--Any payment made to a company, a director of which has a substantial interest in the business of the assessee [Section 40A(2)(b)(v)]; Since, only one individual, Shri S.P. Gupta, held substantial interest in VRV who was not a director of SWC, Clause (v) of Section 40A(2) is not attracted. (Refer list of directors of SWC--Annex. 4).
--Any payment made to the company in which the assessee has a substantial interest or any payment made to a company in which the director of the assessee has a substantial interest or any payment made to a company in which any relative of the director of the assessee has any substantial interest-Section 40A(2)(b)(vi)(B).
Since, neither VRV nor any of its directors nor relative(s) of its director do held substantialinterest in SWC, Clause (vi) of Section 40A(2), is not attracted.
Clauses (i) to (iii) of Section 40A(2) of the Act do not apply since : In the present case since appellant and VRV are companies, Clause (i) of Section 40A(2) is not attracted; --Clause (ii) applies if payment is made to any director of a company or any relative of such director; Since payment was made to SWC, a company, not an individual, being a director or relative of director, Clause (ii) of Section 40A(2) is not attracted.
--Clause (iii) applies to payment made to an individual having substantial interest in the assessee or any relative of such individual; Since payment was made to SWC, a company, not an individual, being a person holding substantial interest, Clause (iii) of Section 40A(2) is not attracted.
It was emphatically stated before the AO and the CIT(A) in the aforesaid years that VRV and SWC are not related persons in terms of Section 40A(2)(b) of the Act. This is also evident from the (sic) of shareholders of VRV and the list of directors of VRV and SWC during the relevant years.
In asst. yr. 1997-98, the CIT(A) however held that the assessee's case is covered by Clause (iv) of Sub-section (b) where a company having a substantial interest in the business or profession of the assessee is covered for this purpose. The relevant observations of the CIT(A) read as under (refer para 4 p. 2 of the order) : "The appellant's case is covered under Clause (iv) of Sub-section (b) where a company having a substantial interest in the business or profession of the assessee is covered for this purpose. The substantial interest is also defined in the Explanation thereto.
According to this if a company has 20 per cent of the voting power or more it is said to have a substantial interest. The AO has already pointed out that the majority shareholding is by the SW which has not been controverted. The learned Authorised Representative further submitted that the employees of SW have the controlling shareholding. Therefore, the payment of royalty to SW is covered under Section 40A(2) and has to be seen whether the payment is excessive or unreasonable." As stated above, the aforesaid observation of CIT(A) is contrary to facts and the position of law. This aspect was specifically brought to the notice of the CIT(A) in the asst. yrs. 1998-99 and 1999-2000.
In the asst. yr. 1998-99, the CIT(A) after elaborately considering and dealing with the issue, held that the provisions of Section 40A(2) of the Act are not applicable (refer para 5.4/p. 16 of the order).
In the asst. yr. 1999-2000, the CIT(A), after considering the orders for the earlier two years, observed that provisions of Section 40A(2) apply due to close business nexus, commercial and equity links between the group companies [refer p. 8 of the order of CIT(A)].
The CIT(A), in the asst. yr. 1999-2000 failed to appreciate that the list of persons prescribed in Section 40A(2) is exhaustive and not illustrative, and no relation other than those prescribed can be imported in the section.
Clause (b) of Section 40A(2), defining the related parties, uses the expression, "are the following, namely" indicating that the list of relationship stated is exhaustive. Reliance in this regard is placed on the decision of the Supreme Court in the case of Mahindra Engineering and Chemical Products Ltd. v. Union of India 1992 (58) ELT 161.
Without prejudice to the aforesaid, the observation that royalty paid is excessive and unreasonable based on another agreement entered into by SWC with M/s Balbir Distilleries Ltd. is erroneous.
The agreement between SWC and Balbir Distilleries Ltd. cannot be compared with the agreement entered into by VRV. The adverse inference drawn from their comparison is based on incorrect understanding of the covenants and the facts of the assessees.
21. As regards application of provision of Section 35A, the assessee submitted that royalty paid to SWC was a revenue deduction. He further argued that under the agreement SWC was also to offer rebate/discount to customers and amount of allocated charges were adjusted against the gross royalty paid by the assessee to SWC. Consequently, SWC received only net royalty for rendering various services as enumerated below.
(i) Controlling quality of spirit : SWC was required to supply to VRV sample of the spirit to be used in the manufacture of IMFL products (refer Clause 2.1).
(ii) Purchase of raw materials : SWC was required to specify all raw materials required for the manufacture, distillation and bottling of the IMFL products and in certain cases arrange procurement thereof (refer Clauses 3.2 to 3.4).
(iii) Purchase of packing materials : SWC was required to provide samples for purchase of packing materials and approve purchase of packing materials (refer Clauses 3.6 and 3.7).
(iv) Quality control : SWC was required to check/control the quality of IMFL products (refer Clause 5). To facilitate the same, SWC was entitled to post its technical representative to : (v) Obtaining import permits : The import permits as may be necessary for the purpose of sale and supply of the IMFL products, etc., manufactured by VRV to the purchaser were to be arranged by SWC (refer Clause 4.4).
(vi) Obtaining verification certificates from excise authorities : SWC undertook to obtain verification certificates where necessary under the Excise Rules from the excise authorities (refer Clause 4.5).
(vii) Sales/Marketing support : SWC undertook to advice VRV as to the marketing arrangement for sale of IMFL products and VRV was required to act in accordance with such directions (refer Clause 6.4).
(viii) Collection of sale proceeds : SWC was responsible to sell and arrange for the collection of sale proceeds and declaration forms required for sales-tax (refer Clause 2 of Appen. 'D').
(ix) Financial support for packing credit : SWC was required to arrange for trade advance to cover stock of packing material stock so that VRV was not burdened with finance of packing materials (refer Clause 5 of Appen. 'D').
(x) Financial support for payment of sales-tax : In the event of delay in realisation of sales, SWC undertook to make available funds required for the payment of sales-tax for the following month (refer Clause 5 of Appendix 'D').
It is pertinent to reiterate that the collection of the sale proceeds was the responsibility of SWC and any bad debt was to the account of SWC.In addition to the aforesaid, SWC granted licence/permission to VRV for the use of brands owned by SWC for manufacturing and bottling of IMFL products.
Thus, net royalty (and not the gross royalty as taken by the AO) was paid by VRV to SWC towards rendering the aforesaid set of services in addition to allowing VRV the non-exclusive licence/permission for the use of various brands/ trademarks owned by SWC for manufacture and bottling of IMFL products.
The AO without appreciating the facts of the case and the position of law held that royalty paid was towards acquisition of patent/trademarks and was covered by Section 35A of the Act. The AO held that royalty to the extent of 13/14th was not allowable under Section 35A of the Act.
Section 35A of the Act provides for amortisation of expenditure on acquisition of patent rights or copyrights which was otherwise capital in nature. The term "acquisition" refers to absolute proprietary rights in the patent or purchase of copyright as opposed to obtaining mere permission or right to use as can be inferred from the meaning of the term "acquire" as explained in various dictionaries (Annex. 1 to this proposition).
22. The royalty paid was a revenue deduction and the provision of Section 35A had not been applied to such payment. The learned counsel relied upon commentary of learned authors Kanga and Palkhiwala, 8th Edition, Vol. 1, wherein the learned author have opined that right to use patent or copyrights and payment made therefor is a revenue expenditure under Section 37 of the Act. Section 35A deals with expenditure, i.e., price paid for purchase of copyright or patent rights.Charanjit Lal v. Union of India AIR 1951 SC 41 explained the term acquisition as follows : 'It cannot be disputed that acquisition means and implies the acquiring of the entire title of the expropriated owner, whatever the nature or extent of that title might be. The entire bundle of rights which were vested in the original holder would pass on acquisition to the acquirer leaving nothing in the former. In taking possession, on the other hand, the title to the property admittedly remains in the original holder, though he is excluded from possession or enjoyment of the property.....' The Supreme Court in the case of Devidas Gopal Krishan v. State of Punjab AIR 1967 SC 1895, explained the term acquisition as under : "Acquisition is the act by which a person acquires property in a thing. 'Acquire' is to become the owner of the property... Context, consistency and avoidance of anomaly demand a restricted meaning.
That it must only mean transfer is also made clear by the nature of the transactions excluded from the acquisition, namely, mortgage, hypothecation, charge or pledge all of them belong to the species of transfer. We must, therefore, hold that the expression 'acquisition' in Clause (ii) of Section 2 of the Act means only 'transfer'." Expenditure incurred on payment for use of technical know-how for a limited duration as opposed to payment for acquisition thereof is allowable as deduction under Section 37(1) of the Act.
In the case of CIT v. Ciba India Ltd. (supra), the assessee entered into an agreement with the Swiss company wherein the Swiss company undertook to deliver to the appellant all process, formulae, scientific data, working rules and prescriptions pertaining to the manufacture or processing of products developed in such company's laboratory. It also granted to appellant full and sole rights and licence to make use, exercise and vend the inventions specified therein in India, and to use certain trademarks in the territory. As per the terms of the agreement, the assessee agreed : (a) not to divulge to third parties without the consent of the Swiss company any confidential information received under the agreement; (b) Without the written consent of the Swiss company, not to assign the benefit of the agreement or grant sub-licences of the patents and trademarks; and (c) Upon termination of the agreement for any cause to cease to use the patents and trademarks and to return to the Swiss company all copies of information, scientific data or material sent to it and to refrain from communication.
Their Lordships held that the assessee did not under the agreement become entitled exclusively even for the period of the agreement, to the patents and trademarks of the Swiss company, it had merely access to the technical knowledge and experience in the pharmaceutical field which the Swiss company commanded. The assessee was on that account a mere licensee for a limited period of the technical knowledge of the Swiss company with the right to use the patents and trademarks of that company. The assessee acquired under the agreement merely the right to draw, for the purpose of carrying on its business as a manufacturer and dealer of pharmaceutical products, upon the technical knowledge available with the Swiss company did not part with any asset of its business, nor did the assessee acquire any asset or advantage of an enduring nature for the benefit of its business.
In the said case, the Court held that the expenditure incurred for use of technical know-how was allowable as revenue deduction under Section 37(1) of the Act, not being a capital expenditure.
The learned counsel for the assessee relied upon several other decisions including the decision of Indore Bench in the case of Etcher Motors Ltd. v. Dy. CIT (2004) 82 TTJ (Ind) 61, wherein the Bench held that there is distinction between the acquisition/purchase of know-how and use of know-how, and where transferor retains property rights in the design, secret formula, etc. and allow the use of such right, the same is in the nature of royalty whereas in an outright sale or purchase, the consideration is for transfer of such rights and cannot be termed as royalty.' 24. The learned counsel for the assessee accordingly argued that payment made for royalty was a revenue deduction not hit by provisions of Section 40A(2)(b) or Section 35A of IT Act. He submitted that learned CIT(A) in asst. yr. 1998-99 took right view of the matter. The view taken in other assessment years was erroneous.
25. The learned Departmental Representative, on the other hand, supported the impugned order. He argued that case of the assessee was hit by provision of Section 40A(2) of IT Act. The bottling charges paid to Balbir Distilleries Ltd. in identical circumstances clearly showed that assessee was claiming deduction of unreasonable and excessive amount. The assessee has further acquired capital asset and an enduring benefit on account of agreement with Shaw Wallace & Co., and accordingly provisions of Section 35A were rightly applied. The assessee was entitled to deduction as provided in the said section. The learned Departmental Representative read out and relied upon decision of Revenue authorities deciding the issue against the assessee.
26. On careful consideration of rival submissions of parties, we are inclined to hold that royalty paid by the assessee to Shaw Wallace & Co. is to be allowed as a revenue deduction. We have considered agreement between the parties dt. 6th July, 1996. Under the agreement the assessee has acquired right to manufacture and sell brands of Shaw Wallace & Co. Even out of the gross royalty payable, Shaw Wallace & Co.
was to allow rebate and discount to the customers on behalf of the assessee for brands manufactured by it. The net amount of royalty was payable to Shaw Wallace.
It is evident from the agreement that Shaw Wallace was to supply the assessee sample of spirit to be used in the manufacture of IMFL. Shaw WaDace & Co. was further required to specify the raw material required for manufacture, distillation, bottling of products, advise on purchase of packing material, facilitate the assessee in having quality control, help in acquiring import permits and in obtaining certificate from excise authorities. Besides the above, SWC was to advise the assessee as to marketing arrangement for sale of IMFL products manufactured by the assessee. Financial support was also required to be provided by SWC. It is clear from the agreement that royalty was paid for carrying on day-to-day business activities of the assessee. It was payment for carrying on, enhance and promote assessee's production (business). It was to add efficiency to the business. The assessee has furnished sale figures on record to show that after the agreement assessee's sales took a quantum jump. Its profitability increased. The cases relied upon on behalf of the assessee are clearly attracted and payment made was royalty for use of technical know-how and experience of Shaw Wallace & Co. The assessee did not acquire any benefit of enduring nature which could be termed as a capital asset.
27. Neither the AO nor the learned CIT(A) in his order has brought any material on record to show that any asset of capital nature was acquired by the assessee. An adverse inference has been drawn against the assessee by the AO for not disclosing the formula used in the manufacture of IMFL products. We are unable to hold that above approach of Revenue authorities was correct. The agreement with the parties clearly showed that amount was paid as royalty for benefits which increased efficiency and saleability of products manufactured by the assessee and in increasing its turnover. On the facts of the case and in the light of case law cited before us, we are unable to hold that royalty paid by the assessee and claimed as a deduction was a capital expenditure. We, therefore, hold that the AO was not justified in applying provisions of Section 35A of IT Act.
28. As far as application of provision of Section 40A(2)(b) is concerned, the Revenue has not shown how Shaw Wallace & Co. had substantial interest in the business of the assessee. As per Explanation to section, the Revenue was obliged to show that Shaw Wallace & Co. either has 20 per cent or more of share in profits (including right to receive dividend) or 20 per cent or more of voting power. The matter cannot be decided on presumption. It has to be proved through clear evidence. In the present case, the: AO on general observation concluded that group of Shaw Wallace & Co. had a substantial interest in assessee's business. He failed to give details of persons who had interest in company and how it was 20 per cent or more as envisaged by Explanation to Section 40A(2) of IT Act. The assessee before the AO and before the CIT(A) had emphatically denied that Shaw Wallace & Co. has substantial interest in business or profit of the assessee. The assessee, therefore, challenged application of Section 40A(2)(b) of IT Act. In such a situation the AO was duty bound to bring clear and cogent evidence on record and not rest his case on a general observation that Shaw Wallace had majority shareholding in assessee-company. What is this majority and how it is proved, it is left to the imagination. The order passed by the learned CIT(A) in asst. yr. 1999-2000 is contrary to facts recorded by the CIT(A) in asst. yr. 1998-99. Without distinguishing facts and without bringing any material on record, contrary view has been taken. We find that in asst. yr. 1998-99, CIT(A) elaborately discussed the issue and after cogent reasons held that provisions of Section 40A(2) are not applicable in this case. We agree with the above reasoning.
As already noted, under Clause (b) of Section 40A(2), definition of related party is given and that is exhaustive. The Revenue authorities have to establish the case within the relationship enumerated in the list. No attempt was made by them to show that the case is covered by relationship indicated in the provision. The decision of Hon'ble Supreme Court in the case of Mahindra Engineering and Chemical Products Ltd. v. Union of India (supra) supports the view that we are taking above.
29. The assessee has also shown that case of M/s Balbir Distilleries Ltd. was not comparable, bottling charges paid to that company were paid under totally different circumstances. The differences were highlighted by the assessee as under : "It is pointed out that the agreement with Balbir Industries was executed in the year 1995 and the agreement with the appellant was executed in the year 1996. The agreement being of commercial nature could contain different conditions for different parties. At the time of agreement with M/s Balbir Industries, Shaw Wallace was not having any bottling facilities in north India. It had to establish its presence and, therefore, it paid higher bottling charges to M/s Balbir Industries. The opportunity cost is a very important consideration while fixing such charges.
The plant of M/s Balbir Industries is a small plant with very low capacity installation (3,00,000 cases per annum). The plant of appellant is very big with more than 4 times the capacity (12,00,000 cases per annum). Naturally, the unit of Balbir will be very high in comparison of the appellant since the variable cost per unit goes down with the increase in capacity and the fixed overheads are also apportioned on a higher number of units. Moreover, the plant of appellant is having two bottling lines whereas M/s Balbir is having one bottling line." The claim has not been controverted before us. We, therefore, hold that royalty paid was neither excessive nor unreasonable. The disallowance made by invoking provisions of Section 40A(2)(b) is unjustified and the same is hereby deleted. Accordingly, we uphold order of CIT(A) for asst. yr. 1998-99 and direct AO to apply the same for asst. yrs.
1997-98 and 1999-2000.
30. In the other common ground the Revenue has challenged deletion of addition of Rs. 1,73,440 on account of deferred revenue expenditure.
This ground in 1997-98 is being raised as an additional ground. The same is permitted to be raised. On the above ground, learned CIT(A) in asst. yr. 1999-2000 has made the following pertinent observations : "In the next ground the assessee is aggrieved by the disallowance of Rs. 1,73,440 made on account of deferred revenue expenditure. In the remand report furnished by the AO it has been stated that : 'These expenses were found by the AO to have incurred by the assessee on advertisement in earlier years. 1/5th of the advertisement expenses was charged by the assessee in the respective years. The AO has disallowed the same amount because the statutory provisions do not prescribe the allowability of any deferred revenue expenditure. Moreover, if the expenditure is of revenue in nature and has been incurred for the purpose of business then on mercantile system of accounting the same has to be claimed in the year in which it has accrued. However, if the same is of capital in nature then only as per the specific provision of the statute and only under specific circumstances as provided by law they can be deferred. In the present case, the expenditure is of revenue in nature and pertains to advertisement. The assessee cannot take the logic that the benefit of these expenses was to be availed in the future years also and accordingly the same has been deferred. This is not correct because the assessee has incurred the expenses in a previous year and were allowable in the same year itself. Also, in a number of case law, it has been held that it is not necessary that the benefit of expenditure should be limited to previous year in which it is incurred and accordingly it should be claimed in the year in which it has been incurred on accrual basis. [Mysore Spinning and Manufacturing Co. Ltd. v. CIT (1966) 61 ITR 572 (Bom) and CIT v. Mysore Spinning and Manufacturing (1970) 78 ITR 4 (SC)]. Therefore, the submission of the assessee on this issue is also not acceptable'." This issue has been discussed at length in the earlier years. I find the CIT(A) for 1997-98 on this issue has held as under : "The third ground of appeal is against the disallowance of Rs. 1,73,440 on account of deferred revenue expenditure written off during the year. The AO disallowed it saying that there is no question of allowance of deferred revenue expenditure under the IT Act. The AO has not discussed whether the expenditure is allowable otherwise. The learned Authorised Representative has submitted that the expenditure was incurred on advertisement and was decided to be written off over a period of 5 years. Accordingly, a sum of Rs. 1,73,440 was debited for the year under consideration. The expenditure is 'wholly and exclusively for the purpose of business' and it has to be allowed during the year under consideration on a deferred basis.
In ITC Classic Finance Ltd. v. Dy. CIT (2000) 112 Taxman 135 (Cal)(Mag) (Calcutta A Bench), 1/7th of the premium payable on redemption of debenture was allowed, following Madras Industrial Investment Corporation Ltd. v. CIT (1997) 225 ITR 802 (SC).
Similarly, since no finding of the expenditure not being for business purposes, it has to be allowed on deferred basis as claimed by the appellant. The addition of Rs. 1,73,440." 31. We have heard both the parties. The learned Departmental Representative submitted that there was no provision to allow deferred revenue expenses. He, however, could not show any material which would make these expenses as capital or inadmissible expenses. As per past history 1/5th of expenses has been allowed as benefit of advertisement was available for more than one year. In the peculiar circumstances of the case and in the light of case law relied upon by the assessee, we do not find any substance in this ground. The same is dismissed.
32. The assessee has further challenged disallowance of Rs. 91,320 in asst. yr. 1998-99. These were claimed to be repair and maintenance expenses. After considering relevant material, we do not find any good ground to sustain the disallowance. The Revenue authorities neither in the assessment order nor otherwise during the course of hearing of appeal has shown any material which would indicate that expenses in question were capital in nature. We, therefore, direct that these expenses be allowed.
33. The assessee in the appeal for asst. yr. 1998-99 has also challenged disallowance of Rs. 3,19,553 relating to disallowance of prior period expenses. The learned CIT(A) while upholding disallowance observed as under : "10. The ground No. 6 relates to disallowance of Rs. 3,19,553 on account of prior period expenses. The AO observed that the assessee has not furnished any evidence to prove that the expenditure is crystallised during the year. The disallowance of Rs. 3,19,553 consists of five items. The first item of Rs. 2,55,536 relates to rate difference on mono-cartons. The appellant purchased mono-cartons from Rainbow Distilleries (P) Ltd. on 10th Dec., 1996.
As there was dispute as to the price of mono-cartons purchased, the appellant-company did not pass any evidence in its books of account on 10th Dec., 1996. Subsequently, at the end of financial year entry was passed only for Rs, 2,35,396 towards purchase of mono-cartons.
The bill of Rs. 4,90,932 raised by the Rainbow Distilleries (P) Ltd. was not fully charged to the books of account because of the dispute. The dispute was finally resolved during the financial year 1997-98 relevant to the asst. yr. 1998-99 and the appellant passed entry for difference price, i.e., Rs. 2,55,536 (Rs. 4,90,932 minus Rs. 2,35,396) on 27th Dec., 1997. The appellant placed reliance on the decisions of Allahabad High Court in the case of Sir Shadi Lal Sugar and General Mills Ltd. v. CIT (1992) 64 Taxman 597 (All) and in the case of CIT v. Oriental Motor Co. (P) Ltd. I have considered the facts of the case. The appellant has not produced any evidence to prove its contention that the dispute was settled during the previous year relevant to asst. yr. 1998-99. The appellant has also not given the details and the nature of dispute and corroborated evidence in support of its contention. In the absence of proof that the dispute was settled during the previous year relevant to asst.
yr. 1998-99, the addition made by the AO is confirmed." 34. The assesses is aggrieved and has brought the issue in appeal before the Tribunal. We have heard both the parties, We do not doubt the proposition that where a dispute arises between the parties, the expenditure is to be allowed in the year in which such dispute is settled and expenses crystallised. This proposition is also not doubted by the learned CIT(A). The disallowance is sustained by him as no evidence was led to show that dispute was settled in the period under consideration, The position before us continued to remain unaltered.
35. The learned counsel for the assessee vehemently contended that assesses had incurred a revenue expenditure and the same was to be allowed either in asst: yr. 1998-99 or in the prior year. The expenditure could not be totally disallowed as incurring of expenses is not in dispute. The matter has not been examined from above point by the Revenue authorities. This may now be done by the AO after affording reasonable opportunity of being heard to the assessee. The impugned order is set aside and the matter is restored to the file of the AO.36. The assessee during the course of hearing of appeal also took up an additional ground urging that assessments made were illegal and void as the same should have been made on the amalgamated-company which was then in existence. In other words, it is contended that M/s Shaw Wallace Distilleries Ltd. came into existence on 1st Nov., 2002 and, therefore, assessment, if any, should have been made on the above successor company. However, ITO did not issue any notice to such company nor subjected the above company to assessment.
The above point admittedly was not raised during the course of hearing of appeal. The alternative submissions of the assessee on merit have already been considered and decided. We, therefore, see no good ground to permit the assessee to raise above additional ground. The same is not entertained and is rejected.
37. The appeals of the Revenue are dismissed whereas those of the assessee are allowed in terms stated above.