R&D Sales Proceeds Not Deducted from Expenditure: High Court Rules

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Case Name:

Commissioner of Income Tax and Another vs. Microlabs Ltd. (High Court of Karnataka)

Income Tax Appeal No. 471 of 2015

Date: 11th March 2016

Key Takeaways:

- The court clarified that sales proceeds from products developed through R&D do not reduce R&D expenditure.

- The decision emphasizes that such sales are part of normal business income and should be treated as business receipts.

- The ruling impacts how companies can claim deductions under Section 35(2AB) (of Income Tax Act, 1961).

Issue

Should sales proceeds from products developed through R&D be deducted from R&D expenditure for tax purposes?

Facts

Microlabs Ltd. engaged in scientific research and developed products through its R&D activities. The company claimed deductions under Section 35(2AB) (of Income Tax Act, 1961) for its R&D expenditure. The tax authorities argued that sales proceeds from these products should reduce the R&D expenditure, affecting the deduction amount.

Arguments

- Microlabs Ltd.: Argued that sales proceeds from R&D products are part of normal business income and should not reduce R&D expenditure.

- Tax Authorities: Contended that such sales should offset R&D expenditure, reducing the deduction claimable under Section 35(2AB) (of Income Tax Act, 1961).

Key Legal Precedents

The court referred to the DSIR guidelines, particularly clause 5(vii), which states that sales realization from assets sold should offset R&D expenditure. However, it clarified that this does not apply to products developed through R&D, which are part of business receipts.

Judgement

The High Court ruled in favor of Microlabs Ltd., stating that sales proceeds from products developed through R&D should not be deducted from R&D expenditure. The court reasoned that these proceeds are part of normal business income and should be treated as such in the company's financial statements.

FAQs

Q1: What does this ruling mean for companies with R&D activities?

A1: Companies can treat sales proceeds from R&D-developed products as normal business income, not reducing their R&D expenditure for tax deduction purposes.

Q2: How does this affect tax deductions under Section 35(2AB) (of Income Tax Act, 1961)?

A2: The ruling allows companies to claim full R&D expenditure deductions without reducing them by sales proceeds from R&D products.

Q3: Why did the court decide in favor of Microlabs Ltd.?

A3: The court found that sales from R&D products are part of normal business operations and should be reflected as business receipts, not reducing R&D expenditure.

The appellant has preferred the present appeal by raising two main substantial questions of law, which are as under:

i) “Whether, on the facts and in the circumstances of the case, the Tribunal is right in law in setting aside the computation made by the assessing authority in respect of claim for deduction under Section 35(2AB) (of Income Tax Act, 1961) of

I.T. Act even when the assessing authority rightly adopted the net expenditure for allowing the weighted deduction and same was done on the

basis of DSIR guidelines wherein it was stated that the receipts to the in-house R&D centre needs to be reduced from gross expenditure and in accordance with parameters of the provision?

ii) Whether on the facts and the circumstances of the case, the Tribunal

was corrected in law in deleting the addition made under Section 14A (of Income Tax Act, 1961)

computed under Rule 8D(2)(ii) (of Income Tax Rules, 1962) amounting to Rs.49,42,473/- even when

the assessing authority rightly quantified the aforesaid disallowance under Section 14A (of Income Tax Act, 1961) as per Rule 8D (of Income Tax Rules, 1962)?

2. We have heard Mr. Aravind, learned counsel appearing for the appellant - Revenue.

3. On the first question, the observations made by the Tribunal in the impugned order from paragraph Nos.12 to 17 are as under:

“12. We have heard the submissions of the ld.

DR and the ld. counsel for the assessee and

also perused the documents filed in paperbook.

As we have already seen, the assessee carries

on scientific research. It is in the business of

manufacture of drugs and pharmaceuticals. It

incurred expenditure on scientific research and

the quantum of such expenditure on scientific

research, which is a sum of Rs.7,80,52,805, is

not in dispute. The weighted deduction u/s.

35(2AB) at 150% was claimed by the assessee

at a sum of Rs.12,57,00,920. What is now to

be examined is the guidelines of DSIR, which

the prescribed authority u/s.35(2AB)(3) (of Income Tax Act, 1961) & (4)

of the Act, has to follow before granting

approval of the scientific research carried out

by the assessee as eligible for deduction u/s.35 (of Income Tax Act, 1961)

(2AB). A copy of the guidelines of DSIR is at

pages 27 to 33 of assessee’s paperbook.

Guidelines 5(vii) is relevant for the present

case and it reads as follows:

“(vii) Assets acquired and products, if

any emanating out of R&D work

done in approved facility, shall not

be disposed off without approval of

the Secretary, DSIR. Sales realization

arising out of the assets sold shall be

offset against the R&D expenditure of the

R&D Centre claimed under section

35(2AB) for the year in which such sales

realization accrues under section

35(2AB) of IT Act, 1961. Expenditure

claimed for deduction under the

subsection shall be reduced to that

extent.”

13. The CIT(A) in his order passed u/s. 154 (of Income Tax Act, 1961)

of the Act has not quoted the first sentence of

the guideline 5(vii) (given above in bold

letters), which in our opinion, is very material.

The above guideline only means that in the

process of carrying out the R&D work, if the

assessee acquires any assets or products that

should not be disposed of without the approval

of Secretary, DSIR. If such assets are sold,

the sales realization arising therefrom are to be

setoff against the R&D expenditure of the R&D

centre which is claimed as decuction u/s.

35(2AB). It is evident from the above

guideline that it is only sales realization arising

out of the assets sold that should be offset

against R&D expenditure. In respect of sale of

products acquired emanating out of R&D work

done in an approved facility, the sale proceeds

need not be reduced from the R&D

expenditure. In our view, the reason for not

including sales realization arising out of

products emanating out of R&D work done and

sold is because such sales would be reflected

as receipts by the assessee in its books of

account and income from business would be

computed treating such sale as part of

business receipts. The receipts arising out of

sale of products will not go to reduce the

expenditure on R&D, whereas the assets

acquired in the process of carrying out the R&D

if they are sold, such sales realization would go

to reduce the expenditure on scientific

research and that is why sales realization

arising out of assets sold is required to be

offset against R&D expenditure. The above

explanation will be sufficient to hold that the

order passed by the CIT(A) u/s. 154 (of Income Tax Act, 1961)

is unsustainable. Nevertheless, we will also

examine as to what is the exact nature of

receipts from sale of products.

14. A copy of license and supply agreement

which was filed by the assessee before the AO

as well as CIT(A) is at pages 5 to 26 of the

assessee’s paperbook. The sale of products is

nothing but the sale of Dossiers by the

assessee to persons not associated with the

assessee or its directors. In the course of

carrying out the scientific research, the

assessee prepares elaborate documents

regarding the products that would emanate

from carrying out scientific research. This

would also include the requirement of health

authorities for grant of license to approve the

products for human use. The assessee gives

the Dossiers so prepared to entities outside

India, who are interested in getting the

marketing authorization for the product in a

particular territory. They pay to the assessee

the Dossier charges and apply for license to

market the products for human use in their

respective territories. On getting the license,

they get marketing authorization from the

assessee. The person who takes the Dossier

(knowhow) takes it for the limited purpose of

registration of product in other countries and

after registration sale of the products in their

country. If they get any order M/s. Micro Labs

will manufacture and sell them at agreed price.

So the knowhow given to them is only for

limited purpose of registering with the drug

control authorities for approval for human

consumption. The foreign entities who get the

dossiers will get rights to market the

assessee’s products in their territory and the

actual manufacture in course of time will be

done by M/s. Micro Labs Limited i.e., the

Assessee.

15. All intellectual property rights, title and

interest of any kind whatsoever in and/or to

the Dossier and the Products shall be the

exclusive property of MICRO LABS (the

Assessee). MICRO LABS i.e., the Assessee

may sell the Dossier to any third party,

including its clients without the consent of

foreign entity buying the dossier. However,

MICRO LABS (the Assessee) shall notify the

person acquiring the dossier of the transfer or

sale of the Dossier to such third party and shall

undertake that such third party respect the

terms and conditions of the agreement with

the other third party who buys dossier from

the Assessee.

16. DSIR guidelines no. vii has specifically

provided that assets acquired if any out of R &

D work shall be disposed with approval of

DSIR. The assessee has been submitting

yearly audit reports & accounts of approved R

& D sanction to DSIR. The R & D accounts

have been separately maintained and separate

P & L Account prepared and the dossier sales

have been credited to P & L Account of R & D

because these sales are part of normal sales.

17. It is clear from the sample copy of the

license and supply agreement filed before us

that the product development charges received

by the assessee will not be covered under

clause 5(vii) of the DSIR guidelines. As we

have already seen, these receipts are credited

to profit & loss account are part of normal

sales. They are, therefore, not to be reduced

from the expenditure incurred by the assessee

on carrying out scientific research on which

deduction u/s. 35(2AB) (of Income Tax Act, 1961) has to be allowed. We

are, therefore, of the view that there is no

merit in ground No.2 raised by the revenue

and that the order passed by the CIT(A)

DATED 9.4.2014 U/S. 154 (of Income Tax Act, 1961) cannot be

sustained and the same is hereby reversed.

Thus, ITA No.764/B/14 by the assessee is

allowed, while ground No.2 raised by the

revenue is dismissed.”

The aforesaid paragraphs show that the Tribunal has

proceeded on the premise that when the regular work is in

the nature of R&D work done and sold, it becomes a

business income and chargeable as business income. It is

only when the assets acquired in the process of carrying

on R&D work, if they are sold, such realization would go to

reduce the expenditure of scientific research.

4. In our view, the approach to the issue

considered by the Tribunal is appropriate. In any case, no

substantial question of law would arise for consideration as

canvassed.

5. For the second question, the observations

made by the Tribunal in the impugned order reads as

under:

“32. Ground No.2 raised by the assessee

reads as follows:-

“2. The learned Commissioner of Income Tax

(Appeals) has erred in sustaining the additions

made by the assessing officer u/s. 14A (of Income Tax Act, 1961) read

with rule 8D (of Income Tax Rules, 1962) on the ground that the appellant

has not produced the evidentiary support in

relation to dispersal of loan and utilization of

loan. Whereas the appellant has produced the

evidence that the amount invested was out of

positive bank balance and no borrowings were

utilized for the purpose of investment.”

33. The assessee earned dividend income of

Rs.38,75,857. It quantified a sum of

Rs.3,22,426 as expenditure incurred in earning

tax free income dividend income which does

not form part of the total income and which is

to be disallowed u/s. 14A (of Income Tax Act, 1961).

34. The break-up of the sum of Rs.3,22,426

is not specifically given, but is stated to be

relating to management fee, legal &

professional charges, security transaction

charges and NSDL charges. It is thus clear

that the assessee by implication had claimed

that there was no expenditure incurred by way

of interest, either directly or indirectly, which is

attributable to the borrowed funds which were

used for the purpose of investment which

yielded tax free income.

35. The AO observed that Schedule G to the

Financial Statements of the assessee had

shown investment to the tune of

Rs.28,45,29,937 in shares mutual funds of

various companies. He was of the view that

such investments cannot be made routinely.

No prudent businessman would make any

investment without applying the resources

wisely. Obviously this entails expenditure,

direct as well as indirect. He thereafter

proceeded to make disallowance u/s. 14A (of Income Tax Act, 1961) of

the Act, which is given as annexure to the

assessment order and enclosed as

ANNEXURE-II to this order.

36. Aggrieved by the assessment order, the

assessee preferred appeal before the

CIT(Appeals).

37. Before CIT(A), the assessee submitted

that interest bearing loans were borrowed for

specific purposes and not for investment

purposes and in support of the above

contention, the Assessee filed copies of

balance sheets as on 31.03.2003 upto

31.03.2009 to show that the various loans

availed from banks were all taken for specific

purposes and could not have been utilized for

making any investments out of which exempt

income was earned. These loans include short

term loans from IDBI Bank, Exim Bank,

Barclays Bank and Standard Chartered Bank in

respect of which it was explained that the

loans could not have been used for making any

long term investment. Copies of some

communications from banks regarding sanction

of the loans were also filed before me to

substantiate the nature of the loan. In respect

of IDBI loan, it was submitted that the same

had been returned back before the year end,

thus bringing the balance to Nil.

38. On consideration of the above

submissions and on perusal of the relevant

documents, the CIT(A) was of the view that

the claim of the Assessee was not evidenced

from the documents submitted in view of the

loans and other sources of funds being mixed

up in the common pool of funds. The CIT(A)

further held that the burden of proof in this

matter clearly continues to rest with the

Assessee and that it was not enough to merely

show that surplus funds were available or that

bank loans had been availed for specific

purposes including short term reasons. A one-

to-one correlation must also be established to

prove that the loans were absolutely utilized

for the purpose for which they were claimed.

The CIT(A) also held that there was no

utilization certificate from the bank filed before

the AO nor was such evidence furnished before

the CIT(A). The CIT(A) also held that the

documents submitted from the bank during the

course of appeal only refer to the disbursal of

the loan and even these specify certain

conditions required to be met. The date-wise

actual disbursal and utilization is not proved

from the ledger copies as submitted. The

CIT(A) also referred to the decision of Mumbai

ITAT in the case of Hercules Hoists Ltd. (ITA

No.7944, 7946, 2255 & 7943/mum/2011),

wherein it was held that with the introduction

of Rule 8D (of Income Tax Rules, 1962) the burden of proof on the assessee

has become “more stringent, so that rather

than showing existence of sufficient capital, the

matter would be required to be examined from

the stand point of utilization of the borrowed

interest bearing funds.” In the absence of

categorical utilization certificate from the bank,

the CIT(A) was of the view that there was no

evidentiary support of the assessee’s claim.

Hence, the disallowance u/s.14A (of Income Tax Act, 1961) as

made by the AO was upheld by the CIT(A).

39. Aggrieved by the order of CIT(A), the

assessee has raised ground No.2.

40. We have heard the rival submissions. A

copy of the availability of funds and

investments made was filed before us which is

at pages 38 to 42 of the assessee’s paperbook

and the same is enclosed as ANNEXURE-III

to this order. It is clear from the said

statement that the availability of profit, share

capital and reserves & surplus was much more

than investments made by the assessee which

could yield tax free income.

41. The Hon’ble Bombay High Court in

Reliance Utilities & Power Ltd. 313 ITR 340

(Bom) has held that where the interest free

funds far exceed the value of investments, it

should be considered that investments have

been made out of interest free funds and no

disallowance u/s. 14A (of Income Tax Act, 1961) towards any interest

expenditure can be made. This view was again

confirmed by the Hon’ble Bombay High Court

in CIT v. HDFC Bank Ltd., ITA No.330 of 2012,

judgment dated 23.7.14, wherein it was held

that when investments are made out of

common pool of funds and non-interest

bearing funds were more than the investments

in tax free securities, no disallowance of

interest expenditure u/s. 14A (of Income Tax Act, 1961) can be made.

42. In the light of above said decisions, we

are of the view that disallowance of interest

expenses in the present case of Rs.49,42,473

made under Rule 8D(2)(ii) (of Income Tax Rules, 1962)

should be deleted. We order accordingly.”

The aforesaid shows that the Tribunal has followed a

decision of the Bombay High Court in the case of CIT v.

HDFC Bank Ltd., (ITA No.330/2012 disposed of on

23/7/2014). When the issue is already covered by a

decision of the High Court of Bombay with which we

concur, we do not find any substantial question of law

would arise for consideration as canvassed.

6. In view of the above observations, the appeal

is dismissed.

Sd/-

JUDGE

Sd/-

JUDGE