Assessee's Deduction of Royalty Paid for Technical Know-how under s. 35AB Requires Fresh Consideration. Court to Interpret Agreement for Capital or Revenue Expenditure and Applicability of Section.

This Civil Appeal is filed by the Revenue against the order of the Punjab & Haryana High Court regarding the deduction of royalty paid for technology know-how. The appeal raises two key questions: whether the applicability of Section 35AB (of Income Tax Act, 1961) was raised and whether the expenditure incurred is revenue or capital in nature. The confusion arises because the order of the Assessing Officer (AO) focused solely on the nature of the expenditure without clearly addressing the applicability of Section 35AB (of Income Tax Act, 1961). However, it is important to determine the nature of the expenditure at the threshold to determine the applicability of Section 35AB (of Income Tax Act, 1961). The High Court is required to authoritatively decide whether the expenditure is revenue or capital in nature and subsequently consider the applicability of Section 35AB (of Income Tax Act, 1961). The question of interpretation of Section 35AB (of Income Tax Act, 1961) was indeed an issue in this case. Therefore, the matter is remitted to the High Court for fresh consideration. The second question regarding the nature of the expenditure is left open for the High Court to decide after examining the agreement between the parties. The impugned judgment of the High Court is set aside, and the appeal is allowed with no order as to costs.

Leave granted.

This Civil Appeal is filed by the Revenue against the order passed by the

Punjab & Haryana High Court in I.T.A.No.131/2004. The impugned decision is dated 18th May, 2006.

M/s. Swaraj Engines Ltd. (respondent herein) entered into an agreement of

transfer of technology know-how and trade mark with Kirloskar Oil Engines Ltd. under which royalty was payable it. The claim for deduction in respect of the said payment was made by the respondent. It is important to note that during the relevant Assessment Year 1995-96, royalty was paid by the assessee as a percentage of net selling price of the licensed goods products.

Two questions arise for determination in this Civil Appeal. Firstly, whether

the question regarding applicability of Section 35AB (of Income Tax Act, 1961) was ever raised by the AO in this case? The second question which arises for determination in this case is whether the expenditure incurred is revenue expenditure or whether it is an expenditure which is capital in nature and depending on the answer to the said question, the applicability of Section 35AB (of Income Tax Act, 1961) needs to be considered.

On the first question, it has been vehemently urged by Shri Iyer, learned

senior counsel on behalf of the respondent-assessee, that the High Court was right in dismissing the Department’s appeal in limine following its earlier judgment in the case of C.I.T. vs. M/s. J.C.T. Electronics Ltd. in I.T.A. No.383/2004. On the first question, there is considerable amount of confusion. It appears that prior to Assessment Year 1995-96, the Department has been contending that the royalty expenditure comes within the ambit of Section 35AB (of Income Tax Act, 1961). However, there is some doubt as to whether the said

contention regarding applicability of Section 35AB (of Income Tax Act, 1961) was at all raised. In this regard, the order of AO is not clear principally because it has focused only on one point, viz., whether such expenditure is revenue or capital in nature. At the same time, it is important to note that even for the applicability of Section 35AB (of Income Tax Act, 1961), the nature of expenditure is required to be decided at the threshold because if the expenditure is found to be revenue in nature, then Section 35AB (of Income Tax Act, 1961) may not apply. However, if it is found to be capital in nature, then the question of amortization and spread over, as

contemplated by Section 35AB (of Income Tax Act, 1961), would certainly come into play. Therefore, in our view,it would not be correct to say that in this case, interpretation of Section 35AB (of Income Tax Act, 1961) was not in issue. Our above reasoning is further fortified by the question framed by the High Court in the impugned judgment which reads as under:

"Whether on the facts and in the circumstances of the case, the

Hon’ble ITAT is right in upholding the decision of the Commissioner of

Income-Tax (Appeals) that the payment of royalty made by the assessee

company to M/s. Kirloskar Oil Engine Ltd. to acquire technology know-

how under the agreement dated 19.10.89, is a revenue expenditure and

does not come within the ambit of provisions of Section 35AB (of Income Tax Act, 1961) of the

Income Tax Act, 1961, whereas the payment is a capital expenditure in

view of the following judgments.

A. Femmur Woodruf & Co.Ltd. V. CIT 102 ITR 665 (Mad)

B. Ram Kumar Pharmaceuticals Works V CIT 119 ITR 33 (All).

C. CIT V. Warmar Hindustan Ltd. 160 ITR 217 (AP)

D. CIT V. Southern Switch Gears ltd. 148 ITR 272 (Mad)"

On bare reading of the said question, it is clear that applicability of Section 35AB (of Income Tax Act, 1961) in the context of royalty paid to Kirloskar as a percentage of the net sale price being revenue or capital in nature and depending on the answer to that question, the applicability of Section 35AB (of Income Tax Act, 1961) also arose for determination before the High Court. Be that as it may, the said question needs to be decided authoritatively by the High Court as it is an important question of law, particularly, after insertion of Section 35AB (of Income Tax Act, 1961).

Therefore, we are required to remit the matter to the High Court for fresh

consideration in accordance with law. On the second question, we do not wish to express any opinion. It is for the High Court to decide, after construing the agreement between the parties, whether the expenditure is revenue or capital in nature and, depending on the answer to that question, the High Court will have to decide the applicability of Section 35AB (of Income Tax Act, 1961) of the

Income Tax Act. On this aspect we keep all contentions on both sides expressly open.

Accordingly, the impugned judgment of the High Court is set aside and the

matter is remitted for fresh consideration in accordance with law.

The Appeal is allowed accordingly with no order as to costs.

(S.H. KAPADIA)

(B. SUDERSHAN REDDY)

New Delhi,

May 06. 2008.