ISSUES IN BUSINESS DEDUCTIONS

GLOBAL TAX ADVISORY SERVICES

Urvashi Kaushik

Dhinal ShahChartered Accountant

Direct Tax Committe of ICAIGoa Branch of WIRC of ICAI

30th October 2010

Business

► “Business” includes any trade, commerce or manufacture or any adventure or concern in

the nature of trade, commerce or manufacture [Section 2 (13)]

► The above definition is not exhaustive

Profession

► “Profession” includes vocation [Section 2 (36)]

► “Profession” implies professed attainments in special knowledge as distinguished from

mere skill. E.g.- tax experts, financial accountants, architects, engineers, etc.

Vocation

► Not defined in the Act

► “Vocation” implies natural ability of person for some particular work.

BUSINESS, PROFESSION, VOCATION

The distinction between business, profession and vocation is however not material since the income from all these activities is taxable under the same head ie PGBP

SECTION 28

Charging section - Scope

► Profits earned from carrying on business at any time during the previous year

► Any compensation due to or received by:

►Any person managing the whole/ substantial affairs of an Indian company;

►Any person managing the whole/ substantial affairs of any other company in India;

►Any person holding an agency in India;

►Where the consideration is for or in connection with termination or modification of

terms of the managing directorship/ agency

► Income earned by any trade/ professional association from specified services provided to

members

► Profits on sale of an import license

► Cash assistance against exports

► Customs or excise duty drawback

SECTION 28

Charging section - Scope

► Profit on the transfer of the Duty Entitlement Passbook Scheme, being Duty Remission Scheme

► Any benefit or perquisite whether convertible into money or not, arising from business/ profession

► Any interest, salary, bonus or commission received by partner of a firm from the firm (excluding any

part which has not been allowed as a deduction to the firm by reason of being in excess to the

specified limits)

► Any sum received under an agreement for

► Not carrying out any activity in relation to business;

► Not sharing any business or commercial rights which are likely to assist in the business

► (covers basically non-compete fees received under an agreement)

► Any sum received under a Keyman insurance policy by an employer in respect of insurance of the

employee including the bonus allocated on such policy

► Burden to prove expenditure

► The burden is on the assessee to prove the claim of expenditure with supporting evidence

► The reasonableness of expenditure is to be seen from the business point of view

LOSS INCURRED IN CARRYING ON BUSINESS

► Whether it is necessary that the assessee must earn some income to become eligible

to claim losses incurred in carrying on business

► If there is direct and proximate nexus between the business operation and the loss, or

if it is incidental to it, then the loss is deductible

► Whether the loss is incurred in carrying on business is a question of fact and it is

important to demonstrate it before tax authorities

► Examples of losses: embezzlement loss, irrecoverable deposits, exchange loss, loss

of inventory etc

EXPENDITURE VS LOSS

► “Expenditure” relates to disbursement : that means something that a trader pays out indicating a sort of violation on his part. He chooses to pay out some disbursement; it is an expense; it is something which comes out of his pocket.

► A “loss” is something different. That is not a thing which he expends or disburses. That is a thing which comes upon him ab extra

► Finlay J., in Allen v. Farquharson Brothers & Co (17 TC 59) quoted in CIT v S.C Kothari (82 ITR 794) (SC)

► Indian Molasses Co. (P.) Ltd. v CIT (37 ITR 66) (SC)

► Business loss and expenditure are different. Explanation to Section 37(1) is applicable only to allowance of business expenditure and not business loss. Hence loss in an illegal business is allowable deduction

► Dr. T.A. Quereshi (287 ITR 547) (SC) following SC judgment in the case of Piara Singh (124 ITR 40-SC)

Issues relating to Setting-up of Business

SET UP OF BUSINESS

► Significance?

► When can a business be considered to have been set up?

► Concept of ‘ready to commence business’

► Time gap between set-up and actual commencement

► The term ‘set up’ of business assumes importance in the context of determining the previous year of any company

► Further, set up is important in the context of section 35D to claim expenses incurred in the pre-operative period

► Set-up has not been defined in the Act – however reliance is placed on various judicial precedents

► As per Oxford English Dictionary setting up means “to place on foot” or “to establish”. In view of the same, a view may be taken that a business can be said to have been set up when it is established, i.e. when it is ready to commence business

SET UP OF BUSINESS – SIGNIFICANCE?

► Expenditure incurred only after the date of setting up business which is of revenue nature is allowed as a deduction in computing business income

► Pre-setup capitalization of expenditure is allowed only of those expenses that contribute directly or bring the assets to the present location and existence. Hence, pre-setup expenditure which does not satisfy this criteria would neither be capitalized nor allowed as a revenue deduction

► In short, you cannot claim a deduction for pre-setup revenue expenditure.

► Business can be said to be set up when it is established and ready to commence

business. There may be an interregnum, an interval, between the time when a

business is set up and the time when a business has commenced, and all expenses

incurred after the setting up of business and before the commencement of business

would be permissible deductions - [Western India Vegetable Products Limited vs CIT

(26 ITR 151) (SC)]

► Saurashtra Cement and Chemical Industries Ltd. (91 ITR 170) (Guj HC) - The business

would commence when the activity which is first in point of time and which must

necessarily precede the other activities is started

► Ashima Syntex (251 ITR 133) – Trial run

► A unit cannot be said to have been set up unless it is ready to discharge the

function for which it is being set up. If the unit is ready to start functioning, it does not

matter that it has not actually started its business on the relevant date. [CIT vs Piem

Hotel Pvt Ltd (209 ITR 616)]

► What is significant about the date of commencement of the commercial production is

the date when the plant is ready for commercial production and not the date when

the plant actually commences commercial production [Eicher Motors Ltd vs DCIT (94

Taxman 316)]

SET UP OF BUSINESS – WHEN CONSIDERED?

“SET UP” IN DIFFERENT BUSINESSESSr. No.

Industry Stage of set up of business

1 Manufacturing business Installation of plant and machinery, obtaining licenses, power connection, completion of trial runs (even if the product is of sub-standard quality or has some defects)

2 Trading business Readiness of infrastructure like office, warehouse etc, actual purchase of goods

3 Manufacturing and trading business

(composite business)

Commencement of trading activity sufficient even if manufacturing activity has not commenced

4 Leasing / Hotel business Property (with the required infrastructure) ready for being let out even if not actually let out

5 Consultancy services / Software development business

Acquisition of place of business, the required assets, recruitment of staff, evidence of clients

Issues relation to previous year expenditure

PREVIOUS YEAR EXPENDITURE

► Crystallization of liability

► Saurashtra Cement and Chemical Ind. Ltd. (213 ITR 523) (Guj HC)

► Revenue should not dispute such claims when rate of tax is same

► Nagri Mills Co. Ltd.(33 ITR 681) (Bom HC)

Issues relating to Current Repairs

► Section 30 provides for the following deductions for purpose of carrying on business or profession, provided that these expenses (in respect of building) are revenue in nature

► Rent and repairs paid by a tenant;

► Current repairs paid by a person occupying the premises other otherwise than as a tenant;

► Sums paid on account of land revenue, local rates or municipal taxes;

► Insurance premium paid.

► Section 31 provides that current repairs and insurance of plant and machinery and furniture will be allowed as deduction, provided that these expenses are revenue in nature and assets used for the purpose of business

► Explanation to Section 30 and 31 inserted with effect from AY 2004-05 clarifies that capital expenditure would not be allowed as a deduction under Section 30 and 31

► Sarvana Spinning Mills P. Ltd. (293 ITR 201) (SC) - Replacement of old asset with new asset would not constitute current repair

► Upholding Sarvana Spinning Mills - Bhojraj Textile Mills Ltd. (SC) (larger bench) (2010-TIOL-22-SC-IT-LB) and Sri Mangayarkarasi Mills (P) Ltd (315 ITR 114)(SC)

SECTION 30 & 31

DEDUCTIBILITY OF CERTAIN EXPENSES

► Expenses on leasehold premises

► Renovation / improvement expenses are deductible subject to following tests:

► Expenditure not resulting in creation / procurement of capital asset

► The lease is a short term lease

► The lessee has undertaken to bear such expenses or are incurred in pursuance of some statutory / regulatory requirement

► Expenses are incurred for more profitable conduct of business

Issues relating to Depreciation

DEPRECIATION - SECTION 32

► Depreciation can be claimed on

Tangible assets such as buildings, machinery, plant or furniture;

Intangible assets such as know-how, patents, copyrights, trade marks, licenses, franchises or any other business or commercial rights of similar nature, (after April 1, 1998)

► Asset must be wholly or partly owned and used for purposes of the business or profession

► Depreciation is allowed only to the owner of the assets

► Use of assets – Active vs Passive

► Passive User

► Nirma Credit & Capital Ltd. (220 CTR 537) (SC)

► Panacea Biotech Ltd. (324 ITR 311) (Delhi HC)

► Use includes passive use and as long as asset is ready for use it is eligible for depreciation

► Block of assets

► Once an asset falls into block of asset, they are eligible for depreciation even if not used for a single day in the year

► Bharat Aluminum Co Ltd.– (187 Taxman 111) (Delhi HC) and Swati Synthetics (38 SOT 208) (Mumbai ITAT)

DEPRECIATION - SECTION 32

► Chapter VIA deduction

► Depreciation to be considered while computing deduction under Chapter VIA

► Plastibends India Ltd. (318 ITR 352) (Bombay HC, Larger Bench)

► Dabur India Ltd. (219 CTR 152) (Delhi HC)

► Vahid Paper Converters. (98 ITD 165) (Ahd) (SB)

► Depreciation on goodwill

► Whether goodwill is an intangible asset eligible for depreciation under Section 32?

► Whether depreciation is admissible on self-generated goodwill?

ARGUMENTS IN FAVOUR OF CLAIMING DEPRECIATION ON GOODWILL

► Goodwill is an intangible asset

► Goodwill is property

► Goodwill could be termed as a bundle of various rights, such as property right, right to

carry trade in fixed locality, right to enjoy all advantages of established trade

connections, etc

► Accounting policies recognize goodwill as an intangible asset (like trademark,

patents, etc), capable of being amortized

ARGUMENTS IN FAVOUR OF NOT CLAIMING DEPRECIATION ON GOODWILL

► Not specifically included in the intangible assets specified under Section 32

► Cannot be treated as ‘any other business or commercial right of a similar nature’

► Depreciation provides for the wear and tear of a capital asset - however, value of

goodwill capable of appreciation over a period of time

► Self generated goodwill does not have a cost of acquisition and accordingly, no

depreciation should be admissible

► Report of the Comptroller and Auditor General of India has observed that depreciation

on goodwill should not be allowed

DEPRECIATION - SECTION 32► Case laws on depreciation on goodwill

In favour

► B. Raveendran Pillai v. CIT (7 Taxmann.com 92) (Kerala High Court)

► Skyline Caterers, (20 SOT 269) (Mumbai ITAT)

► Bosch Ltd.(2009-TIOL-736-ITAT-BANG) (Bangalore ITAT)

► Hindustan Coca Cola Beverages (132 TTJ 602) (Delhi ITAT)

► Guruji Entertainment Network Ltd. (108 TTJ 180) (Delhi ITAT)

► Kotak Forex Brokerage Limited. (33 SOT 237) (Mumbai ITAT)

► A.P. Paper Mills Limited v. ACIT (128 TTJ 596) (Hyderabad ITAT)

► ACIT v. CLC Global Limited (ITA No. 2288/D/2008) (Delhi ITAT)

Against

► R. G. Keshwani, (120 TTJ 1081) (Mum),

► Bharatbhai J. Vyas, (97 ITD 248) (Ahd) (AT)

► Shanmugam Narayanaswamy (279 ITR 15) (AT) (Hyd)

► Depreciation on other commercial rights

► Ashoka Info (P) Ltd. – (123 TTJ 77) – (Pune ITAT) and Reliance Ports and Terminals Ltd (unreported) ( ITA Nos. 1743, 1744 and 1745/Mum/2007) (Mumbai ITAT)

► Toll rights are an intangible asset eligible for depreciation

► Medicorp Technologies India Ltd. (122 TTJ 394) (Madras ITAT) and Real Image Tech. (P) Ltd. (120 TTJ 983) (Madras ITAT)

► Non compete fees eligible for depreciation

DEPRECIATION - SECTION 32

► Depreciation on other commercial rights

► ONGC Videsh Ltd. (127 TTJ 497) (Delhi ITAT)

► Amount paid for acquisition of exploration license eligible for depreciation

► Depreciation on Intellectual property rights

► Modular Infotech P Limited vs DCIT (131 TTJ 243) (Pune ITAT)

► Depreciation eligible on Intellectual property rights

► Depreciation on stock exchange membership card

► Techno Shares and Stocks Ltd (SC) (193 Taxman 248)

► Depreciation eligible on stock exchange membership card.

► The said membership right is a business or commercial right.

► Depreciation on Brand obtained under a scheme of demerger

► KEC International (41 SOT 43) (Mumbai ITAT)

► Depreciation eligible on Brand obtained under a scheme of demerger.

Issues relating to Bad debts

BAD DEBTS

► After amendment inserted with effect from 1 April 1989, it is not necessary to

establish or prove that the debt has become bad.

► It is enough if the bad debt is written off as irrecoverable in the accounts of the

assessee

► TRF Ltd. (230 CTR 14) (SC)

► Vijaya Bank (323 ITR 166) (SC)

► Oman International Bank (313 ITR 128) (Bombay HC)

► Provision for NPA made in terms of RBI directions is not eligible for deduction under

Section 36(1)(vii) as bad debts

► Southern Technologies Ltd. – (228 CTR 440) (SC)

► Write off of advances, whether capital or revenue in nature –can be claimed u/s.28 or

37 – if not, u/s.36(1)(vii)

BAD DEBT

► Deduction on write-off

► Star Chemicals, 11 DTR 311 (Bom)

► Suresh Gaggal, 11 DTR 345 (HP)

► Tuskar Dye Chem, 9 DTR 298 (Del)

► Manner of Write-off – Debit to P & L Account

► Jindal Sons, 121 TTJ 232(Asr.)

► Global Capital Ltd. 121 TTJ 218(Del)

► Position in case of stock broker

► G.R.Pandya Share Broking Ltd.26 SOT 431(Mum),

► B.S.Vasa, 26 SOT461 (Mum),

► Bank of America, 27 SOT 97 (Mum)

► Bonanza Portfolio Ltd. 226 CTR 468 (Delhi HC)

► DB (India) Securities Ltd. (226 CTR 466) (Delhi HC)

► Canon Capital & Finance Ltd (Ahmedabad ITAT) (ITA No. 1119/Ahd/2005) (unreported)

Issues relating to 36(1)(iii)

ALLOWABILITY OF INTEREST U/S 36(1)(III)

► W.e.f. A.Y.2004-05 by insertion of proviso, interest paid on the capital borrowed for “acquisition of asset for extension of existing business”, upto the date asset was put to use, no deduction - Implication.

► Tata Chemicals Ltd. 256 ITR 305 (Mum) (confirmed by S.C).

► Core Health Care Ltd. 251 ITR 61 (Guj) (confirmed by SC)

► Advances to subsidiary:► Advances / loans to subsidiary – interest cannot be disallowed – “For the purpose of business” explained.

► S.A. Builders Ltd. 288 ITR 1 (SC)

► Interest free loan to sister concern► HB Stock Holdings Ltd. (325 ITR 316) (Delhi HC) – Not disallowable as loan given to subsidiary companies before

taking loan from bank

► Mahindra Holdings Ltd., 117 TTJ 721 (Mum)

► Yamaha Motors India Pvt. Ltd., 118 TTJ 395 (Delhi)

► Treatment of Pre incorporation interest► L. G. Electronics, 12 DTR 263 (Delhi)

► Winsome Dyeing, 10 DTR 207 (HP)

► Neha Proteins Ltd., 306 ITR 102 (Raj)

► Interest on application money► Global Capital Ltd., 309 ITR 283 (Delhi)

► Interest free loan and s. 56(2)(v)► Chnadakant H. Shah, 121 TTJ 145(Mum)

► Overriding effect of s.40(b) on excessive interest► Syntholabs Chemicals & Research(Mum)

BORROWINGS BY CONSTRUCTION COMPANIES

► If borrowing is for specific projects, interest will have to be treated as project cost

(where completion of contract method is followed)

► Distinction is drawn between accounting of profit on works in progress method vs.

completed contracts method.

► Lokhandwala Construction (260 ITR 579) (Bom)

► Wall Street Constructions Ltd. (101 ITD 156) (Mum ITAT) (SB) distinguished on facts

Issues relating to 37(1)

GENERAL DEDUCTIONS - SECTION 37

► Residuary section for deduction from the taxable income

► Conditions to be satisfied under section 37(1):

– Expenditure not of the nature described in section 30 to 36

– Incurred in the previous year

– It should not be in the nature of personal expenses

– It should not be for an offence

– It should not be prohibited by law

– It should not be in the nature of capital expenditure

– It should have been laid out or expended wholly and exclusively for business

Some issues►Wholly and exclusively laid out►Capital vs Revenue►Prohibited by Law►Other peculiar expenses

Principles to decide whether covered (emerging out of judicial precedents):

► Money expended not merely out of necessity and with a view to a direct and immediate benefit to the business, but voluntarily and on grounds of commercial expediency and in order to indirectly facilitate carrying on of the business

► Incurred in the assessee’s character as a trader and not some other character

► Purpose must be purpose of assessee’s own business, profits of which are being computed and assessed

► Generation of profits from expenditure incurred is not per se necessary for purpose of determining whether it is wholly and exclusively laid out. What is required is that expense should have been incurred for the purpose of carrying on the business

► Mere fact that to some extent expenditure results in benefit to a third party or that person expending obtains some advantage in some character other than that of a trader, cannot in law defeat the effect of the finding as to the whole and exclusivity purpose

WHOLLY AND EXCLUSIVELY LAID OUT

Capital vs Revenue

► Capital expenditure is incurred in law and on accounting principles only in the following circumstances:

– A new asset is brought into existence

– An advantage or enduring benefit is obtained by the assessee

– The expenditure relates to the fixed capital as distinct from the circulating capital

– The expenditure is of an initial nature to commence a business for the first time

– The expenditure incurred is to acquire a concern or a goodwill

GENERAL DEDUCTIONS – SECTION 37

Prohibited by Law - Examples

► Penalty paid for violation or infringement of any law

► Penalty or damages for contractual obligation

► Sum paid as protection money to certain persons by the assessee, a builder, engaged in the construction activities in areas which were vulnerable to such dangers as extortion, haftas, etc

Legal vs Illegal business

► SC Kothari (82 ITR 794) (SC)

► Piara Singh (124 ITR 40) (SC)

► Hazi Aziz & Abdul Shakoor (41 ITR 350) (SC)

► Maddi Venkatraman & Co. (229 ITR 534) (SC)

► T.A.Querishi (287 ITR 547) (SC)

GENERAL DEDUCTIONS – SECTION 37

Issues relating to Forex losses

TAX TREATMENT OF FOREX GAIN / LOSSParticulars Realized Gain / Loss Unrealized Gain / Loss

Assets acquired from outside India

► To be adjusted in the block of assets & depreciation to be claimed*

► No adjustment in the MAT computation

► To be adjusted in the block of assets on realization*

► No adjustment in the MAT computation

Assets acquired from within India

► Capital Receipt / Loss & hence not taxable / deductible

► No adjustment in the MAT computation

► Elecon Engineering (SC) (230 CTR 1)

Forex loans taken for revenue purpose

Mark to market loss on forex forward contracts

► Realised / unrealised foreign exchange gain / loss on revenue items allowable as deduction under Section 37(1) as business expenditure – Woodward Governor (SC) (312 ITR 254), ONGC Ltd. (SC)

► Forward contract losses eligible for deduction under Section 37(1) in the year in which it is incurred irrespective of year of payment – IFCI (228 CTR 132) (Delhi HC)

► Unrealised mark to market losses foreign exchange losses are contingent in nature and hence, not allowable as a business expenditure – CBDT Instruction No. 2/2010, dated March 23, 2010

► Realised foreign exchange loss could also be speculative loss in terms of provisions of Section 43(5) - CBDT Instruction No. 2/2010, dated March 23, 2010

► Loss on account of valuation of forward contracts on the last day of accounting period is an allowable business loss - Bank of Bahrain & Kuwait (132 TTJ 505) (Mumbai ITAT SB)

*To the extent it relates to principal and interest liability as on date of acquisition of the capital asset

Mark to market loss on Derivative Transactions

MARK TO MARKET LOSS ON DERIVATIVE TRANSACTIONS

► Derivative Transaction

► Transactions in futures and options are for a fixed maturity and as per current stock market

regulations are settled by cash either before or at their maturity date

► Accounting Treatment

► As per AS1 the loss on M2M needs to be recognized in the Profit and Loss Account.

As per AS30, the loss or profit on M2M basis in respect of derivative including hedging

transactions needs to be recognized in the Profit and Loss Account.

► Tax Treatment

► As per provisions of Section 43(5), amended with effect from 1 April 2006, any income

arising from derivative transaction on recognized stock exchange would not be a speculative

transaction

MARK TO MARKET LOSS ON DERIVATIVE TRANSACTIONS► Issues

► Whether losses arising in mark to market derivative transactions could be allowable under the Act

► Whether it be considered as business loss or capital loss

Prior to 1-4-2006 All the derivative transactions are speculative business transactions as amendment in section 43(5) is not retrospective[Shree Capital Services Ltd (Kolkata ITAT) (318 ITR 1)]

Post 1-4-2006 Business Loss

►Trading in derivatives is a

business

►Mark to market loss is only

notional loss

►There is no transfer of capital

asset on balance sheet date

►No consideration is received

for mark to market loss

Capital Loss

►Derivatives are capital asset

►Mark to market loss is loss

arising on balance sheet date

Issues relating to Deductibility of provision for warranties

ISSUE

► Whether provision for warranty created by the manufacturers of goods carrying warranty is in the nature of revenue expenditure allowable as a deduction under Section 37(1) of the Act?

► Whether provision for warranty can be said to be in the nature of a liability which has been incurred during the relevant previous year?

► Whether provision for warranty can be said to be in the nature of a provision created for a contingent liability and should hence not be allowed as a deduction under Section 37(1) of the Act?

ARGUMENTS IN FAVOUR OF DEDUCTIBILITY

Method of accounting

► Provision for warranty is made in accordance with the principles prescribed by the ICAI - mandatorily required to be followed by companies while preparing their accounts

► Provision for warranty is created to arrive at the correct profits for the year under the mercantile system of accounting - a method recognized under the provisions of Section 145 of the Act

► A reasonable method of accounting adopted by the assessee, resulting in the correct determination of profits should not be disturbed (Metal Box Co of India Ltd v their workmen 73 ITR 53)

ARGUMENTS IN FAVOUR OF DEDUCTIBILITY

Basis of creating the provision for warranty

► The provision for warranty based on a scientific basis is allowed as a deduction (Rotork Controls India (P) Ltd. (SC) (314 ITR 62) – distinguished by Mumbai ITAT in the case of Hindustan Dorr-Oliver Ltd. (Lexreported)

► The provision is made on a scientific basis and no ad-hocism is involved (Voltas Ltd v DCIT 61 TTJ 543)

► The method adopted in creation of the provision is scientific, commercially expedient and in accordance with set principles of accountancy (CIT v Majestic Auto Ltd 204 ITR 14)

► Estimate of such liability has been made on the basis of past experience (Jay Bee Industries v DCIT 61 TTJ 403 Asr)

► There is certainty that the expenditure will be incurred and a reasonable approximation of the same is possible (ITO v Wanson India Ltd 5 ITD 102 Pun)

CONCLUSION

► Provision for warranty should be allowable as a deduction under Section 37(1) if:

► The provision has been made on a scientific basis and based on past experience► The method adopted in creating the provision for warranty has been consistently

followed in past and subsequent years

► The above principles in respect of deductibility of provision for warranty also applicable in respect of other provisions created in the books of account

Issues relating to Computer Software

SOFTWARE EXPENSES - TYPES► System software

► Application software

► Platform

► System study

► System installation

► Hardware related

► Training

► Maintenance updation

SOFTWARE – UNDERSTANDING TILL DATE► Ownership & Enduring benefit

► Empire Jute Co. Ltd., 124 ITR 1 (SC)

► Alembic Chemical Works, 177 ITR 377 (SC)

► Purchase & Licenses

► Copy right & copy righted articles and goods

► Profit Earning apparatus

► Transferability

► Existing operations

► Quantum of expenses

SOFTWARE EXPENSES – PRINCIPLES FOR DETERMINING NATURE OF EXPENSES► Software is a tangible asset – goods TCS, 192 CTR 257 (SC)

► License can be acquisition of asset

► Copyrighted article can be acquisition

► All purchases are not capital

► Technological changes

► Less than two years test

► Size of lay out – Central tool

► Profit earning apparatus

► Training Centre / Travel Agent

► Organizational efficiency

► Degree of organizational changes – Radical changes

► Maintenance and up-gradation

► Economic and functional test - paramount

SOFTWARE EXPENSES – CURRENT JUDICIAL POSITION► Amway Criteria for allowance

► Ownership

► Functional

► Enduring benefit

► Amway India Ent. 111 ITD 112 (Del.) (SB)

RELEVANT PRINCIPLES BASED ON JUDICIAL PRECEDENTS

In support of revenue expenditure

► Payment towards application software and expenses incurred for replacement of UPS and printer are revenue expenses - Southern Roadways, (304 ITR 84) (Madras HC)

► Expenses on purchase of computer software are revenue expenses - Varinder Agro Chemicals Ltd., (309 ITR 272) (P & H HC)

► Expenses on website are revenue expenses - Indian Visits Corpn., (176 Taxman 164) (Delhi HC)

► Expenses on upgradation of computers by changing certain parts and thereby improving its efficiency are revenue expenses – Southern Roadways Ltd. (282 ITR 379 ) (Madras HC)

► No degree of durability or permanence attributable to software items and there is no benefit of enduring nature as software needs constant updation given the fast changing technological environment - Citicorp Overseas Software (85 TTJ 87) (Mumbai ITAT)

► Purchase of MS Office is revenue expenses as its not a customised software - G.E. Capital Services Ltd., (214 CTR 551) (Delhi HC)

► Expenses incurred on licence fees for use of ORACLE software are revenue expenses - Asahi India Safety (6 SOT 656) (Delhi ITAT)

► Expenses on acquisition of application software are revenue expenses - IBM India Ltd., (108 TTJ 531) (Bang)

RELEVANT PRINCIPLES BASED ON JUDICIAL PRECEDENTS

In support of revenue expenditure

► Expenses on implementation of ERP package are allowed as revenue expense - Glaxo

Smithkline, 112 TTJ 94 (Chd ITAT) [Contrary decision of Pune ITAT in the case of Sudarshan

Chemical Industries Ltd. (110 ITD 171) ]

► Software programme once developed by assessee cannot be said to be of enduring benefit

and expenses incurred in developing such software programme will be allowable as revenue

expenditure – Business Processing Services (73 ITD 304) (Jaipur ITAT)

► Being an important tool in bringing about a qualitative improvement in the functioning of an

organization, software needs frequent updation due to a fast rate of obsolescence (Media

Video Ltd v JCIT 122 Taxman Mag 28)

► Purchase of software is not an expenditure in the capital field as they become outdated very

fast (Bank of Punjab v JCIT 122 Taxman Mag 235)

RELEVANT PRINCIPLES BASED ON JUDICIAL PRECEDENTS

In support of capital expenditure

► Expenditure on acquisition of an asset (other than trading asset) is always capital expenditure

► Hardware, commonly called as computer (a tangible asset), cannot function without the aid of

software

► Amendment in the rates of depreciation with effect from Assessment Year 2003-2004 provides for

depreciation on computers (including computer software) at the rate of 60%

► The amendment indicates that expenditure on purchase of software was always capital expenditure,

earlier depreciable at the rate of 25% as intangibles

► Though expenditure on upgradation and maintenance of software is revenue expenditure,

expenditure on acquisition of the software is capital in nature – (Maruti Udyog Ltd., 92 ITD 119, Delhi

ITAT)

In support of capitalizing under the block ‘intangibles’

► Being akin to know-how, purchase expenditure of software is a capital expenditure (Arawali

Constructions co Pvt Ltd 259 ITR 30 Raj)

CONCLUSION

► Re-consideration of judicial precedents subsequent to the amendment to the depreciation rates

schedule

► The higher rate of 60 percent, prescribed for computer and computer software, factor in the high

degree of obsolescence associated with such assets

► Computer software defined to mean any computer programme recorded on any disc, tape,

perforated media or other information storage device

► Based on the above, the expenses on purchase of software for internal use to be capitalized

under the block ‘computers’

► This position gets further augmented if such expenditure is capitalised in the books

► Software purchased for commercial exploitation assumes the form of an IPR, which are then

exploited commercially – such software expenses, being akin to know-how to be classified under

the block ‘intangibles’

Issues relating to 14A

BACKGROUND

► Expenditure incurred for earning exempt income is not allowable as deduction under section 14A

► The Assessing Officer (‘AO’) is empowered to determine the amount of expenditure in accordance with method prescribed under Rule 8D if:► AO is not satisfied with the correctness of the claim

made by assessee or► If assessee claims that no expenditure is incurred to

earn exempt income

RULE 8D

Disallowance prescribed under Rule 8D is sum of :Direct Expenditure incurred for earning exempt income

A

Proportionate Interest Expenditure= Interest Expense X Average Value of Investments Average Value of Total Assets

B

Administrative Expenditure@ 0.5% of Average Value of Investments

C

Total A+B+C

RULING OF MUMBAI SPECIAL BENCH – DAGA CAPITAL

► Operation of Section 14A is automatic on earning exempt income

► Computational provisions of Section 14A read with Rule 8D are procedural and clarificatory in nature

► Rule 8D will apply retrospectively to all pending matters

Based on above ruling, the tax authorities applied Rule 8D for all pending assessments.

RECENT RULING OF BOMBAY HIGH COURT IN CASE OF – GODREJ & BOYCE

The key principles laid down by the High Court are as under:

► Section 14A will apply to dividend income although dividend has suffered dividend distribution tax

► The computation method provided by rule 8D is constitutionally valid.

► Rule 8D notified on 24 March 2008 will not have retrospective effect.

► Rule 8D cannot be applied mechanically. ► Only if AO is not satisfied with the claim of tax payer and has

recorded reasons he can compute disallowance under section 14A.

► Upto AY 2007-08, in absence of rule 8D, AO can compute disallowance under section 14A by reasonable method.

RECENT RULING OF BOMBAY HIGH COURT IN CASE OF – GODREJ & BOYCE

The facts in Godrej’s case as mentioned by the High Court are as under:

► Major dividend from group companies► 95% consisted of bonus shares► Most of the shares acquired several years earlier► No stage in the past except in last few years has the

Department attributed any interest or expenditure towards dividend

► Reserves of Rs.276 Cr and Capital of Rs.6.55 Cr more than the investments

► In the relevant year no new investments, but disposal of some old investments

SCENARIO UP TO AY 2007-08

► Rule 8D notified on 24 March 2008 not to have retrospective effect

► However, disallowance to be on reasonable basis

► Could be argued that basis for disallowance to remain the same as made in the past assessments

SCENARIO POST AY 2007-08

► Rule 8D to be applied only if AO not satisfied with the disallowance made by the tax payer himself and has recorded reasons

► Responsibility of tax payer to satisfy the AO► Justify its claim by robust documentation and sound

principles of apportionment

► Responsibility will shift on the AO, to justify why disallowance computed by the tax payer should not be accepted

► Could be argued that the basis for disallowance to remain the same as computed in the past

CONCLUSION

Up to AY 2007-08► Disallowance under section 14A to be computed on a

reasonable basis ► Provide adequate documentation and submissions to

minimize the disallowance to be computed on reasonable basis

Post AY 2007-08► Could be argued that basis of disallowance to remain same as

computed upto AY 2007-08 and not as per Rule 8D► Responsibility will shift on the AO, to justify why

disallowance computed by the tax payer should not be accepted

► Difficult for AO to disregard his own satisfaction with the basis of computation made upto AY 2007-08

Issues relating to contribution towards employee welfare funds

ISSUES RELATING TO CONTRIBUTIONS TOWARDS EMPLOYEE WELFARE FUND

Employer’s contribution to employee welfare funds – Section 43B(b)

► Employer’s contribution to employee welfare funds allowed as a deduction if paid before due

date of filing return of income

► Amendment to Section 43B(b) by omitting the second proviso is retrospective in nature - Alom

Extrusions Ltd. (319 ITR 306) (SC)

Employee’s contribution to employee welfare funds – Section 36(1)(va)

► Employee’s contribution towards employee welfare funds is treated as income of employer under

Section 2(24)(x)

► Employee’s contribution is allowed as deduction only if it is paid before due date under

respective employee welfare Acts and not before due date of filing return of income

► However, following judicial precedents have held that deduction under Section 36(1)(va) is

allowed even if employee contribution is paid before due date of filing return of income

► AIMIL Ltd – 229 CTR 418 (Delhi HC)

► P.M. Electronics Ltd. - 313 ITR 161 (Delhi HC)

► Pik Pen Private Limited - ITA No. 6847/Mum/2008 (Mumbai ITAT) following Alom

Extrusions

THANKS