KPMG Flash News 10 August 2011

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Clarissa Mathews
7 years ago
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1 KPMG IN INDIA KPMG Flash News 10 August 2011 TAX Expenditure incurred on in-house scientific research and development activity are deductible under Section 35(1)(i) or under Section 37(1) of the Income-tax Act Recently, the Delhi bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Parablic Drugs Ltd. 1 (the taxpayer) held that expenditure incurred on in-house scientific Research and Development (R&D) activity are deductible under Section 35(1)(i) or under Section 37(1) of the Income-tax Act, 1961 (the Act), even when the benefit of weighted deduction under Section 35(2AB) of the Act was disallowed to the taxpayer. Facts of the case The taxpayer was a limited company engaged in the business of manufacture of bulk drugs, fine chemicals, etc. For Assessment Year (AY) , the taxpayer incurred expenditure of INR million on R&D activities related to development of drugs. INR 4.44 million was reflected under the head fixed assets and INR million was reflected as deferred revenue expenditure under the head miscellaneous expenditure in the balance sheet. In its return of income, the taxpayer claimed weighted deduction of INR million under Section 35(2AB) of the Act which was150 percent of the total The taxpayer had made an application to the Department of Scientific and Industrial Research (DSIR) under Section 35(2AB) of the Act for claiming the weighted deduction. However, the DSIR approved capital expenditure of INR 4.17 million and the revenue expenditure at INR 2.72 million only. Accordingly, the taxpayer revised its return 1 ACIT v. Parablic Drugs Ltd (ITA No.2111/Del/2010 AY ) 1

2 of income and claimed the unapproved balance of INR 71.1 million as revenue The Assessing Officer (AO) treated INR 71.1 million as capital expenditure and disallowed the same. Taxpayer s contentions The break-up of total expenditure incurred on R&D activities during AY is as under: Capital Expenditure INR 4.44 million Salary & Wages INR 1.96 million Materials/consumables/spares INR million Other revenue expenditure INR million The taxpayer had made an application to DSIR to obtain a weighted deduction to the extent of 150 percent for the R&D However, since the norms fixed by DSIR were stiff only partial approval was granted on which weighted deduction was claimed under Section 35(2AB) of the Act. Expenditure which was capital in nature has already been classified as fixed assets on which depreciation has been claimed. Other expenditures were revenue in nature and deduction was claimed under Section 37(1) of the Act in the revised return. The taxpayer further submitted that even otherwise these expenditure having been incurred on R&D facilities also get covered under the provisions of Section 35(1)(i) of the Act. The taxpayer contended that the AO was factually incorrect in observing that the expenditure incurred was capital Further, the nature of expenditure incurred did not generate any capital asset of enduring benefit. Expenses were shown under the head miscellaneous expenditure on the assets side in the balance sheet. However, these expenditures were revenue in nature but were shown under miscellaneous expenditure to present a better position of profit and loss account and to attract shareholders. The taxpayer relying on the decisions of Tuticorin Alkali Chemicals and Fertilizers Ltd 2, Challapalli Sugar Ltd 3, Seshsayee Paper and Boards Ltd 4, Jai Parabolic 5 contended that the nomenclature given to 2 Tuticorin Alkali Chemicals & Fertilizers Ltd v. CIT [1997] 172 ITR 227 (SC) 3 Challapalli Sugars Ltd v. CIT [1975] 98 ITR 167 (SC) 4 CIT v. Seshsayee Paper and Boards Ltd [1985] 156 ITR 542 (Mad) 5 CIT v. Jai Parabolic [2008] 6 DTR 233 (Del) 2

3 an item of expenditure could not be determinative of the nature of The taxpayer relying on the decision Tata Chemicals Limited 6 contended that even if claim for expenditure did not fall under one section, the same expenditure could be claimed under another section. Tax department s contentions The tax department contended that expenditure incurred on R&D was for the purposes of deriving enduring advantage to the taxpayer. Further, the benefit of such expenditure was not restricted to the year under consideration but it was to spread over many years. Therefore, expenditure should be classified as capital The expenditure incurred by the taxpayer was for trial production and actual production did not commence. Commercial production was to start only after 2-3 years after the complete process was handed over to the production department. The taxpayer itself had classified these expenditures as capital in nature in its audited balance sheet and once expenditure had been classified as capital in nature, the non-approval by the DSIR did not change the character of the expenditure from capital to revenue. The taxpayer also failed to produce any evidence or any certification from the DSIR stating that unapproved balance amount was towards revenue Tribunal s ruling Taxpayer s business is to manufacture bulk drugs, fine chemicals, etc. In the process of its manufacture it has to perform R&D activities so as to make the drugs more effective and to reduce the cost. In the business of manufacturing of drug, process of R&D is continuous process which augments the business of the taxpayer. Expenses of INR 1.96 million on salary and wages cannot be considered as capital expenditure since salary and wages are paid to the manpower deployed for carrying out the R&D activity which is part and parcel of the taxpayer s business. Expenses of INR million relating to material/consumable/ spares, have been used for lab trials for process development. The material was consumed in the R&D process and not part was remaining as the closing stock. Therefore, expenditure incurred on material used for lab trials cannot be considered as capital 6 Tata Chemicals Limited v. CIT [1992] 195 ITR 561 (Bom) 3

4 Expenses of INR million under the head, details of other expenditure directly related to R&D were incurred by the taxpayer for registration of products in other countries or towards obtaining technical know-how fee for producing new drugs, etc. Such type of agreements for transfer of technical know-how is quite common in pharmaceutical industry due to commercial exigency. Accordingly, these expenditure were held to be incurred by the taxpayer in the course of its business and cannot be classified as capital Accordingly, the Tribunal held that all the expenditure incurred by the taxpayer was in the course of its business and therefore none of the expenditure could be classified as capital The Tribunal while dealing with Section 35(1)(i) of the Act observed that revenue expenditure incurred on scientific research related to business is to be allowed as deduction. Accordingly, the Tribunal held that the taxpayer was eligible for deduction of the expenditure under Section 35(1)(i) or under Section 37(1) of the Act. Our comments This is an important ruling for those taxpayers who are not able to claim the allowance of in-house R&D expenditure under Section 35(2AB) of the Act at 150 percent. This decision provides a relief when it is difficult to claim weighted deduction on the entire R&D expenditure incurred. In this ruling, the Delhi Tribunal has held that expenditure incurred on inhouse scientific Research and Development is deductible under Section 35(1)(i) or under Section 37(1) of the Act when the weighted deduction under Section 35(2AB) of the Act has been disallowed to the taxpayer. 4

5 Bangalore Maruthi Infotech Centre, 11-12/1 Inner Ring Road Koramangala, Bangalore Phone: Fax: Chennai KPMG House No.10, Mahatma Gandhi Road, Nungambakkam High Road, Chennai Phone: Fax: Chandigarh SCO st Floor, Sector 8 C Madhya Marg Chandigarh Tel: Fax: Mumbai Lodha Excelus, Apollo mills compound, NM Joshi Marg, Mahalaxmi, Mumbai India Phone: Fax: Pune 703, 7th Floor Godrej Castlemaine, Next to Ruby Hall Clinic, Bund Garden Road, Pune Phone: /65 Fax: Kochi 4/F, Palal Towers, M. G. Road, Ravipuram, Kochi Phone: +91 (484) Fax: +91 (484) Delhi DLF Cyber City, Building no. 10, Block B, Phase II Gurgaon, Haryana Phone: Fax: Hyderabad KPMG, /2 Reliance Humsafar, 4th Floor Road No.11, Banjara Hills Hyderabad Phone: Fax: Kolkata KPMG Infinity Benchmark Plot No. G-1, 10th floor Block - EP & GP, Sector V, Salt Lake City Kolkata Phone: The information contained herein is of a general nature and is not intended to address the circumstances of 2011 KPMG, an Indian Partnership and a member firm any particular individual or entity. Although we endeavour to provide accurate and timely information, there of the KPMG network of independent member firms can be no guarantee 2011 that KPMG, such information an Indian Partnership is accurate as and of the a member date it is firm received of the or that KPMG it will network continue of to independent affiliated member with KPMG firms International affiliated with Cooperative ( KPMG be accurate in KPMG the future. International No one should Cooperative act on such ( KPMG information International ), without appropriate a Swiss professional entity. All rights advice reserved. International ), a Swiss entity. All rights reserved. after a thorough examination of the particular situation. 1

KPMG Flash News 7 July 2011

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