By TIOL News Service

NEW DELHI, NOV 30, 2013: THE issues before the Bench are - Whether when the Indian subsidiary enters into agreement with the parent for right to duplication and imports of master copy, expenditure incurred on import of new versions of master copy having short shelf-life is to be construed as revenue in nature; Whether at the time of adjudication, primacy is to be given to the commercial and business point of view and not to juristic classification; Whether for determining the nature of an expenditure, one has to dwell into the question whether the expenditure, would create an asset which is of value in further assessment periods and should be amortised as long as it has value; Whether in case the enduring benefit test itself justifies the conclusion that the expense is revenue, it would not be proper and appropriate to apply the caveat or exceptions; Whether in case advantage consists of merely facilitating assets in trading operation and conduct of business more efficiently, it would be expenditure on revenue account even though the advantage may be of indefinite future and Whether media cost paid for import of master copy of Oracle Software used for duplication and licensing is an expenditure of a capital nature. And the verdict partly goes in favour of the assessee.

Facts of the case

Oracle India Private Limited, an Indian company, is a subsidiary of Oracle Corporation, USA. It had entered into licence agreement with its parent company under which assessee was granted non-exclusive, non-assignable right and authority to duplicate on appropriate carrier media software products or other products which may be added to the said list, and sub-licence the same to third parties in India. The appellant could enter into enforceable sub-licensing and services agreement in the prescribed form with third parties users. The holding company retained ownership of copyright in the software and all associated and applicable IPRs in the products mentioned or to be added to the said schedule. It was specifically stipulated that nothing contained in the agreement shall confer or deem to confer on the appellant any of the aforesaid rights. The holding company also retained rights to continue to manufacture or distribution activities in the field of software and software products, including the products mentioned or to be added to the said schedule with full rights to produce, reproduce, duplicate and distribute the said products in India or into India. The agreement stipulated that assessee shall duplicate and reproduce the software in India and sub-licence the same as per the terms of the sub-licence deed stipulated and with the holding company retaining entire data/IPR in the software. The assessee was entitled to use the trademark and trade name of the holding company with approval as to the manner of use from the holding company and no royalty or remuneration was to be paid for the said use. Assessee was to pay royalty to the holding company @ 30% of the list price of the licenced products. It was to be also paid on software products put to internal use. The royalty was payable on quarterly fiscal basis and was subject to deduction of TDS. In addition to royalty, assessee had also paid amount to the parent company as expenditure on import of software master copy. These payments were made on separate dates in each AY on import of master media from the holding company.

During assessment, AO held that payments of Rs.94,49,041/- for the AY 1994-95 and similar payments for the other years described as software master copy and documentation was capital expenditure and not revenue in nature. AO referred to the agreement, which was for a term of five years and observed that assessee had acquired copyright and all other associated and applicable IPRs. AO invoked Section 35A and held that on this amount, the appellant was entitled to deduction equal to 1/14th of the expenditure as it was incurred on acquisition of copyright. It was further held that there was transfer of copyright, in addition to other associated and applicable IPRs by Oracle Corporation, USA to assessee company and assessee had acquired the said rights for the purpose of business. On appeal, for AYs 1994-95 to 2004-2005, CIT(A) had reversed the finding of AO and observed that the obsolescence rate in software industry was extremely high and updated version of softwares were developed frequently. Referring to the agreement, CIT(A) observed that the IPRs in the software were not transferred to the assessee by Oracle Corporation, USA. Royalty was payable to Oracle Corporation, USA based upon the number of copies duplicated from each original master copy sold or sub-licensed to third parties. As far as royalty payment was concerned, there was no dispute that it was revenue in nature. Similarly, the cost of procuring the master copy was of recurring nature, which was established and proved beyond doubt from shipment of numerous master copies and the fact that there was no single lumpsum payment. CIT(A) observed that firstly, master copy updated software had to be procured, which was a recurring expenditure. Secondly, there was no enduring benefit as there were corrections; strides and frequent upgradation of software. Thirdly, the expenditure incurred in question was for conduct of business as an integral part of profit earning process and not for acquisition of assets or right of permanent character. Fourthly, the expenditure in question was in nature of procurement of raw material for the purpose of business and not to procure capital and, therefore, was a part of working capital of the company. Thus, CIT(A) asked for remand report. AO submitted a report and also appeared in person. Before the CIT(A), AO somewhat changed his stance and submitted that the expenditure was in the nature of technical services and know-how but, TDS had not been deducted. It was accordingly pleaded that if the expenditure was to be allowed as revenue, it cannot be allowed as a deduction as per Section 40(a)(i). CIT(A) did not agree with AO and observed that the expenditure incurred was neither for extension of business nor for substantial replacement of equipment, which related to carrying on or conduct of business and an integral part of profit making process. It was nothing but for procurement of raw material. CIT(A) overturned the finding of AO that assessee had acquired right of enduring nature by importing master copies and also rejected the finding that Section 35A was applicable. The price paid for master copy or royalty payment did not involve transfer of IPRs and no such rights were acquired by the appellant. The price at which the product was sold did not include the cost of IPRs. The CIT(A) noticed that AO in the appellate proceedings for the first time had relied upon Section 40(a)(i) and observed that the cost of the master copy did not constitute technical know-how or royalty u/s 9.

On appeal, Tribunal relating to AYs 1994-95, 1995-96, 1996-97 reversed the order of CIT(A) and restored the view taken by the AO. It was observed by Tribunal that assessee was a 100% subsidiary of Oracle Corporation, USA and was authorised as per the agreement signed to sub-lease the software products developed by the foreign company. For this purpose, assessee had imported Master Copy of the softwares as goods under the open general licence scheme of the Export Import Trade Policy. Assessee was making duplicate copies from the Master Copy and selling it to local clients. For importing the Master copy it had paid a lumpsum consideration and was also paying royalty @ 30% of the listed price of duplicate softwares sold locally. AO treated lumpsum consideration paid for import of Master Copy as capital expenditure holding that it was an asset of enduring benefits to the assessee. Import of Master Copy with the right of duplication was definitely an asset of enduring benefit. The payment of lumpsum consideration or enduring benefits were not conclusive tests in deciding whether an expenditure was a revenue expenditure or capital expenditure as held by SC in the case of M/s Empire Jute company (2002-TIOL-238-SC-IT) and subsequently reiterated in the case of M/s Alembic Chemical Works (2002-TIOL-160-SC-IT).

Held that,

++ it has been observed that lumpsum payment was made for the master copy and as the appellant also had right of duplication it lead to creation or acquisition of an asset of enduring benefit. It became part of the profit making apparatus and source of income. The Tribunal without disturbing or contradicting the stand of the appellant, on legal principles has held that the expenditure was capital in nature. We have given thoughtful consideration to the said findings, but find that the final conclusion cannot be sustained and should be reversed. Tribunal in the impugned order and the reasoning given therein had not disturbed the finding of CIT(A) or the assertion of the appellant before the AO that the master copies were versions of software developed by Oracle Corporation, USA, a new product offerings, which had high accelerated obsolescence and even at the point of time of import it was difficult whether the version would be replaced by a new or updated version after one day or a month. The life cycle of the version released was limited and improvements and further developments were constant and intermittent. The earlier version had a high degree of obsolescence and the master copy, documentation and policy adopted by the appellant recognised that the master copy did not have enduring or long- term benefit;

++ the Right to duplication and import of master copy though connected, cannot and does not show that the expenditure in question was capital in nature. The import of master copy was for the purpose of creating virtual image for the purpose of duplication. The right to duplication was given to the appellant under the agreement dated 28th May, 1993 and was subject to payment of royalty. The payments in question were not for acquiring the right to duplication. This is not the case of the Revenue or the finding of the AO or the Tribunal. We have also quoted above the sample data for AY 1994-95, which shows that there were as many as 28 imports on different dates after October, 1993 indicating the number of master copies imported. The average price per copy was minimal. We have also noted the findings recorded by the SC as to the nature and character of the software of which virtual image was created from the master copies. This was not a case where the master copies contained operating or system software, which normally do not require frequent upgradation or changes for consideration or price. Neither are we dealing with a case of an assessee who is the end user of software. We are dealing with the appellant who was required to repeatedly pay for the master copy media in view of frequent newer or updated versions of the application software from time to time. Once newer or better version of application softwares was available, the earlier application softwares were not saleable and did not have any market value for the seller i.e. the appellant;

++ the Act does not define the term 'asset' in generality though the term 'block of assets' is defined but the said definition is not relevant. Explanation 3 to section 32 states the term asset for the said provision means tangible and intangible assets being know-how, copyrights etc. The Act, however, more appropriately and pertinently defines the term 'capital asset' in Section 2(14) as property of any kind, but does not include stock in trade, consumable stores or raw materials held for the purposes of his business or profession. Personal effects and agricultural land etc. are also excluded. The term/expression 'expenditure' finds elucidation in Section 37 and it excludes any expenditure of capital nature or personal expenses. There is substantial authority for the proposition that determination of whether an expenditure is capital or revenue in nature must and should be decided keeping in view the nature of the business, commercial reasons for incurring the said expenses in business and the object for which the expense is incurred. Emphasis being placed on business and commercial considerations, rather than pure legal and technical aspects. Thus, primacy is given to practical and business point of view and not on juristic classification. The expression 'capital or revenue expenditure' must be construed in business sense and by applying sound accountancy principles unless there is statutory mandate to the contrary. (see Section 145 and observations of the Delhi HC in CIT v. Virtual Soft Systems Ltd. (2012-TIOL-189-HC-DEL-IT);

++ this aforesaid principle of matching, as we shall elucidate below, is of immense importance and significance. When we determine whether an expenditure is capital or revenue in nature, it exposes and brings to forefront the practice and commercial approach from the true and correct perspective and objective; "income" earned should be taxed. This has to be kept in mind as the guiding principle, subject to the statutory mandate which will override. A statement of accounts prepared on the basis of the aforesaid matching principle will generally reflect the true and correct income earned during the specified period. The said determination would be fair, just and equitable both to the appellant and the revenue. An asset is not normally created when a liability is incurred and it does not give benefit or advantage in future accounting periods or beyond a short/ small length of time, in view of the past practice and practical/ commercial reality. The expenses will be revenue in nature if its usefulness will come to an end within the financial year itself or is for limited time and would not have any residual value thereafter. Therefore, while determining whether expenditure is capital or revenue in nature, we must also dwell into the question whether the expenditure, would create an asset which is of value in further assessment periods and should be amortised ( i.e. depreciated) as long as it has value. (The last portion is obviously subject to the statutory mandate of an enactment, which may prescribe amortisation or depreciation rates. These being fixed by law will override the accounting principles). Thus, when an expenditure incurred does lead to creation of an asset but of a limited or short life, it has to be treated as a liability and not as a fixed asset. The said expenditure cannot be valued for price for future financial years;

++ a word of caution and a caveat for the aforesaid test, is one of importance as was elucidated by SC in Empire Jute Company Limited versus CIT(2002-TIOL-238-SC-IT). The said decision highlights advantage of enduring benefit test but nonetheless it was cautioned that the said test may break down and what is material to be considered is the nature of advantage in commercial sense. If the advantage consists of merely facilitating assets in trading operation or 8enabling the management and conduct of business more efficiently, it would be expenditure on revenue account even though the advantage may be of indefinite future. Thus, in Alembic Chemical Works Company Limited versus CIT (2002-TIOL-160-SC-IT) and Jonas Woodhead and Sons (India) Limited versus CIT, (2002-TIOL-832-SC-IT), the Supreme Court observed that though the technology had been received but it related to a product already under production and to ensure betterment or of the improvement, it was part and parcel of the existing business and, therefore, the benefits were composite partly revenue and partly capital. However, in the present case we need not apply the caveat. The caveats and caution elucidated would apply as exceptions of the enduring benefit tests. When the enduring benefit test itself justifies the conclusion that the expense is revenue, it would not be proper and appropriate to apply the caveats or exceptions. These secondary tests apply when in spite of the primary test of enduring benefit being in negative, i.e. against the assessee a different conclusion against the revenue is justified.The said enunciation has been approved by the Supreme Court in CIT vs. Finlay Mills Ltd. 20 ITR 475 (SC) and Empire Jute and other cases. The term enduring we clarify does not mean permanent, perpetual or everlasting but it refers and indicates that the right acquired must have enough durability to justify it being treated as a capital asset;

++ the view we have taken find support and is in consonance with the view taken by the Delhi High Court in CIT versus Ashahi India Safety Glass Limited, (2011-TIOL-705-HC-DEL-IT) wherein appellant had procured software which was amortised in the books as deferred revenue expenditure but was claimed as a deduction in the income tax income statement. It was observed that the said expenditure along with other expenditures neither created a new asset nor brought forth a new source of income. The expenditure incurred was to upgrade or to run the existing set up. It was to remove deficiencies in the software installed in the earlier years, to modify, customise or upgrade the software. Similarly, in CIT versus G.E. Capital Services Limited, (2007-TIOL-770-HC-DEL-IT) it was observed that the software procured by the assessee in question was not customised software and the software in question required regular upgradation and, therefore, was not of enduring benefit;

++ the Punjab and Haryana HC in CCIT vs.O.K. Play India Private Limited, (2012) 346 ITR 57 has again observed that computer software does not enjoy a degree of permanence and it could be unrealistic to ignore the stand and repeated upgradation and newer versions which have to be adopted and applied on the payment. In Alembic Chemicals Works Company Limited, lumpsum consideration paid for technical know-how to achieve higher level of production by better technology was held to be of revenue account. This was in spite of the fact that there was enduring benefit, but the Supreme court deemed it appropriate to apply a more liberal test on the consideration that in this age of rapidly advancing technology the contention of the Revenue that the expenditure brought into existing capital asset, should be rejected. The need of the age, the environment and the business consideration mattered and were given due recognition and acceptance. The said view has been followed by the Courts in India. As noticed above, in the present case the appellant is duplicating software and sells the same to generate income. It requires master copies, which have to be updated and upgraded to be able to sell the said software. In case the appellant had imported the said software and sold the same, it would be stock in trade and deductible. However, when the master copies were used for duplication and the software replicated and transferred on the media as a result of the said activities was then sold, the master copy itself might not be stock in trade as such in strict sense, but it did not have a long life and its value and life span was small since it perished and diminished when the upgraded version or a better software in form of the next master copy was imported, for the purpose of duplication. When we accept the said position, the requirement of enduring benefit fails and it cannot be said that any capital asset was acquired or purchased. In these circumstances, we need not apply and go into the other test or caveats. The flaw and the error committed by the tribunal is that they applied other tests or caveats without first ascertaining and determining whether enduring benefit test is satisfied or not. The enduring test may not be the sole, exclusive or universal test but is considered to be the primary test;

++ the SC in CIT versus IAEC Pumps limited upheld the decision of the tribunal that payment towards royalty was revenue expenditure and was allowable after observing that the licence for use of patents and designs was for a duration of 10 years with the parties having option to renew or extend the licence. The assessee had been only allowed use and there was no transfer of rights. The rights acquired by the assessee were not exclusive and were for a limited period which could be determined earlier also. Payment was dependent upon quantum of items manufactured. Decision in the case of CIT vs. Denso India Limited, (2009-TIOL-686-HC-DEL-IT) and submission relying upon Section 35A is misconceived. The said provision comes into play only when the expenditure incurred is of capital nature and is on the acquisition of patent rights and copyrights. Merely because expenditure has been incurred for material for duplication without acquisition of proprietary and when the expenditure is not of capital nature, the said Section would not be applicable. In any case, the said provision is not applicable with effect from the 1st day of April, 1998. The view we have taken finds affirmation and support from the decision of the Delhi High Court in Denso India Limited. It supports the case of the appellant as it has been held that depreciation claim in respect of intangible assets would arise only when it is first determined that the expenditure was capital in nature. Reference was made to CIT v. J.K. Synthetics Ltd. (2008-TIOL-671-HC-DEL-IT) where broad principles have been culled out and some of the principles have been set out in seritum. Decision in CIT v. Sharda Motors Industrial Ltd. (2009-TIOL-733–HC–DEL-IT) was also referred too. The question of law mentioned above is accordingly answered in favour of the appellant-assessee and against the Revenue. Interest under Section 234B is mandatory in nature and has to be paid when the statutory conditions are satisfied. Further, the interest has to be paid on the assessed income [see decision of the SC in CIT, Mumbai versus Anjum M.H. Ghaswala and Others, (2002-TIOL-73-SC-IT). Tribunal in the impugned order has already directed that interest u/s 234B shall be determined only after ascertaining the taxability. The questions are accordingly answered in favour of the Revenue and against the appellant. The appeals are accordingly disposed of with no orders as to costs.

(See 2013-TIOL-957-HC-DEL-IT)