Sunday, August 28, 2011

Payment made by the resident company to KPMG, Brazil for assisting in the acquisition of sugar mills in Brazil is not “Fees for Technical Services

The payment made by the resident company to KPMG, Brazil for assisting in the acquisition of sugar mills in Brazil is not “Fees for Technical Services”. Hence, the assessee is not liable to deduct TDS, as held by MumTrib in ITO(IT)-TDS-3 v Bajaj Hindustan Ltd — In favour of: The assessee.


12 August 2011.

ITO(IT)-TDS-3 v Bajaj Hindustan Ltd.



ITAT BENCH “L”, MUMBAI


ITA No. 63/MUM/09(2007-08)






1. This is an appeal by the assessee against the order dated 17/9/2008 of CIT(A) 33 Mumbai relating to assessment year 2007-08.


2. The assessee is a company. It is engaged in the business of manufacturing of sugar. According to the assesse, it engaged the services of M/s. KPMG Corporate Finance Ltd.,
Brazil (KPMG)(Non-Resident), to advice and assist the assessee in acquisition of Sugar Mills/Distilleries in Brazil. In connection with the services rendered by KPMG for the said
purpose, the assessee had made payment to KPMG. The question before the ITO (International Taxation),TDS-3, Mumbai (AO), was as to whether the Assessee was bound to deduct tax at source on the payment made to KPMG in terms of Sec.195 of the Income Tax Act, 1961 (the Act). That would again depend on the question whether the payment by the Assessee to KPMG would be taxable in the hands of KPMG in India.

3. According to Sec.9 of the Act, the following incomes shall be deemed to accrue or arise in India.


(vii) income by way of fees for technical services payable by……..


(b) a person who is a resident, except where the fees are payable in respect of services utilized in a business or profession carried on by such person outside India or for the
purposes of making or earning any income from any source outside India; or The aforesaid clause (b) provides two exceptions. In the first case, the payment if made by a
resident for services which are utilized in a business or profession carried out by such person outside India, then the said payment would not be deemed to be income accruing or arising to the payee in India. The second exception envisaged by clause(b) of Sec.9(1)(vii) of the Act, is if the payment is made by a resident for the purpose of making or earning any income from any source outside India, then the said payment would not be deemed to be income accruing or arising to the payee in India.


4. The AO was of the view that the assessee ought to have deducted tax at source on the payment made to KPMG. According to the AO the amount received from the assessee by
KPMG was in the nature of fees for technical services rendered. The AO was also of the view that in terms of section 9(1)(vii) of the Income Tax Act, 1961(the Act) income by way of Fees for Technical Services (FTS) payable to a person who is a resident shall be income deemed to accrue or arise in India. According to the AO the payment by the assessee to KPMG did not fall within the exceptions and, therefore, the payment would be income which accrues or arises in India in the hands of KPMG chargeable to tax. The AO therefore held that since the amount was chargeable to tax in India in the hands of KPMG, the assessee in the terms of section 195 of the Act ought to have deducted tax at source on the payment made to KPMG.


Since the assessee had not done so the AO treated the assessee as an assessee in default and passed an order for recovery of the taxes that ought to have been deducted and interest thereon in terms of section 201(1) and 201(1A) of the Act.

5. Before CIT(A), the assessee submitted that the assessee was the largest sugar producer in India and in order to expand their operations they appointed KPMG to explore the possibility of acquiring sugar mill/distillery plant in Brazil. In this regard the assessee submitted that KPMG was to provide the assessee the following services:


(i) Assistance in the identification of targets fitting assessee’s needs and contact of those companies;


(ii) Present the assessee selected information on those targets.


(iii) Perform pricing analysis of selected targets;


(iv) Assist the assessee in the acquisition process of target(s), with the internal team of the Assessee and other external advisors named by the company, for a closing of the transactions9s) in the best possible conditions.


6. It was further submitted that the assessee incorporated a company called Bajaj International Paatici Pacoes Ltd. in Brazil in order to acquire sugar mills/distillery plants in Brazil. A copy of the Memorandum of Association of the subsidiary company so incorporated in Brazil was also filed. It was pointed out that the objective of appointing KPMG was to identify and acquire sugar mills/distillery plants in Brazil. Thus the assessee made the payment in question to carry on business outside India and for the purpose of earning any income from any source outside India. It was submitted that the payment made by the Assessee was towards services which would be utilized in the business which will be carried out outside India i.e. Brazil through the Assessee’s subsidiary company and therefore the aforesaid payment would be squarely covered by the first exception provided in section 9(1)(vii)(b) of the Act and will therefore not be taxable in India. It was submitted that the very fact that the sugar mills/distillery plants to be acquired are located outside India would only mean that the income derived from the said mills/plants will be earned from a source outside India therefore payment made to KPMG would be covered even by the second exception provided in clause (b) of section 9(1)(vii) of the Act viz., “for the purposes of making or earning any income from any source outside India”. It was therefore submitted that the payment of USD 100,000 to KPMG does not constitute income deemed to accrue or arise in India under section 9(1)(vii) of the Act and is not taxable in India in the hands of KPMG and therefore the Assessee was not liable to liable to deduct tax at source thereon.

7. Since the aforesaid submission was made by the assessee for the first time before the CIT(A), the CIT(A) called for a remand report from the AO. In his remand report dated
18/1/08, the AO accepted that the contention put forth by the assessee was legal contention and requested the CIT(A) to consider the said contention on merits. However, the CIT(A) informed the CIT(A) that the facts regarding incorporation of a subsidiary by the Assessee in Brazil needed to be verified.

8. On a consideration of the above submissions the CIT(A) noticed that the agreement between the assessee and KPMG was in the form of proposal dated 11/5/2006. The proposal refers to the Assessee being the largest sugar producer in India and its desire to study the possibility of expanding its operations, through transactions involving the acquisition of a sugar mills/ distillery plants in Brazil. For the said purpose the Assessee was considering appointment of a financial advisor to assist during the acquisition process. KPMG being one of the leaders in Brazil in Mergers and Acquisitions (M&A) in the sugar and alcohol section and have already advised in transactions related to disposals of sugar mills and sugar refinery were being engaged for the aforesaid purpose. The proposal also mentions that the acquisition is to be done by the Assessee or any of its subsidiaries or its nearest company or any company controlled by the Assessee.

9. On a consideration of the above features of the Agreement, the CIT(A) was of the view that the Assessee wanted to acquire sugar mills/distillery plants in Brazil. For that purpose, the Assessee had availed the services of KPMG. He found that the services were to be rendered in Brazil and that services are connected with the acquisition of sugar mills/distilleries in Brazil. The CIT(A) was of the view that the words used in Sec.9(1)(vii) clause (b) second exception was “ for the purposes of earning any income from any source outside India.”. He was of the view that the services rendered by KPMG were to be used for the purpose of acquisition of sugar mill / distillery in Brazil for the purpose of earning income from sugar mill / distillery from Brazil. He was of the view that the words used in sec. 9(1)(vii) were vide enough to cover even future source of income. The CIT(A) therefore held that that the services rendered by M/s. KPMG was utilized by the Assessee for the purpose of earning income from a source outside India and therefore the payment by the Assessee of fees for technical services rendered by M/s. KPMG was outside the scope of Sec. 9(1)(vii) of the Income Tax Act. Hence it cannot be considered as income deemed to have accrued in India and not chargeable to tax in India and hence the Assessee is not liable to deduct tax u/s. 195 of Income Tax Act. The demand raised for tax and interest u/s.201(1) and 201(1A) of the Act was deleted.


10. Aggrieved by the order of the CIT(A) the revenue has preferred the present appeal before us.

11. The ld. D.R submitted that the assessee initially accepted before the AO that there was an obligation on its part to deduct tax at source while making payment to KPMG. Only on 17/8/2007 the assessee in a letter to the AO took a stand that the services rendered by KPMG were in the nature of market research and, therefore, not in the nature of FTS. The ld. D.R also drew our attention to the proposal dated 11/5/06 and submitted that the proposal( contained in page 1 to 17 of the assessee’s paper book) is not in the form of an agreement and the genuineness of the claim of the assessee that this was the agreement for rendering services is doubtful. We have examined this contention and find that in the letter dated 17/8/2007 the assessee has made a claim that the proposal ( contained in page 1 to 17 of the assessee’s paper book) was the agreement between assessee and KPMG. The Assessee also made it clear that KPMG was engaged to study the possibility of expansion of assessee’s business for acquisition of sugar mills/distillery plants in Brazil. The AO has proceeded to examine the proposal dated 11/5/2006 accepting the same as an agreement between the parties. At this stage it is not open to the ld. D.R to raise issues concerning the genuineness of the agreement. We, therefore, proceed to examine the case on the basis that the proposal dated 11/5/2006 as contained in page 1 to 17 of the assessee’s paper book constitutes the agreement between the assessee and KPMG in connection with which the assessee made payment to KPMG.

12. The next submission of the ld. D.R was that the assessee was utilizing the services of KPMG in respect of a business or profession carried on by the assessee in India and, therefore, the payment was FTS. Further it was submitted that the claim of the assessee that the payment made to KPMG was “for the purpose of earning any income from any source outside India” ought not to have been accepted by the CIT(A) because the exception contemplated in section 9(1)(vii)(b) of the Act is only in respect of an existing source of income. It was submitted by him that in a case where the source of income is to come into existence at future date the exception cannot apply. It was pointed out by the ld. D.R that the payment in question was for the purpose of earning income from a source outside India which source had not come into the existence and the assessee only proposed to create the source of earning income outside India in future. The ld. D.R brought to our notice Circular No.202, para 16.2 which explains the provisions of Finance Bill 1976, wherein it has been observed as follows:

“16.2 Under the new provision, income by way of “fees for technical services” of the following types will be deemed to accrue or arise in India:


(a) fees for technical services payable by the Central Government or any State Government;


(b) fees for technical services payable by a resident, except where the payment is relatable to a business or profession carried on by him outside India or to any other source of his income outside India, and


(c) fees or technical services payable by a non-resident if the payment is relatable to a business or profession carried on by him in India or to any other source of his income in India.”

13. It was argued that even the Circular talks about source of income outside India which means that it should be an existing source. It was submitted that the exception in clause (b) cannot apply to a future source to be set up. Reliance was also placed on the decision of the ITAT Mumbai in the case of Hindalco Industries Ltd. vs. ITO 91 ITD 64(Mum), wherein it was held that utilization of services is essential by the resident only in business or profession carried on by the resident outside India. If a resident pays FTS outside India for the services to be utilized in India then that income per-se will be treated as income accruing or arising to the person in India.

14. We have considered the arguments of ld. D.R. There is not dispute that the payment in question made by Assessee to KPMG is in respect of services which otherwise fell within the definition of FTS as given in the Act. The dispute is whether the exceptions mentioned in clause (b) to Sec. 9(1)(vii) of the Act would apply so that it can be said that the fees in thenature of FTS has not accrued or arisen to KPMG in India. As far as the first exception in Sec.9(1)(vii) clause (b) of the Act, is concerned viz., “where the fees are payable in respect of services utilized in a business or profession carried on by such person outside India”, we find that the Assessee carries on business in India and has utilized the services of KPMG in connection with such business. Therefore the case of the Assessee would not fall within the first exception, notwithstanding the fact that services were rendered only in Brazil. As far as the second exception mentioned in Sec.9(1)(vii) clause (b) is concerned viz., “ for the purposes of earning any income from any source outside India.”, the undisputed facts are that the Assessee wanted to acquire sugar mills/distillery plants in Brazil and for that purpose also wanted to set up a subsidiary company. In fact, the Assessee had set up a subsidiary company on 8.8.2006 in Brazil. Thus the Assessee was contemplating to create a source for earning income outside India. It is no doubt true that the source of income had not come into existence. But there is nothing in Sec. 9(1)(vii) clause (b) of the Act, to show that the source of income should have come into existence so as to except the payment of fees for technical services. The expression used is “for the purpose of earning any income from any source outside India”. There is nothing in the language of Sec.9(1)(vii) clause (b) of the Act, which would go to show that the same is restricted to only to an existing source of income. We therefore agree with the conclusions of the CIT(A) on this aspect. We therefore uphold the order of the CIT(A) holding that the payment by the Assessee of fees for technical services rendered by M/s. KPMG was outside the scope of Sec. 9(1)(vii) of the Income Tax Act. Hence it cannot be considered as income deemed to have accrued in India and not chargeable to tax in India and hence the Assessee was not liable to deduct tax u/s. 195 of Income Tax Act. The demand raised for tax and interest u/s.201(1) and 201(1A) of the Act was therefore rightly
directed to be deleted. We find no grounds to interfere with the order of the CIT(A) and uphold the order of CIT(A) and dismiss the appeal by the Revenue.


15. In the result, the appeal by the Revenue is dismissed.






Income from license of software not assessable as “royalty”-- Gracemac not followed/Motorola still good law



Income from license of software not assessable as “royalty”. Gracemac not followed; Motorola still good law

The assessee, an Israeli company, entered into an agreement with Reliance Infocomm for supply and licence of software for RIL’s wireless network in India. The assessee received Rs. 3 crores which it claimed to be “business profits” and not taxable for want of a permanent establishment (PE) in India. The AO took the view that the said sum was assessable as “royalty”. This was reversed by the CIT (A) following Motorola Inc 96 TTJ 1 (Del) (SB). In appeal before the Tribunal, the department argued that in view of Gracemac Corp 42 SOT 550 (Del), the use of software was assessable as “royalty”. HELD dismissing the appeal:




(i) Under Article 12 (3) of the India-Israel DTAA, royalty is defined inter alia to mean payments for the “use of” a “copyright” or a “process”. There is a distinction between “use of copyright” and “use of a copyrighted article”. In order to constitute “use of a copyright”, the transferee must enjoy four rights viz: (i) the right to make copies of the software for distribution to the public, (ii) The right to prepare derivative computer programmes based upon the copyrighted programme, (iii) the right to make a public performance of the computer programme and (iv) The right to publicly display the computer programme. If these rights are not enjoyed, there is no “use of a copyright”. The consideration is also not for “use of a process” because what the customer is paying for is not for the “process” but for the “results” achieved by use of the software. It will be a “hyper technical approach totally divorced from ground business realities” to hold that the use of software is use of a “process”. (Motorola Inc 96 TTJ 1 (Del) (SB) and Asia Sat 332 ITR 340 (Del) followed. Gracemac Corp 42 SOT 550 (Del) not followed);






(ii) It is well settled that a DTAA prevails over the Act where it is more favourable to the assessee. The view taken in Gracemac, relying on Gramophone Co AIR 1984 SC 667, that the Act overrides the treaty provisions where there is irreconcilable conflict is not acceptable because (a) it is obiter dicta, (b) contrary to Azadi Bachao Andolan 263 ITR 706 (SC) and (c) Gramophone Co not applicable to I. T. Act as it dealt with law in which specific enabling clause for treaty override did not exist. (Ram Jethmalani vs UOI also considered).


Source: ITATonline

Sunday, August 21, 2011

Fees paid to a foreign company for rendering testing and certification services--Not Income accrued in India

Fees paid to a foreign company for rendering testing and certification services could not be treated as income deemed to accrue or arise in India under Section 9(1)(vii) of the Income-tax Act



Recently, the Delhi Bench of Income-tax Appellate Tribunal (the Tribunal) in case of Havells India Ltd1 (the taxpayer) held that testing fees paid to non-resident company could not be treated as income deemed to accrue or arise in India under Section 9(1)(vii) of the Income-tax Act 1961 (the Act).

Further since the income did not accrue or arise in India, the question of deducting tax at source does not arise and consequently payment made to the non-resident was not to be disallowed under Section 40(a)(i) of the Act.

Havells India Ltd v. ACIT [ITA No.1300/Del/2010, dated 27 May 2011]

Facts of the case

• The taxpayer paid INR 1.48 million to CSA International (CSA), a US Company for getting witness testing of AC Contactor as part of CB report and KEMA certification. CSA was assigned this job since it had a specialized knowledge and facility for the requisite testing and certification.

• The Assessing Officer (AO) held that fees paid for testing and certification services rendered by CSA were in the nature of making available of technical knowledge, expertise and skill of CSA, rendering such services to be ‘Fees for Included Services” as per Article 12(4)(b) of the India-USA tax treaty (tax treaty).

• The AO observed that irrespective of whether the non-resident is having a business connection in India or not, the payment made by the taxpayer as Fees for Technical Services (FTS) being utilised in business in India would lead to income being deemed to accrue or arise in India. Further the AO held that since tax was not deducted at source under Section 195 of the Act in respect of testing fees paid by the taxpayer, the amount of INR 1.48 million would be disallowed under Section 40(a)(i) of the Act.

• The Commissioner of Income Tax Appeal [CIT (A)] relying on the decision of Cochin Refineries Ltd.2 confirmed the disallowance made by the AO.

2 Cochin Refineries Ltd. v. CIT [1996] 222 ITR 354 (Ker)


3 GE India Technology Centre P Ltd v. CIT [2010] 327 ITR 456 (SC)


4 Titan Industries Ltd v. ITO [2007] 11 SOT 206 (Bang)


5 Ishikawajima–Harima Heavy Industries Ltd v. DIT [2007] 158 Taxman 259 (SC)

Taxpayer’s contentions

• The taxpayer contended that it had made exports to the USA and the fees in question had been paid to earn income from the USA, i.e. from a source outside India. Therefore, the fees paid to CSA could not be deemed to accrue or arise in India under Section 9(1)(vii) of the Act and tax was not required to be deducted at source on such payments under Section 195 of the Act.

• The taxpayer relied on the decision of GE India Technology Centre P Ltd3 where it was held that duty to withhold tax did not arise on a mere remittance to a non-resident, unless the remittance consisted of wholly or partly taxable income. Since the fees were payable in respect of services utilised outside India, the said income was not taxable and tax was not required to be deducted at source.

• The taxpayer relying on the decision of Titan Industries Ltd4 contended that provisions of Section 40(a)(i) of the Act had no applicability since services has been utilised outside India for earning an income from a source outside India. Accordingly, the payment was covered in the exception provided in Section 9(1)(vii)(b) of the Act, due to which, there was no need to deduct tax at source under Section 195 of the Act.

• The taxpayer further contended that the CIT(A) had failed to consider the decision of the Supreme Court in Ishikawajimi–Harima Heavy Industries Ltd5 where it had been held that income can be deemed to accrue or arise in India, only if the services were utilised in India as well as rendered in India; that in the taxpayer’s case, neither were the services rendered by CSA in India, nor were they utilised in India.

• The taxpayer further contended that services of CSA did not make available technical know-how to the taxpayer, therefore, it did not amount to FIS under the tax treaty and there was no obligation on the part of the taxpayer to deduct tax under Section 195 of the Act.

Tax department’s contentions

• The tax department contended that testing reports and certifications were obtained from CSA in respect of the manufacturing activity of the taxpayer in India and that the taxpayer did not deduct tax at source while making the payment to CSA.

• The tax department relying on the decision of Cochin Refineries Ltd contended that fees paid to CSA US was in the nature of FTS and it would fall under the definition of FTS within the provisions of Section 9(1)(vii) of the Act and the income was thus taxable in India.

• The tax department contended that the payment was covered as “Fees for Included Services” as referred to in Article 12(4)(b) of the tax treaty as the testing report and certification made available to the taxpayer were in the nature of technical knowledge, expertise and skill made available to the taxpayer. Further the same was utilised in the manufacture and sale of products in the business of the taxpayer in India.

• The tax department contended that if the assessment order was found to be deficient with regards to whether services was utilised in India or not, the matter should be referred to the AO for a fresh decision concerning this aspect of the matter.

Tribunals ruling

• The Tribunal observed that the testing and certification was necessary for the export of the product and was utilised for such export. The said services were rendered and utilised outside India. Therefore, the income fell outside the purview of Section 9(1)(vii) of the Act and did not deem to accrue or arise in India.

• The Tribunal observed that the tax department had failed to prove its contention that the testing and certification were utilised in the taxpayer’s production activity in India. The burden in this regard was entirely on the tax department, which the tax department had failed to discharge.


6 Raymond Ltd v. DCIT [2003] 86 ITD 791 (Mum)


Joint Accreditation System of Australia and New Zealand [2010] 326 ITR 487 (AAR)


Diamond Services P Ltd v. Union of India & Others [2008] 304 ITR 201 (Mum)


NQA Quality System Registrar Ltd v. DCIT [2005] 92 TTJ 946 (Del)


ICICI Bank Ltd v. DCIT [2008] 20 SOT 453(Mum)

• The tax department’s argument on remitting the matter to the AO was neither required, nor appropriate to be adopted. The Tribunal observed that it was not possible to remit the matter to the AO since the appellate authority examines whether the assessment had been framed in accordance with law and if the assessment was not framed in accordance with law it was not the responsibility of the authority to start investigation suo moto and in order to fill up the gap which was missing.

• The Tribunal further observed that the tax department did not bring anything on record to substantiate its observation of the testing and certification services provided to the taxpayer by CSA having been utilised for the taxpayer’s business activity in India. Accordingly, it was held that fees paid by the taxpayer did not deemed to accrue or arise in India and withholding of tax under Section 195 of the Act was not required and thus disallowance under Section 40(a)(i) of the Act was also not required.

Tuesday, August 16, 2011

Payment for Patent Infringement is allowable u/s 37(1)

[2011] 12 taxmann.com 373 (Delhi)

HIGH COURT OF DELHI--Commissioner of Income-tax v. Desiccant Rotors International (P.) Ltd.*

The assessee-company was engaged in the business of manufacturing of environmental control systems such as Rotors, Heat Recovery Wheels, Desiccant Rotors, etc. For the assessment year 2005-06, the assessee filed its income-tax return declaring certain income. Along with the return, necessary documents including profit and loss account was filed. On perusal of the profit and loss account, it was noticed by the Assessing Officer that the assessee had debited certain amount on account of compensation paid towards settlement of dispute. On being asked to clarify the position, the assessee-company furnished a note stating that it had been exporting its products to one of its customers, 'VENMAR', Canada for selling those products further in foreign countries. SEMCO Inc., USA had filed a suit against VENMAR for infringement of their registered patents in USA by selling the products of the assessee-company. VENMAR settled the dispute with SEMCO by paying certain compensation to it. Subsequently, SEMCO instituted the proceedings against the assessee company in the Court of USA alleging that sale of products by the assessee to VENMAR amounted to infringement of their registered patents. Since the cost of litigation was expected to be exorbitant, the assessee-company after considering the advice of its legal representative, settled the dispute with SEMCO by making payment of US $6,75,000. It was, thus, claimed by the assessee that the payment was compensatory in nature to compensate the loss incurred by SEMCO as a result of selling the product covered by patent held by SEMCO to VENMAR. The Assessing Officer opined that amount paid by the assessee to SEMCO was nothing but a 'penalty' or as something akin to penalty and the payment was made only due to infringement which would, in any way, result into a compensation. The Assessing Officer, further, observed that violation of the patents/trademark, etc., is always prohibited by law and, therefore, in view of the provisions contained in Explanation to section 37(1), the expenditure so incurred by the assessee was not allowable. The Commissioner (Appeals) confirmed the order of the Assessing Officer. On second appeal, the Tribunal, accepting the contention of the assessee that the payment was not in the nature of any penalty and no such violation of patent law was held to be proved, and it was only in the nature of compensation due to settlement arrived at between the parties, permitted it as allowable expenditure under section 37.




A.K. Sikri, J. - Before we reproduce the substantial questions of law, which are to be answered, we deem it appropriate to state the facts and circumstances under which these questions of law arise for consideration. The respondent-assessee was incorporated in the year 1984 and has been engaged in the business of manufacturing of environmental control system such as Rotors, Heat Recovery Wheels, Desiccant Rotors, etc. For the assessment year 2005-06, the assessee filed its Income-tax return on 31-10-2005 declaring total income at Rs. 2,49,28,630. Along with the return, necessary documents including Profit and Loss account was filed. Books of account were also produced at the time of assessment and were examined by the Assessing Officer. On perusal of the Profit & Loss account, it was noticed by the Assessing Officer that the assessee has debited an amount of Rs. 3,12,57,152 on account of compensation paid towards settlement of dispute. On being asked to clarify the position, the assessee company furnished a note with relevant documents, vide letter dated 26-12-2007. In the notice, it was stated that the assessee has been exporting its products to one of its customers, viz., M/s Venmar Ventilation Inc. (hereinafter referred to as 'VENMAR'), Canada for selling their products. SEMCO Inc. USA had filed a suit against VENMAR for infringement of their registered patents in USA by selling the products of the assessee company. VENMAR settled the dispute with SEMCO by paying certain compensation to it. Subsequently, SEMCO instituted the proceedings against the assessee company a swell in the Court of USA alleging that sale of products by assessee to VENMAR amounted to infringement of their registered patents. Since the cost of litigation was expected to be exorbitant, the assessee company after considering the advice of its legal representative, settled the dispute with SEMCO by making payment of US $6,75,000. It was, thus, claimed by the assessee that the payment was compensatory in nature to compensate the loss incurred by SEMCO as a result of selling the product covered by patent held by SEMCO to VENMAR. The assessee also filed certain documents along with its submissions.



2. The contention of the assessee, before the Assessing Officer, which has been remained consistent throughout, was that the assessee company had made the payment to SEMCO as a result of settlement arrived at and not on account of infringement of patent law, did not accept the Assessing Officer. The Assessing Officer was of the view that SEMCO had filed the Suit for damages and injunction due to infringement of SEMCO's United States Patent bearing No. 4769053 caused by the assessee company and its customers for manufacturing and marketing the Energy Recovery Wheel products. Further, SEMCO had sued VENMAR in the same Court for infringement of SEMCO's patent by selling the assessee company's product in their patented territory and in those proceedings, the VENMAR had acknowledged that the patent held by SEMCO was valid and enforceable and thus, agreed not to sell the products that would infringe the patent of SEMCO and accordingly compensated SEMCO for such infringement. In these circumstances, according to the Assessing Officer, the amount paid by the assessee to SEMCO was nothing but a "penalty" or as something akin to penalty and the payment was made only due to infringement which would, in any way, resulted into a compensation. The Assessing Officer, further, observed that violation of the patents/trademark, etc. is always prohibited by law and therefore, in view of the provisions contained in Explanation to section 37(1) of the Income-tax Act (hereinafter referred to as 'the Act'), the expenditure so incurred by the assessee was not allowable. The Assessing Officer further took the view that the payment was made to avoid any conviction by the Court of Law for infringement of patent which is not a normal incident of business and therefore, it is not allowable as business expenditure. On this reasoning, the Assessing Officer disallowed the payment of compensation paid by the assessee to settle the dispute and added the same to the assessee's total income.



3. Feeling aggrieved, the assessee preferred an appeal before the CIT(A). The case as pleaded before the Assessing Officer was reiterated before the CIT(A). It was exemplified by submitting that whatever allegations were levelled by SEMCO were denied and disputed in toto by the assessee and even the suit was defended for three years. However, keeping in view the cost of litigation and the advice given by its legal consultants, the assessee found it expedient and proper to reach an out-of-Court settlement. The assessee company emphatically argued before the CIT(A) that the settlement was not on account of any infringement of any law inasmuch as no Court of law held anything or given any finding against the assessee company. It was, therefore, contended that the assessee's case is not covered by Explanation to section 37(1) of the Act and therefore, the payment made in the course of carrying on assessee's business activity is to be allowed as business expenditure. The assessee also placed reliance on the decision of the Supreme Court in the case of Prakash Cotton Mills (P.) Ltd. v. CIT [1993] 201 ITR 684/67 Taxman 546. After considering the Assessing Officer's order and the assessee's submissions, the CIT(A) confirmed the Assessing Officer's order in disallowing the assessee's claim of deduction of payment to SEMCO as a result of out of Court settlement in respect of the proceedings initiated by M/s SEMCO against the assessee company for infringement of their patent rights.



4. Still aggrieved, the assessee went in appeal before the Tribunal. In this appeal, the assessee has been able to convince the Tribunal. Accepting the contention of the assessee that the payment was not in the nature of any penalty and no such violation of patent law was held to be proved, and it was only in the nature of compensation due to settlement arrived at between the parties, the Tribunal has permitted it as allowable expenditure under section 37 of the Act.



5. Section 37, which is a residuary provision, allows the expenditure as deductable while computing the income on the satisfaction of the following conditions:



"(a) Expenditure must not be governed by the provisions of sections 30 to 36 of the Act;



(b) The expenditure must have been laid out wholly and exclusively for the purposes of the business of the assessee:



(c) The expenditure must not be personal in nature; and



(d) The expenditure must not be capital in nature."



6. The Explanation to sub-section (1) of section 37 of the Act has been inserted by the Finance (No. 2) Act, 1988 with full retrospective effect from 1-4-1962 and provides:



"For removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purposes, which is an offence or which is prohibited by law, shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure."



7. The dispute revolves around the issue as to whether the aforesaid expenditure incurred by the assessee was for a purpose which would be treated as an "offence" or which is prohibited by law. If this be so, the expenditure is not allowable. The Tribunal has held that the expenditure incurred is not for a purpose which is an offence or which prohibited by a law. As there was no dispute that the expenditure was, in fact, incurred which is neither personal in nature nor capital in nature and it was incurred wholly and exclusively for the purposes of business of the assessee, the Tribunal permitted the said expenditure thereby allowing the appeal of the assessee.



8. Against this order, present appeal is preferred which was admitted on the following substantial questions of law:



"(i) Whether learned ITAT erred in holding that the payment by the assessee to SEMCO vide Settlement Agreement is not hit by the provisions in Explanation 1 to section 37 of the Income-tax Act, 1961?



(ii) Whether learned ITAT erred in deleting the addition of Rs. 3,12,57,152 paid on Settlement of Dispute which was incurred wholly and exclusively for the purposes of business?"



9. Since the counsel for the parties were ready to finally argue the matter, the arguments were heard simultaneously with framing of aforesaid questions of law. On the conclusion of arguments, request from both the sides was made for filing the written submissions within one week. The same was granted. Though the learned counsel for the assessee has filed the written submissions, the learned counsel for the revenue has not availed of this opportunity. In these circumstances, we proceed to decide the questions of law framed, on the basis of oral submissions of both the parties as well as written submissions tendered by the learned counsel for the assessee.



10. Mr. Sanjeev Sabharwal, learned counsel for the revenue, argued that no doubt, the payment was made by the assessee to M/s SEMCO under the settlement before the judgment could be pronounced by the United States District Court, but the tenor of the said settlement would clearly reveal that such a settlement was arrived at accepting the fact that the assessee had violated/infringed the patent of SEMCO. Damages were paid by the assessee because of this infringement and such a payment, submitted the counsel, was for a purpose which is prohibited by law. His argument was that the law mandates not to infringe patent right of any person and once it is found that the assessee had violated the patent rights of SEMCO thereby compelling SEMCO to institute proceedings against the assessee, it would be a clear case where the payment was made for a purpose which is prohibited by law. Thus, the Explanation was fully applicable and expenses could not be treated as having been incurred for the purpose of business and no deduction is to be allowed on such expenses in the nature of penalty.



11. Learned counsel also took support from the reasons given by the Assessing Officer as well as the CIT(A) in their respective orders. He pointed out that the CIT(A) had clearly held that it was a case where there was an infringement of United States Patent Law by the assessee. The goods were manufactured and sold by the assessee to VENMAR for sale in US and Canada markets and as a manufacturer, the assessee could not escape the primary responsibility by stating that it was not directly involved in infringement. Further, for making a disallowance under section 37 in respect of penalty, etc. finding by a competent Court was not a condition precedent to attract the Explanation to section 37(1). According to the CIT(A), the Explanation simply states that if expenditure is incurred for any purpose, which is an offence, or which is prohibited by law, such expenditure will not be deeded to have been incurred for the purpose of business. The Explanation does even imply that there must be a finding of a Competent Authority or Court that an offence was committed or that any law was infringed. In fact, there may be numerous situations where expenditure is incurred for a purpose, which is prohibited by law, but there may not necessarily be any order of any authority or Court to this effect. Payment of protection money, hafta money, ransom, etc. are examples of such expenditure. There may not be any order prohibiting a person from making payment of protection money but nonetheless the payment will be for a purpose prohibited by law and would not be allowable under section 37 of the Act.



12. Mr. Sabharwal further submitted that the expenditure was not compensatory in nature. It was incurred to avoid the penal consequence of the aforesaid infringement.



13. Ms. Shashi M. Kapila, learned counsel appearing for the assessee countered the aforesaid submission and sought to justify that the reasons given by the Tribunal in spite of its decision. Her first submission was that the provisions of the Explanation were not attracted per se as the expression "prohibited by law" occurring in the said Explanation is limited to law of land alone, i.e., Indian Law. Dilating on this submission, she argued that the expression "offence" and "prohibited by law" occurring in Explanation to section 37(1) of the Act are not defined in the Act. However, section 3(38) General Clauses Act, 1897 defines "offence" to mean "any act or omission made punishable by law for the time being in force". The Calcutta High Court in the case of Susanta Mukherjee v. Union of India [1975] 94 CWN 412 after referring to section 3(38) of the General Clauses Act read with Articles 13(3), 366(10) and 372(1) of the Constitution of India and the decision of the Supreme Court in the case of Edward Mills Co. Ltd. v. State of Ajmer AIR 1955 SC 25 observed in paragraph 13 of the judgment:



"13. It is abundantly clear from the foregoing references to various provisions of the Constitution that a person cannot be convicted of an offence except for violation of law in force at the time of commission of the act charged as an offence. Therefore, in my opinion, the word "any law for the time being in force" as occurring in section 3(38) of the General Clauses Act, 1997 must be construed as "any law for the time being in force" in India. Obviously it has no reference to any law of other countries of the world."



14. According to her, similarly, the expression "prohibited by law" can only mean prohibited by law in force in India. The expression "prohibited by law" as used in the Explanation to section 37(1) has the same contextual import as the expression "forbidden by law" as used in section 23 of the Indian Contract Act, 1872. This came up for the consideration of the Full Bench in the case of Abdul Hameed v. Mohd. Ishaq AIR 1975 All. 166 wherein the Allahabad High Court observed as under:



"12. The expression 'law' has not been defined in the Contract Act, nor in the U. P. General Clauses Act, 1904, but in the Central General Clauses Act, 1897, 'Indian Law' is defined in section 3(29) as below:—



"'Indian law' shall mean any Act, Ordinance, Regulation, rule, order, bye-law or other instrument which before the commencement of the Constitution had the force of law in any Province of India or part thereof, or thereafter has the force of law in any Part A State or Part C State or part thereof, but does not include any Act of Parliament of the United Kingdom or any Order in Council, rule or other instrument made such Act."



This definition is applicable to all the Central Acts and Regulations made after the commencement of the General Clauses Act. The Contract Act was enacted in 1872 before the commencement of the General Clauses Act, 1897. Therefore, this definition is not directly applicable to the Contract Act, but there appears to be no reason why the principles contained in the above definition be not made applicable to even the earlier enactments. 'Law' must, therefore, include not only an Act and Ordinance but also Regulations, rule, order, bye-Law or other instrument which has the force of law. Similar inference can be drawn from the provisions of the Constitution also. For the purposes of Article 13 of the Constitution the term law' includes any Ordinance, order, bye-law, rule, regulation, notification, custom or usage having in the territory of India the force of law.



13. Consequently, where any agreement is forbidden by an order of the competent authority having the force of law, it shall be an agreement forbidden by law as contemplated by section 23 of the Contract Act."



Ms. Kapila, thus, emphatically put that in view of the above, it is clear that the phrase "prohibited by law" as used in the Explanation to section 37(1) of the Act contemplates law in force in India. Her submission was that in the present case, it is an undisputed fact that there is no violation of any patent laws within the territory of India. Section 2(m) of Indian Patent Act, 2005 defines patent as "patent for any invention granted under this Act". Patent right is a statutory right and this right can be applicable only in such states which recognise this right. Patent is valid only in the country of registration. Therefore, a patent registered in USA, Canada, etc. is not a patent recognised by the Indian Patent Act. It is for this reason that the respondent/assessee still continues to manufacture and sell the impugned energy recovery wheel desiccant in India.



15. Without prejudice to the above, her alternate submission was that there was no infringement of even US laws and on the facts of this case, no such finding was recorded by any Court. The payment was made as a result of settlement which payment was compensatory in character. The reason for settlement was explained to the authorities below, viz., in order to buy peace and not to face litigations in US Courts, which is costly. She argued that no damages had been paid under the Indian Patent Act or under the US Patent Laws and there was no evidence to show the infringement. She also argued that in absence of any violation of the provisions of Indian Patent Act, the payment under settlement with SEMCO does not fall within the meaning and scope of expression 'offence' and 'prohibited by law' used in Explanation to section 37(1) of the Act. The assessee still manufactures the energy saving wheel using the impugned desiccant and sells it in India as well as exports it to other countries without any restrictions and no suit has been filed by SEMCO for infringement of its patent in India. However, exports to USA and Canada, past settlement is as per the Settlement Agreement.



16. Ms. Kapila further submitted that even if it is presumed that the payment was made for infringement of patent, that entails only civil damages, which are compensatory in nature and it cannot be said that the payment made was in the nature of penalty. She pointed out that the averments in the plaint filed by SEMCO as per which the only civil damages were claimed and criminal suit was scored out in the plaint. Once the payment is treated as purely compensatory in nature, the same could not be disallowed as per the law settled by the Supreme Court in the case of Prakash Cotton Mills (P.) Ltd. (supra) which principle was reaffirmed by the Apex Court in the case of Mrs. Rajalakshmi Narayanan v. Mrs. Margret Kathleen Gandhi 211 ITR 244 (sic).



17. After giving our thoughtful consideration to the respective submissions, we are of the view that the order of the Tribunal does not call for any interference and both the questions of law set out above need to be answered in negative, i.e., in favour of the assessee and against the revenue.



18. At the outset, we are inclined to accept the submission of the assessee that the paramount and governing consideration behind such a settlement/agreement can be to avoid the expenses and uncertainty of further litigation. It is a matter of common knowledge that litigation can turn out to be quite expensive and it cannot be even possible, what to talk of feasible, for a small time/middle level company in India like the assessee to litigate in US Court. Furthermore, the settlement agreement contains a specific recital to this effect inasmuch as it records "whereas, in order to avoid the expenses or uncertainty or further litigation, the parties desired to settle and adjust all differences and controversies among themselves subject to the terms of this Agreement." No doubt in the Agreement, the assessee accepted the patent of SEMCO. That by itself would not mean that the assessee also accepted that it was infringing the said patent. Secondly, payment is made by the assessee to SEMCO for "loss of goodwill and damages to its capital and for terminating of case US Courts" as is clearly mentioned in clause (3) of the Agreement. No finding is given by any Court that the assessee had violated the patent right of SEMCO. With the aforesaid payment, the "Covenants to Release" recorded in clause (2) is as under:



"2. Covenants to Release



2.1 SEMCO hereby releases, remises and forever discharges the Settling Entities and their agents, attorneys, consultants, offices, employees, representatives, heirs, successors and assigns and their Customers form any and all claims, demands, or causes of action that arise out of or relate to the Action, and any and all obligations, actions, causes of action, suits, debts, contracts, controversies, agreements, promises, damages, judgments, awards, executions, claims and demands whatsoever in law or in equity, and any and all claims for damages (and attorneys' fees and costs) based upon the violation of a federal, state or other statute, regulation or law or arising out of any conduct, contract, employments, action, event or circumstance, under the law of any and all nations, whether known or unknown, which occurred at any time up to an including the date of the execution of this Agreement, except obligations created by this Agreement, any associated licence Agreement and/or by the Consent Judgment to be filed in accordance with this Agreement."



19. It would be pertinent to highlight that the Agreement is applicable within the area defined as "territory". This territory mentions some specific countries in Europe as well as Japan, Australia and Korea. There is no mention of 'India' at all. That clearly implies that SEMCO has no objection if the assessee continues to manufacture the goods in the same manner using same patent which it has been using and marketing it in India or any other countries, which are not stipulated in the 'territory' with respect to which only restraint is provided in the agreement. It is for this reason the assessee even today continues to manufacture those goods and is selling the products in this country. Once we find that the settlement has arrived at under the aforesaid circumstances, there is no room to hold that it was because of the reason that the assessee was violating the patent laws or the payment was made for an objective prohibited by law. This is our view even when we presume that the expression 'prohibited by law' would include US laws and would not be confined to law in India.



20. Moreover, we also agree with the contention of the learned counsel for the assessee that the payment under the settlement is compensatory in nature. The remedy for infringement of patent involves civil action for compensating the damage to private properties. It may be noted that in the plaint filed by it, SEMCO has sought civil damages under sections 284 and 285 of the US Patent Code (US 35). Criminal Suit is scored out in the plaint. The relevant provisions of US 35 (Patent Code) read as follows:



"284. Damages.—Upon finding for the claimant the Court shall award the claimant damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the sue made of the invention by the infringer, together with interest and costs as fixed by the Court.



"285. Attorney fees.—The Court in exceptional cases may award reasonable attorney fees to the prevailing party."



21. It will be seen from the above that the damages are calculated for compensating the owner of the patent rights for the loss of profit/royalty even under the laws of USA. There is no element of penalty even in USA. Even the Indian Patents Act, 1970 (as amended by the Act of 2005) does not prescribe any penalty or fine for infringement of a patent registered under that Act. This is clear from the section 108 of the Indian Patent Act, which reads as under:



"108 Reliefs in suit for infringement.—The reliefs which a Court may grant in any suit for infringement include an injunction (subject to such terms, if any, as the Court things fit) and, at the option of the plaintiff, either damages or an account of profits."



22. Therefore, any payment for infringement of patent, being purely compensatory in nature, cannot be disallowed as per the law settled by the Supreme Court in the case of Prakash Cotton Mills (P.) Ltd. (supra), where the Apex Court observed as under:



"…Therefore, whenever any statutory impost paid by an assessee by way of damages or penalty or interest is claimed as an allowable expenditure under section 37(1) of the Income-tax Act, the assessing authority is required to examine the scheme of the provisions of the relevant statute providing for payment of such impost notwithstanding the nomenclature of the impost as given by the statute, to find whether it is compensatory or penal in nature. The authority has to allow deduction under section 37(1) of the Income-tax Act, wherever such examination reveals the concerned impost to be purely compensatory in nature. Wherever such impost is found to be of a composite nature, that is, partly of compensatory nature and partly of penal nature, the authorities are obligated to bifurcate the two components of the impost and give deduction to that component which is compensatory in nature and refuse to give deduction to that component which is penal in nature."



23. It was an expenditure which was motivated purely by commercial purpose and would be allowable under section 37(1) of the Act as held by the Apex Court in the case of Sri Venkata Satyanarayana Rice Mill Contractors Co. v. CIT [1997] 223 ITR 101.



24. As regards consent judgment passed by the US District Court in accordance with clause 2 read with clause 3 of the Settlement Agreement, the law is well-settled by the Supreme Court in the case of Pulavrathi Venkata Subba Rao v. Valluri Jagannadha Rao AIR 1967 SC 591, wherein the Court held that:



"A compromise decree is not a decision of the Court. It is the acceptance by the Court of something to which the parties had agreed. A compromise decree merely sets the seal of the Court on the agreement of the parties."



25. Since questions formulated are answered on the aforesaid reasoning, it is not necessary to go into the issue as to whether the expression 'prohibited by law' would confine to law in force in Indian only. We leave that question open.



26. We, thus, do not find any merit in this appeal, which is dismissed with costs.





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