2011 (7) TMI 581 - HC - Income Tax

Expenses on settlement/agreement - disallowance as the settlement was on account of any infringement of any law - Held 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. 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 - in favour of assessee.

Issues Involved:
1. Applicability of Explanation 1 to Section 37 of the Income-tax Act, 1961.
2. Nature of the payment made by the assessee to SEMCO and its allowability as business expenditure.

Detailed Analysis:

Issue 1: Applicability of Explanation 1 to Section 37 of the Income-tax Act, 1961

Arguments of the Assessing Officer and CIT(A):
- The payment made by the assessee to SEMCO was viewed as a "penalty" or akin to a penalty due to infringement of SEMCO's patent.
- According to the Assessing Officer, the expenditure was not allowable under Explanation to Section 37(1) of the Income-tax Act, which disallows any expenditure incurred for purposes that are an offence or prohibited by law.
- CIT(A) upheld this view, stating that the infringement of United States Patent Law by the assessee implied that the payment was for a purpose prohibited by law.

Arguments of the Assessee:
- The assessee contended that the payment was compensatory in nature, made to settle the dispute out of court, and not due to any proven infringement.
- The settlement was aimed at avoiding the high costs and uncertainty of litigation in the US.
- The assessee argued that the Explanation to Section 37(1) should only apply to laws in force in India, not foreign laws.

Tribunal's Findings:
- The Tribunal accepted the assessee's argument that the payment was not a penalty but compensatory due to the settlement agreement.
- The Tribunal held that the expenditure was neither personal nor capital in nature and was incurred wholly and exclusively for business purposes.

High Court's Analysis:
- The High Court agreed with the Tribunal's view, emphasizing that the settlement was to avoid litigation expenses and uncertainty.
- The Court noted that no court had found the assessee guilty of patent infringement.
- The payment was made for "loss of goodwill and damages to its capital," which is compensatory and not penal.

Issue 2: Nature of the Payment and Its Allowability as Business Expenditure

Assessing Officer's View:
- The payment was seen as a penalty for patent infringement, thus not allowable as business expenditure under Section 37.

Assessee's Argument:
- The payment was compensatory, not penal, and made to settle a dispute without admitting any infringement.
- The expenditure was incurred wholly and exclusively for business purposes, thus allowable under Section 37.

Tribunal's Decision:
- The Tribunal allowed the expenditure, stating it was compensatory and incurred for business purposes.

High Court's Judgment:
- The High Court upheld the Tribunal's decision, noting that the payment was compensatory and aimed at avoiding litigation costs.
- The Court referred to the Supreme Court's decision in Prakash Cotton Mills (P.) Ltd. v. CIT, which allows deductions for compensatory payments under Section 37(1).

Conclusion:
- The High Court dismissed the appeal, ruling in favor of the assessee and confirming that the payment was compensatory and allowable as business expenditure.
- The Court left open the question of whether "prohibited by law" in Explanation to Section 37(1) applies only to Indian laws or includes foreign laws.

Summary:
The High Court ruled that the payment made by the assessee to SEMCO under a settlement agreement was compensatory and not penal. It was incurred to avoid litigation costs and uncertainty, thus allowable as business expenditure under Section 37(1) of the Income-tax Act. The Court dismissed the revenue's appeal, affirming the Tribunal's decision and leaving open the question of the applicability of "prohibited by law" to foreign laws.

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