2012 (9) TMI 48 - HC - Income Tax

Expenditure on Royalty - Revenue or Capital ? - Held that - According to various clauses of the know-how licence agreement read along with the supplement agreement royalty payable as net sales of taxes the know-how was provided by the contract manufacturer for the limited purpose of manufacture of Revlon products only. The responsibilities of the contract manufacturer were clearly defined in the agreement between the assessee-company and the contract manufacturer, according to which obligation relating to royalty payment was not passed on to the contract manufacturer. The entire benefit of the know-how was meant for manufacturing the products to be supplied to the company and there was no obligation of the contract manufacturer (i.e. the assessee s sister concern) to pay royalty to the licensor - the fact that the assessee chose to manufacture through a contractor, i.e. its sister concern, in this Court s opinion does not undermine its status as a licensee, responsible to pay the royalty - Clause 12.01 of the agreement stipulates that upon expiration or termination of this agreement, the licensee shall have no right to exploit or in any way to use the know-how and shall forthwith discontinue all use of the know-how and shall not thereafter use the know-how, thus the revenue s arguments that the royalty amount to be in the nature of capital expenditure, is meritless - in favour of assessee. Disallowance of publicity expenses - Held that - The reasoning for disallowance of 50% of expenses as the advertising expenses were to be borne by the sister concern dealer, and that the proportion was in respect of its territory, was not upheld as brand promotion enhances the visibility of given products or services, and are often perceived as conferring a competitive advantage on those who adopt those strategies or schemes. Expenditure towards that end is based on pure commercial expediency, which the revenue in this case, ought to have recognized, and allowed - in favour of assessee. Disallowance of consultancy charges u/s 40A (2) - Held that - In order to determine whether the payment is not sustainable, the AO has to first return a finding that the payment made is excessive, under Section 40-A (2) and only if it is found to be so, then the AO has to determine what constitutes the fair market value of the services rendered and disallow the difference between what is claimed and what is such value determined (as fair market value). Apart from the fact that no such exercise was undertaken by the AO, the Court sees that the assessment order went off into a tangent, in following a method that was clearly inapplicable - in favour of the assessee.

Issues Involved:
1. Capitalization of Royalty Payments
2. Disallowance of Publicity Expenses
3. Disallowance of Consultancy Charges under Section 40A(2) of the Income Tax Act

Detailed Analysis:

1. Capitalization of Royalty Payments
The revenue contended that the royalty payments by the assessee should be capitalized to the extent of 25%, arguing that the know-how agreement provided an enduring capital advantage. The assessee countered that the royalty was for the continued use of the brand and patents, not for acquiring an asset of enduring nature. The court referred to several precedents, including Empire Jute Co. v. CIT and Alembic Chemical Works v. CIT, which emphasized that the test of enduring benefit should not be applied inflexibly. The court concluded that the royalty payments were revenue in nature since the know-how and patents did not vest permanently in the assessee. The Tribunal's decision to allow the assessee's appeal on this point was upheld.

2. Disallowance of Publicity Expenses
The assessee claimed publicity expenses for brand promotion, which the AO partially disallowed. The ITAT observed that the expenses were a commercial decision and were consistent with previous years' practices. The court noted that under Section 37 of the Income Tax Act, expenses laid out wholly and exclusively for business purposes are deductible. Citing Gordon Woodroffe Leather Manufacturing Co. v. CIT and Sasson J. David v. CIT, the court emphasized that commercial expediency is the guiding principle. The court found no error in the ITAT's reasoning that brand promotion expenses were necessary for maintaining market competitiveness and were thus allowable.

3. Disallowance of Consultancy Charges under Section 40A(2)
The AO disallowed a portion of consultancy charges paid to MMPL, alleging it was excessive and a means to siphon off profits. The CIT (A) and ITAT found that MMPL actively rendered services to the assessee, and the charges were not excessive. The court referred to Dhanrajgiriji Raja Narsinghji v. CIT and S.A. Builders Ltd. v. CIT, which held that the revenue cannot dictate the reasonableness of business expenses. The AO's reliance on the Companies Act cap for managerial remuneration was inapplicable as it pertained to public limited companies, not the assessee. The court upheld the Tribunal's findings, noting that the AO failed to determine the fair market value of the services rendered.

Conclusion:
All questions of law were answered in favor of the assessee, and the revenue's appeals were dismissed. The royalty payments were deemed revenue expenditure, the publicity expenses were allowable under commercial expediency, and the consultancy charges were justified and not excessive.

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