2019 (3) TMI 1600 - AT - Income Tax

Legal expenses allowable u/s 37 - defending company MD in criminal proceedings - HELD THAT - Admittedly, the assessee has incurred the expenses in connection with the criminal case lodged against the User of the website, MD and the head of the Trust and Safety Functions (TSF). Now the question arises as to whether the MD and the Head of the TSF have in fact committed any offence individually or in connivance with the User who posted the objectionable item? In our considered view, the answer is no. Since the Hon ble Supreme Court has quashed the entire proceedings against the Assessee Company, MD and Head of the TSF, it can safely be concluded that they had not committed any offence and they were made accused in an attempt to hold the company vicariously liable for the offences committed by the User. Since, they had not committed any offence the assessee company decided to defend the MD and Head of the TSF to protect the image and goodwill of the company. Hon ble High Court of Punjab and Haryana in the case of J N Singh Company Pvt. Ltd. 1965 (3) TMI 89 - PUNJAB HIGH COURT the Hon ble High Court of Gujarat in the case of Ahmadabad Controlled Iron Steel Reg. Stockholders Association Pvt. Ltd. 1973 (9) TMI 45 - GUJARAT HIGH COURT have also held that the expenses for criminal litigation for the purpose of protecting business interest of the assessee-company are allowable as business expenditure. Legal expenses incurred should be considered to be the part of the operating cost for computing margins of the assessee for benchmarking the international transaction with its AEs - HELD THAT - In the case of Corporate Executive Board vs. ITO 2015 (9) TMI 1170 - ITAT DELHI has held that if the revenue arising from incurring of such expenses is linked with the preceding year then the claim of such expenses by way of write off made during the year cannot be considered as operating cost of the current year. Hence, the date on which such expenses were incurred is crucial to find out if the expenditure were incurred before or after the date of start of rendering services to its AEs. In the present case, admittedly the expenses incurred pertain to the period prior to the entering into agreement with e-Bay AG, the same cannot be treated as part of operating cost incurred by the assessee for rendering services. Secondly, as pointed out by the Ld. counsel, the expenditure in question is not relatable to the services rendered by the assessee so as to include the same to the operating cost. Hence, the findings of the authorities below are not based on the sound reasoning. We, therefore, allow the objection filed by the assessee in the present case and direct the AO to allow the legal expenses incurred during the year 2007-08 as deduction u/s 37(1) and not to include the said amount in the operating cost.

Summary

Issues Involved:
1. Allowability of legal expenses under Section 37(1) of the Income Tax Act, 1961.
2. Inclusion of legal expenses in operating costs for computing margins for benchmarking international transactions with Associated Enterprises (AEs).

Issue-wise Detailed Analysis:

1. Allowability of Legal Expenses under Section 37(1) of the Income Tax Act, 196
The primary issue was whether the legal expenses amounting to ?91,27,129/- incurred by the assessee in connection with a criminal case should be allowed as a deduction under Section 37(1) of the Income Tax Act, 1961. The assessee argued that the expenses were incurred in the course of business and should be allowable. The Assessing Officer (AO) disallowed the expenses, citing Explanation 1 to Section 37(1), which prohibits deductions for expenses incurred for purposes that constitute an offense or are prohibited by law. The Commissioner of Income Tax (Appeals) [CIT(A)] allowed the expenses, stating that the legal proceedings were initiated against the company's employees in their official capacity and not for any personal offense. The CIT(A) concluded that the legal expenses were necessary to defend the company’s reputation and goodwill, thus qualifying as business expenses under Section 37(1). The tribunal upheld the CIT(A)'s decision, referencing several case laws, including Maruti Udyog Ltd. vs. DCIT, which supported the view that defending employees acting in good faith is a legitimate business expense.

2. Inclusion of Legal Expenses in Operating Costs for Computing Margins for Benchmarking International Transactions with AEs
The second issue was whether the legal expenses should be included in the operating costs for computing margins for benchmarking international transactions with AEs. The assessee contended that the legal expenses were unrelated to the services rendered to e-Bay AG and should not be included in the operating costs. The CIT(A) had held that these expenses should be considered part of the operating costs. However, the tribunal found that the expenses were incurred prior to the agreement with e-Bay AG and were not related to the services provided. Citing the case of Corporate Executive Board vs. ITO, the tribunal concluded that expenses incurred before the commencement of services should not be included in the operating costs. Consequently, the tribunal directed the AO to allow the legal expenses as a deduction under Section 37(1) and not to include them in the operating costs for computing margins.

Conclusion:
The tribunal dismissed the revenue's appeal and allowed the assessee's cross-objection, affirming that the legal expenses were allowable under Section 37(1) and should not be included in the operating costs for benchmarking international transactions.