2016 (3) TMI 691 - HC - Income Tax

Disallowance of agency commission paid for arrangement of loan, holding it to be capital expenditure - Whether on a true and proper interpretation of Explanation-8 to Section 43(1) of the Act interest paid on borrowed funds used for acquisition of capital assets by a running concern can be disallowed as deduction under Section 36(1)(iii) of the Act? - Held that - The proviso to Section 36(1)(iii) was introduced with effect from 1st April, 2004 whereas we are concerned in this case with the assessment year 1997-98 and tat the proviso has only prospective effect. See CIT -Vs.- Associated Fiber and Rubber Industries reported in 1999 (2) TMI 2 - SUPREME Court - Decided in favour of assessee Disallowance of expenditure incurred for software development - revenue v/s capital expenditure - Held that - The Apex Court in Alembic Chemicals 1989 (3) TMI 5 - SUPREME Court has recognised the fact that in a field where advancements are taking place rapidly and where technology which was once the state of the art becomes obsolete in a short time, the test of enduring nature cannot always reliably be applied. Software industry is one such field where advancements and changes happen at a lightning pace and it is difficult to attribute any degree of endurability even to system software let alone application software. In view of the aforesaid discussion, question is answered in the negative and in favour of the assessee.

Issues Involved:
1. Disallowance of agency commission as capital expenditure.
2. Disallowance of interest on borrowed funds for acquisition of capital assets under Section 36(1)(iii).
3. Disallowance of expenditure on software development as capital expenditure.

Issue-wise Detailed Analysis:

1. Disallowance of Agency Commission as Capital Expenditure:
The Tribunal upheld the disallowance of agency commission paid for the arrangement of a loan, considering it as capital expenditure. The assessee argued that this issue is covered by the Supreme Court's judgment in CIT vs. Associated Fiber and Rubber Industries (1999) and that the proviso to Section 36(1)(iii), effective from April 1, 2004, is not applicable to the assessment year 1997-98. The respondent acknowledged that the proviso was deemed retrospective by this Court but reversed by the Supreme Court in M/s. JCT Ltd. vs. Deputy Commissioner of Income Tax (2005). Consequently, the Court ruled in favor of the assessee, answering the question affirmatively.

2. Disallowance of Interest on Borrowed Funds:
The Tribunal disallowed interest paid on borrowed funds used for acquiring capital assets by a running concern under Section 36(1)(iii), interpreting Explanation-8 to Section 43(1) of the Act. The assessee contended that this issue is also covered by the Supreme Court's judgment in Deputy Commissioner of Income Tax vs. Core Health Care Ltd. (2008), which held that the proviso to Section 36(1)(iii) is prospective. The respondent did not dispute this reversal by the Supreme Court. Therefore, the Court ruled in favor of the assessee, answering the question negatively.

3. Disallowance of Expenditure on Software Development:
The assessee incurred an expenditure of ?41,08,556 on software development, treating it as deferred revenue expenditure. The assessing officer disallowed this, classifying it as capital expenditure, allowing only depreciation. The CIT(A) reversed this, treating it as revenue expenditure, citing Supreme Court judgments in Associated Cement Companies Ltd. and Alembic Chemical Works Co. Ltd., and ITAT decisions supporting the revenue nature of software expenses. However, the Tribunal reversed the CIT(A)'s decision, relying on the Rajasthan High Court's judgment in CIT vs. Arawali Constructions Co. Pvt. Ltd., treating the expenditure as capital.

The High Court analyzed the nature of the software, distinguishing between application and system software. It noted that the software in question was an application software aiding in mining operations, which does not result in the acquisition of a capital asset but enhances operational efficiency. The Court referenced the Delhi High Court's judgment in CIT vs. Asahi Safety Glass Ltd., which rejected the enduring benefit test for software expenses, and the Karnataka High Court's judgment in CIT vs. IBM India Ltd., which treated application software expenses as revenue expenditure. The Court emphasized that the test of enduring benefit is not conclusive and must consider the rapid advancements in technology.

The Court concluded that the software expenditure facilitated the assessee's trading operations without creating a new asset, thus qualifying as revenue expenditure. It relied on the Supreme Court's guidance in Empire Jute Co. Ltd. vs. CIT and Alembic Chemical Works Co. Ltd. vs. CIT, which cautioned against mechanically applying the enduring benefit test. Consequently, the Court ruled in favor of the assessee, answering the question negatively.

Conclusion:
The appeal was allowed, with the Court ruling in favor of the assessee on all three issues, affirming the revenue nature of the disputed expenditures.

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