2010 (2) TMI 13 - SC - Income Tax

Disallowance of royalty expenses - Assessee carries on the business of development of Software Package and Packaged Software Products divisible into four groups, namely, (i) Customized Software; (ii) Packaged Software Products; (iii) Agency Products; and (iv) Exports - . In that year, assessee claimed deduction under Section 37 of the Income Tax Act, 1961 in respect of royalty expenses of Rs.3,23,28,158/-. The Assessing Officer held that, only one-sixth of the amount was allowable in view of Section 35AB of the Act and, accordingly, after allowing the benefit under Section 35AB of the Act, the Assessing Officer made a disallowance of Rs.1,12,12,352/-, which was added back to the income of the assessee CIT(A) deleted the addition ITAT confirmed the order of CIT(A) HC refused to frame the questions held that - Keeping in mind the fact that none of the above-mentioned aspects has been considered by the High Court, we are of the view that the High Court should have framed, on the facts and circumstances of these cases, the following question of law for determination Whether allowance of royalty expenses, as claimed by the assessee, are to be allowed in its entirety under Section 37 of the Income Tax Act, 1961, or only one-sixth thereof, as mandated by Section 35AB(1) of the Income Tax Act, 1961, are allowable during the relevant Assessment Years? case remitted before HC to answer the quested framed by the SC

Summary

Issues involved:
Interpretation of royalty expenses under Section 37 of the Income Tax Act, 1961 versus Section 35AB(1) for Assessment Year 1996-1997.

Analysis:
In the present judgment, the Supreme Court addressed the issue of royalty expenses claimed by an assessee for duplicating software in India and supplying it to end-users. The Department contended that only one-sixth of the claimed amount was allowable under Section 35AB of the Income Tax Act, while the assessee argued for full deduction under Section 37. The Court emphasized the need to analyze the nature of the payment, distinguishing between capital and revenue expenditure. It highlighted the importance of examining the contracts and process undertaken by the assessee to determine the expenditure's classification.

The Court discussed the contractual arrangement between the assessee and an American Corporation regarding software duplication. It noted the significance of the customers' direct access to the software, suggesting that the payment may not be solely for duplication. The Court underlined the necessity of understanding the technical aspects of the software industry, such as database systems and duplication processes, to make an informed decision on the nature of the expenditure. It pointed out that the High Court had not considered these critical aspects in its decision.

The Supreme Court concluded by remitting the case back to the High Court with a specific question to determine whether the royalty expenses should be fully allowed under Section 37 or restricted to one-sixth under Section 35AB(1). The Court clarified that its analysis was for guidance and that a detailed examination of the factual foundation was essential. The judgment highlighted the need for a comprehensive review of the contractual arrangements and technical aspects before reaching a final decision. The civil appeals filed by the Department were allowed, and the matter was remitted to the High Court for further consideration.

This judgment underscores the importance of a thorough analysis of technical and legal aspects in tax matters, emphasizing the need for a factual foundation to determine the nature of expenditures under relevant provisions of the Income Tax Act.