2024 (5) TMI 1513 - AT - Income Tax

Nature of expenses - disallowing on adhoc basis 50% royalty expense paid by appellant to Choice Hotels Licensing BV for grant of franchisee rights and use of brand name - CIT(A) tried to bifurcate the annual royalty paid into onetime benefit as one part and recurring benefit on the other part as some manuals and SOPs are provided - HELD THAT - The assessee paid royalty at fixed cost and at variable cost. The royalty is paid for use of brand name and also for technical know-how. The assessee has been provided complete spectrum of Hotel operating and technical services like Hotel Development Project Planning Technical and Pre-opening Services Reservations System Sales and Marketing Support Human Resources Support Quality Assurance Inspections Financial Planning. The payment of royalty is on annual basis and it is paid for the purpose of franchise to operate and maintain hotels in an assigned territory and use its brands such as Quality Comfort Sleep inn Cambria suits. It is a fact that payment of royalty to Choice B.V. was for the use of brand name or trademark. The Assessee accepted non-exclusive right and obligation to operate the franchise and to maintain the franchised hotel in the territory subject to the terms conditions mentioned in the agreement. The royalty paid was meant for the standardization of operations and utilization of brand name. The assessee is precluded from using the brand unless the royalty is paid. Simply by the virtue of provisions of some manuals and SOPs the amount paid cannot be treated as capital expenditure in nature unless it results in acquiring of a capital receipt. CIT (A) though tried to be logical erred in treating the SOPs provided as capital in nature and allowing depreciation when the SOPs themselves do not constitute or given rise any capital asset. Hence the royalty payment made by the assessee which is recurring in nature is hereby directed to be treated as revenue expenditure. The appeal of the assessee on this ground is allowed. Disallowance of entertainment expenses - AO observed that payments were made to individuals and through credit cards - Exact nature of expenses and nexus with the business were not discernable - HELD THAT - Assessee has submitted before the Ld. CIT (A) that it is operating in hospitality sector and the expenses claimed include meals dinners etc. for entertainment of its clientele in order to enhance its customer base in India. The Assessee has furnished additional documents in the form of ledger account summary sheets bills/invoices etc. but the ld. CIT (A) refused to admit the additional evidences. The assessee is directed to furnish the reasons before the ld. CIT (A) for not producing the same before the AO and the ld. CIT (A) shall examine the reasons and adjudicate the matter accordingly. The appeal of the assessee on this ground is allowed for statistical purpose.

Summary

ISSUES PRESENTED and CONSIDERED

The core legal issues considered in this judgment were:

1. Whether the royalty expenses paid by the assessee to 'Choice Hotels Licensing BV' for franchisee rights and brand name usage should be classified as capital expenditure or revenue expenditure.

2. Whether the entertainment expenses claimed under section 37(1) of the Act were justifiably disallowed by the CIT (A) due to lack of evidence proving their business nexus.

ISSUE-WISE DETAILED ANALYSIS

1. Royalty Expenses

Legal Framework and Precedents: The legal question revolves around the classification of expenses as capital or revenue. The court referenced precedents such as Southern Switch Gear Ltd. vs. CIT and Janas Woodhead & Sons (India) Ltd. vs. CIT, which establish that payments resulting in an enduring benefit are typically capital expenditures.

Court's Interpretation and Reasoning: The Tribunal examined whether the royalty payments provided an enduring benefit. The CIT (A) had previously determined that the royalty payments were partly capital in nature due to the enduring benefits derived from technical know-how and operational manuals provided by Choice B.V.

Key Evidence and Findings: The agreement between the assessee and Choice B.V. included provisions for operational manuals, technical support, and marketing services. The CIT (A) concluded that these provisions constituted technical know-how, which could be used beyond the agreement term, thus providing enduring benefits.

Application of Law to Facts: The Tribunal considered the nature of the royalty payments, which were both fixed and variable, for the use of brand names and technical services. It noted that the payments were recurring and necessary for continuing operations under the franchise agreement.

Treatment of Competing Arguments: The assessee argued that the royalty payments were purely for brand usage and did not provide enduring benefits. The CIT (A) attempted to bifurcate the payments into capital and revenue components based on the perceived benefits.

Conclusions: The Tribunal disagreed with the CIT (A)'s bifurcation, determining that the royalty payments were recurring and essential for business operations, thus qualifying as revenue expenditure. The appeal on this ground was allowed.

2. Entertainment Expenses

Legal Framework and Precedents: Under section 37(1) of the Act, expenses must be wholly and exclusively for business purposes to qualify as deductible.

Court's Interpretation and Reasoning: The Tribunal reviewed the disallowance of entertainment expenses due to insufficient evidence of business nexus. The CIT (A) had refused additional evidence submitted by the assessee.

Key Evidence and Findings: The assessee provided sample bills and ledger accounts, but the Assessing Officer found them inadequate to establish a business purpose.

Application of Law to Facts: The Tribunal considered the nature of the hospitality business, where entertainment expenses are often incurred to enhance client relationships and business prospects.

Treatment of Competing Arguments: The assessee argued that the expenses were necessary for business development in the hospitality sector. The CIT (A) required further evidence to substantiate the claim.

Conclusions: The Tribunal directed the assessee to present reasons for not providing evidence earlier and allowed the appeal for statistical purposes, remanding the issue for further examination by the CIT (A).

SIGNIFICANT HOLDINGS

Core Principles Established: The Tribunal reaffirmed the principle that recurring payments necessary for business operations, even if they involve brand usage and technical support, should be classified as revenue expenditures unless they result in acquiring a capital asset.

Final Determinations on Each Issue: The Tribunal allowed the appeal regarding royalty expenses, classifying them as revenue expenditure. For entertainment expenses, the case was remanded for further consideration, with the assessee directed to provide additional evidence to support the business purpose of the expenses.