2006 (9) TMI 117 - AAR - Income Tax

Capital/Revenue Expenditure - ITI one of the suppliers of plant and machinery to MTNL - Terms of the purchase order/agreement provide that if ITI Ltd. fails to deliver equipment within the stipulated time MTNL would be entitled to liquidated damages - As per the stated facts of the case the amount refunded by the applicant company to ITI Ltd. on account of waiver of liquidated damages is not an allowable deduction from its business income under the Income-tax Act 1961

Summary

Issues Involved:
1. Nature of liquidated damages (LD) refunded: capital or revenue.
2. Voluntariness of the LD refund for business purposes.
3. Allowability of LD refund as a deduction under section 37(1) or any other provisions of the Income Tax Act.

Detailed Analysis:

1. Nature of Liquidated Damages Refunded: Capital or Revenue
The applicant, a public sector company, sought a ruling on whether the amount refunded to another public sector company, ITI Ltd., as a waiver of liquidated damages (LD) was an allowable deduction from its business income for the assessment year 2002-03. The LD was initially recovered from ITI Ltd. for delayed supplies of telecommunication equipment.

The ruling determined that the LD recovered was capital in nature. The equipment supplied by ITI Ltd. constituted capital goods for the applicant, and damages recovered due to late supply of such capital assets were held to be capital receipts, not revenue. This conclusion was supported by precedents, including the Supreme Court's decision in Swadeshi Cotton Mills Co. Ltd. v. CIT, which held that payments made to avoid unnecessary investment in capital assets were capital expenditures. Thus, the LD did not fall under section 28(iv) of the Income Tax Act, which deals with profits and gains from business.

2. Voluntariness of the LD Refund for Business Purposes
The applicant argued that the refund of LD was a voluntary business expenditure. However, the ruling found that the refund was not voluntary but was made under the direction of the Telecom Commission. The applicant had initially resisted ITI Ltd.'s request for a waiver, and it was only after the Telecom Commission's directive that the refund was processed. The decision to refund was recorded in the applicant's 160th Board Meeting, indicating compliance with external instructions rather than a voluntary business decision.

3. Allowability of LD Refund as a Deduction Under Section 37(1) or Other Provisions
Section 37(1) of the Income Tax Act allows deductions for expenses laid out wholly and exclusively for business purposes, provided they are not capital expenditures. Given that the LD was deemed a capital receipt, the refund of such damages did not qualify as a deductible business expense under section 37(1). The ruling emphasized that the applicant is a service provider, not engaged in the sale and purchase of telecommunication equipment, and thus the refund did not relate to its business operations.

Further, the ruling referenced the Supreme Court's decision in Tuticorin Alkali Chemicals v. CIT, which stated that adjustments could not be made unless specifically permitted by law, regardless of accounting practices. Since the LD refund was capital in nature, it fell outside the purview of allowable deductions under section 37(1) or any other section of the Income Tax Act.

Conclusion
The ruling concluded that the amount refunded by the applicant to ITI Ltd. on account of the waiver of liquidated damages is not an allowable deduction from its business income under the Income Tax Act, 1961, for the assessment year 2002-03. The decision was pronounced on September 6, 2006.