2012 (9) TMI 264 - HC - Income Tax

Disallowance claim of expenditure on scientific research u/s 35(1) - no new product was developed as there was only modification in the existing product -ITAT allowed the claim - Held that - The Tribunal without discussing full materials on record, came to such conclusion that deduction u/s 35 need to be allowed as these are matters of extreme scientific complexities. What was the nature of the research undertaken, what was the improvement in the existing software aimed at or desired, whether ultimately the product which was launched by the assessee after undertaking such so called scientific research, was a new product substantially different from the existing one or not were some of the issues on which the Tribunal, without bestowing sufficient attention ruled in favour of the assessee. AO could not have rejected such a claim without making a reference to the Board - Held that - Section 35(3) requires a reference to be made by the Board to the prescribed authority when a question arises as to whether and if so to what extent, any activity constitutes or constituted or any asset is or was being used for scientific research. The decision of the prescribed authority on such a question would be final, thus the AO not having obtained such a decision of the prescribed authority though a serious question in the present case had arisen, was not justified in rejecting the assessee s claim for deduction of expenditure incurred for scientific research. Thus rejection of reopening of the entire issue as the Commissioner held that a substantial portion of such expenditure was in any case of revenue nature and in respect of the provision of section 37(1) of the Act, the assessee was entitled to claim full deduction thereof - in favour of assessee.

Issues Involved:
1. Whether the activities carried out by the assessee constituted research activity in terms of section 43(4) and therefore the assessee was entitled to deduction of expenditure incurred, capital as well as revenue, under section 35(1)?
2. Whether, before permitting deduction under Section 35(1) of the Act to the assessee, the Tribunal ought to have obtained the opinion of the Central Board of Direct Taxes on the question whether the expenditure incurred by the assessee on its project was for research activities?

Issue-Wise Detailed Analysis:

Issue 1: Entitlement to Deduction under Section 35(1)
The case revolves around the assessee's claim for deduction under section 35 of the Income Tax Act, 1961, for expenditures incurred on scientific research. The assessee, a company regularly assessed to tax, claimed deductions for the assessment years 1992-93, 1993-94, and 1994-95, asserting that the expenditures were for developing a new software product named MAMIS at its Product Development Centre. The Assessing Officer disallowed the claim, arguing that MAMIS was already developed in 1989 and the expenditures were merely for modifications to suit buyers' needs, not for new scientific research.

The Commissioner (Appeals) upheld the disallowance under section 35 but allowed the expenditures as revenue expenditure under section 37(1). The Tribunal, however, accepted the assessee's claim, noting expert opinions and concluding that the activities constituted scientific research under section 43(4). The Tribunal emphasized that the term "scientific research" has a wide scope and should be liberally construed to encourage research and development activities.

The High Court observed that the Tribunal did not fully discuss the complexities and materials on record before concluding that the activities constituted scientific research. The Court highlighted that scientific research includes a wide range of activities and does not necessarily mean only successful inventions. It stressed that the Tribunal should have thoroughly examined the nature of the research, the improvements aimed at, and whether the product was substantially different from the existing one.

Issue 2: Necessity of Reference to the Central Board of Direct Taxes
The second issue concerns whether the Tribunal should have sought the opinion of the Central Board of Direct Taxes (CBDT) under section 35(3) before allowing the deduction. Section 35(3) mandates that if any question arises as to whether an activity constitutes scientific research, the Board must refer the question to the prescribed authority, whose decision is final.

The Tribunal held that the Assessing Officer should have referred the matter to the Board when a question arose about the nature of the activities. The High Court agreed, stating that the Assessing Officer cannot decide such issues without seeking the opinion of the prescribed authority. The Court noted that the revenue authorities should place the issue before the Board, which would then refer it to the prescribed authority for a final decision.

The Court also addressed whether the revenue should be allowed to seek such a reference at this stage. It decided against it, citing the long passage of time (over 20 years) since the expenditures were incurred, the lack of any attempt by the revenue to seek a reference earlier, and the fact that the Commissioner had already recognized a substantial portion of the expenditures as revenue in nature under section 37(1).

Conclusion:
The High Court concluded that the Tribunal should not have decided the question of whether the activities constituted scientific research without the opinion of the prescribed authority. However, it upheld the Tribunal's decision to reverse the revenue authorities' rejection of the assessee's claim for deduction, given that the Assessing Officer did not seek the necessary reference. The Court dismissed all appeals, reinforcing the need for a reference to the prescribed authority in such cases and emphasizing the broad scope of "scientific research" under the Act.

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