1. The cross appeals by assessee and revenue pertaining to asst. year 1998-99 are directed against the order of learned CIT(A)-III, Bangalore dated 14.6.2002. The appeals by assessee pertaining to asst. year 1999-2000 till 2002-03 are directed against the common order of learned CIT(A)-III, Bangalore dated 4.10.2004. We shall first take up the cross appeals for asst. year 1998-99.
2. The assessee company is engaged in the business of manufacture of perfumery compounds. The first ground of appeal is regarding disallowance of commission paid to Givaudan Roure (India) Ltd. (GRIL).
The assessee claimed payment of commission at the rate of 5% of the turnover. The Assessing Officer disallowed 4/5^thof this payment i.e.
the AO allowed commission payment at the rate of 1% of the turnover.
Learned CIT(A) following his order pertaining to asst, year 95-96 to 97-98 held that commission at the rate of 2% is to be allowed. Whereas the assessee challenges disallowance of commission to the extent of 3%, the revenue challenges the allowance of commission over and above that allowed by the AO.2.1 Similar issue arose before this Tribunal in assessee's appeal for A.Y. 95-96 to 96-97. The Tribunal after elaborate consideration of the fact as well as argument and the results for the years, held as under: All these details have been extracted from the accounts of both the companies and are not in dispute also. From the above, it is clear that the assessee has been showing best results after the holding company has come into play. From the details found in the record, it is clear that M/s Givadaun Roure was responsible for introducing their clients to M/s Hindustan Lever Ltd., M/s Procter & Gamble, M/s Ponds etc., to substantiate the manifold increase in turnover of the assessee. The stand of that M/s Gioaduan Roure took over the shares of the assessee with an object of supporting the assessee and producing all the products required for the multinational company through their production unit in India itself is more strengthened by the unique details furnished by the assessee from their accounts.
The customers were introduced to assessee only by M/s Givadaun Roure. M/s Givadaun Roure has the specialised skills for marketing the assessee's products. The entire products are custom made products. It is the case of the assessee that whenever the products are required by the customers, different samples are manufactured either directly by M/s Givadaun Roure or through the assessee and such samples are first introduced into the local market by the marketing team of M/s Givadaun Roure either directly or through market research organisation and the results are furnished to the manufacturers of Soaps and detergents etc., who could in turn approve certain products and later on order are booked for such products. The claim of the assessee appears to be very very reasonable and justified. The revenue is unable to contrast the meticulous details filed by the assessee and their explanation given are sound and proper. The charts extracted here above will clearly indicate that the claim of the assessee is fully substantiated. But for M/s M/s Givadaun Roure, there could not have been a multi fold increase in turn over and the profit. Keeping in view of all the facts, we are of the view that the claim of the assessee is perfectly justified and in accordance with law. It is ordered accordingly.
2.2 It is agreed by both the counsels that the facts are identical and hence, in view of the finding of this Tribunal, the ground of assessee is to be allowed and that of revenue is to be dismissed.
2.3 Following the aforesaid order of the Tribunal, we hold that commission paid at the rate of 5% of the turnover, is reasonable and accordingly, no part of the commission can be disallowed.
3. The next ground of appeal is regarding disallowance of a sum of Rs. 30,60,000/- being amount paid to one of the Directors Shri Vijay Kumar by way of professional fees. Learned CIT(A), following his order for A.Y.95-96, upheld the disallowance. However, he also directed to follow the order of the Tribunal for earlier year in this regard.
3.1 As stated, the issue regarding payment of commission and consultancy fees to the Director Shri Vijay Kumar arose before this Tribunal for earlier years. The Tribunal, after considering the entire facts and circumstances of the case in para 7 of its order, held as under: From the details furnished in the aforesaid letter, it can be seen that from the asst. year 1991-92 to 1994-95 there is a steep increase in turnover and profit. This cannot be achieved without the technical advise from a qualified and experienced perfumers. It is the case of the assessee that both Shri Vijayakumar and Shri Nagendra are technically qualified and experienced perfumers having more than 15 years of experience in this field. The perfumery compounds and chemicals are specialised work. To manufacture aromatic products, it can be carried out only by the professionals in this line. A minor variance in the technique and formulae will directly affect the quality of products. Further procurement of raw materials is also the most essential factor to maintain quality of the product. The aforesaid Directors were in fact in-charge of production as well as marketing. All these facts were not denied by the revenue. The only apprehension of the revenue is that the payment so made were excessive and unreasonable. To establish this factor, the revenue did not have any material in their possession.
But, on the other hand, looking into the steep increase in the business turnover and the net profit, it is abundantly clear that but for the technically qualified and experienced directors such increase in the business is not possible. It is for the businessman to look into as what is reasonable expenditure. Therefore, looking into these facts and taking into consideration of the totality of the circumstances, the payment of commission on net profit to the directors are very reasonable and not excessive in the year under consideration.
3.2 Respectfully following the order of this Tribunal, the professional fees paid to the Directors are directed to be allowed. The disallowance of Rs. 30,60,000/- is accordingly deleted.
4. The next ground of appeal is regarding disallowance of royalty payment of Rs. 2,39,61,276/- being paid to Givaudan-Roure (International) SA, Switzerland (GRISA). The facts are as under: The assessee entered into licence agreement dated 1.11.95 with one GRISA for payment of royalty. The license agreement provided as under: Whether Licensor is the owner of and possesses valuable confidential information, experience, know-how, trade secrets and formulas relating to the development, formulation, processing, manufacture, use and sale of flavours, fragrances and related materials; and Whereas Licensee wishes to obtain access to said confidential information, experience, know-how, trade secrets and formulas and to use them in its manufacturing processes or product development; and Whereas Licensor wishes to assist Licensee and is willing to transmit such confidential information and know-how to Licensee for use by Licensee in the manufacture and development of its products; and Whereas Licensor is the owner of trademarks and trade names and rights relating to registrations and applications for registration of trademarks in India; and Whereas Licensor has agreed that Licensee shall be permitted to use the trademarks and trade names under the terms and conditions set forth herein for use by Licensee in the manufacture and sale of its products.
Pursuant to the license, the know-how was made available to the assessee company. As per Clause (5) of the said license agreement, in consideration of the rights granted and the services provided under the agreement, the assessee was to pay a royalty at the rate of 5% of the net sales value of the agreement products manufactured and sold by the assessee. The assessee was therefore liable to pay royalty to the extent of Rs. 2,74,88,099/- for A.Y. 98-99. The assessee claimed Rs. 2,39,61,276/- out of the said royalty, as for the balance sum, the tax was not deducted Under Section 195 and hence, in view of Section 40(a)(i), the claim for the balance sum was not made. The AO noted that GRIL is a fully owned subsidiary company of GRISA. GRIL owns 76% of the share of the assessee company. Balance shares were held by erstwhile owner of the company viz. Shri Vijay Kumar and his nominees. For the year ended 31.3.2000, the entire share capital of assessee company was held by GRIL and its nominees. The AO held that though the assessee received know-how necessary for advancement of its business and though the assessee was benefited commercially, yet an entity which holds indirectly 76% of the share of assessee company, the transaction is not at an arms length. The AO in this regard held as under: The argument that the assessee, M/s GRIL and M/s GRISA are all different corporate entities is a tenuous one. After all, it is an accepted judicial dictum that in order to see through the real nature and substance of a commercial transaction for purposes of taxation, one has to look at it after lifting the corporate veil. No doubt assessee and M/s GRISA are two different corporate entities and from a pure juristic point of view they are separate entities having separate judicial existence. But factually GRISA is the real owner of the assessee company with 76% share holdings. In order to make a profit and to improve it, it is necessary for the owner of the business to do everything which will advance the business. It is necessary to put into use one's expertise, knowledge and other resources including money to make profit. In commercial terms what one gets oOut of such investment including the investment of one's know how is the profit from the business. If the profits of business are diverted by any other means such as payment towards know how, one's own effort, a return on investment of money etc., it is not acceptable for purposes of computing the taxable profits from the business. In my view what the assessee has attempted is to reduce the incidence of tax by taking away the profit in the form of royalty instead of taking it away in the form of dividend. In other words, I am of the view that by taking advantage of the fact that the assessee and M/s GRISA are two different legal corporate entities, the assessee has diverted its profits in the form of royalty payment.
He disallowed the same, holding that it is a colourable device. He also held that GRISA has taken away profit in the form of royalty, instead of dividend. Thus, the assessee has substantially reduced its tax liability including the liability Under Section 115-0. Relying upon the decision of Hon'ble Supreme Court in U.O.I. v. Play World Eelectronics (P) Ltd. 184 ITR 308 and in McDowell & Co. Ltd. v. CIT 154 ITR 148, he disallowed the royalty payment. Learned CIT(A) upheld the disallowance.
4.1 Learned Counsel for the assessee submitted that the appellant company has been given a license to make use of the confidential information, experience, know-hoe, trade secrets and formulas relating to the development formulation processing, manufacture use and sale of flavors, fragrances and related materials by GRISA vide License executed on 1.11.1995 between the parties. A copy of the license agreement is filed in paper book. This agreement was put to RBI for approval and RBI vide its letter dt.22^nd Sept., 1997 had approved with certain conditions to be fulfilled as provided therein. One of the conditions was that the royalty payment should not exceed 5% of the domestic sales and 5% of the export (net of taxes) for the period of 3 years. A copy of the said letter of the RBI is enclosed in paper book.
In pursuance of this approval, the supplementary agreement was also made to define the effective date of the operation of the license on 30^thSept., 1997. A copy of the said agreement is enclosed in paper book. Thus it may be appreciated that the agreement between the appellant company and the GRISA was a genuine agreement which had been screened by the RBI which had given the approval and the RBI had also approved the payment of royalty not exceeding 5%. In the circumstances, the payment of royalty at 5% as made by the appellant could not be held to be unreasonable. Even if the parties fall in the susceptible category as contemplated Under Section 40A(2) of the Act, still the payment of royalty could not be held to be unreasonable as having approved by RBI and the payment was well within the margin as approved by the RBI. In this connection reliance is placed on the judgment of Delhi High Court in the case of CIT v. Shriram Pistons and Rings Ltd. 181 ITR 230 wherein the Hon'ble Court has held when a remuneration payable to an employee was approved by the Company Law Board, then the fairness of the remuneration could not be challenged by invoking the provisions of Section 40A(2) of the Act. Further it is not out of place to mention that the appellant himself had agreed that there was license for use of know-how which belonged to GRISA and the appellant had benefited on account of such provision. In the circumstances a payment for availing the use of expertise could not be doubted. In view of the approval of the RBI even the quantum of payment would also not be considered as excessive. Further it may also be appreciated that the payment was not a make believe and an actual payment had been made and the taxes have been deducted at source by invoking the provisions of Section 195 of the Act. In the circumstances, the fairness of the claim of the appellant was indisputable and the disallowance was uncalled for.
The assessing authority was holding that the payment was colorable. The finding was totally on surmises and without any basis. Undisputedly the parties to the agreement are very much in existence. Further the supply of know-how and other expertise as provided in the license was not doubted. The payment to GRISA is also not doubted. Thus the parties are genuine, the payment is for consideration and the payment is also fair as approved by RBI and in the circumstances how could one hold that the transaction is colorable? In fact if the transaction was colorable and the payment was only a make believe, then how could be the approval of RBI is justified? Is it the case of the assessing authority that the RBI had not perused the transaction before the approval was given? Obviously the assessing authority had drawn the conclusion only on surmise because of the relationship between the appellant and GRISA.The appellant had vide its letter dt.24.1.2001 had explained the assessing authority the license obtained and justification for making the payment of royalty of 5%. A copy of the said letter is filed in paper book. It was also submitted that on account of the manufacturing activity of the flavors and fragrances by the appellant with the GRISA's expertise it could procure vast customers who were originally importing the flavors and fragrances from GRISA directly. The appellant submits that on account of this arrangement the turnover of the appellant had gone up substantially which is evident from the following:A.YR Total turnover Net profit Royalty payment Rs. Rs. Rs.1997-98 29,89,10,716 3,59,97,182 -1998-99 25,89,77,088 (2,24,86,874) 2,74,88,0991999-00 52,03,25,322 (3,37,80,173) 2,56,98,9052000-01 61,28,58,230 1,82,04,990 3,04,87,912 It may be noticed that asst. year 1997-98 was the first year after license was put to use. Once the business picked up the turn over had become double (A.Ys: 1999-2000 and 2000-01) and in 2000-01 in spite of royalty payment the appellant could derive profit.
In fact prior to the license agreement the appellant was incurring loss though 1997-98 was a profit year which is evident on looking into the performance of the assessment years 1995-96 and 1996-97.Asst. year Total turnover Net profit1995-96 Rs. 34,53,96,245 Rs. (88,27,058)1996-97 Rs. 23,48,33,033 Rs. (23,09,893) Thus, this arrangement with GRISA had improved the performance of the appellant. In fact the appellant could get substantial turnover from the leading customers who were originally dealing with GRISA directly.
The statistic in this regard is furnished in the paper book. Thus, the agreement between the parties for the legitimate purpose and the payment was also reasonable.
The assessing authority was of the view that the GRISA is holding a major share in the appellant company and consequently it is nothing but a diversion of profit to the extent of substantial portion of the profit of the appellant to GRISA. Mere fact the GRISA is a major shareholder in the appellant company, it is an undisputed fact that the appellant and the GRISA are the two distinct legal entities capable of entering into contract between themselves. The mere fact the GRISA is holding substantial share in the appellant would not mean that whatever GRISA would manufacture could be manufactured by the appellant without the authority given by GRISA. There is no compulsion that the GRISA should supply expertise without consideration. If the consideration obtained by GRISA is excessive, then a part of it could be disallowed.
For this purpose the assessing authority has to prove that the consideration paid by the appellant to GRISA was excessive and over and above the prevailing market value of the services obtained from GRISA.Here again it has to be examined as to whether GRISA comes within the susceptible character as contemplated Under Section 40/4(2) of the Act.
The appellant company is a subsidiary company of M/s Givaudan Roure (India) Ltd. which is a 100% subsidiary of GRISA. The Indian company holding 76% share in the appellant company whereas the GRISA has no shareholding. Section 40A(2) of the Act could be invoked only when the appellant company makes payment to any director of the company or any person (Individual, firm, company, AOP, HUF, etc.) having a substantial interest (i.e. owning at lease 20% voting rights on holding of equity shares)in the company or any person of which a director, partner or member has a substantial interest in the company or any relative of any such director or person. As GRISA is having no shareholding in the appellant company, any of the conditions to invoke Section 40A(2) of the Act are not satisfied. Consequently, GRISA is not in the susceptible character and the provisions of Section 40A(2) are not attracted. In the absence of GRISA having any control in the appellant, not having shareholding in the appellant company, the question of holding that the payment made to GRISA amounted to a payment to self was a wrong conclusion. The payment to GRISA being genuine and for obtaining the benefit by the appellant company and the payment also being reasonable and approved by RBI, the disallowance as made by the assessing authority is unsustainable. He further submitted that when the transaction is at an arms length, the payment made cannot be disallowed. He submitted that for A.Y. 2002-03, as per Section 91 of the Income-tax Act, a transaction with an associated enterprise are to be made at an arms length. For A.Y.2002-03, the AO, being Officer-in-charge of transfer pricing regulation, passed an order Under Section 92CA of the Act whereby the transaction between the assessee and GRISA was treated at an arms length and held that no adjustment Under Section 92C is necessary in respect of the international transactions of payment of royalty to GRISA. Prior to amendment of Section 92 w.e.f. 1.4.2002, even as per earlier provision, Section 92 provided as under.- Where a business is carried on between a resident and a non-resident and it appears to the Assessing Officer that, owing to the close connection between them, the course of business is so arranged that the business transacted between them produces to the resident either no profits or less than the ordinary profits which might be expected to arise in that business, the Assessing Officer shall determine the amount of profits which may reasonably be deemed to have been derived therefrom and include such amount in the total income of the resident.
No exercise has been done by AO or it is not found that because of the connection between the appellant and non-resident, the correct profits are not disclosed. He further invited our attention to the decision of the Hon'ble Supreme Court in the case of Union of India and Anr. v.Azadi Bachao Andolan and Anr. 263 ITR 706 wherein the Hon'ble Supreme Court held as under: If the court finds that notwithstanding a series of legal steps taken by an assessee, the intended legal result has not been achieved, the court might be justified in overlooking the intermediate steps, but it is not permissible for the court to treat the intervening legal step as non est based upon some hypothetical assessment of the real motive of the assessee. An act which is otherwise valid in law cannot be treated as non est merely on the basis of some underlying motive supposedly resulting in some economic detriment or prejudice to the national interests.
4.2 Learned DR Shri Arun Bhatnagar, CIT(A)-III on the other hand strongly supported the order of the learned CIT(A). He submitted that M/s GRIL is a fully owned subsidiary company of M/s GRISA. The payment of royalty to GRISA has to be analysed in the context of these facts concerning the ownership of the assessee company. The payment of royalty to GRISA is defecto a payment to oneself for the reason that GRISA beneficiary owns 76% shares of the assessee company through its fully owned subsidiary GRIL. Hence, the payee of the royalty is none other than an entity which holds more than 76% shares of the assessee company. The transaction therefore is not one at arms length. The argument that the assessee, M/s GRIL and M/s GRISA are all different corporate entities is a tenuous one. It is an accepted judicial dictum that in order to see the real nature and substance of a commercial transaction for the purposes of taxation, one has to look at it after lifting the corporate veil. No doubt, the assessee and M/s GRISA are two different corporate entities, but factually, GRISA is the real owner of the assessee company. It is necessary to put into use one's expertise, knowledge, and other resources including money to make profit. In commercial terms, what one gets out of such investment including the investment of ones own know-how is the profit from business. If the profit of business are diverted by any other means, such as payment towards know-how, ones own effort, a return on investment on money, etc., it is not acceptable for the purposes of computing the taxable profits from the business. Accordingly, what the assessee has attempted is to reduce the incidence of tax by taking away the profit in the form of royalty instead of taking it away in the form of dividend. In other words, the assessee has diverted its profit in the form of royalty payment. The enormous amount of payment made to Shri Vijayakumar in the form of remuneration for alleged professional services is also of the similar nature. By taking away the profits in the form of royalty or professional fees, etc., instead of dividend, the assessee is trying to substantially reduce its tax liability including the liability Under Section 115-O.The assessee's argument that RBI has given its seal of approval to the transaction between the assessee and GRISA and in view of this also, the transaction is to be treated as genuine, is also not correct. RBI's approval is for the purpose of remittance of the money from FERA angle only as is evident from para 7 of the RBI letter ECBG No. 352/HD dated 22.9.97 which reads as under: You may please note that our approval is only for payment towards technology transfer from FERA angle and should not be construed as approval under the provisions of any other law in force.
Obviously, the Reserve Bank has not and certainly cannot interfere with the jurisdiction of an Assessing Officer under the Income-tax Act.
4.3 He relied upon the decision of Hon'ble Supreme Court in the case of Union of India and Ors. v. Playworld Electronics P. Ltd. 184 ITR 308 wherein it was held thus: Even though the corporation might be legal personality distinct from its members, the court is entitled to lift the mask of corporate entity, if the concept is used for tax evasion, or to circumvent tax obligation, or to perpetrate a fraud.
It is true that tax planning is legitimate provided it is within the frame work of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges.
4.4 He invited our attention to the decision of Hon'ble Kerala High Court in the case of CIT v. Paulose & Mathen (P) Ltd. 236 ITR 416. This was a case relating to the applicability of explanation 3 to Section 43(1). The court found that revaluation of assets belonging to a firm taken over by the company which was a partner in the said firm was not bona fide (page 426). The court also observed, relying on the decision of the Apex Court in Sunil Sidharthbhai v. CIT 156 ITR 509 that the Assessing Officer is entitled to penetrate the veil covering a transaction to ascertain the truth. Even if two entities have been created legally, the bona fide nature of a transaction between two such legal entities can be critically examined to arrive at the trust of the matter wherein the court held "the High Court has power to disregard the corporate entity, if it is used for tax evasion or to circumvent tax obligation. Therefore, it could not be said that the Assessing Officer had acted unreasonably or arbitrarily in adopting Explanation 3 to Section 43(1) and fixing the actual cost accordingly".
The Court relied on the following observations of the Apex Court in CIT v. Sri Meenakshi Mills 63 ITR 609 (page 616).
It is true that from the juristic point of view, the point is a legal personality entirely distinct from its members and the company is capable of enjoying rights and being subjected to duties which are not the same as enjoyed or borne by its members. But in certain exceptional cases the court is entitled to lift the veil of corporate entity and to pay regard to the economic realities behind the legal facade.
4.5 He also invited our attention to the decision of Hon'ble Supreme Court in McDowell & Co. (154 ITR 148) wherein the court held thus: Tax planning may be legitimate provided it is within the framework of the law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honorable to avoid the payment of tax by dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges.
There is behind taxation laws as much moral sanction as is behind any other welfare legislation and it is a pretence to say that avoidance of taxation is not unethical and that it stands on no less a moral plane than honest payment of taxation. The proper way to construe a taxing statute, while considering a advice to avoid tax, is not to ask whether the provisions should be construed literally or liberally nor whether the transaction is not unreal and not prohibited by the statute, but whether the transaction is a device to avoid tax and whether the transaction is such that the judicial process may accord its approval to it. It is neither fair nor desirable to expect the Legislature to intervene and take care of every device and scheme to avoid taxation. It is up to the court to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and to expose the devices for what they really are and to refuse to give judicial benediction.
The evil consequences of tax avoidance are manifold. First, there is substantial loss of much needed public revenue, particularly in a welfare state like ours. Next, there is the serious disturbance caused to the economy of the country by the piling up of mountains of black money, directly causing inflation. Then there is 'the large hidden loss' to the community by some of the best brains in the country being involved in the perpetual war waged between the tax avoider and his expert team of advisers, lawyers and accountants on one side and the tax gatherer and his, perhaps not so skilful, advisers, on the other side. Then again there is the 'sense of injustice and inequality which tax avoidance arouses in the breasts of those who are unwilling or unable to profit by it'. Last but not the least, is the ethics of transferring the burden of tax liability to the shoulders of the guideless, good citizens from those of the 'artful dodgers'.
4.6 Shri Bhatnagar also referred to a decision of ITAT, Pune Bench in Taparia Tools Ltd. v. JCIT 81 ITD 508. The head-note in the said case read as under.- Tax planning - whether tax planning within framework of law is legitimate and it is only colourable devices and dubious methods that are to be discouraged - Held, yes, - whether if result of normal transaction is tried to be achieved through a scheme, with only intention to avoid tax, then such scheme can be described as a colourable device even though such scheme may be within the framework of law - held, yes.
4.7 He also referred to a decision of ITAT Mumbai in the case of Kantilal Manilal & Co. v. DCIT 77 TTJ 332. Hon'ble Tribunal held thus: Answer to this contention of the assessee can be very well found in the observations of Lord Howard de Walden, which is quoted by Lord Justice Chinnappa Reddy in the case of McDowell & Co. Ltd. (Supra) at P.153 which reads as under: It scarcely lies in the mouth of the tax payer who plays with fire to complain of burnt fingers.
If the assessee maneuvers for avoidance of tax by colourable device, all consequences would follow when such device is exposed.
In view of the above the Hon'ble Tribunal has further held "even if the transactions are genuine and have been actually acted upon but if they were with the intention of tax avoidance, then the decision of McDowell & Co. Ltd. (Supra) would be squarely applicable.
4.8 He, thereafter, invited our attention to the decision of Hon'ble Karnataka High Court in the case of Avasarala Automation Ltd. v. JCIT 266 ITR 178 wherein at page 190 and 191, Hon'ble Karnataka High Court held thus: As noticed by us earlier, the taxing authority is entitled and is indeed bound to determine the true legal relation resulting from a transaction. If the assessee has chosen to conceal by advice the legal relation, it is open to the taxing authorities to unravel the device and to determine the true character of the relationship Therefore, while every person is entitled to so arrange his affairs as to avoid taxation, the arrangement must be real and genuine and not a sham or make-believe one. In the instant case, the Tribunal, the appellate authority and the Assessing Officer have recorded a finding that the transaction in question is not real and genuine, it is not in the nature of a tax planning which is within the framework of law. The finding recorded by the authorities referred to above does not suffer from any error, much less, an error involving a substantial question of law. Therefore, we are of the view that the Tribunal, having regard to the facts and circumstances of the case was fully justified in relying upon the principle enunciated by the Supreme Court in the case of McDowell and Co. Ltd. In the facts of this case, we are inclined to take the view that while the APSEB was interest in securing financial assistance by way of loan and for the said purpose the machinery/equipment was offered as a security by creating the documents in question to assure repayment of the loan advanced, the appellant found it convenient to enter into such a transaction as a device adopted to avoid payment of tax. Therefore, the Tribunal and the subordinate authorities were fully justified, taking into account several circumstances referred to by them in the orders impugned, to determine the nature of the new and sophisticated acumen adopted to avoid payment of tax legitimately due to the State. In a matter like this, we consider that it is the duty of this Court not to give judicial vindication to such an act of avoidance of payment of tax in the guise of sophisticated use of language as tax planning.
4.9 Lastly, he submitted that the Hon'ble Supreme Court's subsequent decision in case of Azadi Bachao Andolan reported in 263 ITR 706, the earlier Supreme Court decision in case of McDowell cannot be applied to the facts of the appellant's case is concerned, it is pertinent to mention here that "the Supreme Court's decision in McDowell's case reported in 154 ITR 148 was by a full bench of 5 judges. However, the Hon'ble Supreme Court's decision in the case of Azadi Bachao Andolan was by a divisional bench of 2 judges. Further, the Hon'ble Supreme Court decision in case of Azadi Bachao Andolan does not contradict or over-rule its earlier decision in the case of McDowell which has been relied on by the Assessing Officer.
4.10 In reply, learned Counsel for assessee submitted that the claim is made Under Section 37(1) of the Act. The expenses need to be incurred wholly and exclusively for the purpose of business. Once it is found that the assessee has received know-how necessary for advancement of its business and it is also found that the assessee had benefited commercially, the expenses in this regard are to be allowed. He further relied upon the decision of ITAT, New Delhi in the case of ACIT v.Nestle India Ltd. 94 TTJ page 53. He submitted that in the said case also, the facts are identical and after considering all the decisions on the subject, Hon'ble Tribunal deleted the disallowance in respect of royalty payment for technical services made to the parent company.
5. We have carefully considered the relevant facts and arguments advanced. We have also perused the paper book to which our attention was drawn. We have considered the decision cited by both the counsels.
In terms of licence agreement, the assessee availed the benefit of know-how and formula relating to development, formulation, processing, manufacture and use of technology relating to products. This licence was not available to the assessee in earlier years. Prior to date of licence, the clients like Procter and Gamble, Hindustan Leaver, Ponds India etc. were directly importing the raw material like fragrance and chemicals from GRISA. After entering into the collaboration agreement, the fragrance compounds etc. required by these major customers were being manufactured by assessee company and supplied through the orders booked by GRIL But for the license agreement, the assessee would not have executed these orders. These facts are not disputed by the AO.Though he mentions in the order that receipt of know-how necessary for advancement of its business and commercial benefit out of same is not "seriously disputed", we find that the same is not disputed at all. The question is but for the licence agreement, the assessee would have availed the commercial benefit? The answer is clearly 'no'. It is the contention of the AO that the transaction should be carried on at an 'arms length'. A transaction can be said to be at an 'arms length' when the two entities put aside the relation. The transaction is done in commercial way without bringing the relation in between. In such transaction, the consideration due and payable is paid, neither more nor less. The relationship of holding subsidiary, principal agent or any other relations is put aside and the transaction is termed solely on the basis of commercial consideration. A Managing Director of the Company, holding substantially the entire capital, is required to be remunerated for the services he has rendered, or the partners, though owning the entire business, are required to be remunerated as a working partner for the services rendered, or they are also required to be paid interest on the capital introduced. In all such cases, it cannot be said that by paying the remuneration or for rewarding for the services, the transaction is not done at an arms length. A transaction is said to be at an arms length when one is compensated for the benefit received.
Conversely, if it is not so done, it can be considered as a transaction "hands in glove". In the present case, what the assessee did is precisely a transaction at an arms length. While paying for the technology received, the assessee has paid precisely the price payable for the same. Had it not paid the same, it would have been considered as a transaction "hands in glove" and not at an arms length Even though the share capital of assessee company is held by GRIL, which itself is a subsidiary of GRISA, GRISA, Switzerland was under no obligation whether legally or morally, to part with its confidential information, experience, know-how, trade secret and formula relating to the products manufactured by the assessee. The two companies are different legal identities and not bound to supply the technology free of cost. On the contrary, if the technology was transferred free of cost, it would have been held to be a transaction not at arms length. By entering into agreement and by paying the fees, the transaction is to be treated at arms length and but for payment, the inference could have been otherwise. The assessing authority and the appellate authority failed to appreciate that the facts having not been disputed in that the foreign company has provided the know-how on which the appellant company had commercial benefit, the payment is required to be made. The fact that the foreign company might be holding the shares in the appellant company did not make the foreign company and the appellant company one and the same.They are two different legal entities. They were capable of entering into a contract. Further they were also not in the susceptible capacity as provided Under Section 40A(2). Further the payment to a foreign company by way of royalty was not proved to be excessive or more than the market value for the know-how provided. It was also not proved that the payment was only a make believe. On the other hand the royalty payments are actually being made. In the circumstances, the payment being a legitimate business expenditure is required to be allowed Under Section 37(1) of the Act. The other argument that the device was colourable was also without merit. It is an undisputed fact that the foreign company has supplied know how but for which the company could not have expanded its business. The performance of the company is again proved on account of the various customers which could gain by applying the know how provided by the foreign company. Had the foreign company not provided the know how and directly dealt with the various esteemed customers of the appellant, the appellant company would nowhere be in the market. On the other hand, the appellant company having reaped the benefit for obtaining the know-how is providing the fraction of the profit by way of royalty to the foreign company. By no stretch of imagination the agreement may be held to be colourable. The recent judgment of the Hon'ble Supreme Court in the case of UOI v. Azadi Bachao Andolan and Anr. reported in 263 ITR 706 (SC), the Supreme Court has observed as follows: We may also refer to the judgment of the Gujarat High Court in Banyan and Berry v. Commissioner of Income-tax The court nowhere said that every action or inaction on the part of the tax payer which results in reduction of tax liability to which he may be subjected in future, is to be viewed with suspicion and be treated as a device for avoidance of tax irrespective of legitimacy or genuineness of the act; an inference which unfortunately, in our opi9nion, the Tribunal apparently appears to have drawn from the enunciation made in McDowell's case (1958) 154 ITR 148 (SC). The ratio of any decision has to be understood in the context it has been made. The facts and circumstances which lead to McDowell's decision leave us in no doubt that the principle enunciated in the above case has not affected the freedom of the citizen to act in a manner according to his requirements, his wishes in the manner of doing any trade, activity or planning his affairs with circumspection, within the framework of law, unless the same fall in the category of colourable device which may properly be called a device or a dubious method or a subterfuge clothed with apparent dignity.
In the case of the appellant the transaction is being transparent and the genuineness of the same having not been doubted in that the license agreement, the payments, and the benefit applied by the appellant having not been doubted, the disallowance of expenditure of royalty on mere surmises was uncalled for and the same is liable to be deleted.
5.1 It is seen that the expenses are claimed Under Section 37(1) of the Act.
It is not open to the department to adopt a subjective standard of reasonableness and disallow a part of business expenditure as being unreasonably large, or decide what type of expenditure the assessee should incur and in what circumstances. The jurisdiction of the assessing officer is confined to deciding the reality of the expenditure, namely whether the amount claimed as deduction was factually expended as laid down and whether it was wholly and exclusively for the purpose of the business; the reasonableness of the expenditure could be considered only for the purpose of determining whether in fact, the amount was spent; once it is established that there was a nexus between the expenditure and the purpose of the business, the department cannot justifiably claim to put itself in the armchair of a businessman or in the position of the board of directors and assume the said role to decide how much is a reasonable expenditure having regard to the circumstances of the case. But this principle is now subject to express provisions of Section 40A(2). No effort has been made to find out as to what is the market value of service provided and to what extent the amount is excessive or unreasonable. On the contrary, from the order Under Section 92CA of the Act, for AY 2002-03, it is seen that the transaction is treated at arms length and even as per the amended provisions of Section 92, no adjustment in respect of such international transaction has been made.
5.2 The expression "wholly" has been used with reference to the quantum, while the expression "exclusively" refers to the nature or the purpose of the activity in which the expenditure is incurred. In other words, the whole of the expenditure must have been wholly and exclusively incurred for business purposes, in order to qualify for allowance Under Section 37(1) of the Act. If there is a dual purpose, then, it is obvious that the expenditure would not qualify for allowance, for, it will cease to be wholly and exclusively laid out for business purposes CIT v. Hajee Moose & Co. 153 ITR 422-429 (Mad.).
The expression "wholly and exclusively" used in Section 10(2)(xv) of the Income-tax Act, 1922, does not mean "necessarily". Ordinarily, it is for the assessee to decide whether any expenditure should be incurred in the course of his or its business. Such expenditure may be incurred voluntarily and without any necessity and if it is incurred for promoting the business and to earn profits, the assessee can claim deduction Under Section 10(2)(xv) of the Act even though there was no compelling necessity to incur such expenditure. The fact that somebody other than the assessee is also benefited by the expenditure should not come in the way of an expenditure being allowed by way of deduction Under Section 10(2)(xv) of the Act if it satisfies otherwise the tests laid down bylaw (Sasson J. David and Co. P. Ltd. v. CIT 118 ITR 261 (SC).
The adverb "wholly" in the phrase "laid out or expended...for business" refers to the quantum of expenditure. The adverb "exclusively" has reference to the object or motive of the act behind the expenditure.
Unless such motive is solely for promoting the business, the expenditure will not qualify for deduction. It is no doubt true that equitable considerations are irrelevant in determining whether a particular item of expense qualifies itself for deduction see CIT v.Maharashtra Sugar Mills Ltd. 1971 82 ITR 452 (SC). All that has to be considered by the court when such a question arises as to whether a particular item of expense is admissible or not is to see as to whether it is permissible under the Act, in the sense that it is not specifically prohibited and has been wholly and exclusively laid out for the business C.J Patel & Co. v. CIT 158 ITR 487 (Guj.). The decision of ITAT, New Delhi in the case of Nestle India (supra) also supports the case of the assessee.
We accordingly hold that in view of the discussion above, the amount paid by way of royalty to GRISA cannot be disallowed.
In the result, the appeal of assessee is allowed and that of revenue is dismissed.
6. We now take up the appeal of assessee for AY 99-2000 to 2002-03. The first issue in appeal for all the years relates to disallowance of royalty payment to GRISA Switzerland. For the reasons stated in our order for AY 98-99, the disallowance of royalty payment is deleted.
7. The next ground of appeal is regarding addition made to the income by invoking provisions of Section 145A of the Income-tax Act (The Act).
Learned CIT(A) in this regard observed as under: The appellant has been following exclusive method of accounting its purchase of inventories and closing stock without taking into account excise duty component. However, the Assessing Officer by invoking the provisions of Section 145A has re-caste the appellant's trading account for all the years under appeal to determine taxable income by including excise duty component pertaining to opening stock, purchase of inventories and closing stock. Shri Parthasarathi the learned AR of the appellant submitted that the appellant has been following exclusive method of valuing closing stock by not taking into account the excise duty component. It was submitted that in view of the provisions of Section 145A the AO has made adjustments to the total income by taking into account excise duty component. It was argued that if value of closing stock has to be enhanced with excise duty component, the corresponding debit to P&L account with the same amount has to be allowed and the adjustment so made will not have any impact on taxable income of the year. It was submitted that on principle, the AO was justified in making the adjustment in view of the provisions of Section 145A. However, it was argued that the AO has wrongly adopted the figures of excise duty pertaining to opening stock, purchases and also the closing stock. It was also pointed out that the appellant has filed rectification applications Under Section 154 of the IT Act for all the 4 years under appeal. It was also brought to my notice that the AO has rectified the assessment orders for the asst. year 2000-01 to 2002-03 out of which the AO has correctly worked out the adjustment as per Section 145A for asst. year 2000-01 and 2002-03. Vide order sheet noting dated 29.9.2004 it was submitted that ground No. 9 to 11 for asst. year 2000-01 and 2002-03 are not pressed in view of the rectification orders. In respect of asst. year 2001-02, it was pointed out that the AO even though has rectified the impugned order Under Section 143(3) r.w.s. 147, but some mistakes have been committed again. The appellant has preferred another rectification application Under Section 154 dated 16.9.2004 which is still pending. It was also pointed out that for asst. year 99-2000 the appellant's rectification application dated 11.3.2004 is also pending before the AO. Shri Parthasarathi submitted that it will meet the end of justice if the AO attends to the appellant's rectification applications dated 11.3.2004 for asst. year 9-2000 and 16.9.2004 for asst. year 2001-02.
In view of the appellant's submissions, ground Nos. 9 to 11 for asst. year 2000-01 and 2002-03 are dismissed as not pressed. Further in view of the appellant's submissions, ground Nos. 9 to 11 for asst. year 99-2000 and 2001-02 are disposed off with a direction o=to the AO to attend to the appellant's rectification applications dated 11.3.2004 for asst. year 99-2000 and 16.9.2004 for asst. year 2001-02.
7.1 Learned Counsel for assessee submitted that the learned CIT(A) ought to have held that in the light of the method of accounting consistantly followed by the appellant the application of Section 145A of the Act was incorrect and even assuming that Section 145A was to be applied the valuation of the closing stock/opening stock as done by the assessing authority was incorrect and accordingly, the impugned addition in this regard was unsustainable. Though learned CIT(A) has dismissed the ground for AY 2000-01 and 2002-03, as not pressed, he also directed the AO to consider the rectification application for AY 99-2000 and 2001-02. Since the matter was remitted back without any direction, the AO be directed to follow consistency in the matter and following the said practice, the rectification application for AY 99-2000 and 2001-02, is to be disposed off. Learned DR on the other hand relied upon the appellate order.
7.2 We are in agreement with the submission of learned Counsel for assessee. Even though Section 145A has been applied by AO, the same should be applied consistently and in relation to all the years. Thus, the AO is directed to apply Section 145A in relation to asst. year 99-2000 and AY 2001-02, following the same principle as done for AY 2000-01 and 2002-03.