Sum paid for property likely to come into existence and payment for brand building isn’t royalty

If a property was likely to come into existence because of certain payment, the same couldn’t be deemed as 'royalty' because it lacked the condition of 'use or right to use'. Even if payment was made for creation of the brand and not for the use of such brand, the same couldn’t be characterized as 'royalty'

In the instant case the assessee, a foreign company (Marriot), entered into a franchise agreement with a franchisee-hotel in India (‘AHL’) to establish and operate MRHS International Hotel. The franchisee desired certain sales, marketing, publicity and promotion services to be performed outside India in support of the operation of the hotel. It agreed to perform such services.  AHL agreed to pay 1.5% of its gross revenue to the assessee for 'International Marketing Activities'. During assessment the AO brought this amount to tax as "royalty" under Article 12(4) of India-Netherlands DTAA (‘treaty’).  Further, the CIT(A) allowed the assessee’s appeal holding the amounts to be reimbursements. Aggrieved revenue filed the instant appeal.

The Tribunal held as under:

1) As per Article 12(4) of the treaty, in order to cover any payment within the purview of "royalty", it was imperative that the payment must be for a consideration for use or right to use any copyright of the literary artistic work, etc., or any patent, trademark, etc. (i.e., ‘defined property');

2) Payment could be made as a consideration for the use or right to use of the defined property only when such property was in existence at the time of use. If a property didn’t exist or was likely to come into existence because of the payment made, the same couldn’t qualify as 'royalty' because it lacked the condition of 'use or right to use';

3) The term 'royalty' as per Article 12(4) of treaty contemplates a consideration for the use of or right to use of the defined property already in existence and the payment was agreed to  be made for its use or right to use. If the payment made was of such a nature which helped in the creation of the defined property, that couldn’t regarded as royalty;

4) Even if payment made by AHL towards the international marketing activities led to the brand building, it would still be a payment for the creation of the brand and not for the use of such brand, which could  be characterized as 'royalty';

5) Thus, the impugned consideration couldn’t be deemed as 'royalty' under Article 12 of treaty. The actual expenses to be incurred by the assessee might have been more or less than the said fixed rate of consideration. In such a situation, there was every possibility of the assessee having some mark up on the costs incurred by it on advertisement. No material had been placed on record to demonstrate that the actual expenses incurred by the assessee were equal to the amount received.  Thus, the CIT(A) was not justified in deleting the addition by holding that it represented 'reimbursement of expenses'. Matter remanded to AO to decide whether amounts taxable as Business Profits under Article 7 of treaty – Dy. DIT v. Marriott International Licensing Company BV [2013] 35 taxmann.com 400 (Mumbai - Trib.)

Certificate of registration as Income Tax Practitioner is mandatory for representation before revenue authority

Mere possession of educational qualification without undergoing departmental examination is not sufficient to have any right to practice as Income Tax Practitioner. Representative can’t appear before revenue authorities without any certificate of registration as Income Tax Practitioner (‘ITP’)

1) Mr. Y (representative of assessee) was not advocate registered with the State Bar Council. Therefore, he should not have claimed that since he was retired departmental Officer, therefore, without any certificate of registration as ITP he could appear before the Income-tax Authorities and the Tribunal;

2) He had also admitted that though he was practicing in Gwalior, but he was not registered with the CIT, Gwalior. His claim was totally wrong and his conduct was liable to be impeached. Section 288(2)(v) & (vi) provides the meaning of ‘authorized representative’ who have passed any accountancy examination recognized by the Board or any person who has acquired such educational qualifications prescribed by the Board in this behalf;

3) Mere possession of educational qualification without undergoing departmental examination by the Board isn’t sufficient to have any right to practice as ITP. According to Rule 53, 54 and 55 of the IT Rules, the Chief CIT or the CIT shall have to maintain prescribed form to register ITP to whom certificate is issued;

4) The person, who claims to be registered as ITP shall have to file proper application supported by documents to prove his accountancy examination recognized and educational qualifications achieved by him as per Rules;

5) The above provisions of the IT Act and IT Rules clearly prove that Mr. Y is not ITP as provided in the Income-tax Act and Rules. Therefore, without any certificate of registration in his favour under the above provisions, he couldn’t practice before the IT authorities and the Tribunal - SAMAGRA VIKAS MAHILA SAMITI V. CIT [2013] 35 taxmann.com 390 (Agra - Trib.).)

Discount on shares offered under ESOP held as ‘expenditure’ and part of employees’ cost

Discount on shares offered under ESOP is construed, both by the employees and company, as nothing but a part of package of remuneration.  It is deductible on straight line amortization basis over vesting period of the options.

In the instant case the moot question that arose before the ITAT was whether the Employee Stock Option compensation expense, was an allowable deduction in the computation of income under the head “Profits and gains of business or profession”?

The Tribunal allowed deduction on such discount and held as under:

1) When a company undertakes to issue shares to its employees at a discounted premium on a future date, the primary object of this exercise is not to raise share capital but to earn profit by securing the consistent and concentrated efforts of its dedicated employees during the vesting period;

2) Such discounted premium is construed, both by the employees and company, as nothing but a part of package of remuneration. In other words, such discounted premium on shares is a substitute of direct incentive in cash for availing of the services of the employees;

3) The discount on premium under ESOP was simply one of the modes of compensating the employees for their services and was a part of their remuneration. The sole object of issuing shares to employees at a discounted premium was to compensate them for the continuity of their services to the company;

4) Such discount couldn’t be described either as a short capital receipt or a capital expenditure. It was nothing but the employees cost incurred by the company. The substance of this transaction was to disburse compensation to the employees for their services, for which the form of issuing shares at a discounted premium was adopted;

5) By undertaking to issue shares at discounted premium, the company does not pay anything to its employees but incurs an obligation of issuing shares at a discounted rate on a future date in lieu of their services, which is nothing but an expenditure under section 37(1) of the Act;

6) A liability was definitely incurred by the assessee and was deductible, notwithstanding the fact that its quantification might take place in a later year. The discount in relation to options vesting during the year couldn’t be held as a contingent liability;

7) Liability to pay the discounted premium was incurred during the vesting period and the amount of such deduction was as per the terms of the ESOP scheme by considering the period and percentage of vesting during such period. Deduction of the discounted premium was to be allowed during the years of vesting on a straight line basis;

8) The amount of discount claimed as deduction during the vesting period is required to be reversed in relation to the unvested or lapsed options at the appropriate time. However, an adjustment to the income is called for at the time of exercise of option by the amount of difference in the amount of discount calculated with reference the market price at the time of grant of option and the market price at the time of exercise of option - Biocon Ltd. v. Dy.CIT [2013] 35 taxmann.com 335 (Bangalore - Trib.) (SB)

Percentage Completion Method isn’t mandatory for real estate developers, they can follow either Percentage Completion Method or completed contract method

It is not mandatory for all real estate developers to workout their profits by following percentage of completion method as prescribed by ICAI under AS-7

In the instant case the assessee was engaged in the business of developing and selling real estate projects. It filed nil return of income for both the assessment years 2008-09 and 2009-10, by adopting Project Completion Method. During assessment, the AO rejected the assessee's accounts on the ground that it hadn’t followed AS-7 for recognition of revenue as per which income was to be deduced on the basis of Percentage Completion Method. The AO, accordingly, computed the profit on percentage completion method and completed the assessment. Further, CIT(A) upheld the action of  action of AO.

On appeal, the Tribunal held in favour of assessee as under:

1) The assessee maintained complete books of account, which were duly audited by qualified Chartered Accountants. It had also maintained its account on mercantile basis by regularly applying Project Completion Method. The assessee had been consistently followed the same method. The auditors had reported no change in method of accounting adopted by the assessee;

2) The real estate developers are not pure contractors but are sellers of flats or goods. It is not mandatory for all real estate developers to follow Percentage Completion Method as per AS-7 prescribed by ICAI. The AS-7 recognizes the position that in the case of construction contracts the assessee could follow either the Project Completion Method or Percentage Completion Method.;

3) The Apex Court in the case of CIT v. Hyundai Heavy Industries Co. Ltd., [2007] 161 Taxman 191 (SC) also took the similar view and held that both the methods of accounting ( i.e., Project Completion Method and Completed Contract method) were recognized methods of accounting. The assessee was at liberty to choose any of the above methods and if any one of the method of accounting was consistently followed by the assessee, the AO couldn’t change such method of accounting;

4) The completed contract method followed by the assessee, in the instant case, therefore, could not be faulted with by the revenue authorities and on that basis it was not correct to say that the accounts of assessee did not present correct and complete picture of its profits;

5) Therefore, there was no justification in rejection of accounts by application of provisions of section 145(3) and changing the method from project completion to percentage completion method by the AO, which was upheld by the CIT(A). Therefore, the order of the Commissioner (Appeals) was to be set aside - Krish Infrastructure (P.) Ltd. v. ACIT [2013] 35 taxmann.com 38 (Jaipur - Trib.)

Subsidiary co. isn’t a ‘related person’ for section 40A(2); payment made by holding co. isn’t subject to disallowance

Subsidiary company is not a related person within meaning of section 40A(2)(b)(ii) and, thus, payment made by assessee to its subsidiary can’t be disallowed by invoking provisions of said section   

In the instant case the assessee-company had entered into an agreement with its subsidiary company for manufacturing of footwear soles. The manufacturing related jobs were done by subsidiary company for which the assessee paid certain sum which was claimed as business expenditure. The AO allowed 50% of the claim of the assessee and disallowed remaining amount under section 40A(2)(b). The CIT(A) confirmed the order of AO, which was further reversed by the Tribunal. Aggrieved revenue filed the instant appeal.

The High Court held in favour of assessee as under:

1) To attract provisions of section 40A(2), assessee has to incur an expenditure for which a sum is paid or payable to a person as referred to in clause (b) of said Section. As the assessee was a company, the person to whom they had to make payment, in order to attract the said provision, was any director of the company or any relative of the director;

2) Admittedly, in the instant case, the payment was made to the subsidiary company and not to any director or any relative of the said director. Therefore, the requirement of the section was not fulfilled;

3) Merely because, a subsidiary company did not fulfill its obligations, that wouldn’t render the transaction illegal and consequently, it couldn’t be held that the expenditure laid out or incurred was not wholly for the business of the assessee-company;

4) These facts had not been properly appreciated by the assessing authority as well as the lower appellate authority. The Tribunal was therefore justified in directing the deletion of disallowance. Accordingly, the revenue's appeal was to be dismissed – CIT v Raman Boards Ltd [2013] 35 taxmann.com 4 (Karnataka)

Registration to trust couldn’t be denied even if it breached Right to Education Act and generated profit

Registration under section 12A couldn’t be denied to assessee-trust merely on ground that it earned profits by charging substantial fees and had violated requirements of Right to Education Act

In the instant case the assessee, an educational society, filed application for registration under sections 12A. The CIT rejected application for registration on ground that the society was running its institution purely on commercial basis and earning profits by charging substantial fees from students. He also cited violation of requirements of Right to Education Act, 2009 (RTE Act) and non-furnishing of original instrument of establishment of society as reasons for rejection of application. Aggrieved assessee filed the instant appeal to the Tribunal.

The Tribunal held in favour of assessee as under:

1) It was found that the CIT didn’t raise any objection against the objects of assessee-society. Its main object was education, which undeniably was of charitable nature, in line with the provisions of section 2(15);

2) Further, it was not within the CIT's purview to take recourse to the RTE Act to reject assessee’s application. While considering an application for grant of registration under section 12A, the CIT was only required to see whether the object of the applicant was charitable and as to whether its activities were genuine, and no further. The jurisdiction and competence to examine an issue under the RTE Act lay before the authorities mentioned therein;

3) Where the purpose of a trust or institution is education, it would constitute 'charitable purpose', even if it incidentally involves carrying on of commercial activities. Mere charging of high fees was no ground for refusing it registration, where the CIT had not doubted the objects and genuineness of the assessee's activities;

4) Merely because the assessee had generated surplus income after meeting expenditure on its educational activities, such activities could not be regarded as trade and commerce, so as to invite cancellation of registration and that education was a charitable purpose in itself. Thus, in view of the above the order passed by the CIT was to be cancelled  and he was to be directed to grant registration to the society on verifying the original documents of establishment of assessee-society - Shri Gian Ganga Vocational & Educational Society v. CIT [2013] 35 taxmann.com 17 (Delhi - Trib.)

Penalty on assessee having limited operations to be waived off if he had co-operated in proceedings with department

Where an assessee having limited operations had co-operated in proceedings and paid service tax alongwith interest, penalty was liable to be waived off under section 80

In the instant case assessee neither paid service tax nor filed the return in respect of Rent-a-Cab services provided by him. After show-cause notice was issued, he paid service tax alongwith interest, but sought waiver of penalties imposed on him under sections 76 & 77. He sought waiver on the ground that he was a small businessman, he had not collected service tax from service recipients and was passing through financial difficulties.

The Tribunal partly waived off penalty with following observations:-

Taking note of size of operations of assessee and fact that he had co-operated in proceedings and paid service tax alongwith interest, it was appropriate that penalties under section 76, which were almost equal to service tax liability, were required to be waived off by invoking provisions of Section 80. However, penalty imposed under section 77 was to be sustained. - Royal Travels v. Commissioner of Central Excise [2013] 35 taxmann.com 19 (Ahmedabad - CESTAT)

Karnataka HC lays down law on imposition of concealment penalty

In the instant case appeals were filed before the Karnataka HC regarding imposition of penalty. The HC interpreted section 271 and laid down law as under:

1) Penalty under section 271(1)(c) is a civil liability;

2) Mens rea isn’t an essential element for imposing penalty for breach of civil obligations or liabilities;

3) Existence of conditions stipulated in section 271(1)(c) is a sine qua non for initiation of penalty proceedings. Even if these conditions do not exist in the assessment order, at least a direction to initiate proceedings under section 271(1)(c) is a sine qua non for the AO to initiate the proceedings because of the deeming provision contained in section 271(1B);

4) Imposition of penalty even if the tax liability is admitted is not automatic. Even if the assessee has not challenged the order of assessment levying tax and interest and has paid tax and interest, that by itself would not be sufficient for the authorities either to initiate penalty proceedings or to impose penalty, unless it is discernible from the assessment order that it is on account of such unearthing or enquiry concluded by authorities it has resulted in payment of such tax;

5) Even though explanation offered, has not been substantiated by the assessee, but is found to be bonafide and all facts relating to the same and material to the computation of his total income have been disclosed by him, no penalty can be imposed;

6) The penalty proceedings are distinct from the assessment proceedings. The proceedings for imposition of penalty, though emanate from proceedings of assessment, yet are independent and separate aspect of the proceedings. The findings recorded in the assessment proceedings, in so far as 'concealment of income' and 'furnishing of incorrect particulars' would not operate as res judicata in the penalty proceedings;

7) It is open to the assessee to contest the said proceedings on merits. However, the validity of the assessment or reassessment, in pursuance of which penalty is levied, cannot be the subject matter of penalty proceedings. The assessment or reassessment cannot be declared as invalid in the penalty proceedings;

Thus, in light of the above it was clear that merely because the assessee had agreed for certain addition and, accordingly, assessment order was passed and when the assessee had paid the tax and the interest thereon in the absence of any material on record to show the concealment of income, it couldn’t be inferred that the said addition was on account of concealment – CIT v. Manjunatha Cotton & Ginning Factory [2013] 35 taxmann.com 250 (Karnataka)

Freebies promised in election manifesto disrupts free and fair election; SC directs EC to issue guidelines

The Supreme Court held as under:

1) Promise of ‘freebies’ (TV sets, laptops, mixers, grinders etc.) in election manifestoes of political parties was not ‘corrupt practice’ under section 123 of Representation of People Act, 1951. As the said section covered corrupt practices & inducements by  candidates for winning elections (irrespective of whether the candidate’s party forms Government or not) and not promises by political party which it would implement if it forms Govt.;

2) Distribution of ‘freebies’ at State cost using tax revenues falls within the scope of ‘public purposes’ and such expenditure was not unconstitutional. Court can interfere only when expenditure incurred by Govt. is unconstitutional or contrary to a statutory provision. But it can’t interfere on the ground that such expenditure or action is not wise or that the expenditure is not good for the state;

3) Duty of CAG to scrutinize or audit Govt. expenditures arises only after the expenditure was incurred. There is no power or duty of CAG to do “pre-scrutiny” of expenditure before it is incurred;

4) Although promise of freebies in election manifesto is not corrupt practice, such promises and distribution using State funds would influence all peoples and shakes the root of free and fair elections, disturbs level playing field and vitiates the electoral process. Court has limited power to direct Legislature to legislate on particular issue;

5) However, Election Commission has power to issue directions to political parties to ensure level playing field so long as the matter is not covered by any law. Election Commission, thus, directed to issue guidelines to regulate election manifestoes as early as possible - S. Subramaniam Balaji v. Government of Tamil Nadu [2013] 35 taxmann.com 175 (SC)

CUP method deals with price of a product and not the profit margin earned thereon

Comparing margins instead of prices is incorrect application of internal CUP method

Where CIT(A) in his order upheld the internal CUP Method but dealt with profit margins instead of prices, it was an incorrect application of internal CUP Method. Application of any CUP method either internal or external involves dealing with prices of a product and not the profit margin earned thereon. Even in the case of 'internal CUP' Method, the arm's length price to be adopted is the price, subject to admissible adjustments at which the similar transactions are carried out between the assessee and an independent enterprise. Internal CUP has nothing to do with the margins earned by the same enterprise from other transactions - Sabic Innovative Plastic India (P.) Ltd. v. Dy. CIT [2013] 35 taxmann.com 177 (Ahmedabad - Trib.)