ITA Nos. 594/2005, 646/2005 & 559/2006 Page 1 of 32 * THE HIGH COURT OF DELHI AT NEW DELHI Judgment reserved on: 09.08.2011 % Judgment delivered on: 19.08.2011 + ITA Nos. 594/2005, 646/2005 & 559/2006 CIT ...... Appellant Vs M/S V.R.V. BREWERIES & BOTTLING INDUSTRIES Ltd. ..... Respondent Advocates who appeared in this case: For the Appellant: Ms Rashmi Chopra, Advocate For the Respondent: Mr Ajay Vohra, Ms Kavita Jha & Mr Somnath Shukla, Advocates. CORAM :- HON‟BLE MR JUSTICE SANJAY KISHAN KAUL HON'BLE MR JUSTICE RAJIV SHAKDHER 1. Whether the Reporters of local papers may be allowed to see the judgment ? Yes 2. To be referred to Reporters or not ? Yes 3. Whether the judgment should be reported Yes in the Digest ? RAJIV SHAKDHER, J 1. The Income Tax Appellate Tribunal (in short the Tribunal) by a common judgment dated 29.07.2004 has disposed of cross appeals of the assessee and revenue for assessment years 1997-1998, 1998- 1999 and 1999-2000. The said judgment of Tribunal has given rise to the three (3) captioned appeals. It is important to note that while for each of the assessment years under consideration (i.e., assessment year 1997-1998, 1998-1999 and 1999-2000) the ITA Nos. 594/2005, 646/2005 & 559/2006 Page 2 of 32 Assessing Officer has passed orders (on the issue with which we are concerned in the captioned appeals) against the assessee, the Commissioner of Income Tax (Appeals) [hereinafter referred to as „CIT(A)‟] has taken a view in favour of the assessee in the assessment year 1998-99. Since the facts obtaining in the captioned appeals are common and the Tribunal has dealt with the cross appeals by a common judgment, we intend to dispose of the captioned appeals by a common judgment. 2. The assessee at the relevant time was in the business of manufacturing and sale of Indian Made Foreign Liquor (in short „IMFL‟) at the Pathankot, Punjab when, evidently, it entered into an agreement dated 06.07.1996 (in short the „said agreement‟) with a public limited company by the name of Shaw Wallace Co. Ltd. (in short „SWCL‟) for the purposes of manufacturing IMFL products under the brands owned by SWCL or its associated or related companies. The said agreement comprised of following addendums: (i) Annexure 1 provided for: General Terms and Conditions which were to operate inter-se the parties. (ii) appendix „A‟ provided for: specification of spirit. (iii) appendix „B‟ provided for: specification of demineralized water to be used for reducing the strength of spirit. (iv) Appendix „C‟ provided for: trademarks/ brand names etc. (v) Appendix „D‟ provided for: consideration to be paid by the assessee. ITA Nos. 594/2005, 646/2005 & 559/2006 Page 3 of 32 (vi) Appendix „E‟ provided for: Packing material wastage standard. 3. In so far as the General Terms and Conditions contained in annexure „1‟ to the said agreement are concerned, the following clauses would perhaps be relevant to draw out the broad obligations undertaken by the assessee. We propose to extract the same to the extent they are relevant: “2. ARRANGING FOR SPIRIT AND UTILISATION THEREOF 2.1 Shaw Wallace will supply to the UNIT sample of spirit normally used by Shaw Wallace in the manufacture of IMFL products. The sample spirit shall be in accordance with the specifications and tolerances given in Appendix „A‟. 2.2 The UNIT shall procure spirit in such form as may be agreed to by Shaw Wallace in conformity with the sample, specifications and tolerances in such quantities as may be required for the purpose of utilizing the same for the manufacture of IMFL products. 2.3 Unless otherwise agreed in writing the „spirit‟ shall mean manufactured and distilled out of raw materials molasses. 2.4 xxxx 2.5 xxxx 2.7 xxxx 3. MANUFACTURE/BOTTLING OF IMFL 3.1 The UNIT hereby undertakes to manufacture different brands of IMFL, which Shaw Wallace may specify taking into account the market condition from time to time. 3.2 xxxx ITA Nos. 594/2005, 646/2005 & 559/2006 Page 4 of 32 3.3 Unless otherwise agreed to in writing the IMFL products shall be supplied and delivered to the purchasers in bottles sealed, labeled and packed in cartons. 3.4 xxxx 3.5 xxxx 3.6 The packing material shall be as per the specifications of Shaw Wallace as regards size, shape, design, quality etc. Such packing materials shall also conform to the statutory regulations as may be laid down from time to time by the Excise and other authorities. The packing materials shall prominently display the trade/brand names of Shaw Wallace and such other brand/trade names as Shaw Wallace may designate from time to time. 3.7 The UNIT shall purchase the packing materials after getting the samples approved by Shaw Wallace and on terms to be approved by Shaw Wallace. 3.8 xxxx 3.9 xxxx 3.10 If any IMFL product is declared unsaleable in any state on account of its being under strength the UNIT undertakes to take back all such mocks and reprocess them so as to conform to the required specification. All expenses incurred in this connection will be to the account of the UNIT. If stocks are required to be taken back for other reasons, such as, sedimentation etc. the UNIT shall obtain necessary permission from the Excise Authorities for taking back such stocks and arrange for re-processing, the parties will then examine the causes of such defect and the party to bear the cost for the same will be mutually agreed upon based on the report of such examination. The intention of providing for the above terms is to ensure that only quality ITA Nos. 594/2005, 646/2005 & 559/2006 Page 5 of 32 products are sold in the market under the brand names belonging to or designated by Shaw Wallace 4. EXCISE FORMALITIES 4.1 xxxx 4.2 All excise formalities required fo the UNIT (Distillery) shall be the responsibility of the UNIT. The above shall include the registration of the labels with the Excise authorities, obtain permission from the Excise Authorities for the manufacture, bottling, blending, storage, selling and supplying of IMFL products of brands mentioned above and for the use of packing materials as per specifications and requirements of Shaw Wallace as well as for use of Shaw Wallace labels. 4.3 The obtaining of Export passes as may be necessary for the purpose of despatches of the IMFL products manufactured bottled supplied by the UNIT under this agreement shall be the responsibility of and to the account of the UNIT. The responsibility for arranging the import permits as may be necessary for arranging such despatches shall not however be the responsibility of the UNIT. 4.4 The import permits as may be necessary for the purpose of sale and supply of the IMFL products etc. manufactured from the UNIT to the purchaser shall be arranged by Shaw Wallace or the persons designated by Shaw Wallace for purchase of IMFL products. The import permits shall be sent to the UNIT along with the indents with full particulars of the type of products to be dispatched by the UNIT and the place, date and mode of such dispatch. 4.5 xxxx 5. xxxx 6. TRADE MARKS AND MARKETING ITA Nos. 594/2005, 646/2005 & 559/2006 Page 6 of 32 6.1 The trade marks, brand names, design and the get up in which the IMFL products will be sold, supplied and delivered by the UNIT and in particular and not limited to those listed in APPENDIX „C‟ hereto shall always be the sole property of Shaw Wallace or its associate or related companies as the case may be. 6.2 The UNIT hereby acknowledges and accepts that the UNIT never had nor has any right, title or interest therein and shall not at any time claim any right whatsoever to the use of the labels, brand names, trade marks and or get up of the IMFL products belonging to Shaw Wallace or to the nominees associates of Shaw Wallace except under written permission from Shaw Wallace. 6.3 Shaw Wallace hereby authorizes the UNIT as a licensee, under a separate agreement to manufacture, process package and sell the IMFL products of various brands of Shaw Wallace as contained in the APPENDIX „C‟ and such other brands as may be agreed upon from time to time for which Shaw Wallace or its associate or related or nominee company own or will own valid trademark registrations in India or otherwise which names, brands, etc. belong to or are associated with Shaw Wallace or any such other companies mentioned above. 6.4 Shaw Wallace from time to time advise the UNIT as to the marketing arrangement for IMFL of brand names belonging to Shaw Wallace or brands designated by the Shaw Wallace and the UNIT shall act in accordance with the directions of Shaw Wallace in so far as the sale of above brands of IMFL. 6.5 Nothing herein contained or implied shall be construed as precluding in any manner Shaw Wallace or its associated companies or related companies as the case may be from using or licencing the use of the said ITA Nos. 594/2005, 646/2005 & 559/2006 Page 7 of 32 trademarks or brand names or get up on any goods including IMFL in India of elsewhere. 6.6 xxxx 7. CONSIDERATION 7.1 Royalty including charges for services to be rendered by Shaw Wallace are payable by the UNIT to Shaw Wallace at the rates and in the manner set out in APPENDIX „D‟ hereto. The parties may mutually agree to revise the above changes from time to time. 7.2 The UNIT shall be liable to pay the royalty due to Shaw Wallace as specified in the agreement entered into between the parties within the time specified in APPENDIX „D‟. 7.3 No such royalty etc. shall be payable in respect of the IMFL products which are purchased by and supplied to Shaw Wallace under import permits obtained in the name of Shaw Wallace. In the case of such purchases Shaw Wallace shall pay the price of IMFL at the rate mentioned in APPENDIX „D‟. In the case o sale to Permit Holders other than Shaw Wallace the UNIT shall include in the price marketing, royalty and service charges as may be advised to the person undertaking the marketing of the IMFL products. 7.4 xxxx 7.5 xxxx 8. DURATION, TERMINATION AND CONSEQUENCES TEHREOF 8.1 xxxx 8.2 xxxx (a) Upon completion of the period of 5 years unless terminated earlier or renewed ____ the said period of five years, or (b) xxxx ITA Nos. 594/2005, 646/2005 & 559/2006 Page 8 of 32 8.3 Upon such determination of this agreement the UNIT shall cease to be a licensee or registered user of the trade marks or brand names of Shaw Wallace and shall not have any right to use such trademarks or brand names thereafter. The UNIT agrees to cease and desist forthwith from using the said trade marks, brand names, get up of Shaw Wallace and or any similar trademarks upon termination of this agreement for any reasons whatsoever in respect of the goods of Shaw Wallace or goods of the same description or any other goods. 8.4 xxxx 9. xxxx 10. xxxx 11. ASSIGMENT The UNIT shall not assign subject or part with the rights and obligations under this Agreement which are personal to the UNIT provided however Shaw Wallace may at any time designate any of its subsidiary company to undertake the work under this Agreement and be the beneficiary of the terms and conditions of this agreement. 4. At this stage it may also be relevant to note that in so far as the provision for consideration payable under the said agreement is concerned, the details are largely provided in appendix „D‟. The relevant portion of appendix „D‟ reads as follows: “CONSIDERATION 1. The prices at which Shaw Wallace will purchase IMFL products from the UNIT will be computed as under: i) Actual cost of Sprit incurred by the UNIT as per Shaw Wallace‟s direction Plus ii) Actual cost of Electricity and Water charges ITA Nos. 594/2005, 646/2005 & 559/2006 Page 9 of 32 Plus iii) Actual cost of Labour and other expenses which are incurred by the UNIT (with the prior approval of Shaw Wallace) Plus iv) Actual Excise Establishment expenses Plus v) Bottling charges at the rate of Rs 15/- per case (to be reviewed by Shaw Wallace on an annual basis) Plus vi) Packing Materials on actual basis plus wastage as per Annexure „E‟ specifying individual items of packing materials with standard allowable wastages Plus vii) Cost of chemicals for conversion at the rate of Rs 0.50 per case (to be reviewed by Shaw Wallace on an annual basis).” 2. Shaw Wallace will be responsible to sell and arrange for collection of sale proceeds and declaration forms required for sales tax to / from Direct Indentors. The payment shall be made by Direct Indentors by way of Cheque or DD in the name of the Unit. The UNIT, after deducting the value of each product at applicable rates as specified above and the amount representing the statutory dues like Sales Tax, Excise Duty etc., will pay the balance amount to Shaw Wallace (which represents Royalty/ Marketing services charges etc.) (emphasis is ours) 5. Based on transaction which have emanated from the said agreement, the authorities below have returned the following findings for each of the assessment year. We shall briefly refer to ITA Nos. 594/2005, 646/2005 & 559/2006 Page 10 of 32 the findings of each of the authorities in respect of the assessment years in issue. ASSESSMENT YEAR 1997-98 6. The Assessing Officer noted that the assessee had debited an amount of ` 84,01,160/- as payments towards royalty. The assessee had rendered its justification, as noted by the Assessing Officer, vide two letters dated 24.01.2000 and 10.03.2000. By the said letter the assessee had briefly made reference to the said agreement adverted to hereinabove by us. The assessee had indicated evidently that it had executed the said agreement due to lack of demand for its products which was, prior to the agreement, sold under the assessee‟s own brands. The assessee justified the payment on the ground that the arrangement had proved successful and beneficial for its business in as much as it had produced 61634 cases of IMFL as against 621 cases in the earlier year. The assessee went on to suggest that under the said agreement, SWCL provided brand names, sample of spirits, labels, arranged supply of raw- materials and sale through a chain of its customer, which proved beneficial to the assessee. Consequently, the assessee debited in its accounts the amount of royalty paid to SWCLin consonance with the said agreement. The assessee submitted that the amount paid was expended wholly and exclusively for its own business and hence, the expenditure incurred deserved to be allowed fully. 7. The Assessing Officer, however, disagreed with the explanation rendered by the assessee as according to him, this was a case of ITA Nos. 594/2005, 646/2005 & 559/2006 Page 11 of 32 „transfer of income‟ having been undertaken by employing a device of setting up a separate entity. The Assessing Officer came to the conclusion that the day-to-day management and control of the assessee company lay with the Shaw Wallace Group. The fact that the Shaw Wallace Group held majority shares in the assessee was not even disclosed in the audit report or, notes to the accounts or even in the tax audit report, and that, this fact emerged only during the course of assessment. The Assessing Officer compared the bottling charges, which were received by another entity by the name of Balbir Distilleries Limited located at Solan, Himachal Pradesh from SWCL, with that, which were received by the assessee. According to the findings returned by the Assessing Officer, Balbir Distilleries Ltd. received towards bottling charges ` 40 per case in 1995, while the assessee received only ` 15 per case, pursuant to the said agreement, which was decidedly executed between the assessee and the SWCL a year later, i.e., in 1996. According to the Assessing Officer this was a case of transfer of profits. 7.1 Furthermore, the Assessing Officer, on perusal of the terms of the agreement, came to the conclusion that the assessee had acquired right to manufacture and, sale of IMFL products under the SWCL brand name. The Assessing Officer was thus of the view that the payment made by the assessee towards use of trademarks, brand names, designs and get up were in the nature of capital expenditure, and that SWCL had authorized the assessee in that regard vide a separate agreement, which despite repeated directions ITA Nos. 594/2005, 646/2005 & 559/2006 Page 12 of 32 had not been produced by the assessee. Reference in this regard was made to Clause 6.3 read with appendix „C‟ annexed to the said agreement. 7.2 For the aforesaid reasons, the Assessing Officer rejected the alternative claim of the assessee to allow deduction under Section 37 of the Income Tax Act, 1961 (in short „I.T. Act‟). Furthermore, having held that it was in the nature of capital expenditure and hence not an expenditure allowable under Section 37 of the I.T. Act, the Assessing Officer concluded that the assessee had acquired patent rights for the use in its business, and therefore, the condition stipulated under Section 35A of the I.T. Act was satisfied. 7.3 The Assessing Officer went on to observe that a part of the royalty paid was excessive in nature. He proceeded, however, to restrict the expenditure to 1/14th of the amount claimed in the year in issue by invoking provision of Section 35A. Consequently, a sum of ` 78,01,077/-, being 1/14th of the claimed amount, i.e., ` 84,01,160/- was disallowed. 8. Aggrieved by the same an appeal was preferred by the assessee in respect of this aspect with the CIT(A). The CIT(A) proceeded to examine the issue with reference to the application of provisions of Section 40A(2) and Section 35A of the I.T. Act. In so far as the provisions of Section 40A(2) are concerned the CIT(A) adverted to the following: “The appellant‟s case is covered under clause (iv) of subsection (b) where a company having a substantial ITA Nos. 594/2005, 646/2005 & 559/2006 Page 13 of 32 interest in the business or profession of the assessee is covered for this purpose. The substantial interest is also defined in the Explanation thereto. According to this if a company has 20% of the voting power or more it is said to have a substantial interest. The AO has already pointed out that the majority share holding is by the SW which has not been contravened. The Ld AR further submitted that the employees of SW have the controlling share holding. Therefore, the payment of royalty to SW is covered under section 40A(2) and it has to be seen whether the payment is excessive or unreasonable.” 8.1 In conjunction with the above, the CIT(A) took note of the difference in bottling charges paid to Balbir Distilleries Ltd. as against that which was paid to the assessee. The CIT(A) sustained the findings of the Assessing Officer that this was a case of transfer pricing. Accordingly, he disallowed a sum of ` 24,70,929/- out of the total sum claimed, i.e., ` 84,01,160/- under Section 40A(2) of the I.T. Act. As regards the balance sum, i.e., ` 59,30,231/- (84,01,160 – 24,70,929) he applied the provisions of Section 35A of the I.T. Act. Thus in consonance with the provisions of Section 35A, the CIT(A) allowed 1/14th of the said amount, i.e., ` 4,23,588/-. Resultantly, the CIT(A) in fact disallowed an amount equivalent to ` 79,77,572 (24,70,929 + 55,06,643). As against this, the Assessing Officer had disallowed an amount of ` 78,01,077/-. ASSESSMENT YEAR 1998-1999 9. In this assessment year, the Assessing Officer noticed that the assessee had claimed a sum of Rs.5,67,92,000/- as royalty paid to ITA Nos. 594/2005, 646/2005 & 559/2006 Page 14 of 32 SWCL since in the immediately preceding year (i.e., A.Y. 1997-1998), the Assessing Officer had allowed only 1/14th amount towards royalty to the assessee by invoking the provisions of section 35A of the IT Act. He adopted the same methodology. Consequently, apart from a sum of Rs.4,05,671/- which was 1/14th of the amount claimed, the balance sum amounting to Rs.5,27,35,429/- was disallowed. 9.1 Being aggrieved, the assessee carried the matter in appeal to the CIT (A). The CIT (A) considered the matter from two angles. The first being: whether the payment made by the assessee for use of trademark and services rendered by SWCL was in the nature of capital or revenue expenditure? If the inquiry resulted in coming to the conclusion that the payment was in the nature of capital expenditure, whether it was covered under the provisions of Section 35 A of the IT Act. 9.2 Besides this, the CIT(A) also examined the matter as to whether the payments made to SWCL were unreasonable and hence, hit by the provisions of section 40A(2) of the IT Act. 10. In so far as the first aspect was concerned, the CIT (A) on applying the ratio of the decision of the Supreme Court in CIT Vs. Ciba of India Limited (1968) 69 ITR 692 SC came to the conclusion, after interpreting various clauses of the agreement, which interalia included, the termination clause, and clause 9 which, required the assessee to maintain strict confidence in respect of communication, correspondence, records and information, knowledge and documents falling within its domain – that at no stage did SWCL part with any ITA Nos. 594/2005, 646/2005 & 559/2006 Page 15 of 32 asset of its business. According to the CIT (A), the assessee did not acquire any asset of enduring nature; the expenditure incurred by way of royalty was for the purposes of business and hence, in the nature of revenue expenditure. A particular reference was made to the fact that expenditure was incurred by the assessee not only for use of trademark but also towards services rendered by SWCL, in connection with, quality control of “sample of spirit” provided to it, purchase of raw materials, packing materials and in obtaining import permits, etc. 11. In so far as the second aspect is concerned, i.e., whether the payments were hit under section 40A(2) of the IT Act, the CIT (A) returned the following finding of fact while disagreeing with the view taken by the CIT(A)-XIV, New Delhi vide his order dated 20.02.2001 pertaining to Assessment Year 1997-1998 :- “The second issue relates to the applicability of provisions of Sec. 40A(2). The equity capital of the appellant company as on 31.3.1997 was held by the following investment companies and individuals and number of shares held by them are indicated against their names: i) Alaknanda Manufacturing and Finance Ltd. 5,18,800 ii) Tribtis Investment Ltd. 4,50,000 iii) Manaswar Wall Investment Ltd. 3,60,000 iv) Canver Investment Ltd. 1,35,000 v) Maharashtra Distilliaries Ltd. 87,930 vi) Sh. Suraj P. Gupta 8,61,610 vii) Six individuals holding shares 10 60 ITA Nos. 594/2005, 646/2005 & 559/2006 Page 16 of 32 each It may be noted that not a single share is not held by the Shaw Wallace & Co. Ltd…..” 5.3 ….. In the instant case the payment has not been made to any director of the company or any relative of a director, partner or member who has substantial interest in the company. Shaw Wallace & Co. is not holding any equity shares in the company. Now the question arises whether the payment made to Shaw Wallace which has distant and indirect control on the assessee can be said to be a person having substantial interest in the appellant company. The expression “substantial interest” has been defined in Explanation 2 to sub-section (2) of Section 40A. A person is deemed to have substantial interest in the business or profession of such person is beneficial owner of at least 20% of equity capital in case of a company. The expression “not less than 20% of voting power” implies that the person must hold equity shares directly and not distantly.