By Sri K v. Aravind, Advocate

IN THE HIGH COURT OF KARNATAKA AT BANGALORE Dated this the 25[th]day of August, 2014| PRESENT THE HON’BLE MR. JUSTICE N KUMAR ANT) THE HON’BLE MRS. JUSTICE RATHNAKALA ITA No.1073 of 2008 !"# ITA No.72 otf ZO1ITA No.813 of 2007 ITA No.1073 ot 2008 BBRITIWE 1.)The Commissioner ot Income Tax C.R. Building Queens Road. Bangalore iaThe Assistant Commissioner ot Income Tax| Circle-12(3) C.R. Building Queens Road. Bangalore .. Appellant (By Sri K. V. Aravind, Advocate) AND: M/s. Tejas Networks India (P) Ltd.,No.58, 1[St]Main Road. o J.P. Nagar, 3[ra]Phase.Bangalore -560 078 ...Respondent (By Sri Suryanarayana T. Advocate for | M/s. King & Partridge, Advocates) This ITA is filed under Section 260-A of I.T. Act, 1961.arising out of order dated 18-07-2008 passed in ITA|No.1228/BNG/2007, tor the assessment year 2003-2004,|praying to (i) formulate the substantial questions of law|stated therein, (11) allow the appeal and set aside the order|passed by the ITAT Bangalore in ITA No.1228/BNG/2007,|dated 18-07-2008 confirming the order of the Appellate|Commissioner and Assistant Commissioner of Income Tax,|Circle 12(3), Bangalore. ITA No. 72 of ZO1 BEITWERE Ll.The Commissioner ot Income Tax-lIl Central Revenue Building Queens Road| Bangalore iaThe Deputy Commissioner of Income Tax Circle-12(4) C.R. Building Bangalore.. Appellant (By Sri E. Sanmathi, Advocate) AND: M/s. Tejas Networks Ltd.,No.58, 1[St]Main Road.J.P. Nagar, 3[ra]Phase.Bangalore -560 078...Respondent 3 (By Sri Suryanarayana T. Advocate for |M/s. King & Partridge, Advocates) This ITA is filed under Section 260-A of I.T. Act, 1961.arising out of order dated 14-10-2010 passed in ITA|No.719/BNG/2010, for the assessment year 2004-2005,|praying to (i) formulate the substantial questions of law|stated therein, (11) set aside the appellate order dated 14-10-2010 passed by the ITAT, ‘B’ Bench, Bangalore in appeal|proceedings ITA No.719/Bang/2010 as sought for in this|appeal. ITA No.813 otf 200 BETWEEN: 1.)The Commissioner ot Income taxCentral Circle C.R. BuildingQueens Road|BangaloreCentral Circle C.R. BuildingQueens Road|Bangalore iaThe Assistant Commissionerot Income Tax|Circle-12(3)C.R. BuildingQueens Road|Bangalore.. Appellantot Income Tax|Circle-12(3)C.R. BuildingQueens Road|Bangalore.. Appellant (By Sri K. V. Aravind, Advocate) AND: M/s. Tejas Networks India Ltd.,No.98, 1[st]Main RoadJ.P. Nagar, 3[ra]Phase.Bangalore -560 078...Respondent v (By Sri Suryanarayana T. Advocate for | M/s. King & Partridge, Advocates) This ITA is filed under Section 260-A of I.T. Act, 1961.arising out of order dated O8-06-2007 passed in ITANo.470/BNG/2006, for the assessment year 2002-2003,praying to (i) formulate the substantial questions of law|stated therein, (11) allow the appeal and set aside the orderpassed by the ITAT Bangalore in ITA No.470/BNG/2006,dated 08-06-2007 confirming the order of the AppellateCommissioner and Assistant Commissioner of Income Tax,Circle 12(3), Bangalore. TheseITAScomingOT)for.hearingthisN, KUMAR J‘delivered the following: day, JU DBiGMENT These three appeals are preferred by the revenue|challenging the finding recorded by the Tribunal that theexpenditure on prototype development is to be treated asrevenue expenditure and not as a capital expenditure. 2. |The assessee develops and sells leading edgeoptical networking products for worldwide customers. It hasdeveloped soitware differentiated, next generation productsthat enable telecommunication carriers to build convergednetworks that support traditional voice based services as 5 well as new data dominated services. Their product line is |marketed under the brand name TJ100. 3.In the return of income filed for the year 2003-04, the assessee has claimed a sum of Rs.6,00,608,912/- asproduct development expenses. The break up of this figure| 1S: day, JU DBiGMENT These three appeals are preferred by the revenue|challenging the finding recorded by the Tribunal that theexpenditure on prototype development is to be treated asrevenue expenditure and not as a capital expenditure. 2. |The assessee develops and sells leading edgeoptical networking products for worldwide customers. It hasdeveloped soitware differentiated, next generation productsthat enable telecommunication carriers to build convergednetworks that support traditional voice based services as 5 well as new data dominated services. Their product line is |marketed under the brand name TJ100. 3.In the return of income filed for the year 2003-04, the assessee has claimed a sum of Rs.6,00,608,912/- asproduct development expenses. The break up of this figure| 1S: Engineering charges: Rs. 27,660,045/-Employee Cost:Rs. 3,27,47,936/-Material Cost:Rs. 2,49,93,931/- All the expenses incurred by the assessee have been towardsthe development of a single product line, the TJ100 series.The assessee has spent the sums on the import of hardwarecomponents for developing prototypes, towards engineeringcost of these prototypes and for employee costs involvedtherein. The assessee also claimed that the hardware usedwas not reusable and hence was being scrapped oncompletion of activity. The components imported have been|used tor manufacturing Printed Circuit Boards required for|the equipment. Relying on the submission made by the| ; employees to the effect that these PCBs are lying in the officeand the imported components used on the PCBs areavailable in the labs in the Company, all these componentsare retained by the Company for use in Product Developmentof other TJ100 products such as TJ1OOMC, the assessingauthority came to the conclusion that all these productsenable the assessee Company to develop and manutacture aparticular product which is the mainstay of the Company’sturnover in the future years. Even aiter the product issuccessfullydevelopedandmarketed,the.hardware.purchased and the software developed are still used. Theyare used to solve any problems that may come up with theproduct when being used by the customer. Therefore, theassessing authority was of the view that the assessee hassained an enduring benefit by means of the productdevelopment expenditure. The expenditure is not merely tofacilitate the assessee’s business but expenses is used fordevelopment which earned him substantial revenues in thelater years. Therefore, treating it as a capital expenditure, w the said expenditure was added back to the income of theassessee, of course he held that the assessee can claimdepreciation. 4Agegrieved by the same, the assessee preferred anappeal to the Commissioner of Income Tax (Appeals). TheAppellate Authority proceeded on the basis that as per itsown admission, the assessee has derived an enduring benefitfrom the prototypes so developed as the same have not beenscrapped and are still used and, therefore, it upheld theassessing authority’s action of treating the expenditure ascapital. 5Agerieved by the same, the assessee preferred an appeal before the Tribunal. The Tribunal on reconsiderationof the entire material on record, taking note of the variousjudgments on which reliance was placed by both the parties,by a detailed order came to the conclusion that thetechnology in telecommunication is developing at a very fastspeed and new products are to be developed in case one has 4Agegrieved by the same, the assessee preferred anappeal to the Commissioner of Income Tax (Appeals). TheAppellate Authority proceeded on the basis that as per itsown admission, the assessee has derived an enduring benefitfrom the prototypes so developed as the same have not beenscrapped and are still used and, therefore, it upheld theassessing authority’s action of treating the expenditure ascapital. 5Agerieved by the same, the assessee preferred an appeal before the Tribunal. The Tribunal on reconsiderationof the entire material on record, taking note of the variousjudgments on which reliance was placed by both the parties,by a detailed order came to the conclusion that thetechnology in telecommunication is developing at a very fastspeed and new products are to be developed in case one has to remain in the business. The product developed ismarketed for one year only, as the next product will comebefore the end of first year of the introduction of an earlierproduct. A number of prototypes are developed but all suchprototypes are not used as model for the new product. Theprototypes, which are not finally approved for commercialproduction, are rejected and such prototypes are of no use.Only those prototypes are retained, tor which, the Companymanufactures the product. Such prototype is kept for fourto five years, so that the assessee Company is able to redressthe complaint of any customer in case any complaint isreceived. Such prototype is model of the product, which ismarketed and, therefore, it was of the view that the benefit 1s|not derived for a period of more than five years, the benefit isnot of enduring nature and expenses cannot be treated ascapital and, therefore, ultimately it recorded a finding thatthe expenditure on prototype development is to be treated asrevenue and not as capital. It also held that the expenditurein the alternative as allowable under Section 35 (1) (iv) of the Act without any discussion. Aggrieved by the said order, therevenue has filed these appeals. 6.|ITA No. 813/2007 and ITA No. 72/2011 wasadmitted to consider the following substantial questions oflaw:- lL.Whether the Tribunal was right in holdingthat a sum of Rs.6,00,68,512/- incurred for)developing a product TJ-100 having alutility value for a period of 5 years cannot)be considered as a capital expenditure and|depreciation allowed by the AssessingOfficerconfirmedbythe Appellate|Commissioner|treatingas|OmTevenueexpenditure? D2 WhethertheTribunalWasrightin|alternatively holding that the assessee’sclaim regarding expenditure is allowableunder Section 36 (i) (ww) of the Income Tax)Act even if the expenditure is held to be|capital in nature? 10 To|similar questions are framed in IIA No.| 1073/2008 which are as under:- 1.)Whether the Tribunal was correct in holding|that a sum of Rs.5,82,21,211/- incurred fordeveloping a product TJ-100 having autility value for period of 5 years cannot betreated as a capital expenditure and|depreciation allowed as held by theAssessing officer and confirmed by _ thAppellate Commissioner but should beallowed as a revenue expenditure? D2 Whether the Tribunal was correct in holding|that the expenditure allowable should be|alternatively allowed u/s.35(1)(w) of the|Act, as the same had been incurred on.scientific research related to the business|carried on by the assessee? 8. | We have heard the learned counsel appearing for the parties. — QO|Learned counsel for the revenue relying on thestatements of the officials as set out in the order oft the 11 assessing authority contended that, the components areretained by the Company for use by the Company in ProductDevelopment of other products, they are lying in the office,|they are not scrapped as contended by the assessee and,therefore, the expenses incurred towards these componentsis of enduring nature and it is in the nature of capitalexpenditure and the Tribunal was in error in holding itotherwise. — 8. | We have heard the learned counsel appearing for the parties. — QO|Learned counsel for the revenue relying on thestatements of the officials as set out in the order oft the 11 assessing authority contended that, the components areretained by the Company for use by the Company in ProductDevelopment of other products, they are lying in the office,|they are not scrapped as contended by the assessee and,therefore, the expenses incurred towards these componentsis of enduring nature and it is in the nature of capitalexpenditure and the Tribunal was in error in holding itotherwise. — 10. |Per contra, the learned counsel for the assesseesubmitted that, the expenses are incurred for upgradingtheir product every year. It is in the nature of productdevelopment expenses and, therefore, it cannot be treated asa revenue expenditure. The Tribunal was right in treating itas a revenue expenditure. 11.In the light of the aforesaid facts and the rivalcontentions, it is clear that the assessee is in the business ofdeveloping and selling leading edge optical networkingproducts for worldwide customers. It has developed software 12 differentiated,nexTgenerationproductsthatenabletelecommunication carriers to build converged networks.The life span of this product is hardly a year. Because ofcompetition in the market, the assessee has to come outwith new features every year if they want to be in the field.Theretore, there is a constant upgradation of the originalproduct. It is in that context substantial amount is spenttowards employees cost and the upgradation also includesuse of components purchased every year. In fact, thosecomponents are used for manufacturing Printed CircuitBoards. Every year these Circuit Boards under go|modification, changes. Therefore, the expenses incurred inthis regard is in the nature of revenue expenditure. 12.The Apex Court in the case ofEMPIRE JUTE COMPANY LIMITED vs COMMISSIONER OF INCOME TAX [1980 VOL. 124 PAGE 1]has held that,the decided caseshave,fromtimeTotime,evolvedVATIOUStests|fordistinguishing between capital and revenue expenditure butno test is paramount or conclusive. There is no all embracing| formula which can provide a ready solution to the problem; notouchstone has been devised. Every case has to be decided|on its own facts, keeping in mind the broad picture of the’whole operation in respect of which the expenditure has beenincurred.Further they held that,there may be cases whereexpenditure, even if incurred for obtaining advantage of'enduring benefit, may, none the less, be on revenue accountand the test of enduring benefit may break down. It is notevery advantage of enduring nature acquired by an ASSeSSee|that makes it a capital expenditure. What is material toconsider is the nature of the advantage in a commercial sense.If the advantage consists merely in facilitating the assessee’s:trading operations or enabling the management and conductof the assessee’s business to be carried on more efficiently ormore profitably while leaving the fixed capital untouched, the|expenditure would be on revenue account, even though theadvantage may endure for an indefinite future. The test ofenduring benefit is, therefore, not a certain or conclusive testand it cannot be applied blindly and mechanically without regard to the particular facts and circumstances of a givenCAaASEC regard to the particular facts and circumstances of a givenCAaASEC 13. |In fact, the Apex Court in the case of)ALEMBIC CHEMICAL WORKS CO. LITD., vs COMMISSIONER OFINCOME TAX, GUJARAT [1989 VOL. 177 PAGE 377]|heldthat,it would be unrealistic to ignore the rapid advances inresearch in antibiotic medical microbiology and to attribute adegree of endurability and permanence to the technical know-how at any particular stage in this fast-changing area ofmedical science. The state of the art in some of these areas ofhigh priority research is constantly updated so that the know-how cannot be said to be the element of the requisite degree ofdurability and nonephemerality to share the requirements and|qualifications of an enduring capital asset. The rapid stridesin science and technology in the field should make us a littleSlow and circumspect in too readily pigeon-holing an outlaysuch as this as capital. .... The tmprovisation in the procesand technology in some areas of the enterprise wassupplemental to the existing business and there was no 15 material to hold that it amounted to a new or fresh venture. —The further circumstance that the agreement pertained to aproduct already in the line of the assessee’s established|business and not to a new product indicates that what wasStipulated was an improvement in the operations of theexisting business and its efficiency and profitability not’removed from the area of the day-to-day business of the.assessee’s established enterprise. 14.We are oft the view the aforesaid statement of lawequally holds good in the area of telecommunication, may bewith more force. Having regard to the facts of this case, theexpenditure that is claimed is for upgrading the existingproduct. Therefore, the product so upgraded goes onchangingastimePIrORTesscs,Keepinginmind.the|requirement and the competition in the market. TheTribunal rightly held that the expenditure is not in thenature of capital expenditure but is revenue expenditure.Therefore, the first substantial question of law is answered infavour of the assessee and against the revenue. 16 15.In so far as the second substantial question oflaw is concerned, in fact the Tribunal has not given anyreasons and as the assessee succeeds on the firstsubstantial question of law, we are not going into the saidquestion and that question is left open to be agitated at anappropriate time in an appropriate forum. On the groundthat no reasons are given, we set aside the said finding. ckl/-| Sd/-JUDGE| Sd/- | JUDGE