Outsourced clinical trial expenditure is not eligible for weighted Research and Development deduction

Recently, the Mumbai bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Concept Pharmaceuticals Ltd. Vs. ACIT (ITA No. 1739/M/2009, 1034/M/2009) (Judgement Date: 19 November 2010, Assessment Year 2005- 06) held that outsourced clinical trial expenditure is not eligible for weighted Research and Development deduction under Section 35(2AB) of the Income-tax Act, 1961 (the Act). The Tribunal held that the expenditure on clinical trial, though the same is an integral part of scientific research, will be eligible for weighted deduction only if the expenditure is incurred on an in-house Research and Development facility.

Facts of the case

• The taxpayer is engaged in the business of manufacturing and trading of medicines, pharmaceutical formulations, bulk drug etc. for which it had set up an in-house Research and Development facility.

• For AY 2005-06, the taxpayer claimed weighted deduction of INR 36 million on scientific research under Section 35(2AB) of the Act. The claim included an expenditure of INR 1.5 million incurred on clinical trials which were conducted by external agencies since the taxpayer did not have the required facility within its Research and Development centre.

• The Assessing Officer (AO) observed that Section 35(2AB) of the Act was concerned only about in-house Research and Development facility. Accordingly, the AO disallowed the claim of INR 1.5 million on account of expenditure incurred outside the taxpayer’s Research and Development facility.

Taxpayer’s contentions

• Clinical trials and bio-equivalence studies are conducted to understand the product efficacy and its effects on human beings and animals. Since the facilities were not available in the in-house Research and Development facility, these specialized tests had to be conducted by external agencies.

• Clinical trial is an integral part of any scientific research relating to drugs and pharmaceutical development and therefore the expenditure incurred on such trials has to be allowed under Section 35(2AB) of the Act

• Explanation to Section 35(2AB) of the Act inserted with effect from  1 April 2002 removed the ambiguity whether clinical trial could be considered as part of scientific research. The Explanation clarified the position that clinical trial has to be considered as part of scientific research and therefore the expenditure incurred in relation thereto has to be allowed.

• The taxpayer placed reliance on Circular No.763 dated 18 February 1998 and Circular No.14 dated 22 November 2002 issued by Central Board of Direct Taxes (CBDT) in support of the plea. The taxpayer also placed reliance on the Gujarat High Court’s decision in the case of CIT v. Claris Life Sciences Ltd. [2010] 326 ITR 451 (Guj) and the Tribunal’s decision in case of ACIT v. Bharat Bio Tech International Pvt. Ltd. (ITA No.560-636/2007 and ITA No.1327/2008).

Tax department’s contentions

• Weighted deduction under Section 35(2AB) of the Act had been provided to give incentive for in-house Research and Development facility and since the taxpayer did not have the Research and Development facility for clinical trials and bio-equivalence studies, the expenditure incurred on outsourcing of facilities could not be allowed.

Tribunal’s ruling

• The phraseology used in Section 35(2AB) of the Act is “on in-house research or development facility” and therefore only the expenditure incurred on in-house research can be allowed under Section 35(2AB) of the Act. Accordingly, any expenditure incurred outside such facility cannot be allowed as deduction.

• The Explanation to Section 35(2AB)(1) of the Act has only clarified that expenditure incurred on clinical trial in relation to drugs and pharmaceuticals will be part of the expenditure on scientific research. The Explanation nowhere states that expenditure incurred on clinical trial even outside the in-house Research and Development facility can be allowed.

• Circulars which are relied upon by the taxpayer have only explained the provisions of Section 35(2AB) of the Act. These circulars do not provide that even expenditure incurred on clinical trial outside the in-house Research and Development facility will be eligible for weighted deduction.

• The Tribunal distinguished the decision of Gujarat High Court in the case of Claris Life Sciences Ltd. on the basis of facts.

• In the case of Bharat Bio-tech International Pvt. Ltd., which was relied upon by the taxpayer, expenditure on clinical trials conducted outside the in-house Research and Development facility had been claimed for weighted deduction. The Tribunal allowed the claim only on the ground of consistency since similar claim of the taxpayer was allowed in the earlier years. Accordingly, the decision cannot be considered as precedent on the issue of allowability of weighted deduction in respect of expenditure incurred outside the approved Research and Development facility.

• Accordingly, the Tribunal held that the expenditure on clinical trial though the same is an integral part of scientific research will be eligible for weighted deduction under section 35(2AB) only if the expenditure is incurred on an in-house Research and Development facility.

Our comments

This is an important decision of the Mumbai Tribunal wherein it has been held that outsourced clinical trial expenditure is not eligible for weighted Research and Development deduction under Section 35(2AB) of the Income-tax Act, 1961 (the Act).

The Tribunal has interpreted the wordings of Section 35(2AB) and concluded that the Section only allows weighted deduction in respect of in-house Research and Development facility. Any expenditure incurred outside the Research and Development facility would not be eligible for the weighted deduction. This decision significantly impacts existing Research and Development facilities that use external agencies to carry out clinical trials which are integral to drug research and development.