Once the Transfer Pricing Officer accepted arm’s length price of royalty payments, the Assessing Officer could not examine the reasonableness of the said expenditure for disallowance

Delhi High Court in the case of CIT Vs. Oracle India Pvt. Ltd. (ITA No. 383 of 2009, 987 of 2010, 1242 of 2010 and 1247 of 2010) held that once the Transfer Pricing Officer (TPO) has accepted a royalty payment to be at arm’s length, the Assessing Officer (AO) could not disallow the expenditure by applying Section 37 of the Income–tax Act, 1961 (the Act). The High Court further observed under Section 37 of the Act the AO had powers only to examine whether the expenditure claimed has been actually expended and was incurred wholly and exclusively for the purpose of business, and not its reasonableness, which lies solely in the domain of the businessman.

Facts of the case

• The taxpayer, a wholly owned subsidiary of Oracle Corporation, USA imported master copies of software from its parent company, duplicated them on blank discs and sub-licensed the same in the market along with relevant brochures and documents.
• The taxpayer paid a lump sum amount to its parent company for the import of the master copy of the software. It paid royalty at 30 percent of the list price of the products licensed by it. For the Assessment year 1999-00, payment of royalty amounted to INR 350.09 million
• The AO during the course of scrutiny observed that receipts from software licensing amounted to INR 596.88 million however the actual payment of royalty made was more than 30 percent of such receipts since the same was computed on the basis of list price. Hence the AO inter-alia, disallowed an amount of INR 171.02 million under Section 92 read with Section 37(1) of the Act, being the excess amount of royalty paid.
• The Commissioner of Income-tax [CIT (A)] upheld the order of the AO. The Income-tax Appellate Tribunal (the Tribunal) however, reversed the order of the CIT (A) and deleted the dis allowance.

Tax department’s contentions

• The order of the AO and the CIT (A) clearly justify invocation of the provisions of Section 92 of the Act.
• The taxpayer had arranged its affairs in such a manner that the list price was taken into consideration while calculating royalty; however the actual sales was made at a lesser price, thereby siphoning off profits to its parent company.
• The royalty payment could not be allowed under Section 37(1) of the Act as the same was on the basis of the list price and not actual sales price and no effort was made to change the basis. Thus the payment was superfluous.
• Section 92 of the Act was the second step after finding justification of the expense under Section 37 of the Act. The Tribunal erred in not examining the expenditure from the perspective of Section 37of the Act and proceeded to decide the applicability of Section 92 of the Act.

Tax payer’s contentions

• The AO had mixed up the provisions of Section 37 and Section 92 of the Act.
• Section 37 is expense oriented and the focus of this provision was to see whether the expenditure was incurred wholly and exclusively for the purpose of business to entitle same for deduction. Whereas, Section 92 of the Act is pricing oriented.
• The fact that the royalty payment was at an arm’s length price was accepted by the TPO for AY 2002-03 and AY 2003-04 (when detailed transfer pricing regulations came into effect).
• The AO, though having taken cognizance of the order of the TPO, mixed up the provisions of Section 92CA and 37 of the Act, and proceeded to disallow the expense under Section 37 of the Act thereby falling into legal error.
• Further, royalty payments were being made to the parent company on the same basis since Assessment year 1994-95 and were not questioned in those years.
• Reliance was placed on the decision of the Mumbai Tribunal in the case of Reuters India Pvt Ltd v. DCIT [2006-TII-01-ITAT-MUM-TP] (ITA Nos 1089 & 4744/Del/04)wherein it was held that where Section 92 of the Act was invoked the onus was on the AO to bring comparable cases and establish that the taxpayer was earning no profits or less than ordinary profits.

High Court ruling

• The High Court held that for invoking the provisions of Section 92 of the Act, the AO had to establish that payment of royalty resulted in no profits or less than ordinary profits which might be expected to arise in the course of business.
• The AO failed to bring out comparable cases to establish his contentions. Under the provisions of Section 92, onus in this behalf lay on the AO. This pertinent aspect coupled with the fact that the TPO had accepted the royalty payment to be at an arm’s length price (in AY 2002-03 and AY 2003-04), the AO’s contentions that the taxpayer was earning less than ordinary profits was not correct.
• Once it is held that the payment of royalty by the taxpayer is not hit be the provisions of Section 92 of the Act and the price fixed is ALP as determined by the TPO himself, there is no reason to hold that the expenses would not be allowed under Section 37 of the Act.
• The High Court held that as long the expenses were incurred wholly and exclusively for the purpose of business, no dis allowance could be made under Section 37of the Act.
• The contention of the tax department was inappropriate since the AO was not required to sit in the arm’s chair of the taxpayer and decide as to how affairs of the business are to be run. The question of commercial expediency is to be judged by the taxpayer and not by the AO as held in various legal decisions i.e. Atherton v. British Insulated and Helsby Cables Ltd. 10 TC 155 (HL),  Eastern Investments Ltd v. CIT [1951] 20 ITR 1 (SC) , CIT v. Walchand [1961] 65 ITR 381(SC)
• The AO committed serious errors in mixing the provisions of Section 92 and Section 37 of the Act.
• The High Court upheld the order of the Tribunal and deleted the dis allowance made.

Our Comments

• The principle of commercial expediency to be decided by the taxpayer and not the AO has been reaffirmed by the Delhi High Court. It has been held that to invoke Section 92 of the Act, it is the duty of the AO to establish that a particular transaction has resulted in the taxpayer earning less than ordinary profits from the business, by bringing out comparable cases. Where the TPO has accepted the arm’s length nature of the transaction, it appears that the AO cannot question the very basis / excessiveness of payment made.