Income Tax Appellate Tribunal - Hyderabad
M/S. Indigne Pharmaceuticals Pvt.Ltd, ... vs Assessee on 2 January, 2006
IN THE INCOME TAX APPELLATE TRIBUNAL
HYDERABAD "A " BENCH, HYDERABAD
BEFORE SHRI B. RAMAKOTAIAH, ACCOUNTANT MEMBER AND SHRI
SAKTIJIT DEY, JUDICIAL MEMBER
ITA Nos. 1541Hyd/2011 & 1874/Hyd/2012
Assessment Years: 2007-08 & 2008-09
M/s. Indigene Pharmaceuticals ACIT, Cir-2(1)
Jubilee Hills, Hyderabad. Hyderabad.
PAN:AAACI9956L
(Appellant) (Respondent)
Appellant by Shri PVSS Prasad
Respondent by Shri P. Somasekhar Reddy
Date of Hearing 17-12-2013
Date of pronouncement 14 -02-2014
ORDER
PER SAKTIJIT DEY, J.M:
These two appeals filed by the assessee are directed against assessment orders passed u/s 143(3) read with section 144C(5) of the Act pertaining to the assessment years 2007-08 and 2008-09. Since common and identical issues are involved in these two appeals these are taken up together and disposed of by this combined order for the sake of convenience.
2. The assessee has raised 10 grounds. Ground No.1 and 10 are general in nature hence, they do not require adjudication.
3. Ground No.2 is also dismissed as not pressed.
Ϯ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘
4. Ground No.3 is in two parts. In ground No.3(a), the assessee has challenged the addition of Rs.8,33,45,495/- by treating the arms' length price as nil.
5. Briefly the facts are, the assessee is a company registered under the Company's Act, 1956. The assessee is a subsidiary of Indigene Pharmaceuticals Inc. USA. The business activity of the assessee is in research & development works in the fields of chemicals, agrochemicals, bulk drugs etc. For the assessment year under dispute i.e. for 2007-08, the assessee filed its return of income on 26-102007 declaring a loss of Rs.14,08,78,326/-. In course of scrutiny assessment proceedings, the Assessing Officer noticing that the assessee has entered into international transaction with its AE by reimbursing an amount of Rs.8,33,45,495/- towards cost of R & D work, made a reference to the TPO, Hyderabad for determining the ALP of the transaction. During the proceedings before the TPO, he noted that as per the TP report, the assessee is a rapidly growing bio-pharmaceuticals and research oriented company engaged in the activity of developing, manufacturing and marketing of molecular combination based healthcare products for global prescription (Rx) and Consumer Health Care (CHC) markets having its research and development ( R & D) operations in Hyderabad. As per the financials for the previous year 2006-07, the operating revenue was admitted at nil and operating expenses at Rs.14,30,83,391/- which resulted in a loss of Rs.14,08,78,326/-. He noted that as per the report in form No.3CB, the international transaction with its AE Indigene Pharmaceuticals, Inc. USA pertains to the reimbursement of expenses paid for R & D project amounting to USD 18,44,154 (converted into Indian rupee at Rs.8,33,45,495). As per FAR analysis, the functions performed relates to conducting key development steps relating to the project for development and commercialisation of prioritised leads in metabolic and respiratory disorders. The principal R & D activities for the project relating to the development and commercialisation of prioritised leads in metabolic and ϯ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ respiratory disorders are being carried out by Indigene India. Only certain R & D work in the nature of special lead development steps is outsourced to Indigene USA. As the project is yet to be completed, Indigene India has not started full fledged marketing and business development efforts. However, considering the fact that the project is at advanced stage of completion and anticipating good response due to unique features, indigene India has entered into strategic partnerships with CSIR which gives Indigene the first option to commercialise CSIR's R & D in pharmaceutical products for the worldwide markets. Indigene India has established partnership with the Appollo Hospitals Group for conducting clinical studies and medical advice for Indigene's products and Indigene India made arrangements for the funds required for meeting working capital and fixed capital requirements. The main source of funds is by way of financial support from Department of Science and Technology (DST), Government of India. Indigene India used the appropriate technologies for executing the project and the choice of technologies to be used is done only by Indigene India without any input from Indigene USA. In the process of R & D activities carried out, Indigene India has outsourced certain R & D support activity in the nature of special lead development to Indigene USA on pure cost reimbursement basis towards following services:-
a) Initial Pharmaceuticals
b) Pre-clinical development studies
c) Formulation development and stability studies
d) Clinical studies
e) CGMP studies
f) Common Technical documentation
g) Global Regulatory Requirements
ϰ
/d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ
DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘
h) Any other activities related to lead candidate development
6. The TP report also stated that Indigene USA does not carry out any advance marketing function for marketing the products to be launched after completion of the project. For carrying out the R & D support activities, Indigene USA claims reimbursement from Indigene India in respect of actual cost incurred by it. Out of the R & D activities specified by Indigene India, Indigene USA outsourced some of the activities to independent consultants, institutions and companies. The TP study further stated that the entire fixed assets for R & D activities for the project are employed by the Indigene India. So far as Indigene USA is concerned, since it carries R & D activities as per the specifications of Indigene India, no specific assets are being used exclusively for carrying out R & D activities for the project. Indigene USA uses its assets which are already been employed for the purpose of its own business on need basis. It is also clear from the TP study that indigene India assumes all risks including market risk, financial risks and all other risks. In the TP study the assessee has chosen itself as tested party for transfer pricing analysis because segregation of project cost and net operating assets of Indigene USA that are attributable solely to related party transactions would be complex and unreliable. The costs incurred and the operating assets owned by Indigene India, are on the other hand, generally easily segregated and identified and therefore indigene India is the tested party. Comparable Uncontrolled Price (CUP) method has been selected as the most appropriate method because Indigene India has reimbursed expenses incurred by Indigene USA in respect of R & D work in the nature of special lead development steps. Therefore, the first step is to identify a comparable uncontrolled transaction for the reimbursements of expenses made by Indigene India to its AE. Indigene USA claims reimbursement of expenses actually incurred by it. These expenses are either incurred by Indigene USA in-house or outsourced to third parties. As such, transactions relating to actual cost incurred by Indigene USA in-house or ϱ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ by way of outsourcing to third parties are identified as comparable transactions available for the reimbursement of expenses made by assessee.
7. The TPO after going through the agreement between the assessee and its AE dated 2-1-2006 and the agreement between the assessee and the Department of Science and Technology, Government of India noted that under Development and commercialisation of prioritised leads in metabolic and respiratory disorders with the project duration of 15 months under PRDSF programme, loan of Rs.17 crores has been sanctioned to Indigene India to undertake the above said programme having project cost at Rs.24.87 crores. Out of the soft loan of Rs.17 crores sanctioned by the DST, an amount of Rs.10 crores would be disbursed at the beginning of the first year and the second instalment of Rs.7 crores would be disbursed after first monitoring meeting. As per the terms and conditions of the agreement with DST, the loan will be unsecured loan carrying a simple interest of 3% per annum and clause- 2.4 of the agreement stipulates product implementation period will be the moratorium period and will not be liable for repayment of instalments and interest. Clause- 2.6 of the agreement provides that the assessee should timely repay the loan along with instalment of interest as per the schedule notified and any delay in repayment will entail payment of penal interest @12% per annum compounded monthly for the period of delay and successive two defaults will entail recall of the total outstanding loan immediately. Clause 2.8 of the agreement specified that Industrial Partner i.e., assessee shall utilise the loan only for the purpose of the project and not for any other purpose including civil constructions and renovation of the R & D and associated facilities. Diversion of funds to other purposes will entail cancellation of the loan and immediate repayment of the outstanding loan amount with a penal interest @ 12% compounded monthly. Clause-3 of the agreement stipulates that Indigene India must have an R & D centre which has valid recognition of ϲ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ Department of Scientific and Industrial Research (DSIR), Government of India, if not registered; the firm will undertake to get the R & D centre so recognised within 12 months. The TPO observed that the assessee has outsourced certain R & D activities to its parent company Indigene USA and for carrying out such R & D activities, the AE has raised debit notes, altogether 12 in number, amounting to USD 18,44,154, which on the basis of application of CUP was found by the assessee to be within arm's length. The TPO however rejected TP study submitted by the assessee by treating it to be unreliable due to the following reasons:-
i) No record/information of uncontrolled transactions taken into account for analysing their comparability with the international transactions entered into, including a record of the nature, terms and conditions relating to any uncontrolled transaction with third parties which may be of relevance to the pricing of the international transactions is furnished.
ii) No record/information of the analysis performed to evaluate comparability of uncontrolled transactions with the relevant international transactions is furnished
iii) No record/information of the transactions further outsourced by Indigene Inc. USA in respect of the work outsourced by Indigene India is furnished
8. The TPO noted that as per the TP report Indigene India was incorporated on 24-4-2002 while Indigene USA was incorporated on 7-3-
2002 meaning thereby, both entities came into existence at the same time. He further noted that one of the conditions for availing loan under the PRDSF scheme is that the industrial partner must have an R & D centre which has valid recognition of department of Scientific and Industrial Research (DSIR), Government of India. He further noted that the intellectual property rights (IPRs) of the projects would lie with Indigene India and DST, Government of India is entitled for royalty of ϳ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ 0.5% of the net sale value of the products for a period of 10 years from the date of first sale of each product or till such time the patent rights are enjoyed. Diversion of funds to other purposes will entail cancellation of the loan and immediate payment of outstanding amount with a penalty interest at the rate of 12% compounded monthly. The TPO analysing the financials of the assessee noted that during the financial year ending March, 2006, share application money of Rs.8,70,20,000 has been received. This amount has been kept with banks which is reflected as cash/bank balances at Rs.8,47,74,281. An amount of Rs.86,04,949 has been received as advance.
9. However, the share application money and trade advance of USD 450000 have been refunded back to Indigene USA in the financial year 2006-07 and no reason has been shown why this money is returned back to Indigene USA. Indigene India from the year, 2002 has claimed that it is engaged in R & D work and as per the P & L account, some expenditure towards the same has been debited. However, in the financial year 2006- 07, R & D to the tune of Rs.8,33,45,495/- out of total operating expenses of Rs.12,59,21,902 has been claimed to have been outsourced. On considering the above fact, the TPO noted that DST has advanced soft loan to Indigene India to promote research activities within the country, in order to provide skilled employment and to boost the country's R & D capabilities. Therefore, what is the cost advantage, Indigene India gets by outsourcing R & D work to its parent Indigene USA, when it claims that it has a well established facility in the country that is, at ICICI knowledge Park, Hyderabad is not established by way of any analysis. The economic reason for outsourcing any business activity is that of lower cost in the chosen location particularly on account of manpower costs and generally the work is outsourced from developed countries to developing countries such as countries like US and UK to countries like India. He further noted that the assessee could not demonstrate that the R & D work which is outsourced to its AE cannot be undertaken in India, if not, at what cost ϴ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ the said work could have been done. He further noted that when both the parent, Indigene USA and the subsidiary, Indigene India started their operations at the same time in the respective geographies having similar capabilities and functionality, then what is the reason for which Indigene India started outsourcing its R & D work to its AE is not ascertained. He further noted that Indigene USA did not have any research facilities of its own which is evident from the fact that it has outsourced the R & D work to third parties. Further, the documents entered into between Indigene USA and such third parties are also not furnished for examination. The TPO was of the view that by claiming that the research and development work has been outsourced to third parties through its AE, Indigene USA, assessee has to substantiate the said outsourcing of work with support of proper evidence. However, no documentation is filed to prove the nexus between the so called outsourced work and the actual work carried out elsewhere so as to say that Indigene India has benefitted from such work. He further note that as per TP documentation filed by the assessee there is no functional difference between the assessee and its AE in so far as activities undertaken.
10. The TPO observed that on one hand the assessee claims that the principal R & D work of the aforesaid project is being carried out in Hyderabad and on the other hand, it claims that certain R & D work is outsourced to Indigene Inc. USA. In these circumstances, it becomes imperative to verify the claim of outsourcing of R &D work vis-a-vis transfer price of reimbursement made to AE when the assessee has undertaken to do such research work at the designated laboratory stipulated by DST for obtaining short term loan under PRDSF programme. He noted that there is no documentation available with the assessee to show that the work outsourced is work useful and identifiable with reference to the research work mandated by DSIR, Government of India. The TPO noted that agreement dated 2-1-2006 under which the R & D work was outsourced to the AE is of general nature and not a specific ϵ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ one. The agreement states that the first party i.e., the assessee would request the second party i.e. AE to conduct the key development steps on a need basis in USA and Europe. Further clause 3 of the said agreement states that the Indigene USA may carry out any of the activities which are outsourced either in its own research facilities, employing its personnel for carrying out the research activities or it can also outsource some of the activities to other consultants, institutions, and companies. However, the basis of pricing of the so called outsourced work is not spelt out in the agreement. The agreement do not indicate/mention as to which is the dedicated laboratory in which the R & D work outsourced by Indigene India is undertaken and who are the people designated to undertake the said work. The TPO therefore opined that in absence of any such documentation and verifiable information the uniqueness of the R & D work outsourced remains unexplained as the R & D work carried out is one and the same. The TPO further noted that the agreement between the assessee and its AE is silent on the issue of sharing of intellectual property rights such as patents, know-how, drug master files, dossiers, its valuation, pricing etc. Although the assessee submits that it is difficult to estimate the commercial value of the final products, but there is no documentation to verify as who has the rights over the new drug products and their marketing in India and abroad. There is no documentation available so as to verify whether any filings have been made before the regulatory authorities in India and abroad and if at all it is filed who owns the ultimate intangibles that are going to be generated out of this R & D work carried out in USA/Canada.
11. The TPO observed that the onus is on the assessee to prove the actual receipt of intra-group services from its AE and the benefits derived there from with support of proper documentation that is amenable for examination and verification. Thus, apart from documenting the aspects such as description of the business operations of the group and the taxpayer, detailed analysis of functions performed, assets employed and ϭϬ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ risk assumed etc., which are mentioned in section 92D read with Rule 10D, one must demonstrate that the service recipient is benefitted from the provision of the intra-group service and the same must be proved beyond reasonable doubt. The TPO referring to the OECD guidelines on intra group services observed that there is no documentation on record to show as to what is the quantum of work which was further outsourced out of the work outsourced to Indigene USA. It was noted by the TPO that like the assessee, its parent company Indigene USA is engaged in similar type of R & D work and has recorded sales of USD 102,166 for 31-3-2007 and USD 469,958 for the 31-3-2008. He further noted that the payment received from the assessee did not constitute the income of its parent company for the financial year 2006-07. From the aforesaid facts, the TPO inferred that if the AE has outsourced its own R & D work to third parties in USA and Canada, the taxpayer failed to explain with any cogent reasons as to why the so called research work has not been outsourced directly to third parties in USA and Canada. The TPO observed that the assessee could not substantiate with proper documentation to prove the nexus between the so called outsourced work and actual work carried out elsewhere so as to say that Indigene India has benefitted from such work. The aforesaid issues were raised in a show cause notice issued to the assessee. Though the assessee submitted a detailed reply but the TPO was not convinced with the same and concluded that no significant R & D work was undertaken by the assessee in the country against which loan has been granted by the DST. The claim of the assessee that R & D work was outsourced to its AE is not verifiable as there is no documentary evidence available with the assessee with reference to the services actually carried out and delivered. He noted that the assessee has failed to explain as to what are the benefits that are going to accrue out of such payment. Therefore, he inferred that the funds given to its AE assumes the character of loan and not expenditure. He further inferred that what are the R & D activities carried out by its AE for its own purpose and what ϭϭ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ are the activities carried out for the purposes of the assessee abroad remained unsubstantiated and if at all any R & D work was carried out it can only for the benefit of the AE and not the assessee. The TPO held that the entire outsourcing of R & D work by the assessee to its AE is a sham transaction and in reality the assessee has diverted the loan obtained from DST to its AE for purposes other than business and proceeded to determine the ALP as under:-
1) ALP payment made in the form of reimbursement to AE Nil
2) Price paid Rs.8,33,45,495
3) Excess paid being adjusted u/s 92CA Rs.8,33,45,495 After proposing such adjustment, the TPO further observed that since the funds advanced to the AE is in the nature of loan, the assessee is liable to charge interest on such advance at the rate of 14% per annum as per the prevailing market rate and accordingly determined the ALP of interest on fund given to its AE at Rs.1,16,68,369. In the aforesaid manner, the total adjustment u/s 92CA proposed by the TPO came to Rs.9,50,13,864/-
12. On the recommendations made by the TPO, the Assessing Officer completed the assessment u/s 143(3) read with section 92CA of the Act by making the addition of the amount of Rs.9,50,13,864. That besides the Assessing Officer noted that the assessee had claimed expenditure of Rs.12,59,21,902/- u/s 35(1)(i) under the head 'scientific research expenditure'. The Assessing Officer in view of the observation made by the TPO that the R & D work was carried out for the benefit of the parent company held that the expenditure claimed u/s35(1)(i) cannot be allowed and accordingly added back the same to the income of the assessee. The Assessing Officer also made further addition of Rs.46,50,544/- on ϭϮ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ account of non deduction of tax at source. In the aforesaid process, the total income was determined at Rs.8,47,07,980/- as against the loss returned of Rs.14087326/-. Being aggrieved of the draft assessment order, the assessee filed an objection before the DRP.
13. Before the DRP, the assessee challenged the finding of the TPO by raising various objections. It was specifically contended by the assessee that the entire outsourcing of the R & D work was approved by the DST as well as the expert committee of DPRP. Therefore, the conclusion arrived at by the TPO in terming it a sham transaction is without any basis. It was also contended by the assessee that it is not a fact that entire R & D activities were outsourced to the AE. In fact, the R & D work which could be carried out in the laboratories in India i.e., relating to development of innovative and intellectual property backed prescription (Rx) Medicines in the area of metabolic disorders (such as diabetes) was carried out in India. Only R & D work relating to respiratory disorder (such as Allergy Rhinitis) was outsourced to AE as no facility for such work is available in India. It was contended by the assessee that the TPO without properly verifying the documents submitted before him and without properly reconciling the actual work done by the assessee as well as by its AE should not have considered the transaction as sham and determined the ALP at Nil. The DRP after considering the submissions of the assessee negated all the contentions. The DRP endorsed the view of the TPO that the assessee was required to have R & D centre with the recognition of DSIR and soft loan of Rs.17 crores were disbursed by the DST to promote research activities in the country in order to provide a boost to R & D capability.
14. The DRP also endorsed the view of the TPO that when the global companies were on Indian territories in the field of drugs and pharmaceuticals, there is no reason why the assessee should outsource the research and development activities to the AE. Further, the DRP also ϭϯ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ noted that, as observed by the TPO, the documentation entered into between Indigene USA and third parties have not been furnished before the TPO. So far as the assessee's contention that the DST and DPRP had endorsed the outsourcing of R & D work, the DRP observed that what the DST and expert committee of DPRP had desired was conducting of R & D project in accredited and compliant laboratory under the US-FDA and European guidelines, but it never endorsed the outsourcing of R & D work to overseas laboratory. The DRP further observed that the there is no evidence brought on record by the assessee to show that it had made any efforts to locate such laboratories in India. The DRP observed that the finding of the TPO that the assessee could not demonstrate that the R & D work which was out sourced to AE could not be undertaken in India either by way of any correspondence/discussion/meetings/contracts etc., when there are several USFDA research centres/labs functioning in the country remained uncontroverted. The DRP observed that in absence of any evidence it is not clear as to how the assessee could conclude that the facilities were not available in India. With regard to assessee's contention that third party invoices should be treated as external CUP, the DRP observed that the requirement in CUP method is very strict. The assessee has not brought any transaction where an Indian entity had outsourced the work to an independent party in USA. As pointed out earlier, the documentation entered between Indigene USA and third parties have not been furnished before the TPO. The TPO has pointed out that as per the agreement dated 2-1-2006 the R & D work outsourced was general in nature. The agreement did not specify either the dedicated laboratory or the designated people for carrying the outsourced work and it becomes important in view of the fact that the activities carried out by the assessee and the AE were similar in nature. The TPO has pointed out on page 30 of the order that the man power in the invoices consisted of employees and consultants of its AE. In view of similarity of work carried out by the assessee and its AE, it becomes important to know as to how ϭϰ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ the cost has been allocated between the two. The DRP on the basis of the aforesaid facts finally concluded that the finding arrived at by the TPO cannot be interfered with. The DRP further went on to observe that even assuming that the reimbursement of expenditure is within arm's length, the expenditure cannot be allowed as there is no compliance of provisions contained u/s 195 of the Act. The DRP held that the payment made towards research and development work is in the nature of fees for technical services requiring deduction of tax at source as per section 195 of the Act. Since the assessee has not deducted any tax at source, the expenditure is not allowable as per section 40(a)(ia) of the Act. Accordingly, the DRP upheld the addition of Rs.8.33 crores.
15. The learned AR submitted that in the year 2003 to 2006, R & D work relating to Phase-A of the Project was carried out. The appellant has submitted all the documents in connection with R&D expenses incurred like proposal to DST for phase B portion of the project, loan agreement, minutes of expert committee meetings, summary of project progress reports etc before the Ld TPO during the course of hearing. It was submitted, as part of assessee's global development and regulatory registration plan the joint expert team consisting of officials of the Drugs & Pharmaceuticals Research Programme (DPRP) and the appellant had decided that all development work was to be conducted in India and abroad. This was done to ensure that all the development work and corresponding results are in compliance with international drug development and registration standards. This was very important to ultimately seek the approvals from the Drug Controller General of India and US FDA in the US, EMEA in Europe where the regulatory hurdles are very stringent. It was to ensure that development work is done only in accredited laboratories and testing facilities. The joint team identified that the new drug candidate for the treatment of diabetes shall be conducted in India and the new drug candidate for treatment of respiratory disorders shall be conducted abroad. The selected CMC, pre clinical and clinical safety and efficacy studies of the project were to be conducted in only accredited and compliant laboratory and testing facilities under the US-FDA and European guidelines in order to avoid any undue ϭϱ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ repetition of work done due to non compliance reasons. Therefore the appellant outsourced to Indigene USA to manage and coordinate select studies of the project relating to respiratory disorders. It was submitted under Phase B of the development program two drug product candidates were prioritized for further development for treatment of diabetes and related complications. It is to be appreciated here that the loan proposal submitted by the appellant to the Department of Science and Technology clearly specifies that all the research related work will be conducted in accredited facilities under US-FDA guidelines. The R&D work for treatment of diabetes and its complications was to be conducted in India, since the appropriate facilities that meet international standards are available in India, R&D work relating to respiratory disorders was conducted outside India as the appropriate facilities that meet international standards were not available in India. Hence part of R&D work was conducted in India and part outside India. It was submitted that the assessee had submitted documents before the TPO and the reasons why R&D work pertaining to allergic rhinitis disease was outsourced outside India. Both DPRP and DST have duly acknowledged the fact that the R&D activities need to be carried out outside India to meet regulatory requirements. He submitted that it is to be appreciated that as per the Joint Committee (Expert Committee under Drugs & Pharmaceuticals Research Programme (DPRP) and the Assessee's R&D team) the CMC, pre clinical and clinical safety and efficacy studies of the project were to be conducted in only accredited and compliant laboratory and testing facilities under the US-FDA and EMEA guidelines. This was done to avoid any undue repetition of the work done due to non- compliance reasons. Any repetition of work due to non-compliance reasons would result in significant delay and increased cost. Therefore in order to mitigate both time and cost overrun in the project Indigene India had outsourced selected studies of the project to Indigene USA. It is also to be kept in mind that the proposal submitted by the assessee to Department of Science and Technology for securing the loan clearly specifies that all CGMP, GLP, GCP work / will be conducted in the accredited facilities under US FDA guidelines.
16. It was submitted, the actual cost of R&D work associated with Phase B has ϭϲ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ been conducted either in house in India or outsourced to third parties by Indigene USA. The third parties in USA have billed to Indigene USA and Indigene USA in turn has billed Indigene India on cost-to-cost basis. There is no profit mark up and as of date no revenues are generated from this project. It was submitted that only after successful development of any Rx Drug from this project and after the developed product receives regulatory approval from the appropriate regulatory authorities for marketing of the product, then only it is possible to commercialise the product and result in revenue generation. Learned AR submitted, the agreement by and between Indigene (India) and Indigene (USA) clearly indicates that any revenues generated from the project would be shared on a pro-rata basis and it would be based on each party's total expenses incurred for the completion of the project which would include Phase A, Phase B, Phase C and Phase D. The very fact that the DPRP and DST have duly acknowledged that R&D activities need to be carried out outside India to meet regulatory requirements is an indicator that R&D work needs to be outsourced. The fact that DST has advanced an amount of Rs 17 crores is an indicator about the genuineness of the project. The DST being a Govt. of India department would not make an advance of Rs 17 crores without going into the details of the project, activity of the company, the purpose for which it was set up, background of the directors etc. He submitted, the assessee has given copies of invoices raised by the AE on third parties. These third parties are independent entities and are in no way related to the AE. It is also very difficult to physically demonstrate the benefits received by the assessee from its AE. The benefits of R&D would be known only after the product is launched in the long run. With regard to the allegation of the TPO that AE does not own any R & D facility in USA and further assessee could not with proper evidence substantiate why research activity could not be carried out in India, the learned AR submitted, it is not ϭϳ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ necessary that tax payer or the AE should own R&D facility. The fact is that the work was undertaken with the help of third parties who are consultants and the work was carried out by them in hired facilities. He submitted that various submissions and documentation furnished would show that only R&D activities pertaining to respiratory disorders were outsourced whereas other R&D activity was carried out in India only. What could not be carried out in India was only outsourced and not the entire activity. This is evident from the fact that even in India substantial amount of R&D expenditure was incurred. It was submitted, all documentary evidence in the form of debit notes, agreements with AE showing details of expenses incurred were submitted to the TPO. Learned AR submitted that the test of commercial expediency for determining whether the expenditure was necessary and reasonable has to be adjudged from the point of view of the businessman and not of the revenue. Expenditure can never be linked to the income earnings ability or the value addition the expenditure has bought into the business as the same cannot be quantified. Hence, the legitimacy of expenditure cannot be questioned. In support of such contention, the learned AR relied upon the following decisions:-
i) Mumbai ITAT in the case of Dresser-Rand India (P) Ltd Vs Addl.CIT (2011) 47 SOT 423 (Mum)
ii) Delhi High Court in the case of CIT Vs EKL Appliances (ITA No's 1068/2011 & 1070/2011)
iii) Hyderabad Bench in case of Social Media India Ltd. Vs. ACIT (ITA No.1711/Hyd/2012 dated 4-10-2013.
17. The learned DR strongly supporting the reasoning of the TPO submitted that agreement between the assessee with its AE is of general nature. There is no condition in the agreement with regard to the rights of the parties so far as confidentiality is concerned. Both the assessee ϭϴ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ and the AE are engaged in same activity. Hence, there is no reason to outsource the work to AE, more so when AE itself is not doing itself but is getting it done by further outsourcing. He submitted that, the DST of Govt. Of India has given unsecured loan of Rs.17 crores at a very low rate of interest which was diverted by the assessee to its AE apparently without any business purpose and solely for the benefit of AE. The learned AR referring to the proposal for loan at page 60 of paper book submitted that research in Respiratory Disorder was an ongoing project in India. It was submitted that there is no mention in the proposal that R & D work will be done in USA. He submitted, documentation submitted to DST is totally silent about outsourcing. The learned DR submitted that immediately after loan was sanctioned the assessee refunded back the advance and share application money to its AE, which shows that loan amount was utilised for the benefit of AE. He submitted that, the discussions made by the TPO in his order clearly establish that it was diversion of funds for non business purpose. The assessee has neither established the cost advantaged or benefit derived by producing proper documentation and evidence before the TPO. Apart from producing some debit notes raised by AE and some invoices the assessee has not produced any other evidence to prove that R & D work was actually outsourced or the AE has actually carried out such R & D work outsourced to it. Therefore, it was submitted by the learned DR that since the TPO has clearly established on record that none of the transactions are at arm's length the adjustment made is justified.
18. We have heard the parties at length and considered elaborate submissions made before us at the time of hearing as well as through written submissions. We have also perused the order of the authorities below and other relevant materials on record. The Company had a project associated with the Research and Development of Innovative and Intellectual Property backed Prescription (Rx) Medicines in the areas of Respiratory Disorders (such as Allergy Rhinitis) and Metabolic Disorders (such as Diabetes) for global ϭϵ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ markets. Initially the R&D efforts of this project have been initiated as part of Phase A of the project during 2003 to 2006. During the Financial Year 2007-08, under Phase-B of the project, there were two types of R&D work carried out viz., the Rx drug candidate for the effective treatment of Diabetes (Metabolic Disorders); and the new Rx drug candidate for the effective treatment of Allergic Rhinitis (Respiratory Disorders). During the financial year 2007-08 under Phase-B, there were two types of R & D works carried out relating to molecular combination based healthcare products for global prescription(Rx) and consumer health care (CHC) markets. On perusal of the order of the TPO as well as DRP, it becomes abundantly clear that they have refused to accept the transaction as genuine on the following reasons:-
I) The assessee has not shown the reasons why it had returned back the share application money of Rs.8,70,20,000 and advance of USD 450000 to its AE. Whereas it has taken loan of Rs.17 crores from DST out of which an amount of Rs.8,33,45,495/- paid to the AE towards reimbursement of expenses.
II) The assessee has not substantiated what is the cost advantage in outsourcing the work to the AE when it is claimed that it is well established facility at Hyderabad for undertaking such activities. III) The assessee could not demonstrate that the R & D work outsourced to its AE cannot be undertaken in India. IV) The assessee has not supplied documents entered into between Indigene USA and third parties with regard to the outsourcing of work by Indigene USA to third parties.
V) There is documentation available which could show that the work outsourced is like useful and identifiable with reference e to the research work mandated by the DST of Government of India. VI) The basis of pricing of outsourcing had not been spelt out in the agreement.
19. It is further held that as per the OECD guidelines, the assessee has to show that it has benefitted from the provisions of entire group services. There is no documentation on record to show as to what is the quantum of work outsourced by Indigene USA to third parties. The man power as per the documents furnished is mostly confined to consultants ϮϬ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ of Indigene USA who are on pay rolls of Indigene USA. These persons are engaged by Indigene, USA for own research work. Therefore, when the personnel are doing the same nature of work, it is not known how the cost of employees is apportioned between Indigene USA and Indigene India when there is no difference between Indigene, USA and Indigene India. When the man power cost is as high as 1200 USD per man day in USA compared to USD 100 per man day in India, what is the rationale behind spending such huge amount by the assessee vis a vis benefit derived from such outsourcing. It is held, in the garb of reimbursement of R & D outsource, the assessee has actually diverted its funds to its parent company for its research and development activity. Hence, the transaction is nothing but a sham transaction. In other words, it is a simple loan transaction. Out of the total amount of Rs.17 crores sanctioned by the department of Science and Technology, the assessee has refunded an amount of Rs.8,70,20,000/- to its AE on account of share application money and balance amount of Rs.8,33,44,475/- has been diverted in the garb of R & D work which in reality was never outsourced. The funds available from DST are placed at the disposal of the parent company while interest at the rate of 3% was paid to the DST. As against this, it is the contention of the assessee that the assessee has submitted all documents in connection with R & D expenses before the TPO. It is contended that the assessee has taken a business decision of conducting the development work in India and abroad to ensure that all development work is in compliance with the standard fixed by the Regulatory Authorities. It is also contended by the assessee that the DST and the monitoring committee have endorsed such outsourcing of work to its AE.
20. A perusal of the loan agreement between the DST and assessee, relevant clauses of which have been dealt with herein before, show that there is no restriction in the 'agreement' that the research and Ϯϭ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ development work cannot be outsourced to an outside country. Only thing it says is, the assessee must have arranged the facility with the regulatory standard to undertake such R & D income. It is the contention of the assessee that the entire R & D work was not outsourced but only a portion of work i.e. relating to Respiratory disorders has been outsourced to the AE as no facilities are available which comply to the standard of US and European Regulatory Authority in India. In this context, it is to be noted that the TPO as well as the DRP have held that outsourcing of research and development work was in violation of the agreement entered into with the DST.
21. It is not disputed that the entire project of R & D was under
the aegis of DST. It is also a fact that the DST and the monitoring committee review the progress of the project undertaken by the assessee at regular intervals. This is very much evident from the minutes of meeting of the monitoring committee and progress report which are placed in the paper book. On a perusal of the minutes of midyear monitoring committee meetings of the project, held on 18- 11-2006 and 8-8-2007, copies of which are at pages 130 and 133 of paper book, certainly gives an impression that the monitoring authority was aware of part of R & D work being carried out abroad. The minutes further make it clear that being satisfied with the progress of the project it recommended release of balance amount of loan. The minutes also reveal that the monitoring committee was also satisfied with regard to utilisation of loan sanctioned by the DST. It is also a fact that the assessee has submitted the final project report (copy at page 152 of paper book for assessment year 2008-09) to the concerned authority. This project report mentions in detail about the result of R & D work undertaken with the financial assistance of DST. The said report clearly mentions about ϮϮ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ undertaking clinical trials in Switzerland and Germany. From these facts, it has to be understood that the DST as well as the monitoring committee were kept posted with all facts relating to the project and they were aware of the fact that a part of the project is carried out abroad. The authorities are also aware of utilisation of loan amount. However, neither the DST nor monitoring committee had ever alleged that the loan amount was diverted to purposes other than for which it was sanctioned. Clause 2.8 of the agreement entered with DST authorises it to recall the loan if the assessee utilises it for any purpose other than the project. Had there been any violation of the terms of loan agreement, the DST would certainly have recalled the entire loan amount for violation of loan condition. Nothing of that sort has happened as appears from the materials on record. Therefore, when neither the DST nor the monitoring committee have made any adverse remark with regard to the R & D activity carried on by the assessee itself or by outsourcing to its AE, the TPO or DRP cannot term the transaction between the assessee and its AE as sham merely on presumption without bringing any cogent evidence to prove so.
22. When the assessee has taken a business decision of outsourcing a part of the R & D activity it is not for the department to question it. It is for the assessee to decide what is best for his business interest. The department cannot step into the shoes of a businessman and ask him to conduct his business in a particular manner or advice him what to do or not. The Income-tax Appellate Tribunal, Mumbai Bench in case of Dresser Rand P. Ltd. Vs. Addl. CIT (supra) has held as under:-
"" We find that the basic reason of the Transfer Pricing Officer's Ϯϯ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ determination of ALP of the services received under cost contribution arrangement as 'NIL' is his perception that the assessee did not need these services at all, as the assessee had sufficient experts of his own who were competent enough to do this work. For example, the Transfer Pricing Officer had pointed out that the assessee has qualified accounting staff which could have handled the audit work and in any case the assessee has paid audit fees to external firm. Similarly, the Transfer Pricing Officer was of the view that the assessee had management experts on its rolls, and, therefore, global business oversight services were not needed. It is difficult to understand, much less approve, this line of reasoning. It is only elementary that how an assessee conducts his business is entirely his prerogative and it is not for the revenue authorities to decide what is necessary for an assessee and what is not. An assessee may have any number of qualified accountants and management experts on his rolls, and yet he may decide to engage services of outside experts for auditing and management consultancy; it is not for the revenue officers to question assessee's wisdom in doing so. The Transfer Pricing Officer was not only going much beyond his powers in questioning commercial wisdom of assessee's decision to take benefit of expertise of Dresser Rand US, but also beyond the powers of the Assessing Officer. We do not approve this approach of the revenue authorities. We have further noticed that the Transfer Pricing Officer has made several observations to the effect that, as evident from the analysis of financial performance, the assessee did not benefit, in terms of financial results, from these services. This analysis is also completely irrelevant, because whether a particular expense on services received actually benefits an assessee in monetary terms or not even a consideration for its being allowed as a deduction in computation of income, and, by no stretch of logic, it can have any role in determining arm's length price of that service, When evaluating the arm's length price of a service, it is wholly irrelevant as to whether the assessee benefits from it or not; the real question which is to be determined in such cases is the price of this service is what an independent enterprise would have paid for the same. ;.. Similarly, whether the AE gave the same services to the assessee in the preceding years without any consideration or not is also irrelevant. The AE may have given the same service on gratuitous basis in the earlier period, but that does not mean that arm's length price of these services is 'nil'."
The Hon'ble Delhi High Court in case of CIT vs. EKL Appliances Limited (24 Taxman . com 1999) held as under:-
Ϯϰ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ "19. There is no reason why the OECD guidelines should not be taken as a valid input in the present case in judging the action of the TPO. In fact, the CIT (Appeals) has referred to and applied them and his decision has been affirmed by the Tribunal. These guidelines, in a different form, have been recognized in the tax jurisprudence of our country earlier. It has been held by our courts that it is not for the revenue authorities to dictate to the assessee as to how he should conduct his business and it is not for them to tell the assessee as to what expenditure the assessee can incur. We may refer to a few of these authorities to elucidate the point. In Eastern Investment Ltd. v. CIT, (1951) 20 ITR 1, it was held by the Supreme Court that "there are usually many ways in which a given thing can be brought about in business circles but it is not for the Court to decide which of them should have been employed when the Court is deciding a question under Section 12(2) of the Income Tax Act". It was further held in this case that" it is not necessary to show that the expenditure was a profitable one or that in fact any profit was earned". In CIT v. Walchand & Co.
etc., (1967) 65 ITR 381, it was held by the Supreme Court that in applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of business, reasonableness of the expenditure has to be judged from the point of view of the businessman and not of the Revenue. It was further observed that the rule that expenditure can only be justified if there is corresponding increase in the profits was erroneous. It has been classically observed by Lord Thankerton in Hughes v. Bank of New Zealand, (1938) 6 ITR 636 that "expenditure in the course of the trade which is un-remunerative is none the less a proper deduction if wholly and exclusively made for the purposes of trade. It does not require the presence of a receipt on the credit side to justify the deduction of an expense". The question whether an expenditure can be allowed as a deduction only if it has resulted in any income or profits came to be considered by the Supreme Court again in CIT v. Rajendra Prasad Moody, (1978)115 ITR 519, and it was observed as under:-
"We fail to appreciate how expenditure which is otherwise a proper expenditure can cease to be such merely because there is no receipt of income. Whatever is a proper outgoing by way of expenditure must be debited irrespective of "whether there is receipt of income or not. That is the plain requirement of proper accounting and the interpretation of Section 57(iii} cannot be different. The deduction of Ϯϱ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ the expenditure cannot, in the circumstances, be held to be conditional upon the making or earning of the income."
It is noteworthy that the above observations were made in the context of Section 57(iii) of the Act where the language is somewhat narrower than the language employed in Section 37(1) of the Act. This fact is recognized in the judgment itself. The fact that the language employed in Section 37(1) of the Act is broader than Section 57(iii) of the Act makes the position stronger.
20. In the case of Sassoon J. David & Co. Pvt. Ltd. v. CIT, (1979) 118 ITR 261 (SC), the Supreme Court referred to the legislative history and noted that when the Income Tax Bill of 1961 was introduced, Section37(1) required that the expenditure should have been incurred "wholly, necessarily and exclusively" for the purposes of business in order to merit deduction. Pursuant to public protest, the word "necessarily" was omitted from the section.
21. The position emerging from the above decisions is that it is not necessary for the assessee to show that any legitimate expenditure incurred by him was also incurred out of necessity. It is also not necessary for the assessee to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred "wholly and exclusively" for the purpose of business and nothing more. It is this principle that inter alia finds expression in the OECD guidelines, in the paragraphs which we have quoted above.
22. Even Rule 10B(1)(a) does not authorize disallowance of any expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same or that in the view of the Revenue the expenditure was un-remunerative or that in view of the continued losses suffered by the assessee in his business, he could have fared better had he not incurred such expenditure. These are irrelevant considerations for the purpose of Rule l0B. Whether or not to enter into the transaction is for the assessee to decide. The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allowability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the assessee has suffered continuous losses. The financial health of assessee can never be a criterion to judge allowability of an expense; there is certainly no authority for that. What the TPO has done in the Ϯϲ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ present case is to hold that the assessee ought not to have entered into the agreement to pay royalty/ brand fee, because it has been suffering losses continuously. So long as the expenditure or payment has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning. As provided In the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and suitable adjustment but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorized".
Following the aforesaid decision of the Hon'ble Delhi High Court, the Income-tax Appellate Tribunal Hyderabad Bench in case of Social Media India Limited vs. ACIT (ITA No.1711/Hyd/12 dated 4-10-2013 held as under:
" 11. The principles laid down by the Hon'ble Delhi High Court in the aforesaid case equally apply to the facts of the case under consideration. The TPO has to examine the price paid by the assessee and determine the ALP under the provisions of Transfer Pricing and its Rules. It does not authorize the TPO to disallow any expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same nor on the reason that the assessee has not justified the benefit principle. For these reasons, we are not inclined to approve the action of TPO/DRP. However, since they have not examined that this expenditure is only reimbursement of expenditure. In order to examine this aspect, we direct the AO to examine the nature of expenditure and if the amount is only reimbursement paid through AE to third party for their services, we direct the AO to allow the expenditure as claimed after due verification. With these directions the orders of the TPO and DRP on the issue are set aside and examination of the expenditure/claim of reimbursement is restored to the file of the AO. The grounds 5 to 7 raised on this issue are allowed for statistical purposes.
23. If we apply the principles laid down as aforesaid, the only thing that the TPO is required to examine is whether the payment made to AE towards reimbursement of R & D expenditure is within arm's length. With regard to the question raised by the TPO and DRP to the effect that USFDA compliant laboratories when are available in India what is the Ϯϳ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ need for outsourcing such work, the specific contention of the assessee is there are no such facility available in India for research and development work of respiratory disorders. Therefore, when the department is contradicting such contention then it is for the department to bring on record material to show that such facilities are available in India and what would be cost of research and development work with regard to this particular research work. In the aforesaid circumstances, we are of the view that without bringing sufficient evidence on record to prove that the transaction between the assessee and its AE is not genuine, the conclusion arrived at by the TPO/DRP that it is a sham transaction, cannot be accepted. Of course, it needs to be mentioned that TPO as well as DRP have noted that the assessee neither produced any documentation or any other evidence to substantiate its claim that reimbursement of expenditure to AE is within arm's length. In that case, TPO has ample power to call upon the assessee to produce necessary documents or he can himself obtain information by means of necessary enquiry. If the assessee fails to justify the CUP applied by it then it is open for the TPO to adopt any other method as provided under the statute to find out the arm's length price of the expenditure incurred. However, it is the contention of the assessee that the invoices between the AE and other third parties in USA/Canada are there which can be considered as external CUP. On a perusal of the order of TPO it becomes absolutely clear that in his effort to justify the transaction as not genuine, the TPO has failed to examine and make necessary enquiry to find out whether the expenditure incurred towards outsourcing R & D work is within arm's length. Considering the totality of facts and circumstances, we are of the view, the TPO is required to examine this aspect thoroughly and in detail. The assessee also has to justify its stand that internal/external CUP provided would be an appropriate indicator towards arm's length price charged. We therefore remit this issue to the file of the Assessing Officer/ TPO to examine it thoroughly by calling from Ϯϴ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ the assessee necessary documents as may be considered appropriate by the TPO. The TPO may also make enquiry on his own, if deemed necessary, to find out comparable cases of similar nature which can help him in deciding whether the cost reimbursed is within the arms length or not. However, the TPO must confront the assessee the result of such enquiry and allow reasonable opportunity to put forward his contention. With the aforesaid observation, we remit this issue to the file of the Assessing Officer/TPO who shall decide afresh after affording a due opportunity of being heard to the assessee.
24. So far as the DRP's conclusion that expenditure incurred by the assessee needs to be disallowed u/s 40(a)(i) is concerned, in our view the DRP has completely misdirected itself while coming to such conclusion. A perusal of the certificate dated 6-7-2007 issued by the DCIT, Circle 2(1), Hyderabad a copy of which is at page 186 of paper book, clearly shows that assessee was permitted to pay an amount of Rs.20 crores to its AE towards reimbursement of expenditure incurred on assessee's behalf without deducting tax at source. That being the case, no disallowance could be made u/s 40(a)(ia). That apart it is the consistent stand of the assessee that reimbursement of expenditure is on cost to cost basis and there is no income to the AE. That apart, payment is towards services rendered outside India. In these circumstances, conclusion of the DRP is untenable.
25. Ground No.3(b) reads as under:-
" The learned ACIT/DRP is not justified in law in observing that the assessee company is still in the pre-commencement Ϯϵ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ stage and thereby disallowing the entire scientific research expenditure incurred in India amounting to Rs.4,25,76,407"
26. Briefly the facts are, during the scrutiny assessment proceedings, the Assessing Officer noticed that the assessee had claimed deduction of Rs.12,59,29,902/- under the head 'scientific research expenditure' u/s 35(1) (i). When the assessee was asked to justify the deduction claimed by the Assessing Officer the assessee submitted that it has been incorporated mainly to carry on research and development work in the fields of chemical, agrochemical bulk, drugs, pharmaceuticals and biological products. It was submitted that the company has focussed on discovery, developing and delivering molecular combination base, health care product (multiceutics) for global prescription (RX) and consumer health care (chc) markets. It was submitted that during the previous year the assessee has carried out research and development activity only. It was stated that the project is not only unique but also rare as no other Indian Pharmaceutical company has yet developed and commercialised a new innovative drug for global market particularly to meet the regulatory requirements of USFDA and European (EMEA) Authorities. After considering the submissions of the assessee, the Assessing Officer though accepted that the assessee is engaged in scientific and development activity which is also the object of the company as per the memorandum and articles of association, he however noted that as per the P & L account, the assessee had admitted interest income of Rs.33.87,799/- and credit balance written off of Rs.7808/-. No business income was offered for taxation. The Assessing Officer therefore opined that as the assessee company is not conducting ϯϬ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ any business activity therefore the question of engaging itself in research activity to facilitate development of such business activity does not arise. The Assessing Officer on interpreting the provision of section 35(1) opined that the deduction shall be admissible when any expenditure, not being in the nature of capital expenditure and it is incurred on a scientific research which must be related to the business carried on by the assessee. Therefore two conditions have to be fulfilled.
(i) There must be a business carried on by the assessee and (ii) scientific research must relate to the said business.
27. The Assessing Officer noted that the scientific research relating to business as defined u/s 43(iv)(iii)(a) would mean that it includes the cases of scientific research which may lead to facilitate an extension of that business of the assessee. However, in the instant case, the assessee is engaged in scientific research activity which is catering to the needs of business carried on by the AE. He therefore held that the relationship of the said expenditure on scientific research which is not in connection with the assessee's business but for others is not covered u/s 35(1)(i) of the Act. He therefore disallowed the total expenditure of Rs.12,59,21,902/- including the expenditure of Rs.4,25,76,407/- relating to research activities in India. The assessee objected to such disallowance before the DRP. The DRP after considering the submissions of the assessee was of the view that as per section 35(1) of the Act only in case where in house research relates to its business, the same can be allowed. The pre-commencement period expenses for the earlier three years before commencement of business are deductible in the previous year in which the business is commenced. The DRP further ϯϭ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ observed that in order to claim deduction the assessee should produce the certificate from the prescribed authority i.e. DGIT(E) in concurrence of Secretary, department of Science and Technology. The DRP further observed that even with regard to capital expenditure for in-house research conducted, the pre- commencement period expenses is to be allowed as per explanation to section 35(2)(i)(a). The DRP observed that as per the assessee's own admission, business receipts are yet to flow in hence the expenditure relates to the pre commencement period. The DRP observed that to the extent that the business has not commenced i.e., the commercialisation of the product has not been commenced. The pre-commencement expenditure revenue expenditure is governed by the provisions of section 35(1) and in so far as the conditions laid down therein are not fulfilled the entire expenditure of Rs.12.59 crores cannot be allowed as deduction. The fact that the commercialisation of the product has not commenced is evident from the cost contribution arrangement (CCA) submitted by the assessee.
28. The DRP finally concluded that the pre-commencement expenditure on R & D relating to the first three years, to the extent certified by the prescribed authority is to be deemed as expenditure allowable in the previous year in which the business commences and not in the present assessment year. The DRP therefore upheld the disallowance of expenditure claimed u/s 35(1) of the Act. However, DRP held that since the amount of Rs.8,33,45,495/- has already been added to the income of the assessee by virtue of TP adjustment u/s 92CA, the same addition cannot be made again. The DRP therefore confirmed the disallowance of Rs.4,25,76,407/-.
ϯϮ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘
29. The learned AR submitted before us that the expenditure claimed by the assessee is revenue in nature since it is incurred in connection with research and development and would fall under ambit of expenditure on scientific research and therefore would qualify as eligible expenditure to be claimed u/s 35(1)(i) of the Act. It was submitted that since the entire expenditure relates to the assessee's business only it is allowable as expenditure. Without prejudice to the aforesaid submissions, the learned AR submitted that in section 35(1)(iv) of the Act, the expression used is "expenditure of a capital nature" which has a wider import than the words capital expenditure used in section 35(1)(i) of the Act. Therefore, it would bring within its purview all expenditure which are treated to be capital in nature. Since the Assessing Officer has treated the expenditure as capital in nature, it is allowable u/s 35(1)(iv). The learned AR submitted even as per the meaning of scientific research, provided u/s 43(4) the expenditure incurred by the assessee on research and development is an eligible expenditure. In this context, the learned AR relied upon the decision in case of Ayushakti Ayurved P Ltd. Vs. ACIT (37 SOT 313) wherein the Income-tax Appellate Tribunal, Mumbai Bench held that the object behind the enactment of section 35 of the Act is to encourage research and development activities. As an incentive, the legislature has given this benefit by way of deduction in respect of the capital expenditure incurred by the assessee. The provision being for the benefit of the assessee, if the assessee incurs capital expenditure for the purpose of research and development then revenue should not deprive the assessee of the benefit of deduction under the provisions of section 35 of the Act. The assessee also relied upon the decision of Mumbai Tribunal in the case of ϯϯ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ Transweigh (India) Limited vs. ITO (22 SOT 338). The learned AR further submitted that in the subsequent assessment year i.e., Asstt. Year 2008-09 though the assessee has claimed similar deduction of expenditure, the Assessing Officer has allowed the expenditure incurred in India. With regard to the observation of the DRP regarding the approval of DSIR, the learned AR submitted that the same is required in the case of weighted deduction.
30. The learned departmental representative, on the other hand, supported the orders of the Assessing Officer and the DRP.
31. We have heard the submissions of the parties and perused the material on record. On a perusal of the orders of the Assessing Officer and DRP, it is to be noted that while the Assessing Officer has disallowed the deduction claimed by holding that it does not relate to the business of the assessee, the DRP has sustained the disallowance by observing that the expenditure relates to pre- commencement period of business. However, it is the specific contention of the assessee that there is no dispute to the fact it has commenced its business. It is further contention of the assessee that not generating income does not mean that the assessee has not commenced its business. After considering the submissions of the parties in the context of the materials on record, we are of the view that the finding of the Assessing Officer as well as DRP is not on the basis of cogent evidence. It is also a fact that Assessing Officer has allowed similar expenditure claimed in the subsequent assessment year i.e. assessment year 2008-09. Further, on going through the provisions contained under section 35(1) and 35(2) of the Act it is to be noted that both revenue expenditure as well as capital expenditure incurred towards scientific research relating to the ϯϰ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ business of the assessee is eligible for deduction. It is also not disputed that the object for which assessee is incorporated is R & D activities. There is enough material on record to show that assessee is carrying on R & D activities. Hence, it cannot be said that assessee has not commenced its business. Not showing profit and showing loss does not mean non commencement of business. Considering the aforesaid facts, we direct the Assessing Officer to allow the expenditure of Rs.4,25,76,407/- incurred in R & D activities carried out in India. This ground is allowed.
32. In view of our finding in ground No.3 above, which also covers the issue raised in ground Nos. 4 to 7, no separate adjudication of these grounds is required.
33. In ground No.8, the assessee has challenged addition of Rs.25,00,365/- being interest to be disallowed on the reimbursement of expenses to its AE amounting to Rs.8.33 crores.
34. Brief facts relating to the aforesaid issue are during the proceeding before the TPO, he held that since the reimbursement of expenditure to its AE amounting to Rs.8.33 crores was a diversion of funds and not for the purpose of the business of the assessee, it is in the nature of a interest free loan to the AE. The TPO therefore held that interest at the rate of 14% should be treated as the amount chargeable by the assessee on the amount of Rs.8,33,45,495/- advanced to the AE should be treated as ALP of the interest on funds given to the AE. Accordingly, he made an adjustment of Rs.1,16,68,369/- on this account. The DRP though held that there is no direct evidence on record to show that the transaction was a loan transaction, however the DRP endorsed the ϯϱ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ view of the TPO that the money expended is not for the purpose of business of the assessee and the R & D activities carried out is not established. The DRP therefore opined that the funds that are passed on to the AE is for other than business purposes. Once the funds are paid for non business purposes, interest expenditure is to be disallowed corresponding to the funds diverted. Accordingly, the DRP directed to disallow 3% of Rs.8,33,45,496/- being interest payable to DST.
35. After considering the submissions of the parties, we are of the view that the disallowance made cannot be sustained. Since we have already held that the transaction between the assessee and its AE relating to outsourcing of research and development activity cannot be held to be a sham transaction or diversion of funds, as a natural corollary, it cannot be held that the amount advanced to the AE is for non business purposes. We therefore direct the Assessing Officer to delete the addition of Rs.25,00,003/-.
36. Ground No.9 reads as under:-
" The ACIT was legally erroneous in observing that interest income of Rs.33,87,799/- is not business income since the business of the assessee had not commenced and the same is to be treated as income from other sources"
As can be seen from the impugned assessment order the Assessing Officer treated the interest income of Rs.33,87,799/- as income from other sources by relying upon the observation made by the DRP that the assessee has not commenced its business operations. On a perusal of the draft assessment order, it is noted that this issue was never raised by the Assessing Officer in the draft ϯϲ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘ assessment order and in fact he has accepted it as business income. As a result, it never came up for consideration before DRP. On careful reading of sec. 144C and particularly sub-sections (5) and (13), it becomes absolutely clear that the Assessing Officer shall complete the assessment in conformity with the directions of DRP. The use of word 'shall' in sub-section (13) shows that it is mandatory on the part of Assessing Officer to pass the final assessment order by only implementing the directions of the DRP. Therefore an issue which is not considered in the draft assessment order and consequently was not subject matter for consideration before DRP could not be dealt with in the final assessment order. We therefore direct the Assessing Officer not to treat the amount of Rs.33,87,799/- as income from other sources. Since we have held that the Assessing Officer cannot treat it as income from other sources the alternative contention of the assessee for set off of this income against loss determined has become academic, hence not required to be decided. Hence, this ground is considered to be allowed.
ITA No.1874/Hyd/2012- Asst. year 2008-0937. Ground Nos. 1 and 6 are general, hence they are not required to be adjudicated upon.
38. Ground Nos. 2 to 4 are identical to ground No. 3(a) in ITA No.1541/Hyd/2011. Following our decision in ITA No.1541/Hyd/11 (supra) while deciding ground No.3(a), we remit this issue also to the file of the Assessing Officer/TPO for deciding afresh in terms with our direction given above.
ϯϳ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘
39. GroundNo.5 relates to disallowance of Rs.15,59,189/- being 1.5% interest paid on the loan sanctioned by the DST. This issue is identical to issue raised in ground No.8 of ITA No.1541/Hyd/11 (supra). Following our decision in ITA No.1541 as mentioned above, we direct the Assessing Officer to delete the addition made. Accordingly, this ground is allowed.
40. In the result, both the appeals filed by the assessee are partly allowed.
Order pronounced in the court on 14-02-2014.
Sd/- Sd/-
(B. RAMAKOTAIAH) (SAKTIJIT DEY)
ACCOUNTANT MEMBER JUDICIAL MEMBER
Hyderabad,
Dated the 14 th February, 2014.
Jmr*
Copy forwarded to:-
1. C/o Sri S. Venugopal, FCA, Flat No.5H, Krishna Aparetments, 8-3-324, Yellareddyguda lane, Ameerpet Assessee Roads, Hyderabad.
2. ACIT, Cir-2(1), Hyderabad.
3. Dispute Resolution Panel, Bangalore.
4. The DR, Income-tax Appellate Tribunal, Hyderabad. ϯϴ /d ŶŽƐ͕͘ ϭϱϰϭ ĂŶĚ ŽƚŚĞƌƐ ŽĨ ϮϬϭϭ DͬƐ /ŶĚŝŐĞŶĞ WŚĂƌŵĂĐĞƵƚŝĐĂůƐ͕ ,LJĚ͘