Delhi High Court
Deputy Cit vs Tcil Bellsouth Ltd. on 31 March, 2003
Equivalent citations: (2004)89TTJ(DEL)851
ORDER
MY. Mayar, A.M.:
These are five appeals by revenue against the orders of Commissioner (Appeals) dated 30-3-1995 and 27-3-1998, relating to the assessment years 1990-91 to 1991-92 and 1992-93, 1993-94 and 1995-96, respectively. Sirnilar grounds are involved in all the appeals i.e., with regard to the allowance of expenditure incurred on development of software package under section 35 and 37 of the Income Tax Act, 1961.
2. Cross-objections have been filed by the assessed in the assessment years 1992-93, 1993-94 and 1995-96 raising alternative contentions in the event that the revenue's appeals succeed.
3. The assessed- company is engaged in the business of development of software and export of software services. The assessed is a joint venture company whose principal shareholding is as under
(i) Telecommunications Consultants India ITD.
40% (a Govt of India undertaking)
(ii) Bellsouth International 40% (an American Telecom Co.)
(iii) SBI Capital Market 11 %
(iv) DSS Enterprises (P) ITD.
9% 100%
4. During the assessment year 1990-91, the assessed- company has incurred expenses of Rs. 60,33,981 on the development of computer software for the telecommunication industry. These expenses were capitalized in the books of account under the head 'miscellaneous expenditure' as part of capitalized software costs and written off as deferred revenue expense over five years in accounts. However, these expenses were claimed as a revenue expense in the income-tax return under section 37 of the Income Tax Act, 1961. During the course of assessment, alternative claim was made under section 35 of the Income Tax Act.
5. The assessing officer did not accept the claim of the assessed in regard to this expense either as revenue under section 37 or as scientific research expenditure under section 35 on the following basis :
(i) Business of the assessed is development and sale of software' and 'export of software services' and not that of research and development.
(ii) Expenses incurred on software development is not revenue in nature as it creates a valuable asset in the hands of the assessed
(iii) The assessed has adopted a tax treatment which is different from the accounting treatment made for the same expenditure in the books of accounts. Whereas in its accounts the assessed has not charged expenditure to P&L a/c but treated it as capitalized software cost and shown it in the balance sheet, in computing the income under Income Tax Act, the assessed has written off the entire expenditure incurred during the year on the development of the software under section 37.
(iv) The assessed has not shown as to how the expenditure on development of software is in the nature of expenditure on research and development and as such claim under section 35 is rejected. :
(v) The assessed has relied on 'Accounting Standards' such as FAS 86 and AS 8 and 9 but has not himself fully followed the same in accounts and in any case the same do not apply under the Income Tax Act.
(vi) The opinion of the Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India has not shown as to how the expenditure on development of software is expended on research and development. As the assessed has not accepted the advice of the EAC that the software development cost results in a valuable asset, the claim of the assessed is not accepted. The opinion of the EAC has also not been endorsed/adopted by the Institute of Chartered Accountants.
(vii) The assessed has changed its claim under the Income Tax Act from section 37 to section 35.
(viii) The assessed has used a lot of scientific and technical jargon whereas as per the assessing officer in plain and simple language, the process of development of an application software consists of studying the elements of manual system, adding or deleting steps in the manual system to suit the needs of computer environment and writing instructions in computer language so that the computer can perform the steps which were being performed by human beings.
6. The Commissioner (Appeals) observed that the claim of the software development expenditure made under research and development, was treated as a shift in stand by the assessing officer, but in her. opinion a different explanation for the expenditure incurred need not be considered with bias as what is material are the actual facts and the legal position. She agreed with the opinion of the EAC, that rights to use software product developed can be sold over and over again over a considerable time period and the product developed therefore becomes a valuable asset which should be capitalized. Therefore, the assessed's action of capitalizing software cost in accounts was correct. She thereby agreed with the assessing officer on the point that software cost could not be treated as revenue expenditure as a valuable asset had come into existence. The Expert Advisory Committee (EAC) had also recommended that entire expenditure on development of software whether revenue or capital was deductible under section 35 of the Income Tax Act. The main objection of assessing officer was that AS8 did not deal with the issue as to whether development of software is research and development activity. Commissioner (Appeals) found the description of the process of development of software too simplistic, not based on complete and deep knowledge of the development of sophisticated software package used in the line of telecommunication. Commissioner (Appeals) observed that as per assessed such a system did not exist in the past and was developed with the help of highly paid technical experts and the whole process was beyond the scope of understanding of a non-technical person. The development of the software as per the assessed is not a one-time process but an ongoing process until the desired end result was achieved and like, any other research and development work it was possible that the desired end results were not obtained and the whole cost incurred may prove to be unproductive. The various stages started from the fact-finding stage in the process of this research or planned investigation where after new objectives were added, along with other stages including derivation of the logical system, preparation of logical specification model and were followed by programming and concluding by establishing good systems quality assurance. Therefore, keeping in view the process of research and development undertaken by the assessed, the expenditure was said to be covered under the provisions of section 35 of the Income Tax Act. However, as per the Commissioner (Appeals), as the expenditure involved was for bringing a. valuable asset into existence, it was capital in nature.
7. The learned departmental Representative strongly placed reliance on the order of the assessing officer and also went through the Commissioner (Appeals) order. departmental Representative argued that the assessed was basically carrying out the activities towards developing a product, which was sold as such after its development Therdfore, there wa's no research or development, since the very activities involved in the development of the software itself constituted the manufacturing process of making the product of the company, i.e., the software package. departmental Representative reiterated the fact that the method as adopted by the assessed for treatment of the software development expense in the books was different to that as adopted under the Income Tax Act for computing the taxable income. departmental Representative also pointed out to the aspect regarding the expenditure resulting in the creation of a valuable asset and therefore being not allowable as revenue expense. departmental Representative raised the issue regarding no second appeal being filed by the assessed against the Commissioner (Appeals) orderand therefore by implication the assessed had also admitted to the expenditure being of capital nature. departmental Representative also' pointed out-that there was a shift in stand by the assessed in their claim under section 37 to section 35 of the Income Tax Act departmental Representative thereby summed up that as the expense was accepted as capital, there was no question of it being allowed on revenue account under section 37 and as the assessed had not shown how the expense was incurred for scientific research purposes, therefore, the claim under section 35 was also not tenable.
8. Shri Anil Chopra and Shri B.S. Bedi, CAs, appeared on behalf of the assessed. The learned counsel gave a brief background of the assessed and its business which was primarily development and sale of software. It's objects included research and development related to it's business. The authorised representative elaborated the complex and highly technical aspects which were involved in the process of the development of the software. It was submitted that the research and development involved had to be seen in the context of the ever and rapidly changing high technology involved in the income-tax industry. It was further explained that research was the original and planned investigation undertaken with the hope of gaining new scientific or technical knowledge and understanding whereas development was the translation of the research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, process, systems or services. It was categorically stated that it was totally out of the scope of a common man to develop such highly sophisticated and intellectually inclined computer softwares. The development of such softwares involved highly skilled labour, knowhow and expertise and other related factors of a high technical order. Our attention was drawn to the fact that to the two principal joint venture partners were giobally reputed technical experts in this industry. He submitted that research and development and the expenditure involved was an integral part of the business and profit earning process of the assessed. He urged that whether capital or revenue expenditure, the scientific research expenditure involved was admissible as a deduction under section 35. He further submitted that it was a settled proposition that it is only the real commercial net income which was capable of being taxed. No deduction under any head was being allowed to the assessed over the years for this expenditure. Thus, revenue was seeking to tax gross receipts which was not permissible. It was also pointed out that the expenditure involved was quite substantial keeping in view the times when the said expenditure was incurred.
9. The learned authorised representative explained that in the business of the assessed it is not the software package developed through scientific research which was sold. It is only the copies of the same subject to customization that was licensed out subsequently to customers.
10. The authorised representative sought support from the order of the Commissioner (Appeals) and relied on Expert Advisory Committee opinion, Accounting Standards, written submissions, etc. in the paper book. He also relied on the gist of case law filed in respect of the claim for software development expenses under section 35 of the Income Tax Act as well as on the propositions that entries in the books of accounts are not decisive or conclusive for computing the taxable income, that expenses on computer software are revenue expenses and that the expenditure on development of software is revenue and not capital. Reliance was also placed on the CBDT notification No. S.O. 452, dated 8-2-2000, which has notified the manufacture or production of computer software being an article or thing for the purpose of scientific research.
11. The learned authorised representative clarified that the cross-objections were filed for only assessment years 1992-93, 1993-94 and 1995-96 and not for assessment years 1990-91 and 1991-92. He also contended that even where cross-objections were not filed as in the A.Y. 1990-91 and 1991-92, the subject-matter of the appeal was not restricted to the ground raised by the revenue, as held in several oases including that of the jurisdictional High Court in the case of CIT v. Edward Keventer (P) ITD. (1980) 123 ITR 200 (Del). It has been held in the said case that "the subject-matter of an appeal should be understood not in a narrow and unrealistic manner but should be so comprehended as to encompass the entire controversy between the parties which is sought to be got adjudicated upon by the Tribunal. In a case where there are interconnected grounds of appeal and they have impact on the same subject-matter, the scope of the appeal should be broadly considered in the correct perspective". Our attention was also drawn to r. 27 of the Tribunal Rules.
12. The learned departmental Representative opposed the submissions as made by the learned authorised representative and submitted that the activities of the assessed were not research and development. The learned departmental Representative, again reiterated that the expenditure was held as a valuable asset by the Commissioner (Appeals). The learned departmental Representative also submitted that the observation made by the Commissioner (Appeals) regarding the assessing officer giving a very simplistic version of the development process involved was not correct.
13. We have heard the rival submissions and considered them carefully. We have also-carefully gone through the facts and material placed ch record and have considered the ratio of various case law relied upon by the learned authorised representative. The business of the assessed consists of development and sale of software and export of software services. The assessed has been developing softwares for the telecommunication industry. It has been pointed out to us that the process of development of softwares involves highly skilled technical personnel along with various other scientific research activities which go together to complete the research and development involved. We agree with the Commissioner (Appeals) that the assessing officer has taken a very simplistic view of the whole process involved in the development of the software. The assessed has explained vide letter dated 22nd Dec., 1992, as to how the various stages involved during the development of the software clearly show the existence of research and development activity. In the first stage, i.e., fact finding or planned investigation, the system analyst starts with the terms of reference having access to historical records with a hope of gaining technical knowleqge or understanding in new areas. The system analyst thereby builds a paper model of the existing system in which each movement of data is represented by a set of data flow diagrams/flow charts. The result of this stage would be to define the current physical description of the system to clearly identify the data structures involved. After the initial investigation, the terms of reference are expanded to include new objectives and thereby to index the scope of a full investigation. A number of methods are used to collect facts by the system analyst which include inter alia observation, record searching, special purpose records, sampling, questionnaire and interviewing. The second stage is the derivation of the logical system wherein the 'who' or 'where' or 'how' details are removed to leave a statement of work done which ultimately leads to the specification of requirements. More than one option may emerge on relative importance of different desired features, keeping in view the hardware/software considerations etc. These optio . ns are then subjected to cost benefit analysis and after careful deliberation, alternatives are shortlisted. The third phase or design phase commences with the logical specification model as presented by system analyst The designer has to consider various factors such as objectives of the design, specification presented by analyst before finally producing a good workable physical design for the system. The systems designer then analyses techniques for designing systems; to meet the specified performance criteria and improves design wherever necessary. The system designer is also concerned with procedures required to handle and process data, user and main interface, screen layout and such other factors involved The fourth phase i.e., the programming phase is the point at which all the facts gathered through the application of the previously acquired skills and techniques are used for development d the whole system. Finally, the process of development is concluded by performing various tests, etc. for establishing good systems quality assurance. Thereafter a systems review process is undertaken to ensure that the original defined objectives were actually met There are always, however, endless possibilities of backtracking at any stage which would invalidate the work done at the previous stages. To sum up, system design and development is the translation of investigation findings into a plan or design for the production of new or substantially improved systems which result in a software package. As seen from the above, the software development process, therefore, consists of a whole series of processes wherein the systems analysis and design constitute the research activity and the programming, quality control, debugging. and testing etc., constitutes the development activity.
14. As per section 43(4)(i) scientific research means : any activities for the extension of knowledge in the fields of natural or applied science including agricultural, animal husbandry or fisheries; (ii) * references to expenditure incurred on scientific research include all expenditure incurred for the prosecution, or the provision of facilities for the prosecution, of scientific research, but do not include any expenditure incurred in the acquisition of rights in, or arising out of, scientific research; (iii) references to scientific research related to a business or class of business include (a) any scientific research which may lead to or facilitate an extension of that business or, as the case may be, all businesses of that class. Further, as per section 35(1)(iv) in respect of any expenditure of a capital nature on scientific research related to the business carried on by the assessed such deduction as may be permissible under the provisions of sub-section (2) shall be allowed
15. As per sub-section (2) of section 35 for the purposes of clause (iv) of sub-section (1), in case where such capital expenditure is incurred after 31st day of March, 1967, the whole of such capital expenditure incurred in any previous year shall be deducted for that previous year.
16. It is important to note that CBDT vide its notification No. S.O. 452, dated 8th Feb., 2000, has notified the manufacture or production of computer software being an article or thing for the purpose of section 35(2AB)(1) of the Income Tax Act Therefore, this notification clearly shows that the CBDT envisages the activity of manufacture or production of computer software as a scientific research activity.
17. We agree with the argument of the learned counsel for the assessed that it is not for the common man to carry out such activities and produce such new software package without the assistance of highly technical and other scientific factors involved.
18. In view of the above, it is clear that the activity of the assessed in developing the software would come into the ambit of the admissible provisions of section 35 which is applicable in the instant case. We are of the view that the assessed is carrying on scientific research activity and the expenditure involved on development of software related to the business of the assessed is allowable under section 35 of the Income Tax Act, 1961. As the expenditure involved is admissible under section 35 as scientific research, whether the same be considered to be revenue or capital expenditure, for the purposes of this decision, we are not expressing any further view whether the said expenditure is of capital or revenue nature. We have already held that expenditure in scientific research is eligible for deduction under section 35. -
19. We have also carefully considered the following rulings filed by the counsel of the assessed regarding the claim under section 35 of the Income Tax Act (1) Ewac Alloys ITD. v. ITO (1982) 2 ITD 651 (Bom) Cost of laboratory equipment under transit and cost of building under construction-Section 35 claim allowed though assets not put to actual use in the relevant year.
(ii) Industrial Cables (India) ITD. v. L4C (1986) 57 CTR (7kib)(Chd) 4 New machine developed and used for business-Section 35(1)(iv) deduction allowed
(iii) ITO v. Polychem ITD. (1983) 17 TW (Born) 155 Expenditure on setting up of pilot plant for manufacturing product in respect of Which formula and process developed by some other institute allowed under section 35. Pilot plant was to see whether process secured could be exploited on'a commercial scale-that too was held to be Research. Investigation as to whether scientific formula could be exploited on commercial scale is itself a research for purpose of section 35.
(iv) UP Electronics Corpn. ITD. v. LAC (ITA No. 1854/A1V1985-Selected orders of ITAT-Taxman 1992 p. 605) Meaning of scientific research-Project reports considered research and development'.
(v) CIT v. National Rayon Coipn. ITD. (1985) 44 CTR (Bom) 103: (1985) 155 ITR 413 (Bom) Expenditure on pulp pilot plant related to business allowed under section 36(2).
The above rulings also support the view of the assessed that the activity of developing the software clearly constitutes scientific research related to the assessed's business.
20. We may mention that there have been conflicting references to the Accounting Standards by both parties. It is not the Accounting Standards which would be decisive of the admissibility of the assessed's claim but the facts as read in the context of the relevant provisions of the Income Tax Act that need to be seen. We, however, agree with the opinion of the EAC that such expenditure on development of software is an admissible deduction under section 35.
21. We have considered the gist of case law relied upon by the assessed with regard to other propositions put forth therein. The assessed has relied upon the following ease law for the proposition that expenses on computer software are revenue expenses :
(i) Business Information Processing Services v. Assistant Commissioner (2000) 67 ITJ Qp) 131 (2000) 73 ITD 304 Qp)
(ii) Income Tax Officer v. Jacob Pucadyil (1993) 46 TEJ (Ahd) 136: (1992) 43 ITD 459 (Ahd)
(iii) ITC Classic Finance ITD v. Dy. CIT (2000) 112 Taxinan 153 (Cal)(Trib)
(iv) bank of Punjab ITD. v. Jt. CIT (2002) 122 Tamnan 235 (Chd)(Trib)
(v) Media Video ITD. v. Jt. CIT (2002) 122 Tamnan 28, 31 (Del)(Mag)
(a) Regarding the claim of the assessed that the expenditure on development of software is revenue and not capital, reliance has been placed on the following case law:
(i) Empire Jute Co. ITD v. CIT (1980) 17 CTR (SC) 113: (1980) 124 ITR 1 (SC)
(ii) Alembic Chemical Works Co. ITD. v. CIT (1989) 77 CTR (SC)) 1 : (1989) 177 ITR 377 (SC)
(iii) Pragya Tools ITD v. CIT (1980) 16 CTR (AP)(FB) 356 . (1980) 123 ITR 773 (AP)(F8)
(iv) CIT v. Biitish India Corpn. ITD. (1987) 60 CTR (SC) 54 : (1987) 165 ITR 51 (SC) It is, however, clarified that as the claim of the assessed' is being allowed under section 35, the above rulings are not considered in this case. The expenditure is allowable as a deduction under section 35 whether the same be revenue or capital expense.
22. It is a well-settled proposition of law that entries in the books of accounts are not decisive or conclusive for computing the taxable income. The assessed has relied on the following case law in support of the said proposition with which there can be no dispute and with which we respectfully agree.
(i) Kedarnath Jute Mfg. Co. ITD. v. CIT (1971) 82 ITR 363 (SC))
(ii) Pullangode Rubber Produce Co. ITD v. State of Kerala & Anr 1972 CTR (SC)) 253: (1973) 91 ITR 18 (SC))
(iii) India Cements ITD v. CIT (1966) 60 ITR 52 (SC)
(iv) State Bank of India v. CIT (1985) 49 CTR (SC) 379: (1986) 157 ITR 67 (SC))
23. The expenses incurred on the development of computer software during the assessment years 1990-91, 1991-92, 1992-93, 1993-94 & 1995-96 are Rs. 60,33,981, 33,13,305, 11,43,545, 8,81,253 and 4,10,040, respectively. In all the years similar issues are involved and, therefore, all the appeals are being taken together. For the reasons stated above. Revenue's appeals for all the said years are rejected. We hold that in all the said years, the assessed is entitled to deduction under section 35 for the said expenditure as scientific research expenditure related to the assessed's business.
The assessed has also moved cross- objections for the assessment years 1992-93, 199394 and 1995-96, raising alternative contentions in the event 'that the revenue's appeals succeed. As we have held the expenditure on the software development as cientific research under section 35, the cross-objections filed by the assessed have become infructuous.
24. In the result, the appeals of the revenue are dismissed and the cross objections by the assessed are also dismissed.