Whether pre-operative legal expenses incurred for expansion of same line of business but with a new production facility can be said to be revenue in nature - YES:

THE issues before the Tribunal are - Whether pre-operative legal expenses incurred for expansion of the same line of business but with a new production facility can be said to be revenue in nature - Whether expenditure incurred on product Registration, Trade-mark Registration fees and Patent Registration creates any intangible asset and hence it is capital in nature not allowable as deduction u/s 37(1) – Whether clinical trial expenditure incurred by the assessee is eligible for weighted deduction u/s 35(2AB) even if it was incurred outside the approved R&D facility - Whether, for the purpose of deduction u/s 80IC, the profit of the eligible Undertaking has to be worked out by excluding the indirect cost incurred towards exploitation and free usage of the marketing network established by the assessee over a number of years and also the value of the self-generated brand and allocating such cost to the said Unit. And the verdict partly goes against the assessee.

Facts of the case

A) Appellant company is a Manufacturer and trader of Pharmaceutical goods, diagnostic kits and medical instruments. A return of income for the year under consideration i.e. A.Y. 2006-07, the year under appeal, was filed declaring total income at Rs. (-) 42,70,55,684/-, however, income declared U/s 115 JB at Rs.148,01,16,388/-. The return was revised twice by the assessee. As per the AO, the assessee had claimed pre-operative expenses to the tune of Rs four million. A query was raised in respect of the legal expense of Rs.24,00,000/- and the assessee informed that the company wanted to set-up a new project in the FY 2002-03 at Uttaranchal, but that did not work out, and alternatively it was decided to set-up a new unit at Baddi, Himachal Pradesh. The said expenditure was related to a project which did not take off, and the assessee booked the same under the head 'legal expenses'. The assessee submitted that where the expenditure incurred was not for starting of a new line of business but for the purpose of expansion or extension of the business already being carried on; then such an expenditure was deductible as revenue expenditure u/s 37(1) of the Act. The AO ultimately held that the expenses incurred by the assessee towards the new project of Rs.24,00,000/- was 'capital in nature' and the same was disallowed. As far as the directions of the DRP was concerned, it was opined that the said expenditure represented 'legal-expenses' incurred for setting up a new project. The DRP upheld the view of the AO.

B) While assessing the return, the AO noted that under the head 'Marketing Expenses' an amount of Rs.2,68,03,226/-was debited which was related to the "Product Registration Expenses". It was explained that the pharmaceutical products requires registration from Government Drug Regulatory Authority, therefore, the said expenditure was incurred. It was also explained that the pharmaceutical goods could not be exported to other countries unless and until the products are approved and registered with that authorities of the respective countries. The AO's objection was that once the product is registered and approval is granted by that country then the assessee can continue to export its goods over a long period of time. The registration thus entitles a benefit of enduring nature. It was like marketing right and the assessee has created an intangible asset. As per AO without getting the marketing rights i.e. an intangible asset, the assessee could not sell its product in the respective countries and hence treated the same as capital expenditure. However, it was decided to allow depreciation u/s 32 (1) (ii) of the Act. The DRP affirmed the action of the AO.

C) Weighted deduction for expenditure on Scientific Research u/s.35(2AB) in respect of Clinical Trial and Bio-equivalence Study - Revenue officer noted that the assessee has incurred expenditure on 'Research and Development' of Rs.78,93,71,812/-. The assessee has claimed 150% deduction as prescribed u/s 35 (2A B) i.e. Rs.118,40,57,718/-. It has also been noted by the A.O. that as per a certificate issued by Department of Scientific and Industrial research, New Delhi, revenue expenditure for in-house research was at Rs.6413.97 lacs and expense for clinical trials was at Rs.1437 lacs. The AO alleged that the said clinical trials were incurred outside the approved facilities. So the AO asked the assessee to substantiate it's claim for the allowability of enhanced rate of deduction @ 150% U/s 35(2AB) of the Act, especially when the expenditure was not incurred by the assessee in the approved in-house facility. The AO reiterated that as per the D S I R certificate, expenses of Rs.1437.50 lacs on clinical trial was incurred outside the approved facility. There was a reference of section 43 [4] of the Act, in which the term "scientific research" has been defined.

The AO held that the enhanced deduction is available on expenditure on scientific research on in-house 'Research & Development' as approved by the prescribed authority as in Sec. 35(2AB)(1). According to him as per the language of this section clinical trial has to be in-house, otherwise the use of this terminology in this section would become redundant. It is a settled position of law that no word used in the statute is redundant. The AO has concluded that the clinical trial expenses and bio equivalence study is allowable under Sec. 35(1)(i) only up to 100% and hence the excess deduction by 50% i.e. Rs.13,42,49,052/- was not allowed. The DRP further added that a monitoring mechanism has been prescribed for granting weighted deduction u/s 35(2AB). An approval for outside clinical trial is not prescribed in the mechanism. The action of the A.O. was approved.

D) Deduction u/s.80IC - The assessee claimed a deduction of Rs.116,48,51,853/- u/s.80IC of IT Act in respect of a Unit situated at Baddi, Himachal Pradesh. It was the second year of the Unit. The assessee has claimed exemption at 100% of the profit of the said Unit. The total turnover of the said Unit as per P&L account was at Rs.199,13,22,749/-. The AO compared the overall financial position of the assessee-company, hence in this regard it was noted that the total turnover of the assessee-company was at Rs.1488.1 crores, on which profit before tax as per books was declared at Rs.176.8 cores. The AO compared the percentage of profit of the Baddi Unit with other Units as also the overall percentage of profit of the company.

As per the allegation of the AO, the assessee had shown abnormally higher profit @ 58.66% for the Baddi Unit. That the said profit was claimed as exempt u/s.80IC of IT Act. In this connection an another observation of the AO was that in respect of other Units on which there was no eligibility of claim of deduction either u/s.80IC or u/s.80IB, the rate of profit was shown at a very low figure.

In respect of the computation of deduction u/s 80IC for Baddi Unit, the AO observed that the direct cost allocated for working out the profits were the manufacturing cost incurred during the year and the depreciation of the assets directly used in the said Unit. The other expenses; namely, marketing expenses, corporate expenses and interest expenses which were incurred by the Head Office were allocated on the sales ratio basis. The AO also compared that in respect of certain other Units, the expenditure has not been allocated. As per the allegation, no expenditure whatsoever had been allocated to the Baddi Unit on the ground that the said Unit had no business connection with other divisions. The AO allege that the expenses, such as, indirect cost, advertisement, marketing expenses, research & development expenses, etc. were not allocated towards the profit of the Baddi Unit and in this manner the profit of the Baddi Unit was escalated to get higher benefit of deduction u/s.80IC of IT Act. The AO has then noted down that in the past the products, now manufactured by the Baddi Unit, were purchased from the out- side manufacturers on Principle to Principle (P2P) basis. A list of 27 such products was reproduced by the AO.

It was observed that the AY under consideration was the second year of the assessee's claim for deduction u/s.80IC for Baddi Unit. Prior to setting up of the Baddi Unit, the assessee was purchasing all those 27 products, now been manufactured at Baddi, from the manufacturers on P2P basis. As per AO, earlier when the goods were purchased on P2P basis from the manufacturers the agreed sale price paid by the assessee for those products was although inclusive of the cost of raw-material, packing material, manufacturing expenses, taxes, etc. plus a reasonable amount of profit of the said manufacturer, but even then the price was lower than the selling rate charged by Baddi Unit. The AO has compared the purchase cost incurred on P2P basis with the production cost and selling rate from Baddi Unit and thereupon he has worked out that the average selling rate was higher of Baddi Unit. As per the tabulation made by the AO, undisputedly the assessee used to earn a good margin of profit when purchasing the goods from manufacturers of those goods on P2P basis. The AO computed the overall percentage of profit in respect of the said 27 products, which were stated to be now manufactured in Baddi Unit. On the basis of the said calculation, it was opined by the AO that the years prior to the setting up of the Baddi Unit, the assessee was having a gross margin of about 80% for those 27 products. The AO has then made out an another list and compared the average selling rate of Baddi Unit with the average selling rate of the products purchased on P2P basis.

The AO has thus demonstrated that the assessee was having a gross margin of profit of about 80% in respect of those 27 products, however, after the Baddi Unit was started, the profit of margin was increased upto 86% of the said Unit. As per AO, after the setting up of the manufacturing Unit at Baddi, the assessee has earned a further profit of 6% more. Thereafter, the AO has further elaborated the impact of declaring additional profit that it was just for the purpose of claiming higher deduction u/s.80IC, which according to him was escalated due to non-allocation of some of the cost incurred by the assessee-company. The AO discussed that costs like (i) marketing network, (ii) selling cost, (iii) distribution cost, (iv) administrative work, (v) brand value, etc. which were handled by other divisions of the assessee-company have not been allocated to this unit. According to him, when the goods are transferred from Baddi Unit to the Marketing Division for selling the products, it is the manufacturing cost and a reasonable amount of profit which should have been charged.

So, according to A.O. the branch transfer price could be the price which the P2P supplier were charging for those products. The additional profit earned was the profit earned by setting up the Baddi Unit. That alone could be eligible for 80IC deduction. As per A.O's reasoning, prior to setting up the Unit the assessee was already earning profits on those products. Likewise, in respect of brand of the company it was observed that the brand is owned by the company and not by the undertaking at Baddi. Even the self generated brand has immense value which is created by incurring heavy R&D expenses. Likewise, a huge marketing network has been set up by the assessee-company and owned by the company and not owned by the Baddi Undertaking, commented by AO. On account of brand and marketing net work the assessee used to get better profit which were accrued to the assessee prior to the setting up of the Baddi Unit in respect of those very products which were purchased from other manufacturers on P2P basis.

The AO's main thrust after the elaborate discussion was that only the manufacturing profit of the Baddi Unit is the profit which alone is eligible for deduction u/s.80IC. The assessee-company was generating substantial profit on account of its brand value and marketing network on those products when acquired/purchased on P2P basis. The ultimate sale price, on that point of time, as per AO, for those products consisted the (i) profit from manufacturing of the product which was taken by P2P supplier, (ii) profit derived from brand value of the product and (iii) profit derived from marketing network of those products. The AO has then invited attention on the provisions of section 80IC and opined that the profits and gains of an eligible business is the only source of income of the assessee. He has referred section 80IC(7) r.w.s.80IA(5), so that the profits of the eligible undertaking is to be computed as if such eligible business is the only source of income. His conclusion was that the sale price of the products manufactured at the Baddi Unit should be the cost of the production plus a reasonable amount of profit which should have been charged, however, the average sale price was escalated by claiming profit derived on sale of products manufactured by Baddi Unit which according to him, the alleged huge profit was not correct for the purpose of claiming the deduction u/s.80IC of the IT Act.

So it was reiterated that the price at which the said products could have been sold would be in line with the price charged by the P2P manufacturer. To that extent only the sale price of the products produced at the Baddi Unit should be taken into account for 80IC deduction and the escalated sale price required to be reduced for computing the profits eligible u/s.80IC. The AO has suggested that the assessee should have passed entries in its books of accounts for internal transfer from Baddi Unit to the Head Office for marketing at arm's length price. Instead of doing so, the assessee has for taxation purposes shown the ultimate sale price. The ultimate sale price is the price of the head office which owns the assets in the form of brands and marketing network and after considering the cost of production the head office in turn should have fixed the ultimate sale price and not the Baddi unit. According to AO, as far as the sale price in the hands of Baddi Unit was concerned, the sale price must be recorded at arm's length price for internal transfer and not the ultimate sale price.

According to AO, the assets, such as, brand value and marketing network are the assets owned by the assessee company as a whole organization. Those assets were not owned by the said Undertaking, i.e. Baddi Unit. Those brands were acquired prior to the setting up of Baddi Unit. The profits of the assessee-company were on account of three reasons; viz. (i) manufacturing assets, (ii) brand assets and (iii) marketing assets. Out of the three, only the manufacturing assets was owned by the said Undertaking, i.e. Baddi Unit. Hence the profit only to the extent of the "manufacturing profit" could be said to be derived from the Baddi Undertaking, which according to AO, was eligible for deduction u/s.80IC of IT Act. The AO also discussed the words used in the Statute and quoted that the word "derived from" is narrower in connotation as compared to the word "attributable to". Finally, the AO has computed the profit allegedly derived from Baddi Unit and held that the remaining profit was derived from exploitation of brand and marketing network thus not derived from the Baddi Unit, hence not eligible for deduction. The DRP approved the calculation of the AO.

E) Transfer Pricing - The assessee-company paid "service charges" @ 10% mark-up to M/s.Zydus Healthcare (U.S.A.) LLC in respect of product registration services. Besides, assessee has made reimbursement of expenses incurred. It was also noted that similar reimbursement of expenses for product registration were also made to Zydus Healthcare South Africa and Zydus France, but no "service charges" paid to those Associate Enterprises.

A distinction was described to the TPO that the product registration charges as reimbursed to Zydus (USA) LLC, i.e. AE, was not engaged in independent business. Whereas no product registration charges were paid to other AEs they being engaged in independent business, therefore, there was no question of payment of any mark-up charges. However, the said claim was not accepted by the TPO and concluded that the services charges @ 10% was recommended for upward adjustment by treating the transaction as mere reimbursement of expenses and no mark-up was allowed for these zero risk administrative operations i.e. non business operation. When the matter reached to DRP, it was directed to AO to allow a mark-up of 2% instead of NIL.

On appeal, the Tribunal held that,

A) + undisputedly, the assessee had incurred the legal expenditure to set-up a manufacturing unit at Uttaranchal in the F.Y. 2002-03. The said project could not be started, resultantly it was decided for the year under consideration to transfer the 'pre-operative' expenses to revenue under the head 'Legal & Professional' expenses. The assessee is in the business of manufacturing of Pharma Products and the Uttaranchal project was also stated to be for the production of Pharma Products. With this factual background we have noticed that the decision of CIT vs. Ambica Mills Ltd relied upon by the A.O., underlines that if expenses incurred are in connection with the "setting up of a new business" then such expenses will be on 'capital account', but where the setting up does not amount to starting of new business but expansion or extension of the business already being carried on by the assessee, expenses in connection with such expansion or extension must be held deductible as revenue expenses;

+ we are of the view that the factual matrix of the case has demonstrated that the expenditure in question was not for setting up a new line of business but for the setting up a new production unit for expansion of the same line of business already in existence hence allowable as revenue expenditure;

B) + Product Registration Expenses - for pharmaceutical product the assessee is required to obtain a registration from government drug regulatory authority. The assessee company has obtained its various products registered in other countries. The pharmaceutical products have also been registered by the local authorities as also the medical associations situated in India. About trademark and patent registration, the admitted factual position is that the assessee is manufacturing pharmaceutical products. Those products have been branded with their distinctive trademarks. By the registration of the product the assessee has safeguard against infringement of its patent. By the registration of trademark and patent the assessee has exclusive right of use. By incurring the said expenditure the assessee has protection of its running business. It is noticeable that the assessee has not obtained any new product or acquired any new trademark or acquired any new patent rights. The products were stated to be in existence and nothing new has been acquired or purchased by the assessee. The expenditure has enabled the assessee to run the existing business smoothly. Under the facts it is wrong to suggest that an asset either tangible or intangible was acquired by the assessee. The assessee is already in the business of manufacturing of pharmaceutical products. The assessee also carries on scientific research work. For the protection of the result of the research the assessee has to get the patent registered. Rather it is fallacious to presume that an intangible asset was acquired. Enduring benefit is not the only criteria. An enduring benefit has to be coupled with the acquisition of an asset;

+ the payments in question are inextricably linked with the working of the assessee's business. By incurring those expenditure the assessee has not acquired any new right of permanent character. The licenses or the registrations are required to be renewed and therefore part of the day to day running expenditure of the business. If an expenditure can give a benefit which is said to be endured for one year or even annually year after year then it is unreasonable to hold that any enduring benefit taken place to the assessee. An expenditure incurred in the existing line of business in order to run the business smoothly then though the business may run smoothly in future in the years to come but in the absence of creation of any new asset, such an enduring benefit may not tantamount to rendering of capital expenditure. Considering the totality of the factual matrix, the assessee’s claim is allowed;

C) + Weighted deduction for expenditure on Scientific Research u/s.35(2AB) in respect of Clinical Trial and Bio-equivalence Study - the term "in-house" can be termed that by utilizing the staff of an organization or by utilization of resources of the organization if a research is conducted within the organization; rather than utilization of external resources or staff; then it can be called as in house research;

+ if the language used in section 35(2AB)(1) is closely examined, it says, quote "incurs any expenditure on scientific research on in-house research and development facility", unquote. The significance is that the Statute has used the terminology "on in-house". To understand the intention of using the word "on" we can say that "scientific research with respect to in-house research and development". We can also read in this manner that any expenditure on "scientific research" engaged in an in-house research and development facility. We can also read the sentence in this manner that any expenditure on scientific research directed towards in-house research and development facility. Therefore, the language of this section do not suggest that any expenditure on scientific research should be within the in-house research and development. The language do not suggest that the research is to be conducted within four walls of an undertaking. Had the Legislature intended to restrict the research within the four-walls of a compound, then the possible terminology could be that "any expenditure on scientific research by a in-house research and development facility". Therefore by using the word "by" the meaning gets changed and then it can be read that through the action or means of in-house research the expenditure is incurred;

+ clinical trial is one of the various steps involved in a scientific research specially for the development in a new drug. For the purpose of clinical trial a pharmaceutical company is required to set up a in-house research facility. To conduct the research the qualified team of scientists may have to collect data's from several resources, both, within the premises or outside the premises. But the data's so collected by them is to be brought into the in-house research facility and on the basis of those collected data's or clinical trials carried out the team of experts thereafter arrived at a result. Therefore, for the purpose of conducting scientific research the requirement is that in house research and development facility is to be created or established by an organization. Even by the introduction of Explanation the scope of "expenditure on scientific research" was defined which is required to be in relation to drug and pharmaceutical and thus include expenditure incurred on clinical drug trial;

+ the assessee has placed several approvals through which the Directorate General of Health Services has accepted the bio-equivalence report of the studies in respect of new drugs form the assessee's laboratory. Under the totality of the circumstances of the case and in the light of the material placed and the discussion made hereinabove, the conditions as prescribed u/s.35(2AB)(1) of the Act has been complied with by this assessee, therefore, entitled for the prescribed deduction;

D) + deduction u/s.80IC & 80IB – the AO has proceeded to disturb the profit of the Baddi Unit and held that only 6% profit is eligible for deduction u/s.80IC.While doing so, identically, the AO has not pinpointed any defect in the working of the "profit" of the Baddi Unit;

+ there was no finding by the AO that upto the extent of 80%, the profit was attributed to the assessee-company. The segregation between 80% and 6% was not on account of any evidence through which it could independently be established that the major portion of the profit could be attributed to the assessee-company and rest of the profit could only be attributed to the Baddi Unit;

+ on perusal of the P&L account, it is an admitted factual position that the assessee has in fact debited certain expenses which have included head office expenses, such as, marketing expenses and corporate expenses. Meaning thereby the net profit of the Baddi Unit was not merely production cost minus sale price, but the difference of sale price minus all general expenses which were attributable to the sales. Therefore, it is not reasonable to say that unreasonably the profit was escalated. The difference between the two percentages of profit, i.e. about 28% (G.P. – N.P.) thus represented the expenditure which could be said to be in respect of marketing network and brand of the product related expenses. The AO has not complained about the allocation of expenditure as made by the assessee while computing the profit of the Baddi Unit. Once the assessee has itself taken into account the related expenses to arrive at the net profit, then it was not reasonable on the part of the Revenue Department to further reallocate those expenses by curtailing the percentage of eligible profit;

+ on careful reading of sub-section 5 of section 80-IA, it transpires that the said eligible profit should be the only source of income. If we examine the separate profit & loss account of Baddi Unit, then it is apparent that the only source of income was the sales of the qualified products. In the said P&L A/c there was no component of any other sources of income except the sale price and otherwise also the assessee has confined the claim only in respect of the eligible profit which was derived from the sales of the pharmaceutical products. This section do not suggest that the eligible profit should be computed first by transferring the product at an imaginary sale price to the head office and then the head office should sale the product in the open market. There is no such concept of segregation of profit. Rather, the profit of an undertaking is always computed as a whole by taking into account the sale price of the product in the market;

+ though Section 80IA(8) has its own importance but the area under which this section operates is that where one eligible business is transferred to any other business. The word used in this section is "business" and not the word "profit". Hence, an inference can be drawn by describing these two words and thus have precisely noted that 'eligible business' has a different connotation which is not at par or identical with the "eligible profit". The matter we are dealing is not the case where business as a whole is transferred. This is a case where manufacturing products were sold through C&F in the market. Even this is not the case that first sales were made by the Baddi Unit in favour of the head office or the marketing unit and thereupon the sales were executed by the head office to the open market. Once it was not so, then the fixation of market value of such good is out of the ambits of this section. If there is no inter corporate transfer, then the AO has no right to determine the fair market value of such goods or to compute the arm's length price of such goods. The AO has suggested two things; first that there must be inter-corporate transfer, and second that the transfer should be as per the market price determined by the AO. Both these suggestions are not practicable. If these two suggestions are to be implemented, then a Pandora box shall be opened in respect of the determination of arm's length price vis a vis a fair market and then to arrive at reasonable profit. Rather a very complex situation shall emerge. Specially when the Statute do not subscribe such deemed inter-corporate transfer but subscribe actual earning of profit, then the impugned suggestion of the AO do not have legal sanctity in the eyes of law;

+ the segment reporting of profit is although in practice but the purpose of such reporting is altogether different. Such segment information is particularly useful for financial analysis, so that the management may keep a close watch on the performance of the diversified business lines. The areas of demarcation are business segment, geographical segment, etc. But as far as the Revenue of an enterprise is concerned while segmentation is required, then Revenue from sales to external customers are reported in the segmented statement of profit and loss;

+ if no apportionment can be made in respect of the process of a particular business, then that will not be considered to be a part of the business at all. The principle of apportionment was the criteria for segregating the manufacturing profit if it was feasible to do so. As against that in the present case the assessee has computed the profit of the Baddi Unit on the basis of the well accepted principle of accountancy that a profit is accrued where a transaction is closed, meaning thereby the profit arises solely at the time of sale;

+ the AO's proposition of segmentation of eligible profit of the manufacturing unit was not altogether meaningless. This approach of the AO cannot be brushed aside on the fact of it. But at present, when the method of accounting as applicable under the Statute, do not suggest such segregation or bifurcation, then it is not fair to draw an imaginary line to compute a separate profit of the Baddi Unit. The Baddi Unit has in fact computed its profit as per a separately maintained books of account of the eligible manufacturing activity. To implement the method of the computation at stand alone basis, as conveyed by the AO, the manufacturing unit has prepared a profit & loss account of its manufacturing-cum-sale business activity. If the Statute wanted to draw such line of segregation between the manufacturing activity and the sale activity, then the Statute should have made a specific provision of such demarcation. But at present the legal status is that the Statute has only chosen to give the benefit to "any business of drug manufacturing activity" which is incurring expenditure on research activity is eligible for this prescribed weighted deduction. The segregation as suggested by the AO has first to be brought into the Statute and then to be implemented. Without such law, it was not fair as also not justifiable on the part of the AO to disturb the method of accounting of the assessee regularly followed in the normal course of business. It is true that otherwise no fallacy or mistake was detected in the books of accounts of Baddi Unit prepared on stand alone basis through which the only source of income/profit was the manufacturing of the specified products. Therefore, the AO's action of segregation was merely based upon a hypothesis, hence hereby rejected;

E) + transfer Pricing - for the purpose of computation of arm's length price u/s.92C first of all most appropriate method is to be decided and thereafter as per the provisions of section 92C(2) the benefit of variation between the arm's length price so determined and the price at which the international transaction has actually been undertaken is prescribed;

+ the matter requires reconsideration at the level of the AO only to examine the correctness of the computation as suggested by the assessee according to which the adjustment is suggested. As far as the part relief granted by the DRP by allowing mark-up @ 2% is concerned, once there is no dispute about the most appropriate method being adopted by both the sides, the said direction of the DRP need not to be disturbed. The AO has to simply examine the said calculation in the light of the second proviso to section 92C(2) of IT Act and if any relief is permissible, then the same can be granted but as per law.