IN THE ITAT DELHI BENCH ‘C’, SPECIAL BENCH

Amway India Enterprises

v.

Deputy Commissioner of Income-tax, Circle-1(1), New Delhi

VIMAL GANDHI, PRESIDENT, N.V. VASUDEVAN, JUDICIAL MEMBER AND P.M. JAGTAP, ACCOUNTANT MEMBER

IT APPEAL NOS. 3072 AND 3247(DELHI) OF 2002, 128 (DELHI) OF 2005 AND 72(DELHI) OF 2006

[Assessment years 1998-99, 2001-02 and 2002-03]

February 15, 2008

Section 37(1) of the Income-tax Act, 1961 - Business expenditure – Allowability of – Assessment years 1998-99, 2001-02 and 2002-03 – Whether in order to decide nature of expenditure as to whether it is capital or revenue, three tests, i.e., ownership test, enduring benefit test, and functional test have to applied - Held, yes – Whether by applying said tests, expenditure is treated as capital expenditure either when it results in acquisition of capital asset by assessee as owner thereof or when it results in accrual of advantage of enduring nature to assessee in capital field – Held, yes – Whether when assessee acquires a computer software or for that matter licence to use such software, he acquires a tangible asset and becomes owner thereof but, question as to whether expenditure on acquiring computer software is capital or revenue cannot be decided on basis of ownership test alone but has to be seen from point of view of applicability of other tests also – Held, yes – Whether since computer software becomes obsolete with technological innovation and advancement within a short span of time, it can be said that where life of computer software is shorter, (say less than 2 years), it may be treated as revenue expenditure; any software having utility to assessee for a period beyond two years can be considered as accrual of benefit of enduring nature, however, that by itself will not make expenditure incurred on software as capital in nature and functional test also needs to be satisfied - Held, yes – Whether for applicability of functional test, advantage which an assessee derives from use of computer software has to be seen in a commercial sense; if advantage is in capital field then same would be capital expenditure, if advantage consists merely in facilitating assessee’s trading operations or enabling management and conduct of assessee’s business to be carried on more efficiently or more profitably, while leaving fixed capital untouched, expenditure would be on revenue account – Held, yes – Assessee incurred certain expenditure for acquiring different computer softwares for use in its business and claimed deduction of same as revenue expenditure – However, without applying abovesaid criteria to determine exact nature of expenditure incurred by assessee, Assessing Officer rejected its claim – Whether since said exercise was required to be done in respect of each and every software acquired by assessee, matter was to be restored back to Assessing Officer for doing such exercise – Held, yes

Section 32 of the Income-tax Act, 1961 – Depreciation – Allowance/Rate of – Assessment years 1998-99, 2001-02 and 2002-03 – Whether since computer software contained in a disk is tangible property by itself, use by assessee of such software in his business is enough to allow claim for depreciation under section 32(1)(i) at 25 per cent – Held, yes – Whether, however since with effect from 1-4-2003, computer software has been classified as a tangible asset under heading ‘plant’ in Appendix-I to Income-tax Rules, 1962, assessee would be entitled to depreciation at 60 per cent from said date – Held, yes

FACTS

The assessee-company incurred certain expenditure for acquiring computer softwares for use in its business. The assessee claimed that since all the softwares were essentially in the nature of application software and only facilitated in its day to day operations, the expenditure in question was of revenue nature. It was also claimed that the said expenditure did not result in enduring benefit as the life of application software was invariably short and the same was bound to become technically obsolete very fast. The Assessing Officer disallowed the assessee’s claim on ground that the said software were part of the plant and machinery of the assessee and had long lasting use of more than three to four years and, thus, the same resulted into enduring benefit to it. He, therefore, treated the expenditure incurred by the assessee as capital in nature and by treating the same as part of its plant and machinery, allowed depreciation thereon at the normal rate of 25 per cent. On appeal, the Commissioner (Appeals) upheld the order of the Assessing Officer. In second appeal, the assessee contended that by incurring the impugned expenditure, it had acquired only the licence to use the software and there was no outright purchase of software giving ownership to the assessee of the said software so as to treat the same as a capital expenditure. On the other hand, the revenue contended that acquiring a license to use software was the common mode of purchase of software and, therefore, the expenditure incurred on such purchase of software giving enduring benefits to the assessee was a capital expenditure. The Division Bench noted that there were divergent views expressed by the various Courts on the issue relating to the exact nature of expenditure incurred on software being capital or revenue. Therefore, it referred the matter to the Special Bench. Meanwhile, a similar issue relating to allowability of software expenditure arose for consideration before the Division Bench in the case of a company ‘S’. The said ‘S’ was engaged in the business of software development as well as running a training centre to impart specialized training to the students in software technology. It purchased computer software and claimed that the software which it purchased becomes obsolete in about six months time due to fast changes in technology in the IT Sector and, therefore, such expenses were to be considered as revenue expenditure. The Assessing Officer disallowed the said claim. On appeal the Commissioner (Appeals) allowed the assessee’s claim. On revenue’s appeal, the Division Bench, in view of the fact that a similar issue had already been referred to the Special Bench, referred the case of ‘S’ also to the Special Bench.

HELD

A resume of the various judicial pronouncements shows that there cannot be any specific or precise test, which can be applied conclusively or universally for distinguishing between capital and revenue expenditure. It is a blurred and undefined or area in which anyone can be get lost. Different minds may come to different conclusions with equal propriety. The cardinal rule is that the question whether a certain expenditure is on capital or revenue account should be decided from the practical and business view point and in accordance with sound accountancy principles and this rule is of special significance in dealing with expenditure on expansion and development, of business. While dealing with this complex issue, three tests generally applied to decide the nature of expenditure as to whether it is capital or revenue, are the test of enduring benefit, ownership test and functional test. Applying the said tests, expenditure is treated as capital expenditure either when it results in acquisition of capital asset by the assessee as owner thereof or when it results in accrual of advantage of enduring nature to the assessee in the capital field. In the first situation, the ownership test assumes greater significance because the acquisition of capital asset by the assessee as a result of incurring expenditure is a condition. If the expenditure is resulting merely in acquisition or creation of asset without the assessee becoming owner thereof, it cannot be said that the said expenditure is a capital expenditure. The coming into existence of an asset as a result of incurring expenditure alone, thus, is not sufficient to treat the said expenditure as of capital nature unless the asset coming into existence is also owned by the assessee [Para 43]

In other situation, the expenditure can be treated as capital expenditure only when it results in accrual of advantage of enduring nature to the assessee in the capital field. The relevant tests applied to determine the nature of expenditure in such a situation are the functional tests and the test of enduring benefit. An advantage is to be considered as of enduring benefit if the benefit accruing is not of a transient nature but is of such durability as to justify it being treated as a capital asset. It is, thus, necessary that in order to treat any expenditure as capital expenditure, the same should result in accrual of advantage of enduring benefit and such benefit should accrue to the assessee in the capital field. What exactly is meant by accrual of benefit in the capital field is that the said benefit should form part of the profit-making apparatus of the assessee’s business. [Para 44]

Computer software – Ownership test – Supreme Court Decision in the case of Tata Consultancy Services v. State of Andhra Pradesh [2004] 271 ITR 401/ 141 Taxman 132.

For applying the ownership test in the context of computer software, the preliminary issue that arises is whether the computer software is a tangible or intangible asset and whether the assessees get ownership right by acquiring the same. The contention of the assessees was that as per the agreement under which software was commonly acquired, the assesses acquired only a licence to use the computer software for their own purpose and there was as such no acquisition of any asset, much less a capital asset. As regards the decision of the Supreme Court in the case of Tata Consultancy Services v. State of Andhra Pradesh [2004] 271 ITR 401 it was contended that the same was rendered in the context of levy of sales tax and transfer of right to use the software was held to be a sale of goods exigible to sales tax in the light of extended definition of ‘sale’ as given in Explanation (iv) to section 2(n) of sales tax law. It was contended that the said decision of the Supreme Court especially rendered in the context of extended definition given in the relevant statute could not be applied in the context of Income-tax Law. [Para 45]

The contention raised by the assessee could not be accepted. It was no doubt true that a transaction of sale of computer software package off the shelf was held to be a sale of ‘goods’ by the Supreme Court in the case of Tata Consultancy Services (supra) relying, inter alia, on the extended definition given in section 2(n) of the Andhra Pradesh General Sales Tax Act, 1957. But it was not the only basis on which the decision of the Apex Court was exclusively based. [Para 46]

On the other hand, the view of American Courts on the issue as well as its own decision was taken into account and relied upon by the Supreme Court to hold that a software, whether customized or non customized, satisfies all the attributes of being a ‘goods’ and as such, the same is capable of being bought and sold and becomes an object of trade and commerce. [Para 54]

The ratio laid down by the Supreme Court in the case of Tata Consultancy Services (supra) holding that computer software put in a medium of disk would be goods can only lead to the conclusion that purchase of such disk is acquiring a tangible asset. If the disk, tape or floppy or other electronic medium in which the software is stored is by itself goods, then the assessee who acquires the same, acquires a tangible asset. Computer Software has not been defined in the Act, but in Note-7 to Appendix-I to the Income-tax Rules, 1962 it has been explained to include computer programme recorded on any disc, tape, perforated media or other information storage device. Therefore, computer software (whether in canned form or uncanned form) is goods and a tangible asset by itself. The question whether an assessee by purchase of a disk containing software has purchased a capital asset or not should not, therefore, be viewed from the angle of acquisition of any copyright or any of the bundle of rights comprised in such copy right. An assessee purchasing such a software becomes owner thereof. But the test of ownership in the computer software in the light of the question whether the same is capital or revenue cannot be decided on the basis of ownership test alone but has to be seen from the point of it’s utility to businessman and to see how important an economic or functional role it plays in his business. In other words, the functional test becomes more important and relevant because of the peculiar nature of a computer software and its possible use in different areas of business touching either capital or revenue field or its utility to a businessman which may touch either capital or revenue field. The manner in which the computer software is used is again peculiar. General mode is to acquire computer software on a license. That by itself will not be sufficient to conclude that the said expenditure is revenue expenditure, if on application of the functional test, it is found that the expenditure operates to confer a benefit in the capital field. On the other hand, some computer software may have a very limited economic life so as to be treated as capital expenditure, though owned by an assessee. [Para 55]

Whether expenditure on computer software gives an enduring benefit to an assessee :

For ascertaining as to whether expenditure on computer software gives an enduring benefit to an assessee, the duration of time for which the assessee acquires right to use the software becomes relevant. Having regard to the fact that software becomes obsolete with technological innovation and advancement within a short span of time, it can, be said that that where the life of the computer software is shorter (say less than 2 years), it may be treated as revenue expenditure. It is also evident from the amendment to the law with effect from 1-4-2003 granting 60 per cent depreciation on computer software that even the Legislature considers the life of computer software as about two years by providing the higher rate of depreciation at the rate of 60 per cent thereon so as to enable assessee to write off the same to the extent of 84 per cent even when treated as capital asset within a period of two years. An assessee may own a software outright or be a licensee but the same may operate to confer benefit only in the revenue field and, therefore, it may have to be regarded as revenue expenditure. The decision of the Supreme Court, in the case of Empire Jute Co. Ltd. v. CIT [1980] 124 ITR 1/3 Taxman 69 lays down that it is not every advantage of enduring nature acquired by an assessee that brings the case within the principle laid down in this test (enduring benefit test). What is material to consider is the nature of the advantage in a commercial sense and it is only where the advantage is in the capital field that the expenditure would be disallowable on an application of this test. If the advantage consists merely in facilitating the assessee's trading operations or enabling the management and conduct of the assessee's business to be carried on more efficiently or more profitably while leaving the fixed capital untouched, the expenditure would be on revenue account, even though the advantage may endure for an indefinite future. In other words, the functional test would become material and if on application of the same it is found that the expenditure operates to confer benefit in the revenue field, then the same would be revenue, irrespective of the duration of time for which the assessee acquires rights in a software. The period of advantage in the context of computer software should not be viewed from the point of view of different assets or advantage like tenancy or use of know-how because software is a business tool enabling a businessmen's ability to run his business. [Para 56]

Whether the expenditure operates to add the profit earning apparatus of the assessee (Functional Test):

The advantage which an assessee derives has to be seen. The nature of advantage has to be seen in a commercial sense. If advantage is in the capital field then the same would be capital expenditure. If the advantage consists merely in facilitating the assessee’s trading operations or enabling the management and conduct of assessee’s business to be carried on more efficiently or more profitably, while leaving the fixed capital untouched, the expenditure would be on revenue account. However, if assets/advantage is pat of profit earning apparatus, it is capital. [Para 57]

The following factors would be relevant to determine whether the advantage operates in the capital field on revenue field :

(i) Nature of business of the assessee : It is necessary to obtain an understanding of the business function or effect of a concern's software. Software normally functions as a tool enabling business to be carried on more efficiently. The scope, power, longevity of such a tool and its centrality to the functions of the business will all bear on its treatment.

In the case of ‘S’, one of the assessees in the cases referred to the Special Bench, the assessee was engaged in the business of software development as well as running a training center to impart specialized training to the students in software technology. If the software were used in such business to impart training to the students, then the same would be part of the profit making apparatus of the assessee and consequently expenditure on software, capital.

Another example which could be considered was that of acquisition of Turbo Gold Software for Rs.17.61 lakhs by the assessee in the instant case. The said software helped in compression of size of e-mails sent through the Lotus Notes Mailing System and it included licenses for 150 users who were using Lotus Notes Mailing System and software license for running on its servir. If use of this software in the business of the assessee was limited to facilitate merely an effective and fast communication in order to increase its organizational efficiency, the same cannot be treated as forming part of the profit-making apparatus of the assessee. On the other hand, if such software was being used by an assessee engaged in the business of placement agency where the applications from persons seeking jobs are invited through e-mail and are also forwarded to the concerned clients through e-mail, the same may from part of profit-making apparatus of the assessee's business of placement agency and can be treated as a capital asset.

(ii) As a general rule it may be stated that the more expensive the computer software the more it is likely to be a central tool of the business and the more enduring is likely, to be its effect adding to the profit earning apparatus. If there are associated capital expenditure like purchase of new computer equipment for running the software developed under a project, then it can be considered as capital expenditure. This is especially the case where the new hardware is not merely desirable but necessary for this purpose.

(iii) Degree of associated organisational change: Similarly the degree of change intended in the way operations are carried out as a result of the computer software, for example, savings in the number, and changes in the location, of staff used to provide services to customers will have a bearing. The more radical the changes, the more likely the expenditure will be capital. These changes are likely to be most radical when operations previously carried on manually are computerised.

(iv) It has to be borne in mind that computer software industry is of a fast changing nature. Therefore, whatever software purchased by an assessee would become outdated much earlier than expected. The assessee has, therefore, to upgrade his software. An element of upgrading does not automatically make the expenditure capital. The presence
of an element of upgrading, therefore, will not necessarily cause the expenditure in question to be capital. [Para 58]

The conclusions on the issue under consideration, thus, could be summarized as
under:-

(i) When the assessee acquires a computer software or for that matter the license to use such software, he acquires a tangible asset and becomes owner thereof.

(ii) Having regard to the fact that software becomes obsolete with technological innovation and advancement within a short span of time, it can be said that where the life of the computer software is shorter (say less than 2 years), it may be treated as revenue expenditure. Any software having its utility to the assessee for a period beyond two years can be considered as accrual of benefit of enduring nature. However, that by itself will not make the expenditure incurred on software as capital in nature and the functional test also needs to be satisfied.

(iii) Once the tests of ownership and enduring benefit are satisfied, the question whether expenditure incurred on computer software is capital or revenue has to be seen from the point of view of its utility to a businessman and how important an economic or functional role it plays in his business. In other words, the functional test becomes a more important and relevant because of the peculiar nature of the computer software and its possible use in different areas of business touching either capital or revenue field or its utility to a businessman which may touch either capital or revenue field. [Para 59]

Having laid down the criteria for determining the nature of expenditure incurred on acquisition of software, whether capital or revenue, these criteria need to be applied to determine the exact nature of expenditure incurred by the assessees in the instant cases for acquiring different softwares. Since this exercise was required to be done in respect of each and every software independently having regard to the abovesaid criteria, the matter was to be restored back to the file of the Assessing Officer for doing such exercise. The Assessing Officer shall examine the question whether expenditure on computer software was capital or revenue in the light of the criteria laid down above after giving an opportunity of being heard to the assessees. If on such examination, the Assessing Officer comes to the conclusion that the expenditure was capital expenditure, then the question regarding allowing depreciation will be decided in accordance with the principles laid down in the subsequent paragraphs. [Para 60]

Though a licensee, the person purchasing the disk or other medium containing the software is owner to the extent of the rights comprised in the license. The decision of the Supreme Court in the case of Tata Consultancy Services (supra) supports the view that software contained in a disk is tangible property by itself. The use by the assessee of such software in his business is enough to allow the claim for depreciation. The rights which an assessee acquires by purchasing the disk or magnetic medium containing the computer software with limited or absolute right to use the same by itself would satisfy the requirements of the plant. The assessee's ownership of limited right over the tangible asset is sufficient to conclude that the assessee is the owner of the plant. There is, therefore, no difficulty in allowing depreciation claim at 25 per cent under section 32(1)(i) read with Appendix-I, Part-A division III (1) to the Income-tax Rules, 1962. With effect from 1-4-2003, computer software has been classified as a tangible asset under the heading ‘Plant’ in Appendix-I to the Rules entitled to depreciation at 60 per cent. The assessee would be entitled to depreciation at 60 per cent from 1-4-2003. [Para 61]

The assessees argued that the rate of depreciation on computer software from 1-4-1999 should be 60 per cent. The basis of this argument was that depreciation on computers was originally allowed treating them as a plant only at 25 per cent. With effect from 1-4-1999, computers were treated as different class of asset falling within the depreciation of plant and depreciation was allowed at 60 per cent. With effect from 1-4-2003, computer software was also included along with computers. The argument of the assessee was that the amendment to the rules was merely clarificatory and, therefore, even on computer software with effect from 1-4-1999, 60 per cent depreciation should be allowed. The contention of the assessees could not be accepted. The amendment is prospective. It is not clarificatory for the reason that computer and computer software are two different items of assets. If the Legislature wanted to allow depreciation at 60 per cent with effect from 1-4-1999 on computer software, it would have said so specifically by making the provisions retrospective. [Para 62]

Therefore, it was proper deemed proper to refer back the cases to the President for placing the appeals before the regular Division Bench for decision in accordance with the ruling of the Special Bench on the issue of expenditure on software and decision on other issues after hearing the parties. [Para 63]