IN THE HIGH COURT OF KARNATAKA AT BANGALORE

Dated this the 25th day of August, 2014

PRESENT

THE HON’BLE MR. JUSTICE N KUMAR

AND

THE HON’BLE MRS. JUSTICE RATHNAKALA

ITA No.1073 of 2008

c/w
ITA No.72 of 2011
ITA No.813 of 2007

ITA No.1073 of 2008

BETWEEN:

1. The Commissioner of Income Tax

C.R. Building
Queens Road
Bangalore

2. The Assistant Commissioner

of Income Tax
Circle-12(3)
C.R. Building
Queens Road
Bangalore …Appellants

(By Sri K. V. Aravind, Advocate)

AND:

M/s. Tejas Networks India (P) Ltd.,

No.58, 1st Main Road
 2

J.P. Nagar, 3rd Phase

Bangalore -560 078 …Respondent

(By Sri Suryanarayana T. Advocate for

M/s. King & Partridge, Advocates)

This ITA is filed under Section 260-A of I.T. Act, 1961

arising out of order dated 18-07-2008 passed in ITA
No.1228/BNG/2007, for the assessment year 2003-2004,
praying to (i) formulate the substantial questions of law
stated therein, (ii) allow the appeal and set aside the order
passed by the ITAT Bangalore in ITA No.1228/BNG/2007,
dated 18-07-2008 confirming the order of the Appellate
Commissioner and Assistant Commissioner of Income Tax,
Circle 12(3), Bangalore.

ITA No.72 of 2011

BETWEEN:

1. The Commissioner of Income Tax-II

Central Revenue Building
Queens Road
Bangalore

2. The Deputy Commissioner of Income Tax

Circle-12(4)
C.R. Building
Bangalore …Appellants

(By Sri E. Sanmathi, Advocate)

AND:

M/s. Tejas Networks Ltd.,

No.58, 1st Main Road
J.P. Nagar, 3rd Phase
Bangalore -560 078 …Respondent
 3

(By Sri Suryanarayana T. Advocate for

M/s. King & Partridge, Advocates)

This ITA is filed under Section 260-A of I.T. Act, 1961

arising out of order dated 14-10-2010 passed in ITA
No.719/BNG/2010, for the assessment year 2004-2005,
praying to (i) formulate the substantial questions of law
stated therein, (ii) set aside the appellate order dated 14-10-
2010 passed by the ITAT, ‘B’ Bench, Bangalore in appeal
proceedings ITA No.719/Bang/2010 as sought for in this
appeal.

ITA No.813 of 2007

BETWEEN:

1. The Commissioner of Income tax

Central Circle
C.R. Building
Queens Road
Bangalore

2. The Assistant Commissioner

of Income Tax
Circle-12(3)
C.R. Building
Queens Road
Bangalore …Appellants

(By Sri K. V. Aravind, Advocate)

AND:

M/s. Tejas Networks India Ltd.,

No.58, 1st Main Road
J.P. Nagar, 3rd Phase
Bangalore -560 078 …Respondent
 4

(By Sri Suryanarayana T. Advocate for

M/s. King & Partridge, Advocates)

This ITA is filed under Section 260-A of I.T. Act, 1961

arising out of order dated 08-06-2007 passed in ITA
No.470/BNG/2006, for the assessment year 2002-2003,
praying to (i) formulate the substantial questions of law
stated therein, (ii) allow the appeal and set aside the order
passed by the ITAT Bangalore in ITA No.470/BNG/2006,
dated 08-06-2007 confirming the order of the Appellate
Commissioner and Assistant Commissioner of Income Tax,
Circle 12(3), Bangalore.

These ITAs coming on for hearing this day,

N. KUMAR J delivered the following:

JUDGMENT

These three appeals are preferred by the revenue

challenging the finding recorded by the Tribunal that the

expenditure on prototype development is to be treated as

revenue expenditure and not as a capital expenditure.

2. The assessee develops and sells leading edge

optical networking products for worldwide customers. It has

developed software differentiated, next generation products

that enable telecommunication carriers to build converged

networks that support traditional voice based services as

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well as new data dominated services. Their product line is

marketed under the brand name TJ100.

3. In the return of income filed for the year 2003-

04, the assessee has claimed a sum of Rs.6,00,68,512/- as

product development expenses. The break up of this figure

is:

Engineering charges: Rs. 27,66,645/-

Employee Cost: Rs. 3,27,47,936/-
Material Cost: Rs. 2,45,53,931/-

All the expenses incurred by the assessee have been towards

the development of a single product line, the TJ100 series.

The assessee has spent the sums on the import of hardware

components for developing prototypes, towards engineering

cost of these prototypes and for employee costs involved

therein. The assessee also claimed that the hardware used

was not reusable and hence was being scrapped on

completion of activity. The components imported have been

used for manufacturing Printed Circuit Boards required for

the equipment. Relying on the submission made by the

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employees to the effect that these PCBs are lying in the office

and the imported components used on the PCBs are

available in the labs in the Company, all these components

are retained by the Company for use in Product Development

of other TJ100 products such as TJ100MC, the assessing

authority came to the conclusion that all these products

enable the assessee Company to develop and manufacture a

particular product which is the mainstay of the Company’s

turnover in the future years. Even after the product is

successfully developed and marketed, the hardware

purchased and the software developed are still used. They

are used to solve any problems that may come up with the

product when being used by the customer. Therefore, the

assessing authority was of the view that the assessee has

gained an enduring benefit by means of the product

development expenditure. The expenditure is not merely to

facilitate the assessee’s business but expenses is used for

development which earned him substantial revenues in the

later years. Therefore, treating it as a capital expenditure,

 7

the said expenditure was added back to the income of the

assessee, of course he held that the assessee can claim

depreciation.

4. Aggrieved by the same, the assessee preferred an

appeal to the Commissioner of Income Tax (Appeals). The

Appellate Authority proceeded on the basis that as per its

own admission, the assessee has derived an enduring benefit

from the prototypes so developed as the same have not been

scrapped and are still used and, therefore, it upheld the

assessing authority’s action of treating the expenditure as

capital.

5. Aggrieved by the same, the assessee preferred an

appeal before the Tribunal. The Tribunal on reconsideration

of the entire material on record, taking note of the various

judgments on which reliance was placed by both the parties,

by a detailed order came to the conclusion that the

technology in telecommunication is developing at a very fast

speed and new products are to be developed in case one has

 8

to remain in the business. The product developed is

marketed for one year only, as the next product will come

before the end of first year of the introduction of an earlier

product. A number of prototypes are developed but all such

prototypes are not used as model for the new product. The

prototypes, which are not finally approved for commercial

production, are rejected and such prototypes are of no use.

Only those prototypes are retained, for which, the Company

manufactures the product. Such prototype is kept for four

to five years, so that the assessee Company is able to redress

the complaint of any customer in case any complaint is

received. Such prototype is model of the product, which is

marketed and, therefore, it was of the view that the benefit is

not derived for a period of more than five years, the benefit is

not of enduring nature and expenses cannot be treated as

capital and, therefore, ultimately it recorded a finding that

the expenditure on prototype development is to be treated as

revenue and not as capital. It also held that the expenditure

in the alternative as allowable under Section 35 (1) (iv) of the

 9

Act without any discussion. Aggrieved by the said order, the

revenue has filed these appeals.

6. ITA No. 813/2007 and ITA No. 72/2011 was

admitted to consider the following substantial questions of

law:-

1. Whether the Tribunal was right in holding

that a sum of Rs.6,00,68,512/- incurred for
developing a product TJ-100 having a
utility value for a period of 5 years cannot
be considered as a capital expenditure and
depreciation allowed by the Assessing
Officer confirmed by the Appellate
Commissioner treating as a revenue
expenditure?

2. Whether the Tribunal was right in

alternatively holding that the assessee’s
claim regarding expenditure is allowable
under Section 36 (i) (iv) of the Income Tax
Act even if the expenditure is held to be
capital in nature?
 10

7. Similar questions are framed in ITA No.

1073/2008 which are as under:-

1. Whether the Tribunal was correct in holding

that a sum of Rs.5,82,21,211/- incurred for
developing a product TJ-100 having a
utility value for period of 5 years cannot be
treated as a capital expenditure and
depreciation allowed as held by the
Assessing officer and confirmed by the
Appellate Commissioner but should be
allowed as a revenue expenditure?

2. Whether the Tribunal was correct in holding

that the expenditure allowable should be
alternatively allowed u/s.35(1)(iv) of the
Act, as the same had been incurred on
scientific research related to the business
carried on by the assessee?

8. We have heard the learned counsel appearing for

the parties.

9. Learned counsel for the revenue relying on the

statements of the officials as set out in the order of the

 11

assessing authority contended that, the components are

retained by the Company for use by the Company in Product

Development of other products, they are lying in the office,

they are not scrapped as contended by the assessee and,

therefore, the expenses incurred towards these components

is of enduring nature and it is in the nature of capital

expenditure and the Tribunal was in error in holding it

otherwise.

10. Per contra, the learned counsel for the assessee

submitted that, the expenses are incurred for upgrading

their product every year. It is in the nature of product

development expenses and, therefore, it cannot be treated as

a revenue expenditure. The Tribunal was right in treating it

as a revenue expenditure.

11. In the light of the aforesaid facts and the rival

contentions, it is clear that the assessee is in the business of

developing and selling leading edge optical networking

products for worldwide customers. It has developed software

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differentiated, next generation products that enable

telecommunication carriers to build converged networks.

The life span of this product is hardly a year. Because of

competition in the market, the assessee has to come out

with new features every year if they want to be in the field.

Therefore, there is a constant upgradation of the original

product. It is in that context substantial amount is spent

towards employees cost and the upgradation also includes

use of components purchased every year. In fact, those

components are used for manufacturing Printed Circuit

Boards. Every year these Circuit Boards under go

modification, changes. Therefore, the expenses incurred in

this regard is in the nature of revenue expenditure.

12. The Apex Court in the case of EMPIRE JUTE

COMPANY LIMITED vs COMMISSIONER OF INCOME TAX

[1980 VOL. 124 PAGE 1] has held that, the decided cases

have, from time to time, evolved various tests for

distinguishing between capital and revenue expenditure but

no test is paramount or conclusive. There is no all embracing

 13

formula which can provide a ready solution to the problem; no

touchstone has been devised. Every case has to be decided

on its own facts, keeping in mind the broad picture of the

whole operation in respect of which the expenditure has been

incurred. Further they held that, there may be cases where

expenditure, even if incurred for obtaining advantage of

enduring benefit, may, none the less, be on revenue account

and the test of enduring benefit may break down. It is not

every advantage of enduring nature acquired by an assessee

that makes it a capital expenditure. What is material to

consider is the nature of the advantage in a commercial sense.

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. The test of

enduring benefit is, therefore, not a certain or conclusive test

and it cannot be applied blindly and mechanically without

 14

regard to the particular facts and circumstances of a given

case.

13. In fact, the Apex Court in the case of ALEMBIC

CHEMICAL WORKS CO. LTD., vs COMMISSIONER OF

INCOME TAX, GUJARAT [1989 VOL. 177 PAGE 377] held

that, it would be unrealistic to ignore the rapid advances in

research in antibiotic medical microbiology and to attribute a

degree of endurability and permanence to the technical know-

how at any particular stage in this fast-changing area of

medical science. The state of the art in some of these areas of

high priority research is constantly updated so that the know-

how cannot be said to be the element of the requisite degree of

durability and nonephemerality to share the requirements and

qualifications of an enduring capital asset. The rapid strides

in science and technology in the field should make us a little

slow and circumspect in too readily pigeon-holing an outlay

such as this as capital. …. The improvisation in the process

and technology in some areas of the enterprise was

supplemental to the existing business and there was no

 15

material to hold that it amounted to a new or fresh venture.

The further circumstance that the agreement pertained to a

product already in the line of the assessee’s established

business and not to a new product indicates that what was

stipulated was an improvement in the operations of the

existing business and its efficiency and profitability not

removed from the area of the day-to-day business of the

assessee’s established enterprise.

14. We are of the view the aforesaid statement of law

equally holds good in the area of telecommunication, may be

with more force. Having regard to the facts of this case, the

expenditure that is claimed is for upgrading the existing

product. Therefore, the product so upgraded goes on

changing as time progresses, keeping in mind the

requirement and the competition in the market. The

Tribunal rightly held that the expenditure is not in the

nature of capital expenditure but is revenue expenditure.

Therefore, the first substantial question of law is answered in

favour of the assessee and against the revenue.

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15. In so far as the second substantial question of

law is concerned, in fact the Tribunal has not given any

reasons and as the assessee succeeds on the first

substantial question of law, we are not going into the said

question and that question is left open to be agitated at an

appropriate time in an appropriate forum. On the ground

that no reasons are given, we set aside the said finding.

Sd/-
JUDGE

Sd/-
JUDGE

ckl/-