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(Explained With Case law: Adadyn Technologies)

Introduction

  • Income tax relies on the concept that the amount of tax a person pays should be based on that person's ability to pay due to which Chapter VI was introduced in Income Tax Act.
  • A deduction is an expense that can be subtracted from the taxable income of an assessee to reduce the amount owed as specified in The Income Tax Act,1961.

General Deductions

Any expenditure other than sections 30 to 36, shall be allowed as deduction provided the following conditions are satisfied:

  1. It is not in the nature of the capital expenditure.
  2. It is not in the nature of personal expenditure.
  3. It is laid out wholly and exclusively for the purposes of business and profession of the assessee.
Deductions under Section 37 of the IT Act, 1961

Further, it is clarified that some specified expenditures not deemed to have been incurred for the purpose of business or profession.

Explanation 1

Any expenditure incurred by assessee which is an offence or prohibited by law.

  • In respect of payments on account of protection money, extortion, bribes or any other unlawful expenditure is not allowable as business expenditure.
 

Explanation 2

Any expenditure incurred by an assessee on activities relating to Corporate Social Responsibility under section 135 of the Companies Act, 2014.

  • As stated in Rule 4 and Rule 6 of Corporate Social Responsibility (CSR), activity undertaken in pursuance of normal course of business shall not be regarded to CSR Activities.
  • Donations to Swach Bharat Kosh and Clean Ganga Fund, PM CARES, deductions can be claimed under section 80G.
  • The CSR expenditure which is of the nature described in section 30 to 36 of the act can be allowed as deduction on fulfilment of the specified conditions. For example: Donation to certain trusts under section 35(1)(ii)/ 35(1)(iii) can be claimed as deduction by the assessee.

SECTION 37(2B)

Payments Made To Political Party

No allowance shall be made in respect of expenditure incurred by an assessee on advertisement in any souvenir, brochure or the like published by a political party.

  • Since donations to political party and electoral trust are expenditures not incurred for the purpose of business and profession, they are disallowed.
  • However, under sections 80GGB and 80GGC, the aforesaid deductions can be claimed on fulfilment of certain conditions.
 

CASE STUDY

[2020] IN THE ITAT BANGALORE BENCH
Adadyn Technologies (P.) Ltd.
v/s
Commissioner of Income Tax, Bengaluru

Section 37(1) of the Income-tax Act, 1961
(Allowability of Business Expenditure)

Allowability of Expenditure on Abandoned project

  • Whether Expenditure (including Marketing and Salary Expenses) incurred towards development of new software platform, which was later abandoned, due to rapid change in technology, be treated as revenue expenditure or capital expenditure.

Brief facts of the case

  • Adadyn Technologies is engaged in the business of rendering customized internet advertising services (Advertising based on customer’s Interests, search history) for mid-sized advertisers such as news, financial services, and entertainment etc. to achieve more with any size marketing budget.

Income Model

​​​​​​Pragmatic Model

  • The pragmatic business consists of services rendered to international customers which involves online display, buying and selling of advertisement, sales on online software platform such as Appnexus.
  • Appnexus is an online advertising software, through which Microsoft (say) streamline all its ad inventory for bidding to Ad Buyers or lease tools to various Publishers for fixed rental.

Flowchart

Reselling Model

  • Adadyn India buys advertisement inventory from the website (Publishers) and resells it to its customers (predominantly Google). In other words, reselling an advertisement space of publisher to customers for which software was to be developed.

In Assessment year 2015-16

  • Assessee was developing a new software platform (for less sophisticated client base, who could not afford to pay license fee for platform such as AppNexus) but such new platform was abandoned during subsequent financial year due to rapid change in technology was treated as part of revenue expenditure.
  • Product had never been put to use and no depreciation had been claimed.
  • Expenditure (including salaries on technical personnel and marketing expenses) incurred towards development of new software platform was treated as part of revenue expenditure.

The assessee has filed its return of income for assessment year 2015-16 on 28-11-2015 declaring total income of Rs. 14,16,63,540/-

CASE: SCRUTINY

i. Assessing Officer

Q. Why expenses pertaining to development of software platform shall not be capitalized?

Assessee

  • The product that it was developing cannot be termed as an independent product, which can be put to use.
  • Expenses including salaries on technical personnel and marketing expenses were incurred to determine the practicality of the proposed new software, cannot be considered as capital expenditure.

Assessing officer

  • The assessee is the owner of the software platform being developed.
  • Software would give future benefits to the assessee and will lead to the expansion of business.
  • The amount of expenditure indicated that it is central tool of business and should be considered as capital expenditure.

Accordingly, disallowed an amount of Rs. 6,06,30,146/-being expenditure incurred on salaries for software product development and its marketing as revenue expenditure.

ii. APPEAL BEFORE CIT

Assessee

  • Accounting Standards-26 issued by the ICAI

‘In the research phase of a project, an enterprise cannot demonstrate that an intangible asset existed from which future economic benefits are probable.

Further, the standard states that expenditure on research should be recognized as expenditure, when it is incurred.’

  • Expenditure incurred to determine the feasibility of a new project, which is already carried on by the assessee even if it is for expansion of business cannot be treated as capital in nature.
  • The marketing expenses were incurred primarily towards attracting potential customers for development of business in general.

CIT

  • The new software platform is the backbone of the new line of business of Reselling of online digital advertisement space.
  • Software under development is expected to give enduring benefit to the assessee and being a new intangible product, one can recognise the intellectual property in the same.

iii. ITAT

Order Passed

  • As per Accounting Standard-26 prescribed by the ICAI for treatment of expenditure of research and development expenses, the standard clearly laid down the procedure for accounting of research expenditure, as per which expenditure on research should be recognised as an expenditure when it is incurred.
  • The Accounting standard further states that in the research phase of the project, an enterprise cannot demonstrate that an intangible asset exists from which future economic benefits are probable. Therefore, Expenditure incurred for development of new software- Revenue Expenditure.
  • The marketing expenses were incurred in order to show cause the capabilities of Adadyn to the potential customers and this is a clear indication that other expenses were incurred primarily towards attracting potential customers for development of business in general for the company- Revenue expenditure.
  • Expenditure incurred by the assessee towards salary cost were revenue in nature as there was no development of any new independent product for this market- Revenue expenditure.

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Category Income Tax, Other Articles by - Vidushi Agrawal  



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