IN THE SUPREME COURT OF INDIA

CIVIL APPELLATE JURISDICTION

CIVIL APPEAL NO.1667 OF 2010 (Arising out of S.L.P. (C) No.18545 of 2009)

Commissioner of Income Tax, Ahmedabad         ...Appellant(s)

Versus

M/s. Mastek Limited                       ...Respondent(s)

W I T H

Civil Appeal No.1668 of 2010 (Arising out of S.L.P. (C) No.16713 of 2009)

O  R  D  E  R

Delay condoned.

Leave granted.

Heard learned advocates on both sides.

These two civil appeals are filed by the Department  

against the order dated 2nd September, 2008, of the Gujarat  

High Court refusing to formulate, inter alia, the following  

question of law:

“Whether the Income Tax Appellate Tribunal, in the  facts and circumstances of this case, was right in  confirming the order passed by the Commissioner of  Income Tax (Appeals) deleting the additions made  by the Assessing Officer on account of royalty  expenses?”

...2/-

- 2 -  

In the lead matter, which is civil appeal arising out  

of  S.L.P.  (C)  No.18545  of  2009,  the  facts  are  as  under:  

Assessee carries on the business of development of Software  

Package and Packaged Software Products divisible into four  

groups,  namely,  (i)  Customized  Software;  (ii)  Packaged  

Software Products; (iii) Agency Products; and (iv) Exports.  

In the lead matter, we are concerned with Assessment Year  

1996-1997  and  with  the  Agency  Products.   In  that  year,  

assessee claimed deduction under Section 37 of the Income Tax  

Act, 1961 [`Act', for short] in respect of royalty expenses  

of Rs.3,23,28,158/-.  The Assessing Officer held that, only  

one-sixth of the amount was allowable in view of Section 35AB  

of the Act and, accordingly, after allowing the benefit under  

Section  35AB  of  the  Act,  the  Assessing  Officer  made  a  

disallowance of Rs.1,12,12,352/-, which was added back to the  

income of the assessee.  On appeal filed by the assessee, the  

Commissioner of Income Tax (Appeals) deleted the additions  

made by the Assessing Officer, which view was confirmed by  

the  Income  Tax  Appellate  Tribunal  [`Tribunal',  for  short]  

following it's earlier decision in the assessee's own case in  

I.T.A.  No.4968/1995  and  others  dated  25th November,  1999.  

Being  aggrieved  by  the  decision  of  the  Tribunal,  the  

Department instituted Tax Appeal No.606 of 2008 in the High  

Court which, as stated hereinabove, refused to formulate the  

above proposed question, hence, these civil appeals.

During  the  year  under  consideration,  the  assessee  

claimed that it had paid royalty as below:

...3/-

- 3 -  

Ingress Corporation Rs.27969750

Comshare Rs.2727591

LMB Rs.1639817

Rs.32328158

In respect of the said payments, the assessee claimed  

deduction under Section 37 of the Act on the ground that the  

assessee  had  made  the  said  payments  towards  royalty  for  

“duplicating” the software by the name `Ingres' in India and  

supplying  the  same  to  the  end-users.   According  to  the  

assessee, the ownership of the said software was retained by  

Ingres Corporation [which is an American based Multi-National  

Company in United States]; that for each copy, which stood  

duplicated and sold to the customers in India, the assessee  

had paid royalty to the Corporation based on its sale value  

and, thus, such payment towards royalty formed part of the  

expenditure incurred by the assessee in making the sales.  

Before us, it was argued on behalf of the assessee that the  

payment of royalty was for duplicating the software `Ingres'  

in India and for supplying the same to the end-users.  In  

this connection, it was pointed out that there is a vital  

difference between payment of consideration for acquisition  

of a software and payment for acquisition of the right to use  

the said software.  According to the assessee, in the former  

case,  the  payment  would  constitute  capital  expenditure  

whereas,  in  the  latter  case,  it  would  constitute  an  

expenditure under Section 37 of the Act.   

...4/-

- 4 -  

At the outset, we may reiterate what we have stated  

earlier in so many judgements, namely, that the Department  

has to analyse the process undertaken by the assessee(s),  

analyse the contracts and the price structure to ascertain  

the nature of payment  Depending upon the analysis  of the  

process  of  “duplication”  in  the  context  of  the  contracts  

signed by the assessee with the American Corporation, one has  

to  find  out  whether  the  expense  incurred  is  a  Revenue  

expenditure or a capital expenditure.  Moreover, one cannot  

proceed  to  decide  such  cases  merely  on  the  basis  of  the  

labels  affixed  to  a  given  process.   In  this  case,  the  

assessee  contends  that  it  makes  payment  to  the  American  

Corporation  in  the  United  States  for  “duplicating”  the  

software.  Before coming to the dictionary meaning of the  

word “Duplication”, we may state that `Ingres', according to  

the Department, is a software which is a `Back-end System',  

which, in turn, is used to develop other softwares therefrom  

depending on the needs of the customers.  In the present  

case, the customers of the assessee are Reliance Industries  

Limited,  Anand  Bazar  Patrika,  Air  India,  etc.   One  more  

aspect  needs  to  be  highlighted.   The  contract/arrangement  

between the assessee and the American Corporation in this  

case  consists  of  two  parts,  namely,  commercial  and  

manufacture.   From the said contract/ arrangement, it, prima  

facie,  appears  that  the  above  customers  are  given  direct  

access  to  the  software  `Ingres'  and,  according  to  the  

Department, this is one reason why royalty is shared between  

the assessee and the American Corporation in the ratio of 60  

: 40.  According to the Department, such high ratio itself  

suggests that the impugned payment is not for “duplication”,  

simpliciter.  

...5/-

- 5 -  

According  to  the  Dictionary  of  Computer  by  W.R.  

Spencer,  a  “Database  System”  [which  is  also  called  as  

`Database  Management  System']  is  an  integrated  software  

system that facilitates accessing, entering and deletion of  

data.  According to the Dictionary of Computer by Prentice  

Halls,  `Database  Management  System'  is  a  collection  of  

software  programmes  designed  to  manage  and  maintain  a  

collection of records [Database] by providing facilities for  

storing, organizing and retrieving related information, as  

and  when  required.   According  to  the  same  Dictionary,  

`Duplicating' is a process of copying from a source data  

medium  to  a  destination  data  medium,  which  has  the  same  

physical form: for example, to copy a file from one magnetic  

tape to another magnetic tape is “duplication”.  According to  

Microsoft's Computer Dictionary, a “Back-end processor” is a  

processor  that  manipulates  data  sent  to  it  from  another  

processor:  for  example,  a  high  speed  graphic  processor  

dedicated to painting images of a video display operates in  

response  to  commands  passed  “back”  to  it  by  the  main  

processor.  According to the same Dictionary, the part of a  

compiler that transforms the source code into object code is  

called “Back-end”.  A Back-end processor is a slave processor  

that performs a specialized task, such as providing rapid  

access to a database, freeing the main processor for other  

work.   Such  function  is  called  `Back-end'  because  it  is  

supporting to the computer's main function.

Keeping  in  mind  the  fact  that  none  of  the  above-

mentioned aspects has been considered by the High Court, we  

are of the view that the High Court should have framed, on  

the facts and circumstances of these cases, the following  

question of law for determination:

...6/-

- 6 -  

“Whether  allowance  of  royalty  expenses,  as  claimed by the assessee, are to be allowed in  its entirety under Section 37 of the Income Tax  Act,  1961,  or  only  one-sixth  thereof,  as  mandated by Section 35AB(1) of the Income Tax  Act,  1961,  are  allowable  during  the  relevant  Assessment Years?”

Accordingly, we hereby remit these cases to the High  

Court for answering the above question.

Before  concluding,  we  may  clarify  that  we  have  

highlighted  some  technical  and  legal  aspects  mentioned  

hereinabove  only  for  the  purpose  of  pointing  out  that  

applicability of Section 37 vis-a-vis Section 35AB of the Act  

can be decided if there is a proper factual foundation on  

those aspects.  Our reasons, mentioned above, should not be  

treated as conclusive.  We are of the view that an in-depth  

exercise needs to be carried out to understand the actual  

process undertaken by the assessee to be examined in the  

light  of  the  contract/arrangement  with  the  American  

Corporation [including the purchase order and the position of  

the royalty shared by the assessee and the said Corporation].  

Therefore, we have not examined the case on merits.  Our  

reasons given herein are only to support this Order remanding  

the case to the High Court.  We leave contentions on both  

sides  expressly  open.   If  the  High  Court  comes  to  the  

conclusion that further foundational facts are required to be  

examined, it may remit the case to the Authorities below, if  

it deems fit.

...7/-

- 7 -  

Subject to what is stated above, civil appeals filed  

by the Department are allowed and the matter stands remitted  

to the High Court for deciding the question framed by us  

hereinabove.

No order as to costs.

......................J.               [S.H. KAPADIA]

......................J.               [AFTAB ALAM]

New Delhi, February 10, 2010.