Deduction u/s 80-O computed applying average net profit margin for domestic income not considering fixed costs was distorted apportionment-Delhi High Court

In its  latest judgment , Delhi High Court has held that deduction under Section 80-O of the Income tax Act, 1961 computed applying average profit margin for domestic income and not considering fixed costs was a distorted apportionment of net profit.

Case Law Details:
ITA 264/2002 ITA 415/2004
M/s Continental Carriers …… Appellant vs. Commissioner of Income Tax …. Respondent
date of Judgment: 26/04/2016

Important Case Law Referred:
CIT v. EHPT India P. Ltd.: (2013) 350 ITR 41 (Del)

CIT v. Bilahari Investment P. Ltd.:(2008) 299 ITR 1 SC
CIT v. Realest Builders & Services Ltd.: (2008) 307 ITR 202 SC
CIT v. McMillan & Co.: 33 ITR 182 SC
CIT v. Woodward Governor India P. Ltd.: 312 ITR 254 SC
CIT v. Jagatjit Industries Ltd.: 339 ITR 382 SC
Lalchand Bhagat Ambica Ram v. CIT: 37 ITR 288 (SC)
CIT, Chennai v. M/s Matrix Intel Pvt. Ltd. Chennai: 2006-TIOL-389-HC-MAD-IT
CIT v. Satish Kumar Chandna: 311 ITR 276 (Del)

Brief Facts of the Case:
The controversy in both the appeals was related to the method of computing the income received or brought into India in convertible foreign exchange for the purposes of deduction under Section 80-O of the Act.

The Assessee was a partnership firm involved in the business of clearing and forwarding of goods for import and export, in India. In 1988, the Assessee commenced a new business activity which resulted in income by way of commission from foreign enterprises. The commission was brought into India in convertible foreign exchange and was eligible for deduction under Section 80-O.

For claiming the deduction for AY 1993-94 , the assessee  computed the average profits of 10 years @ 11.5% when it did not have any commission from foreign enterprise and applied it for deduction from consolidated net profits to compute its Foreign Income . Whereas the AO applied the ratio of assessed income to gross receipts on the commission received and computed the deduction under Section 80-O accordingly. For AY 1997-98, the assessee, computed the 80-O deduction by deducting 80% of the expenses relating to postage, telegram, telephone and fax etc. and 10% of the expenses relating to salaries from the gross commission received from foreign enterprises to compute its Foreign Income. 50% of the Foreign Income so computed was claimed as deduction. AO again rejecetd the computation and applied the same methodology as in AY 1993-94.

CIT(A) rejected the assessee’s appeal for AY 1993-94 and 1997-98 and held that since, the Assessee had not maintained separate books of accounts, the most scientific method for determining Foreign Income would be by allocating expenses between the domestic income and income from foreign enterprises on a proportionate basis.  

ITAT also held that the formula adopted by the AO in estimating the Foreign Income was reasonable and scientific.

Observation of the High Court:

The Court observed that fixed Costs are costs which have to be incurred irrespective of whether the assessee earns any income or not. Typically, such costs include costs for basic infrastructure, office space, etc. and such costs do not vary with the volume of business. In the method as adopted by the Assessee, no part of the fixed cost was allocated to foreign business and at best, only the marginal variable costs were sought to be attributed to earning Foreign Income which resulted in a distorted apportionment of net profits of the assessee between domestic income and foreign income.

Illustration given by the Court:

21. To illustrate the above point, let us consider a hypothetical case of an assessee who’s revenue receipts from business (Existing Business) in a particular year is Rs.1,00,000/-. He incurs office rentals and establishment costs of Rs. 60,000/-and other variable expenses of Rs. 20,000/-; thus declaring a profit of 20,000/- (translating to a net profit margin of 20%). In the next year, he expands his business by commencing a new activity (‘New Business’) from the same establishment which results in additional revenues of Rs. 50,000/- for which he incurs incremental variable cost of Rs. 10,000/-. Assuming that the revenues from existing business remain static and there are inflationary pressures on costs; the assessee would earn a profit of Rs. 60,000/- and his overall net profit margin would increase to 40% (i.e 60,000/150,000). If the method as canvassed by the Assessee is accepted, and the costs are allocated to the Existing Business based on the profit margin prior to commencement of New Business, the entire office rentals and establishment costs of Rs. 60,000/- would be allocated to the Existing Business even though the same establishment was used for carrying on the New Business. The result would be that while the profit margin of the Existing Business would continue to be assumed at 20% and the profit margin of the New Business would be reflected at 80%. 

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