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Petitioner: Messrs MERCK (PVT.) LTD, KARACHI and others VS Respondent: COMMISSIONER INLAND REVENUE, ZONE-I, LTU, KARACHI and others
Court Name: Appellate Tribunal Inland Revenue Judge(s): Seema Imran, Manzoor Ahmed Title:Messrs MERCK (PVT.) LTD, KARACHI and others vs COMMISSIONER INLAND
REVENUE, ZONE-I, LTU, KARACHI and others Case No.: I . T. As Nos. 648/KB and 691/KB of 2012 Date of Judgment:2015-12-08 Reported As: 2016 PTD (Trib.) 1356 Result: Order accordingly Judgment ORDER DR. MANZOOR AHMED, ACCOUNTANT MEMBER.---These two cross appeals have been filed both the Department and the taxpayer against the Order No,138/A-1, dated 08.06.2012 of the learned CIR (Appeals-I), Karachi, which are being taken up through this consolidated order. 2. The appellant/taxpayer has agitated through the following grounds of appeal:- 1) The CIR(A) has erred in maintaining the action of the DCIR in disallowing unrealized exchange loss of Rs. 5,947,631/- being notional in nature and not allowable under section 34(3) of the Income Tax Ordinance, 2001; 2. The CIR(A) has erred in maintaining the action of the DCIR in allocating expenses of Rs. 289,411/- against insurance commission without considering the fact that for earning insurance commission no expenses were incurred by the company and hence provision of section 67 read with 13 cannot be attracted. 3. The Department has agitated through the following grounds of appeal:-- 1) The learned CIR(A) has erred in deleting the disallowance of Encapsulation Charges; 2) The learned CIR(A) has erred in Annulling the addition made under section 111(1)(c) of the Income Tax Ordinance, 2001; The learned CIR(A) has erred in annulling the disallowance of Royalty claim; 4) The learned CIRCA) has erred in deleting the addition made in the Scrape sale; 5) The learned CIR(A) has erred in vacating the apportioning of Workers' Profit Participation Fund to income covered under Final Tax Regime.
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4. Brief facts of the case as gathered from the record are that the taxpayer/appellant is a pharmaceutical manufacturing company. Return of income for the Tax Year 2010 was e-filed on 29.09.2010 declaring taxable income under normal law at Rs.615,416,526/- and receipts covered under Final Tax Regime at Rs.662,577,282/- with FIR tax liability thereon at Rs.13,544,779/-. The return so filed has been treated as assessment order issued under section 120 of the Income Tax Ordinance, 2001. The case of the taxpayer was selected for audit under section 177 of the Ordinance by the CIR, Zone-IV, LTU, Karachi vide order dated 26.05.2011. Subsequently, the CIR was pleased to delegate the powers and functions under section 210 of the Ordinance to the office for conducting the audit under section 177 of the Ordinance vide Notification dated 26.05.2011. Accordingly, IDR and various other letters and notices were issued to the taxpayer for the purpose of audit. In response, the ARs of the taxpayer/company attended the proceedings from time to time and filed required explanation/clarification/reply along with details and documents. The AR was confronted the discrepancies, which were observed during the audit proceedings. 5. Both the parties being aggrieved and dissatisfied with the treatment meted out by the learned CIR(A) under section 129(1) of the Income Tax Ordinance 2001. Hence, the present appeals have been filed before this forum. 6. On the date of hearing, Mr. Mukhtar Ali Sher, DR appeared on behalf of the Department while Mr. Amin Malik, FCA appeared on behalf of the taxpayer/,company. 7. We have heard the arguments put forward by both the parties regarding each appeal. The learned AR supporting the grounds of appeal by him vehemently argued regarding the appeal filed by him and learned DR also argued in favour of appeal filed by the Department. 8. After a patient hearing to both parties in appeal, we intend to decide the appeal by the taxpayer/appeal first. Taxpayer's Appeal in I.T.A. No,648/KB of 2012 Ground No,1 9. Being a general ground, need not any specific comments as the learned AR, during the hearing did not further elaborate any specific point on it. Ground No,2 10. The appellant/taxpayer has agitated confirmation of the action of DCIR by the learned CIR(A) regarding disallowance of unrealized exchange loss of Rs.5,947,631/- being notional in nature and not allowable under section 34(3) of Income Tax Ordinance, 2001. It would be fair to quote the findings of the learned CIR(A) here, for the sake of facility: Quote I have considered the submissions made by both the sides. The Department has disallowed the claim of exchange loss recorded by conversion of outstanding foreign currency, liabilities at the exchange rate prevailing at year end with the contention that it is notional in nature. The foreign currency liabilities have actually been paid in the succeeding year. Therefore, I confirm action of disallowing notional claim and direct the DCIR to allow the claim of the exchange loss in the next tax year when the currency liability is actually paid. Unquote Here before us, the appellant/taxpayer furnished written arguments on the issue, the relevant portion of which is reproduced hereunder:-- Quote 2.3 Your appellant furnishes a breakup (Annexure A) of unrealized exchange loss booked at year ended December 31, 2009 and subsequently paid. From the break up you would note that your appellant has booked the exchange loss on outstanding LCs based on the invoices (denominated in foreign currency) already received by them before the year end. Under the provisions of section 71 this liability is to be accounted for in Pak Rupee. Accordingly, the foreign currency is translated
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into Pak rupees by using the applicable rate of exchange prevailing A as at December 31, 2009 issued by the State Bank of Pakistan. Therefore the conditions specified in the subsection (3) of section 34 of the Income Tax Ordinance, 2001 to claim a liability as an allowable expense is fulfilled. 2.4 The action of the DCIR to disallow exchange loss on the basis that it is notional in nature is against the very basis of computation of income prescribed by the Ordinanee: It seems that by disallowing the exchange loss the department is in fact proposing the taxpayer that a liability incurred in foreign currency is not to be accounted for under the Ordinance till it is actually paid in the subsequent year, This proposition' is patently erroneous as the department has always been taxing any amount receivable in foreign currency (i,e, income to be received in foreign currency subsequent to the year end) in the year of its recording on accrual basis, irrespective of its receipt in subsequent period. It should be appreciated (hat the department is not allowed to blow hot and cold in the same breath. Unquote We have considered the arguments of the AR and perused the order of DCIR and the learned CIR(A), in the light of section 34(3) of Income Tax Ordinance, 2001. It is observed that section 34(3), envisages certain parameters to be observed by the taxpayers who are maintaining their accounts on accrual basis. It would be better to reproduce the relevant provision of the Ordinance. Quote Section 34. - Accrual basis accounting: 1) ............................ 2) ............................ 3) Subject to this Ordinance, an amount shall be payable by a person when all the events that determine liability have occurred and the amount of the liability can be determined with reasonable accuracy': Unquote Here the taxpayer/appellant, has himself admitted that there is a certain amount of unrealized exchange loss. Although the DCIR, confronted the taxpayer at disallowance of exchange loss at Rs.16,510,240/- but following the submission, of breakup by the taxpayer and admission on his part that an amount of Rs.5,947,631/- is unrealized exchange loss. Apparently, this does not conform to the provisions of section 34(3) of the Ordinance, 2001, which allows to record the liability for the persons maintaining the accounts on the accrual basis when all the events that determine the liability have occurred. Here, the exchange loss recorded pertains to unrealized exchange loss. As such, we find no legal infirmity in order of the learned CIR(A) and the same is hereby maintained. Ground No,3 of Appeal 11. Through this ground of appeal the appellant has agitated against allocation of expenses of Rs.289,411/- against insurance commission. The learned CIR(A) upheld the addition giving following observation: Quote The DCIR had allocated expenses of Rs.389,411/- against insurance commission by invoking provisions of section 67 read with rule 13(3)(b). The AR contended that the provisions of section 67 read with rule 13 were to be applied when it was established that the expenditure under consideration can be related to earning more than one class of income. The AR further explained that for earning insurance commission no expenses were incurred by the company and hence provisions of section 67 read with rule 13 were not attracted. The AR explained that in insurance business, such commission is allowed to the insurer of assets without having incurred any cost there against.
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I do not subscribe to the views of the AR as no income can be earned without incurring expense. Therefore the action of the Taxation Officer is maintained. Unquote Hue before us, the learned AR of the appellant submitted following arguments: Quote It is submitted that the insurance commission is received on insurance premium paid .For insuring the business assets. Accordingly, in substance insurance commission is reduction/rebate on premium paid by your appellant. The earning of insurance commission evidently does not require entailing any common expenses. Insurance commission of Rs. 776998/- has no nexus with any administration and other expenses. Where an expense does not relate to a particular activity no apportionment is required under the provisions of section 67 of the Ordinance. Unquote We have carefully considered the arguments put forth by the appellant. We feel that insurance commission is part and parcel of the main business activity as the same relates to "business assets". Hence, the allowable expenses are to be apportioned against this income also. Since this income falls under PTR, the allowable expenses against NTR will be reduced accordingly. Resultant addition to Normal Tax Regime income has been worked out by the DCIR according to rule 13(3)(b) read with section 67 of the Ordinance and confirmed by the learned CIR(A). We think that since the income of insurance commission is part and parcel of business activity, the treatment meted out under section 67 read with 13(3)(b) is correctly worked out and confirmed by the learned CIR(A). We find no reason to interfere with the order of DCIR and CIR(A) and impugned addition is maintained. The appeal is disposed off in the manner as indicated above. Departmental Appeal in I.T.A. No,691/KB of 2012 Ground No,1: 12 This is a general ground and needs not any specific findings. Ground No,2 13 Through this ground the Department has agitated the deletion of the disallowance of Encapsulation Charges by he learned CIR(A), which has be disallowed by the DCIR. The controversy began with the order of DCIR under section 122(1)(5). The Assessing Officer confronted, the taxpayer during the audit proceedings that it has claimed deduction on account of Encapsulation Charges at Rs.118,334,702/- paid to Messrs Merck Pharmaceutical (Pvt.) Limited Karachi and it is noted by him that these payments were in the nature of services rendered by Messrs Merck Pharmaceutical (Pvt.) Limited for the respondent and the respondent was under legal obligation of deducting tax at source under the provisions of section 153(1)(b). Non-deduction of tax at source, has resulted in disallowance of the above claim as provided under section 21(c) of the Ordinance. He, however, noted that instead of tax deduction at 6%, the respondent has deducted tax at 3.5% treating the payments as supplies made by Messrs Merck, Pharmaceutical (Pvt.) Limited Karachi. The Assessing Officer giving effect to the tax deducted as payment of 6% has allowed Rs.23,760,667/- and balance Rs.95,174,035/- was disallowed invoking section 21(c) of the Ordinance. To be further precise the show cause reply by taxpayer and inference drawn by DCIR is reproduced as under:-- Quote 'As per note-20 of the audited accounts, you have claimed deduction on account of Encapsulation charges at Rs.I18,334,702/- paid to Messrs Merck Pharmaceutical (Pvt.) Limited, Karachi. During the audit proceedings documentary evidences provided in the shape of tax deduction challans and copies of exemption certificates were examined and it was observed that you have not deducted tax on payments made to the said company on the pretext that the recipient has produced exemption certificates issued by the Commissioner of Income Tax. Large
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Taxpayer Unit, Karachi being Nos. CIT/E&C/L TU/2009/6 dated 15.01.2009 and No, CIT/E&C/L TU/2009/2 dated 03.08.2009. Perusal of both the exemption certificates, however, reveals that exemption from tax was only valid for payments on account of goods manufactured by Messrs Merck pharmaceutical (Pvt.) Limited and not on payments for services. .Admittedly, you have made payments on account of encapsulation charges which fall under the definition of "services" Tendered by Messrs Merck Pharmaceutical (Pvt.) Limited and you were under legal obligation to deduct tax on such payments under the provisions of section 153(1)(14 of the Income Tax Ordinance, 2001. The perusal of documentary evidences, however, revealed that you have deducted tax of Rs.1,389,640/- only 3.5% instead of applicable rate of 6%. Therefore, the claim of deduction on account of payment of Rs. 23,160,667/- made to Messrs Merck Pharmaceutical (Pvt.) Limited on which tax has been deducted at Rs.1,389,640/- is admissible as per law, and the balance claim of payments of Rs. 95,174,035/- is intended to be disallowed under the provision of section 21(c) of the Income Tax Ordinance, 2001. In response, the learned AR filed reply vide letter dated 14.02.2012, crux of which is as under: (a) M/s. Merck Pharmaceutical (Private) Limited (MPPL) is a manufacturer of soft gelatin capsule and not a toll manufacturer. (b) MPPL is a single activity company being the owner of plaint and machinery and process to convert its own raw material into a soft gelatin capsule. (c) There was a valid exemption certificate available to MPPL, which was issued to it knowing that MPPL is a manufacturer of soft gelatin capsule. (d) Our client gets its materials encapsulated from MPPL, who is manufacturer of soft gelatin capsules. (e) The manufacturing process is such that gelatin is made and the materials of our client are encapsulated in the process. (f) After examining the reply along with supporting detail and evidences, following inferences have been drawn: (a) The taxpayer has itself admitted the fact that Messrs Merck Pharmaceutical (Pvt.) Limited (MPPL) is a manufacturer of gela fin capsules and the taxpayer is only obtaining encapsulation services by providing material for filling in the empty gelatin capsules manufactured by MPPL. (b) The taxpayer has further admitted that they are actually getting their materials encapsulated from MPPL, while MPPL is just encapsulating the material so provided by the taxpayer. (c) The taxpayer has stated that MPPL is a manufacturer and not a toll manufacturer; however, this contention has been found unsatisfactory, as even if MPPL is a manufacturer, it is manufacturer of empty gelatin capsules and not manufacturer of finished capsules. Material, which is filled in the empty capsules is not manufactured by MPPL, rather the same is provided by the taxpayer. Accordingly here the relevant matter for consideration is whether the taxpayer is getting supply of goods from MPPL or getting services in the name of encapsulation services. (d) When the taxpayer is itself accepting that raw material was provided by them, while MPPL is just filling the provided raw material into capsules; there remains no doubt that MPPL is not making supply of manufactured capsules only. Had MPPL supplied empty capsules to the taxpayer, then there would have been no doubt that they are making supplies; however in the instant scenario they are actually providing services instead of supplies only. (e) Further, perusal of exemption certificates issued by the Commissioner, Large Taxpayers' Unit, Karachi reveals that exemption from tax was only available for payments on account of goods manufactured by MPPL and not on payments for services rendered. Even if MPPL. Had provided exemption certificate, it was obligation of the taxpayer to consider the encapsulation process in the context of manufacturing or services and theh to deduct tax under section 153 of the Ordinance.
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(f) Furthermore, it is observed that the taxpayer has itself declared these expenses in the audited accounts as "encapsulating Charges" and not "Supplies'. Admittedly, the taxpayer has tnade payments on account of encapsulation charges, which fall under the definition of "services" rendered by MPPL and the taxpayer has failed to discharge its legal obligation by not deducting tax on such payments under the provisions of section 153(1)(b) of the Income Tax Ordinance, 2001. (g) It is also noted that the taxpayer has got toll manufactured some of its products from Messrs Linz Pharmaceuticals (Pvt.) Limited and Messrs Bosch Pharmaceuticals (Pvt.) Ltd and accordingly deducted tax thereon at the rate of 6% under section 153 of the Ordinance; however same process has been carried out with MPPL with the name of, encapsulation charges by deducting tax at the rate of 3.5% under section 153 of the Ordinance. (h) The learned AR has argued that section 2I(c) cannot be invoked in the instant case, as the recipient company has filed its return and discharged its tax liability; however this contention has been found unsatisfactory, as the issue under consideration is the disallowance of expenses under section 21(c) of the Ordinance due to failure of tax deduction in accordance with the provisions of law. Section 21 of the Ordinance is an independent provision, which is certainly penal in nature, if a taxpayer fails to perform required actions or comes within the ambit of certain situations; hence discharge of tax liability or filing of return and disallowance of expenses under section 21(c) cannot be dragged together to neutralize the effects of each other. The clauses of section 21 categorically provide for disallowing certain expenses, even if these are genuine business expenses. For example, expenses under one head exceeding Rs.50,000/- paid in cash (with 'few exceptions) are inadmissible expenses under section '21(1), even though the same may be genuine business expenses or withholding tax may be deducted as per law. (i) Hence, being the value addition services, the same comes within the ambit of contract as envisaged in Circular No,7 of 1992. Therefore, on payments made to MPPL, it was the legal obligation of the taxpayer to deduct tax 6% which was not done as also admitted by the taxpayer itself in the explanation supra. (ii) In view of the above, the encapsulation charges paid to MPPL during the year under reference amounting to Rs. 95,174,035/-, on which tax has not been deducted, are hit by the mischief of section 21(c) of the Income Tax Ordinance, 2001. Accordingly, the claim of said deduction is disallowed and added back in the income of the taxpayer. Unquote Against this the respondent went in appeal before the learned CIR(A). The learned CIR(A) deleted the above additions. The arguments and findings of the learned CIR(A) are reproduCed.Here for ready reference: Quote These grounds relate to disallowance of encapsulation charges under section 21(c) of the Ordinance for non-deduction of tax on payment. The DCIR has observed that such payments constituted payments for contractual services and are not payments against the supply of goods. He therefore held that the exemption certificate issued under section 153(1)(a) to the payee company M/s Merck Pharmaceuticals (Private) Limited was not applicable in respect of payments made by the appellant. He therefore disallowed the expense for non-deduction of tax under section 21(c) of the Ordinance. The AR contended that the appellant had bona fidely acted on the valid exemption certificate whereby the Commissioner had directed the payer not to deduct tax on payment representing sale of goods manufactured by the payee company. The AR contended that the payee is a single activity company exclusively engaged in the manufacture of soft gelatin capsule. He further stated that the payee company imports and purchases raw materials and convert the same into finished gelatin capsules by using. a process/formula on its plant and machinery. He therefore insisted that
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there is no doubt that the payee company is a manufacturer of soft gelatin capsule. He further produced a few soft gelatin capsules to substantiate his contention that unlike hard shell capsule, soft gelatin capsule cannot be supplied as empty capsules. Due to the nature of product it can only be supplied in the finished form which is not separable from the medicine it encloses. The AR said that the department being Statisfied that the payee company is a manufacturer of gelatin capsules, had issued the exemption certificate to it. The AR also referred to the order under section 122(5A) dated April 1, 2008 for tax year 2005 in case of the payee company, wherein the issue whether the payee is assessable as toll manufacturer under the Final Tax Regime or is entitled for normal taxation being the manufacturer and supplier of gelatin capsule has been settled after detailed discussion and consideration of the facts of the case. In that order it was concluded by the department that the payee is a manufacturer and supplier of soft gelatin capsule and is therefore assessable under normal tax regime. The AR informed that the same position stands till date including the return of income filed by the payee company for tax year 2010 which is the assessm ent order under section 120 for the period relevant to current proceedings against the appellant. He therefore argued as to how a position admitted by the department in case of the payee company can be changed when examining whether tax was correctly deducted by the appellant on payment made to the payee company. The AR without prejudice to his above submissions further stated that the action of disallowing the expense under section 21(c) is also legally incorrect as the payee company had already discharged its tax liability of the relevant year by filing its return which is deemed to be an assessm ent issued by the commissioner. He for this purpose relied on the decision reported as 1996 PTD (Trib) 911 and 2010 PTD (Trib) 37 including the decision of the Tribunal reported as 2010 PTD (Trib.) 930 wherein it has been held that the decisions given under section 24(c) of the repealed Ordinance are squarely applicable to eases under section 21(c) of the Income Tax Ordinance, 2001. ' I have given due consideration to the arguments and the facts of the case. Primarily, the DCIR initiated action under section 21(c) on the assumption that the payee company is engaged in toll manufacturing services liable to withholding of tax at 6 per cent instead of being covered by the exemption certificate issued for payments against supply of goods. However, the position taken by the DCIR in appellant's case is contrary to the assessment made against the payee company. The orders passed in case of payee reflect that the department has held that the payee is a manufacturer and its income is assessed under normal tax regime. Therefore, the taxation officer has no basis available to treat the payment made by the appellant as payment for contractual services. The higher appellate authorities have as held that provisions of section 21(c) of the Ordinance cannot be invoked where the recipient has already filed its return of income and discharged its admitted tax liability. I have therefore order to delete the disallowance made by the taxation officer under section 21(c) of the Income Tax Ordinance, 2001. Unquote Here before us the learned DR emphasized that the order of DCIR be restored and the learned CIR(A) was not justified to delete the addition, which is made on solid legal and factual grounds. The learned AR, however, supported the decision of the learned CIR(A) and put forth following further written arguments: Quote The respondent had bonafidely acted upon the exemption certificate issued by the Commissioner E&C Division LTU directing not to deduct tax on payment for supply of goods manufactured by the payer. The said exemption certificate remained in field at the time of payment and has never been cancelled.
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The aforesaid…
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