ITAT: Settlement Payment for Patent Dispute Allowable as Business Expenditure, Not Penal in Nature

Cross-appeals were filed by the Revenue and another by the assessee against the order of the CIT(A), NFAC for AY 2014-15. In the Revenue’s appeal, two issues were raised; addition of Rs. 44.98 crore made by taxing the income of Vega Industries (Middle East), treating it as a proprietary concern of the assessee; and disallowance of additional depreciation of Rs. 8.09 lakh. In the assessee’s appeal, the primary dispute concerned the disallowance of Rs. 31.11 crore paid to Magotteaux International, Belgium, for the settlement of a patent infringement suit filed in the US. The Assessing Officer had treated the payment as penal in nature and disallowed it under Explanation 1 to Section 37(1).

CIT(A) Held: The CIT(A) upheld the view, holding that the payment arose from a violation of patent rights and was hit by Explanation 3 to Section 37(1). The assessee argued that the settlement was a compensatory payment made to amicably end a civil dispute, and not for any act prohibited by law. It was pointed out that patent infringement under US law is a civil matter involving compensatory damages and not an offence, and that the amendment inserting Explanation 3 w.e.f. 1.4.2022 could not apply retrospectively.

Issue Raised: Whether the Rs. 31.11 crore paid by the assessee for settlement of an overseas patent dispute is disallowable under Section 37(1) as being for a purpose prohibited by law, or allowable as a business expenditure.

ITAT Held: The Tribunal decided that the payment made to settle the patent dispute was compensatory and not penal. It noted that the settlement agreement described the payment as a mutual compensatory settlement to avoid litigation, and not as a royalty or penalty for infringement. Referring to CIT v. Desiccant Rotors International Pvt. Ltd., it was held that such payments, made out of commercial expediency to avoid protracted litigation, are allowable under Section 37(1). The Bench further held that Explanation 3 to Section 37(1), inserted in 2022, which expanded the disallowance to cover laws outside India, cannot be applied retrospectively to AY 2014-15. The subsequent clause (iv), inserted in 2024, also applies only to notified laws and does not include patent law. The disallowance was therefore deleted.

The Tribunal reiterated that Vega Industries, UAE, is a distinct foreign company and that additional depreciation on electrical installations forming part of plant and machinery is allowable at 15%. Thus, the Revenue’s appeal was dismissed and the assessee’s appeal was allowed in full.

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