Contribution towards costs of research / for the use of process or formula is Royalty

On the terms of the agreement, it appears to us, that it is only an agreement to share the product of the Research and Development allegedly without payment of royalty, but paying a consideration for the use described as the contribution towards the costs of the researchincurred by that particular party. This payment occurs only on use of the product of the research and not otherwise. This payment can hence only be understood as a consideration for the use of the process or formula developed by that member. It would satisfy the definition of royalty under Explanation 2 to Section 9(1 )(vi) of the Act. The applicant is either the recipient of the consideration or the conduit through which the consideration is paid to the concerned party.

Paragraph 3 of Article 12 of the DTAC between India and Germany defines royalty. As far as the use of a secret formula or process and the use of information concerning industrial, commercial or scientific experience is concerned, it does not differ significantly from the definition in the Act. Hence, what is paid for by ‘A” India to the applicant under the agreement would be royalty.

BEFORE THE AUTHORITY FOR ADVANCE RULINGS

(INCOME TAX), NEW DELHI

22nd Day of March, 2012

A.A.R. No. P of 2010

R U L I N G

[By Justice P.K. Balasubramanyan]

The applicant is a company based in Germany. It is primarily engaged in the business of executing contracts for assembly and supervision of paint shop, including supply of materials and supervision of installation for various automobile companies. A group of companies, hereinafter referred to as the “A” group are its affiliate’s .The group has formulated a research and development policy. As per that policy, all Research and Development activities for the ‘A’ group is coordinated through the applicant. ‘A” entities who wish to participate in the Research and Development, enter into a Cost Allocation Agreement. That agreement provides that the Research and Development will be  undertaken by any or all parties to it with a stipulation that the applicant is the administrator under the agreement The entire cost of the research is to be shared by the parties to the agreement based on an allocation key. The participants are allowed a royalty-free unlimited access to the research results including any Intellectual Property Rights generated from the research and development. Though all are thus joint owners of the Intellectual Property Rights, the rights are registered in the name of the applicant.

2. The applicant approached this Authority essentially for a ruling whether payments made to the applicant by ‘A’ India, in terms of the Cost Allocation Agreement, can be treated as income in the hands of the applicant and whether it is not merely a reimbursement of the expenses incurred for the Research and Development. It also wanted to know, whether in any event, the payment can be treated as ‘fees for technical services’ or ‘Royalty’ as sought to be done by the Revenue. By order dated 12.9.2011, this Authority allowed the application under section 245R(2) of the Income-tax Act, to give a ruling on the following questions:

1. Whether pursuant to the Cost Allocation Agreement (CAA) the payments to be made by ‘A’ India Private Limited (“A India”) to the Applicant, representing the ‘A ’ India’s share of the costs incurred towards Research and Development (“R&D ”) activities, constitutes “Income” in the hands of  Applicant within the meaning of the term of Section 2(24) of the Income-tax Act, 1961 (“the Act”) liable to tax under the Act?

2. If the answer to Question No. 1 is in the affirmative, will the amount received by the Applicant under the CAA constitute business income of the Applicant. If so, in view of the facts as stated in ANNEXURE II and ANNEXURE III is there a Permanent Establishment in India under “Agreement between the Government of the Republic of India and the Government of the Federal Republic of Germany for the avoidance of double taxation with respect to taxes on income (“India-Germany Tax Treaty”) in connection with the R&D activity of the Applicant and any part of the amount received by the Applicant from ‘A’ India under CAA, is attributable to such Permanent Establishment in India under the India-Germany tax treaty and hence taxable in India?

3. If the answer to Question No.2 is in the affirmative are the expenses connected with the Permanent Establishment (i.e. expenses, if any in connection with R&D activities) be allowable as a deduction from the amount so received?

4. In the answer to Question No.1 is in the affirmative, i.e. there is “income” accruing to ‘A’ Germany and answer to Question No.2 is negative, then whether the amount is taxable as “Fees for Technical Services” under the Income-tax Act read with the India-Germany Tax Treaty?

5. If the answer to Question No.1 is in the affirmative but answer to Questions No.2 and Question No.4 are negative, i.e. there is “income” taxable under the Act accruing to ‘A’ Germany but is not in the nature of “Business Income” or “Fees for Technical Services”, then whether the same is  taxable as “Royalty” under the Income-tax Act read with the India-Germany Tax Treaty?

6. Based on the answers to the above queries what is the rate and on what amount should the tax be deducted at source by ‘A’ India on the payments made under CAA to the Applicant?

3. We may now consider the Costs Allocation Agreement relied on by the applicant. It is described as a revised agreement which supersedes an earlier agreement dated 1.1.2004. The revised agreement is concluded with effect from 1.1.2008. The applicant is party no. 1 to that agreement. Its 100% Indian subsidiary is party no. 15. Altogether, 24 companies belonging to the group, including the applicant and the Indian subsidiary, are parties to the agreement. It is recited that the parties involved, work in a similar line of business and under similar conditions, certain functions and services are made available by the individual parties. For that reason, all parties can assume the role of service provider and the receiver of services. The agreement then sets out the duties of the service provider. In paragraph 1(1) the purpose of the agreement is said to be to ensure that the cost of services enumerated in section 2 of that agreement is allocated appropriately between all the companies in the group which are parties to that agreement. It is reiterated that in terms of the agreement, the contracting parties can be both service provider and service recipient. The applicant  agrees to act as Administrator (clearing centre) of the settlement of that agreement. The activities of the service provider group company are restricted to advisory and economic support and it is not to encroach upon the decision-making powers of the manager or other decision makers. Clause 2 sets out the type of services. In terms of the agreement, the contracting parties providing the service render for the contracting parties receiving the service, the services more particularly described in Exhibits. 1 and 2 to the agreement which are to form an integral part of the agreement. Exhibit 1 deals with Research and Development, and Exhibit 2 with Management Service fees. It has been emphasized in the written submissions and during the argument, that the ruling sought for are only relating to the services described in Exhibit 1, namely, Research & Development, and they do not embrace the management service. It is, therefore, only necessary to notice the other terms in so far as they relate to ‘Research & Development’. Clause 3 deals with costs allocation. It is provided that the direct and indirect costs in connection with the services named under clause 2 as well as the processes from the granting of common license and Ususufrutary rights, shall be isolated in separate cost centres and recorded according to the recognized cost centre accounting procedure. In the case of services named in Clause 2, Exhibit 1, namely ‘Research & Development’, they shall be  separated according to the business units. Only those costs shall be taken into account which result from services rendered to the parties to this agreement. The allocable costs of the individual parties of the group, thus, ascertained shall then be added together separately for the individual projects in ‘Research & Development’. Each party is to add altogether the costs it has been allocated from the receipt of the services in ‘Research & Development’ separated according to the business units. The parties clarify that the licensing revenues generated by licensing the jointly developed results will be netted against the ‘Research & Development pool’s costs’ and will be shared in proportion to the anticipated direct benefits. As the amount of actual costs would only be known following the close of the performing party’s financial year, monthly accruals of 1/12 of the yearly amount was to be initially recorded based on the budget prepared by the parties rendering the services before the beginning of the financial year. The allocation formula set out therein which reflected the actual benefit has to be reviewed annually and was to be adjusted and if necessary was to be used as the basis for the services. For Research & Development, 50% of the research and development costs was to be split according to the relative business sales by business unit of a company. 50% of the research and development costs was to be split according to the relative operating profits by business units of a company.  Business unit of a company with negative operating profits, would be set with EURO- 0 for that part of the allocation. The contracting parties agree to accrue the cost allocation determined on the basis of the budget on a monthly basis. The contracting party providing the services was to draw a final statement until the end of the financial year at the latest on the basis of the actual costs of the previous financial year. The statement was to be submitted to the Administrator, viz. the applicant. Subsequent payments resulting from the final statement was to be paid by the contracting party receiving the services, on December 15 in the current year. Payments and reimbursements if not made in due time was to be subject to an interest rate of 2% above EURIBOR. The contracting parties, are to have a mutual right to information on the nature and scope of the services rendered in the year being billed. They are to have an audit report prepared which confirmed that the costs allocation had been computed and paid in accordance with the written agreements of the parties, the pre-requisite for the charging of costs allocation were in place and the direct and indirect costs are associated with services rendered in accordance with costs allocation agreement and that the costs were actually incurred.

4. Clause 9 of the agreement provides that the parties thereof grant to each other – as far as acceptable by law – the right to exploit any technology developed under the agreement within their  respective geographic regions. The parties acknowledge and agrees that title and full ownership of the products and all components thereof including all enhancements new versions and modules are to remain with all parties to the agreement. They further acknowledge and agree that the products and all components thereof inclusive of the ideas and expressions therein contained are trade secret or copyrighted products of all parties to the agreement and proprietary to it. The agreement was to remain in force for 3 years, thereafter it would stand automatically renewed for a further year, unless terminated by one of the parties with a notice as stipulated therein. There were no collateral agreements to that agreement and the agreement was to replace all oral and written agreements till then subsisting.

5. Exhibit 1 which forms part of the agreement, contains the definition of ‘Research & Development’ and also describes what is not included in Research & Development. It then provides within the context of the annual planning, that all the companies involved, prepare and approve a research & development budget. If it turned out, that the budget has been exceeded, the changes compared to the Budget have to be presented before the Budget value is over-run, explained and got approved. The non-approved budget or budget over-runs are not considered within the framework of the cost allocation.

6. No doubt, this agreement contemplates the grant to each other by the parties, the right to exploit any technology developed under the agreement within their respective geographic regions. It also does provide for allocation of costs of the individual parties of the group ascertained as provided in the agreement. The cost allocation seems to be dependant on the rendering of services by one and the receipt of service by the other. It is not seen to be a clear sharing of the costs of Research & Development, subject of course, to a credit being given for the amount spent by a particular party carrying on the Research & Development at its own expenses but for the benefit of all. What is the effect of this agreement, now remains to be considered.

7. The agreement contemplates the providing of services by one party to another of the parties to the agreement and the receipt of services by that other. While allocating costs, it provides that ‘only those costs shall be taken into account which result from services rendered to the parties to this agreement’. So, the incurring of costs depends on the receipt of services from one of the contracting parties. What one has to look for is whether the parties share the costs of the ‘research and development’, the result of which is to be owned by all of them, irrespective of whether one uses it or not, before attributing common ownership. On the terms of the agreement, is it ownership of the title to the research or  of the right to use it? One does not find a direct provision that the costs are shared by all. Even in the application, it is stated: “As per the CAA, the entire costs of the R&D undertaken are shared between ‘A’ entities participating in the CAA based on an allocation key” what is that cost of the R&D allocation key, is not explained. Clause 9 dealing with ownership rights speaks of mutual grant of ‘right to exploit any technology developed under this Agreement within their respective geographic regions’. Though the agreement asserts that the ownership of the products shall remain with all parties to the document, it is not made clear on what consideration that happens. Contribution by the user member to the researching member among the signatories, cannot confer title to the research on all. It, therefore, appears to be a case where, the parties to the agreement individually spend on research and development, they allow the other parties to use the product of their research, the service receiver is liable only for the costs relating to the service and any exploitation of the product and earning therefrom by licensing it to others, goes to reducing the cost of the research and development and benefits all the parties. It is clear that a party not using the product of a particular research done by a member, does not contribute towards the costs of research irrespective of it not having used it. In that sense, the sharing of cost of the R&D allocation key does not have a meaning.

8. It is argued on behalf of the applicant that the parties to the agreement become the joint owners of the product of the research and what they pay is the contribution towards the expenses for the research and development and that payment cannot be treated either as royalty or as fees for technical services as contended by the revenue. It is pointed out that the user by the party of the product is without payment of any royalty. It is reiterated that the ruling is sought only on payment for research and development covered by Exhibit 1 in the agreement. On behalf of the revenue it is submitted that the present agreement is merely a renewal of the earlier agreement of the year 2004 and in terms of that agreement the Indian subsidiary of the applicant was regularly withholding tax and there was no occasion for the applicant to approach this Authority. As a matter of fact the present application was hit by clause(i) of the proviso to Sec 245 R (2) of the Income-tax Act. The Indian subsidiary was merely an erection contractor. It did no research. Its so called contribution for research and development was a mere façade to repatriate income from this country without paying tax and that should not be countenanced. On a scrutiny of the agreement it can be seen that it was not a case of investing in research and development but it was a case of a service provider and service receiver and payment made was for the service and it partook the character of fees for technical services or royalty.

9. Counsel for the applicant placed reliance on the Ruling in ABB Ltd. In re (322 ITR 564) to contend that the ratio of the said ruling would apply to this case and here also, the position is the same. On going through that ruling it can be seen that that was a case where the parties shared the expenses for the research and thereby became the joint owners of the product which they were entitled to share without payment of royalty. In the preamble to the agreement in the present case what is stated is that “All companies named above are companies belonging to the ‘A’ group. Given that the parties are involved in similar line of business and under similar conditions, certain functions and services are made available by the individual parties. For this reason all parties can assume the role of service provider and receiver of services. The parties receiving services are interested in these services and hope to gain a benefit from them and to save costs which would be incurred if they performed these services themselves.” The duties of service providers are then set out. We have already referred to the cost allocation. The agreement in ABB contract specifically provided that “The total costs for corporate R&D shall be borne by the parties in proportion to the value added achieved by the parties ”. We do not find a similar cost sharing provision in the present agreement. Here, the cost is paid for the service rendered as is clear from clauses 2 and 3 of the agreement. There is no sharing of Cost irrespective of the use of the product of the Research. The payment is made only when the product or process is used. Hence it is difficult to accept the submission that the parties to the agreement have become the joint owners of the product of the research. The ratio of ABB ruling is hence not applicable.

10. On the terms of the agreement, it appears to us, that it is only an agreement to share the product of the Research and Development allegedly without payment of royalty, but paying a consideration for the use described as the contribution towards the costs of the research incurred by that particular party. This payment occurs only on use of the product of the research and not otherwise. This payment can hence only be understood as a consideration for the use of the process or formula developed by that member. It would satisfy the definition of royalty under Explanation 2 to Section 9(1 )(vi) of the Act. The applicant is either the recipient of the consideration or the conduit through which the consideration is paid to the concerned party.

11. Paragraph 3 of Article 12 of the DTAC between India and Germany defines royalty. As far as the use of a secret formula or process and the use of information concerning industrial, commercial or scientific experience is concerned, it does not differ significantly from the definition in the Act. Hence, what is paid for by ‘A” India to the applicant under the agreement would be royalty.

12. The theory of reimbursement propounded cannot stand. The payment occurs only when the process or scientific experience is used by a member. It is not a sharing of costs or reimbursement of a part of the expenses incurred for the research as and when it is completed. Since it is a payment for use and the payment depends solely on use, the payment can be understood only as royalty.

13. In view of our conclusions as above, we rule on question no.1 that what is paid is royalty income in terms of the Act and the DTAC. We may notice that on the facts as set out, the applicant is only an ‘administrator (clearing centre) of the settlement of the Cost Allocation Agreement as regards Research and Development. The income received is passed on to the concerned party to the agreement who has expended monies for the research and development. We feel that this question is relevant only as regards the actual receiver of the payment as per the so-called allocation key.

14. We have ruled that this payment would be royalty in terms of paragraph 3 of Article 12 of the DTAC and under section 9(1 )(vi) of the Act. It will, hence, be royalty income liable to be taxed in India  under Article 12.2 of the DTAC between India and Germany. Question no.2 is ruled on thus.

15. Questions nos. 3 and 4 stand answered in the light of our rulings on questions 1 and 2. The question of Permanent Establishment does not arise. The question whether the applicant has a Permanent Establishment in India is left open. It is also not necessary to rule on the question whether the payment is fee for technical services.

16. On question no. 5, our ruling is that the payment which is income at the hands of the recipient, is royalty and is taxable as such in India.

17. On question no. 6, we rule that the deduction of tax at source should be at the prescribed rates as provided by the Act.

18. Accordingly, the ruling is pronounced on this, the 22nd day of March, 2012.

NF