224. Norms and principles to be applied in assessing foreign/Indian participants in technical collaboration

1. It has been represented to the Board that in determining the tax liability of foreign and Indian participants in technical collaboration agreements, different norms and principles are being applied by different Income-tax Officers with the result that there is a great deal of uncertainty in the minds of the foreign parties regarding the incidence of Indian tax on the income derived by them under such agreements.  A suggestion has, therefore, been made that in order to remove this uncertainty, the various tax problems arising under technical collaboration agreements may be reviewed by the Board and detailed instructions issued to the Assessing Officers so that there is uniformity as well as certainty in the matter of tax treatment.

2. It may be observed at the outset that the tax problems arising in the cases of foreign collaborations are extremely varied and diverse and the decision depends not merely upon the terms of the particular agreement but also on the nature of the technical know-how actually imparted thereunder. It is, therefore, not possible to lay down clear-cut solutions to cover all conceivable situations.  Only general principles and guidelines can be indicated which should be applied in individual cases according to the facts of each case.

3. “Technical know-how” is a term of wide connotation and includes several kinds of technical knowledge, assistance and services.  There are several ingredients constituting technical know-how such as (i) the design of the product to be manufactured, (ii) the design of the process for manufacture, (iii) the design and engineering of the plan, and (iv) the erection and commissioning of the plant, etc., etc.  There are also different ways of imparting technical know-how which may be (i) through outright sale of designs, know-how, etc., (ii) by lending the services of foreign technicians, (iii) by giving technical assistance during the period of agreement, (iv) through royalty or licensing agreements, or (v) through foreign capital participation.  A further important aspect is whether or not the nomenclature used in the collaboration agreement really indicates the correct nature and purpose of the payment.  In such cases, the real nature and purpose of the payment has to be ascertained and taken into account.

4. Broadly speaking, the tax problems arising under technical collaboration agreements are of two kinds, viz., those relating to the admissibility of the expenditure incurred in the assessments of the Indian participant, and those relating to the taxation of the amounts in the hands of the non-resident participant.  As regards the former, i.e., the admissibility of the expenditure in the hands of the Indian participant, the question would be whether the expenditure has been incurred for acquiring or bringing into existence an asset or advantage of enduring benefit to the assessee’s business. If so, the expenditure will have to be regarded as one on capital account.  On the other hand, if the expenditure has been incurred for running the business and working it with a view to produce profits, the payment would be allowable as revenue expenditure.  The question has necessarily to be examined with reference to the facts of each particular case and no general proposition can be laid down that all payments for technical know-how should be regarded as revenue payments or that they are always capital in nature.

5. A point to be remembered in this connection is that the nature of a receipt as capital or revenue in the hands of the non-resident participant is not always determinative of the nature of the outgoing in the hands of the person who pays it. If the payment is an outright payment for, say, the acquisition of a secret process formula, the benefit of which would enure permanently to the Indian participant’s business, there would be every justification for treating the payment in question, as of a capital nature.  It may, however, well happen that the payment has been received by the foreign participant in the ordinary course of his business so that it has to be assessed as a revenue receipt in his hands.  It can also happen in some cases that the receipt might be regarded as a capital receipt in the hands of the foreign participant but the payment may be regarded as revenue expenditure in the  assessment  of  the  Indian  participant.  However,  before  disallowing  theexpenditure in the assessment of the Indian participant as capital expenditure, the Income-tax Officer must fully understand and comprehend the nature of the asset or enduring benefit which the assessee has acquired.  If what has been acquired under the agreement is merely a licence for the user, for a limited period, of the technical knowledge of the foreign participant, together with or without the right to use the patents and trade marks of the foreign party, the payment would not bring into existence an asset of enduring advantage to the Indian participant, and should be regarded as expenditure incurred for the purpose of running the business during the period of the agreement.  The payment would, therefore, be revenue in nature.  The recent decision of the Supreme Court in the case of CIT v. Ciba of India Ltd. [1968] 69 ITR 692 provides clear guidance in cases of this type.

6. The first step, therefore, in dealing with foreign collaboration agreements is to analyse the terms of the agreement and ascertain the facts relating to the working or implementation of the agreement in order to find out, what rights or benefits or property have been acquired under the agreement by the Indian participant and for what consideration.  In a case where the payment is made wholly or in part for a specific service or the supply of clearly defined item of technical know-how, no difficulty is likely to arise in determining the nature of the payment, i.e., whether expenditure is on capital or revenue account.  It happens, however, that in several agreements, the payment of a single sum is stipulated for a variety of services, assistance and information supplied by the foreign participant.  Sometimes, this payment is expressed as a percentage of sales made by the Indian undertaking.  The Income-tax Officer will, therefore, have to go into the facts and determine the extent to which the payment made represents consideration for :

a.   the mere use of technical knowledge and information for running the business during the period of the agreement;

b.   the user of patents or trade marks; or

c.   the acquisition of an asset or benefit of enduring advantage to the business.

While payments for (a ) and (b) above would be allowable as revenue expenditure in the hands of the Indian participant, expenditure under (c) would be of a capital nature.

7. Where the technical know-how obtained relates to the design and engineering of the plant in India or the erection and commissioning of the plant, the payment should be treated as forming part of the cost of the machinery and plant and depreciation and development rebate should be allowed thereon.

Where, however, the technical know-how is not directly relatable to the depreciable assets and cannot be regarded as forming part of their cost, the expenditure, though treated as capital, would not be eligible for the allowance of depreciation and development rebate.

As regards technical know-how obtained in the form of drawings and designs and technical information and knowledge concerning the product to be manufactured and the process of manufacture, it will be sometimes difficult to decide whether the payment made therefor is capital or revenue expenditure. A pertinent question to be answered in this connection will be : Have the technique and knowledge obtained through the designs, drawings, etc., become the property of the Indian participant for all time to come or only for the duration of the agreement ? If it is only for the duration of the agreement, the next question is whether the agreement is for such a long period that the Indian participant might still be said to have acquired an enduring benefit for the purpose of his trade.  Further, after the conclusion of the.period of the collaboration, what are the rights and benefits, if any, which would permanently accrue to the Indian participant’s business?  These and other related questions have to be looked into in order to decide whether the expenditure is capital or revenue in nature.  If as a result of this examination, it is found that no asset or advantage of a permanent or enduring character is acquired by the Indian participant, the expenditure should be treated as revenue expenditure and allowed as a deduction.  It may, however, be noted in this connection that if the said expenditure, on product and process designs and drawings is treated as capital expenditure, the Indian participant will not be entitled to any depreciation or development rebate on the outlay.  The amount cannot also be amortised and allowed over a period of years (unless the payment is for the acquisition of patent rights which are discussed separately) as there is at present no provision to this effect in the Income-tax Act.

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As regards expenditure of a capital nature incurred after February 28, 1966 on the acquisition of patent rights or copyrights used for the purpose of business, section 35A provides that the expenditure will be allowed as a deduction in equal instalments over a period of 14 years.

8. As regards the foreign participant is tax liability also the first question would be whether the amount received for the supply of technical know-how, is a receipt on capital account or revenue account.  The answer would again depend on the facts of the case.  It has to be observed that the nature of the outgoing in the hands of the Indian participant will not always be determinative of the nature of the receipt in the hands of the foreign party.  In the U.K., it has been held by the Courts that a receipt from the sale of know-how would be a capital receipt only where the sale of the technical know-how or the imparting of technical knowledge and information results in the transfer or parting with the property or asset or any special knowledge or skill which would ripen into a form of property and that after such transfer, the transferor is deprived of using the asset—see Moriarty v. Evans Medical Supplies Ltd. [1959] 35 ITR 707.  In all other cases, where no capital asset or property is parted with and the transaction is merely a method of trading by which the recipient acquires the particular sum of money as profits and gains of that trade, the consideration received for the sale of technical know-how will be on revenue account.

9. If the amount received by the foreign participant is a revenue receipt in his hands and the amount is received by him outside India, the further questions that would arise are, whether the payment is :

a.   for services rendered abroad, or

b.   for services rendered in India, or

c.   represents royalty.

If the amount received by the foreign participant is for services rendered entirely outside India, that sum will not be subject to tax in India, because the income will be accruing to the non-resident wholly outside India.  Where the payment received is for services rendered in India, the amount will be taxable in India, subject, of course, to the deduction of legitimate expenses of a revenue nature incurred by the foreign participant for the purpose of earning such income.  If the payment received is royalty, the question of allocating the income between India and outside India would not arise and the whole amount would be liable to tax in India where the patent has been exploited.  Deduction will, however, be admissible against the royalty income for the cost of current services rendered in order to earn the royalty.

10. The cases where payments of each of the above categories are clearly and truly ascertainable from the terms of the agreement and with reference to all relevant facts will not present serious difficulty.  But in cases where the agreement stipulates a consolidated payment or where the true character of the payment is different from that ascribed to it in the agreement difficulty would arise in the allocation of the payment for the various services rendered under the agreement.  Ordinarily, a payment expressed as a percentage of the sales in India is to be treated as payment of royalty and taxed in India.  When the payment is stated to be for technical know-how or services rendered abroad but is related to the sales, the Income-tax Officer will have to go into the facts of the case and determine the extent to which the payment attributed to technical services abroad represents in fact payment for (i) services abroad, (ii) services in India, and (iii) royalty or extra royalty for exploiting the know-how in India.

It is, therefore, necessary that the utmost care should be exercised by the Assessing Officers in determining the true nature of the payment when it is a consolidated figure or is expressed as a percentage of sales, by whatever terms the contracting parties may decide to call it.  Allocation of the payment among the various services in India and abroad towards the royalty element, if any, included in the arrangement, has to be made objectively and after a careful appraisal of the precise terms of the collaboration agreement and the actual manner in which the terms have been implemented in practice.

11. With reference to cases of foreign capital participation it may be noted that where shares are allotted to a non-resident participant in the form of equity capital of an Indian concern, in consideration for transfer abroad of technical know-how or services or delivery abroad of machinery and plant, and the payment is not taxable under section 5(2)(b) as income accruing or arising or deemed to accrue or arise in India, it has been decided that no attempt should be made by the department to bring to tax the profits or gains on such transaction merely on the ground that the situs of the shares is in India.  However, if any operations are effected or services are rendered in India, the income will, to that extent, accrue or arise in India and will be chargeable to tax in India.  If payments of royalty are made by way of free issue of equity shares, the value thereof will of course be liable to tax.  It is only those shares which are issued at the time of incorporation of the Indian company in lieu of a lump sum payment for the technical know-how delivered abroad, that will be exempt from income-tax as well as the tax on capital gains.  Further, if the shares issued in consideration for technical know-how at the time of the incorporation of the Indian company are subsequently sold, the capital gains realised therefrom would be subject to tax.  Preference shares allotted will be treated in the same way as equity shares in this regard.

12. In the end, a reference may be made to the provisions of section 195, particularly sub-section (2) of that section, which deserves to be more widely made use of than is being done at present.  In a foreign technical collaboration, where the Indian participant who is responsible to pay a technical fee, etc., to the foreign party, considers that the whole of such sum would not be income chargeable in the hands of the recipient, he could apply to the Income-tax Officer under section 195(2) for determination of the appropriate proportion of such payment which would be taxable and in respect of which tax is to be deducted in accordance with sub-section (1).  In effect, therefore, this sub-section provides for an advance ruling being given by the Income-tax Officer in the matter of the tax liability of the non-resident participant. [* * *]

Circular : No. 21 [F. No. 7A/40/68-IT(A-II)], dated 9-7-1969.

JUDICIAL ANALYSIS

EXPLAINED IN – The above circular was explained in CIT v. Union Carbide Corporation [1994] 206 ITR 402 (Cal.), with the following observations :

“In any case, if the Central Board of Direct Taxes, while explaining the law, engages in a forensic exercise and wants the officers to understand its view of the provision of law as though it was declaring law as a competent judicial or quasi-judicial authority empowered to decide questions of law between contending parties, that would be of no effect and the instruction issued on that basis cannot be elevated to the status of “information” in its special significance in the context of section 147(b).

We have persued the circular of the Board and we find that the Board has made its own interpretation as to how the law relating to the assessability of technical service fees should be understood by the Assessing Officer.  If the amount received by the foreign participant is a revenue receipt in his hands and the amount is received by him outside India, the further questions that would arise are, whether the payment is :

(i)    for services rendered abroad, or

(ii)    for services rendered in India, or

(iii )   representing royalty.

If the amount received by the foreign participant is for services rendered entirely outside India, that sum will not be subject to tax in India, because the income will be accruing to the non-resident wholly outside India.  Where the payment received is for services rendered in India, the amount will be taxable in India, subject of course, to the deduction of legitimate expenses of a revenue nature incurred by the foreign participant for the purpose of earning such income.  If the payment received is royalty, the question of allocating the income between India and outside India would not arise and the whole amount would be liable to tax in India where the patent has been exploited.  Deduction will, however, be admissible against the royalty income for the cost of current services rendered in order to earn the royalty.

It is not that the circular merely draws the attention of the Assessing Officers to existing judge-made law in the form of judicial decision or proclamation in the shape of decisions coming from quasi-judicial authority competent to decide questions of law between contending parties.

The opinion of the Board can be information for the purpose of the relevant section only where it expresses the opinion while performing its appellate function……” (pp. 411-412)

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