Taxability Of Incomes And Expenses Under Foreign Collaborations

The globalisation of economic reforms throughout the world has led to an increasing degree of inter-dependence between countries in the fields of technology, manpower, finance, etc. While drafting foreign collaboration agreements both parties have to necessarily take into consideration the tax laws in the respective countries. This is necessary so as to ensure, on the one hand, that the statutory requirements under the various tax laws in India and the other country are met, as also, on the other hand, to minimise the burden of tax which falls on the income, profits and gains arising from the collaboration. The present article discusses the various facets in which foreign collaborations may be made and the tax implications involved therein.

1. Taxability of different kinds of income under Foreign Collaborations

1.1 Interest

Under section 2(28A) of the Income Tax Act, 1961, ‘interest’ means interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised. The definition of interest also includes any service fee or other charges in respect of loans, debts, deposits, etc. as well as commitment charges on non-utilised portion of credit facilities.

Section 9(1)(v) provides that income by way of interest payable by the Government, or by a person who is resident or by a person who is a non-resident, shall be income deemed to accrue or arise in India, subject to the following exceptions:

      (i)   interest payable by a resident in respect of any debt incurred or any moneys borrowed and used for the purposes of a business or profession carried on by him outside India;

     (ii)   interest payable by a resident in respect of any debt incurred or any moneys borrowed and used for the purpose of making or earning any income from any source outside India;

    (iii)   interest payable by a non-resident in respect of any debt incurred or money borrowed and used for the purpose of a business or profession carried on by him outside India.

1.2 Royalty

Royalty has been defined in Explanation 2 to section 9(1)(vi) to mean the consideration (including any lump sum consideration but excluding any consideration which would be the income of the recipient chargeable under the head ‘capital gains’) for:

      (i)   the transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property;

     (ii)   the imparting of any information concerning the working of or the use of patent, invention, model, design, secret formula or process or trade mark or similar property;

    (iii)   the use of any patent, invention, model, secret formula or process or trade mark or similar property;

    (iv)   the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB;

     (v)   the imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill;

    (vi)   the transfer of all or any rights including the granting of a licence in respect of any copyright, literary, artistic or scientific work including films or video tapes for use in connection with television or tapes for use in connection with radio broadcasting but not including consideration for the sale, distribution or exhibition of cinematographic films; or

   (vii)   the rendering of any service in connection with the activities referred to in (I) to (v) above. Further, CBDT Circular No. 202 dated 5.7.1976 has clarified that ‘royalty’ would include both industrial royalties and copyright royalties.

Section 9(1)(vi) deems income by way of royalty as accruing or arising in India in the following three cases:

      (i)   Royalty payable by the Central Government or any State Government must be deemed to accrue in India regardless of who is the payee and what is the amount of royalty and also irrespective of the purpose of the payment;

     (ii)   Royalty payable by any resident taxpayer to any person, whether resident or non- resident, would be deemed to accrue in India in every case except where the payment is relatable to a business or profession carried on by the resident outside India or for the purpose of making or earning any income from any other source outside India; and

    (iii)   Royalty payable even by a non-resident would be deemed to accrue in India in cases where the payment is relatable to any business or profession carried on by the non- resident in India or to any other sources of the non-resident’s income in India.

However, the definition excludes any income which might otherwise be chargeable as capital gains. Thus, a receipt of a capital nature for the total change in ownership of the patents, invention, model, design, drawings, specifications, trade mark, secret formula or process, data, documentation, etc. representing technical know-how provided by foreign collaborators to Indian taxpayers would not give rise to income by way of royalty while the authority given under the collaboration agreement to the Indian taxpayer to use for the purpose of his business the drawings, designs, patents, etc., representing technical know-how which would continue to belong to the foreign collaborator would come within the purview of royalty for purposes of deeming the same accruing in India, thus, making the non-resident liable to tax under this provision. For this purpose, it is immaterial whether the royalty is paid as a lump sum or as a recurring payment; it is also immaterial whether the royalty is described as such under the collaboration agreement or is known as licence fees, copyright charges or by any other name.

Under section 115A(1)(b)(A), royalty income is taxable in the hands of non-corporate non- residents and foreign companies at the rate of 10% if it is received in pursuance of an agreement made after 31st May, 2005, 20% if it is received in pursuance of an agreement made after 31st May, 1997 but before 1st June, 2005, and at the rate of 30% if such agreement is made on or before 31st May, 1997. The conditions attached to this provision are as follows:

      (i)   The recipient of the royalty should be a foreign company or a non-corporate non-resident.

     (ii)   The royalty may be received from the Government or an Indian concern.

    (iii)   The royalty should be received in pursuance of an agreement made by the foreign company with the Government or the Indian concern after 31st March, 1976.

    (iv)   Where the agreement is with an Indian concern, it should be approved by the Central  Government.

     (v)   Where the agreement relates to a matter included in the industrial policy (prevailing at that time) of the Central Government, the agreement should be in accordance with that policy.

    (vi)   The conditions (iv) and (v) shall not apply where the royalty is received in consideration for the transfer to an Indian concern, all or any rights in respect of copyright in any book, or for the transfer to a person resident in India, any computer software.

  (viii)   In computing the royalty income, no deduction shall be allowed under sections 28 to 44C and section 57.

It is to be noted that section 115A is not applicable in respect of royalty income covered under section 44DA (1).

1.2.1 Source Rule for “royalty” – section 9 (1) (vi) [CBDT Circular 202, dated May 7, 1976]

A non-resident taxpayer is chargeable to tax in India in respect of income by way of royalty which is received or is deemed to be received in India or which accrues or arises or is deemed to accrue or arise in India. The Income-tax Act, however, does not contain any definition of the term “royalty” nor is there any clear cut source rule specifying the circumstances in which royalty income can be regarded as accruing or arising in India. Further, lump sum payments made for the supply of know-how are not chargeable to tax where such know-how is supplied from abroad and the payment therefor is made outside India even though the know-how is used in India, if no part thereof is attributable to any services rendered in India.

The Finance Act, 1976 has inserted a new clause (vi) in section 9(1) clearly specifying the circumstances in which the royalty income will be deemed to accrue or arise in India and also defining the term “royalty”.

Under the new provision, royalty income of the following types will be deemed to accrue or arise in India:

     (a)   royalty payable by the Central Government or any State Government;

     (b)   royalty payable by a resident, except where the payment is relatable to a business or profession carried on by him outside India or to any other source of his income outside India; and

     (c)   royalty payable by a non-resident if the payment is relatable to a business or profession carried on by him in India or to any other source of his income in India.

In view of the aforesaid amendment royalty income consisting of lump sum consideration for the transfer outside India of, or the imparting of information outside India in respect of, any data, documentation, drawings or specifications relating to any patent, invention, model, design, secret formula or process or trade mark or similar property, will ordinarily become chargeable to tax in India. In order, however, to ensure that foreign suppliers of technical know-how who had entered into agreements or had finalised proposals for the receipt of such lump sum royalties with the approval of the Central Government on the understanding that such payments would be exempt from income-tax, it has been provided that such lump sum payments received under approved agreements made before 1-4-1976 will not be deemed to accrue or arise in India, and for this purpose, an agreement made on or after 1-4-1976 will be deemed to have been made before that date if the following conditions are fulfilled:

      (i)   In the case of a taxpayer other than a foreign company, if the agreement is made in accordance with proposals approved by the Central Government before that date.

     (ii)   In the case of a foreign company, if the condition referred to in (a) above is satisfied, and the foreign company exercises an option by furnishing a declaration in writing to the Income-tax Officer that the agreement may be regarded as having been made before 1-4-1976. The option in this behalf will have to be exercised before the expiry of the time allowed under section 139(1) or section 139(2) (whether fixed originally or on extension) for furnishing the return of income for the assessment year 1977-78 or the assessment year in which the royalty income first became chargeable to tax, whichever assessment year is later. The option so exercised will be final not only for the assessment year in relation to which it is made but also for every subsequent year.

[The intention of giving an option to foreign companies to claim that agreements made on or after 1-4-1976 may be regarded as agreements made before that date is that where exemption from income-tax in respect of lump sum royalty is allowed, the balance of the royalty income should be charged to tax at the rates applicable in the case of such income derived under approved agreements made before that date. In other words, taxpayers exercising the option will be placed on a par with taxpayers deriving royalty income under approved agreements made before 1-4-1976 in all respects. This aspect has been explained in detail in paragraph 36.1 of the circular.]

For the purposes of the aforesaid source rule, “royalty” has been defined in Explanation 2 to section 9(1)(vi). It will be seen that the definition is wide enough to cover both industrial royalties as well as copyright royalties.

Further, the definition specifically excludes income which would be chargeable to tax under the head “Capital gains” and, accordingly, such income will be charged to tax as capital gains on a net basis under the relevant provisions of the law. The amendments referred to in this paragraph have come into force with effect from 1-6-1976, and will apply in relation to the assessment year 1977-78 and subsequent years. [Section 4(b) (Part) of the Finance Act]

1.3. Fees for technical services

Explanation 2 to section 9(1)(vii) defines ‘fees for technical services’ as any consideration (including lump sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel) but does not include consideration for any construction, assembly, mining or like project undertaken by the recipient. Further, any income of the recipient chargeable under the head “salaries” will also not form part of fees for technical services.

The taxability of fees received for technical services is on similar lines as royalty income. Under section 115A(1)(b)(B), income-tax shall be charged at 10% if the technical fees has been received in pursuance of an agreement made after 31st May, 2005, at 20% if such fees are received in pursuance of an agreement made after 31st May, 1997 but before 1st June, 2005, and at 30% if the said agreement was made on or before 31st May 1997. No deduction shall be allowed under sections 28 to 44C and section 57 in respect of any expenditure or allowance, for the purpose of computing the aforesaid income. In this regard, the following issues are relevant. Section 115A, however, does not apply in respect of fees for technical services covered under section 44DA (1).

1.3.1 Source Rule for ‘fees for technical services’ – section 9(1)(vii) [CBDT Circular 202, dated May 7, 1976]

As in the case of royalty, the Finance Act, 1976 has amended the Income-tax Act clearly specifying the circumstances in which income by way of “fees for technical services” will be deemed to accrue or arise in India and also defining the expression “fees for technical services”. For this purpose, a new clause (vii) has been inserted in section 9(1).

Under the new provision, income by way of “fees for technical services” of the following types will be deemed to accrue or arise in India:

     (a)   fees for technical services payable by the Central Government or any State Government;

     (b)   fees for technical services payable by a resident, except where the payment is relatable to a business or profession carried on by him outside India or to any other source of his income outside India; and

     (c)   fees for technical services payable by a non-resident if the payment is relatable to a business or profession carried on by him in India or to any other source of his income in India.

The expression “fees for technical services” has been defined to mean any consideration (including any lump sum consideration) for the rendering of managerial, technical or consultancy services, including the provision of services of technical or other personnel. It, however, does not include fees of the following types, namely:

1. Any consideration received for any construction, assembly, mining or like project undertaken by the recipient. Such consideration has been excluded from the definition on the ground that such activities virtually amount to carrying on business in India for which considerable expenditure will have to be incurred by a non-resident and accordingly, it will not be fair to tax such consideration in the hands of a foreign company on gross basis or to restrict the expenditure incurred for earning the same to 20 per cent of the gross amount as provided in new section 44D. Consideration for any construction, assembly, mining or like project will, therefore, be chargeable to tax on net basis, i.e., after allowing deduction in respect of costs and expenditure incurred for earning the same and charged to tax at the rates applicable to the ordinary income of non-resident as specified in the relevant Finance Act.

2. Consideration which will be chargeable to tax in the hands of the recipient under the head “Salaries”.

The aforesaid amendment has come into force with effect from 1-6-1976, and will apply in relation to the assessment year 1977-78 and subsequent years.

1.4 Transfer of know-how

Royalty payments may be in exchange for something in addition to the mere use of the invention. Usually the licence contracts include “know-how” provisions. In other words, the licensor not only grants the right to use the invention but also undertakes to supply the licensee with technical `know-how’. The Madras High Court in Fenner Woodroffe & Co., v CIT (1976) 102 ITR 665 (Mad.) has explained that know-how may be taken as comprehending within it the fund of knowledge or experience gained by a manufacturer during the long number of years in which they had been manufacturing on the formulae, the engineering drawings and specifications, mechanical details or processes and general knowledge that is associated with the production and development which is in the exclusive knowledge of the trade.

Know-how is also referred to as a manufacturing technique. It is an intangible asset. The House of Lords in Moriarty  v Evans Medical Supply Ltd. (1959) 35 ITR 707 laid down the criteria to be applied to determine whether the transaction involving dealings in know-how would constitute a receipt of payment of a capital or revenue nature. If the assessee sells its know-how and realises the price for the same, the money realised for providing the know-how would be a receipt of a capital nature. On the other hand, in a case where the assessee who owns the know-how continues to own it and allows the other person only the right of use of such know-how the payments received towards the use of the know-how by another person would be a revenue receipt liable to tax. The question whether the transaction involved is one of purchase or sale of know-how or is that of allowing the other person the right to use it will have to be determined with reference to the facts and circumstances of the case. Where the receipt is of a capital nature, it would be wholly outside the purview of tax under section 9(1)(vi) as royalty. Further, receipts of a capital nature which would otherwise have been liable to tax under the head “capital gains” (e.g. on transfer of patents, designs, drawings, secret formula, etc. forming part of the know-how) would not be liable to tax in the hands of the collaborator in India particularly when the transfer does not take place in India. Therefore, only if the transfer takes place in India, the non-resident collaborator would attract liability to capital gains tax in respect of the transfer of know-how, but not otherwise.

1.5 Export of goods from India by non-residents

Clause (b) of the Explanation to section 9(1)(i) provides that in the case of every non-resident, no income should be regarded as being deemed to accrue or arise to him in India through or from operations which are confined to the purchase of goods in India for the purpose of export. Thus, even in cases where the non-resident has an agency or office in India but the agent or branch office in India does nothing more than the purchase of the goods for their export, there would be no question of income accruing to the non-resident under the deeming provisions although in effect the non-resident may derive income outside India from the goods so exported ultimately on their sale outside India and the profits arising from such export are traceable to the business connection in India through the agency, branch or office. The exemption is, however, subject to the non-resident taking precaution to ensure that even a negligible part of the goods purchased are not sold in India and the whole of the goods purchased are only exported. The country to which the export is made is immaterial for the purpose. Of course, care should be taken in every case to secure that no part of the sale proceeds for the goods exported is received directly or indirectly, in cash or in kind in India by or on behalf of the non-resident. In view of this benefit of total exemption from income-tax without any monetary or other limits and conditions, every possible export should be made by foreign collaborators and their Indian counterparts to secure that the benefit of exemption under clause (b) of the Explanation to section 9(1)(i) is obtained, wherever practicable.

2. Tax treatment of payments made for expenses, etc.

2.1 Nature and amount of expenses dependent upon various factors

The carrying on of a business in India by different categories of taxpayers involves a variety of expenses being incurred by them both in India and outside. The nature and amount of the expenses would, however, depend on the nature of the business, the purpose of incurring the expenditure and the stage at which it is incurred.

2.2 Expenses incurred prior to the setting up of the business do not qualify for any allowance or deduction

In general, a substantial portion of the expenditure is incurred after the business of the taxpayer in India is actually set up. The expenses incurred prior to the setting up of the business do not qualify for any allowance or deduction in computing the taxable profits of the business in India since the previous year of the business cannot be regarded as having commenced until the business is actually set up. Therefore, expenses which are incurred prior to the setting up of business and which are directly related to the acquisition of capital assets including their installation, whichever necessary, have to be capitalised and the assessee would become entitled to claim depreciation allowance and investment allowance (where applicable) in respect thereof from the time the business commences its normal operations by virtue of the commercial production being started.

2.3 Foreign collaborators need to be careful about allowance or disallowance of various expenses

Wherever the expenditure is disallowable because of the restrictions under section 37(1) read with section 28 of the Income-tax Act, 1961, the Indian taxpayers will have to be extremely careful to examine, before entering into the foreign collaboration agreement whether the scheme of foreign collaboration could be modified suitably to secure that such a disallowance is not attracted. This is because of the fact that the incurring of any expenditure which is disallowable would effectively mean that the Indian taxpayers’ financial position would be substantially weakened by virtue of the agreement under which the disallowable expenditure becomes liable to be incurred. The reason for this is not far to seek. Under the scheme of the Income-tax law in India, any expenditure which is incurred by a taxpayer carrying on business and which is disallowed in computing the taxable profits would result in an addition to the real income of the assessee to the extent of the disallowed expenditure. Consequently, the taxpayer in India will not only be having the commitment of paying the amount of expenditure but also be faced with the problem of having to pay a sizeable amount towards income-tax with interest on the amount of notional income attributable to the disallowed expenditure in his income-tax assessment.

Section 37(1) would be the primary guiding provision for the purpose of determining the admissibility or otherwise of the expenditure incurred by the Indian taxpayer. Under this section, it is obligatory for the assessee to establish, for the purpose of obtaining an allowance in respect of the expenditure incurred by him, that the expenditure is of a revenue nature and has been incurred wholly and exclusively for the purpose of the business or profession carried on during the previous year, the income of which is assessable to tax in India.

2.4 Principles for determining whether expenditure is of capital or revenue nature

The criteria for deciding the nature of the expenditure to ascertain whether it is capital or revenue is not one of universal application and the decision in each case will have to depend on the facts and circumstances of the case. The question whether a particular expenditure is capital or revenue in nature and is accordingly deductible or not for purpose of computing the taxable profits is essentially a mixed question of law and fact. The broad principles for making a distinction between capital and revenue expenditure were outlined by the Andhra Pradesh High Court in Hylam Ltd. v CIT (1973) 87 ITR 310 are mentioned as follows:

            1.      If the expenditure is for the initial outlay or for acquiring or bringing into existence an asset or advantage of an enduring benefit to the business that is being carried on or for the extension of the business that is going on or for substantial replacement of an existing business asset, it would be capital expenditure.

            2.      If, on the other hand, the expenditure, although for the purpose of acquiring an asset or advantage is for running the business or for working out that asset with a view to producing profit, it would be revenue expenditure.

            3.      If the outgoing is related to the carrying on or the conduct of the business that it may be regarded as an integral part of the profit earning process or operations and not for acquisition of an of an asset of a permanent character, possession of which is a condition precedent for the running of the business, then it would be expenditure of a revenue nature.

            4.      Special knowledge or technical knowledge or a patent or a trademark is an asset and if it is acquired for payment for use and exploitation for a limited period and what is acquired is not an asset or advantage of an enduring nature and at the end of the agreed period that advantage or asset reverts back intact to the giver of the special knowledge or the owner of the patents or trademarks, it would be expenditure of a revenue nature.

            5.      If it is intrinsically a capital asset, it is immaterial whether the price of it is paid once and for all or periodically or whether it is paid out of the capital or income or linked up with net sales; the outgoing in such a case would be of the nature of capital expenditure.

            6.      If the amount paid for the acquisition of an asset of an enduring nature is settled for the mere fact that the amount so settled is chalked out into various small amounts or periodic installments, the capital nature of the expenditure would not cease to be so or be altered it into the nature of revenue expenditure.

            7.      A lump sum amount for liquidating recurring claims would not cease to be revenue expenditure or get converted into capital expenditure merely because its payment is spread over a number of years. It is the intention and object with which the asset is acquired that determines the nature of the expenditure incurred over it and not the method or the manner in which the payment is made or the source of such payment.

            8.      If the expenditure is recurring and is incurred during the course of business or manufacture, it would be revenue expenditure.

            9.      An asset or advantage of an enduring nature does not mean that it should last forever. If the capital asset is in its nature a short-lived one, the expenditure incurred over it does not for that reason cease to be a capital expenditure.

        10.      It is not the law that if an enduring advantage is obtained the expenditure for securing it must always be treated as capital expenditure. If the advantage acquired is to get any stock-in-trade of the business then it would be revenue expenditure. But if what is acquired is not the advantage of getting any stock-in-trade directly but of something which has to be dressed up or processed before it is converted into stock-in-trade, the expenditure incurred over it would be capital expenditure”.

Compiled by FCA Kamal Garg. He is the fellow member of ICAI. He is engaged in IFRS – Audit and Advisory, FEMA, Valuation and International Taxation services. For any queries and suggestions, he can be approached at [email protected]

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