The Hindu Business Line : A matter of interpretation

Collaboration agreements are the order of the day. Indian companies enter into technical collaboration agreements with foreign ventures so as to bring in knowhow and expertise into India. These agreements stipulate the terms of the payment.

Question arises whether the payments made to the foreign collaborator will be considered as deductible business expenditure in the hands of the Indian company in its tax assessments. Three decade back, in the celebrated CIBA India case, the Supreme Court laid down the rule that mere access to the technical knowledge and experience which the foreign company commanded will mean that the payment is only revenue in nature.

This will be so if the Indian company does not become entitled to the patents and trademarks of the foreign company. Payments made for use of knowhow leading to increase in the yield of penicillin in the existing plan were considered as revenue expenditure in the Alembic case. Enduring character of the payment is no longer considered a test. The test can break down if the impact of the knowhow is only on running of business. But it will be capital in nature if the knowhow is meant for starting a new venture.

Shriram Pistons case

One would have thought that the plethora of judicial rulings on the subject in the past 30 years had settled the issue once and for all. Yet, cases continue to arise before High Courts and the Revenue is agitating the matter even in 2008. Shriram Pistons and Rings Ltd (307 ITR 363) entered into a technical collaboration agreement with Riken Piston Ring Ind. Co. Ltd, of Japan for manufacture of piston rings.

The agreement provided for comprehensive technical knowhow and assistance for manufacturing and selling piston rings. It covered manufacturing, drawings and specifications and processes. One of the vital clauses in the agreement stipulated that the Indian licensee will pay to the Japanese licensor 8,820,000 yen in consideration of knowhow sold by the licensor and the payment was subject to appropriate Indian taxes.

The Revenue jumped on the use of the term ‘sold’ in the agreement and started arguing that it was a case of outright sale of knowhow and the payment fell in the capital field. There were other clauses in the agreement enabling the Indian company to sub- license the knowhow to another Indian party with the prior consent of the Japanese collaborator.

Confidentiality was to be maintained. Right of the Indian company to market products manufactured under the agreement would cease upon the expiry of the agreement. Agreement was for a period of five years. The Indian company would have a perpetual non-exclusive right to manufacture the products under the agreement without further payments.

Right to use or sale?

The question raised was whether what was transferred to the Indian company was only a right to use the knowhow or was it a sale of knowhow in perpetuity.

The Delhi High Court considered various authorities on the subject. It went into the various clauses in the agreement. The agreement was valid only for five years and could be terminated even earlier. The court observed: “There is no magic in the word ‘sold’ used in the agreement because on a reading of the agreement as a whole, it appears to us that what was transferred was only a right to use the technical knowhow and there was no sale of the knowhow which the assessee could exploit. The assesse’s rights were hedged in with all sorts of conditions, clearly making it a case of right to use the technology and not sale of the technical knowhow”.

The Indian company can sub-licence the knowhow only with the prior written permission of the Japanese collaborator. The Indian company was entitled to use the name of the Japanese collaborator in the marketing of its products but that right would cease upon the expiry or termination of the agreement.

The ruling

Finally, the court concluded that there was no sale of technical knowhow and the payment made by the Indian company to the Japanese collaborator should be allowed as revenue expenditure.

Going through the law reports on the subject, one will find that rarely does the Revenue succeed in its claim for treating payments for collaboration and knowhow as capital expenditure.

The CIBA case of 1968 still holds the field. Possibly, there can be bifurcation of the expenditure into capital and revenue if it can be shown that part of the know-how was for setting up the plant. Even so, as the Supreme Court itself noted in the Scientific Engineering case, that knowhow expenditure falling in the capital field can be considered ‘plant’ under Section 43(3) of the Income-Tax Act, 1961 entitled to depreciation allowance under Section 32. They fall in the category of intangible assets.

It is difficult to understand what the Revenue is fighting for in various High Courts on this issue.

(The author is a former Chief Commissioner of Income-Tax. blfeedback@thehindu.co.in)

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