Commissioner of Income Tax vs Chemicals and Plastics (I) Ltd.

Ratnam, J.—At the instance of the Revenue, u/s 256(1) of the Income Tax Act, 1961 (hereinafter referred to as ""the Act""), the following

common question of law for the assessment year 1968-69 to 1972-73, has been referred for the opinion of this court :

Whether, on the facts and in the circumstances of the case, the entire royalty paid by the assessee to its foreign collaborator, B. F. Goodrich

Chemical Company, under the collaboration agreement dated October 1, 1962, for providing continuing know-how to the assessee was liable to

be deducted as revenue expenditure ?

The assessee is a limited company carrying on the business of manufacturing P.V.C. resins and compounds. The company, on October, 1,

1962, entered into a collaboration agreement with B. F. Goodrich Chemical Company, styled as ""Technical Service Agreement"", the relevant

clauses of which will be noticed in detail later in the course of this judgment. Thereunder, provision was made for payment of royalty by the

assessee to the foreign collaborator, B. F. Goodrich Chemical Company, in respect of what had been styled in the agreement as ""accumulated

know-how"" and ""continuing know-how"". In so far as the payment of royalty by the assessee for accumulated know-how furnished by B. F.

Goodrich Chemical Company (hereinafter referred to as ""B. F. Goodrich Company"") is concerned, that has been capitalised in the books of the

company and, therefore, the payment of royalty in respect of the ""continuing know-how"" furnished by B. F. Goodrich Company in terms of the

agreement alone figures in these refreences. In the course of the Income Tax of the assessment proceedings for the relevant assessment years, the

Income Tax Officer disallowed 25% of the royalty payment made by the assessee on the ground of cap[capital expenditure in the view that the

continuing know-how secured to the assessee and advantage of enduring benefit. On appeal preferred by the assessee before the Appellate

Assistant Commissioner, the AAC took the view that the payment of royalty was not to be considered in isolation, but represented a part of the

terms of the general pattern of technical assistants receivable by the assessee, according to the terms of the collaboration agreement, and the result

of the acquisition of technical know-how and other services, for which royalty was paid, would be of a permanent character and resulted in a

benefit of enduring nature to the assessee. The disallowance of part of the royalty paid was thus upheld. On further appeal before the Tribunal, on

a consideration of the collaboration agreement, it was of the opinion that the payment of royalty by the assessee in respect of the continuing know-

how should be regarded as having been made to enable the assessee to carry on its manufacturing activities and business in the light of the latest

technical developments, changes and innovations, and should, therefore, be regarded as an expenditure intimately linked to the manufacturing

activity of the assessee. It was also further pointed out by the Tribunal that the bifurcation of the amount of royalty paid partly into capital and

partly into revenue, as had been done by the authorities below, would lead to the result that such payments would, sometimes, lead to the

conclusion that it had yielded an asset of enduring advantage and sometimes not and such a division was not only opposed to the terms of the

agreement, but also to ordinary comprehension. The Tribunal, therefore, held that the entire expenditure by way of royalty paid, calculated at 3%

of the net realised sales, represented revenue expenditure and that the disallowances of 25% of the royalty so paid, could not be justified. That is

how the question set out earlier has been referred to this court for its opinion in these references.

Learned counsel for the revenue, Referring to clauses 1-B, 1-C, 1-D and 1-I of the collaboration agreement with the foreign collaborator,

contended that the payment of royalty provided thereunder was in the nature of a consolidated payment, part of which was attributable to capital,

even though under the terms of the agreement, such payments had been earmarked for accumulated know-how as well as continuing know-how.

Under the enabling clauses in the agreement, the use of the continuing know-how by the assessee, even after the expiry of the agreement, was

stated to result in an enduring advantage to the assessee, so as to render the royalty payment in respect of continuing know-how, an item of capital

expenditure. Reliance, in this connection, was placed by learned counsel on the decisions in M.R. Electronic Components Ltd. Vs. Commissioner

of Income Tax, Madras, and CIT v. Southern Switchgear Ltd. [1984] 148 ITR 272 . On the other hand, learned counsel for the assessee

submitted that the payment of royalty under the terms of the collaboration agreement for the acquisition of continuing know-how was only in the

nature of acquiring knowledge and skill in respect of the latest technical advances in relation to the manufacturing activity undertaken by the

assessee that would facilitate the assessee in the carrying on of its business of manufacture of P.V.C. resins in a manner which would be most

advantageous to the assessee and the expenditure incurred in connection therewith, could not by any stretch of imagination be characterised to be

capital expenditure, but that it would only be revenue expenditure and, therefore, the Tribunal was right in its conclusion. Our attention in this

connection was drawn to the decisions in Empire Jute Co. Ltd. Vs. Commissioner of Income Tax, ; Commissioner of Income Tax, Tamil Nadu-III

Vs. Sundaram Clayton Ltd., and Commissioner of Income Tax, Tamil Nadu-III Vs. Madras Rubber Factory Ltd., .

It would be necessary, before proceeding to consider the rival submissions made, to consider the relevant clauses in the collaboration agreement

dated October 1, 1962. Clause 1-B of the agreement runs as under :

1-B. B. F. Goodrich also agrees to furnish to furnish to the company in the United States of America, to the extent permitted under the laws of the

United States of America and under contracts with the Government of the United States of America, its departments, bureaus, or agencies and not

prohibited by reason of the source from which obtained or by prior commitments entered into with others, (1) all technical information,

Knowledge, and data, sometimes herein referred to as ""know-how"", now known to and used by B. F. Goodrich in the manufacture of PVC and

related materials, sometimes hereinafter referred to as ""accumulated know-how"", and (2) all such know-how developed or hereafter known to and

used by B. F. Goodrich during the term of this agreement in the manufacture of PVC and related materials, sometimes hereinafter referred to as

continuing know-how"", and thus to keep the company fully and regularly informed with respect to the manufacturing methods being employed by

B. F. Goodrich so that the company many have and enjoy the full benefit of such know-how and manufacturing skill in its manufacture of PVC and

related materials.

Further, B. F. Goodrich will furnish to the company in the United States of America such information relating to the conversion of PVC and related

materials into finished articles and products, together with data as to the use of such materials, as is customarily furnished by B. F. Goodrich to its

customers in the United States of America as an incident to the sale of such materials.

Clauses 1-C and 1-D run as follows :

1-C. B. F. Goodrich agrees further, upon the request and at the expense of the company, to perform in the United States of America services as

follows :

(1) advise the company, from time to time, as to the kind, type and best sources of supply for the purchase of machinery, equipment, raw materials

and supplies required for the equipping and operation of the company''s factory.

(2) select, inspect and purchase for the account of the company, either in its name of in the names of B. F. Goodrich, such machinery, equipment,

raw materials and supplies as are requested by the company for the equipping and operation of the said factory.

(3) test and analyse PVC and related materials and ingredients for use in the manufacture thereof as the company may send to Cleveland, Ohio,

U.S.A. from time to time, and report the results of such tests and analysis to the company.

(4) provide, in the factories of B. F. Goodrich located in the United State of America and engaged in the manufacture of PVC and related

materials, training of technical personnel for the company, and provide other engineering and technical personnel for the company and provide

other engineering and technical services of a miscellaneous nature, relating to the production of PVC and related materials and which B. F.

Goodrich may be in a position to furnish.

(5) at any time within seven years from the date of this agreement, prepare or have prepared and furnish to the company, in the event it at any time

during said seven years'' period should decide to alter or enlarge its factory or expand its manufacture of PVC and related materials, such

preliminary designs, drawings, blueprints, specifications and engineering and technical services as are necessary in connection with the construction

and equipping of such alteration, enlargement or expansion and which B. F. Goodrich may be in a position to prepare or have prepared and

furnish, and,

(6) advise the company, from time to time, as to operating and sales procedures, techniques and materials now or hereafter known to and used by

B. F. Goodrich and to provide such other services in the establishment and operation of the company as B. F. Goodrich may be in a position to

furnish or have furnished.

1-D. B. F. Goodrich, upon the request and at the expense of the company and to the extent that such may be performed within the United State of

America, also will consult with and assist the company in the selection of a factory site in India, and will procure for the company trained and

competent engineers and technicians as deemed advisable and necessary by B. F. Goodrich to supervise the laying out and initial quipping of the

factory, and trained and competent persons necessary to supervise the production of PVC and related materials including the compounding and

processing of the required ingredients and the distribution of the finished PVC and related materials. Such persons shall be subject to the approval

of the company and if any such person shall become unsatisfactory to the company, B. F. Goodrich, upon request by unreasonably any such

replacement.

Clause 1-I is to the following effect :

1-I. The company, solely for the accumulated know-how furnished by B. F. Goodrich under article 1-B hereof, will issue to B. F. Goodrich in

payment therefore shares of the ordinary capital of the company in such member as at their par value are equivalent to three hundred and fifty

thousand dollars (U.S. 350,000) in the currency of the United States of America, computed at the rate of exchange quoted by the Reserve Bank

of India for the conversion of Indian rupees to U.S. dollars on the date on which the shares are issued by the company to B. F. Goodrich, such

date being established in that certain investment agreement for the founding of the company. All the said shares shall be free to B. F. Goodrich of

any tax which may be imposed by the national or any local Government of India as the result of the issuance or the receipt of said shares, the

company agreeing to pay to or on behalf of B. F. Goodrich a sum equal to the amount of any such tax.

The company, for the continuing know-how furnished by B. F. Goodrich, under article 1-B hereof will pay B. F. Goodrich, on or before the last

day of the month next following each calendar quarter, beginning with the calendar quarter in which the company makes its first invoiced sale and,

thereafter, a royalty equal to three percent (3%) of the company''s net realised sales in the respective calendar quarter of all PVC and related

materials manufactured by it during the term of this agreement, converted to the currency of the United States of America at the highest rate (that is

to say, the largest unit of U.S. dollars for each Indian rupee) authorised by the Government of India and quoted by the Reserve Bank of India for

U.S. dollar funds in exchange for currency of India on the date payment of the royalty is due as hereinabove provided. Said royalty shall be subject

to any applicable tax in India. If payment of the royalty is not remitted on the due date as the result of action by the Government of India, the

aforesaid conversion rate shall be such rate on the date the royalty is due or on the date of actual payment whichever is more favourable to B. F.

Goodrich. If payment is not remitted on the due date because of the non-availability of U.S. dollar exchange solely as a result of action by the

Government of India, the aforesaid conversion rate shall be such rate on the date the royalty was due.

On a careful consideration of the aforesaid clauses, it is seen that clauses 1-C and 1-D are not very helpful for the purpose of deciding the

precise character of the royalty payment made by the assessee in respect of the acquisition of continuing know-how. It is only under clause 1-B,

the provision is made under two distinct heads, viz., ""accumulated know-how"" and ""continuing know-how"" In so far as the continuing know-how,

which alone forms the subject-matter of these references is concerned, the agreement provides that the assessee-company shall be fully and

regularly informed by the foreign collaborator with respect to the manufacturing methods employed by it, in order that the assessee company may

have the benefit of such know-how in its manufacturing skill in the production of PVC and related materials. It is only to enable the assessee to

know the latest developments in the manufacturing methods that the continuing know-how has been agreed to be made available to the assessee

by the foreign collaborator, for which, under the second clause occurring in clause 1-I, the assessee-company had agreed to pay a royalty equal to

3% of the company''s (assessee''s) net realised sales to the foreign collaborator. Based purely on the terms of the collaboration agreement, it

appears to us that the payment of 3% royalty in respect of the continuing know-how is only to secure information and knowledge with reference to

the latest technical development and updated techniques of manufacture of PVC resins and compounds and that would only enable the assessee to

employ such knowledge or manufacturing skill in its manufacturing activities, as to improve its production and the quality of its products. We are,

therefore, unable to accept the contention of learned counsel for the Revenue that the agreement is a consolidated one in relation to the payment of

royalty or that part of it is attributable to capital. As pointed out earlier, the imparting of latest technical information, knowledge and intelligence

about the recent and up to date developments in the manufacture of PVC resins and compounds would only be imparting intelligence or

information. which might be employed by the assessee-company in its manufacturing activity for the better utilisation of its manufacturing activities

by applying the latest developments and techniques. We are also unable to accept the contention of learned counsel for the Revenue that imparting

of such information and knowledge relating to the latest developments and techniques in the manufacture would result in an enduring advantage to

the assessee, as that could also be used even after the expiry of the period of agreement. Basically, under the agreement, what is intended to be

imparted is only updated information and knowledge regarding methods of manufacture, which can be advantageously employed in the business of

carrying on its manufacturing activity by the assessee-company and the mere circumstance that such knowledge may be used by the assessee in the

course of running of its business even after the expiry of the period of agreement, would not make it any the less manufacturing skill received by the

assessee for purposes of improving its methods of manufacture for securing more efficient production of goods of high quality and economically as

well. We also do not see how, if during the period of agreement, what is imparted is only knowledge, skill and information useful to the assessee in

its manufacturing activities, it ceases to be so after the expiry of the agreement. Whether it be during the period when the agreement is in force or

even thereafter, in our law view, on the terms found in the collaboration agreement, the payment of royalty by the assessee is only towards securing

information and intelligence regarding the up-to-date developments in the manufacturing processes involved leading to an efficient, economical and

profitable production of goods. We are, therefore, unable to accept the contention of learned counsel for the Revenue.

We may now refer to the decisions relied on by learned counsel for the Revenue. In CIT v. Southern Switchgear Ltd. [1984] 148 ITR 272 , the

assessee, under the terms of a collaboration agreement entered into with a foreign company, paid a lump sum, though in five equal instalments, and

claimed deduction of such payment as revenue expenditure, one-fourth or which was disallowed by the Income Tax Officer on the ground that

such payment secured an enduring benefit to the company and this was also affirmed on appeal by the Appellate Assistant Commissioner as well

as the Tribunal. On a reference to this court, it was held, on a consideration of the clauses of the agreement in that case, that the assessee obtained,

through the agreement, an enduring advantage and benefit and such benefit was available to the assessee for its manufacturing and industrial

processes and the exclusive right of manufacture conferred on the assessee should be considered as an independent right secured by the assessee

from the foreign company, which was of an enduring nature and, therefore, the Tribunal was right in the view it took that 25% of the technical and

aid fees has to be regarded as being capital in nature. It was also further pointed out that the royalty payment resulted in the acquisition of an

exclusive privilege of manufacturing and selling of products and the acquisition of such a right was rightly regarded by the Department and the

Tribunal as partly towards capital and partly towards revenue. On the terms of the agreement in this case, it is seen that there is no question of the

assessee having secured, by the payment of royalty, any exclusive privilege of either the manufacture of the sale of the products and that would

suffice to distinguish that decision from the present one, and, therefore, that decision would be inapplicable here. In M.R. Electronic Components

Ltd. Vs. Commissioner of Income Tax, Madras, , under the terms of the collaboration agreement, there was an element of acquisition of right

exploitable in future and it was, therefore, held that it did not relate to the running of the business. Such is not the position on the terms found in the

agreement and referred to earlier. Under clause 9(a) of the agreement in that case, it was provided that assistance should be rendered in the

construction of the factory, but no separate consideration was provided for such assistance and, therefore, it was held that a part of the

consideration was liable to be ascribed to capital. On the other hand, in this case, as could be seen from the clauses referred to already, a part of

the royalty payment, even under the terms of the agreement, has been provided for services to be rendered, which had also been capitalised. In

other words, under the terms of the agreement in this case, a clear distinction is made between that portion of the royalty which is considered as

capital and that which is considered to be revenue with reference to the acquisition of knowledge of skill relating to improvements in the methods

and techniques of manufacture of PVC resins and compounds. We are of the view that the decision of the Supreme Court in Empire Jute Co. Ltd.

Vs. Commissioner of Income Tax, , relied on by learned counsel for the assessee, would have and important bearing on this question. The

assessee in that case purchased ""loom hours"" and claimed the expenditure incurred in connection therewith u/s 10(2)(xv) of the Indian Income Tax

Act, 1922. The question arose whether that expenditure was capital or revenue. The Supreme Court pointed out at page 10 as follows :

What is material to consider is the nature of the advantage in a commercial sense and it is only where the advantage is in the capital field that the

expenditure would be disallowable on an application of this test. If the advantage consists merely in facilitating the assessee''s trading operations or

enabling the management and conduct of the assessee''s business to be carried on more efficiently or more profitably while leaving the fixed capital

untouched, the expenditure would be on revenue account, even though the advantage may endure for an indefinite future. The test of enduring

benefit is, therefore, not a certain of conclusive test and it cannot be applied blindly and mechanically without regard to the particular facts and

circumstances of a given case. But even if this test were applied in the present case, it does not yield a conclusion in favour of the Revenue. Here

by purchase of loom hours, no new asset has been created. There is no addition to or expansion of the profit-making apparatus of the assessee.

The income-earning machine remains what it was prior to the purchase of loom hours. The assessee is merely enabled to operate the profit-making

structure for a longer number of hours. And this advantage is clearly not of an enduring nature.

We are of the view that the aforesaid observations of the supreme court are apposite, for, by the acquisition of the knowledge pertaining to the

latest development and techniques, the assessee is enabled to carry on the business more efficiently or more profitably and that would not in any

manner effect the capital even though the knowledge or information provided may be available to the assessee for an indefinite future. In

Commissioner of Income Tax, Tamil Nadu-III Vs. Madras Rubber Factory Ltd., , this court had occasion to consider the terms of a collaboration

agreement entered into between the assessee and a foreign collaborator in relation to the nature of payment of royalty for consultancy services

supplied by the foreign collaborator, from time to time, for running the factory and for the maintenance or production. On a consideration of the

provisions in the agreement, it was held that the agreement itself maintained a distinction between the two aspects of collaboration, viz., one

connected with the initial setting up of the factory and the other connected with the running of the factory and there was no question of payment of

fee for the consultancy services being considered as having any capital element in it, but that the entire payment was allowable as a revenue

outgoing. It would be useful in this connection to refer to the following observations at pages 683 and 684 :

It may be conceded that what Mansfield or its resident engineer in India were imparting to the assessee on operational matters might tend to

outlast, and endure beyond, the contract period. This, however, is a common characteristic of all knowledge which a person acquires. There is a

saying in Tamil that knowledge once acquired is everlasting, and it cannot be destroyed either by flood or by fire, nor can it be obliterated or even

diminished by being imparted to others. Technical or commercial knowledge acquired by a trader or industrialist is of his this kind enduring, if not

everlasting. Expenditure to acquire it cannot be disallowed merely because knowledge dies hard. It is only where the expenditure bears on the

fixed capital or other capital structure of the assessee that it can be regarded as capital in nature. Where the expenditure, although enduring in

character has its impact on the running of the business, there can be no doubt that it is out and revenue expenditure. If the position were otherwise,

practically any item of revenue outgoing in the day-to-day running of a business can be broken up and dissected in an effort to discover in it some

fractional element or other of a capital nature, merely on the score that the resulting benefit or advantage tends to pay in business. This, however, is

not the law.

In our view, there is no principle or authority to support the partial disallowance which the Income Tax Officer made in this case out of the total

amount of fees and royalties paid by the assessee to Mansfield. It can not be said that the object of this payment or even its end-result had

enlarged the assessee''s fixed capital equipment of the capital structure. The assessee is no doubt in a position to keep for itself all that it had learnt

from Mansfield during the contract period. But this only serves the assessee to run its business as efficiently after the contract period as it did during

that period. We do not, therefore, accept the thesis that any part of the fees can be regarded as having any capital element deserving of

disallowance under the Income Tax Act.

In the light of the observations referred to above, we are of the view that the accumulated technical know-how, in respect which the assessee

paid royalty, is really in the nature of knowledge acquired by the assessee having an impact on the carrying on of the manufacturing activities and

though it may be enduring, if not everlasting, the expenditure incurred on its acquisition cannot be disallowed on the only ground that knowledge

dies hard. We may now refer to Commissioner of Income Tax, Tamil Nadu-III Vs. Sundaram Clayton Ltd., , where, under the terms of the

collaboration agreement, royalty was paid for purposes of obtaining relevant know-how for manufacture and sale of materials manufactured, part

of which was disallowed by the Income Tax Officer, which was upheld by the Appellate Assistant Commissioner and confirmed by the Tribunal.

On a consideration of the terms of the collaboration agreement in that case, this court pointed out, on a reference, that where the payment of

royalty is purely for the purpose of obtaining the relevant know-how for the manufacture and sale of materials manufactured, such payments are

not liable to be treated as capital expenditure. Emphasis was also laid on the quality of the expenditure incurred with reference to the object for

which it was incurred and judged by that test, we are of the view that there is no capital element in the expenditure incurred in this case. Thus, on a

consideration of the terms of the collaboration agreement, in the light of the principles laid down in the decisions referred above, the entire royalty

payment made by the assessee in the relevant assessment years in question, in terms of the agreement for the acquisition of continuing technical

know-how, should be treated as having been incurred in connection with the running of its business and no capital element is involved in it. We,

therefore, answer the question referred to us in the affirmative and against the Revenue. The assessee will be entitled to the costs of this reference.

Counsel''s fee Rs. 500 (one set).