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

V. Ratnam, J.—At the instance of the revenue, u/s 256(1) of the income tax Act, 1961 (''the Act''), the following common question of law for the assessment years 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 Co. under the collaboration agreement dated 1-10-1962 for providing continuing know-how to the assessee was liable to be deducted as revenue expenditure?

The assessee is a limited company, carrying on business of manufacturing P.V.C. resins and compounds. The company, on 1-10-1962, entered into a collaboration agreement with B.P. Goodrich Chemical Co. 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 Co., in respect of what had been styled in the agreement as ''accumulated know-how'' and ''continuing know-how''. Insofar as the payment of royalty by the assessee, for accumulated know-how furnished by B.F. Goodrich Chemical Co. (''B.F. Goodrich Co.'') 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 Co. in terms of the agreement alone figures in these references. In the course of the assessment proceedings for the relevant assessment years, the ITO disallowed 25 percent of the royalty payment made by the assessee on the ground of capital expenditure in the view that the continuing know-how secured to the assessee, an advantage of enduring benefit. On appeal preferred by the assessee before the AAC, he took the view that the payment of royalty was not to be considered in isolation, but represented a part of the general pattern of technical assistance 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 terms 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 inventions, and should, therefore, be regarded as an expenditure intimately linked up with the manufacturing activity of the assessee. It was also further pointed out by the Tribunal that the bifurcation of the amount of royalty 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 percent of the net realised sales, represented revenue expenditure and the disallowance of 25 percent 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.

The 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. The enabling clauses in the agreement for the use of the continuing know-how by the assessee, even after the expiry of the agreement, were 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 the learned counsel on the decisions in M.R. Electronic Components Ltd. Vs. Commissioner of Income Tax, Madras, and Commissioner of Income Tax, Tamil Nadu-II Vs. Southern Switchgear Ltd., On the other hand, the 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 PVC 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 a 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, the relevant clauses in the collaboration agreement dated 1-10-1962. Clause 1-B of the agreement runs as under:

1-B. B.F. Goodrich also agrees 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.P. 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 may 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 or 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 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 analyses to the company, (4) provide, in the factories of B.F. Goodrich located in the United States of America and engaged in the manufacture of PVC and related materials, training of 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 States 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 equipping 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 the company, will seek a replacement, but the company agrees not to request 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 therefor shares of the ordinary capital of the company in such number as at their par value are equivalent to Three Hundred and Fifty Thousand Dollars (U.S. $ 3,50,000) 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 of 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 percent) of the company''s net realized sales in the respective calendar quarter of all PVC and related materials manufactured by it during the terms of this agreement, converted to 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) authorized 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 herein-above 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 the 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 1C and 1D 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 1B, provision is made under two distinct heads, viz., ''accumulated know-how'' and ''continuing know-how''. Insofar 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 percent 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 percent royalty in respect of the continuing know-how, is only to secure information and knowledge with reference to the latest technical developments and updated techniques of manufacture of PVC resins and compounds and that would only enable the assessee to employ such knowledge of 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 the 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 the 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 method 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 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 the learned counsel for the revenue. We may now refer to the decisions relied on by the learned counsel for the revenue. In Southern Switchgear Ltd.''s case (supra), 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 a revenue expenditure, one-fourth of which was disallowed by the ITO on the ground that such payment secured an enduring benefit to the company and this was also affirmed on appeal by the AAC 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 percent of the technical 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 in the manufacture or 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.''s case (supra) 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, 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 the 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 or 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.''s case (supra) relied on by the learned counsel for the assessee, would have an 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 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 or 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 developments and techniques, the assessee is merely enabled to carry on the business more efficiently or more profitably and that would not in any manner affect the capital, even though the knowledge or information provided, may be available to the assessee for an indefinite future. In Madras Rubber Factory Ltd.''s case (supra), 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 collaborators from time to time, for running the factory and for the maintenance of production. On a consideration of the provisions in the agreement, it was held that the agreement itself meticulously 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 that 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:

...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 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 out 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 the business. This, however, is not the law.

In our view, there is no principle or authority to support the partial disallowance which the ITO made in this case out of the total amount of fees and royalties paid by the assessee to Mansfield. It cannot be said that the object of this payment or even its end-result had enlarged the assessee''s fixed capital equipment or 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 IT Act.

In the light of the observations referred to above, we are of the view that the accumulated technical know-how, in respect of which, the assessee paid royalty, is really in the nature of knowledge acquired by the assessee having an impact on the carrying on of 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 Sundaram Clayton Ltd.''s case (supra) 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 ITO, which was upheld by the AAC 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 purposes of obtaining 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 to 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. We therefore answer 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).