Commissioner of Income Tax vs Lucas-T.V.S. Limited (No. 1)

Ismail, J.—At the instance of the Commissioner of Income Tax, Madras, the Income Tax Appellate Tribunal, Madras Bench, u/s 256(1) of

the Income Tax Act, 1961, has referred the following questions of law, arising out of the order of the Tribunal dated December 31, 1971, relating

to the four assessment years 1964-65 to 1967-68 for the opinion of this court:

(1) Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the disputed 50% of the

technical aid fees to Messrs. Joseph Lucas (Industries) Ltd., England, was revenue expenditure and, therefore, liable to be allowed as deduction

from the income of the assessee ?

(2) Whether, on the facts and in the circumstances, the Appellate Tribunal was right in law in holding that the initial depreciation should not be

deducted in determining the written down value of assets for computation of capital employed in the newly established industrial undertaking under

rule 19 of the Income Tax Rules, 1962 ?

The assessee is a limited company engaged in the manufacture of electrical equipments like generators, starters, regulators, etc., and distributors

for commercial vehicles, tractors, cars and motor cycles. It entered into a technical collaboration agreement dated June 6, 1962, with a foreign

company, Messrs. Joseph Lucas (Industries) Ltd., England, hereinafter referred to as the foreign company. The foreign company granted to the

assessee the exclusive right and licence to make, use, exercise and vend items of the electrical equipment for vehicles and engines and service

tools. The agreement which has been annexed to the statement of the case marked annexure "" A "" contains several clauses which will give a clue as

to the nature of the arrangement arrived at between the parties. In the agreement the foreign company is termed as "" the grantor"" and the assessee

is termed as "" the licensee "". It also refers to the fact that the grantor is registered as proprietor of or has rights (including the right to sub-licence) in

the patents effective in the licensed territory, meaning the geographical area of India. Such registered patents have been referred to in the first part

of the first schedule to the agreement and the second part of the first schedule refers to the patents for which the grantor had then made application.

Clause (e) of the preamble states that the grantor had agreed to grant to the licensee such licence in connection with inventions comprised in the

said patents and licensed devices as mentioned in the agreement. Clause 2(d) defines "" non-exclusive right "" as meaning right enjoyed by the

licensee in common with the grantor, its successors and assigns and all other persons to whom the grantor had granted or the grantor, its

successors and assigns shall thereafter grant the like right.

Clause 3(a) refers to the nature of the right granted to the licensee and the same is as follows :

The exclusive right and licence to make use, exercise and vend the Licensed Devices and parts thereof within the Licensed Territory, ALWAYS

PROVIDED that the Grantor shall have the right to import into the Licensed Territory any of the Licensed Devices made by or for or under licence

from the Grantor and which are fitted as original equipment on vehicles or engines made outside the Licensed Territory and also have the right to

import spare parts and/or replacements which shall be sold either through licensee or through Lucas''s wholly owned subsidiary company Lucas

Indian Service Private Limited AND PROVIDED FURTHER that the exclusive licence herein granted shall be subject to any licence which the

Grantor may at the date hereof have granted in respect of the licensed devices in the Licensed Territory.

Clause 6 provides that the licence and agreement shall become effective on the first day of October, 1962, and shall continue in force for a period

of ten years from such date and thereafter may with the consent of the parties be extended for further five-year periods.

There is a provision for termination of this licence even before the expiry: of the period of the said ten years for stated reasons mentioned in

clause 10. Clause 10(a) stated that if any of the fees or royalties or other payments payable under the agreement shall be in arrear and remain

unpaid for a period of thirty days after the same became payable as therein referred to, whether or not a formal demand therefore shall have been

made by the grantor, the grantor can terminate the licence. Clause 10(b) provided for termination in the event of bankruptcy, etc., of the licensee.

Clause 10(c) also enabled the grantor to terminate the licence if the licensee granted a sub-licence or assigned the agreement or the licence,

contrary to the terms of the agreement in favour of a third party.

Clause 7(a) deals with payments to be made under the agreement. Under Clause 7(a)(i), in consideration of the technical services rendered by

the grantor, a fee amounting to one per cent. of the factory cost of all licensed devices and spare parts for such devices manufactured and sold by

the licensee shall be paid by the licensee to the grantor. Under Clause 7(a)(ii), in consideration of the licences and other rights granted under, the

agreement in respect of the scheduled patents and the grantor''s designs, a royalty amounting to two per cent., of the factory cost of all licensed

devices and spare parts for such devices manufactured and sold by the licensee shall be paid by the licensee to the grantor. Clause 7(a)(iii) states

that in respect of licensed devices which are exported outside the licensed territory, a royalty of one per cent. in addition to the fees and royalties

referred to in Clauses 7(a)(i) and (ii) above, shall be paid.

There is a provision dealing with improvements to the patented material that may be made by the licensee. Clause 7(e) states : "" If at any time

during the continuance of this licence, the licensee shall make or discover any improvement or addition to the licensed devices or the working of the

same or is now or shall hereafter become the owner of or has now or shall hereafter obtain the control of any such improvement or addition then

and in any such case the licensee will communicate and explain the same to the grantor which shall enjoy a royalty-free licence under any patent

that the licensee may obtain covering such improvement or addition for the term of such patent.

There is a reciprocal provision with regard to the improvements that may be made by the grantor which is contained in clause 8(b) and that

clause is more or less similar to Clause 7(e) except for the fact that in respect of such improvements or additions, the patentable right shall remain

with the grantor.

Clause 7(h) imposes an obligation on the licensee to recognise and acknowledge the validity of every patent at any time licensed under the

agreement and prohibits the licensee, during the continuance of the licence or after termination thereof, from contesting the validity of any such

patent either directly or indirectly or in any way assisting counsel or procuring others so to do.

Clause 7(i) is important and it states that the licensee will not without the written consent of the grantor during the continuance of the licence or at

any time after its termination disclose to any third party any manufacturing information supplied to or acquired by the licensee under the agreement

except such information as is made available to the general public by or with the consent of the grantor.

Clause 9 expressly provided that the licensee shall have no power at any time to assign the licence or to grant any sub-licence or in any way to

charge, mortgage or deal with the rights granted under the agreement without the previous consent in writing of the grantor first had been obtained.

Under Clause 14(c), the obligation to keep information confidential set out in the agreement in sub-clause 7(i) shall continue indefinitely. Clause

14(d) provided that if the licensee had stock in hand of the licensed devices at the date of termination, it might within one year after the date of

termination dispose of such stock and its obligations regarding payment of royalties, keeping of records and submission of reports shall be deemed

to continue in respect of such stock in hand, so disposed of.

It is with reference to this agreement the assessee claimed amounts which it paid by way of fees and royalties provided for in Clause 7(a) of the

agreement, as deductible expenditure in the computation of the profits or gains. The Income Tax Officer held that 50% of such expenditure was

capital in nature as it brought into existence an enduring asset, namely, necessary information for the manufacture of the patented articles, and

therefore only 50% of the amounts paid by the assessee could be allowed as deduction. However, on appeal preferred by the assessee, the

Appellate Assistant Commissioner held that the assessee had not acquired any capital asset or derived any enduring benefit under the technical

collaboration agreement and that the assessee''s case was on all fours with the decision of the Supreme Court in Commissioner of Income Tax,

Bombay Vs. Ciba of India Ltd., and accordingly allowed the entire technical fees as revenue expenditure. Aggrieved by the order of the Appellate

Assistant Commissioner in respect of the assessments for all the four years, the department preferred appeals and all these appeals were disposed

of by a common order of the Tribunal. The Tribunal held that the principles laid down by the Supreme Court in Commissioner of Income Tax,

Bombay Vs. Ciba of India Ltd., applied to the facts of the present case and that consequently the Appellate Assistant Commissioner was fully

justified in reversing the order of the Income Tax Officer. It also held that the initial depreciation was not to be deducted for computation of capital

for the purpose of Section 84 of the Income Tax Act, 1961. It is the correctness of these conclusions that are challenged in the form of questions

extracted already referred to this court.

As far as the first question is concerned, we are clearly of the opinion that the principles laid down by the Supreme Court in Commissioner of

Income Tax, Bombay Vs. Ciba of India Ltd., directly apply to the facts of the present case. The terms of the agreement which have been extracted

in the judgment of the Supreme Court would appear to be more or less similar to the ones which the assessee entered into with the foreign

company in the present case, to which we have already drawn attention. The Supreme Court in the judgment in question pointed out at page 699 :

The assessee did not, under the agreement, become entitled exclusively even for the period of the agreement, to the patents and trade marks of

the Swiss company; it had merely access to the technical knowledge and experience in the pharmaceutical field which the Swiss company

commanded. The assessee was on that account a mere licensee for a limited period of the technical knowledge of the Swiss company with the right

to use the patents and trade marks of that company.

After referring to the terms of the agreement, the Supreme Court further pointed out at page 701 :

The following facts which emerge from the agreement clearly show that the secret processes were not sold by the Swiss company to the assessee

: (a) the licence was for a period of five years, liable to be terminated in certain eventualities even before the expiry of the period; (b) the object of

the agreement was to obtain the benefit of the technical assistance for running the business ; (c) the licence was granted to the assessee subject to

rights actually granted or which may be granted after the date of the agreement to other persons; (d) the assessee was expressly prohibited from

divulging confidential information to third parties without the consent of the Swiss company; (e) there was no transfer of the fruits of research once

and for all; the Swiss company which was continuously carrying on research had agreed to make it available to the assessee ; and (f) the stipulated

payment was recurrent dependent upon the sales, and only for the period of the agreement.

The Supreme Court also pointed out at page 700 :

The assessee acquired under the agreement merely the right to draw, for the purpose of carrying on its business as a manufacturer and dealer of

pharmaceutical products, upon the technical knowledge of the Swiss company for a limited period : by making that technical knowledge available

the Swiss company did not part with any asset of its business nor did the assessee acquire any asset or advantage of an enduring nature for the

benefit of its business.

We are of the opinion that the above reasoning of the Supreme Court will clearly apply to the facts of the present case. We have already

referred to the fact that the arrangement itself is termed as ""licence ""and ""agreement"" and that the foreign company is called the "" grantor "" and the

assessee is called the "" licensee "". Even assuming that this nomenclature is not decisive of the character of the arrangement, the other terms to which

we have drawn attention will clearly show that the assessee had not acquired any capital asset nor the foreign company had parted with any capital

asset in favour of the assessee. Mr. Jayaraman, learned standing counsel for the department, repeatedly contended before us that there is nothing in

the agreement prohibiting the assessee from manufacturing identical articles with the know-how which it had already obtained, even after the

termination of the agreement. We are unable to find any support whatever for this contention from the terms of the agreement. We have already

referred to the clause wherein it is provided that even the stock which remained at the hands of the assessee after the expiry of the period of the

licence should have to be sold within a period of one year and the royalties payable in respect thereof should be paid. If that be the case with

regard to the products already manufactured and remaining unsold on the date of the termination of the agreement, it will automatically follow that

the assessee had no right to manufacture fresh articles on the basis of the know-how which it obtained from the foreign company.

The learned counsel also drew our attention to the use of the word '' exercise '' occurring in Clause 3(a) of the agreement, namely, "" The

exclusive right and licence to make, use, exercise and vend the licensed devices and parts thereof within the licensed territory "" and contended that

the word "" exercise "" contemplated a continuous right to use on the part of the licensee, even after the agreement came to an end. We are unable to

agree with this contention, because the word "" exercise "" would appear to be a common word used in such agreements and, as a matter of fact,

identical collocation of words finds a place in the agreement in the case of Commissioner of Income Tax, Bombay Vs. Ciba of India Ltd., ,

considered by the Supreme Court itself.

Having regard to all these circumstances, we are clearly of the opinion that the present case is on all fours with Commissioner of Income Tax,

Bombay Vs. Ciba of India Ltd., , decided by the Supreme Court, referred to already. Consequently, we hold that the entire payments made by the

assessee to the foreign company will be in the nature of licence fee and, therefore, will constitute an item of expenditure in the computation of its

profits and gains. The result is, as far as the first question is concerned, we answer the same in the affirmative and in favour of the assessee.

As far as the second question is concerned, it turns upon the construction of rule 19 of the Income Tax Rules, 1962. Rule 19(1) states that for

the purpose of Section 84, the capital employed in an undertaking or a hotel to ""which the said section applies shall be taken to be--in the case of

assets acquired by purchase and entitled to depreciation--if they have been acquired before the computation period, their written down value on

the commencing date of the said period. Rule 19(6) defines the expression, ""written down value."" in Clause (iv) thereof, as meaning "" written down

value computed under Sub-section (6) of Section 43 as if for the words ''previous year'' the words ''computation period'' were substituted.

Section 43(6) of the Income Tax Act, 1961, defines ""written down value"" as meaning:

(a) in the case of assets acquired in the previous year, the actual cost to the assessee;

(b) in the case of assets acquired before the previous year, the actual cost to the assessee less all depreciation actually allowed to him under this

Act, or under the Indian Income Tax Act, 1922 (XI of 1922), or any Act repealed by that Act, or under any executive orders issued when the

Indian Income Tax Act, 1886 (II of 1886), was in force :

Provided that in determining the written down value in respect of buildings, machinery or plant for the purposes of Clause (ii) of Sub-section (1) of

Section 32, ''depreciation actually allowed'' shall not include depreciation allowed under Sub-clauses (a), (b) and (c) of Clause (vi) of Sub-section

(2) of Section 10 of the Indian Income Tax Act, 1922 (XI of 1922), where such depreciation was not deductible in determining the written down

value for the purposes of the said Clause (vi).

Thus, a combined reading of Rule 19(1) and (6) read with Section 43(6) of the Income Tax Act, 1961, will clearly show that the initial

depreciation shall not be deducted in computing the written down value for the purpose of calculating the capital. However, it would appear that a

curious argument was advanced before the Tribunal on behalf of the department, which is found in paragraph 10 of the order of the Tribunal,

namely, ""The contention of the revenue is that initial depreciation should not be deducted only for purposes of Section 32(1)(ii) and for purposes of

Rule 19, the deduction is permissible"". We are unable to appreciate this argument. As a matter of fact, Rule 19(6) dealing with the written down

value throws one back to Section 43(6) and Section 43(6) will necessarily include the proviso thereto and the proviso expressly states that initial

depreciation will not be included in the expression "" depreciation actually allowed.

Consequently, the Tribunal was right in holding that the initial depreciation should not be deducted for arriving at the written down value for the

computation of the capital for the purposes of Section 84 of the Income Tax Act, 1961. Hence, we answer the second question also in the

affirmative and in favour of the assessee.

The assessee will be entitled to its costs. Counsel''s fee is fixed at Rs. 500 (Rs. Five hundred only).