M.R. Electronic Components Ltd. vs Commissioner of Income Tax, Madras

Sethuraman, J.—This is a reference under s. 256(1) of the I.T. Act, 1961, referring the following questio :

Whether, on the facts and circumstances of the case, the Tribunal was right in holding that a portion of the royalty paid to the foreign company

under the technical aid agreement was capital in nature ?

The assessee was incorporated on December 31, 1962, as a private limited company. It became a public company under s. 43A(2) of the

Companies Act of 1956. It carried on the business in manufacture and sale of Morganite Volume Controls. It wanted to manufacture carbon

tracks and switch parts and assembling switches in India. M/s. Morganite Register Ltd., is a company incorporated under the English Companies

Act in the U.K. It will be referred to as the foreign company hereafter. the foreign company was a manufacture and distributor of carbon tracks,

potentiometers and other products, which have a world-wide reputation for their quality and durability. The assessee-company was originally

formed with the intention of manufacturing and marketing in India the products of the foreign company and its associates and also of such additional

products as may be mutually agreed upon between the foreign company and the assessee-company. The assessee was desirous of being given the

right to ask the foreign company for guidance as to its development as well as technical knowledge which the foreign company had in procuring

and marketing the products. The assessee-company also requested the foreign company to render technical advice and assistance for the

furtherance of its objects which the foreign company agreed to do, render of procure upon the terms and conditions, An agreement was entered

into on September 6, 1963, between the assessee-company and the foreign company. In the agreement if was stated that the foreign company was

formed with a nominal equity capital of Rs. 10,00,000 out of which 5,000 shares of Rs. 100 each had already been issued to and fully subscribed

by Indian shareholders. The shareholders in the Indian company being desirous that the foreign company should enable the Indian company to

manufacture full the products in India and to sell them under the terms of the technical agreement wanted the machinery described in the first

schedule to the said agreement to be supplied by the foreign company. The foreign company agreed to render technical aid and to supply the plant

and machinery on the basis that equity shares in the Indian company of a value of Rs. 3,00,000 would be allotted and issued to it. The Indian

sharesholders, who subscribed to this agreement, agreed to take up 2,000 shares of Rs. 100 each in the Indian company. The Govt. of India by its

letter, dated December 29, 1962, approved the arrangement of the foreign company holding shares in the Indian company for a nominal value not

exceeding Rs. 3,00,000 and also to the payment of royalty as provided for in the agreement of technical aid, the terms of which were contained in

a draft marked as annex. A to the main agreement. The foreign company was to sell to the Indian company the requisite machinery, and if its value

was less than Rs. 3,00,000, then to the extent of the differece between Rs. 3,00,000 and the value of the machinery, shares had to be issued in

favour of the foreign company for cash consideration. The techincal aid agreement was to be entered into as soon as the Indian company was in a

position to do so. the agreement was not assignable. There were also suggestions in its for amending the memorandum and articles of association.

The main features of the technical aid agreement, which is found as annex. A to the main agreement, may not be referred to. It adverts to the

foreign company having been requested to tender technical advice and assistance, and supply formula and information within its possession for the

furtherance of the Indian company''s objects. The foreign company was appointed as consultant and technical adviser for a period of ten years

from the date of commencement of production of the goods contemplated by the assessee. The period of ten years was liable to be extended at

the option of the foreign company for a further period of ten years. So long as the Indian company performed its obligation under the agreement,

the foreign company agreed to provided to and procure for the Indian company such technical assistance and advice, and offer such formula, and

information as could be made available by the foreign company to enable that Indian company to manufacture the products in India. Clause 4(a)

contemplated the foreign company affording training at its words in England to men selected by the Indian company from time to time. The

employees under training were to be paid by the Indian company. the foreign company was also to send its staff to india to assist the Indian

company on the construction and equipment of its works and on processes and manufactures. The amount payable to the said staff sent on

deputation was to be determined by the foreign company, and paid for by the Indian company. In any case, where the foreign company

considered that the Indian company could manufacture and sell economically in India any products additional to the products described in the first

schedule to the agreement, the foreign company would give to the Indian company an opportunity to manufacture such additional product : See

clause 5(a). Sub-cluase (b) of clause 5 laid down the procedure to be adopted in making an offer to the Indian company for manufacture

additional items. The foreign company under clause 6 agreed as consultant and technical adviser to disclose to the Indian company from time to

time all technical information within its competence relating to the manufacture of the products in India and to give to the Indian company the full

benefit of its knowledge, and the marketing and distribution thereof. the foreign company had also agreed to grant necessary licences to be used in

India in connection with the manufacturing rights. The licences to manufacture would cease upon the termination of the present agreement. The

Indian company was permitted to use all the trade marks, brand names, trade names and by, and products, of the Indian company. The period

during which the trade marks, etc., were available was also co-terminous with the main agreement. The foreign company could not without the

consent of the Indian company be engaged in the importation into or sale in India of any products manufactured buy the Indian company under the

terms of the agreement. Wherever the demand for the products was in excess of the manufacturing capacity of the Indian company the products

were to be imported from the foreign company and sold in sufficient quantities so as to meet and satisfy the demands of the Indian market in full.

The Indian company agreed to purchase its requirement of material components or half-finished products from the foreign company. The

agreement contemplated also the Indian company exporting the good manufactured at economical and competative prices, but the righht to export

was not exclusive. Clause 9 provides for the consideration payable under the agreement, and runs as follow :

(a) In consideration of rights granted by Morganite (foreign company) to the company (Indian company) under this agreement the company

shall pay to Morganite in respect of each year or other financial period of the company a fee by way of royalty of 5 per cent (which will be subject

to deduction of Indian Taxes) on the annual net sales of the products by the company in such year or other financial period.

The net sales were taken to be the total of the invoices rendered by the Indian company to third parties for the products supplied, excluding

freight and insurance charges and the value of all components imported by the Indian company. the Indian company was to keep at its usual place

of business books of account, which would be open for inspection by the foreign company in order to enable it to verify for itself the amount

payable to its. The payment were to be made in steriling in the U.K. on the expiration of one month from the date on which the accounts were

certified by the Indian company''s auditors. Interest was payable in case of default of payment within the period of one month. Clause 10(a)

provided that in consideration of the technical information imparted and the secrets disclosed by the foreign company to the Indian company the

exclusive rights conferred on the Indian company to manufacture products by processes discovered and/or perfected by the foreign company, the

Indian company agreed to use its best endeavours to preserve and increase the goodwill and business connection in respect of all such products in

India. The Indian company agreed to confine its activities only to the manufacture and sale of the products contemplated by the agreement. Only

with the written consent of the foreign company, any other product could be manufacture or dealt with by it. The Indian company was to keep the

information passed on to it in strict confidence, and all plans, drawings, specification and descriptions furnished by the foreign company to the

Indian company were to be the property of the foreign company and on the termination of the agreement by any means or for any cause

whatsoever were to be delivered to the foreign company. Any information relating to the improvement discovered in the course of the manufacture

by the Indian company had to be passed on to the foreign company, and the foreign company was to be entitled to the sloe and exclusive benefit

thereof.

Production of the articles contemplated by the agreement commenced from December 1, 1966. We are now concerned with the assessment

year 1968-69 to 1972-73. The relevant previous year ended on June 30, 1967, to June 30, 1971. The Indian company in its assessment claimed

deduction of the amount paid to the foreign company in according with the terms of the agreement described above. The amount so claimed came

to Rs. 66,181, Rs. 1,52,880, Rs. 1,65,000, Rs. 2,00,720 and Rs. 3,37,676 for the respective years. The ITO took the view that the deduction

claimed by the assessee pertained not only to the use of trade marks, designs, licences of the foreign company, but also for the supply of technical

know-how which gave the assessee an advantage of enduring nature. He, therfore, disallowed 50% of the royalty as capital expenditure.

The assessee appealed against the assessments. The appeals for 1968-69 to 1970-71 came up for consideration before one AAC and the

appeals for the other two years before his successor. The AAC who disposed of the appeals relating to the first set of the years held that the

royalty was paid for the use of the technical knowledge which was closely linked up with the manufacturing activities and that, since the payment

was made only to acquire technical information enabling the Indian company to carry on its business and earn profits, the entire payment of royalty

was to be allowed as revenue expenditure. The AAC who disposed of the appeals for 1971-72 and 1972-73, took a different view. In his

opinion, there was justification for treating a part of the royalty paid, for the technical knowhow and other services rendered by the foreign

company, as capital expenditure. He considered that 25% of the royalty should be disallowed as capital expenditure and modified the assessment

accordingly. The result was that there were two sets of appeals before the Tribunal. for the first three years, appeals were filed by the ITO and for

the second two years they were filed by the assessee. The Tribunal which dealt with all the appeals together in its order dated April 19, 1974, held

that a portion of the royalty paid represented capital expenditure and that the AAC, who dealt with the last two years, had correctly and

reasonably apportioned the capital element in the expenditure at 25%. The result was that the AAC''s order for the assessment years 1971-72 and

1972-73 was affirmed and the order of his predecessor for the earlier years was modified. The assessee has brought the matter on reference

contesting the disallowance of 25% as capital expenditure.

In the submission of the assessee the entire expenditure was allowable as revenue expenditure as the assessee had actually paid for the

machinery either in the shape of shares or otherwise. He (the assessee''s counsel) pointed out that initially the Indian company agreed to pay a lump

sum of 10,000 and that as the Govt. Of India did not approve of this arrangement, the foreign company agreed to forgo this payment subject to the

Indian company paying a 5% royalty on the sale of the manufactured products. It was also stated that actually there was no service rendered in the

erection of the machinery by it as two of the Indian engineers, who were working in the foreign company''s establishment in the U.K. were deputed

to the Indian company and were taken over by it as its employees. His point was that the payments was wholly referable to the technical services

rendered by the foreign company.

For the department the submission was that this is a case where the assessee had started the manufacture of a new product with the assistance

of the technical aid agreement, that the manufacture was being done for the first time and that the payment made for techincal assistance would in

such a case involve and initial outlay, which would be capital expenditure. It was also contended that the Indian company had the benefit of the

agreement for a reasonably long period, viz., 10 years in the first instance with an option of renewal for a further period of ten years and that,

therefore, there was what can be called ""enduring benefit"". Several decisions were referred to in this context by both sides.

In Jonas Woodhead and Sons (India) Ltd., Madras Vs. Commissioner of Income Tax, Madras, , the assessee entered into an agreement with

an English company for the manufacture in India of all types of springs and suspensions for road and rail vehicles manufactured by the English

company. The technical information and know-how in the possession of the English company was to be passed on to the Indian company-

assessee. There also the information relating to the setting up of the plants for the manufactures of the products including drawings, specifications,

etc., were to be communicated to the Indian company-assessee. The agreement provided for payment of royalty dependent on the turnover of the

manufactured products. The ITO treated 1/4 payment of royalty as consideration for services provided by the English company of an enduring

nature. He, therefore, disallowed the relevant amount as capital expenditure and his order was confirmed by the AAC and by the Tribunal. In

dealing with the reference against the order of the Tribunal it was observed at p. 60 as follow :

.... ultimately the question has to be decided on the basis of the terms of the particular agreement and the only general principle that can be derived

from the decisions is that under the terms of an agreement, if the assessee acquired a benefit of enduring nature that will constitute ''acquisition of an

assest'' and, on the other hand, if the assessee had acquired merely technical knowledge for the manufacture of any particular item for a specified

duration, then he had acquired only a licence to use the other party''s patent and knowledge and the amount would constitute ''revenue

expenditure.

The rationale behind the above view is obvious. No two agreements of this kid contain identical terms.

Thus, the matter had to be decided only on the terms of the agreement under consideration. In order to illustrate the way in which the matter

has been considered in the decided cases, we may briefly refer to some of the recent decisions. In CIT v. Lucas-TVS Ltd. (No. 1) [1977] 10 ITR

338) the assessee was granted the exclusive right and licence to make use, exercise and vend various items of electrical equipment for vehicles and

engines and services tools. The Appellate Tribunal held that the entire technical fees paid by the assessee was liable to be allowed as deduction.

When the matter came before this court on reference, the conclusion of the Tribunal was affirmed on the ground that in that particular case even the

stock which remined in the hands of the assessee after the expiry of the period of the licence had to be sold within a period of one year and the

royalties payable therefore, were to be paid. It was considered that there was no scope for any manufacture of fresh articles on the basis of the

know-how obtained from the foreign company.

In Commissioner of Income Tax Vs. I.A.E.C. (Pumps) Ltd., , the agreement provided for the use of the patents and designs of the foreign

collaborator for a period or ten years with an option to renew the same with the approval of the Govt. of India. The ITO held that 15% of the

annual payment was alone allowable as revenue expenditure. the AAC increased this allowable expenditure to 50%. The Tribunal allowed the

entire amount paid. It was found on reference that what was granted by the foreign company was only a licence and what was paid to the foreign

collaborator was only a licence fee and not any price for the acquisition of any capital asset. It was, therefore, held by this court that the entire

payment was allowable as a revenue expenditure.

In Additional Commissioner of Income Tax and Another Vs. Southern Structurals Ltd., , the foreign company agreed to participate in the

equity capital of the Indian company. One of the terms of the agreement provided that after the expiration of the agreement the assessee would be

free from any further obligation to pay any amount to the foreign company, while the assessee-company would have the continued use, free of

change, of all information made available by the foreign company during the period of the agreement. It was held that such a payment was capital

expenditure, as there was an enduring benefit obtained in consideration of the expenditure claimed.

The cases discussed above exemplify the two terminals between which such cases fall. The case of Additional Commissioner of Income Tax

and Another Vs. Southern Structurals Ltd., illustrates those categories where there is an enduring benefit. The two other cases show that the

agreement made available licence of technical know-how, trade marks and patent rights. While the expenditure is clearly capital where there is an

enduring benefits, it would revenue if it is for the use of the know-how limited to a period. The cases that fall in between the terminals would

require examination on facts, as there is a likelihood of the expenditure being capital in part and revenue in part. The determination of the exact

percentage of the capital and the revenue element in the payment has to a large extent to be left to the fact-finding authority.

It is thus necessary to analyse the terms of the agreement in the present case to find out how far the terms bear on the revenue or capital

character of the expenditure. From the technical aid agreement it is clear that the foreign company had undertaken to advise the Indian company on

the construction and equipment of its works and also on processes and manufactures. The foreign company agreed also to enable the Indian

company to produce additional products in any case where the foreign company considered that the Indian company could manufacture in and sell

economically such products. Thus, there were terms in the agreement which provided for technical assistance in the matter of the designing and

construction of the factory and for fresh items of manufacture. The consideration provided in clause 9(a) was in respect of the rights granted by the

foreign company to the Indian company. Even assuming that actual assistance in the matter of construction has not been availed of by the Indian

company for some reason or other-there is no clear finding on this aspect-still in so far as clause 9(a) provided for payment for services including

those in the matter of the construction of factory, the amount has to be described as capital expenditure. In such cases, we have to find out the

object of the expenditure. If the object of the expediture was with reference to the erection of the factory, then to that extent the revenue would be

entitled to disallow that portion of the expenditure as of the consideration is attributable to the manufacture of fresh items, as no other consideration

has been provided for the manufacture of fresh items excepting those under clause 9(a), there would be an element of acquisition of a right

exploitable in further. Pro tanto, it does not relate to the running business. It is in this sense that we have to hold that part of the expenditure was

clearly capital in nature. In para 11, the Tribunal observed as follow :

(5) Since some of the rights conferred under the agreement related to setting up of the profit earing apparatus, structure and framework of the

business of the assessee resulting in an enduring benefit and advantage to the business and since some of the rights under the agreement relate to

routine business operation carried on by the assessee for earing profit and since a composite fee is paid by way of royalty for all the services

rendered by Morganite, there is every justification to disallow portion of the royalty paid as relating to capital expenditure.

(6) Since an asset and an advantage of enduring benefit of the assessee''s business is thus acquired and brought into existence as a result of the

technical aid agreement, it is immaterial that the payment was made once for all or was made periodically.

These are the considerations which are relevant to the point in question and cannot be considered as alien to the solution of the problem of the

expenditure being partly capital in nature. On the facts herein, we are satisfied that the Tribunal was justified in principle in making an allocation of

the royalty paid between capital and revenue. The question is, accordingly, answered in the affirmative and in favour of the revenue. The revenue

will be entitled to its costs. Counsel''s fee Rs. 500.