JUNE 03, 2019

By Subhashree R

DISPUTE in Income Tax on whether an expenditure is of capital or revenue nature is as old as the income tax law itself. Even today, the opinion would be divided on many items of expenditure with equally convincing arguments on both sides of the divide. Permutations and combinations of different set of facts and legal principles give rise to new insights on this issue every time. Royalties, license fee and other lumpsum payments made under a technical collaboration agreement has been one such expenditure, which has been subject matter of examination by courts time and again.

Recently, the issue again came up for consideration in the case of Honda Cars India before the High Court of Delhi, wherein the High Court Commissioner of Income Tax-LTU v. Honda Cars Ltd, - 2019-TII-39-HC-DEL-INTL held that the lumpsum payments made under the technical collaboration agreement with Honda Japan were in the nature of revenue expenditure. The interesting aspect about this case is that, for the same company, in respect of one of the earlier assessment years Honda Siel Cars India v. CIT - 2017-TII-20-SC-INTL, the Supreme Court had held a similar lumpsum payment to be capital expenditure. Let us analyze what factors led to the High Court distinguish the earlier ratio laid down by the Apex Court.

Decision of the Supreme Court

The initial agreement was entered into in 1995 for technical collaboration (TCA) along with three Memorandum of Understanding (MoU) for exchange of technicians, supply of parts and supply of manufacturing facilities. The lumpsum paid after commencement of commercial production was in question before the Supreme Court. The assessee claimed that as per the terms of agreement what is received is a limited right to use the technical information and since there was no transfer of any asset nor any advantage received by it which continued after the termination or expiry of the agreement, the expenditure was revenue in nature.

However, the Supreme Court held that the payment was capital in nature based on the following reasoning:

1) The TCA was crucial to the commencement of entire business of the assessee and the business was co-extensive with the agreement. Thus, the payments pertained to the setting up of the business and gave the assessee an enduring advantage

2) The agreement was capable of being renewed and hence, the business of the assessee would continue to depend on the foreign entity for manufacture.

3) The payment was not for effective improvements in an existing business but resulted in establishment of a new business, new plant etc.,

Decision of the High Court

On the other hand, the Delhi High was concerned with a subsequent TCA entered into in 2005 after the expiry of the initial TCA. The Delhi High Court held that the payment would be revenue in nature taking into account the following:

1) The royalty paid for AY 2010-11 was in terms of a new agreement entered into on 1-4-2005 which was well after the assessee had commenced operations and hence, the payment was not towards setting up of a new manufacturing facility.

2) There is distinction between payments made during the formative years and after commencement of operations.

Time and purpose of expenditure is important

It would thus appear that the time at which the expenditure is incurred is important. Though in Shriram Refrigeration - 1981 127 ITR 746 Delhi it was observed that the purpose for which the expense is incurred namely for day to day running of the business would be determinative of the nature of expenditure irrespective of whether it is incurred at start of the business or later, the fact that the expenditure was incurred in the initial years carried a lot of weight in the decision of the Apex Court in the case of the Honda. It quoted the judgement of Alembic Chemical Works v. CIT - 2002-TIOL-160-SC-IT and noted that the royalty payments in that case were held to be revenue in nature since the assessee was already engaged in production of penicillin and the royalty in question was for improvising existing process in business.

Lingering questions

The landmark judgments for instance Ciba - 2002-TIOL-1537-SC-IT-LB apply the test of whether there is transfer of asset or whether the licensee gets any right to use the IP after the expiration of the agreement. The Apex court in the case of Honda was however guided by the decision in Alembic Chemical Works Co. Ltd (supra), wherein the Apex Court had held that since the expenditure in question was not for a completely new plant and there was only upgradation of the existing asset, it was revenue in nature. Thus, the fact that the tangible assets (plant and machinery) were new and the technical assistance pertained to setting up of a new structure, tilted the determination in favour of capital expenditure. The Apex Court does state that out of many tests, the one most appropriate in the facts and circumstances of the case should be applied.

The TCA in Honda case can be said to be a typical agreement with a principal, who would be licensing the IP and would also provide technical assistance and/or advise to ensure that the IP is being used/implemented properly. From the facts of the case, it appears that the assistance and advise/license of IP continued beyond the term of the initial TCA. Of course, instead of the renewal as contemplated, a fresh agreement was entered into. Thus, while the nature of service-information provided, assistance by foreign technicians may be the same, the fact that the assessee had already commenced production long ago seems to make a big difference. The fact that the assessee required such assistance even after commencement indicates that the assessee has not received any enduring benefit from the initial years and continues to be dependent on the licensor. In such a scenario, can it be said that the assessee received enduring benefit in the capital field on account of the initial lumpsum payments? Would the decision in respect of the payments under the new agreement change if instead of the 10th or 11th years, a fresh agreement was made in the 5th or 6th year? Perhaps one take away from these cases is that a payment may be treated as capital or revenue based on the time at which it is incurred in the life of the venture. That adds one more dimension to this never-ending battle between capital and revenue.

[The author is an Advocate, Direct Tax, Lakshmikumaran & Sridharan, New Delhi and the views expressed are strictly personal]