No Indian pains for capital gains
This article appeared in the Economic Times on 5th December, 1998
X Ltd intends to remit DM 500,000 to ABC A.G., a company incorporated in Germany, for purchase of design and drawings in pursuance of a purchase agreement entered into outside India in 1995 and approved by the Government.
X Ltd. contends that nothing is taxable in the hands of ABC A.G. as the assets purchased (design and drawings) are capital goods. Companies in the past have faced a similar situation. Tax expert Naresh Ajwani examines the implications of the above transaction. Interestingly, the tax impact differs if the design and drawings are for plant and machinery and not for the actual process of production.
Purchase of design and drawings raise some interesting issues. One needs to look at both the Income Tax (I-T) Act, 1961 and the provisions of the Indo-German double tax avoidance agreement (DTAA). The provisions of section 90(2) of the I-T Act permit the Germany company -- ABC A.G. to adopt either the provisions of the Indian tax laws or the DTAA, whichever are more favourable to it.
In the normal course, while dealing with the situation it has also to be examined whether the fees paid for the design and drawings constitute 'Royalty' or would they be taxable under any other heads such as 'Capital Gains', 'Business Income' or 'Other income'.
For the purpose of this case study, the examination is mainly confined to whether such fees would be in the nature of royalty income. As the date of the agreement is also important, let us assume that though the agreement was entered into in 1995, the fees have been paid in the financial year 1997-98.
Domestic tax laws
Under the I-T Act, tax under section 115A is at 20 per cent on the gross amount of royalties and technical service fees earned by the foreign company. This rate is provided the agreement for payment was in pursuance of an agreement entered into after May 31, 1997 and was approved by the Central Government. The foreign company is taxed at a higher rate of 30 per cent if such agreement was made prior to May 31, 1997.
In this case study, ABC A.G. will subject to tax (if the I-T provisions are applied) at the higher rate 30 per cent on its gross fees, as the agreement with the Indian company X Ltd was entered into in 95. Even if the agreement has been entered into outside India, and design and drawings may have been received outside India, the German company cannot escape tax liability owing to the provisions of section 9(1)(vi) of the I-T Act.
Various clauses of section 9 specify the situations wherein income can be 'deemed to accrue or arise in India and thus be taxable in India. Under the provisions of section 9(1)(vi) income by way of royalty is payable by a person who is a resident, except where the royalty is payable in respect of any right, property or information used or services utilised for the purpose of a business or profession carried on by such person outside India or for the purchase of making or earning any income from any source outside India is income deemed to accrue or arise in India.
In other words, if a resident (in this case XYZ Ltd.) makes royalty payment the income in the hands of the recipient will not be subject to Indian taxes only if the royalty payments were towards a business carried out by XYZ Ltd. outside India or earning income from a source outside India.
The constitutional validity in case of a similar provision -- section 9(1)(vii) dealing with taxability of fees for technical services received outside India has been referred by the Supreme Court to a Constitution bench in the case of electronics Corporation v CIT (178 ITR 65). Let us digress a bit and examine what would be the tax implications if such payment were stated as taxable under the head capital gains.
As per section 9(1)(vi), explanation 2, clause (I), 'royalty' means the consideration for transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property. It includes lumpsum payments made but excludes any consideration which in the hands of the recipient would be chargeable as capital gains.
But this does not mean that capital gains do not fall under deeming provisions of section 9. Section 9(1)(i) is well equipped to take into cognisance income arising through the transfer of a capital asset situated in India. In this eventuality, if the capital gains is long term in nature the tax under the provisions of the Income Tax Act will be 20 per cent (assuming that the design and drawings are property situated in India).
Now coming to treaty laws. Under Article 12 of the Indo-German DTAA the tax on royalties is 10 per cent on the gross amount.
This will be payable by ABC A.G. in India. If the income is treated as capital gains then, the DTAA provides for tax only in Germany. Royalty has been broadly defined under Article 12(3). Royalty means payment of any kind for the 'use' or the 'right to use' any design or model, plan, secret formula or process. It, however, does not cover payment for outright purchase of such property.
Outright purchase of property gives rise to capital gain, business income or other income as the case may be. Article 12 (Royalties) primarily covers payments where the property remains with the owner and it is only licenced to the user.
Article 13 deals with Capital Gains. Under Article 13(5) of the DTAA, any capital gains which arise in a source country, and which is not on account of immovable property, business property or shares, will be taxable where the seller is resident.
Thus, capital gain earned by a Germany company on sale of drawings will be taxable in Germany only. This surmise is, of course, on the presumption that the designs and drawings constitute the capital asset of the Germany company.
Let us draw an analogy with the case of CIT v Davy Ashmore India Ltd (190 ITR 626 -- Cal H.C.). In this case, the Indian company had purchased drawings and designs for a plant from a UK company.
The UK resident seller provided complete rights to the design and drawings to the Indian company. The assessing officer sought to tax this income in India as royalty. The question which arose before the Calcutta High Court was whether this was the correct stance.
It was pointed out before the high court that the definition of royalty under the I-T Act was different from those in the provisions of the DTAA. The Calcutta High Court ruled that as there was an outright sale of design and drawings by the foreign company to the Indian company, the amount of consideration received by the foreign company could not be taxed in India as royalty income.
It can be said that if the agreement gives full rights to use, enjoy & exploit the property (such as design and drawings) in any manner as may be deemed fit by the purchaser and there is a complete alienation of the property, then the income arising in the hands of the recipient cannot be treated as royalty under the DTAA.
Complexities arise if full rights are not given to the Indian purchaser. For example, use of the property may be permitted only within India. Some guidance is available under the OECD Model commentary relating to software. Paras 15 and 16 of Article 12 of the OECD Model admits that difficulties would arise in cases of extensive but partial alienation of rights.
While each case will depend upon its particular facts, in general such payments are likely to be Commercial Income (covered by Article 7 or Article 14) or Capital Gains (covered by Article 13), rather than Royalties (covered by Article 12). Thus, if the payment is in substance for alienation of substantial rights, it should not be treated as royalty. Otherwise, the entire amount will be taxable as royalties.
If the payment for procuring designs and drawings relates to the production process, does it change the tax implications? If the designs are not resaleable by the user, the payments will be royalty in the hands of the recipient. A reference needs to be made to the provisions of the Indo-US DTAA. Here it may be appropriate to bring out the meaning of royalties as per the Indo-US DTAA.
As per article 12(3) of the Indo-US DTAA, royalty includes gains from alienation of intellectual property, apart from consideration for use or right to use. Hence, as per this DTAA, payments made for drawings and designs even if they result in alienation of property will be treated as royalty income. This is not the case under the Indo-German DTAA or under the I-T Act.
If it is not a sale of property, then the payment will be considered royalty. The tax will be on the gross amount at ten per cent (under the more favourable treaty provisions). If it can be treated as capital gains then such income will not be taxable in India but only in Germany.