Intellectual Property Rights
(Direct and Indirect Taxation)

Editorial Note : Best Research Paper of 3rd Nani A. Palkhivala Research Paper Competition for the year 2007.

“... As we enjoy great advantages from the inventions of others, we should be glad of an opportunity to serve others by any invention of ours; and this we should do freely and generously.”

— Benjamin Franklin

I. Introduction — Taxation of intangible assets

Society is currently moving through a transition, from a community whose wealth is based on tangible assets, to a community whose true wealth lies in intangible forms of property. We are moving towards a period where knowledge and ideas are more valuable than physical property. With widespread internet access, the creation of Intellectual Property (hereinafter referred to as ‘IP’) is no longer the bastion of large corporations. Any person can develop value through a copyright, a patentable invention or a trademark. As IP continues to grow as a wealth creation tool, individuals and corporations will be faced with the challenge of determining the value of the property, and the effect that such property will have on taxes1. IP is changing the way companies are looking at assets and tax planning. The impact of Intellectual Property Rights (hereinafter referred to as ‘IPR’) in developing economies, where more often than not, native Intellectual Property remains untapped, is enormous. While IP is all about innovation and human creativity, its objective is to create incentives that maximise the difference between the value of the IP that is created and used and the social cost of its creation, including the cost of administering the system2.

With the coming of age of the knowledge economy, some of the existing management ideologies are undergoing an unprecedented change. IPRs have become extremely important due to the changing trade environment which is characterised by global competition, short product cycle, high investments in Research & Development (hereinafter referred to as ‘R & D’), etc. Since the early days of trade and economic activity, companies have invested a lion’s share of their resources in R & D. These investments have allowed them to create new products, to differentiate themselves, and to become leaders in their sectors. The success of such expenditures is due, in large part, to the protection of each company’s IPRs. In today’s economy, the trend is towards increasing investment in intangible assets3.

IP such as patents, copyrights and trade secrets are classified as intangible property4. It is considered intangible because it is totally divorceable from the tangible property in which the intellectual element is embodied. This would imply that IP is ‘an intangible asset acquired or created by companies for use on a continuous basis, in the course of the company’s activities”5. This is exemplified by the fact that more than 62% of the value of companies worldwide lies in intangible assets6. It is no surprise, that Indian companies are estimated to have the highest percentage of intangible assets7. The intangible character of such property leaves them open to relocation, reconstruction, reformulation and general manipulation by tax payers in order to achieve double tax outcomes8. Geographical barriers are soon disappearing and unlike other kinds of property, IPRs can be simultaneously held in many countries at the same time. A great web of bilateral tax treaties governs methods of taxation, allocation of income and profits, etc. It would be very surprising if IP is allowed to escape this tax net. Right from tax credits for R & D, through allowances for IP assets the entire cycle of IP creation and use is affected by the taxation system9.

With increasing globalisation, companies are likely to face international taxation issues right from their infancy. Intellectual property law and taxation has been the subject of considerable development over the past years. If there was one component of the legal fabric of IP commercialisation that kept all the stitches together, it would be taxation10. Taxation was once defined as the art of plucking the goose with the least amount of hissing11. Any attempt to provide a review of tax issues on a subject as broad as IP, runs the risk of becoming either a long recitation of detail or something so general that it is of no actual application12. The ability to realise and leverage the value of IP is high on the agenda of an increasingly large number of forward-looking companies. It is thus imperative for companies to think beyond the creation and protection of IP and focus on how and where to create IP in order to minimise tax liability.

II. Controversial issues with reference to case laws

1. Direct Taxation

Intellectual Property Rights under Income Tax

The Income-tax Act, 1961, as the name indicates is a statute taxing income and not capital, on the analogy that fruits of a tree can be plucked but the tree should not be disturbed13. Assets are subject to depreciation for the purpose of computation of income and intangible assets like IP would be no different. There are numerous contentious issues pertaining to IPRs and Income Tax, which inter alia include the tax treatment of goodwill, the difference between capital expenditure and revenue expenditure, transfer of IPRs and its impact on capital gains, the treatment of expenditure incurred on intangible assets, double taxation, royalties, software transactions, etc. These are some the issues which have been examined in detail in the following paragraphs.

• Treatment of Goodwill for the purpose of Income Tax

In R.C. Cooper vs. Union of India14 it was observed that ‘goodwill’ is that component of the total value of the undertaking which is attributable to the ability of the concern to earn profits over a course of years or in excess of normal amounts because of its reputation, location and other features. In CIT vs. Srinivasa Setty15 it was held that where ‘goodwill’ has been built up by the carrying on of a business or profession, its transfer would not attract tax under the head ‘capital gains’ since the coming into existence or the growth of goodwill has not cost anything in terms of money. The issue pertaining to the bifurcation of goodwill from IP at the time of assessment of tax liabilities is a contentious one. The value of goodwill is the difference between the value of the assets and the actual consideration paid. Income from technical fees or royalty cannot be directly attributable to ‘goodwill’ as unlike IP it cannot be licensed out.

Valuation of intangible assets, although not a new concept, is quite recent with respect to its application in India. IP can be clearly distinguished from goodwill. In the United Kingdom and Australia, the Generally Accepted Accounting Principles (hereinafter referred to as ‘GAAP’) provides for goodwill as an ‘umbrella concept’ consisting of unidentifiable intangible assets which does not include IP, is capable of individual identification and which can be sold separately16. It has become axiomatic that self-generated goodwill will have no cost of acquisition17. The law was subsequently amended and Section 55 of the Income-tax Act specifically provided for goodwill as a capital asset, the sale of which would attract capital gains tax. Accountants have been debating whether ‘goodwill’ is an intangible asset and if depreciation can be claimed on the same. Battle lines could thus be drawn on the question of depreciation of goodwill. Separate valuation of goodwill, as a balance-sheet item, will help corporates deal with problems arising in the case of mergers and demergers18.

• Capital Expenditure vs. Revenue Expenditure

The difference between Capital and Revenue expenditure has been enunciated in Section 37 of the Income tax Act, 1961 (hereinafter referred to as ‘IT Act’). There are numerous tests for determining whether a particular item of expenditure constitutes revenue or capital expenditure. But the tests must be applied in proper regard to the facts of each case, because no one test or principle or criterion is paramount or irrefutable or of universal application. Expenses incurred on the creation of IP could be written off as capital expenditure/revenue expenditure. There is a thin demarcating line between capital expenditure and revenue expenditure. The Hon’ble Supreme Court19 has observed that ‘in the light of fast changing technology, an asset for which a lump sum payment has been made, which had all along been considered as capital expenditure, can no longer be treated as an asset of enduring benefit and therefore in such circumstances even the lump sum payment can be treated as a revenue expenditure’.

In L. H. Sugar Factory and Oil Mills (P.) Ltd. vs. CIT20, the Hon’ble Supreme Court observed as follows:

“…the celebrated test laid down by Lord Cave L.C. in British Insulated and Helsby Cables Ltd. vs. Atherton [1925] 10 TC 155 (HL) at page 192, where the learned Lord stated that:

When an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, . . . there is very good reason for treating such an expenditure as properly attributable not to revenue but to capital”. The threshold question for determining the tax treatment of expenditure on the development of IP is whether it is on income/revenue or on capital account. Expenditure incurred on the creation of IPRs, or for the enjoyment of existing IPRs may be deductible under section 37 of the IT Act. While expenditure of capital or of a capital nature is not deductible, capital allowance deductions may instead be available for certain types of expenditure on IP. In CIT vs. IAEC (Pumps) Ltd.21, it was held that the amount paid by the assessee to a foreign company for granting a licence to use its patents exclusively in India for a period of 10 years with the intention of renewing it further, would be revenue in nature. In CIT vs. British India Corpn. Ltd.22 where a lump sum payment had been made to a distributor chosen by the foreign collaborator as a condition of an agreement which entitled the assessee to benefit from the trademark and the specialized process of the collaborator, it was held to be revenue expenditure. Similarly, in Alembic Chemical Works Co. Ltd. vs. CIT23 where a lump sum consideration was paid for technical know-how in order to achieve higher levels of production by the use of better technology was held to be on revenue account. In view of the above cases it is now settled that:

1. In the present day conditions of rapid scientific development, technical know-how which changes rapidly, cannot be treated as a capital asset;

2. Even where technical know-how is a capital asset, the amounts paid for its use or for the use of trademark, or the right to manufacture and sell certain goods, are allowable as revenue expenditure24.

• Research & Development

The Research & Development (hereinafter referred to as ‘R & D’) tax concession regime provides for a more favourable income tax treatment for R & D expenditure. A taxpayer has several methods to choose from when deciding how to treat R & D expenditure for tax purposes. As per Section 35(1) of the Act, a deduction of 100%, not being expenditure in the nature of cost of any land and building is available with respect to scientific research. The term ‘Scientific Research’25 has been defined in Section 43(4)(i) of the IT Act.

Section 35(1)(i) grants deductions for revenue expenditure as laid out by the Assessee himself on scientific research related to the business26. Expenditure deductible under Section 35(1)(i) should be incurred on scientific research carried on either by the Assessee himself or on his behalf27.

Section 80GGA grants a deduction in respect of donations made to a scientific research association, etc. approved under Section 35, where the donor does not have income chargeable under the head of business income. Section 35(2AB) grants a deduction pertaining to expenditure on scientific research incurred by a company engaged in the business of biotechnology or in the business of manufacture or production of any drugs, etc.

Capital Expenditure on acquisition of Patents or Copyrights

Section 35A of the IT Act provides for expenditure incurred on the acquisition of patents or copyrights. Payment made for the right to use patents28 or copyrights is allowable under Section 37 as Revenue Expenditure. This Section deals with Capital expenditure, i.e. the price paid for the purchase of copyrights29 or patent rights30.

• Capital Gains Tax & IP

Sections 45 to 55A of the IT Act deal with capital gains31. The capital gains tax will generally apply where the transfer of IP is on capital account. Where the IP was initially developed or acquired by the transferor and expenditure was on capital account, that expenditure will form the cost base of the IP. If, however the expenditure was originally deductible on revenue account and the transferor subsequently holds the asset on capital account, the full amount of the capital proceeds received by the transferor will be a taxable capital gain, as the asset will have a nil cost base. Capital gains does not refer to an income which accrues from day to day over a period but which arises at a fixed point of time, namely, on the date of transfer. Therefore, in respect of capital gains, the taxable event occurs as on the date of the transfer of the capital asset32. With respect to the transfer of IPRs, where the transfer involves the payment of the entire consideration amount in one go, the transfer would inevitably result in capital gains33, which is assessable and the purchaser is entitled to claim depreciation at the prescribed rates. Similarly, when a person transfers IP to another person, he loses the right over the IP. Only when the person loses the right over the IP would it be considered as a transfer of asset and would be treated as capital gains. In India, long-term capital gains would come into the picture only when the asset is transferred after 3 years. Long-term capital gains are taxed at the rate 20% while short-term capital gains are taxed at the rate of 30%.

• Double Taxation

The Central Government, under Section 90 of the Income tax Act, has entered into Double Taxation Avoidance Agreements (DTAA), which are essentially bilateral agreements, with several countries. These DTAAs serve the purpose of providing protection to tax payers against double taxation and thus preventing any discouragement which the double taxation may otherwise promote in the free flow of international trade, investment and transfer of technology. The income of only those non-resident assessees who have a Permanent Establishment (hereinafter referred to as P.E.)34 in India is taxable. Whereas a tax payer’s own country (referred to as home country) has a sovereign right to tax him, the source of income may be in some other country (referred to as host country), which country also claims a right to tax the income arising in that country. The result is that income earned by a resident out of India is subject to tax in India, as it is part of the total world income and also in the host country which provides the source for that income. In Modiluft Ltd. vs. D.C.I.T. the Tribunal opined that in Article 12(2) of the DTAA between India and U.S.A., the Indian revenue had not given a clear direction in regard to assessment schemes in relation to the income assessed outside India, could also be assessed in India.

• Taxation of Royalties

A royalty is usually received by giving a right to another person to use a property belonging to the owner. For example, royalty has been stated to be compensation paid under a licence granted by the owner of a patent or a copyright to another person who wishes to use the same, the right which the owner has is an intangible commodity though the same is in respect of a material object, namely, a patent or a drawing. Similarly, commission is usually paid for services rendered by one person to another. A fee would also be receipt of money for services rendered. The services which are to be rendered, in such a case, are in discharge of their professional functions and duties. Any other payment which is received should also be of a similar nature such that a claim under Section 80 of the Income tax Act, 1961 can be made. Royalties fall under the ambit of ‘assessable income’ for the purpose of Income Tax. Royalties in every case are taxable as ‘income from other sources’.

With the taxing authorities becoming increasingly aggressive in the auditing process, the spotlight now seems to be on the holder of the IP. Due to the slow recovery from the economic downturn and the shrinkage of state tax revenues in the last couple of years, states have eventually turned their gaze on inter-corporate transactions. Many states in India have unearthed income earned by companies by way of royalty generated by licensing IP. Broadly speaking, the income that is contemplated under Section 80-O has to be either for professional services rendered or a receipt for permission to use IP owned by the assessee. This is evident from the fact that the section itself states that the income which is received is to be in consideration, for use outside India, of any patent, invention, model, scientific knowledge, experience or skill. All this would fall under the category of, what is more commonly known as, “know-how”35.

Section 44D of the Act36 provides for a special method for computing income by way of royalty or fees for technical services in the case of foreign companies. While a limited deduction on account of expenses incurred to earn the royalty or technical fees is permitted in respect of agreements before 1st April, 1976 no deduction at all is to be allowed on account of such expenses in the case of agreements made on or after that date but before 1st April, 2003. The Section marks a departure from the general rule that the tax under this Act is on income and not on gross receipts.

Section 115A of the Act also deals with tax on dividends, royalty and technical service fees received by foreign companies. The consideration for the grant of a licence to reproduce or modify a computer programme, where the absence of such a licence would infringe the copyright of the software, could be construed to be ‘royalty’ for the purpose of Section 9(vi) of the IT Act. In the context of the Indo-US Tax Treaty, the Authority for Advance Rulings (AAR) in the case of Pro-Quip Incorporation vs. CIT37 held that the outright sale of drawings/ designs is different from an arrangement for use or the right to use such designs and payments in the former scenario do not constitute royalties. In Hindalco Industries vs ITO38, the Hon’ble Mumbai Tribunal held that the payments made to specialised credit rating agencies (for credit rating) cannot be treated as payments for the supply of scientific, technical, industrial or commercial information since the payment is for ‘professional services’ and hence such payments are not taxable as ‘royalties’ under the Indo-Australian Tax Treaty. Any lump sum consideration paid which is in the nature of income chargeable under the head ‘Capital gains’, is excluded from the meaning of royalty. Only payments made for ‘Information’ which is otherwise not available in the public domain could be construed to be ‘royalty’39. In CIT vs. H.E.G. Ltd.40 it was held that payment for every form of commercial information is not royalty. Some sort of expertise or skill is required in framing the information to classify the payment as royalty. Initial supply of technical know-how in the state of formation or even where the technical know-how is for manufacture of a product, rendered from abroad, can well be taken as a sale of a capital asset supplied from abroad41.

• Cross-border Software Transactions

The tax treatment of cross-border software transactions has always been under the scanner, particularly whether payments for software should be characterised as ‘royalty’ or ‘business income’. If it is characterised as ‘royalty’, tax needs to be withheld at the applicable withholding tax rate whereas if it is characterised as ‘business income’, the levy of tax would depend on whether the foreign entity has a P.E. in India or not. The Bangalore Tribunal in the case of Lucent Technologies, Hindustan vs. ITO42 held that the payment made for importing software is for the acquisition of the copyrighted software as opposed to ‘copyright’ and is not subject to withholding tax43. It was also held that where the acquisition of software is inextricably linked with acquisition of hardware when a company has purchased the copyrighted article and has not acquired the copyrights in the software, it is not justifiable to break up the transaction into separate payments for hardware and software. The transfer of a copy of the computer programme (a copyrighted article), is regarded as the sale of an article which is taxable as business income. The Finance Ministry has held that IPRs such as integrated circuits or undisclosed information would not be covered under ‘taxable services’, as these rights are not covered or prescribed under Indian law44.

A conflict looms large between the forces of technology and the interests of IP. The Entertainment Industry has been crying foul as Internet users transfer copyright material without any inhibition, while at the same time the software industry continues to create tools that further aid in facilitating the sharing and distribution of data that is licensed or protected by copyright. This has translated into a larger problem with respect to the tax that has to be paid. The Government loses crores of Rupees every year due to piracy and illegal duplication and distribution of copyrighted material and in particular computer software.

2. Indirect Taxation

Sales Tax — Impact on Intellectual Property

The levy of sales tax on intangibles has been marred by controversy. The Supreme Court in Tata Consultancy Services vs. State of Andhra Pradesh45 has held that states have the power to levy sales tax on the transfer of intangible assets. The Hon’ble Supreme Court also opined that “the term ‘goods’ includes all types of movable properties, whether those properties be tangible or intangible. In India the test to determine whether a property is ‘goods’ for the purpose of sales tax, is not whether the property is tangible or intangible or incorporeal. The test is whether the item concerned is capable of abstraction, consumption and use and whether it can be transmitted, transferred, delivered, stored, possessed, etc.” Generally, ‘goods’ for the purpose of sales tax laws including laws imposing V.T.A. will include not merely tangible property but also intangible property. This necessarily implies that states have the right to tax transfer of IP.

In CIT vs. Sun T.V. Ltd. it was held that “… ‘goods’ may be tangible property or an intangible one. It would become goods provided it has the attributes thereof having regard to (a) its utility; (b) capable of being bought and sold; and (c) capable of being transmitted, transferred, delivered, stored and possessed. If the above attributes are satisfied, the same would be goods”. According to Section 286 of the Constitution, no state can levy a tax on a sale or purchase which takes place outside the State or while importing goods into India or exporting goods out of India. The Hon’ble Supreme Court in the Tata Consultancy Services case46, while affirming its earlier judgment in the case of Associated Cement Companies vs. Commissioner of Customs47, held that a software programme consists of various commands and the copyright may remain with the originator of the programme, but the moment copies are made and marketed by the copyright possessor, it becomes goods, which are susceptible to sales tax.

• Determination of situs of Intangible Property

Section 4 of Sales Tax Act lays down the test for the determination of situs of sale for the purpose of taxation. Prima facie, this Section would apply to only tangible property. However, IP by its very nature, as has been well documented above, is primarily intangible in nature. The applicability of Section 4 to intangibles therefore seems to be in jeopardy. Would this then imply that intangibles cannot be brought within the purview of the Sales Tax Act? This despite the fact that Article 286 of the Constitution specifically prohibits states to levy tax on purchase of goods where such sale takes place outside the state or in the course of the import/ export of goods into and out of the territory of India. States in India levy sales tax on the transfer/ assignment of IP. There may be several issues pertaining to the location of the intangible property and the power of the state to levy tax on such property. This certainly calls for clarification by the concerned authorities and also to lay down rules or procedures for the determination of the situs of intangible property.

• Section 3 of the Sales Tax Act — Applicability to Intangible Property

Section 3 of the Act lays down that for the purchase of goods in the course of interstate trade or commerce to take place, there must be the movement of goods from one state to another. It would rather be unproblematic to determine the movement of tangible property. However the problem would arise when it comes to the determination of movement of IP. The Hon’ble Supreme Court48 has observed that the actual movement from one state to another pursuant to a contract of sale is necessary, is settled law.

• Section 5 of the Sales Tax Act — Applicability to Intellectual Property

Section 5 of the Act, like in the case of Section 3, stipulates that there has to be the actual movement of goods, for sale or purchase of goods to take place, in the course of import or export. Physical movement is absent in the case of IP. Can this imply that there can never be transactions in the course of interstate trade or commerce while importing or exporting intangibles? Both tangible and intangible property is treated alike for the purpose of imposition of tax both in respect of ordinary and deemed sales. It would thus be erroneous to assume that in the absence of movement of IP, there can never be a transaction with respect to IP in the course of interstate trade and commerce.

• Section 9 of the Sales Tax Act — Applicability to Intellectual Property

Section 9 of the Act confers the power on that particular State to collect tax, where the movement of goods commences. States are empowered to retain the tax so collected by virtue of Article 269(1) of the Constitution of India. As has been enunciated earlier, it is practically impossible to identify the physical movement of intangible goods. That being the case, is it practicable to levy a tax as laid down under Section 9 wherein the commencement of movement of goods has to be identified? The irony being that Section 2(d) of the Sales Tax Act also includes within its ambit ‘all other kinds of movable property’ which includes intangibles as well. If tax has to be levied under Section 9, the movement of intangible goods must necessarily be presumed to be notional. This uncertainty needs to be addressed by the authorities at the earliest.

Service Tax — Impact on Intellectual Property

Service Tax was first introduced by the Government of India through Chapter V of the Finance Act, 1994. The Government of India has made services49 pertaining to Intellectual Property50 as a taxable service51. Prior to 10-9-2004, the transfer of IPRs fell under the ambit of ‘consulting engineer services’. The taxation of IP services has sparked off a debate. There seems to be an iota of uncertainty with respect to the definition of the term ‘Intellectual Property service’, as it includes the permanent transfer of IPRs whereas a clarification issued by the Ministry states that a permanent transfer does not amount to rendering of service. The permanent transfer of IP would not be in the nature of a service and hence would not attract service tax. Instead, the transaction would amount to a transfer of intangible property. Service tax may be levied only when the owner of the IP, transfers the IPR temporarily.

• Transfer of Know-how

The issue as to whether the transfer of know-how would fall within the ambit of service tax has been the subject of unending debate/ argument in courts. With services pertaining to IP being made a taxable service, whether or not the transfer of know-how would be subject to service tax had remained unclear, until recently. The Government of India52 has clarified that IP not specifically dealt with under any law applicable in India, is not intended to be covered under the provisions of the Finance Act for the levy of Service Tax. This clarification has only compounded the problem. Since know-how (as an IP) has not been dealt with in detail in any of the enactments in India it may not be subject to levy of service tax as per the clarification issued by the Government.

• Liability to pay Service Tax on services pertaining to IP — When and how does it arise?

With respect to IPRs, where the service provider, who is providing services pertaining to IP, is situated in India and the recipient of the services is also situated in India, the onus of paying the service tax is on the person rendering the service. But if the person who owns the IPR resides outside India and the recipient of the service is situated in India, then the liability to pay service tax would have to be ascertained. With respect to the liability to pay service tax, prior to the introduction of the Taxation of Services Rules (Provided from outside India and received in India) Rules, 2006, it would be pertinent to take into consideration the definition enunciated under Section 65(105) and Rule 2(1)(d)(iv) of the Service Tax Rules, 1994.

Taking into consideration the above-mentioned section/ rule, where the service provider (owner of IPR) is situated outside India and does not have any office or permanent establishment in India, the onus of paying pay service tax shifts to the recipient of the service (if he is situated in India) despite the fact that under general principles of taxation, the liability to pay service tax is on the person rendering the service. The onus would shift to the person availing of the service, solely when taking into consideration, the above-mentioned provisions; i.e., Section 65(105) and Rule 2(1)(d)(iv).

The position has entirely changed ever since the introduction of the Taxation of Services (Provided from Outside India and Received in India) Rules, 2006. These Rules read with Section 66A of the Finance Act, 1994 drastically widen the scope of levy of service tax. According to the Rules, under the circumstances enunciated in the previous paragraph, the recipient of the service would be considered to have rendered the service himself. Hence where the IPR holder is situated outside India and where the recipient of the service is situated in India, the liability to pay service tax is on the recipient of service. Countries where IP is owned, typically require that charges be made. Countries on the receiving end are naturally inclined to challenge them. If the IP related service is rendered by a person resident in India and the recipient of the service is situated outside India, the tax liability would be governed by the provisions laid down in Export of Services Rules, 2005. The value of the service on which service tax is payable is generally the gross amount charged by the service provider. With respect to IPRs, the Government of India53 has exempted an amount which is equivalent to the amount of cess paid towards the import of technology from being paid54.

Customs — Impact on Intellectual Property

Customs duty is levied under the Customs Act, 1962 read with the Customs Tariff Act, 1975. Even intangible property like IP would fall within the ambit of the Customs Act. Goods imported or exported are subject to customs duty which is levied at a rate stipulated under the Customs Tariff Act, 1975. With respect to imports into India, only when equipment is imported along with the importation of any technical know-how, would there arise any IP related issue while ascertaining the price of the imported goods for the purpose of valuation of customs duty.

• Customs — Valuation

Article 7 of the General Agreement on Tariffs and Trade (GATT) lays down the policies pertaining to customs valuation. The Agreement on Customs Valuations stipulates that for the calculation of the duty that is levied, it is essential to ascertain the value on which the duty is to be levied. Customs duty is payable as a percentage of the ‘Assessable value’. The value may be either the ‘value’ as defined under Section 14(1) of the Customs Act, 1962 which applies for the valuation of imported and exported goods55 or the ‘tariff’ prescribed under Section 14(2) of the Customs Act.

The value of goods for the purpose of customs duty shall be deemed to be the price at which the goods is ordinarily sold, or offered for sale or for delivery at the time and place of importation or exportation in the course of international trade. The Customs Valuation (Determination of Price of Imported Goods) Rules, 1988 lays down six methods for the valuation of imported goods56.

Fee paid to the holder of IPRs must be in addition to the customs, if it relates to imported goods. This would include licences, royalties, etc. for the use of IP or the right to re-sell or distribute the imported goods. The value of the goods on which customs duty is levied in India includes the price charged by the supplier for the IP, which has been added to the cost of the goods. However as per the provisions of the Customs Valuation (Determination of Price of Imported Goods) Rules, 1988, the charge pertaining to the right to reproduce the imported goods, shall not be added to the price that is payable for the purpose of determination of the customs value. The fees paid towards the use of IP, fees paid for training, etc. is not subject to the levy of customs duty. The Hon’ble Supreme Court57 has held that technical service charges and payments made for training cannot be included in the value on which customs is levied. A new Duty Free Import Authorisation Scheme has been introduced by the Government according to which, the inputs required for export production are exempt from basic customs duty, additional customs duty, education cess, etc.

Central Excise — Impact on Intellectual Property

Central Excise is a duty on goods manufactured indigenously. It is levied only in cases where goods come into existence as a result of the manufacture and when the goods are marketable. Central Excise which is evaluated on a self-assessment basis in India, is calculated based on the tariff, the maximum retail price (MRP) and the transaction value. Of late, the Central Government has been stressing on the retail price while levying excise duty. It has also issued a comprehensive list of goods which would attract valuation based on the retail price.

As per Section 4(1)(a) of the Central Excise Act, 1944, if the Assessee and the buyer of the goods are not related and the price of the goods is the sole consideration for the sale, excise duty would then be levied on the transaction value58. If price is not the sole consideration for the sale, then the value of the artwork, plans, engineering, etc. undertaken for the production of goods would be treated as additional consideration flowing directly or indirectly from the buyer to the Assessee with respect to the sale. Section 4(1)(a) of the Act, is however not applicable to goods in respect of which a tariff value has been fixed under Section 3(2) of the Central Excise Act, 1944.

The Government of India has exempted goods falling under the Schedule to the Central Excise Tariff, 198559, provided such goods are manufactured by an Indian company and the goods are patented by its owner in two countries which includes India, U.S.A. or any of the country of the E.U., for a period of at least 3 years.

• Inclusion of brand-name by contract manufacturer

The Hon’ble Supreme Court60 has opined that under an Agreement for sale, where the goods are produced by and on behalf of the customer according to his specification, the value for the purpose of excise would be the price at which such goods are sold to the customer and the value of the trademark cannot be included in the value of the goods. For the purpose of valuation, in cases involving goods manufactured by a contract manufacturer, the principles laid down by the Hon’ble Supreme Court in Ujgar Prints Ltd. and Pawan Biscuits Ltd. would apply.

• Liability of contract manufacturer to pay excise duty on recorded CDs

A film or a music company generally acquires copyright of the songs or movies on the payment of a lump sum amount as royalty to the artist or the producer. The company would send the content on a convenient medium to a contract manufacturer for manufacturing CDs on the payment of the job charges. On receiving the finished good from the contract manufacturer, the company (copyright owner) would then sell the CDs. There are several issues with respect to the liability to pay excise duty. The expenses incurred by the company towards marketing of the product could possibly be excluded from the assessable value of the CDs. The original CD that was given by the company to the contract manufacturer contains the original recorded music or the movie, the value of which would also include the royalty paid, etc. This value could probably be included as a percentage of the net sale value. The Hon’ble Supreme Court61 has however observed that royalty would be included in the assessable value of the goods.

Stamp Duty — Impact on Intellectual Property

Stamp Duty has to be paid for all transactions involving the execution of documents or instruments62 as provided for in the Indian Stamp Act, 1899. Stamp Duty can be levied only by the Union by virtue of Article 246 of the Constitution. Article 268 of the Constitution lays down that the States in which stamp duty is levied and collected shall have the right to retain the proceeds. Intellectual Property instruments which purport transfer63 are subject to stamp duty. If a single instrument pertains to several different issues, stamp duty is payable on an aggregate amount of the stamp duty payable on the separate instruments64. Where a single instrument pertaining to a single issue, falls under more than one description as provided for in the Schedule, the highest rate specified among the different heads would be applicable65. Diligence must be exercised while assigning values to the sale. The Registrar of Trademarks can impound the document under Section 72 of the Trade Marks Rules, 2002. Instruments pertaining to copyrights are exempt from stamp duty under Section 18.

3. Miscellaneous

Transfer Pricing

An important concern with respect to taxation of IPRs is Transfer Pricing, which calls for a detailed analysis. IP transactions raise the issue of regulation of transfer pricing. Transfer pricing rules are of varying complexity and are often difficult to apply when there are no readily available comparables, which is often the case with IP. Transfer pricing exemplifies the way in which tax authorities are tightening up codes for foreign operators and how these policies encroach on global expansion policies. With respect to the concept of transfer pricing, there are two basic categories of assets, tangible and intangible. The tangible assets inter alia include equipment, machinery and inventory while intangible assets include IP, R & D, technical expertise, etc. Transfer prices are the prices at which services, tangible property and intangible property are traded across international borders between related parties and cover the tax levied on inter-corporate transactions. Transfer pricing is significant as a variation in the transfer price would inevitable affect the profits of the business subject to tax in India. The main objective of transfer pricing is to avail tax benefits and therefore there arises the need for regulations pertaining to Transfer Pricing in IP. Tax Authorities can employ any of the methods, which inter alia include the Arm’s Length Principle, Cost Contribution Arrangement & Global Formulatory Arrangement, according to the nature of the transaction to determine the appropriate transfer price of IP. It is difficult to apply the arm’s length principle to intangibles because of ambiguity in defining ‘intangibles’ and also due to the difficulty in assigning a specific value for purpose of taxation. In India, transactions between related (associated) parties fall under the ambit of Accounting Standard AS 18 (Paragraph 25)66 and IAS67 24 internationally. These standards require disclosure of certain aspects involved in such transactions. The Finance Act, 2001 introduced the detailed Transfer Pricing Regulations (T.P.R.) in India68. The rules pertaining to transfer pricing has been notified on 21st August, 2001.

Taxation of Know-how

Although there is no universally accepted definition of ‘know-how’, but as defined by the Hon’ble Courts, includes secrecy and any other secret information as to a device, process, formula and the nature of the patentable subject matter. The Income tax Act, 1961 specifically deals with the expenditure incurred on acquiring know-how69. The Act allows deduction, spread over 6 years, of a lump sum consideration paid for acquiring know-how for the purposes of business, even if later the assessee’s project is abandoned or if such know-how subsequently becomes useless or if the same is returned70. A payment made for acquiring know-how or the use of know-how which is one revenue account is allowable under Section 37, and does not attract Section 35AB of the Act at all71. Know-how would require direct expenditure and could be written off as revenue expenditure. Consideration for the supply of know-how could be construed to be ‘royalty’ for the purpose of Section 9(vi) of the Income tax Act, 1961. Taxation of technical know-how has remained a contentious issue for quite a while. Although know-how is in the nature of intangible goods, it nevertheless falls under the definition of ‘goods’ under Value Added Tax/sales Tax Laws and is hence chargeable to State Value Added Tax. A permanent transfer of technical know-how is taxed as a sale of intangible goods. In Alembic Chemical Works Co. Ltd. vs. CIT72 a lump sum consideration paid for technical know-how to achieve higher levels of production by better technology was held by the Supreme Court to be on revenue account.

Intellectual Property holding companies

Over the last decade or so, businesses generating significant revenue from IP, have organized Intellectual Property Holding Companies (hereinafter referred to as ‘IPHC’) to reduce state taxes while separating IP assets from other corporate liabilities. In case of an IPHC, the parent company creates a corporate subsidiary in the parent state itself or in a foreign country where there is either no tax that is levied or where the rate of tax is relatively low. IP assets are then created by or transferred to the subsidiary. The subsidiary would then enter into licence agreements under which the parent corporation and non-related corporations agree to pay the IPHC royalties in exchange for an exclusive or non-exclusive right to use the IP assets. Since most IPHCs are organized in low tax jurisdictions, royalties received by the IPHC are generally tax-free. The parent company that paid the royalty could also deduct the payment as a deductible expense, thereby reducing the income of the parent company.

Of the various benefits arising from the establishment of an IPHC, the greatest is the reduction in the enterprise’s total obligation for taxes. Authorities exempt some or all of a corporation’s income from taxation. The tax savings in this regard may be considerable. In addition to the tax benefits, the creation of an IPHC can increase corporate efficiency in the operation of the business. By consolidating ownership of IP, the separate entity can provide centralized management of IP assets on a global scale. India has not witnessed the mushrooming of such companies yet but in the developed countries these companies have been established and commercial exploitation of IPRs and tax mitigation is their primary objective.

III. Comparison with other countries

United Kingdom

The United Kingdom (hereinafter referred to as ‘UK’) has launched a system that it refers to as ‘R & D credits’, although the relief available comes as a deduction from income rather than a credit against tax. In recognition of the increasing importance of IP to business, the Government has introduced a new regime for the taxation of IP and other intangible assets. The tax treatment of these assets follows GAAP with income, expenditure and amortisation relating to intangibles being treated as revenue. With respect to intangible assets acquired before 1-4-2002, the tax treatment will continue to follow the ‘old’ regime for the taxation of intangibles, so long as these assets are owned by their existing owners73. A person who resides in the UK and carries on trade, which involves the exploitation of IP, is taxable upon any sums which he receives from such exploitation whether or not they are received in the UK. It would also include lump sum payments made for the grant of a licence to exploit the right or for the total or partial assignment of the right74 or as compensation/damages for infringement because any sum which a trader derives from carrying on of his trade is income75.

Capital Gains tax

IP represents property which can be transferred and can in certain circumstances result in chargeable capital gain or an allowable capital loss. This however would be subject to the normal capital gains tax provisions applicable in the UK. All forms of property are assets for this purpose including incorporeal property such as copyrights and other forms of IP76. But an author who commutes royalties for a lump sum is liable to income tax77. A person who is ordinarily resides in the UK is chargeable to capital gains tax on the disposal of assets wherever situated, except those individuals who are not domiciled in the UK. Non-residents are outside the scope of capital gains tax78.

Stamp Duty

Stamp duty was abolished on instruments relating to intellectual property, executed on or after 28-3-2000 by the Finance Act, 200079. In the UK, the payment of stamp duty on assignments and transmission of trademarks has been terminated.

Double Taxation Relief

Many countries apply a withholding tax on royalty payments to a non-resident, as in the case of the UK. If the recipient of a foreign royalty resides in the UK, the rate of withholding tax is often reduced or eliminated under the appropriate Double Taxation Avoidance Agreement (DTAA) between the UK and the country where the royalty arises. It should be borne in mind that a DTAA in the UK normally overrules the provisions of the enactments levying tax.80.

Royalties

In order to prevent royalties from being taxed twice on the introduction of the corporate intangible fixed asset regime, royalties already brought into account prior to 1-4-2002 are not to be brought into account thereafter81. The new tax regime does not apply to trade or service marks held by partnerships, unincorporated businesses, etc. Neither are there provisions for treating royalties received on licensing trademarks as annual payments as there is for a patent royalty, nor is there any withholding requirement where the owner of the trademark is resident outside the UK because trade marks and service marks have an indefinite life, licensing of which is often a part of a franchise arrangement, can be commercially advantageous82.

United States of America

The tax treatment of IP does not follow the GAAP in the United States of America (hereinafter referred to as ‘U.S.’). On the contrary, the treatment of intangible assets has been set out in the U.S. Tax Legislation. Tax deductions are available for U.S. tax purposes for all the IP assets. Transfer of IP by persons situated in the U.S.A. to foreign corporations is taxed in the U.S.A. Where such a situation arises in a tax-free transaction, it would give rise to a deemed licence, under the terms of which, the U.S.A. based transferor would be required to include in the annual income, an amount that is commensurate with the income derived from the foreign transferee’s exploitation of IP.

The source company generally imposes a withholding tax on passive sources of income. If a corporation incorporated in the U.S.A. licences its IP to persons located in another country, the company situated in the U.S.A. is likely to receive royalties from the foreign company with the withholding tax having been subtracted, unless it has a contractual right which provides for the contrary. The U.S.A. generally taxes the world income of the companies incorporated in the U.S.A. Foreign corporations with no business activities in the U.S.A. are subject to tax on payments of certain categories of income like dividends, interest or royalties from sources in the U.S.A. Sec. 197 of the Internal Revenue Code allows the amortization of any intangible asset which is acquired after 9-8-1993 and which is held in the conduct of trade or business83. Royalties received from trademark licences are taxable as income in the U.S.A. The basis of taxation depends upon whether the taxpayer is a cash or accruals basis taxpayer. The position relating to payments of trademark royalties is a mirror image in that they will be deductible on a cash or accruals basis, according to the basis adopted by the taxpayer84. There is no provision for the payment of stamp duty in the U.S.A.

Other countries

The tax treatment of IP in Germany follows the GAAP. Germany is a relatively high tax jurisdiction with profits being taxed at a corporate income tax rate of between 38% and 40%85. The tax treatment of IP does not follow GAAP in Australia. On the contrary, the treatment of these assets is set out in the Australian tax legislation with the treatment varying based on the nature of the intangible asset involved. Perhaps the most contentious issue pertaining to taxation of IP in Australia is that capital allowances are not available with respect to the acquisition cost of trademarks and goodwill. Australia not being a predominantly high tax jurisdiction, the fact that capital allowances are not available in respect of acquired trademarks and goodwill implies that Australia is not the ideal location to have IP assets. Trademarks and goodwill cannot be amortised for the purpose of taxation in France. In Ireland, generally no tax deductions are available with respect to acquired IP. However, a new legislation has reduced the rate of corporation tax to 12.5%. There is also a special legislation that is in place in Ireland which provides for exemptions with respect to patents that have been developed and registered in Ireland. The legislation provides for tax exemption for income derived from ‘qualifying patents’, where the holder of the patent resides in Ireland. Stamp duty is however not levied with respect to transfer of IPRs in Ireland. The tax treatment in the Netherlands follows the GAAP. The cost of internally generated IP is fully tax deductible on an accrual basis86.

IV. Suggestions

There was a time when Indian companies used to invest only 2-3% of their revenue in R & D, but this figure has seen a meteoric increase in recent time. For most Pharma companies, IP is perhaps more valuable than any of its tangible property. Cadila Healthcare, for instance, spent nearly 9.2% of its total turnover on R & D87. Globalisation, new technologies and e-business have led to new business models in which information, IP and knowledge have become core business assets and key drivers of competitive advantage88. The national expenditure on R & D in India increased from Rs. 8,913.61 crores in 1996-97 to Rs. 12,901.54 crores in 1998-9989. Governments over the world seek to provide ‘tax benefits’ to foster innovation and this is testament to the fact that IP plays a vital role in the development of the economy. One of the by-products of socio-economic policy for development in many countries is the acceptance of ‘fiscal dirigism’90 in tax laws91. By integrating global strategies with the applicable tax regulations early in the planning process, companies could potentially save billions of Rupees. Companies could, in the process, steer clear of the everlasting confrontation with the tax authorities. Multinational Corporations are transferring their IP assets to low-tax jurisdictions in such an aggressive manner that the low-tax jurisdictions collect higher corporate revenues than the latter. This is perhaps an ideal illustration of the Laffer’s Curve effect.

First and foremost, it is essential for the tax system to deal with intangible assets in an effective manner. However, this has not been the case in India. Our current tax laws governing the tax treatment of intangible assets is complex, inconsistent and out of date. For instance, different classes of expenditure are written off at different rates, or not at all, with no rationale behind it. This is disadvantageous to Indian businesses and may even lead to a situation where multinational companies acquire and own IP assets only outside India.

IP has not been recognized as an accounting concept till date and a reform to this effect will better equip the tax system to cope in a business environment in which the value of intangible assets is being realised. The Government would do a lot of good by laying down clear tests to distinguish between revenue and capital expenditure. A clarification in this regard and the introduction of an aligning tax would reduce tax compliance costs for both business and revenue. If that is not feasible, the Government must clearly ensure that proper guidelines are in place to determine what would fall under the categories of capital and revenue expenditure respectively. It would be advisable to introduce a more coherent definition of IP payments. This would provide greater certainty and clarity and would process of collecting tax more effective. A new legislation on IP and taxation needs to be introduced, the aim of which must be to replace the various existing tax treatments for intangibles with a system covering all intangible assets. There needs to be a transitional “catch-up” rule for royalties that have been taxed or relieved on a paid basis. A new rollover relief also needs to be made applicable with respect to the disposal of intangible assets.

The structuring of acquisitions and disposals also needs to be more tax-sensitive. The rules currently applicable in India are complex and need careful consideration to establish the tax consequences of any transaction involving IP. While both IP and tax laws are aimed at promoting socially desirable activities, additional tax incentives are needed to promote the dissemination of technology to the public for the maximum social good. To achieve the policy goals of ultimate innovation and creation, the Government should introduce incentives to encourage owners of patentees to donate, obsolete patents to universities, hospitals, etc. for the purpose of R & D which would act as a shot in the arm for such organisations.

A system of direct payment combined with marginal cost pricing would make the process more transparent which would inevitably lead to better resource allocation92. The Government also needs to evolve a mechanism whereby IP assets are valued. By insisting on valuing IP assets by companies, it would ensure better compliance with taxation requirements. Numerous other benefits would also ensue as a result of valuation of IP assets. IP valuation would also help in the determination of the initial cost base of IP for the purpose of capital gains and for the purpose of payment of stamp duty. There is also the need to evolve a mechanism for the purpose of calculating the transfer price in cross-border IP transactions. The number of inter-corporate transactions is increasing by the day and so is their complexity. This makes compliance with the various requirements even more arduous. It is against this background that the Transfer Pricing Regulations applicable in India need to be consonant with the global scenario.

It is imperative for the Government to encourage companies to set up IPHCs in India. The Government also needs to regulate the IPHCs, as most IPHCs are set up with the ulterior motive of tax avoidance (although the formation of IPHCs is not illegal), since minimising tax liability in a legitimate manner is the prerogative of all corporations. The Government, however must not under any circumstances, come down on such companies with an iron hand but on the contrary must promote those companies. There has been the consistent effort to evolve the optimal method of raising tax revenues by tax authorities, for quite a while now. The regulation of taxation on IP needs to be modified, so as to take into account the interests of those who have invested millions of Rupees in R & D and other related activities. The impact of the implementation of taxation mechanisms with respect to IP which are investor friendly, would pave the way for corporations to pay taxes promptly.

References

Books

• Copinger and Skone James on Copyright (Kevin Garnett, Gillian Davies & Gwilym Harbottle ed., London: Sweet & Maxwell, 15th edn., 2005).

• David M. Klien, ‘Intellectual Property in Mergers & Acquisition’ (Thomson West, 2004).

• Gordon V. Smith & Russell L. Parr, ‘Intellectual Property- Licensing and Joint Venture Profit Strategies (John Wiley and Sons, Inc., 3rd edn.).

• Hillary E. Pearson & Clifford G. Miller, ‘Commercial exploitation of Intellectual Property’ (New Delhi: Universal Law Publishing Co. Ltd., 1st Indian Reprint, 1991).

• James J. Fawett & Paul Torremans, ‘Intellectual Property and Private International Law’ (Oxford: Darendon Press, 1998).

• Kanga, Palkhivala and Vyas, The Law and Practise of Income Tax (New Delhi: Lexis Nexis Butterworths, 9th edn., Vol. I, 2004).

• Kevin Garnett, et al, Copinger & Skone James on Copyright (London: Sweet & Maxwell, 15th edn., 2005).

• K. C. Gopalakrishnan, ‘A text book on Tax Law’, N.L.S.I.U.

• Mark Anderson, ‘Technology Transfer, Law, Practice & Precedents’ (Lexis Nexis Butterworths, 2nd edn.).

• Neil J. Wilkof & Daniel Burkitt, ‘Trade Mark Licensing’ (London: Sweet & Maxwell, 2nd edn., 2005).

• Nigel A. Eastaway, et al, ‘Intellectual Property and Taxation’ (London: Sweet & Maxwell, 6th edn., 2004).

• Rodney D. Ryder, Intellectual Property Law- Concept to Commercialisation (New Delhi: Macmillan, 2005).

• R. Brown, ‘The Law of Personal Property’ (W. Raushenbush, 3rd edn., 1975).

• Stanley Surrey, ‘Definitional problems in Capital Taxation – Tax Revision Compendium’, Vol. 11, U.S.A.

• W. R. Cornish, ‘Intellectual Property: Patents, Copyright, Trademarks & Allied Rights’ (London: Sweet & Maxwell, 2nd edn.)

Articles

• Anil B. Deolalikar & Lars-Hendrik Roller, ‘Patenting by Manufacturing in India: Its Production and Impact’, The Journal of Industrial Economics, Vol. 37, No. 3 (Mar., 1989), pp. 303-314.

• Deleault, Nicholas, “How Intellectual Property Assets Affect Estate Taxes?” Ezine Articles 14 March, 2007.

• <http://ezinearticles.com/?How-Intellectual-Property-Assets-Affect-Estate Taxes&id=488954>

• Dudley L. Miller, ‘Taxation of Income from Literary Property Owned by Nonresident Aliens’, The Yale Law Journal, Vol. 54, No. 4 (Sep., 1945), pp. 879- 885.

• Isabel Verlinden & Patrick Boone, ‘Reporting Intellectual Property’, Pricewaterhouse Coopers LLP.

• <http://www.buildingipvalue.com/05_TI/031_034.htm>

• M. S. Prasad, ‘Income Tax Reliefs for Authors and Pantentees’ (2003) 180 CTR (Articles) 114.

• V. Ramaswami, ‘Deduction in respect of Royalty of Patents’ (2003) 182 CTR (Articles) 21.

Journals/Periodicals

• All England Law Reports

• All India Reporter

• Current Tax Reporter

• Excise and Law Times

• Income Tax Reports

• Supreme Court Cases

• University of Pennsylvania Law Review

Websites

• http://www.buildingipvalue.com/

• http://www.economictimes.indiatimes.com/

• http://www.hinduonnet.com/

• http://www.iccwbo.org/

• http://www.indianpatents.org.in/

• http://international.westlaw.com/

• http://ipr.indlaw.com/

• http://www.jstor.org/

• http://www.manupatra.com/