Nut Crackers

Questions & Answers
Direct Taxes

Anant N. Pai,
Chartered Accountant

Questions :

  1. What are Trade Secrets?

  2. What sort of ‘Confidential Marketing Information’ constitutes ‘Trade Secrets’?

  3. Does ‘Confidential Marketing Information’ constitute “capital assets”?

  4. How are gains from assignment of ‘Confidential Marketing Information’ in nature of Trade Secrets taxed?

Answers are given below

Q. 1. What are Trade Secrets?

Ans: 1.1. A Trade Secret is a formula, practice, process, design, instrument, pattern or compilation of information used by a business to obtain an advantage over competition within the same industry or profession. In some jurisdictions, such secrets are referred to as “confidential information”; while in others they are a subset or example of confidential information.

Trade Secrets are property rights and can be sold or licensed.

There is generally no protection by registration available for Trade Secrets in law as available for other intellectual properties like trade marks, patents, designs etc.

Protection is done by ensuring confidentiality, more particularly from employees as they constitute the resource providers for information on trade secrets. For example, employment contracts are structured to bind employees with confidentiality and wrongful divulging of the same may amount to breach of contract.

1.2. Trade Secrets often comprise customer lists and other sensitive marketing information. Such Confidential Marketing Information constitutes valuable property in law.

1.3. Trade Secrets are defined by a number of sources in USA.

First, under the Restatement of Torts, §757 (1939), "a trade secret may consist of any formula, pattern, device or compilation of information which is used in one's business, and which gives him an opportunity to obtain an advantage over competitors who do not know or use it. It may be a formula for a chemical compound, a process of manufacturing, treating or preserving material, a pattern for a machine or other device, or a list of customers."

Second, trade secrets are defined under the Uniform Trade Secrets Act:

"Trade secret" means information, including a formula, pattern, compilation, programme, device, method, technique or process that: (1) derives independent economic value, actual or potential, from not being generally known to, and not being easily ascertainable by proper means, by other persons who can obtain economic value from its disclosure or use, and (2) is the subject of efforts that are reasonable under circumstances to maintain its secrecy.
Third, the Illinois Trade Secrets Act, provides that trade secrets are "information, including but not limited to, technical or non-technical data, a formula, pattern, compilation, programme, device, method, technique, drawing, process, financial data, or list of actual or potential customers or suppliers, that:

  1. is sufficiently secret to derive economic value, actual or potential, from not being generally known to other persons who can obtain economic value from its disclosure or use; and

  2. is the subject of efforts that are reasonable under the circumstances to maintain its secrecy or confidentiality.

1.4. In summary, a trade secret may consist of any formula, pattern, physical device, idea, process, and compilation of information or other information that both:

  • provides the owner of the information with a competitive advantage in the marketplace, and

  • is treated in a way that can reasonably be expected to prevent the public or competitors from learning about it, absent improper acquisition or theft.

Confidential Marketing Information which gives it possessor a competitive edge in the market is also a breed of trade secrets.

Q.2. What sort of ‘Confidential Marketing Information’ constitutes trade secrets?

Ans. 2.1 The generally known items of Trade Secrets are stated below by way of illustrations. It can be seen that ‘Confidential Marketing Information” is also included as a species of trade secrets.

  1. Technical Information/Research & Development

  • Proprietary Technology Information

  • Proprietary Information Concerning Research and Development

  • Formulas

  • Compounds

  • Prototypes

  • Processes

  • Laboratory Notebooks

  • Experiments and Experimental Data

  • Analytical Data

  • Calculations

  • Drawings — All types

  • Design Data and Design Manuals

  • Vendor/Supplier Information

  • R & D Reports — All Types

  • R & D Know-How and Negative Know-How (i.e., what does not work)

  1. Production/Process Information

  • Cost/Price Data

  • Proprietary Information Concerning Production/Processes

  • Special Production Machinery

  • Process/Manufacturing Technology

  • Specifications for Production Processes and Machinery

  • Production Know-How & Negative Know-How

  1. Vendor/Supplier Information

  • Vendor/Supplier Information

  • Cost/Price Data

  1. Quality Control Information

  • Information Concerning Quality Control

  • Quality Control Procedures

  • Quality Control Manuals

  • Quality Control Records

  • Maintenance Know-How & Negative Know-How

  1. Sales & Marketing Information

  • Proprietary Information Concerning Sales & Marketing

  • Sales Forecasts

  • Marketing and Sales Promotion Plans

  • Sales Call Reports

  • Competitive Intelligence Information

  • Proprietary Information Concerning Customers

  • Proprietary Customer Lists

  • Customer Needs and Buying Habits

  • Know-How Concerning the Management of Customer Confidence

  • Proprietary Sales And Marketing Studies and Reports

  1. Internal Financial Information

  • Proprietary Financial Information

  • Internal Financial Documents

  • Budgets

  • Forecasts

  • Computer Printouts

  • Product Margins

  • Product Costs

  • Operating Reports

  • Profit and Loss Statements

  • Proprietary Administrative Information

  1. Internal Administrative Information

  • Internal Organization

  • Key Decision Makers

  • Strategic Business Plans

  • Internal Computer Software

Q.3. Does ‘Confidential Marketing Information’ constitute “capital assets”?

Ans. 3.1. The expression ‘capital asset’ has been defined in section 2[14] of the Income-tax Act to mean property of any kind held by an assessee, whether or not connected with his business or profession, but excluding certain assets expressly stated therein like any stock-in-trade, consumable stores or raw materials held for the purposes of his business or profession;

We have seen that Trade Secrets constitute a species of intellectual property. Therefore, Confidential Marketing Information would constitute a capital asset.

Q.4. How are gains from assignment of ‘Confidential Marketing Information’ in nature of trade secrets taxed?

Ans. 4.1. As with other types of properties — such as goods, accounts receivable, patents and trademarks — trade secrets may be sold by one business to another. Most trade secret sales occur as part of the sale of the business owning the trade secret, but that is not mandatory.

An assignment of Confidential Marketing Information will thus constitute a transfer of capital asset [i.e., the trade secret].

4.2. Section 48 of the Income-tax Act provides the mechanism to compute capital gains. Capital gains are to be computed by deduction from the net transfer consideration the cost of acquisition and cost of improvement therein.

An issue came up before the Supreme Court in the case of CIT vs. B.C. Srinivasa Shetty [1981] 128 ITR 295 {SC} as to whether there is an taxable capital gains in case the capital asset transferred does not have a cost of acquisition. The capital asset in issue was goodwill of the business, which was self generated and not acquired for any price, The Supreme Court held that in such a case there is no taxable capital gains because the computation machinery in section 48 fails. The computation machinery in section 48 presupposes that the capital asset transferred must have a cost of acquisition and if there is no such cost, then the computation machinery fails. There are no capital gains in such a case.

4.3. The Legislature then brought a series of retaliatory amendments in section 55[2] of the Income-tax Act, which defines “cost of acquisition” for the purposes of section 48 by providing that where the capital asset involved is “goodwill of a business or a trade mark or brand name associated with the business or a right to manufacture, produce or process any article or thing or a right to carry on any business, tenancy rights, stage carriage permits or loom hours,” the cost of acquisition will be taken as NIL, if it is not purchased by paying a price.

So, the present condition of law is that as regards these capital assets, the capital gains will be taxed on its transfer, despite the fact that the same have not be purchased at a price.
The Supreme Court decision in the case of CIT vs. B.C. Srinivasa Shetty [1981] 128 ITR 294{SC} stands overridden by this amendment as regards these capital assets.

However, as regards any other capital asset which does not have a cost of acquisition, the Supreme Court decision remains intact as good law.

4.4. Confidential Marketing Information in nature of trade secrets may be self generated in its business and not acquired for any price.

Confidential Marketing Information is not amongst the capital assets enumerated in Section 55[2][a] for which the cost of acquisition is to be deemed as Nil, even when there is purchase price for it.

There would therefore be an arguable case for contending that there is no taxable gains on transfer of such self generated Confidential Marketing Information based on the decision of the Supreme Court of CIT vs. B.C. Srinivasa Shetty [1981] 128 ITR 294 (SC) as cited above.