Research and development (R&D) in all fields is a costly affair, but more so in bio-technology, where molecules are first evolved, developed and then subjected to arduous and expensive clinical trials. Till such time that the molecule reaches the final stage, it is simply work-in-progress (WIP), even though the idea and formulation are valuable.
Further development of the WIP is even more expensive and needs an even larger source of funding. To brave cash crunches and the inherent risk of uncertainty in R&D, a common and relevant modus operandi for many WIP technologies is to transfer such WIP into another group company or a joint venture company. Such transfer is intended to facilitate further fine-tuning of the WIP until eligible for commercial exploitation, through licensing, manufacturing, production or processing.
The recent decision of the Mumbai Income Tax Appellate Tribunal (ITAT) in Bharat Serums and Vaccines Ltd.,1 comes as a relief to such entities engaging in transfer of WIP. The ITAT has held that in such a transaction, the transferor undertakes transfer of a capital asset which is a WIP. However, no mechanism to ascertain its cost of acquisition has been provided under the Income-tax Act, 1961 (IT Act). In view of this, relying on a landmark decision of the Supreme Court, the ITAT ruled that such receipt cannot be taxed as capital gains under the IT Act.
In this case, the assessee had received certain sums from its subsidiary (which thereafter became a Joint Venture with another entity) as consideration for assignment of the know-how under development – i.e., the scientific, medical and technical knowledge relating to the development and manufacture of an oncological drug under development. The assessee did not offer this amount to tax while filing its return of income, as it claimed that it was a capital receipt, not subject to tax, whereas the assessing officer and subsequently the CIT(A) decided to the contrary.
While the assessing officer treated the amount as business income chargeable to tax under section 41(3) of the IT Act, the CIT(A)'s order was founded upon the legal fiction contained in section 55(2)(a) of the IT Act. This provision deems that the cost of acquisition of a self-generated capital asset associated with the 'right to manufacture, produce or process any article or thing' is nil. In the CIT(A)'s opinion, the know-how transferred by the assessee comprised of a 'right to manufacture, produce or process' the oncological drug and, accordingly, its cost of acquisition being nil, the entire sum received by the assessee in consideration of the assignment of know-how was to be taxed as capital gain.
The ITAT agreed that this was a transfer of a capital asset and as such should ideally attract capital gains taxation in the hands of the transferor. However, the issue on which the appeal was predicated was whether the 'know-how' under development is covered under section 55(2)(a) as a 'right to manufacture'.
First, the ITAT examined the phrase 'right to manufacture' and concluded that know-how was still under development. Hence the transferee did not acquire any right to manufacture, produce or process any article or thing at this stage. The transfer of know-how could not be construed as a 'right to manufacture' as contemplated under section 55(2)(a). With the assignment of the know-how, the assessee's joint venture did not automatically attain any rights to manufacture or produce the drug, but simply received the technical knowledge under development, to be used in future, to enable or simplify the manufacture of the drug.
Second, the ITAT relied on the landmark decision of the Supreme Court of India in B.C. Srinivasa Setty,2 and held that since the IT Act did not provide for a mechanism to compute cost of acquisition of self-generated assets such as know-how, which did not fall within the scope of section 55, and the cost of acquisition was in no way ascertainable, the computation machinery for capital gains tax in this case failed.
In its order, the ITAT made a passing reference to the distinction between transfer of know-how and patent, and opined that the latter would confer a right to manufacture and would fall within the scope of section 55(2)(a). This is a notable observation, especially in light of the ITAT's earlier decision of February 2017 in the assessee's own case,3 which involved the assignment of the assessee's patent over a drug.
There, the ITAT had held that the facts were squarely covered by section 55(2)(a), while observing that patents are, by their very nature, indicative of the right to manufacture the underlying product. The ITAT relied heavily on the words of the assignment agreement to arrive at the conclusion that the transferee was unconditionally permitted to manufacture the drug pursuant to the agreement.
The ITAT further noted that the patent was registered for commercial exploitation and was transferred to the assignee to exploit it commercially. This opens up a debate: it would be interesting to see how the courts would deal with taxation of income pursuant to transfer of patents. Patents are inherently negative rights, in as much as they bestow upon the patent holder a right to prevent the manufacture of the product by those other than the holder of the patent right.4 Since one can only confer a right that one owns, the patent holder can only assign a right to prevent the manufacture of the product by anybody other than the transferee, but not a direct right to manufacture the product by the transferee.
Although the recent order of the ITAT would find favour with companies that strategically exchange know-how and such other scientific or technical knowledge under development, the analysis as to whether a transfer is of a right to manufacture and hence, is chargeable to capital gains, must be undertaken carefully on facts and circumstances of the case. Courts and tribunals have also ruled that income from such transactions would be taxable as business income if, for instance, the assessee only shared the know-how and did not fully transfer the same to its counterpart.5 This is because sharing of know-how would not lead to cessation of a source of income and hence cannot be treated as a transaction attracting capital gains tax.
That said, it is useful to know which way the wind blows: caution must be paid to the wording of commercial transfer or knowledge-sharing agreements, to ensure that they spell out the conditions required to attract taxability or exemption, as they factually should.
1 Bharat Serums and Vaccines Ltd. v. ACIT, I.T.A. No.4701/Mum/2012 (Mumbai – Trib.), decided on May 24, 2019.
2 CIT v. B.C. Srinivasa Setty,  128 ITR 294 (SC).
3 Bharat Serums and Vaccines Ltd. v. ACIT,  187 TTJ 598 (Mumbai – Trib.).
4 Section 48, Patents Act, 1970.
5 Lyka Labs Ltd. v. ACIT,  36 ITR(T) 364 (Mumbai – Trib.).
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