Tax on income is a way to finance the public expenditure. With the passage of time as the ways of earning have changed so have the type of taxes levied. In the modern business structure, transactions related to intellectual property are taking the center stage and have tendency to be the biggest money spinner in business transactions. The Income Tax Act 1961, has added certain provisions related to the taxation of the income accrued through Intellectual Property Rights transaction. The basis of tax for IP Rights transactions is different as per the provision of the Act. The nature of the expenditure is of utmost importance. Once the nature is determined it is easy to identify whether the amount paid is taxable or would be allowed as deduction.
PROVISION IN INCOME TAX ACT 1961
The various provisions for taxation of income related to Intellectual Property Rights are:
Section 9(1) (VI) of the Income Tax Act 1961 provides for taxation of income by way of royalties. If the royalty is payable in respect of any right, property or information used or services utilized for the purposes of a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India it is not taxable. Income by way of royalty as a lump sum consideration for the transfer of rights outside India, or the imparting of information outside India in respect of, any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process or trade mark or similar property, if such income is payable in pursuance of an agreement made before the 1st day of April 1976, and the agreement is approved by the Central Government, is not taxable.
Section 32(1) (ii) of the Income Tax Act 1961 explained Depreciation of assets. Depreciations are allowed in the case of know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of a similar nature, being intangible assets acquired on or after the 1st day of April 1998. Deductions are available for expenditure (other than capital expenditure) on scientific research.
Section 35A of the Income Tax Act 1961 explained the expenditure on acquisition of patents and copyrights rights. If they are purchased for a lump sum consideration with an enduring benefit, the purchaser is entitled to claim depreciation over a period of time. If it is paid as periodical payments, then it can be claimed as expenditure fully incurred for the purpose of business. Upon any expenditure which was incurred after the 28th day of February 1966 but before 1st April 1998, on the acquisition of patent rights or copyrights for the purpose of business, deductions will be allowed for each of the previous years on an amount equal to the appropriate fraction of the amount spread over 14 years. In the case of amalgamations, if the amalgamating company sells or otherwise transfers the rights to the amalgamated company (being Indian company) the deductions are not applicable to the amalgamating company.
Section 35AB of the Income Tax Act 1961 explains the deductions on expenditure on know-how. Where the assessee has paid in any previous year, any lump sum consideration for acquiring any know-how for the use of his business, one-sixth of the amount so paid shall be deducted in computing the profits and gains of the business for that previous year, and the balance amount shall be deducted in equal installments for each of the five immediately succeeding previous years. It means that the expenditure will be deductible in six equal installments for six years.
In case of Scientific Engineering House (P) Ltd. v. CIT1 the Hon'ble Supreme Court held that "The underlined portion, namely, "likely to assist in the manufacture or processing of goods" clearly suggests that know-how covered by this section is which would assist in manufacture or processing of goods. It does not include, in our opinion, the know-how acquired by the assessee for setting up the plant and machinery. Therefore, the assessee was justified in capitalizing the same to the plant and machinery and claiming depreciation thereon."
In case of IFFCO v. Commissioner of Central Excise2 the Central Excise Tribunal held that "know-how" is a parcel of closely-held information relating to industrial technology, sometimes also referred to as trade secret which enables its user to derive commercial benefit from it. "Know-how" as an intellectual property, would mean a proprietary series of practical, non-patented knowledge, derived from the owner's experience and tests, which is secret, substantial, and identified.... "Know-how" must be described in a sufficiently comprehensive manner in order to verify whether it meets the secrecy and substantiality criteria." In other words, according to the Tribunal, know-how which was out in the public domain and which did not need special knowledge or training for it to be put to use was not intellectual property.
If, where the know-how referred to in sub-section (1) is developed in a laboratory, university or institution referred to in Sub-Section (2B) of Section 32A, one-third of the said lump sum consideration paid in the previous year by the assessee shall be deducted in computing the profits and gains of the business for that year, and the balance amount shall be deducted in equal installments for each of the two immediately succeeding years.
There are certain other deductions for scientific research which are provided under Section 80 GGA under the head "deduction in respect of certain donation for scientific research or rural development"
- Any sum paid to for scientific research or to a university, college or institution to be used for scientific research.
Section 80QQA provides deduction for income from copyrights. "In the case of an individual resident in India, being an author, the gross total income of the previous year relevant to the assessment year commencing on April 1, 1980, or to any one of the nine assessment years next following that assessment year or April 1, 1992 or to any one of the next four assessment years following that assessment year, any income derived by him in the exercise of his profession on account of any lump sum consideration for the assignment or grant of any of his interests in the copyright of any book, or of royalties or copyright fees (whether receivable in lump sum or otherwise) in respect of such book, a deduction to the amount of 25 per cent will be allowed on such amount."
No deduction will be allowed if the book is either in the nature of a dictionary, thesaurus or encyclopedia or is one that has been prescribed or recommended as a text book, or included in the curriculum, by any university, for a degree or post-graduate course of that university. Also, no deduction is allowed if the book is written in any language specified in the Eighth Schedule to the Constitution or in any such other language as the Central Government may, by notification in the Official Gazette, specify in this regard having the need for promotion of publication of books of the nature referred to in clause (a) in that language and other relevant factors.
Section 80-O provides for income from patents
Where an Indian Company receives any income from foreign state or foreign enterprise in consideration for using any patent, registered Trademark, invention, design etc and the income is received by way of convertible foreign exchange in India or having been received as convertible foreign exchange outside India or having been converted into convertible foreign exchange outside India is brought into India, a deduction of 40% for an assessment year beginning on the 1st day of April, 2001, a deduction of 30% for an assessment year beginning on the 1st day of April, 2002, a deduction of 20% for an assessment year beginning on the 1st day of April, 2003 and 10% for an assessment year beginning on the 1st day of April 2004 should be allowed. But no deduction shall be allowed in respect of the assessment year beginning on the 1st day of April, 2005 and for subsequent years.
Section 80 OQA provides for income from Copyrights. Any income derived by the author in exercise of his profession on account of any lump sum consideration for the assignment or grant of any of his interests in the copyright of any of his books or of royalty or copyright fees, a deduction of 25% from that income shall be allowed. No deduction shall be permitted when the book is in the nature of dictionary, thesaurus or encyclopedia or any book that has been added as textbook in the curriculum by any university for a degree of graduate or post graduate course of the university. Also no deduction will be allowed for a book which is written in any language specified in the 8th schedule of the constitution or in any other language as the Central Government by notification in the official gazette specifies for the promotional need of the language.
Section 80QQB – Deductions in respect of royalty income, etc., of authors of certain books other than text-books; "any income derived by [the author] in the exercise of his profession on account of any lump sum consideration for the assignment or grant of any of his interests in the copyright of any book, or of royalties or copyright fees (whether receivable in lump sum or otherwise) in respect of such book, there shall, in accordance with and subject to the provisions of this section, be allowed, in computing the total income of the assessee, a deduction from such income of an amount equal to 25% thereof."
Deduction in respect of Royalty on Patents is provided under Section 80RRB. "Where in the case of a patentee -an assessee, being an individual, who is resident in India, , in receipt of any income by way of royalty in respect of a patent registered on or after the 1st day of April, 2003 under the Patents Act, 1970, and his gross total income of the previous year includes royalty, be allowed a deduction, of an amount equal to the whole of such income or three lakh rupees, whichever is less." In the case of compulsory license is being granted in respect of any patent under the Patents Act, 1970, the income by way of royalty for the purpose of allowing deduction under this section shall not exceed the amount of royalty under the terms and conditions of the license settled by the Controller under that Act.
GREAT DEBATE OF REVENUE VS CAPITAL EXPENDITURE OF THE INCOME TAX ACT 1961
The treatment of capital expenditure and revenue expenditure is always a contentious issue. Capital expenditure refers to expenditure on the procurement or enhancement of non-current assets (assets that the business intends to keep for 12 months or longer). Revenue expenditure refers to expenditure that the business incurs either for the purpose of trade or for maintenance of the earning capacity of non-current assets. This question is also of importance while we talk about the expenditure on Intellectual Property Rights. The difference between Revenue and Capital expenditure is critical while establishing tax liability as well. A revenue expense is deductable from a business' chargeable income, while capital expenditure is not. The idea is that it is unfair to tax a business on revenue, when there were expenses incurred in generating that revenue. As a result, taxes are levied against net profits as opposed to gross profits.
The Hon'ble Supreme Court in case of Alembic Chemicals Ltd. v. Commissioner of Income Tax3 held that 'There is also no single definitive criterion which, by itself, is determinative as to whether a particular outlay is capital or revenue. The "once for all" payment test is also inconclusive. What is relevant is the purpose, of the outlay and its intended object and effect, considered in a common sense way having regard to the business realities. In a given case, the test of "enduring benefit" might break down.' Consequently the decision of the High Court to not to allow tax deduction to the appellants were reversed. The Court concluded that even though the procurement of technical know-how with lump sum payment was considered as capital expenditure, it cannot be treated as an asset of enduring benefit and it can be treated as revenue expenditure.
The Hon'ble Supreme Court in case of Assam Bengal Cement Companies Ltd. v. CIT4 observed that "If the expenditure is made for acquiring or bringing into existence an asset or advantage for the enduring benefit of the business it is properly attributable to capital and is of the nature of capital expenditure. If, on the other hand, it is made not for the purpose of bringing into existence any such asset or advantage but for running the business or working it with a view to produce the profits, it is a revenue expenditure. The aim and object of the expenditure would determine the character of the expenditure whether it is a capital expenditure or revenue expenditure."
It is clear from these decisions that the purpose and object of transaction will determine the nature of expenditure.
Taxation of income is necessary in a developing country like India as it is the main source of financing the public expenditure. Intellectual Property Rights are of great value and the holder of these rights has to invest a great amount of labour and money in creating these rights. Regarding, how to charge the money invested and the value of these rights for taxation purpose is a question, whose answer depends upon the nature of the transaction. Once the nature is determined then it is easy to charge the income or expenditure according to the various provision of the Income Tax Act. For charging tax it is necessary to determine whether the transaction is revenue or capital in nature. All the decisions will depend upon the facts and circumstances of each case.
2 ((2007)7VST 6 CESTAT)
3 (1989) 177 ITR 377 (SC).
4  27, ITR 34 SC.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.