1. This is a reference at the instance of the Commissioner under section 66(1) of the Indian Income-tax Act, 1922. The following question has been referred for our determination by the Tribunal :
'Whether, the sums of Rs. 2,20,663, and Rs. 3,19,834 paid to the Swiss company under annexure 'A' is an admissible deduction under section 10(2)(xii), 10(2)(xv) of the Indian Income-tax Act, 1922 ?'
2. A few facts may be stated :
The reference arises out of the assessments of the assessee-company for the two years 1960-61 and 1961-62, the relevant previous years are the years ending on 31st March, 1960, and 31st March, 1961 respectively. M/s. J. B. Advani & Co. Ltd. was a company carrying on business in Bombay. On 13th February, 1951, it entered into an agreement with a company in Panama called M/s. Holding Intercito Ltd. By the said agreement the two parties agreed to form a new company for the manufacture in India of electrodes with a capital of Rs. 10 lakhs, of which Rs. 9 lakhs were to be subscribed. Under the said agreement the Panama company was to take 20% of the authorised capital. The new company was to be called M/s. J. B. Advani Oerlikon Electrodes Ltd. This company, which was subsequently formed, is the assessee-company. On the very same date, M/s. J. B. Advani & Co. entered into another agreement with M/s. European Intercito Ltd. of Switzerland (which is hereinafter referred to as the 'Swiss Company'). The Swiss company was the owner of the patented process know as Oerlikon Intercito process for the manufacture of electrodes required in electric welding. The patent was available in India also. We shall have occasion to refer to the provision of the said agreement in some detail later on.
3. Under article 8 of the said agreement the licensee, in consideration of the rights transferred to it under the agreement and of the obligations assumed by the Swiss company, agreed to pay to the Swiss company a running royalty of 2% and a contribution of 3%. The agreement was to ensure for a minimum period of fifteen years.
4. It may be mentioned that in this reference we are concerned only with the 3% contribution provided in article 8 and not with the 2% running royalty inasmuch as the later payment has been allowed and there is no dispute about it.
5. Subsequently, the benefit of this agreement was taken over by the assessee-company which had assumed all the rights and obligation of J. B. Advani & Co. under the agreement with the Swiss Company.
6. For the two years in question the assessee-company paid to the Swiss company the amounts of Rs. 2,20,663 and Rs. 3,19,234 being the contribution at 3% under article 8. The claim of the assessee for deduction of the two amounts mentioned above for the two years was accepted by the Income-tax Officer. Subsequently, however, the Commissioner of Income-tax, Bombay City I, considered that the action of the Income-tax Officer in allowing 3% research contribution as a deduction was erroneous and prejudicial to the interests of the revenue and took action under section 33B of the Indian Income-tax Act, 1922. After giving the necessary opportunity to the assessee, the Commissioner passed order under that section modifying the assessment in question so as to disallow the amounts claimed as deduction. The assessee, thereafter, carried the matter to the Income-tax Appellate Tribunal contending that the amounts claimed as deduction should be allowed under section 10(2)(xii) or section 10(2)(xiv) of the said Act or, in any event, under the residuary section 10(2)(xv) of the said Act. Reliance was placed on the specific terms of the agreement as well as on the correspondence between the assessee and the Swiss company. The Tribunal held that the assessee had not made out a case for allowance under section 10(2)(xii) or section 10(2)(xiv) of the Act, but that the assessee would be eligible for allowance of the expenditure under section 10(2)(xv) of the Act. The Tribunal accordingly directed that the amounts disallowed under the orders or the Commissioner under section 33B should be allowed as deduction in the assessments in question.
7. It will be necessary now to refer in some detail to the agreement with the Swiss company as also to indicate the nature of the correspondence between the assessee-company and the Swiss company. Article 1 of the said agreement declares that the Swiss company is the owner of certain process by virtue of certain patent rights belonging to it, and by article 2 a licence is granted to the licensee, the assessee-company, for the sole manufacturing and selling rights of the said process for India, Ceylon, Burma, China, Malaya, Indonesia and the Far East; these countries have been subsequently referred to in the agreement as the specified territory. Article 3 contains the rights and obligations particularly of the licensee as regards manufacturing of electrodes. Article 4 provides that, subject to an import licence being granted, the licensee is to order from an associate of the Swiss company a complete electrode manufacturing plant according to the schedule attached to the agreement. Article 6 provides that, during the tenure of the agreement, the Swiss company would place at the licensee's disposal all improvements in connection with the manufacture of welding electrodes and machinery free of charge. A reciprocal obligation is also assumed under the very clause by the licensee and the Swiss company is permitted, in its turn, to use the improvements communicated by the licensee to the Swiss company in Switzerland as well as in other countries. Article 8 provides for royalties and clause (a) thereof may be fully set out :
'8(a). - In consideration of the rights transferred to the licensee under this agreement and of the obligations assumed by Intercito, the licensee undertakes to pay Intercito a running royalty of 2% (two per cent.) and a contribution of 3% (three per cent.) for the ordinary research work which includes analyses, development of new formulae being special to the requirement of the Indian market and any research work which may be asked for by the licensee in order to enable the licensee to the smooth running of his production and to meet the demands of the market. The royalty and the fee for research will be calculated on the net market selling price charged to customers, i.e., after deduction of all charges as freight, taxes and commissions. They are also due to electrodes which may be used in the licensee's own establishments or sold to them. The calculation in this case is based on the initial cost increased by 10%. Royalty and contribution fee of research work are due on all electrodes manufactured with the Oerlikon Intercito extruding press without considering whether the manufacture is based on Oerlikon Intercito recipes, the licensee's own recipes or other recipes.'
8. In his order, the Commissioner considered the two amounts paid to the Swiss company in the two years in question as amounts paid for research contribution and concluded that they were not admissible as deduction. In his order, the Commissioner construed article 8 as providing that 2% is earmarked as running royalty for the rights conferred on the assessee and 3% is earmarked as a research fee or contribution. He read article 8 with article 6 and observed that research is directed towards improving the method of production of the electrodes and evolving improved formulae of recipes therefor. According to the Commissioner, the research expenses were incurred for the improvement of capital asset and, therefore, assumed the character of capital expenditure.
9. It may be stated that before the Commissioner the assessee-company had not drawn attention to the correspondence between the assessee-company and the Swiss company. An opportunity was sought before the Tribunal to lead this additional evidence, which was granted. According to the Tribunal, the correspondence produced before it showed that correspondence had been exchanged by the assessee with its associate in Switzerland with reference to the processes employed by the assessee in its manufacture; in this correspondence various problems that arose in the course of manufacture in India have been referred to the Swiss company and its assistance is sought for the solution of such problems. The point sought to be made out was that although some wider research was carried on in Switzerland by the Swiss company, as far as the assessee-company was concerned it was merely utilising the facility afforded in Switzerland in the shape of laboratories, etc., in order to solve some of the difficulties encountered by the assessee in its own manufacture in India.
10. It is necessary to refer in detail to the correspondence which is made part of the statement of the case as annexure 'D' (collectively). But a perusal thereof would seem to bear out the point urged by the assessee before the Tribunal. In fact, if the later part of article 8(a) is carefully scrutinised, it is clear that the research work which may be sought for by the licensee was 'in order to enable the licensee to the smooth running of his production and to meet the demands of the market'. It is obvious, therefore, that this was not a contribution for the general research work carried on by the Swiss company at its laboratories in Switzerland but in the nature of payment contemplated to be made in order to obtain assistance from the Swiss company for the solution or various problems and difficulties as would arise in the day-to-day working of the assessee-company and such solutions as were necessary for the smooth running of the assessee-company's factory and for meeting the demands of the market. The correspondence would also indicate that this is how the provisions in article 8(a) above set out were understood by the parties and acted upon. The Tribunal upheld the view of the Commissioner that the two amounts were not deductible under section 10(2)(xii) or section 10(2)(xiv). According to the Tribunal, it was not possible to accept that 3% contribution was payable exclusively for general research, but it was a sort of composite payment as indicated in para. 8 of the order of the Tribunal. According to the Tribunal, this nature of the contribution rendered it ineligible for being considered as an allowable deduction under section 10(2)(xii) of the Act.
11. As far as the contention of the assessee under section 10(2)(xiv) was concerned, the Tribunal observed that the assessee had not placed before the Tribunal any evidence to show that any asset of a capital nature was brought into existence.
12. The Tribunal finally considered whether the expenditure in question was allowable under section 10(2)(xv) of the Act. The Tribunal considered the decision of this court in Commissioner of Income-tax v. Ciba Pharma Private Ltd. : 57ITR428(Bom) , which was subsequently upheld by the Supreme Court in Commissioner of Income-tax v. Ciba of India Ltd. : 69ITR692(SC) and held that the view of the Commissioner that this was not an allowable expenditure under the residuary clause could not be upheld. According to the Tribunal, the contribution was for research carried on to produce knowledge which was acquired by the assessee-company and which was useful in the conduct of the business of the assessee during the period of the agreement; it would, therefore, come within the scope of section 10(2)(xv). The departmental representative before the Tribunal attempted to distinguish Ciba's case : 57ITR428(Bom) principally on the basis that the agreement in Ciba's case : 57ITR428(Bom) was for a period of five years, whereas the agreement with the Swiss company was to ensure for fifteen years.
13. The learned counsel for the revenue before us took us through the judgment of the Supreme Court in Commissioner of Income-tax v. Ciba of India Ltd. : 69ITR692(SC) ) as also through the observations of the Madras High Court in Fenner Woodroffe & Co. Ltd. v. Commissioner of Income-tax : 102ITR665(Mad) . The Madras High Court has also set out in its judgment the facts and the reasoning of the Andhra Pradesh High Court in Hylam Ltd. v. Commissioner of Income-tax : 87ITR310(AP) .
14. In our opinion it is unnecessary to try to apply the principles enunciated by the Supreme Court in Ciba's case : 69ITR692(SC) to the clause of the agreement in question. It is not possible to hold that the 3% contribution considered separately by itself is referable to the rights given to the licensee to use the Oerlikon Intercito process as well as the further obligation on the Swiss company under article 6 of the agreement to place at the licensee's disposal subsequent improvements in the said manufacturing process. As a matter of fact, the Commissioner seems to have considered that the running royalty of 2% is to be considered as a payment for the licensee's right to use the said parented process in the specified territory, and the 3% contribution has not been considered as a contribution made by the licensee-company to the Swiss company for its research facilities. It is necessary to consider whether such allocation is justified or not. However, we shall proceed on the footing assumed by the Commissioner and accept that the 3% contribution is 'for the ordinary research work which includes analyses, development of new formulae, etc.', being subject to the requirements of the Indian market and such research work which may be asked for by the licensee in order to enable the licensee to the smooth running of his production and to meet the demands of the market. Even on this footing it is difficult to see how this provision can be co-related with the mutual obligation cast on the Swiss company and the licensee under article 6 of the agreement. Fairly read, the provisions contained in article 8(a) above set out would indicate that the 3% contribution is in the nature of payment for continuous consultancy service as may be required by the assessee for its special problems pertaining to the Indian market and to enable the assessee for the smooth running of its production in its manufacturing. This is also borne out by the correspondence between the parties concerned, to which reference has been made earlier.
15. If this is the proper way to read article 8(a), it would seem that the expenditure can be rightly regarded as having been made for the purpose of running the business or working it with a view to produce the profits (See Assam Bengal Cement Co. Ltd. v. Commissioner of Income-tax : 27ITR34(SC) ). If that be so, it must be properly regarded as revenue expenditure.
16. In Commissioner of Income-tax v. Ciba of India Ltd. : 69ITR692(SC) it has been observed that the payment made to recoup another person for expenditure on scientific research incurred by that other person, even if it might ultimately benefit the assessee, was, unless it was carried on for or on behalf of the assessee, not expenditure laid out or expended on scientific research related to the business of the assessee under section 10(2)(xii). In the view that we have taken, viz., that by such contribution the assessee did not acquire any asset of a capital nature, the provisions contained in section 10(2)(xiv) do not come into the picture at all.
17. Section 10(2)(xv) allows allowance being made in respect of 'any expenditure not being an allowance of the nature described in any of the clauses (i) to (xiv) inclusive and not being in the nature of capital expenditure or personal expenses of the assessee laid out or expended wholly and exclusively for the purpose of such business, profession or vocation.' In our opinion, the contribution at the rate of 3% must be regarded as expenditure laid out or expended wholly and exclusively for the purpose of the business of the assessee as payment for some advisory or consultancy service and it cannot be regarded in the nature of capital expenditure. It may be pointed out that even in Hylam's case : 87ITR310(AP) the Andhra Pradesh High Court considered certain payments for consultancy service and allowed the assessee two-thirds of such payments after making apportionment between capital and revenue in the proportion of 1 : 2. The provisions contained in the later part of article 8(a) of the agreement would seem to be in the nature of payment made to the Swiss company for what may be comparable to such consultancy service. The question of apportionment of such service between capital and revenue does not arise inasmuch as no case for the same has been made out by the department. The correspondence exchanged between the assessee-company and the Swiss company would seem to indicate that the questions referred to the Swiss company for their opinion and solution were mainly concerned with the day-to-day needs of the assessee-company in several different aspects and were not really of the nature contemplated in acquisition of assets of enduring nature.
18. In the result, the question referred to us is answered as follows : The two sums mentioned are admissible deductions under section 10(2)(xv) of the Indian Income-tax Act, 1922.
19. The Commissioner will pay the costs of this reference to the assessee.