ISMAIL J. - The Income-tax Appellate Tribunal, Madras Bench, under section 256(1) of the Income-tax Act, 1961, has referred the following question of law for the opinion of this court :
'Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in holding that payments made to Seymour for technical service fees in the sum of Rs. 3,333 for the assessment year 1963-64, Rs. 9,575 for each of the assessment years 1964-65 and 1965-66, Rs. 9,570 of the assessment year 1966-67 and Rs. 9,585 for the assessment year 1967-68 were not admissible as a deduction ?
The assessee was incorporated as a company mainly with the object of carrying on the business of one day alarm clocks. Clocks bearing the trade marks 'West Clox', 'Ben' and 'Big Ben' are manufactured by Messrs. General Time Corporation of U. S. A. Messrs. L. D. Seymour, New York (hereinafter referred to as 'Seymour'), was the agent of Messrs. General Time Corporation of U. S. A. A representative of the assessee entered into negotiations with Seymour in U. S. A. some time in January, 1959, and an oral agreement was reached between them on January 29, 1959. This was followed by an agreement between Seymour and the assessee for the collaboration which is described as 'Heads of agreement' and which is dated New York, January 7, 1960. Seymour agreed under the agreement to pass on to the assessee certain technical know-how to enable them to manufacture one day alarm clocks in India and the assessee agreed to pay a sum of Rs. 75,000 or $15,000 in instalments spread over five years. There were also other clauses under which certain payments such as royalty at 5% of the sale price of products were to be made by the assessee to Seymour in consideration of certain facilities and supply of tools and dies, technical knowledge, information advice, etc. The assessee required the approval of the Government of India for the agreement for collaboration with Seymour. There was correspondence in this regard consisting of letters from the assessee to the Ministry of Commerce and Industry, Government of India. The correspondence showed that at the instance of the Government the technical fees were reduced from $15,000 to $10,000, that the period of royalty was reduced from 10 years to 5 years, and that the arrangement was that there would be progressive increase in the manufacture of indigenous parts, though at the outset it would be a matter of assembling imported parts. The Governments approval for the agreement of collaboration with Seymour for the production of 96,000 pieces of one day alarm clock was conveyed in their letter dated April 19, 1960. Thereafter, a formal agreement dated New York, June 24, 1960, was entered into between Seymour and the assessee and it is in the form of a letter addressed by Seymour to the assessee. That letter was signed on behalf of the assessee with the remark 'agreed'. It is stated in the letter that it served to confirm the earlier agreement on January 29, 1959, subject to certain conditions, two of the conditions being that royalty of 5% of the net selling price was to be paid by the assessee and technical know-how fee of $10,000 would be paid by the assessee in five equal annual instalments. The agreement was for a period of five years with the understanding that an extension was contemplated if the first five years are satisfactory to both parties and subject to the assessee obtaining the approval of the Government.
The agreement was not renewed at the end of the five years, but the assessee entered into collaboration arrangement with the General Time corporation of U. S. A. In this connection there is a letter dated December 28, 1967, from the Government of India in the Ministry of Industrial Development and Company Affairs addressed to the assessee which showed that the Government approved the agreement between the General Time Corporation on the one hand and the assessee on the other hand. The purpose of the collaboration was for implementation of the expansion programme of the assessee for manufacture of alarm clocks and pendulam clocks, the capacity after expansion being two lakhs pieces per annum.
As far as the present reference is concerned, we are not concerned with the second agreement; we are concerned only with the original agreement which came to an end on the expiry of the period of five years. Pursuant to that agreement the assessee paid a royalty of Rs. 1,03,420 for five years in question. Similarly, the assessee paid a sum of Rs. 41,638 towards $10,000 agreed to be paid as technical know-how fees spread over a period of five years. The assessee in respect of the assessment years in question claimed both these payments as deductible items.
The Income-tax Officer as well as the Appellate Assistant Commissioner allowed the payment of royalty only as deductible but held that the sum of Rs. 41,638 paid during the five years in question by way of technical know-how fees was in the nature of capital expenditure, and, therefore, could not be deducted. The appeal to the Income-tax Appellate Tribunal also failed. It is the correctness of this conclusion of the Tribunal in respect of the payment of Rs. 41,638 that is challenged in the form of the question extracted already and referred to this court :
The findings of the Tribunal in this behalf were :
(1) The assessee which was incorporated with the object of carrying on the business of manufacture of alarm clocks did not have the necessary background knowledge for commencing the business and set about acquiring the whole apparatus from abroad and as a result entered into an agreement with Seymour,
(2) The bargain between the parties can be gathered if the course of events is considered including the 'Heads of agreement', the correspondence with the Government and the formal agreement between the collaborators. The bargain was that $10,000 was to be paid for the technical know-how which was to be transferred by providing blue prints of parts, technical instructions, etc., whereas there were separate payments to be made, e.g., for tools and dies and machinery, etc., and the payment of royalty was related to the supply of tools and dies, certain technical know-how advice etc.
(3) The technical know-how fee of $10,000 related to the acquisition of initial technical know-how which was to enable the assessee to commence the manufacture of the clocks in India.
(4) This know-how is not exactly the same thing as the right to use certain know-how and is itself a capital asset. The kind of know-how acquired by the assessee for the payment of $10,000 consisted of the initial knowledge passed on through blue prints, technical instructions, etc., for launching the project of manufacture and assembly of clocks. Such know-how is an asset and the payment has been made to acquire the know-how and merely incidental to the carrying on of the business of the assessee-company.
It is the correctness of these findings which have to be considered in the present reference.
As the Tribunal itself has pointed out, the nature of the arrangement reached by the parties has to be gathered from what are called the 'Heads of agreement' dated January 7, 1960, as well as the final agreement reached between the parties on June 24, 1960. The first paragraph in the heads of agreement states :
'These heads of agreement constitute a contract between the parties and are intended to be embodied in a further agreement as soon as the conditions mentioned in paragraph 13 below have been satisfied.'
Paragraph 13 contemplated the consent of the appropriate Government authorities in the United States of America being obtained. Paragraph 3 of the heads of agreement states that for the purpose of enabling the assessee of manufacture in India for the time being one-day alarm clocks under the brand names of Hustler and Big Ben, Seymour will supply the assessee directly or through their principal tools, dies, machinery, moving parts, and non-moving parts, technical know-how, etc. In the present reference we are concerned with the technical know-how only and for that purpose, paragraphs 3(c) and 4 are important.'
Paragraph 3(c) stated :
'For the purpose of enabling Time-Aids (assessee) manufacture in India for the time being one-day alarm clocks under the brand names of Hustler and Big Ben, Seymour will supply Time-Aids directly or through their principals, the following : ........
(c) Technical know-how initially for the assembly of clocks and subsequently for the progressive manufacture of the majority of the parts of India. This would be accomplished by providing blue prints of various parts, technical instructions an quality control and tests for durability of the various parts made in India.'
Paragraph 4 stated :
'In respect of the above technical know-how information and advice that will be imported to Time-Aids to enable them to manufacture one-day alarm clocks in India, a sum of Rs. 75,000 or $15,000 to be paid to Seymour as follows....' (The manner of payment was indicated).
From these two paragraphs it is clear that the payment of $ 15,000 was referable to the supply of technical know-how, information and advice originally for assembling the clocks in India, out of the imported parts and subsequently for the progressive manufacture of the parts themselves. As we have pointed out already, the sum of $ 15, 000 provided for in the heads of agreement was cut done at the instance of the Government of India to $ 10,000 and that is incorporated in the final agreement dated June 24, 1960. Similarly, the period of the agreement originally mentioned in the heads of agreement as ten years was reduced to five years with an option for renewal for another five years with the permission of the Government of India. Clauses 4, 5 and 9 of this agreement read as follows :
(4) A technical know-how fee of $ 10,000 will be paid to us in the equal annual instalments.
(5) We will arrange to have your company as use of the trade marks WESTCLOX, BEN, BIG BEN, to be applied to one-day alarm clocks manufactured under this licensing agreement........
(9) The licensing agreement will be for a period of five years. However it is our mutual understanding that an extension is contemplated if the first five years are satisfactory to both parties to this agreement, and that you will obtain prior approval of the Government of India for such extension.'
Thus, clause (9) of the final agreement describes the agreement as 'licensing agreement.' If the agreement was in substance of licensing agreement there is no dispute that the know-how fee of $ 10,000 paid to Seymour by the assessee would constitute only the payment of the licensing fee, and, therefore, would be an item of deductible expenditure. If, on the other hand, notwithstanding the nomenclature of the agreement as 'licensing agreement', the substance of the agreement was for the acquisition of the know-how for the purpose of bringing into existence an endurable asset, certainly the expenditure will be in the nature of capital expenditure, and, therefore, cannot be deducted. The assessee actually contended before the Tribunal that the agreement was only a licensing agreement and that it did not bring into existence and endurable asset. In paragraph 14 of the order of the Tribunal, the Tribunal refers to this argument, where it points out :
'Shri Venkataraman argued that this is a case of a licensing arrangement that the payment was for a short period of only five years, that though the assessee set up the business newly after its incorporation, the position was the same in the case of Ciba of India Ltd. : 69ITR692(SC) , and that, therefore, it should be held that the expenditure was in the nature of revenue expenditure. It was further urged that the arrangement was that a trained employee of Seymour should come to India to train the Indian officers and the staff in the art of assembly and manufacture of parts, that the quality of clocks thus manufactured was not very satisfactory, that in the result the arrangement was not renewed and a different kind of arrangement was entered into with the General time Corporation at a later stage and that all this itself shows that the assessee had not acquired anything of enduring benefit.
The Tribunal itself did not in its order find that the agreement was not a licensing agreement as contended for by the assessee-company. All that it pointed out was that the assessee was incorporated with the object of carrying on the business of the manufacture of the alarm clocks, that in the instant case, the kind of 'know-how' acquired by the assessee by the payment of $ 10,000 consisted of the initial knowledge passed through blue prints, technical instructions, etc., for launching the project of the manufacture and assembly of the clocks, and that such know-how is an asset and the payment has been made to acquire the know-how and not merely incidental to the carrying on the business of the assessee-company. We are clearly of the opinion that the facts of this case definitely establish that the arrangement entered into between the parties was only a licensing agreement. In the first place, the final agreement describes itself as licensing agreement and though the nomenclature given by the parties to the agreement may not be conclusive, still it is one of the factors to be taken into account for deciding whether the agreement was really a licensing agreement or not. In the second place, the agreement was only for a very short duration of five years. The next aspect to be borne in mind is that the know-how was in the initial stages for assembling the clock out of the imported parts and in the later stages of manufacturing the parts themselves indigenously for the purpose of assembling the clock. There is absolutely nothing to show in the agreement that even after the expiry of the period of the agreement the assessee was entitled to make use of the know-how for manufacturing the clocks in question. These features will clearly indicate that the payment of $ 10,000 was only a licensing fee, viz., a fee for the use of the technical know-how for manufacture of the clocks for the period of the agreement. In this context, the expression occurring in paragraph 3 of the heads of the agreement, viz., 'for the purpose of enabling Time-Aids (the assessee) to manufacture of India for the item being one-day alarm clocks under the brand names of Hustler and Big Ben', will be relevant.
Having regard to all the above circumstances, we are of the opinion that the arrangement entered into between the parties was only a licensing agreement and the payment made by the assessee, which is a subject-matter of this reference, was only the payment of licensing fee, and, therefore, that cannot be said to be an expenditure of capital nature, and consequently, that was an item to be deducted in computing the profit and gains of the business of the assessee. The result is that we answer the question referred to this court in the negative and in favour of the assessee.
There will be no order as to costs.