Transfer of intangible rights: Sale or service?

In a recently reported
case of Mahyco Monsanto Biotech (India) Pvt. Ltd. vs. Union of India 2016 (44)
STR 161 (Bom) whereunder two writ petitions, one filed by the captioned company
(referred to as the Monsanto) and the other filed by Subway Systems (India)
Pvt. Ltd. (Subway), Hon. Bombay High Court painstakingly examined whether each
of the transactions involved were liable for VAT or service tax.  Although the facts in both the petitions were
totally different, interestingly the petitions were tagged together on finding that
the issue involved was similar.  Facts in
both the cases are briefly summarized below:

Monsanto’s
case:

The petitioner, Monsanto
supplied to third parties certain type of hybrid cotton seed which was infused
with a proprietary technology that protects it against a known menace to cotton
corp.  From these hybrids, these parties
generate large quantities of sowable seeds which are in turn sold to cotton
farmers.  The end product seeds thus have
the benefit of menace protection technology. 
The parties to whom the technology is provided in the form of seeds, (known
as donor seeds) make commercial use of the technology.  In the backdrop of these facts, Monsanto has
claimed that this is a case of offer of technology through container seeds.  The party pays for technology and not
container.  They do not sell any goods to
the end user.  Therefore, there being no “transfer
of right to use”, they should be exigible to service tax.  Central to their claim was
non-exclusivity.  Monsanto licensed to various
third parties the said technology.  Those
developers in turn cannot sub-license the technology.  They use it to produce sowable seeds.  Therefore the recipients of technology obtain
right to use the technology but there is no transfer of that right.  The container seed is the only means by which
technology can be transferred.  Provision
of technology was followed by training for using donor seeds and developing
foundation seeds and training for undergoing regulatory tests before the
licensee could produce foundation seed. For this, a one-time fixed fee plus a
trait fee was received by Monsanto under the agreement with third parties.  Petitioner’s plea was that service tax and
VAT are mutually exclusive and well settled relying inter alia on BSNL 2006 (2) STR
161 (SC), Imagic Creative Pvt. Ltd.
vs. CTO 2008 (9) STR 337 and Association
of Learning and Finance Companies vs. UOI 2010 (20) STR
417.  The petitioner’s main
contention was that there did not involve “transfer
of right to use goods” in the transaction of providing donor seeds.  This was pleaded mainly on the ground that
there is absence of ‘exclusivity’ and inability of the transferor to transfer
the same right to another in terms of twin
tests comprised in the five attributes required to be satisfied as laid
down in the case of BSNL (supra).  In
this judgment to constitute a transaction as one of “transfer of right to use the goods”, 5 attributes are required to
be satisfied viz. there are goods available for delivery, there is consensus ad
idem as to the identity of the goods, the transferee must have a legal right to
use the goods and the twin tests of temporary ‘exclusion’ of the transferor to
have the said right i.e. during the period the transferee has such right and
incapacity of transferor to again transfer the same rights to others.  According to the petitioner, the said test
applies to tangible and intangible goods equally and therefore the law laid
down in Duke & Sons (1999) 1 Mah LJ
26, Tata Sons Ltd. vs. State of Maharashtra
(2015) 80 VST 173 (Bom) and Nutrine
Confectionary Co. Pvt. Ltd. vs. State of Andhra Pradesh (2011) 40 VST 327 (AP)
did not represent correct position in law as certain facts were not made available
to the Court at the time these cases were decided. For instance, when Duke
& Sons’ case (supra) was decided, judgment of Supreme Court interpreting
Article 366 (29A)(d) was not available.  Further,
in Nutrine’s case (supra), BSNL’s test was not correctly applied and it was contrary
to BSNL.  Based on these submissions
among others, it was pleaded that their case is one of permissive use only and
not a sale or deemed sale. Since such transaction of permissive use is covered
under service tax law, it is one of service.

Subway’s
case:

In this case, the
transaction is a franchise agreement. Subway has claimed that franchise
agreement is a pure service.  Its
franchisees in Mumbai have obtained right to display Subway’s trademarks.  The franchisees enjoy no title to these trademarks.  This is therefore neither a sale nor a deemed
sale.  Subway’s business consists of possessing
non-exclusive sub-license from Subway International B.V., a Dutch LLC (which in
turn received in a second layer from an American company owning proprietary
rights) to establish, operate and franchise others to operate SUBWAY branded
restaurants, serving sandwiches and salads under the service mark, SUBWAY in
India.  Under franchise agreements
entered into with third parties, specified services are listed to enable
franchisee to operate sandwich shops in Subway’s name.  The rights are limited and they are non-transferable
or non-assignable.  Further, Subway
reserves the right to compete with its franchisees.  Consideration from the franchisees is received
by way of one-time franchise fee and royalty payable weekly based on weekly turnover.  The petitioner paid service tax since 2003 on
these fees.  The State Government however
contended that since the franchisee has acquired right to use trademarks, there
is a transfer of right to use those trademarks and therefore claimed VAT on
this in 2014 and issued notice to this effect and subsequently several show
cause notices as well as exparte assessment order.  The petitioner pleaded that the franchise
agreement was not one for sale or transfer of right to use but merely
permitting the franchisee to display certain marks and use certain technologies
and methodology to prepare salads and sandwiches for sale and this was a
permissive use.  Subway could enter into
as many / as few agreements with other franchisees even simultaneously and
could compete with its franchisees.  The
license provided thus is limited.  Apart
from this factual aspect, it was also pleaded for Subway that in the light of
several decisions of the Supreme Court on various composite contracts, Article
366(29A) was amended in 1983 whereby only under six specific situations,
transactions could be considered deemed sale and the amendment allowed specific
composite contracts to be divisible and by separating element of ‘sale’ it
could be taxed.  Subway’s agreement could
not be split and sale was not distinctly discernible.  However, the revenue contended that
‘franchise’ and ‘trademarks’ are expressly covered under MVAT Act since 2005 as
‘goods’ and therefore liable for VAT. 
Both revenue and the petitioner relied on Tata Sons Ltd. vs. State of Maharashtra (2015) 80 VST 173 (Bom). The
petitioner chiefly relied on Asian Oilfield
Services vs. State of Tripura (2015) SCC (online Tai 483 and BSNL (Supra) 
and Imagic Creative (supra).

Findings
of the Court:

The Court on a very
careful consideration in Monsanto’s case found that although ld. Counsel for
the petitioner commended that the transaction of transferring technology was
one of “permissive use”, in view of the Court, the said interpretation was not
supported by law.  The Court observed
that the seeds transferred were fully vested in the transferee.  On the issue of effective control, the Court
observed that effective control over the said seed and therefore that portion
of the technology embedded in the seeds was also transferred to the transferee.  The transferee could do whatever it wished
and Monsanto had no control left after the transfer.  Hence the transfer was to the exclusion of
Monsanto India and this satisfied the twin test laid down in BSNL.  The Court, in this context categorically observed
that BSNL’s judgment noted various factual aspects and the test was therefore
set out in those circumstances. Thus Hon. Supreme Court in that case did not
have occasion to consider its applicability to intangible property like
intellectual property.  The Court thus
also observed that Tata Sons (supra) was interpreted accordingly whereas Kerala
High Court in Malabar Gold (para 35), 2013 (32) STR
3 (Ker) took a contrary view.  It took
BSNL test to be applicable as a general proposition.  The Court expressed that they had serious
reservation about its universal applicability by stating, “we do not think this can ever be a correct reading of BSNL”.  Further that the Bombay High Court in Duke &
Sons (supra) held that test would not be applicable in the case of
trademarks.  According to the Court
therefore the law laid down in Duke & Sons is a good law.  The Court thus considered the instant case to
be the case of a transfer of the right to use goods while inter alia also
referring to various clauses in the agreement pointed out by the revenue in
support thereof.  For instance under a
specific clause 7.1, the sub-licensee could assign the agreement and its rights
and obligations under the agreement to its wholly-owned subsidiaries without
permission of Monsanto.  This according
to the Court would not happen if there was only permissive use as claimed by
the petitioner. Revenue’s reliance on the case of G. S. Lamba & Sons vs. State of Andhra Pradesh (2011) 43 VST 323
was viewed as well-founded by the Court while observing that in the instant
case, sub-licensing actually amounted to passage of effective control.  The Court also drew analogy in fair detail
with downloading of software by purchasing license.  The Court observed that when a license is
purchased, it is still a sale although what the user has purchased is a right
to use software.  Proprietary rights to
the software do not have to be transferred or sold.  On identical lines in the instant case
identified technology, the one which was infused in seeds were transferred to
use as the transferee wished.  The
intellectual property may continue to be owned by Monsanto.

Finding this case to be diametrically
opposed to model in the case of Subway, the Court observed that primarily
reliance on the case of Asian Oilfield and BSNL by the petitioner was correct
as Subway’s transaction could not be split into two distinct or severable
components.  If State was to be permitted
to tax the whole transaction, it would mean extending upon the power of the
Centre under the Union List.  The Court
noted that agreement between Subway and its franchisee is a bare permission to
use as there is no passage of any kind of control or exclusivity to the
franchisees and for all the reasons in law and fact that licensing of
technology in Monsanto is held to be transfer of right to use, the franchise
agreement in Subway’s case must be held permissible use only. 

The Court however noted
with caution to state that this did not mean that every franchise agreement
will necessarily be outside the purview of amended MVAT Act.  However, merely because of inclusion of
franchisees under MVAT Act would not automatically make all franchise
agreements liable to VAT.  There may be
class of agreements of franchise that would have all incidents of a ‘sale’ or a
“deemed sale” i.e. transfer of the right to use to attract VAT and not
otherwise.  However, limiting its view on
the agreement under the case of Subway, the Court opined that the facts of the
case does not constitute a sale exigible to VAT.  Equally it rejected a proposition that the
transaction which is nothing but a service could be converted as sale merely because
an entry is inserted in the State statute. 
Subway agreements are purely licensing agreements consisting of permissive
right to franchisees to use defined intangible rights, therefore not amenable
to VAT but a service liable for service tax.

Conclusion:

The above decision in
particular in the case of Subway relying on the decision of Tata Sons Ltd. vs. State of Maharashtra
(2015) 80 VST 173 (Bom) based on an altogether different aspect reached a
verdict that the franchise agreement involved is exigible to service tax than
one reached in the  case of Malabar Gold Pvt.
Ltd. (supra).  In Subway’s case above, it
is found that only “permissive use” is granted under the agreement and
therefore it cannot be interpreted as “transfer of right to use goods” whereas
Kerala High Court decided “franchise agreement” as one of service simply based
on interpreting the tests provided in BSNL’s case (supra) as having general
proposition even vis-à-vis intangible goods like intellectual property. It is
important to note that in this case, the Court has categorically made a point
in the context of Monsanto’s case that in the case of BSNL (supra), Hon.
Supreme Court did not have occasion to examine the aspects of transfer of
intangible goods such as intellectual property. Therefore the tests laid down
therein for determining a transaction of “transfer of right to use goods”
should not be followed as having universal application and especially in the
context of transactions involving transfer of use of intangible goods.  A thin line divides a transaction of service
from that of sale.  The controversy soon
is likely to be part of history with the onset of GST regime coming into force
in a short while.  Yet, one cannot ignore
the hardship faced in this regard by a large number of tax compliant entities
which have paid tax under one law and has  to face wrath of the other for want of
appropriate law and mechanism to resolve the manmade issue.

(Readers may read the
above with March, 2016 issue of BCAJ article on transfer of use of intangibles
under service tax feature).