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).