Taxation of Payments for Technical Plan or Technical Design

In the second, third and fourth parts of the article published in January, February and March 2011, we discussed taxability of the payments for technical plans and technical designs with reference to various judicial pronouncements with a view to understand how the case law has developed over the years and to cull out guiding principles.

In this final and concluding part, based on our earlier discussion and analysis of various judicial pronouncements and other available material, we have attempted to cull out few general guiding principles/broad propositions in respect of taxability or otherwise of the payments for technical design and technical plans, which could be applied in various practical situations, depending upon the facts and circumstances of each case. It is important to note that we have only considered and analysed the aspect relating to taxation of payments for Technical Plan or Technical Design. Other aspects relating to PE, etc. have not been discussed or analysed here.

Appropriate meaning of the word ‘design’ as appearing in Article 12 relating to Royalties and section 9(1)(vi) of the Act, in contrast with the word ‘Technical Design’ appearing in FTS/FIS Article in certain Indian treaties:

As pointed out in part I of the article, definition of the term ‘Royalty’ in the Act as well as definition of ‘Royalties’ under the Model Conventions consider payments of any kind received as a consideration for the use of, or the right to use, any ‘design’, as royalty.

Similarly, in respect of DTAAs entered into by India with various countries where the word FTS has been given a restricted meaning, the typical definition of FTS provides that the term ‘fees for technical services’ means, inter alia, payments of any kind to any person in consideration for the rendering of any technical or consultancy services which make available technical knowledge, experience, skill, know-how or processes, or consist of the development and transfer of a technical plan or technical ‘design’.

Therefore, in respect of DTAAs entered into by India with various countries where the word FTS has been given a restricted meaning and which also have relevant article regarding royalties containing the word ‘design’, a question arises as to what is meaning of the same term ‘design’ appearing in two different definitions of the term Royalty and FTS, in the same article of the same treaty.

In this connection, attention is invited to para 10.2 of the Commentary on Article 12 of the OECD Model Tax Convention (July, 2010), which reads as under:

“10.2 A payment cannot be said to be ‘for the use of, or the right to use’ a design, model or plan if the payment is for the development of a design, model or plan that does not already exist. In such a case, the payment is made in consideration for the services that will result in the development of that design, model or plan and would thus fall under Article 7. This will be the case even if the designer of the design, model or plan (e.g., an architect) retains all rights, including the copyright, in that design, model or plan. Where, however, the owner of the copyright in previously-developed plans merely grants someone the right to modify or reproduce these plans without actually performing any additional work, the payment received by that owner in consideration for granting the right to such use of the plans would constitute royalties.” (Emphasis supplied)

It is important to note that the above para 10.2 provides that in a case where the payment is made in consideration for the services that will result in the development of that design, model or plan, the same would fall under Article 7, as the OECD Model Tax Convention does not contain FTS article.

From the above, it clearly emerges that only in those cases where a design or plan already exists and any payment is made for use of or right to use the same, then only the same could be considered as ‘Royalty’ and not otherwise.

Hence, in cases where the payment is made for the development of a design or for development and transfer of a design, the same cannot be construed or characterised as royalty but the same would fall within the meaning of the term FTS.

It is important to note that, there is no FTS clause in 16 treaties signed by India i.e., in DTAAs with Greece, Bangladesh, Brazil, Indonesia, Libya, Mauritius, Myanmar, Nepal, Philippines, Saudi Arabia, Sri Lanka, Syria, Tajikistan, Thailand, United Arab Emirates, United Arab Republic (Egypt). In such cases, in respect of development and transfer of designs, the payment would fall under Article 7 relating to Business Profits and in the absence of any PE in India, the same would not be taxable in India.

It is, therefore, advisable to minutely look in various clauses of the relevant agreements and also to properly know the nature of payment in relation to designs, to determine whether the same would be taxable as royalties or not.

Payment for customised designs/designs supplied in connection with/along with the supply of plant and machinery, equipments etc. — Not to be taxable as royalties:

In many cases, payment for customised designs is made in connection with supply of plant and machinery, equipments, etc. which is necessary for proper supply, erection and commissioning of plant and machinery.

In this connection, courts have taken consistent view that in such circumstances, the payment of designs shall not be considered as royalties. In this connection, the following observations of the Madras High Court in the case of (2000) 243 ITR 459 CIT v. Neyveli Lignite Corporation Ltd. are very important:

“The term ‘royalty’ normally connotes the payment made by a person who has exclusive right over a thing for allowing another to make use of that thing which may be either physical or intellectual property or thing. The exclusivity of the right in relation to the thing for which royalty is paid should be with the grantor of that right. Mere passing of information concerning the design of a machine which is tailor-made to meet the requirement of a buyer does not by itself amount to transfer of any right of exclusive user, so as to render the payment made therefor being regarded as ‘royalty’.

In a contract for the design, manufacture, supply, erection and commissioning of machinery which does not involve licence of the patent concerning the machinery, or copyright of its design, mere supply of drawings before the manufacture is commenced to ensure that the buyer’s requirements are fully taken care of and the supply of diagram and other details to enable the buyer to operate the machines, and also to assure the buyer, that the machines will perform to the specification required by the buyer, such supply is only incidental to the performances of the total contract which includes design, manufacture and supply of the machinery.
The price paid by the assessee to the supplier is a total contract price which covers all the stages involved in the supply of machinery from the stage of design to the stage of commissioning. The design supplied is not to enable the assessee to commence the manufacture of the machinery itself with the aid of such design. The limited purpose of the design and drawings is only to secure the consent of the assessee for the manner in which the machine is to be designed and manufactured, as it was meant to meet the special design requirements of the buyer.

There is no transfer or licence of any patent, invention, model or design. The design referred to in the contract is only the design of the equipment required to be manufactured by the supplier abroad and supplied to the purchaser. The information concerning the working of the machine is only incidental to the supply as the machinery was tailor-made for the buyers. Unless the buyer knows the way in which the machinery has been put together, the machinery cannot be maintained in the best possible way and repaired when occasion arises. No licence of any patent is involved. Sub-clause (vi) and also of section 9(1) would have no application as the design was only preliminary to the manufacture and integrally connected therewith. The other three sub-clauses also in the circumstances of the case are not attracted.” (Emphasis supplied)

In this connection useful reference may also be made to the cases of ITO v. Patwa Kinariwala Electronics Ltd., (2010) 40 SOT 148 (ITAT Ahd.) and CIT v. Mitsui Engineering and Ship Building Co. Ltd., (2003) 259 ITR 248 (Delhi).

Therefore, in cases where customised designs/ drawings are supplied in connection with supply, erection and commissioning of machinery and equipments, etc., on the facts of any given case, it would be possible to argue that the same does not constitute Royalty or FTS.

Payment for designs considered as part of Cost of capital equipment:

In certain circumstances, on the facts of the given case, the ITAT has held that the payments for de-signs would constitute part and parcel of the cost of the capital equipments/machineries supplied.

In this connection, reliance could be placed on the following decisions of the ITAT:

    ACIT v. King Taudevin and Gregson Ltd. (Bang.) (2002) 80 ITD 281

    Skoda Export VO Ltd. v. DCIT, (2003) TII 18 ITAT

    ADIT v. Zimmer AG, (2008) TII 21 ITAT-Kol.

In King Taudevin’s case (supra), the ITAT held that the documentation services comprising of technical drawings, designs and data could be treated as book and constituted ‘plant’ or ‘tools of trade’. What was received by the Indian company in the instant case from the foreign company was capital asset and the remittance to the foreign company was by way of payment of purchase price for the capital goods imported from abroad.

Similarly, in Skoda Exports’ case, it was held that the receipt by the non-resident assessee for import of drawings and designs and technical documents is in the nature of plant and machinery and hence cannot be considered as FTS.

In Zimmer AG’s case, the ITAT held that the sup-ply of engineering drawings and designs together with supply of plant and equipments constituted one composite supply, which enabled ‘S’ to erect, commission, set up, operate and maintain the plant for manufacture of bottle-grade PET resins. Without the supply of engineering drawings and designs, ‘S’ could not have been able to set up, operate and maintain the plant at Haldia and, therefore, engineer-ing documentation formed an integral part of the plant and machinery supplied by the assessee.

The ITAT further held that the assessee did not supply any secret formula, processes, patents, engineering know- how developed by it which would enable ‘S’ to start business of manufacture of plant and machinery or any other product. Supply of engineering, drawing and designs was incidental to selling of plant and equipment which was tailor-made to suit specific requirement of ‘S’ for setting up a petro-chemical project at Haldia. Therefore, the supply of engineering drawings and designs was integral part of supply of plant and equipment and it could not be viewed in isolation and, therefore, payment made by ‘S’ was not for acquiring mere right to use engineering documentation, so as to constitute royalty.

In appropriate cases, based on the facts and circumstances, it could be possible to gainfully use the ratios laid down by the aforesaid decisions and contend that the payment for drawing would be part of supply of plant and equipment and would not constitute royalty or FTS and hence not taxable in India.

Payment for ‘Outright Purchase/Sale’ of designs and drawings, not taxable:

In many cases, based on the facts of the given cases, the ITAT/AAR/High Courts have held that the payments for designs and drawing are for the outright sale of designs and drawings to the Indian entity and the same would be covered by Article 7 relating to Business profits and in absence of a PE in India, would not be taxable in India.

In this connection, useful reference may be made to the following cases, which have been summarised in earlier parts of the article:

    CIT v. Davy Ashmore India Ltd., (Cal.) (1991) 190 ITR 626

    The Indian Hotels Company Ltd. v. ITO — Un-reported, ITA No. 553/Mum./2000

    Munjal Showa Ltd. v. ITO, (2001) 117 Taxman 185 (Delhi) (Mag.)

    Pro-Quip Corporation v. CIT (AAR), (2002) 255 ITR 354

    DCIT v. Finolex Pipes Ltd., (2005) TIL 25 ITAT Pune-Intl.

    Abhisek Developers v. ITO, (2008) 24 SOT 45 (Bang.) (URO)

    Parsons Brinckerhoff India Pvt. Ltd. v. ADIT, [2008]-TII-27-ITAT-(Del)-Intl

    CIT v. Maggtonic Devices Pvt. Ltd., (2009) TII 21 HC HP-Intl.

    International Tire Engineering Resources LLC (2009) TII 25 ARA-Intl.

In this regard, for considering whether a particular transaction of payment for design and drawings would constitute ‘Outright Sale’, the following important points should be kept in mind:

    a) In all cases, where the non-resident supplier of designs and drawings, does not retain any property or ownership rights in the designs and drawings, the same could constitute outright sale of designs and drawings. (CIT v. Davy Ashmore India Ltd.)

    b) Wherever the purchaser is entitled to use the designs and drawings, as he likes and he is entitled to sell or transfer the designs and drawings as per his wish, then in those cases it could constitute outright sale.

    c) If the agreement vests only a limited right and places restrictions as to the use of designs and drawings, then it cannot be said that there has been an out-and-out sale or transfer of the designs and drawings.

    d) In any alienation of right or property is made for consideration and such consideration is payable contingent upon productivity, use or disposition, then the same would not consti-tute ‘outright sale’, but the same could be considered as royalty.

    e) If the agreement has a secrecy/confidentiality clause, which prohibits the Indian party from disclosing the information received from the foreign party, the logical inference would be that there is no outright transfer of the designs/drawings/plans.

    f) Similarly, if the agreement restricts the Indian party from selling the designs, drawing and plan to the third party, the logical inference would be that there is no outright transfer in the property of the designs and drawings.

    g) Where the agreement for the supply of designs is for a limited period of the agreement and not for all times to come, the conclusion should be that there is no outright transfer of designs.

    h) Where the transfer is on ‘Non-exclusive’ basis, it conveys the idea that the designs and drawings that the seller owns and possesses are not transferred absolutely to the purchaser and that the seller is not divested of the proprietary rights and interest in the designs and drawings and hence the same cannot be considered as outright sale.

It would, therefore, be extremely important to minutely study and understand the facts and circumstances of each case and based on the relevant parameters, examine as to whether the payment is being made for outright purchase/sale of designs and drawings. If the payment is actually made for the outright purchase of designs, then based on the various judicial precedents cited above and the principle laid down by the courts, it should be possible to successfully contend that the same should not be taxable in India.

Meaning of the word ‘transfer’ in the words ‘development and transfer of a technical plan or technical design’:

A question arises for consideration as to what is the meaning of the word ‘transfer’ appearing in the words ‘development and transfer of a technical plan or technical design’. Does the word ‘transfer’ refer to absolute transfer of rights of ownership or mere use of such design by the person of other contracting state?

As pointed out above, absolute transfer of rights of ownership or transfer of all rights, title and interest, would generally make the transaction an outright sale and the same would not fall within the meaning of the term FTS.

In the context of the phrase ‘development and transfer of a technical plan or technical design’, the word transfer, in our view, would mean de-velopment of design and transfer of the same for the use of such developed design. In that event it would be FTS. Mere transfer of existing design, without any further development, would generally fall with in the definition of term royalty.

This question came up for consideration in the case of Gentex Merchants (P.) Ltd. v. DDIT (IT), (2005) 94 itd 211 (Kol.). In this regard, the ITAT held as under:

“From the agreement between the assessee and the American company it is apparent that the latter was to deliver the technical draw-ings and designs to the former for its own use and benefit in India. The term transfer as used in Article 12(4) does not refer to the absolute transfer of rights of ownership. It refers to the transfer of technical drawing or designs to be effected by the Resident of one State to the Resident of other State which is to be used by or for the benefit of Resident of other state. The said Article 12(4)(b), in our opinion, does not contemplate transfer of all rights, title and interest in such technical design or plan. Even where the technical design or plan is transferred for the purpose of mere use of such design or plan by the person of other contracting state and for which payment is to be made, Article 12(4)(b) will be attracted. The facts on record clearly indicate that under the agreement the American company was required to deliver such technical designs or plan for the sole use by the assessee-company in India. In fact, the assessee did use these technical plans and drawing for constructing and/or installing the Water Feature at 22 Aurangazeb Road, New Delhi. In the above circumstances we are of the opinion that the payments effected under the agreement with the American company squarely fell within the defini-tion of ‘fees for included services’ and therefore the assessee was liable to deduct tax @ of 15% of the amount payable, u/s.195 of the Act.”

Thus, it is very important to examine the factual position, in any given case and then determine the character of the income i.e., as to whether any such transfer would tantamount to FTS, royalty or outright sales.

Whether the concept of ‘make available’ be applied to ‘development and transfer of a technical plan or technical design’:

It is important to note that neither of the three model conventions i.e., OCED, UN and US Model Convention, contain separate Article relating to FTS. Thus, the concept of FTS appears to have originated from Indian DTAAs.

As of now, India has signed 79 DTAAs with various countries. Out of these, DTAAs with nine countries have FTS Article containing the concept of ‘make available’. These countries are: Australia, Canada, Cyprus, Malta, Netherlands, Portuguese Republic, Singapore, UK and USA.

In addition, due to existence of ‘Most Favoured Nation’ (MFN) clause in the protocols to the seven DTAAs providing for restricted scope of the FTS Article, it is possible to apply the concept of ‘Make Available’ in those cases. These countries are: Belgium, France, Hungary, Israel, Kazakstan, Spain and Sweden. In case of Swiss Confederation, the MFN clause in the protocol provides for further negotiations, but does not provide for automatic application of the restricted scope and of the concept of ‘make available’. Hence, practically as of now, the benefit of Swiss DTAA, the MFN clause is not available until the negotiations actually take effect and the same is made effective.

In case of DTAAs abovementioned 8 countries (except Singapore) having ‘make available’ concept in the FTS Article, the typical language of the Article e.g., India-USA DTAA reads as under:

“(b)    make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design.”

However, in case of India-Singapore DTAA, the same article reads as under:

“(b)    make available technical knowledge, experi-ence, skill, know-how or processes, which enables the person acquiring the services to apply the technology contained therein; or

    c) consist of the development and transfer of a technical plan or technical design, but excludes any service that does not enable the person acquiring the service to apply the technology contained therein.

For the purposes of (b) and (c) above, the person acquiring the service shall be deemed to include an agent, nominee, or transferee of such person.”

A question, therefore, arises as to whether the concept of make available could be applied in the case of second limb of the clause i.e., ‘or consist of the development and transfer of a technical plan or technical design.’

This question came up for consideration in the case of SNC -Lavalin International Inc. v. DDIT, IT, Delhi (2008) 26 SOT 155 (Delhi). The ITAT in this case held as under:

“Thus, if the payment for rendering any technical or consultancy service is ‘fees for included services’, if such services either make available technical knowledge, experience, skill, know-how or process or consists of the development and transfer of a technical plan or technical design. When the payment is for development and trans-fer of a technical plan or technical design, it need not be coupled with the condition that it should also make available technical knowledge, experience, skill, know-how or process, etc. The words ‘make available’ go with technical know-how, experience, skill, know-how or process, etc. but do not go with “constraints of the development and transfer of a technical plan or a technical design”. The second limb in clause (b) of sub-article (4) of Article 12 of DTAA can be invoked when the amount is paid in consideration for rendering of any technical or consultancy services and if such services consists of the development and transfer of a technical plan or a technical design also. By the way, the condition of mak-ing available technical knowledge is not sine qua non for considering the question as to whether the amount is fees for included services or not particularly when the payment is only where the technical or consultancy services consists of development and transfer of a technical plan or technical design only. This will be considered as ‘fees for included services’ within the meaning of Article 12(4) of the Act and hence, in terms of Article 12(2) tax rate should be charged.” [Emphasis supplied]

However, it is important to note that in case of India-Singapore DTAA, the portion relating to development and transfer of design and draw-ings have been made in to a separate clause (c) instead of keeping the same in the same clause as is the case with 8 other DTAAs mentioned above. On a proper reading of the Article 12(4)(c) of India-Singapore DTAA, as mentioned above, it would appear that in the case of Singapore, due to the peculiar language of the clause (c), concept of make available would be applicable even in case of development and transfer of a technical plan or technical design. This proposition is yet to be tested before a judicial forum.

Architectural designs and drawings:

The issue of taxability of architectural designs and drawings is a contentious one. The issue which arises is whether the contracts between the parties is a contract of service and whether the payment made by the assessee constituted a purchase consideration for the transfer of title in the drawings? There is a cleavage of judicial opinion in the matter.

In Abhishek Developers’ case (BCAJ March, 2011 Sr. No. 21 page 61), the ITAT, Bangalore bench held, on the facts of the case, following the un-reported decision of the Mumbai Bench of ITAT in the case of Indian Hotels Company Ltd. v. CIT, (BCAJ, January 2011, Sr. No. 7 page 43), that the transaction in question was a transaction of sale and not a case of rendering technical services as contemplated u/s.9(1)(vii).

However, in the following cases, a contrary view had been taken and the payment has been held to be in the nature of FTS/FIS:

    a) Gentex Merchants (P.) Ltd. v. DDIT (IT), (2005) 94 ITD 211 (Kol.)

    b) HMS Real Estate Pvt Ltd., (2010) 190 Taxmann 22 (AAR)

    c) GMP International GmbH, (2010) 188 Taxmann 143 (AAR).

Fees for Technical Services:

In the following cases, the payment for designs and drawings was held to be in the nature of FTS:

    a) AEG Aktiengesellschaft v. CIT, (2004) TII 05 HC Kar.-Intl (BCAJ, February, 2011 page 53)

    b) Rotem Company v. DIT, (2005) 148 Taxmann 411 (AAR)

In this case, the AAR held that the contract comprises of elements of fees for technical services within the meaning of DTAAs with Japan and Korea and the same is not in the nature of business profits.

    c) Mangalore Refinery and Petrochemicals Ltd. DCIT, (2007) TII 49 ITAT Mum-Intl. (BCAJ, February, 2011, pages 54-55)

    d) SNC — Lavalin International Inc. v. DDIT, (2008) 26 SOT 155 (Delhi)

    e) Worley Parsons Services Pty. Ltd. (2009) 179 Taxman 347 (AAR)

It may noted that in the India-Australia DTAA, FTS are covered under Article 12(3) and described as ‘Royalty’ and the term ‘Fees for Technical Services’ has not been used.

However, in ITO v. De Beers India Minerals (P.) Ltd., (2008) 115 ITD 191 (Bang.), the payment for certain services was held not to be in the nature of ‘Fees for technical services’ as the payments were not in consideration for the development and transfer of technical plan and technical design under Article 12(5) of the India-Netherlands DTAA.

Royalties:

In the following case, the payment was held to be in the nature of royalty:

    a) Leonhardt Andra Und Partner, GmbH v. CIT, (2001) 249 ITR 418

In this case, payment was made to the German company in connection with design of the bridge to be built. In absence of definition of the term royalty under the old India-Germany DTAA, the court held it to be royalty u/s.9(1)(vi) of the Act.

    b) DCIT v. All Russia Scientific Research Institute of Cable Industry, Moscow (2006) 98 ITD 69 (Mum.) [BCAJ, January 2011, Page 44, Sr. No. 8]

    c) DCIT v. Majestic Auto Ltd., (1994) 51 ITD 313 (Chd.) (BCAJ, February 2011, Page 49-50, Sr. No. 10)

    d) International Tire Engineering Resources LLC (2009) 185 Taxmann 209 (AAR) (BCAJ, March 2011, Page 69-71, Sr. No. 10)

In this case, part of the payment i.e., payment relating to non-exclusive right to use the know-how, was held to be in the nature of royalty.

India-USA DTAA — Memorandum of Understanding (MoU):

In the context of technical plan, Example 5 of the MoU is relevant and the same reads as under:

“Example (5):

Facts:

An Indian firm owns inventory control software for use in its chain of retail outlets throughout India. It expands its sales operation by employing a team of travelling salesmen to travel around the countryside selling the company’s wares. The company wants to modify its software to permit the salesmen to assess the company’s central computers for information on what products are available in inventory and when they can be delivered. The Indian firm hires a U.S. computer programming firm to modify its software for this purpose. Are the fees which the Indian firm pays treated as fees for included services?

Analysis:

The fees are for included services. The U.S. company clearly, performs a technical service for the Indian company, and it transfers to the Indian company the technical plan (i.e., the computer program) which it has developed.” (Emphasis supplied)

It is a moot point whether ‘modification of a computer software’ results in transfer of technical plan, in all circumstances. This Example 5 of the MoU relating to article 12 of the India-USA DTAA, has not been subject matter of judicial scrutiny as yet.

The above example seems to support the ratio of the decision of the ITAT in the case of SNC-Lavalin International Inc. v. DDIT, IT, Delhi (2008) 26 SOT 155 (Delhi), wherein it was held that the words ‘make available’ go with technical know-how, experience, skill, know-how or process, etc. but do not go with the phrase ‘development and transfer of a technical plan or a technical design’.

Conclusion:
In view of the broad propositions emerging from the above discussion of various judicial pronouncements and statutory provisions, the reader would be well advised to minutely study and analyse the relevant contracts/agreements and all the relevant facts of the matter on hand and apply appropriate legal propositions discussed in the article. The law on the subject is still developing and has not attained finality on various aspects. The readers are advised to keep themselves updated with various developments on the topic.