Commissioner Of Income-Tax, Tamil Nadu-Iii v. Madras Rubber Factory Ltd.

The Judgment of the Court was delivered by

Balasubrahmanyan, J.:— These tax cases are concerned with a point arising out of a technical collaboration agreement between the assessee, an Indian company, and an American company called “Mansfield Rubber and Tyre Company Inc.” The agreement dealt with two distinct matters: (i) the planning and setting up of a tyre factory in Madras, for the assessee-company; and (ii) a continuous supply of information and technical consultancy services for a period of years for running the assessee's factory after its installation. On both, the assessee sought the collaboration of Mansfield. On both, Mansfield gave the requisite collaboration. The consideration payable by the assessee to Mansfield was set out in the agreement. But it was distinct and separate for each aspect of collaboration. For supply of blue print for setting up the factory, there was a separate consideration. The assessee had to pay the American collaborator in this regard a lump sum consideration of 100,000 dollars. For supply of plant and machinery of foreign make for the factory to be set up in India, there was another distinct provision. The Indian company was to allot to Mansfield fully paid equity shares of the value of 500,000 dollars instead of cash payment.

2. There is no dispute that these two payments, namely, 100,000 dollars paid for import of the factory equipment, and 500,000 dollars worth of equity shares allotted to Mansfield in consideration for supply of blue print and factory installation, were in the nature of capital expenditure in the hands of the assessee-company. The assessee accordingly did not claim any deduction for this capital outlay either in drawing up its profit and loss accounts or in formulating its income-tax returns. The other part of the consideration payable by the assessee to Mansfield related to payment for consultancy services supplied by Mansfield from time to time for running the factory and for maintaining production. The collaboration agreement laid down that this part of the consideration was to be paid for by the assessee to Mansfield at the rate of so much on the gross value of the products turned out from the factory after commencement of production. The ITO took the view that by and large the payment made by the assessee for consultancy services supplied by the foreign collaborator for running the factory would be on revenue account. Nevertheless the officer thought that there must be some capital element even in this consideration paid to the foreign firm for technical advice on the day-to-day running of the factory: The officer, however, had no means of precisely identifying the capital element in this payment. He accordingly resorted to a rough and ready estimate, and disallowed 25 per cent, of the fees paid by the assessee as relating to capital element, and allowed the balance of 75 per cent, alone as a revenue outgoing.

3. The AAC, as well as the Appellate Tribunal, differed from the ITO. They held that there was no warrant for the disallowance of any portion of the royalty fees paid by the assessee to Mansfield in consideration of their supply of technical information and consultancy services for running the factory.

4. In this reference, the Tribunal's decision is challenged by the Department on the following question of law:

“Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the entire payment of royalties made by the assessee-company to its collaborator, M/s. Mansfield Tyre and Rubber Company, U.S.A, was revenue expenditure and, therefore, liable to be allowed as a deduction from the income of the assessee?”

5. The question impliedly reiterates the Department's stand that 25 per cent, of the fees paid by the assessee to Mansfield has to be disallowed as partaking of the nature of capital expenditure, having regard to the nature, object and effect of the payment.

6. Collaboration agreements and know-how payments are the economic consequences of the peace. When they first emerged after World War II, the tendency of people around was to regard them with peculiar respect, if not veneration. Even tax courts, in the beginning, approached collaboration and know-how as out of the ordinary. The novelty of the jargon has since worn off. So too the inhibitions on our understanding. We are now capable of deciding, with confidence and ease, questions of the kind which were once thought difficult to answer, such, for instance, as to whether a given know-how payment is capital or revenue. We are assisted in this task by the fact that collaboration agreements are invariably reduced to writing, often set down in rigid legal prose, leaving very little to be inferred from outside. Whenever, therefore, a question is raised about the nature of the commitment of one or the other of the parties to a collaboration agreement, we have only to go into the relevant clauses to be able to arrive at a satisfactory solution. A different approach is not indicated merely because the questions which call for our answers relate to taxation. They too depend, first and foremost, on the terms of the documents. Once their meaning is grasped, the rest is merely the application of the usual tests we employ to every other commercial contract. The tools of our understanding are the same; the materials are the same; customer alone is different, namely, the Revenue.

7. In this case too, the arguments from the bar were addressed, understandably enough on the terms of the collaboration agreement between Mansfield and the assessee-company. Two clauses in particular figure much in the discussion. Clause 1(g) of the agreement lays down that Mansfield had undertaken to do, once the assessee's factory was set up and got going. Clause 2(f) deals with the consideration payable to Mansfield on this aspect of collaboration. Both clauses, it seems to us, are singularly free from ambiguity of any kind. Under the former provision, Mansfield was to maintain at the assessee's plant a full-time engineer qualified as a production and quality control expert. This resident engineer was to keep the assessee informed of the specifications, chemical formulae and other technical developments at Mansfield's plant at Ohio in America and also make the relevant information available to the asses-see's technical personnel. The resident engineer was also to be available for advice to the assessee's technicians, on all working days excepting days when he was on leave of absence. The general aim expressly avowed in this clause was that development and improvements in Mansfield's Ohio plant must be “simultaneously made available” to the assessee-company.

8. In consideration of the services undertaken by Mansfield under cl. 1(g) to be performed directly as well as through their resident engineer, Mansfield was to get a remuneration called “fees”. Clause 2(f) lays down that fees have got to be calculated on the gross sale price of the products turned out by the assessee's factory. This calculation varied from product to product. Tyres and tubes were classified under one head, miscellaneous products other than tyres and tubes were grouped under another head. The fees payable to Mansfield were calculated at a flat rate of 2 per cent, on the gross sale value of the miscellaneous products. For tyres and tubes, however, graduated rates were fixed. For instance, a rate of 2½ per cent, was to be calculated on the value of the first 120,000 tyres produced; for production in excess of 120,000 tyres but up to 180,000 the rate was 2 per cent, and so on.

9. On a plain reading of these two provisions in the agreement it is clear to us that no part of the fees payable by the assessee to Mansfield can partake of the character of capital payment. The whole of the fees was avowedly intended by the parties as a consideration for technical consultancy services which are requisite for keeping the factory going. The agreement itself, as we pointed out before, keeps the two aspects of Mansfield's collaboration meticulously distinct and separate: One connected with the initial setting up of the factory and the other connected with the running of the factory. The object and end-result of the former expenditure is the emergence of the tyre factory, which represents the assessee's fixed capital equipment. The object and end-result of the fees paid by the assessee to Mansfield after the installation of the factory is to run it as an industrial unit, produce trading stock, and turn it into profit. There can be no doubt whatever that even as the former represents capital expenditure, the latter represents revenue outgoings. It is not suggested that payment by the assessee to its own workmen and staff, payment of purchase price of raw material, the incurring of overheads are not wholly and exclusively expenditure of a revenue character. It is not suggested that these outgoings, although they form part of the assessee's operational expenses, must yet be regarded as expenditure of a mixed or composite character, capital as to a portion, and revenue as to the rest. We do not see how any different principle can be enunciated for considering the nature of the fees payable to the foreign collaborator when it constitutes, all the while, only another component of the factory's running expenses. As we earlier observed, payments under a foreign collaboration agreement are not something special, but are to be viewed in just the same way as payments under any other ordinary commercial contract. We are satisfied that the terms of the agreement in this case, whether express or implied, do not afford any scope for disallowing any portion of the consultancy fees payable to Mansfield for the duration of the contract period as capital expenditure.

10. Mr. Jayaraman, learned counsel for the Revenue, directed his argument to one aspect of the agreement which he considered significant. He stressed, not what the agreement expressed, but what it left unexpressed. There, was no provision in the agreement, he said, which obliged the assessee to return to Mansfield all the formulae, specifications, and other technical information it had received from the Ohio plant during the subsistence of the contract. Learned counsel pointed out that whereas the assessee was not under any obligation to pay Mansfield any royalty or consultancy fee after the end of the contract period, there was nothing to prevent the assessee from putting to use, till the end of time, all the technical know-how it had learnt from the literature sent by Mansfield from America during the term of the contract. Herein lies, according to Mr. Jayaraman, the element of enduring benefit to the assessee, and, with it, the element of capital expenditure in the fees and royalties payable by the assessee to Mansfield under the agreement.

11. We must reject the argument of Mr. Jayaraman as unsound. It is based on the supposition that any expenditure or outlay by a taxpayer which results in enduring benefit to his trade must, without more, be regarded as capital in character. The truth, however, is that enduring benefit is not the acid test of capital expenditure in all cases. Even its celebrated author, Viscount Cave, while laying down this test in Atherton v. British Insulated and Helsby Cables Ltd., [1925] 10 TC 155 (HL), did not mean to propound a doctrine in unqualified terms. In the recent Empire Jute Co.'s case, [1980] 124 ITR 1, our Supreme Court has had occasion to clarify this position. They explained Viscount Cave's dictum this way enduring benefit or advantage might enure to an assessee's business either in a capital field of its activity or in a non-capital field; in every case, therefore, the inquiry must be directed as much to the character of the expenditure as to the nature of the advantage derived therefrom.

12. The Supreme Court's enunciation of the test of enduring benefit is particularly apposite in the present case. It may be conceded that what Mansfield or its resident engineer in India were imparting to the assessee on operational matters might tend to outlast, and endure beyond, the contract period. This, however, is a common characteristic of all knowledge which a person acquires. There is a saying in Tamil that know-ledge once acquired is everlasting, and it cannot be destroyed either by flood or by fire, nor can it be obliterated or even diminished by being imparted to others. Technical or commercial knowledge acquired by a trader or industrialist is of this kind, enduring, if not everlasting. Expenditure to acquire it cannot be disallowed merely because knowledge dies hard. It is only where the expenditure bears on the fixed capital or other capital structure of the assessee that it can be regarded as capital in nature. Where the expenditure, although enduring in character has its impact on the running of the business, there can be no doubt that it is out and out revenue expenditure. If the position were otherwise, practically any item of revenue outgoing in the day-to-day running of a business can be broken up and dissected in an effort to discover in it some fractional element or other of a capital nature, merely on the score that the resulting benefit or advantage tends to pay in the business. This, however, is not the law.

13. In our view, there is no principle or authority to support the partial disallowance which the ITO made in this case out of the total amount of fees and royalties paid by the assessee to Mansfield. It cannot be said that the object of this payment or even its end-result had enlarged the assessee's fixed capital equipment or the capital structure. The assessee is no doubt in a position to keep for itself all that it had learnt from Mansfield during the contract period. But this only serves the assessee to run its business as efficiently after the contract period as it did during that period. We do not, therefore, accept the thesis that any part of the fees can be regarded as having any capital element deserving of disallowance under the I.T Act.

14. In support of his construction of the agreement in this case, Mr. Jayaraman particularly relied on two reported decisions, CIT v. Ciba of India Ltd., [1968] 69 ITR 692 rendered by the Supreme Court, and the Fenner Woodroffe case, [1976] 102 ITR 665, rendered by this court. Both were cases dealing with foreign collaboration agreements in which the tax treatment of royalty paid for acquiring foreign know-how was in question. In the Supreme Court case, the agreement in question contained, inter alia, an express provision requiring the assessee to return to the foreign collaborator all the formulae and specifications at the end of the contract period. In the Madras case, a clause of this kind was not to be found in the agreement in question. According to learned counsel's comparative study of these two decisions, the presence or absence of a provision for a return of the specifications at the end of the agreement made all the difference for the determination of the real nature of the expenditure in each case. In the one case, it was said, the provision was regarded by the court as decisive and on that basis the royalty paid to the foreign collaborator was dealt with as an item of revenue expenditure. In the other case, according to learned counsel, the absence of a like provision led the court to arriving at the opposite, conclusion that the expenditure was capital in nature. We do not have to consider whether and to what extent the Supreme Court was swayed by the presence of the clause in question. Nor do we have to examine the validity of the assumption that a return of the specifications to the foreign collaborator at the end of a collaboration agreement would automatically obliterate the experience gained by the assessee in working these specifications for the duration, for, our task in this case is cut out for us. What we have is an agreement in writing between two commercial concerns which cries aloud for being construed on its own terms. Earlier decisions of courts, even though rendered on agreements in this genre, can only come in our way and clutter up our decision. They are neither precedents to be followed, nor aids to construction to be adopted. The Ciba case, [1968] 69 ITR 692 (SC) and the Fenner Woodroffe case, [1976] 102 ITR 665 (Mad), whether considered separately or in juxtaposition, do not lay down any rule of construction which regards the presence or absence of a provision for return of the know-how literature to the foreign collaborator as a crucial factor in the construction of collaboration agreements. We, therefore, desist from further consideration not only of these two decisions, but of other reported cases cited before us during argument.

15. In the result, our answer to the question of law is in the affirmative and in the assessee's favour. The Department will pay the cost of this reference to the assessee. Counsel's fee Rs. 500 (one set).