Technical Know-How Fees: Supreme Court Classifies as Capital Expenditure in Honda Siel Cars Case (2017)

Introduction

Can payments made for technical know-how be considered a capital investment or a regular business expense? The Supreme Court of India recently tackled this question in a case involving Honda Siel Cars India Ltd. and the Commissioner of Income Tax, Ghaziabad. This case explores whether the fees paid for technical assistance to establish a new manufacturing plant should be classified as capital expenditure or revenue expenditure for tax purposes. The judgment was delivered by a bench of Justices A.K. Sikri and Ashok Bhushan, with Justice A.K. Sikri authoring the opinion.

Case Background

In 1995, Honda Motors Company Limited, Japan (HMCL, Japan) formed a joint venture with SEIL Ltd., an Indian company. This led to the incorporation of Honda Siel Cars India Ltd. (the assessee). Subsequently, in 1996, the assessee entered into a Technical Collaboration Agreement (TCA) with HMCL, Japan. Under this agreement, HMCL, Japan agreed to provide a license and technical assistance to the assessee, including various forms of technical know-how and information.

The assessee agreed to pay a lump sum fee of 30.5 million US dollars in five equal annual installments to HMCL, Japan. These payments were to begin from the third year after the start of commercial production. Additionally, the assessee was also obligated to pay a royalty of 4% on both internal sales and exports, subject to taxes. The core dispute arose over whether this lump sum technical fee should be classified as a revenue expenditure or a capital expenditure.

Timeline

Course of Proceedings

Initially, the assessee classified the technical fee as revenue expenditure in its return for the Assessment Year 1999-2000. The Assessing Officer initially allowed this. However, a notice was later issued under Section 148 of the Income Tax Act, arguing that the expenditure was capital in nature. Consequently, the Assessing Officer treated the payments as capital expenditure in subsequent years as well.

The assessee’s appeals to the Commissioner of Income Tax (Appeals) [CIT(A)] were dismissed. However, the Income Tax Appellate Tribunal (ITAT) allowed the appeals, classifying the expenditure as revenue expenditure. The Income Tax Department then appealed to the High Court of Allahabad, which reversed the ITAT’s order. The High Court agreed with the Assessing Officer that the payments were capital expenditure. The assessee then challenged this decision before the Supreme Court.

Legal Framework

The primary legal issue revolves around the classification of expenditure under the Income Tax Act. Specifically, the question is whether the lump sum fee paid for technical know-how is a revenue expenditure, which can be deducted from taxable income, or a capital expenditure, which is treated as an investment.

The Technical Collaboration Agreement (TCA) between HMCL, Japan and the assessee defined the terms of the technical assistance. Article 14 of the TCA specified the lump sum fee of 30.5 million US dollars, payable in five annual installments, and a 4% royalty on sales. The agreement also detailed the scope of the license, which included the provision of manufacturing facilities, intellectual property rights, know-how, and technical information.

Article 19 of the TCA specified that the agreement would be effective for a period of ten years from the date of agreement or seven years from the date of commencement of commercial production. Article 21 outlined the consequences of termination, including the discontinuation of manufacturing and the return of technical information.

Arguments

Assessee’s Arguments:

• The assessee argued that it had only acquired the right to use the technical know-how provided by HMCL, Japan, for manufacturing products during the term of the TCA.
• The ownership rights in the know-how remained with HMCL, Japan, and the assessee was not authorized to transfer the know-how to any third party.
• The assessee contended that the payment was for a limited right to use the technology and did not create any asset of enduring nature.
• The assessee relied on the Delhi High Court’s decision in CIT vs. Hero Honda Motors [(2015) 327 ITR 481(Delhi)], which held that similar payments were revenue expenditure.

Revenue’s Arguments:

• The Revenue argued that the technical know-how was used to set up a new company, which is an asset of enduring nature.
• The Revenue contended that the expenditure was for bringing a new business into existence and not merely for running an existing business.
• The Revenue relied on the High Court’s view that the technical know-how was not only for running the business but also for bringing it into existence.
• The Revenue argued that the technical know-how agreement included not only transfer of technical information but also complete assistance for establishing the plant and machinery.

The core of the dispute was whether the technical know-how fee was for a long-term asset (capital expenditure) or for the day-to-day running of the business (revenue expenditure). The assessee argued that it was merely a license to use technology, while the Revenue argued it was for setting up a new business.

Issues Framed by the Supreme Court

The Supreme Court framed the following issue for consideration:

1. Whether the technical fee of 30.5 million US dollars, payable in five equal installments, should be treated as revenue expenditure or capital expenditure.

Treatment of the Issue by the Court

Authorities

The Supreme Court considered the following authorities:

Judgment

The Supreme Court upheld the High Court’s decision, classifying the technical know-how fee as a capital expenditure. The Court reasoned that the fee was not merely for running an existing business but for establishing a new manufacturing plant. The Court emphasized that the Technical Collaboration Agreement (TCA) was crucial for setting up the plant, and the lump sum payment was for acquiring the necessary technical know-how to start the new business.

The Court analyzed the authorities as follows:

• M/s. Jonas Woodhead and Sons (India) vs. Commissioner of Income Tax, 1979 (117) ITR 55: The Court agreed with the High Court’s reliance on this case, which held that when a new plant is set up, the technical know-how fee is a capital expenditure.
• CIT vs. Hero Honda Motors [(2015) 327 ITR 481(Delhi)]: The Court distinguished this case, noting that it pertained to an existing business, unlike the present case where a new plant was being set up.
• Commissioner of Income Tax, Bombay City I v. Ciba India Limited, (1968) 69 ITR 692 (SC): The Court acknowledged the principle that a mere license to use technology is a revenue expenditure, but distinguished it by stating that the present case involved setting up a new business.
• Alembic Chemical Works Co. Ltd. v. Commissioner of Income Tax, Gujarat, (1989) 177 ITR 377: The Court reiterated the principles laid down in this case, emphasizing that the aim and object of the expenditure determine its nature.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the fact that the technical know-how was used to establish a new manufacturing plant, rather than to improve an existing one. The Court emphasized that the Technical Collaboration Agreement was integral to setting up the entire manufacturing unit. The fact that the agreement was for a limited period was considered, but the Court noted that the life of the manufacturing plant was co-extensive with the agreement.

The ratio of fact to law in this case is as follows:

The Court’s reasoning was that the technical know-how was essential for setting up the new plant and, therefore, the expenditure was capital in nature.

The court did not consider any alternative interpretations, as its reasoning was based on the specific facts of the case. The decision was reached by applying the enduring benefit test and considering the purpose of the expenditure.

The Court quoted from the judgment:

• “The very purpose of Agreement between the two companies was to set up a joint venture company with aim and objective to establish a unit for manufacture of automobiles and part thereof.”
• “Thus, a new business was set up with the technical know-how provided by HMCL, Japan and lumpsum royalty, though in five instalments, was paid therefor.”
• “Since, it is found that the Agreement in question was crucial for setting up of the plant project in question for manufacturing of the goods, the expenditure in the form of royalty paid would be in the nature of capital expenditure and not revenue expenditure.”

Key Takeaways

• Technical know-how fees for setting up a new manufacturing plant are considered capital expenditure.
• The enduring benefit test is crucial in determining whether an expenditure is capital or revenue.
• The purpose of the expenditure is a key factor in classifying it as capital or revenue.
• Agreements for setting up new businesses are treated differently from agreements for improving existing businesses.

This decision may have implications for future cases involving technical collaborations and the establishment of new manufacturing units. It clarifies that when technical know-how is integral to setting up a new business, the expenditure is likely to be treated as capital in nature.

Directions

No specific directions were given by the Supreme Court other than dismissing the appeals with cost.

Development of Law

The ratio decidendi of this case is that technical know-how fees paid for setting up a new manufacturing plant are to be classified as capital expenditure. This judgment reinforces the enduring benefit test and emphasizes the importance of considering the purpose of the expenditure.

The Supreme Court did not explicitly overrule any previous judgments. However, it distinguished the case from CIT vs. Hero Honda Motors, clarifying that the principles applicable to existing businesses do not apply to new businesses.

Conclusion

In conclusion, the Supreme Court dismissed the appeals and upheld the High Court’s decision, classifying the technical know-how fees paid by Honda Siel Cars India Ltd. as capital expenditure. The Court emphasized that the expenditure was for setting up a new manufacturing plant and not for running an existing business. This decision clarifies the distinction between capital and revenue expenditure in the context of technical collaborations and the establishment of new businesses.