Thursday 24 May 2012

AAR holds that R&D cost sharing payments are taxable as royalty

Facts
 A Systems („applicant‟) is a company based in Germany and engaged in the business of executing contracts for assembly and supervision of paint shop, including supply of materials and supervision of installation for various automobile companies.
 The applicant and its affiliates formulated a Research and Development („R&D‟) policy. Affiliates who wish to participate in the R&D have entered into a Cost Allocation Agreement („CAA „) in terms of which R&D activities will be undertaken by any or all of the parties; the applicant will be the administrator under the agreement.
 The entire cost of the research is to be shared by the parties to the agreement based on an allocation key.
 All the participants to the agreement are allowed royalty-free unlimited access to the research results, including any Intellectual Property Rights.
 All the parties to the agreement shall be the joint owners of the IPR‟s, however, the rights are registered in the name of the applicant.
Issues before the AAR
 Whether the payments made towards the CAA by the Indian affiliate to the applicant were liable to deduction of tax at source.
Observations and Ruling of the AAR
 In terms of the agreement, the contracting parties can assume the role of service provider and receiver of services. The activities of the service provider are restricted to advisory and economic support.
 The costs in relation to the R&D activities will be isolated in separate cost centres and only those costs shall be taken into account that result from the services rendered to the parties to the agreement.

The licensing revenues generated by licensing the jointly developed results will be netted off against the R&D cost and will be shared in proportion to the anticipated direct benefits.
 50% of R&D costs were to be split according to the relative business sales by business unit of a company and the balance 50% of the costs on the basis of relative operating profits.
 The parties have granted each other, as far as acceptable by law, the right to exploit any technology developed under the agreement within their respective geographic regions. The title and full ownership of the products and all components are to remain with all parties to the agreement.
 Cost allocation seems to be dependent on the rendering of services by one and the receipt of the service by the other. It is not seen to be a clear sharing of costs of R&D.
 The incurring of cost depends on the receipt of services from one of the contracting parties. There is no direct provision in the agreement that the costs are shared by all.
 The parties to the agreement individually spend on R&D and then subsequently allow the other parties to use the product of their research. The service receiver is liable only for the costs relating to the service and any exploitation of the product and earning therefrom by licensing it to others goes to reduce the cost of the R&D and benefits all the parties.
 The parties receiving services are interested in these services and hope to gain a benefit from them and to save costs which would be incurred if they performed these services themselves.
 The cost is paid for the service rendered; there is no sharing of cost irrespective of the use of the product of the research. It is difficult to accept the submission that the parties to the agreement have become joint owners of the product of the research.
 A party not using the product of a particular research done by a member does not contribute towards the costs of the research. Hence, the sharing of cost of the R&D allocation key will not have a meaning.
 It appears to be an agreement to share the product of the R&D allegedly without the payment of royalty, but paying a consideration for use which is described as the cost contribution towards research incurred by the service provider.
 The theory for reimbursement propounded by the applicant cannot be accepted. The payment occurs only when the process or scientific experience is used by a member. It is not a sharing of costs or reimbursement of a part of the expenses incurred for the research as and when it is completed. Since it is a payment for use and the payment depends solely on use, the payment will be treated as royalty.
 The payments can be understood as a consideration for the use of the process or formula developed by the member and therefore characterized as „Royalty‟ under the Income-tax Act, 1961 as well as the India-Germany tax treaty.
Conclusion
Based on the set of facts, the AAR concluded that payments for use of R&D will be treated as royalties.
Source: A Systems (AAR No. P of 2010)(21 taxmann.com 371) dated, March 22nd, 2012.

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