Royalty-Free Grant of License in a Composite Settlement Agreement Treated as Amounting to Tax Avoidance
The Indian Authority of Advance Ruling (“AAR”) recently held, in the case of Upaid Systems Limited1 (“Upaid”) that a certain portion of the amount payable under a settlement agreement, entered into for settling disputes arising from imperfect assignment of intellectual property, and which in addition to other clauses, contains a specific clause for grant of a royalty-free license over the existing, pending and future patents of Upaid, is attributable to such grant of royalty and thereby taxable.
This ruling is of significance for all business and other transactions involving composite contracts with specific values being ascribed by the parties to the various items forming part of the contract.
Upaid and its predecessors, companies incorporated in the British Virgin Islands, had entered into various agreements with Satyam Computer Services Limited (“Satyam”) and its predecessor, for development of software by Satyam and assignment of title, interest, intellectual property rights and copyright thereof to Upaid.
Subsequently, Upaid, after acquiring patent holder rights over such software, initiated proceedings against third parties for patent infringement. During the course of such proceedings, it discovered that Satyam had furnished forged signatures of its employees in inventors’ assignment agreements. Having failed to get any assistance from Satyam in proving the documents as genuine, Upaid was forced to settle the proceedings on unfavourable terms.
Thereafter, Upaid initiated proceedings against Satyam for forgery and breach of contract and a settlement agreement (“Settlement Agreement”) was entered into between the parties. As per the Settlement Agreement, Satyam was to pay to Upaid USD 70 million towards damages in connection with the forged signatures and Unpaid on its part granted Satyam a perpetual worldwide, royalty-free license on all its existing, pending and future patents.
Arguments and Ruling
The proceedings before the AAR primarily centered on the question of whether the amount receivable by Upaid from Satyam under the Settlement Agreement would be taxable in India and could be withheld by Satyam.
Upaid’s primary argument was that the entire amount payable under the Settlement Agreement was in the nature of a capital receipt and not a revenue receipt and hence not taxable in India. The revenue did not controvert this contention, but instead argued that the capital receipt is in the nature of capital gains and therefore taxable in India.
The revenue, alternatively, also argued that a certain portion of the USD 70 million payable under the settlement agreement is attributable to the grant by Upaid of a license to Satyam in respect of its patents and that such portion is taxable as royalty, though the Settlement Agreement has specifically termed the grant of license to be royalty-free. To this, Upaid argued that the recital in the Settlement Agreement to the effect that the license granted is royalty free is conclusive and that the revenue cannot disregard the same.
The AAR, concurred with the alternative argument of the revenue. It held that the license granted to Satyam by Upaid is a ‘valuable right’, which, normally, in the commercial world, is not normally parted with without receiving any consideration unless special circumstances exist. In the circumstances of the case where the parties to the Settlement Agreement were severing all business relationships, the AAR held that the license was obviously something bargained for. Therefore, the USD 70 million payable under the Settlement Agreement took within its fold consideration for the grant of license by Upaid. The AAR held that such a mere recital in the Settlement Agreement was nothing but an attempt to avoid payment of tax on grant of license. In reaching such a conclusion, the AAR, placed reliance on the following observation from the Ramsay2 ruling:
“While obliging the court to accept documents or transaction as such found to be genuine, as such, it does not compel the court to look at a document or a transaction in blinkers, isolated from any context to which it properly belongs”.
On the question of apportionment of the USD 70 million and earmarking a portion of it towards royalty, the AAR left the same to be decided by the Assessing Officer as suggested by Upaid.
With respect to the remaining portion of the USD 70 million, the AAR held the same to be a capital receipt not amounting to capital gains since there was no divesture of title by Upaid over its patents.
Though a well-balanced judgment in the particular facts of the case, this ruling highlights the importance of ensuring that composite agreements involving various items clearly demarcate the amount attributable to the different items and especially, where there is a deviation from normally adopted commercial practices. Additionally, it is critical that the agreement reflects the commercial rationale / justification behind such deviation.
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