Composite offshore supply contract for design and equipment delivery: payment not split as "royalty" u/s9(1) Explanation 2; appeal dismissed

The dominant issue was whether consideration under a composite offshore supply contract could be bifurcated so as to treat a portion as "royalty" under Explanation 2 to s. 9(1) of the Income-tax Act, 1961, thereby deeming income to accrue or arise in India. The HC held that where the consideration covered integrated obligations for design and for engineering, manufacturing, shop testing, and packing up to f.o.b. port of embarkation, it was not feasible to apportion the amount towards design separately; consequently, any transfer of design, if at all, did not fall within the scope of "royalty" under the Explanation, following the principle in a DB decision of another HC. The appeal was dismissed for absence of any substantial question of law.

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Issues:
Interpretation of "royalty" under Explanation 2 of section 9(1) of the Income-tax Act, 1961.

Analysis:
The judgment of the High Court in this case revolves around the interpretation of "royalty" as per Explanation 2 appended to section 9(1) of the Income-tax Act, 1961. The primary issue raised in the appeal under section 260A of the Act was whether the transfer of design, along with other components like engineering, manufacturing, shop testing, and packing, could be considered as royalty chargeable under the said Explanation. The Commissioner of Income-tax (Appeals) and the Income-tax Appellate Tribunal had previously found that no royalty could be charged due to the agreement between the parties. However, the appellant contended that design, being one of the components transferred, could fall within the scope of Explanation 2 to section 9(1).

Upon considering the arguments, the High Court opined that it was not feasible to separate the consideration for design from the other components transferred. The Court referred to a Division Bench judgment of the Madras High Court in a similar case, where it was held that in a contract involving design, manufacture, and supply of machinery without licensing any patent or copyright, the design supplied was only incidental to the total contract. The price paid covered all stages from design to commissioning, and the design was not meant for the buyer to manufacture the machinery themselves. The High Court found that none of the sub-clauses in Explanation 2 under section 9(1)(vi) applied to the design and engineering carried out by the supplier abroad in this case. It was concluded that the design was preliminary to manufacture and integrally connected therewith, and hence, did not attract the provisions of the Act regarding royalty.

In light of the above analysis and the precedents cited, the High Court held that no substantial question of law arose for consideration in the appeal and subsequently dismissed the appeal.

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