Royalty paid tax-free must be grossed up when another party bears the tax under the contract

Where a royalty agreement stipulates payment free of Indian tax and requires the Indian agent to bear that tax, the recipient is entitled to the stated net royalty only after grossing up. The tax discharged by the agent is treated as an additional benefit forming part of the recipient's taxable income, so the assessable amount is the gross sum needed to leave the agreed royalty intact after tax. On that construction of the contract, the royalty had to be assessed on a grossed-up basis, and the assessment including tax borne by the agent was upheld.

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Issues: Whether, on the terms of the royalty agreement, the assessee's taxable income was confined to the stipulated royalty net of tax or had to be grossed up to include the tax borne by the Indian agent.

Analysis: The agreement fixed royalty at a specified percentage of sales and further provided that payments were to be made without deductions for taxes or other charges assessed in India, such taxes to be assumed by the Indian agent. On a true construction of these clauses, the assessee was entitled to receive the stated royalty free of tax, and the tax borne by the agent was an additional benefit accruing to the assessee. Where remuneration is agreed to be paid tax-free, the assessable income is the gross amount necessary to leave the stipulated net sum in the hands of the recipient after tax is borne by another party.

Conclusion: The assessee's income had to be grossed up by the tax paid on its behalf, and the assessment made by the Tribunal was correct.

Final Conclusion: The reference was answered in favour of the Revenue, holding that the royalty was assessable on a grossed-up basis including the tax borne by the agent.

Ratio Decidendi: Where a contract stipulates payment of income free of tax and another party undertakes to bear the tax, the tax so borne forms part of the recipient's taxable income and the amount must be grossed up accordingly.

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