2012 (5) TMI 345 - AAR - Income Tax

Payments under Cost Allocation Agreement deemed royalty income under India-Germany Tax Treaty

The Authority concluded that payments made under the Cost Allocation Agreement by 'A' India to the Applicant constitute royalty income taxable in India ... Whether payments made to the applicant (a company based in Germany), in terms of the Cost Allocation Agreement, can be treated as income in the hands of the applicant and whether it is not merely a reimbursement of the expenses incurred for the Research and Development. - held that:- The theory of reimbursement propounded cannot stand. - 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 can be understood only as royalty. Royalty income liable to be taxed in India under Article 12.2 of the DTAC between India and Germany. Issues Involved:1. Whether payments made by 'A' India to the Applicant under the Cost Allocation Agreement (CAA) constitute 'Income' under Section 2(24) of the Income-tax Act, 1961.2. If affirmative, whether the amount received constitutes business income and if there is a Permanent Establishment (PE) in India under the India-Germany Tax Treaty.3. Allowability of expenses connected with the PE as a deduction.4. If not business income, whether the amount is taxable as 'Fees for Technical Services' under the Income-tax Act and the India-Germany Tax Treaty.5. If not business income or fees for technical services, whether it is taxable as 'Royalty' under the Income-tax Act and the India-Germany Tax Treaty.6. Rate and amount of tax deduction at source by 'A' India on payments made under CAA.Issue-wise Detailed Analysis:1. Income under Section 2(24) of the Income-tax Act:The applicant, a German company, questioned if payments by 'A' India under the CAA represent income. The agreement allows 'A' entities to participate in R&D activities, sharing costs based on an allocation key. The Authority concluded that the payments are not merely reimbursements but constitute income, specifically royalty, under Explanation 2 to Section 9(1)(vi) of the Act. The agreement's terms indicate that payments occur only upon using the research product, thus qualifying as royalty rather than a simple cost-sharing arrangement.2. Business Income and Permanent Establishment (PE):Given the conclusion that the payments are royalty, the Authority ruled that the income is not business income. Consequently, the question of whether there is a PE in India under the India-Germany Tax Treaty does not arise. The Authority left the question of PE open, focusing instead on the nature of the income as royalty.3. Deduction of Expenses Connected with PE:Since the income was classified as royalty and not business income, the issue of deducting expenses connected with a PE did not arise. The Authority's ruling on royalty income rendered this question moot.4. Fees for Technical Services:The Authority did not need to address whether the payment constitutes 'Fees for Technical Services' due to the ruling that the payments are royalty. The payment's nature as royalty under both the Income-tax Act and the India-Germany Tax Treaty precluded it from being classified as fees for technical services.5. Taxable as Royalty:The Authority ruled that the payments are taxable as royalty under both the Income-tax Act and the India-Germany Tax Treaty. The payments for using the research product meet the definition of royalty in Paragraph 3 of Article 12 of the DTAC and Explanation 2 to Section 9(1)(vi) of the Act. The applicant's role as an administrator or clearing center does not alter the nature of the payments as royalty.6. Tax Deduction at Source:The Authority ruled that tax should be deducted at source at the prescribed rates under the Act. The payments, classified as royalty, are subject to tax deduction as per the applicable provisions.Conclusion:The ruling pronounced on March 22, 2012, concluded that payments under the CAA are royalty income, taxable in India under the India-Germany Tax Treaty. The questions of business income, PE, and fees for technical services were rendered irrelevant by this classification. Tax deduction at source should follow prescribed rates under the Act.