Royalty taxation under a treaty: grossed-up tax borne by payer is included, but unpaid royalty cannot be taxed on accrual alone.

Royalty under the DTAA was analysed on a receipt-based footing. For grossing-up, the Tribunal held that "gross amounts" of royalties include the tax borne by the payer on behalf of the recipient, so the treaty rate applies to the grossed-up amount rather than only the net sum received. For unpaid royalty, the Tribunal held that income could not be taxed merely on accrual or book entry basis where the treaty taxed royalties when paid; the accounting method could not override that payment-based treaty rule. The result was that grossing-up was accepted, but royalty not actually paid for the relevant period was not taxable.

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Issues: (i) Whether royalty income was taxable on the gross amount including tax borne by the payer, or only on the net amount received by the assessee under the treaty and the Act; (ii) Whether royalty for the period during which the agreement had ceased and no payment was made was taxable on accrual basis.

Issue (i): Whether royalty income was taxable on the gross amount including tax borne by the payer, or only on the net amount received by the assessee under the treaty and the Act.

Analysis: Article 12 of the DTAA prescribed taxation on the 'gross amounts' of royalties. The expression was not defined in the treaty, so guidance was taken from the Income-tax Act, particularly section 198, which treats sums deducted at source as income received for computing income. On that basis, the gross amount of royalty was held to include the amount paid and the tax borne by the payer on behalf of the assessee. The view that the tax component could be excluded while applying the treaty rate was rejected.

Conclusion: The royalty was taxable on the gross amount, and not merely on the net amount received; the revenue succeeded on this issue.

Issue (ii): Whether royalty for the period during which the agreement had ceased and no payment was made was taxable on accrual basis.

Analysis: The treaty language taxed royalties that were 'paid' to the resident of the other contracting state, and the Tribunal applied the same receipt-based approach to royalty income. Since the amount for the relevant period had been provided in the payer's books but had not actually been paid to the assessee, it could not be brought to tax merely on accrual or book entry basis. The system of accounting was held not to override the treaty's payment-based taxation of royalty.

Conclusion: The unpaid royalty for the period when the agreement was not in force was not taxable; the assessee succeeded on this issue.

Final Conclusion: The royalty issue was decided partly in favour of the revenue and partly in favour of the assessee, while the interest issue was left to be examined by the assessing authority. The assessee's appeal was allowed and the revenue's appeals were allowed for statistical purposes.

Ratio Decidendi: Where the treaty taxes royalty on the 'gross amounts' paid to a non-resident and the term is undefined, the gross amount includes tax borne by the payer and the treaty operates on receipt basis, so unpaid royalty cannot be taxed on mere accrual.

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