Tax law takes care of fiscal incentives for the acquisition, use and spread of all types of knowledge, especially scientific knowledge connected with manufacturing industries. Several sections in the Income-Tax Act allow tax exemption for expenditure connected with scientific research. Quite often, what is known as capital expenditure is allowed to be deducted in full and, for this, the debatable judicial term "capital expenditure" has been brought into the statute book without corresponding definition of the same.

Lumpsum for knowhow

Section 35 AB of the Income-Tax Act, 1961 allowed deduction, spread over six years, of a lumpsum consideration paid for acquiring knowhow for the purposes of business even if later on the company's project is abandoned or if the acquired knowhow subsequently becomes useless or is returned. What would otherwise have been disallowed as capital expenditure fell for consideration under Section 35 AB for proportionate deduction for six years.

Swaraj Engines case

Swaraj Engines Ltd started business in manufacturing engines on January 1, 1989. The company obtained assistance and technical knowhow services from Kirloskar Oil Engines Ltd to maximise its production and improve product quality.

Ownership rights were not passed on in respect of such knowhow. There were restrictive clauses in the agreement dated October 19, 1989, which was to be in operation for five years and could be renewed thereafter. Payment was to be made by Swaraj Engines at 3 per cent of total sales based on production. What was stipulated in the agreement was an improvement in the operation of the existing business and its efficiency and productivity.

Swaraj Engines paid Rs 26,65,340 to Kirloskar as royalty for the acquisition of knowhow for the manufacture of diesel engines. The assessing officer (AO) took the view that the case fell under Section 35AB of the Act and would not be allowed as revenue expenditure. He allowed one-sixth of the total amount as deduction and the balance was disallowed.

Revenue expenditure

In the appeal, the company pleaded that royalty paid every year is not a lumpsum amount but represented a percentage of sales. It argued that Section 35AB was not applicable and the entire claim should be allowed under Section 28 or Section 37. The Punjab and Haryana High Court decided the matter in favour of the company and allowed the whole expenditure, treating it as revenue in nature. It observed:

"The effort of the Revenue to bring the expenditure within the domain of Section 35AB of the Act is totally misplaced since the prerequisites for application of Section 35AB of the Act is that the payment has to be a lumpsum consideration for acquiring any knowhow. This precondition is totally missing in the case in hand as the payment being made to Kirloskar Oil Engines Ltd is not lumpsum payment, for acquiring of knowhow; rather, the same was payable periodically on the basis of percentage of invoiced price depending upon the number of engines manufactured. It is not a case of outright sale of technical knowhow. So in our view it will not fall within the domain of Section 35AB of the Act."

The court was inclined to agree with the company that the technical information given by Kirloskar was non-exclusive and non-transferable (CIT vs Swaraj Engines Ltd 2006 154 Taxman 243). Section 35AB was applicable to knowhow acquired on or after April 1, 1986, but before April 1, 1998. Capital expenditure on acquisition of knowhow on or after April 1, 1998, will get the benefit of depreciation at 25 per cent on the written-down value (WDV). Such depreciation may work out to be higher than the allowance contemplated under Section 35AB.

From assessment year 1999-2000 onwards, depreciation is allowable on certain specified intangible assets such as knowhow, patients, copyrights, trademarks, licences, franchises and any other business or commercial rights which are similar in nature. Trade name, secret formula or process, invention, model design, etc., will all fall for consideration for 25 per cent depreciation under Section 32. Such intangible assets will form a block separate from that of tangible assets. Knowhow outside the ambit of definition given under Section 32 will have to be considered under Section 37 of the Act.

T. C. A. Ramanujam
(The author is a former Chief Commissioner of Income-Tax.)