On 17 May, a bench of Ravindra Bhat and Deepa Sharma, JJ. of the Delhi HC delivered a common judgement in appeals and petitions filed by McDonald’s India, GlaxoSmithKline Asia, Bikanerwala Foods, and Sagar Ratna Restaurants against revenue authorities. The judgement sheds some much-needed light on the taxation of IP licences (albeit in the twilight of the current tax regime’s life).
McDonald’s, Bikanerwala and Sagar Ratna were trademark owners who licensed their brands out through franchise agreements. GSK Asia licensed out trademarks dealing with the Horlicks brand to SmithKline Beecham Consumer Healthcare Ltd. for sale in India, Nepal and Bhutan.
All the licences were non-exclusive, and the petitioners received consideration valued at a percentage of the revenue earned from the sale of trademark-bearing products (burgers, food, health drinks, biscuits, etc.).
The question before the court was whether sales tax or VAT under the Delhi VAT Act 2004 had to be paid on the consideration received by the licensors in these transactions.
For those of you unfamiliar with the tax regime and its applicability to IP licences, I read all about it in this wonderfully illuminative post on a Bombay High Court judgement from August 2016. In it, the author outlines the constitutional framework, the relevance of the sales/service distinction, the deeming of some transactions (“Transfers of Rights to Use Goods”) as sales by constitutional fiat, and the awkward applicability of this whole scheme to IP transactions. If you haven’t already done so, I highly recommend that you read the earlier post (if nothing else, because I’m sure the author would be thrilled if you did).
Essentially, IP falls within the meaning of “goods”, and licences are essentially “rights to use” these goods. The question, therefore, is whether a given licence amounts to a transfer of the right to use IP. Yes, and the transaction is a deemed sale, meaning the state government can make a neat penny out of it. No, and the transaction is only a service, meaning that you only have to pay service tax to the central government.
In the specific case of food brands like McDonalds, there’s one additional aspect that merits attention: the presence of specific provisions (Ss. 65(47) and 65(48) of the Finance Act 1994) dealing with franchises.
If you skimmed through the previous post I linked, you’ll find that it concerned Monsanto and Subway Systems, both of which claimed that their respective IP licences were merely permissive, and did not constitute TRUGs. The bench relied on some dodgy precedent (Duke, which came before any SC guidance on the issue was available, and Tata, which was binding) to conjure up a new metric to assess whether a licence would constitute a TRUG: if the transaction was perfectly reversible at the option of the licensor, it would be permissive. If not, it would amount to a TRUG and therefore be VATable.
The DHC examined the McDonald’s Master Licence Agreement and found it to be a composite franchise agreement which provided trade secrets, know-how, recipes, training, etc. along with the trademark to the franchisee. Citing Commissioner v. International Travel House, the court held that any such composite contract that non-exclusively provided a bunch of services could not be VATable.
The court went one step further to exonerate Bikanerwala and Sagar Ratna on the ground that their agreements made it clear that they were providing franchise services (which are explicitly listed in the Finance Act 1994). Because cases such as International Travel House prohibit the revenue from breaking down such listed services to isolate their sale components, franchisors must enjoy a general immunity against the levy of VAT on trademark licences contained in their franchise agreements.
So far so good, but it’s around paragraph 37 that the judgement seems to lose its way. Having returned a conclusive finding in respect of franchise agreements, the court finds it fit to take things even further by arguing:
The subject matters in List I and List II of the Seventh Schedule to the Constitution are distinct and once a particular service is subject to service tax, it cannot be treated as a sale of goods and subject to VAT. Thus, the definition of “intellectual property” and levy of sales tax on transfer of right to use trade marks, patents and copyrights etc. will not apply in the case of a franchise agreement.
Essentially, the court seems to be of the view that once a sale is part of a composite contract, the goods allegedly transferred cease to be goods. This is odd, because the fact that “IP amounts to goods” for the purposes of taxation is a somewhat settled position. The Delhi HC seems to have held that wherever an IP transfer occurs as part of a declared service, such IP would no longer be goods. The contrary approach, followed by most other High Courts, is to admit that the IP in question is a good, but examine whether a transfer took place. The Delhi HC’s approach is disingenuous because it introduces a Schrodingerian element to the character of IP: it’s only a good if its transfer is a part of a declared service transaction, the court tells us.
There’s another, more practical problem with this whole business of putting carts before horses. The Finance Act contains, as it must, a certain degree of vagueness. It contains an entry, for instance, called intellectual property services – which includes temporary transfers or permissive licensing agreements. Taking the bench’s position to its logical conclusion, no IP licence that purports to be “temporary” can ever amount to a TRUG – whether or not a transfer of rights is evidenced is immaterial because there are, in the court’s eyes, no goods to be transferred!
In any case, the court seems to realise that none of these reasons (including the composite contract justification) will apply in GSK’s case, and finally cuts to the chase in paragraph 44. As in Madras and Kerala (and unlike Bombay), the court easily finds the BSNL test squarely applicable.
In response to the Bombay decision, I’d written (but never posted) this:
The legal standard adopted by the court in Monsanto is not one of temporary transfers v. permanent transfers of intellectual property – if it was, then it would be in agreement with established precedent in Kerala and Tamil Nadu. On the contrary, it is a standard of reversibility. If the transfer of the IP right is entirely reversible, it would amount to a service. In any situation where perfect reversibility was not possible or practical, the transaction would incur VAT liability. In comparison to the exclusive control standard, temporality and reversibility are both incredibly difficult to apply, for the simple reason that both of them require an adjudication outside the here and the now. Instead of the relatively easy task of inquiring into the nature of the arrangement at present (exclusive v. non-exclusive), the court must either look into past conduct of the parties within the arrangement, or (more problematically) peer into a crystal ball to determine the consequences of a hypothetical termination of the contract, as the Monsanto court has done.
It appears that the Delhi High Court has finally got it right: in applying BSNL, it holds that “[f]or a transfer of the right to use goods to be effective, such transfer of right should be one that the transferee can exercise in exclusion of others“. In addition,
“The Appellant and the Petitioners grant a non-exclusive license to the franchisees, which can be revoked upon non-compliance of the terms and conditions as stipulated in their franchise arrangement. Clearly, this does not amount to a transfer of the right to use goods.”
And just like that, like a distracted schoolboy or a meandering river, the Delhi HC picks a well-defined, easily discernible, ex ante standard to ascertain whether an IP licence amounts to a TRUG. Two decades of litigation (spanning from Duke) in various High Courts have yielded varying answers before seemingly culminating in this judgement. Too bad it’s all going to be useless in a month. Such is life.