Technology transfers are important in developing markets such as India, which rely on manufacturing. Transfers are usually paid by royalties or licensing fees. However, transfers are sometimes treated as contributions towards capital in technology-based joint ventures.
Permission to use or the sale of technology are subject to strict tax frameworks, both domestically and under international tax treaties. The wrong categorisation can fall foul of the Indian tax authorities as well as the tax offices in the home countries of foreign partners. Determining the difference and acting accordingly is vital.
Consideration for the right to use technology is commonly referred to as a royalty and falls under the broad definition in section 9 of the Income Tax Act, 1961 (act), of income deemed to accrue or arise in India. This includes the transfer of all or any rights to technology. International tax treaties define such consideration more restrictively as a payment for using or the right to use technology.
Permission to use technology is a non-exclusive right. The transferor retains the absolute right and discretion to discontinue manufacturing and can file a patent. The transferee must return proprietary components at the end of the agreement and has a duty of confidentiality to restrict disclosure. Complete ownership is never transferred to the transferee.
In domestic transactions, the licensee must deduct a withholding tax of 2%-10% as the case maybe before paying royalty fees to the licensor. The licensor has to pay a 22% tax on the net royalty fee. For international royalty payments both one-time and periodic payments are permitted and can be in the form of regular payments such as monthly or quarterly. The special income tax rate of 20% plus surcharges and subject-specific levies under section 115A of the act, or the income tax rate of 10% to 25%, depending on the terms of the particular tax treaty, will be levied. The rate more beneficial to the taxpayer applies.
Giving consideration for the sale of technology, it is classified as a capital transaction and is taxable as a capital gain or business profit. In a sale, the transferee has exclusive rights to the specified usage.
The transferee has the right to sub-license, is under no obligation to return the technology, and may file patents and designs in their own name. A technology transfer agreement without exclusive rights during a limited period, within a limited geographical area, with additional payments for use and giving consideration in the form of a substantial lump sum payment, can also constitute a sale of the technology. A foreign transferor can be taxed only in their home country on either a capital gain or business profit following an outright sale unless they have a permanent establishment (PE) in India.
In India, taxation on a sale is similar to that for permission to use technology. If a foreign transferor has a PE in India, tax will be levied on capital gains. This is 20% for a long-term capital gain, where the asset is held for more than 24 months. A short-term capital gain, with the asset held for less than 24 months, will attract tax of 30%.
The difference between a permission and a sale is important. Transferees must withhold tax on the amount paid in agreements granting permission to use. Mistakes or non-compliance attract interest and penalties under the act. On the other hand, transferees withholding taxes unnecessarily cause losses to themselves and overseas transferors.
Parties must understand the difference between permission to use and the sale of technology, and ensure the correct position is clearly set out in technology transfer agreements. The transferor may seek an advance ruling from the Income Tax Department (department) as to which category an agreement falls into. Where an error has been made and an incorrect withholding carried out, the transferor may apply to the department for a refund.
The transferor can also invoke the mutual agreement procedure and move the application to the competent authority under the double taxation avoidance agreement between India and their home country. Correctly classifying technology transfers is essential and must be unambiguous in the agreement. Fortunately, errors of judgment can be rectified up to six years after wrongful deductions were made.
Gautam Khurana is the managing partner and Abhishek Hans is a partner at India Law Offices.