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1967 (4) TMI 203 - COURT OF APPEAL

1967 (4) TMI 203 - COURT OF APPEAL - [1969] 71 ITR 661 - Dated:- 5-4-1967 - M. R. Lord Denning, Davies And L. Russell, JJ. JUDGMENT APPEAL from Cross J. [1967] 1 W. L. R. 304; [1967] 1 All E. R. 369 Imperial Chemical Industries (hereinafter called I. C. I. ) appealed to the Commissioners for the Special Purposes of the Income Tax Acts against the following assessments to income tax made under Case I of Schedule D in respect of its trade in fibres : 1958-59, ₹ 2,186,000 less ₹ 1,815,0 .....

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ns were sums falling to be included as trading receipts in computing the amount of the assessments or the loss. The relevant facts found by the commissioners were summarised in the judgment of Cross J. as follows : In 1941, Mr. Whinfield and Dr. Dickson, two research chemists employed by Calico Printers' Association Ltd. (C. P. A.), invented a method of producing terylene polymers and of so manufacturing them that they could be drawn cold to yield fibres of great strength and pliability, a h .....

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under which C. P. A., in return for royalties, granted I. C. I. for 20 years or the duration of the patents, whichever should be longer, an exclusive licence to exploit the rights of C. P. A. under its patents throughout the world, except in the United States of America, where C. P. A. had already arranged for the development of the invention by others. Clause 6 of the agreement expressly empowered I. C. I. at its discretion to grant licence rights in respect of the patents to third parties. In .....

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to supply Terylene to the textile trade and get guidance as to the forms in which it would be suitable for use by the trade. By the end of 1950, it was clear, not only to I. C. I. and C. P. A. but to the textile trade both here and abroad, that Terylene had enormous commercial possibilities. In November, 1950, I. C. I. authorised the expenditure of 8+ million pounds on the construction of a full-scale terylene plant at Wilton, and, before it was completed, it was decided in April, 1953, to doubl .....

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Even if I. C. I. had been itself prepared to face the huge capital expenditure involved in setting up sufficient terylene plants abroad to meet the foreign demand it was very doubtful whether at that time-1952 or 1953-Treasury approval would have been forthcoming. Accordingly, after prolonged consideration, I. C. I. decided to grant licences to manufacture equivalents of Terylene to five European companies who were thought by reason of their competence, financial stability and enthusiasm for th .....

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ght to draw any distinction between them on the basis of those differences and Cross J. proposed to neglect them and to set out the relevant parts of one agreement as representative of all. For this purpose, he would take that between I. C. I. and A. K. U., executed on April 14, 1956. The relevant parts of that document were as follows : ARTICLE I (A). The ' Agreement Products ' referred to in this agreement are : (i) flat singles continuous filament yarns, thrown singles continuous fila .....

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leable forms which will normally be discrete particles such as powders or granules. (B) The ' Manufacturing Licence Field ' is the processes and apparatus for the manufacture of : (i) terephthalic acid and polymethylene terephthalateforming derivatives of terephthalic acid from paraxylene, including all products which are intermediate between paraxylene and polymethylene terephthalate-forming derivatives of terephthalic acid; and (ii) the agreement products. (C) The ' User Licence Fi .....

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t in the First Schedule hereto all of which are licensed exclusively to I. C. I. (G) the ' I. C. I. patent rights ' are the patents in The Netherlands, Belgium, Austria, Brazil, Czechoslovakia, Hungary, Mexico, Poland and Spain owned by I. C. I. which : (i) are set out in the Second Schedule hereto; and (ii) have resulted or will result from any patent application in the said countries set out in the Second Schedule hereto; and (iii) result from any patent application in the said countri .....

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b-licences and licences shall be for the respective lives of the patents to which they relate and shall confer on the licensee the following rights : (i) in The Netherlands and Belgium, exclusive rights for the manufacture, use, treatment, import and sale of the products of the manufacturing and user licence fields subject, however, to the provisions of clauses 2 and 3 of this article; and (ii) in Austria, Brazil, Czechoslovakia, Hungary, Mexico, Poland and Spain, non-exclusive rights . . . . AR .....

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ny third party at the following rates. (i) On the first 10,000,000 lb. of agreement products sold, utilised or imported in any agreement year, 5+ per cent. (iii) On all agreement products sold, utilised or imported in such year in excess of 10,000,000 lb., 3 per cent . . . . ARTICLE IX Technical assistance. 1. For the purpose of enabling the licensee to design, erect, and operate a plant in The Netherlands and/or Belgium for the manufacture of agreement products I. C. I. will impart to the licen .....

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censee will be all such information which shall have come into I. C. I.'s possession before January 1, 1954, and it shall be imparted by I. C. I. supplying to the licensee copies of relevant existing drawings, technical reports and data of I. C. I. and by allowing responsible members of the licensee's technical staff access to appropriate pilot and commercial plants and laboratories of I. C. I. and giving them all facilities and advice so as to enable the licensee to put on the market th .....

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acture agreement products in The Netherlands or Belgium other than for use in the manufacture of films and further I. C. I. agrees that I. C. I. will as a condition of giving technical information in the manufacturing licence field in any agreement entered into with any third party in any other country during the said period require the licensee under any such agreement to keep such information secret and confidential (to the extent to which the licensee is required to keep the same secret and c .....

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. For the consideration mentioned below I. C. I. hereby covenants for itself and C. P. A. that during the period from February 2, 1954, until December 31, 1966, neither I. C. I. nor C. P. A. will themselves or either of them manufacture or sell nor aid any third party to manufacture or sell agreement products in The Netherlands, Belgium or Luxembourg except for use in the manufacture of films. I. C. I. hereby further covenants with the licensee that it is fully authorised and entitled on behalf .....

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equent years, provided that the said capital sum of ₹ 400,000 or any outstanding part thereof shall be payable over a shorter period or in one payment at the option of the licensee, which option may be exercised at any time on six months ' notice to I. C. I. in writing. If the licensee shall elect to exercise such option a discount will be allowed to the licensee at a rate to be agreed between the parties. Two points about the agreements merited special attention : First, the covenant .....

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e invalid. The second feature of the agreement was that the whole of the lump-sum consideration was attributed to the covenant in Article X and no part of it to the obligation of I. C. I. to impart know-how contained in Article IX. On that point, the case (paragraph 32) stated : This was not because it was agreed that such information was not of importance. I. C. I., if not the European companies, considered that it was important and of substantial value but was willing to undertake in the agree .....

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panese companies. Accordingly, on February 7, 1957, I. C. I. entered into an agreement with two Japanese companies Teikoku and Toyo. In this case, no heads of agreement were entered into beforehand. By this agreement, I. C. I. granted the two Japanese companies exclusive sub-licences of the C. P. A. master patents and exclusive licences of the I. C. I. patents in consideration of annual royalties. It undertook that it would impart to those companies certain technical information and would not, d .....

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X (which was headed "Capital payment") ran as follows : The licensees will pay to I. C. I. in sterling in London such a capital sum as after the deduction of Japanese tax will amount to one million thirty-five thousand pounds (Rs. 1,035,000). The said capital sum shall be payable in five equal instalments each of two hundred and seven thousand pounds (Rs. 207,000), the first of such instalments being due and payable within thirty days after the effective date of this agreement and the .....

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which I. C. I. supplied thereunder helped them to make a quick start and was undoubtedly of considerable value to them. While it was the intention of I. C. I. that the Japanese Article X payments should be related to the covenants contained in Article IX (9) of that agreement, it was not the case that there was any understanding between the parties to this effect. Nor did we have before us any evidence which we could regard as establishing that there was any understanding between the parties of .....

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values under these heads. I. C. I. at all times accepted that the royalty payments under the various agreements should be included in its accounts as trading receipts. It contended, however, before the commissioners that the sums expressed to be payable under the agreements with the European companies in consideration of the sale of manufacturing and selling rights (i.e., the keep-out covenants) and the sums payable under Article X of the agreement with the Japanese companies should not be treat .....

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ipts in computing I. C. I. 's trading profits. The commissioners held that the decision in Margarison v. Tyresoles Ltd. [1942] 25 Tax Cas. 59 applied to the sums payable under the covenants and that they were capital receipts. The parties having agreed the figures on the basis of the commissioners ' decision in principle, the commissioners allowed the appeal and claim, adjusting the assessments appealed against as follows : 1958-59, assessment increased to ₹ 2,350,899 (agreed capit .....

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rted by keep-out covenants, and that the part paid in the form of capital attributed to the keep-out covenants was capital for tax purposes. The Crown appealed. W. A. Bagnall Q. C. and J. Raymond Phillips for the Crown. Taking the A. K. U. agreement as defining the rights of the parties, there was an exclusive licence for a royalty, know-how for no separate sum and keep-out covenants for a lump sum. It is wrong to say that there is in this case a dichotomy between fixed and circulating capital, .....

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this transaction was the sale of an asset. Bankes L. J. put the right test in British Dyestuffs Corporation (Blackley) Ltd. v. Inland Revenue Commissioners [1924] 12 Tax Cas. 586, 596. The sum paid was consideration for obligations undertaken by I. C. I. in the exploitation in the course of its trade of his patent and licence rights. The granting of exclusive licences is not the same as an assignment by I. C. I. of all its rights. [RUSSELL L. J. The substance is that I. C. I. has done the equiva .....

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Reid Ibid. 428, and Lord Radcliffe ([1962] 1 W. L. R. 425, 430). One way of exploiting a patent is to manufacture and sell under it : another is to grant licences. The granting of sub-licences was part of the overall business of the fibres division. In Musker v. English Electric Co. Ltd. ([1964] 41 Tax Cas. 556), lump sums received for know-how were held to be income receipts : see per Lord Radcliffe (Ibid. 585). The ratio of Moriarty v. Evans Medical Supplies Ltd. ([1958] 1 W. L. R. 66; [1957] .....

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e other side of the picture was the same; the French company were the manufacturers.] The case does not preclude the court from finding for the Crown. It does not decide that such a payment must be capital, it only rejects the argument that under the circumstances of that case it must be income. Margerison v. Tyresoles Ltd. ([1942] 25 Tax Cas. 59) was in reality a case of a sole agency agreement or in the nature of a premium for an agreement to share gross receipts; it is quite different from a .....

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. In Beare v. Carter ([1940] 2 K. B. 187; 56 T. L. R. 762; 23 Tax Cas. 353; [1940] 8 I.T.R. (Supp.) 127) the problem was whether the taxpayer was carrying on the profession of an author. For the lump sums to be properly partly capital there must be the element of disposition of an asset. [RUSSELL L. J. What if I. C. I. had assigned the rights outright on similar financial provisions ?] Then the lump sums would have been capital. [Reference was made to Rustproof Metal Window Co. Ltd. v. Inland Re .....

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ed are capital. If the patents had been assigned an asset would have disappeared from the balance sheet. Looking at these operations, are the transactions just part of I. C. I.'s trade or are they the giving up of part of it ? F. Heyworth Talbot Q. C. and Neil Eiles for the taxpayers, I. C. I. There is nothing strange about the idea that the way in which a taxpayer arranges his transactions may affect his tax liabilities : see per Romer L. J. in Inland Revenue Commissioners v. Ramsay [1935] .....

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o manufacture without infringing the patents was in the nature of a capital asset. A lump sum received in sterilisation could not be other than capital. [Reference was made to Inland Revenue Commissioners v. British Salmson Aero Engines Ltd. [1938] 2 K. B. 482; [1939] 7 I.T.R. 245, and Margerison v. Tyresoles Ltd. 25 Tax Cas. 59] To discover the consideration for the lump sum it is necessary to look first at the agreement. Only if it is spurious is it proper to look behind it : see per Upjohn J. .....

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ke the example of a lease. If I. C. I. had to pay a lump sum for the right to produce in Russia that would not be a revenue payment, the present case is the correlative. The European companies were sufficiently impressed by the chance of I. C. I. competition to insist on the covenants. Commercial reality governed the apportionment of consideration. There is no doubt here but that the rights were fixed capital assets. [Reference was made to Nethersole v. Withers 64 T. L. R. 157.] Patent rights ar .....

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ndon and Thames Haven Oil Wharves Ltd. v. Attwool [1967] Ch. 772; [1967] 2 W. L. R. 743; [1968] 70 I.T.R. 460, C. A.. This case is in substance the same. [Reference was made to Glenboig Union Fireclay Co. Ltd. v. Inland Revenue Commissioners 1922 S. C. (H. L.) 112; 12 Tax Cas. 427.] LORD DENNING M. R. In the 1950s Imperial Chemical Industries Ltd. were exploiting a new fibrous material which they called Terylene. They manufactured it on a large scale at Wilton, but they could not make enough to .....

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million. The detailed facts are set out in the case stated and in the report at first instance [1967] 1 W. L. R. 304; [1967] 1 All E. R. 369, and I need only pick out the salient points. The master patents for Terylene were owned by the Calico Printers' Association, who granted I. C. I. an exclusive licence to exploit them and to grant sub-licences to others. The ancillary patents were owned by I. C. I. themselves. I. C. I. were unable themselves to exploit the world market for Terylene. So .....

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alty of ₹ 10,000 a year for 10 years. (3) I. C. I. agreed to provide know-how. No separate consideration was stated for know-how because I. C. I. expected to get their return by way of the royalties coming in sooner. (4) I. C. I. agreed to keep-out of the Netherlands, Belgium, and, in addition, Luxembourg, and not to operate there in the patented article Terylene or in products similar to Terylene for the period of the patent and a little longer. In return for this keep-out covenant, the l .....

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pted by the Crown. The question for decision is as to the ₹ 400,000 payable for the keepout covenant by annual instalments. Was it a trading receipt and taxable as part of the income of I. C. I. or was it a capital receipt which is not taxable? In considering this question, I would point out that this keepout covenant is not a covenant in gross. It does not stand by itself. It is ancillary to the grant of a licence. Its effect can best be understood by remembering the different kinds of li .....

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as well as anyone else. A keep-out covenant is a covenant which bolsters up an exclusive licence. It makes express that which would otherwise be implied. The licensor covenants expressly with the licensee that he will not enter on the domain which he has granted to the licensee. In the present case the keep-out covenants are somewhat wider than the exclusive licence in area, time and products. But this makes no difference to the tax position. The receipts by I. C. I. bear the same character-capi .....

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nvoice value of products sold or utilised (this was for use of the master patents of C. P. A.). (2) A royalty of a fixed sum payable each year (this was for use of the ancillary patents of the I. C. I.). (3) A lump sum payable by instalments over six years (this was said to be for the keep-out covenant. Now I. C. I. are not dealers in patent rights or patent licences. When they granted this exclusive licence, they were to my mind disposing of a capital asset. If this had been an assignment of pa .....

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ual payments are revenue receipts. Or he may dispose of it in part for one and in part for the other. Each case must depend on its own circumstances. But it seems to me fairly clear that if, and in so far as, a man disposes of patent rights outright (for example, by an assignment of his patent, or by the grant of an exclusive licence) and receives in return royalties calculated by reference to the actual user, the royalties are clearly revenue receipts. If, and in so far as, he disposes of them .....

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e patent rights outright for a lump sum, which is arrived at by reference to some anticipated quantum of user, it will normally be income in the hands of the recipient (see the judgment of Lord Greene M. R. in Withers v. Nethersole Sub nom. Nethersole v. Withers [1946] 1 All E. R. 711, 716; 28 Tax Cas. 501, C. A.; approved by Lord Simon [1948] 64 T. L. R. 157, 159; [1948] 1 All E. R. 400; 28 Tax Cas. 501; [1948] 16 I. T. R. (Supp.) 92, H. L. in the House of Lords). But if, and in so far as, he d .....

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indow Co. Ltd. v. Inland Revenue Commissioners [1947] 2 All E. R. 454, 459; 29 Tax Cas. 243; [1948] 16 I.T.R. (Supp.) 57, C. A., per Lord Greene M. R., who emphasised that it was a non exclusive licence there. Similarly a lump sum for know-how may be a revenue receipt. The capital asset remains with the owner. All he does is to put it to use. Applying these criteria, in the present case it is quite clear that the royalties for the master C. P. A. patents and the royalties for the ancillary I. C. .....

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l sum payable by instalments; and not as an annuity or a series of annual payments. In these circumstances I am quite satisfied that the lump sum was a capital receipt and I. C. I. are not taxable upon it. I find myself in entire agreement with the judgment of Cross J. and I would dismiss the appeal. DAVIES L. J. I agree. A clear statement of the law on this matter is to be found in a passage in Lord Greene M. R.'s judgment in the Nethersole case 28 T. C. 501, 512, to which my Lord has refer .....

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ht upon its real character, including, of course, the terms of the agreement under which the licence is granted. If the lump sum is arrived at by reference to some anticipated quantum of user it will, we think, normally be income in the hands of the recipient. If it is not, and if there is nothing else in the case which points to an income character, it must, in our opinion, be regarded as capital. This distinction is in some respects analogous to the familiar and perhaps equally fine distinctio .....

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1, 518; [1948] 16 I.T.R. (Supp.) 92. As I think, Cross J. applied the law, as one would have expected, with complete accuracy in the present case, I would refer to a passage in his judgment [1967] 1 W. L. R. 304, 312-313, where he said : The contention of the Crown before me, as before the commissioners, was that the various agreements were simply the mode in which I. C. I. chose to exploit some of its patent rights in the course of its trade and that the lump-sum payments were simply part of th .....

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ents in question contained in substance dispositions of the whole interest of I. C. I. in the patents in the various countries supported by the keep-out covenants. A transaction of that sort does not seem to me to be in the least like the imparting of know-how for reward and if the parties chose to arrange that part of the consideration received by I. C. I. should take the form of a capital payment, and be attributed to the ' keep-out ' covenants. I do not see why that part should not be .....

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s a sub-licence of the patent for the whole of the life of the patent. That seems to me to be precisely the same as the sort of transaction which the Crown conceded would result in a capital receipt and not a revenue receipt. I therefore agree that the judgment of Cross J. was correct in every respect, and I would dismiss the appeal. RUSSELL L. J. Without doubt the exclusive licences under the C. P. A. patents, and the allied but subsidiary I. C. I. patents, were fixed capital assets of I. C. I. .....

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the subject of this appeal. But the Crown contends that the outcome is the exact opposite because I. C. I. only granted sub-licences under the C. P. A. exclusive licences and licences under the I. C. I. patents, and has, therefore, not disposed of or realised its fixed capital assets. But in considering whether I. C. I. have made such a disposition, regard must be had to the reality of the situation. Taking again the Dutch and Belgian example : before the agreement with A. K. U., I. C. I., by vi .....

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I. C. I. and effectively vested in A. K. U. In exchange I. C. I. acquired a contractual obligation on the part of A. K. U. to pay a sum of ₹ 400,000, and in addition royalties related directly to the extent of user in the case of the C. P. A. patents and consisting of an annuity in the case of the I. C. I. patents. I. C. I. had deprived itself completely of all ability thereafter to turn that part of its fixed capital to account whether by direct use of the inventions or by licensing for .....

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