Use of patents in CDMA handsets sold in India, held taxable u/s9(1)(vi)(c).

Facts in Brief:

1.  The assessee, an American company, was engaged in the business of design, development, manufacture and marketing of digital wireless communication products and services, based on CDMA technology.

2.  It developed and supplied CDMA based integrated circuits and systems software for wireless, voice and data communication, multimedia functions and global positioning system products and granted licence to Original Equipment Manufacturers (OEMs) to manufacture the wireless products, for the right to use its intellectual property folio, including certain patent rights essential to and useful in the manufacture and sale of wireless products.

3.  As per the business model adopted by the assessee, 'licensees typically paid a non-refundable licence fee in one or more instalments and ongoing royalties based on the sale of products incorporating or using the licensed property'.

4.  It claimed that royalty received by it, from manufacturers of OEMs who were doing business in India in the sense they were selling their products in India, should not be brought to tax in India as both the contracting entities were situated outside India; the obligations arising out of the licencing agreements were outside India; the OEMs using the patents were outside India; the OEMs' usage of patent was outside India; and the royalty received under the licencing agreement had already suffered tax outside India.

5.  The Assessing Officer, however, held that royalties arising to the assessee from the sale of infrastructure equipment and handsets by the OEMs to Indian customers was taxable in India as per section 9(1)(vi) and article 12(7)(b) of the India-US Tax Treaty.

6.  The assessee raised objections before the Dispute Resolution Panel but without any success.

  On appeal, ITAT held as under:

7.  It is necessary to examine whether the use of patents, for which the impugned payments have been made by the OEMs to the assessee, was in manufacturing process of the handsets or in the use of the patented technology embedded in the CDMA handsets. However, as this aspect of the matter, no matter how fundamental it is, is a highly technical aspect which may also need benefit of expert advice, it is fit and proper to remit it to the file of the Assessing Officer for recording necessary factual findings after obtaining technical reports on the same and collecting such details, as may be necessary, and after giving due opportunity of hearing to the assessee and confronting the assessee with all such material as he may use against the assessee, by way of a speaking order.

  RELEVANT PARAS OF JUDGMENT ARE AS UNDER:

8.  When a non-resident earns royalty income from licensing manufacture of a product which is used by subscribers to India mobile service operators, earnings from such a royalty income are hit by the deeming fiction of 'income deemed to accrue or arise in India' under section 9(1)(vi). 

9.  CDMA is an acronym for 'Code Division Mutiple Access' - an access method for fully digital wireless data transimission system. It is only an access method and, unlike its competitor GSM, which is a standard developed to describe protocols for digital cellular networks used by mobile phones, it is not a complete protocol or platform for mobile communications. In 1995, IS-95i.e. CDMA one, the first operating system to use CDMA, was invented and produced by assessee. 

10.  While the expression 'CDMA technology', in everyday use as indeed in most of the discussions in the present context, refers to 'operating systems using CDMA technology', which are invented and produced by assessee, the precise technical meaning of CDMA technology is restricted to an 'access method for wireless data transmission system'. It is very important to bear in mind this distinction between colloquial use of the expression 'CDMA technology' and its technical meaning.

11.  It is also important to bear in mind that unless a CDMA handset, whether manufactured in India or abroad, is whitelisted by a network, it cannot be used by a subscriber on that network. In other words, the use of a CDMA phone instrument, whether locked or unlocked, by a subscriber is dependent on the network's permission to do so. That means a consumer can only use or switch phones with his carrier's permission, and a carrier doesn't have to accept any particular phone onto its network. It could, but typically, many carriers choose not to. Of course, in the case of an instrument which is locked for use on a service provider, no further whitelisting is usually needed inasmuch as practically the locking process itself takes care of the whitelisting as well. 

12.  The Andhra Pradesh High Court's, in the case of Syed Asifuddin v. State of Andhra Pradesh[2005] Crl. LJ 4314, held that all CDMA handsets, at that point of time, 'had special codes dedicated to them and these are intended to identify the phone, the phone's owner and the service provider'. The SID (i.e., System Identification Code), is a unique 5-digit number that is assigned to each service provider and the ESN (Electronic Serial Number) is a unique 32-bit number programmed into the phone when it is manufactured by the instrument manufacturer, and it is on the basis of the ESN that the handset is recognized. When the CDMA phone is switched on, it listens for a SID on the control channel and when phone cannot find any control channels to listen to, the cell phone displays 'no service' message as it is out of range. 'When cell phone receives SID', as noted by the Court, 'it compares it to the SID programmed into the phone and if these code numbers match, cell knows that it is communicating with its home system'. 

13.  As appreciated by the Court, when SID programmed into the handset does not match with SID of a service provider, the handset cannot work. The Court further noted that, 'Alongwith the SID, the phone also transmits registration request and MTSO which keeps track of the phone's location in a database, knows which cell phone you are using and gives a ring'. 

14.  It would, therefore, appear that, in the understanding of AP High Court, the CDMA handsets were service provider specific. 

15.  Once a higher tier of the judiciary, i.e., Andhra Pradesh High Court, expresses the views so set out above - particularly to the effect that the CDMA handsets, by the virtue of SID control mechanism inbuilt therein - as at the relevant point of time, were service provider specific, it cannot ordinarily be open to a lower tier of the judicial system, i.e. this Tribunal, to conclude that the CDMA handsets supplied by the OEMs, at the relevant point of time and before the advent of OMH, could not have been service provider specific and all these handsets could be used on networks of any of the service provider at the sweet will of the end user. There has to be some material to demonstrate that the findings of the Andhra Pradesh High Court were not valid in the present context, to demonstrate that the technical parameters were different in the present context or that the understanding of the Court is at variance with the actual facts of the instant case. There is no material to come to such conclusions. 

16.  In any case, as a corollary to the working of handsets as explained above as well, unless ESN of a CDMA handset was registered with a service provider as belonging to a particular subscriber, and approved by the service provider as such, such a CDMA handset could not have been used by any subscriber. 

17.  All these aspects, as are the subject matter of these varying perceptions, are purely factual, but highly technical aspects and one must have the benefit of unbiased opinion of technical experts, much more than smooth generalizations from the legal luminaries, to come to a definite conclusion. There cannot be a room for tentative conclusion, based on hypothetical presumptions, on a fundamental aspect which has been so strenuously argued by the parties and which goes to the root of the matter.

18.  In view of all these factors, it would be fit and proper to remit the matter to the file of the Assessing Officer for recording categorical findings in this regard by obtaining expert technical opinion, by recording witnesses, if necessary, of experts and after confronting the assessee with whatever material he brings on record in this respect. It is only after such an exercise has been carried out that a call can be taken on whether the stand of the assessee, on this purely factual but highly technical aspect, can be accepted. 

19.  The question that really arises, therefore, is whether the royalty paid by the assessee with respect to commercial use of the handsets which are sold by the assessee will be taxable in the tax jurisdiction in which the handsets are manufactured, i.e. the situs of manufacture of handsets, or in the tax jurisdiction where the handsets are used, i.e., the situs of use of handsets. 

20.  The taxation of royalties for use of a technology, on the first principles, is the situs where the technology is used. Accordingly, when the royalty is for use of a technology in manufacturing, it is to be taxed at the situs of manufacturing the product, and, when the royalty is for use of technology in functioning of the product so manufactured, it is to be taxed at the situs of use. 

21.  Section 9, which is an unambiguous extension of source rule, deals with the 'incomes' which are deemed to accrue or arise in India'. Clearly, therefore, an income, in order to be taxed in India under section 9, need not accrue or arise in India.

22.  Post 1976 Amendment, the scope of deeming fiction under section 9 extended to royalties not only paid by an Indian resident, unless such a payment extended to a business carried out or to any source outside India, but also to royalties paid by the non-residents as long as it was relatable to a business carried on in India or to any source in India. The clear emphasis on taxation on the basis of usage in business rather than on the basis of residence of the payer, so far as taxation of royalties is concerned, was, thus, clearly discernible from the post amendment legal position in section 9(1)(vi). 

23.  A plain look at the definition of royalty, in conjunction with section 9(1)(vi)(c), makes it clear that the taxation of royalties is in the source jurisdiction in which related business is being carried on by a person, rather than the jurisdiction in which he is tax resident, and it extends to,inter alia, 'the use of any patent, invention, model, design, secret formula or process or trade-mark or similar property'. Where does an assessee use a patent in business is, therefore, the decisive factor in determining taxability of royalties, rather than where is the assessee located.

24.  It is important to bear in mind the fact that taxation of royalties is not a taxation of business profits of any entity, but, quite contrary thereto, it is taxation of the consideration of a patent or knowhow, etc., which belongs to the person who owns the patents. It is, thus, taxation of income of the person owning the patents and it is taxation in the jurisdiction of end use of patents. The emphasis is on the situs of use of the patent rather than situs of the entity making payment for the royalty. A fortiorari, if the use of patent is used in the manufacturing process, for example, the taxation should be in the tax jurisdiction in which manufacturing activity is carried on rather in the tax jurisdiction in which ultimate consumer of product is located. However, if the patent is used by the end consumer and the manufacturer of a product is only a conduit for collection of such a consideration for use by the end consumer, the taxation would be warranted in the end use jurisdiction. 

25.  In the instant case, the patents are licenced by the assessee to the OEM and the OEM carries out manufacturing activity of the CDMA handsets outside India. 

26.  No doubt, manufacturing is an important part of business but the business per se is little more than manufacturing even when an income is partly carried out in India but the royalties are payable in respect of such part of the business as is carried on in India, it would be taxable in India.

27.  One of the important factors, which will have bearing on the determination of the question as to whether or not the OEMs carried on business in India for attracting taxability under section 9(1)(vii)(c) is whether the CDMA handsets made by the OEMs were India specific and whether the assessee, as a part of its business, was carrying on any operations in India. When an OEM is making an India specific product and when that assessee is carrying out a part of his business activities in India, it cannot be said that the assessee is not carrying on business, even if not manufacturing, in India. In such a situation, the assessee may not be wholly carrying out his business in India but carrying on business wholly in India or exclusively in India is not even asine qua non for attracting taxability under section 9(1)(vii)(c). On the aspect of the matter as to whether these products were India specific, the matter stands restored to the file of the Assessing Officer for fresh examination. 

28.  In the contemporary global scenario, the place of business of an entity is not merely the place of manufacturing the products. Even a place where the entity has a permanent establishment is also a place where the assessee is carrying on its business inasmuch as the very definition of the permanent establishment, under the basic PE rule, is a 'fixed place of business through which the business of enterprise is wholly or partly carried on'. When an entity accepts the taxability by the virtue of having a PE, normally it cannot be said that the assessee is not carrying out business in that tax jurisdiction. 

29.  Clearly, therefore, even existence of a PE amounts to virtual projection of a business in the tax jurisdiction in which the PE is situated. When a business entity has a virtual projection in another tax jurisdiction, it would, essentially imply that such an entity is carrying on business in the jurisdiction in which such a PE is situated. 

30.  However, in all fairness, as the issue regarding existence of the permanent establishments, in India, of the OEMs has been taken up for the first time before the Tribunal, this apsect of the matter needs to be examined in detail, after giving assessee a reasonable opportunity of hearing and after confronting the assessee with all the material that the revenue authorities may gather in support of their claim, at the assessment stage. On this aspect of the matter also, the matter deserves to be remitted to the file of the Assessing Officer. 

31.  zIt is a case in which even such basic information as the price and number of CDMA handsets sold by these OEMs in India, in respect of which the assessee had received the royalty, was not furnished by the assessee and the assessee had, instead of parting with precise information about the quantity and price of handsets sold in India, requested the Assessing Officer to 'adopt the information available on your records and apply the rate of royalty as determined in the assessment order for the assessment year 2006-07 for computing the royalty income on handsets for assessment year 2007-08'. The assessee has been behaving in a somewhat evasive manner all along. In these circumstances, the ends of justice require that this matter is restored to the file of the Assessing Officer for ascertaining correctness of foundational facts furnished by the assessee to the effect that the OEMs were not carrying on any business in India, which,prima facie, seems to be highly doubtful even if not conclusively incorrect. When an OEM has a PE in India, it could not be open to him to say that he was not carrying on any business in India. Of course, this is still to be examined whether the royalties paid were used 'for the purposes of' the business which was carried on in India. 

32.  As the matter is remanded back to the Assessing Officer for fresh examination on this fundamental aspect of the OEMs carrying on business in India, all those issues on the scope of the first limb of section 9(1)(vi)(c) will be rendered infructuous in case it is held that the assessee was, by the virtue of having a PE, carrying on business in India. 

33.  Unlike in the case of fees for technical services, which is an active work, the royalty is paid for use of a patent which does not require much of an active association by the person receiving royalty. While fees for technical services is a consideration for the work done, royalty is a consideration for use of an asset-tangible or intangible. Viewed thus, even going by the interpretation given by the co-ordinate bench in the case of Metro & Metro v. Addl. CIT [2014] 147 ITD 207/[2013] 39 taxmann.com 26 (Agr - Trib.), the royalty is a consideration for use of an intangible asset and is covered by the second limb of exception clause set out in section 9(1)(vi)(b). 

34.  In view of the above the royalty paid by the OEMs to the assessee, if it is held to be in respect of use of patents in CDMA handsets sold in India, will be taxable under second limb of section 9(1)(vi)(c) but then one has to examine whether or not, as a matter of fact, the royalty paid by the OEMs to the assessee, was for use in the manufacturing process or for use of patents in the CDMA handsets by the end consumer. 

35.  The expression 'for the purpose of making or earning any income from any source in India' not only involves active earnings such as a business in India but also a passive earning by exploiting an asset in India. It is, however, important to bear in mind the fact that an asset or a property, so exploited to make or earn an income in India, need not only be a physical or tangible asset or property. There is no reason to exclude exploitation of an intangible assets or intangible property from such a usage of asset leading to taxation in the source country. 

36.  It is, thus, clear that in order to attract taxability under second limb of section 9(1)(vi)(c) the asset or property, exploitation of which leads to 'making or earning of any income from any source in India', is not only a physical asset or software but also an intangible asset such as 'technology related intangible assets, such as, process patents, patent applications, technical documentation such as laboratory notebooks, technical know-how'. 

37.  The connotations of the expression 'intellectual property' cover much more ground that 'software' simplicitor and essentially include use of any patent or patented technology which is embedded in a CDMA handset. 

38.  Software is an intellectual property, but that cannot be the only intellectual property embedded in a CDMA handset. The patented CDMA handset technology is clearly one such intellectual property. 

39.  On this subject, it is useful to take note of a recent press report, that the Delhi High Court has asked homegrown handset maker Micromax to pay a royalty that amounts up to 1 per cent of the selling price of its devices to Ericsson for using the Swedish equipment maker's patents on technologies that are essential to manufacture the products. 

40.  Undoubtedly, there cannot be any adjudication on the basis of a press report, nor does this report, in any way, demonstrate that in the case of this assessee also the royalty was for use of patents or patented products, and not for use of patents in the manufacturing process. However, what this development does show that the payment of royalty on the basis of use of patented product in a jurisdiction is one of the, even if not universally applicable, criterion. The claim of the revenue, to the effect the payment was for use of intellectual properties embedded in the handsets even though the royalty is collected from the OEM cannot, thus, be simply brushed aside as beyond the realm of possibilities. 

41.  No doubt, the application of second limb of section 9(1)(vii)(c) was not examined in sufficient detail by the Assessing Officer but then as long as the subject matter of assessment remains the same as was dealt with by the Assessing Officer, the Tribunal is duty bound to deal with all the related legal aspects of the matter. The proceedings before the Tribunal are not adversarial proceedings. While the subject matter of dispute before the Tribunal may not be enlarged, and, to that extent, the case of the revenue authorities cannot be improved, there is no bar on examining all the related factual and legal aspects of the subject matter of issue before the Tribunal. The subject matter of dispute is taxability of royalty paid by the OEM to assessee in respect of CDMA handsets sold in India. Whether this income is taxable under first limb of section 9(10(vi)(c) or in second limb of section 9(1)(vi)(c), does not make much of a material difference so far as scope of proceedings in instant case is concerned. 

42.  Since the Assessing Officer had brought the impugned royalties to tax under the first limb of section 9(1)(vii)(c), there was no occasion to hold that the income in question could also be brought to tax under second limb of section 9(1)(vii)(c) but that does not denude this Tribunal of the powers, as also corresponding duty, to examine that aspect of the matter or have that aspect of the matter is examined.