Direct Tax Alert

Background

Section 32(1) of the Income-tax Act, 1961 (IT Act), prescribes the mode and manner of depreciation of capital assets and categorises “assets” into tangible assets and intangible assets. Licences are identified as intangible assets and are, therefore, capital in nature. Any capital asset is depreciable in terms of Section 32 of the IT Act unless specifically dealt with elsewhere. One of the exceptions to depreciation is amortisation. Section 35ABB of the IT Act is one such section which provides the mode and manner of amortisation of expenditure incurred for obtaining licence to operate telecommunication services.

Any expenditure (not being expenditure of the nature described in sections 30 to 36¹ of the IT Act and not being in the nature of capital expenditure or personal expenses of the taxpayer), laid out or expended wholly and exclusively for the purposes of business or profession shall be allowed in computing the income chargeable under the head "Profits and gains of business or profession" as per section 37 of the IT Act. There is no well-settled law or a single definite criterion to determine whether a particular expenditure is revenue or capital in nature. Decisions by various judicial authorities have time and again iterated that the demarcation between capital and revenue expenditure depends on the facts of the case, purpose of expenditure, benefits obtained, etc.

In this regard, recently, the Supreme Court² had an occasion to interpret whether variable component of telecom licence fee paid by telecom companies is capital or revenue in nature. We, at BDO in India, have summarised the ruling of the Supreme Court and provided our comments on the impact of this decision.

Facts Of The Case

The taxpayer was engaged in the business of establishing, maintaining and operating telecommunication services and had procured licenses in different telecom circles under a license agreement executed in 1994. The said license was non-transferable and non-assignable and gave the right to operate the services within a geographical area on a non-exclusive basis.
The National Telecom Policy of 1994 was substituted by the New Telecom Policy of 1999. The said Policy of 1999 stipulated that the licencee would be required to pay a one-time entry fee and additionally, a licence fee on a percentage share of Annual Gross Revenue (AGR) (variable license fee). The entry fee chargeable would be the fee payable by the existing operator up to 31 July 1999.
The period of license was stated to be 20 years from the effective date of the 1994 license agreement. Migration to the Policy of 1999 was on the condition and premise that the conditions should be accepted as a package in entirety and simultaneously.
The taxpayer migrated to the Policy of 1999 on acceptance of conditions and treated the licence fee paid up to 31 July 1999, i.e., the one-time licence fee as capital expenditure.
For the relevant year under consideration, the taxpayer filed a nil return of income. During assessment proceedings, it was noted that INR 118,881,000/- paid by the taxpayer as variable license fee was claimed as revenue expenditure. The tax officer held that the variable licence fee paid ought to have been amortised over the remainder of the licence period. Accordingly, a deduction of INR 9,906,750/- was allowed under section 35ABB of the IT Act and the remaining amount of INR 108,974,250/- was disallowed.
Aggrieved, the taxpayer filed an appeal before the First-Appellate Authority which held that the variable licence fee would be allowed as revenue expenditure under section 37 of the IT Act. Aggrieved, the tax authorities preferred an appeal before the Delhi Tax Tribunal which was dismissed following its earlier order in the favour of the taxpayer. Further aggrieved, the tax authorities filed an appeal before the Delhi High Court. The High Court divided the licence fee into two periods, i.e., before and after 31 July 1999 and observed that the licence fee paid or payable for the period up to 31 July 1999 should be treated as capital expenditure (qualifying for deduction under section 35ABB of the IT Act) and the balance amount payable on or after the said date should be treated as revenue expenditure. Aggrieved by the aforesaid decision, the tax authorities filed an appeal before the Supreme Court.

Supreme Court Ruling

The question for consideration before the Supreme Court was:

Whether the variable annual licence fee paid by the taxpayer to the Department of Telecommunications under the policy of 1999 is revenue in nature and is to be allowed under section 37 of the IT Act or the same is capital in nature and is required to be amortised under section 35ABB of the IT Act?
Whether the Delhi High Court was right in apportioning the licence fee as partly revenue and partly capital?

While ruling in favour of the tax authorities, the Supreme Court made the following observations:

Relevant legislature and provisions

Section 35ABB of the IT Act operates and is effective when the expenditure itself is of a capital nature and is incurred for acquiring a right to operate telecommunication services or is made to obtain a licence for the said services. The said expenditure may be incurred before the commencement of business to operate telecommunication services, or thereafter at any time during any Fiscal Year. Such expenditure must represent the payment actually made to obtain a licence.

The Telegraph Act is the parent legislation under which licences to establish, maintain or work a telegraph are issued. Section 4(1) of the Telegraph Act states that the Central Government may grant a licence to any person to establish, maintain or work a telegraph within any part of India on such conditions and in consideration of such payment as it thinks fit. Further, the Central Government under section 8 of the Telegraph Act can revoke any license issued under section 4 of the Telegraph Act on grounds of default in payment of consideration.

Terms of licence Agreement

The pertinent qualitative changes effected in the licence conditions, following migration into 1999 policy regime, are as below:

Parameters for distinction	Telecom Policy 1994	Telecom Policy 1999
Details of the payments to be made by the operator	Fixed licence fee for the first 3 years; From the 4^th year onwards, the licence fee to be paid based on the number of subscribers, irrespective of the revenue account by the licencee from such subscribers, subject to the prescribed minimum.	One-time entry fee paid by existing telecom operators and entry fee that was paid by all the new entrants; Variable annual licence fee paid as a percentage of AGR
Permitted number of operators in a circle	Two	No restriction
Licence validity	10 years, subject to extension	20 years, subject to extension
Right of licencee to assign/ transfer the licence	Non-assignable and non-transferable.	Restriction on assignment/ transfer relaxed.

Tests laid down by the Supreme Court in various decisions from time to time

In the case of Empire Jute Co.³ it was held that capital expenditure is with a view to bring into existence an asset for the enduring benefit of the trade. However, if the expenditure leaves the fixed capital untouched though the benefit is for an indefinite period, it will be revenue expenditure.
In the case of Assam Bengal Cement⁴, it was held that if the expenditure is made for the initial outlay or for extension of a business or a substantial replacement of the equipment, it is capital expenditure. If the expenditure is for running the business or working it with a view to produce profits, it is revenue expenditure.
In the case of Alembic Chemical Work⁵, it was held that every case is to be judged in the context of business necessity or expediency. It is not necessary that in all cases, once and for all payment would result in an enduring benefit, nor it is a firm rule that periodical payment would not carry an enduring benefit. Therefore, what is relevant is the nature of the obligation and whether the subsequent payment made in instalments relates to or has nexus with such original obligation or not. Where the subsequent payments are towards a purpose which is identifiably distinct from the original obligation of the taxpayer, the same would constitute revenue expenditure. However, where each of the successive instalments relate to the same obligation or purpose, the cumulative expenditure would be capital in nature.

Payment made to acquire a right versus payment for royalty

Acquisition of a right would mean purchase of an asset for an enduring advantage of the purchaser meaning thereby that the ownership of the said right vests with the purchaser.
Payment of royalty is to use a right or asset for a stipulated duration. The right or asset is not per se acquired by the person or entity authorised to use it but continues to vest with the owner of such right or asset.
It was held in the case of Travancore Sugars⁶ and Mewar Sugar⁷ that in order to qualify as royalty, the payment must have no nexus with the acquisition of a capital asset. Further, in the case of Gotan Lime⁸ it was held that if a payment is made, not towards securing an enduring advantage or asset, but towards a right to use an asset, the same would be royalty and hence, revenue in nature.

Other observations

Reliance placed by taxpayer on a few decisions⁹ will not come to their aid since in those cases, there were two independent transactions and the compensation paid was in respect of two distinct matters- one component to be capital in nature and the other revenue. The purpose of payment was traceable to different matters and accordingly, it was held that the payments could be apportioned. However, in the present case, the entry fee as well as variable licence fee is for the same matter.

The licence issued under Section 4 of the Telegraph Act is a single licence to establish, maintain and operate telecommunication services. Since it is not a licence for divisible rights that conceive of divisible payments, apportionment of payment of the licence fee as partly capital and partly revenue expenditure is without any legal basis.
The Madras High Court in Sarada Binding Works¹⁰ held that the right to run the business is capital in nature, whereas the sharing of 10% profit per annum is revenue in nature. In the concluding paragraph, the Madras High Court made the following firm conclusions as to why 10% profit sharing would constitute a revenue expenditure:
- That payments calculated as a certain percentage of profits of a business for an indefinite period of time as royalty cannot be treated as payments by instalments of a capital sum;
- The payment of royalty was related to the future profits of the taxpayer and had no nexus with the capital sum.

However, in the present case, it cannot be said that the variable licence fee payable annually has no nexus with the acquisition of the capital asset, i.e., the licence to render telecom services, as, it is the payment of entry fee as well as the variable licence fee which together enable the taxpayer to carry on the said business. Hence the aforesaid case would not apply to the present case having regard to its distinct facts.

In Mewar Sugar (supra), it was held that the payment of 2% royalty on the sugar manufactured was revenue expenditure while the payment made in respect of the monopoly rights obtained was capital in nature. The right to carry on trade would have remained unaffected whether or not royalty payment was made. However, in the present case, any failure to pay the annual variable licence fee will inevitably lead to revocation of the licence under Section 8 of the Telegraph Act and the taxpayer will be disabled from carrying on the business of offering telecommunication services. Therefore, continuation of the right to carry on the said business is contingent on payment of both, entry fee as well as variable licence fee.
The fact that failure to pay the annual variable licence fee leads to revocation or cancellation of the licence vindicates the legal position that the annual variable licence fee is paid towards the right to operate telecom services.
Though the licence fee is payable in a staggered or deferred manner, the nature of the payment, which flows plainly from the licensing conditions, cannot be recharacterised. A single transaction cannot be split up in an artificial manner into capital payment and revenue payments by simply considering the mode of payment.
It is trite that where a transaction consists of payments in two parts, i.e., lump-sum payment made at the outset, followed up by periodic payments, the nature of the two payments would be distinct only when the periodic payments have no nexus with the original obligation of the taxpayer. However, in the present case, the successive instalments relate to the same obligation, i.e., payment of licence fee as consideration for the right to establish, maintain and operate telecommunication services as a composite whole. This is because in the absence of a right to establish, maintenance and operation of telecommunication services are not possible. Hence, the cumulative expenditure would have to be held to be capital in nature.
Thus, the composite right conveyed to the taxpayers by way of grant of licences is the right to establish, maintain and operate telecommunication services. The said composite right cannot be bifurcated in an artificial manner, into the right to establish telecommunication services on the one hand and the right to maintain and operate telecommunication services on the other. Such bifurcation is contrary to the terms of the licensing agreement(s) and the Policy of 1999.
Even under the 1994 Policy regime, the payment of license fee consisted of two parts. Having accepted that both the components- fixed and variable of the licence fee under 1994 Policy regime must be duly amortised, there was no basis to classify the same under the Policy of 1999.
The nature of payment being for the same purpose cannot have a different characterisation merely because of the change in the manner or measure of payment or for that matter the payment being made on an annual basis.
Therefore, the nomenclature and the manner of payment is irrelevant. Payment after 31 July 1999 is a continuation of the payment before 31 July 1999 albeit in an altered format without taking away the essence of the payment. It is mandatory payment traceable to the foundational document i.e, the licence agreement as modified post migration to the 1999 policy. Consequence of non-payment would result in ouster of the licensee from the trade. Thus, this payment is intrinsic to the existence of the licence as well as the trade itself. Hence it has to be treated or characterised as capital only.

BDO In India Comments

The determination of an expenditure as capital or revenue in nature has always been a contentious issue with a very thin line of difference. This decision by Supreme Court might have wider ramifications since its ratio could be applied in other types of licence fees as well and not just limited to telecom licenses. In case of telecom companies, this may result in higher taxes in the initial period of licence term thereby increasing their incremental cash outflows in the form of taxes and leading to blockage of funds. The decision may lead to retrospective tax demands along with penalties for telecom companies and may increase litigation on matters related to section 35A and 35ABA of IT Act.

¹ Section 30 to 36 of the IT Act provides deductions for computing profits and gains of business or profession and subject to certain conditions to avail such deductions.

² CIT Delhi vs. Bharti Hexacom Ltd. & Others, Civil Appeal No. 11128 of 2016, Supreme Court

³ Empire Jute Co. vs. CIT, [1980] 124 ITR 1 (Supreme Court)

⁴ Assam Bengal Cement Co. Ltd. vs. CIT, [1955] 27 ITR 34 (Supreme Court)

⁵ Alembic Chemical Works Co. Ltd. vs. CIT [1989] 3 SCC 329 (Supreme Court)

⁶Travancore Sugars and Chemicals Ltd. vs. CIT [1966] 62 ITR 566 (Supreme Court)

⁷ Mewar Sugar Mills Ltd. vs. CIT, (1973) 3 SCC 143 (Supreme Court)

⁸ M/s Gotan Lime Syndicate vs. CIT, [1966] 59 ITR 718 (Supreme Court)

⁹ Jonas Woodhead and Sons Ltd. vs. Commissioner of Income Tax, (1997) 224 ITR 342

⁹ CIT vs. Best and Co. (Pvt.) Ltd., (1966) 60 ITR 11,

⁹ Southern Switch Gear Ltd. vs. CIT, (1998) 232 ITR 359

¹⁰ CIT vs. Sarada Binding Works, (1976) 102 ITR 187 (Madras High Court)