Introduction
In this case, Company A spends on scientific research by making payments to Company B, a pure scientific research institution. The transactions involve:
- Funding for Research: Company A pays Company B to conduct scientific research.
- Royalty Payments: Company A later pays Company B for the right to use patents developed from the research.
This analysis evaluates the tax treatment for both Company A (payer) and Company B (recipient) under the Income Tax Act, 1961.
Scenario 1: Company A Funds Scientific Research Conducted by Company B
Tax Treatment for Company A (Payer)
1. Allowability of Research Expenditure (Section 35)
- Section 35(1)(ii): If Company B is an approved scientific research institution, the payment made by Company A qualifies for a 100% deduction as expenditure on scientific research.
- Section 35(1)(i): If the research is conducted in-house by Company A itself, deduction is allowed only if the research is related to its business.
- Section 35(2AA): If Company A makes a contribution to a national research institution approved under Section 35(1)(ii), an additional weighted deduction (100%) is available.
- Non-Approved Institution: If Company B is not approved under Section 35, Company A cannot claim a deduction under Section 35, but can claim it as a business expense under Section 37(1), provided the expenditure is wholly and exclusively for business.
2. Deduction Timing
- The deduction under Section 35 is allowed in the year of payment, even if the research does not yield a patent or a tangible asset.
3. TDS Implication
- As per Section 194J, if Company A’s payment is for technical services and Company B is not a government institution, TDS @10% applies.
- If Company B is a government-recognized research institution, TDS may not be required.
Tax Treatment for Company B (Recipient)
1. Treatment of Research Funding Received
- Section 10(21): If Company B is an approved scientific research association, income received from Company A is fully exempt from tax.
- Non-Exempt Institution: If Company B is not approved under Section 10(21), it must include the payment as business income under Section 28 and pay tax at the normal corporate tax rate.
2. Conditions for Tax Exemption
- Company B must be approved by the prescribed authority under Section 35(1)(ii) and Section 10(21).
- The exemption is valid only if the funds are used exclusively for scientific research.
Scenario 2: Company A Pays Royalty to Company B for Patent Usage
Tax Treatment for Company A (Payer)
1. Deductibility of Royalty Payment
- Section 37(1): Royalty paid by Company A to Company B is allowed as a deductible business expense if it is incurred wholly and exclusively for business purposes.
- Section 40(a)(i): If the royalty is paid to a non-resident research institution, and TDS is not deducted, the expense is disallowed.
- Amortization of Lump-Sum Royalty (Section 35A): If royalty is paid as a lump sum for the right to use a patent, deduction is available in five equal annual installments.
2. TDS on Royalty Payment
- As per Section 194J, Company A must deduct TDS @10% before making a royalty payment.
- If the royalty is paid to a foreign entity, TDS is deducted under Section 195 at the applicable rates.
Tax Treatment for Company B (Recipient)
1. Taxability of Royalty Income
- Section 28: If Company B is a non-exempt entity, royalty income is taxable as business income.
- Section 10(21): If Company B is an approved scientific research institution, royalty income is fully exempt.
- Patent Box Regime (Section 115BBF): If Company B is a patent holder and qualifies under Section 115BBF, royalty income from patents developed and registered in India is taxed at a concessional rate of 10%.
2. Advance Tax Liability
- If royalty income is taxable, Company B must pay advance tax under Section 208 based on estimated income.
Summary of Tax Treatment
| Transaction | Tax Treatment for Company A | Tax Treatment for Company B |
|---|---|---|
| Research Funding to Company B | Deduction under Section 35 if Company B is an approved institution; otherwise, deduction under Section 37 | Exempt under Section 10(21) if Company B is an approved research institution; otherwise, taxable as business income |
| Royalty Payment | Deductible under Section 37(1); TDS @10% (Section 194J) | Exempt under Section 10(21) if Company B is an approved research institution; otherwise, taxable as business income |
| Royalty from Patents | If paid as lump sum, deduction is spread over 5 years under Section 35A | If taxable, patent royalty is taxed at 10% under Section 115BBF |
Key Considerations for Tax Planning
- Company B Should Obtain Approval under Section 35(1)(ii)
- This allows Company A to claim a 100% deduction, making the transaction tax-efficient.
- Company B Should Register Patents in India to Avail 10% Tax Rate under Section 115BBF
- This significantly reduces tax liability on royalty income.
- Company A Should Ensure TDS Compliance to Avoid Disallowance
- Deducting TDS at the correct rate prevents disallowance under Section 40(a)(i).
- Structured Payments Can Optimize Tax Benefits
- Instead of lump-sum payments for patents, royalty-based payments can allow full deduction in the year of payment.
Conclusion
- If Company B is an approved scientific research institution, Company A gets a 100% deduction under Section 35, and Company B’s income is exempt under Section 10(21).
- If Company B is not approved, Company A still gets a deduction under Section 37, but Company B has to pay tax on its income.
- Royalty payments are deductible expenses for Company A and taxable income for Company B, with possible 10% concessional tax under Section 115BBF if patents are involved.
A well-structured transaction with proper approvals can optimize tax benefits for both companies while ensuring full compliance with the Income Tax Act, 1961.
This analysis evaluates the tax treatment for both Company A (payer) and Company B (recipient) under the Income Tax Act, 1961.
Patent Box Regime under Section 115BBF
The Finance Act, 2016, introduced Section 115BBF into the Income Tax Act, establishing a Patent Box Regime. This provision offers a concessional tax rate of 10% (plus applicable surcharge and cess) on royalty income earned by an eligible assessee from the exploitation of patents.
Key Features of Section 115BBF
- Eligible Assessee: The benefit is available to a resident in India, excluding individuals and Hindu Undivided Families (HUFs).
- Qualifying Income: Income must be in the form of royalty received from the exploitation of a patent.
- Conditions:
- The patent should be granted under the Patents Act, 1970.
- The eligible assessee must be the true and first inventor of the invention and its patentee.
- The assessee should have developed the invention and registered the patent in India.
Applicability to Company A
In the given scenario, Company A is utilizing a patent developed and owned by Company B. Company A pays royalties to Company B for the use of this patent. Since Company A is not the patentee and does not earn royalty income from the patent, it cannot avail the concessional tax rate under Section 115BBF.
Tax Treatment of Business Income from Patented Products
The Income Tax Act does not provide a specific concessional tax rate for business income derived from the use of patents developed by another entity. Therefore, the income earned by Company A from the sale of goods manufactured using the patent will be taxed at the normal corporate tax rate applicable to the company.
Conclusion
Based on the provisions of the Income Tax Act, 1961, there is no provision that allows a lower tax rate on business income for a company utilizing a patent developed by another entity. The concessional tax rate under Section 115BBF is specifically for royalty income earned by the patentee. Therefore, Company A’s income from its commercial business, even when using the patent developed by Company B, will be subject to taxation at the standard corporate tax rates.
Upon reviewing the provisions of the Income Tax Act, 1961, and relevant legal precedents, it is evident that there is no provision offering a concessional tax rate on business income derived from the use of patents developed by another entity.
The Patent Box Regime under Section 115BBF provides a 10% tax rate exclusively on royalty income earned by the patentee from patents developed and registered in India. This benefit does not extend to business income generated from the utilization of such patents by non-patentees.
In the absence of specific Indian case law directly addressing this issue, the principle of “expressio unius est exclusio alterius”—the express mention of one thing excludes all others—applies. By explicitly granting tax benefits to patentees under Section 115BBF, the legislature has excluded non-patentees from such concessions.
Therefore, Company A, utilizing a patent developed by Company B, is subject to the standard corporate tax rates on its business income, as no statutory provision or judicial precedent provides for a reduced tax rate in such circumstances.
Stox N Tax 
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