Hegde, J.
1. This is a reference under section 66 (1) of the Indian Income-tax Act, 1922, to be hereinafter referred to as the 'Act'. The said reference was made by the Income-tax Appellate Tribunal, Bombay Bench, at the instance of the assessee. The question of law referred for the opinion of this court is :
'Whether, on the facts and in the circumstances of the case, the sum of Rs. 26,713 was properly disallowed as a capital expenditure ?'
2. The assessee, the Mysore Kirloskar Limited, is a company manufacturing machine tools, workshop equipment, etc.
3. For manufacturing Capstan and Turret lathes of particular designs, the assessee entered into a collaboration agreement with M/s. Alfred Herbert Ltd., on August 1, 1958. The agreement was to last for a period of 15 years. Under clause 3 of the agreement, Herbert was to provide the assessee with manufacturing technique from time to time and also furnish two complete sets of detailed and general arrangements, drawings, material specifications and parts lists relating to the appropriate machines. Herberts had also to supply patterns, jigs, fixtures and special tools at certain agreed prices. One of the employees of Herbert was to superintend the assessee's factory and manufacture. The assessee could send its employees for training to the Herbert Company at England. Under clause 8 of the agreement, it is provided that the machines manufactured by the assessee should be sold under the trade mark 'HERBERT KIRLOSKAR'. On the machines the assessee had also to make it clear that the machines were made for and to the designs of Alfred Herbert Limited. All information about improvements in the design, manufacture or using of the products, were to be the subject-matter of mutual communication between the assessee and Herbert.
4. Clause 12 of the agreement is the most important clause for our present purpose. It reads thus :
'In consideration of the facilities information and manufacturing technique provided by HERBERT hereunder M. K. (Mysore Kirloskar) shall remunerate HERBERT as follows :
(i) on the execution of this agreement to pay HERBERT in respect of 'know-how' to be supplied hereunder the sum of Pounds 1,000 (one thousand pounds sterling) in respect of Herbert No. 7B Combination Turret Lathes and upon agreeing to manufacture any further machine a further Pounds 1,000 (one thousand pounds sterling) in respect of each and every other type of machine manufactured hereunder.
(ii) On MK's invoice of all products manufactured and sold hereunder (including any goods completed after the date of termination as provided in clause 17 hereof) MK will make a payment to HERBERT of 7 1/2% (seven and one-half per cent.) subject to any deduction for tax payable - under Indian law.
(iii) No payment under the provision of clause 12 (ii) shall be made in respect of component parts purchased by MK from HERBERT for assembly into the products the subject hereof.'
Under clause 15, Herbert agreed not to authorise or assist any other concern in India to manufacture the products and spare and component parts therefor, if the conditions mentioned therein are fulfilled.
Under clause 18, the assessee undertook and agreed that it will observe strict secrecy as to all confidential and secret documents, information and 'know-how' supplied to it by Herbert under the agreement and will not directly or indirectly use the 'know-how' experience and information acquired by it pursuant to the agreement so as to assist any other person, firm or company to manufacture products similar to the products of any of them or otherwise to the detriment of Herbert. But it is provided therein that disclosure to the assessee's own staff or its sub-contractors shall not constitute a breach of that clause.
5. It is clear from the terms of the agreement and the other facts proved in this case, that till the date of the agreement, the assessee was not manufacturing either Herbert No. 4 Capstan Lathes or Herbert No. 7B Combination the basis of the 'know-how' supplied by Herbert. It may be further seen that though under the agreement Herbert was required to supply all the 'know-how' acquired by it during currency of the agreement, but whatever 'know-how' came to be supplied to the assessee, the same became a part of its own 'know-how'. There was no objection for utilising that 'know-how' by the assessee even after the period of agreement came to an end in the event the assessee complied with the terms of the agreement during its currency. In pursuance of the agreement, the assessee paid during the relevant accounting year a sum of Rs. 26,713 as provided in clause 12 of the agreement. The question for consideration is whether that item of expenditure should be considered as a capital expenditure or as a revenue expenditure.
6. The Income-tax Officer, the Appellate Assistant Commissioner as well as the Income-tax Appellate Tribunal have all come to the conclusion that the expenditure in question is a capital expenditure.
7. The Income-tax Appellate Tribunal dealt with that question in paragraph 3 of its order. This is what it says :
'It was submitted on behalf of the assessee in the appeal before us that the sum of Rs. 26,713 was only revenue expenditure as the amount was paid in respect of drawings and designs relating to articles whose manufacture was likely to change from time to time. We are unable to consider that the amount represents revenue expenditure. The cases which have been considered by the income-tax authorities are those which relate to the recipients. We are not concerned in this assessment with any receipt in respect of the supply of any technical know-how. In this branch of law, what is applicable to the recipients is not necessarily applicable to the payer. The payment may be a capital one in the hands of the payer, while in the hands of the recipient it may be revenue in nature. We have to consider in this case as to what was the object of this expenditure. Taking the terms of the agreement and clause 12 in particular, we consider that the object in making this expenditure is the receipt of blue print, which represents in fact the technical know-how with which the assessee could produce the lathes it intended to manufacture. The expenditure here is thus for the purpose of getting the know-how. The payment is made only once and for all so as to enable the assessee to manufacture on the basis of the blue print the same lathes if it was so minded for the entire period of 15 years. The expenditure is also liable to be treated as one incurred for initiating a new line of business or expansion of business by the manufacture of a particular variety of lathes. The advantage obtained by the assessee by securing these blue prints is liable to endure for a full period of 15 years. In our opinion, this is a case where the several tests normally applied for finding out whether the expenditure is a capital one are satisfied. Clause 12 itself shows the distinction between the running royalty and the initial payment was obviously considered necessary because the agreement does not provide for any minimum manufacture. The assessee need not take up the manufacture of such lathes. This may invite the operation of clause 15 whereby Herberts can enter into similar agreements in the event of the assessee's manufacturing capacity not being adequate to satisfy the demand for this type of lathes in India. In our opinion, the absence of requirement of a minimum manufacture shows that Herberts got a lump sum payment for disclosure of know-how. The assessee is liable also to pay a sum of Pounds 1,000 at the time when a fresh type of lathes is manufactured under the terms of this agreement. This shows that it is an initial payment which is independent of royalty. More such payments may have to be made when new items of lathes are taken up. This does not detract from the position that in respect of the lathes for which the blue prints have now been obtained, there is capital expenditure. When there is manufacture and sale, the running royalty becomes payable and that will be the consideration for patents, etc., being put to use. But this is for a different object. Some stress was laid about the payment being small. The size or quantum of payment does not determine its character, at least in this case. We have to see the nature and object of the payment being small. The size or quantum of payment does not determine its character, at least in this case. We have to see the nature and object of the payment which in this case disclose a capital element.'
8. The distinction between capital expenditure and the revenue expenditure has been well brought out, if we may say so with respect, in the decision of the Supreme Court in Assam Bengal Cement Co. Ltd. v. Commissioner of Income-tax. Therein their Lordships observed thus :
'In cases where the expenditure is made for the initial outlay or for extension of a business or a substantial replacement of the equipment, there is no doubt that it is capital expenditure. A capital asset of the business is either acquired or extended or substantially replaced and that outlay whatever be its source whether it is drawn from the capital or the income of the concern is certainly in the nature of capital expenditure. The question however arises for consideration where expenditure is incurred while the business is going on and is not incurred either for extension of the business or for the substantial replacement of its equipment. Such expenditure can be looked at either from the point of view of what is acquired or from the point of view of what is the source from which the expenditure is incurred. If the expenditure is made for acquiring or bringing into existence an asset or advantage for the enduring benefit of the business it is properly attributable to capital and is of the nature of capital expenditure. If on the other hand it is made not for the purpose of bringing into existence any such asset or advantage for the enduring benefit of the business is thus acquired or brought into existence it would be immaterial whether the payment was made once and for all or was made periodically. The aim and object of the expenditure would determine the character of the expenditure whether it is a capital expenditure or a revenue expenditure. The source or the manner of the payment would then be of no consequence. It is only those cases where this test if of no avail that one may go to the test of fixed or circulating capital and consider whether the expenditure incurred was part of the fixed capital of the business or part of its circulating capital of the business or part of its circulating capital. If it was part of the fixed capital of the fixed capital of the business it would be of the nature of capital expenditure and if it was part of its circulating capital it would be of the nature of revenue expenditure. These tests are thus mutually exclusive and have to be applied to the facts of each particular case in the manner above indicated.'
9. The test laid down in the above decision was adopted by the Supreme Court in State of Madras v. G. J. Coelho.
10. Bearing in mind the afore-mentioned tests, we have now to see whether the 'know-how' acquired by the assessee can be considered as a capital asset. We have earlier mentioned that machines were to be manufactured by the assessee on the basis of the 'know-how' supplied by Herbert were new types of machines. Therefore, it is clear that the 'know-how' in question was to be utilised not for the purpose of manufacturing the machine that the assessee was already manufacturing, but for the purpose of bringing into production new types of machines solely on the basis of the 'know-how' supplied by Herbert.
11. In A. Y. S. Parisutha Nadar v. Commissioner of Income-tax, the Madras High Court laid down that section 10 (2) (xv) of the Act relating to expenditure laid out or expended wholly and exclusively for the purpose of the assessee's business, clearly indicates that the expenditure should relate to a business which is already in existence and not one that is to come into existence in the future.
12. If the 'know-how' supplied by Herbert can be considered as a capital asset, then there is no doubt that the expenditure incurred by the assessee for acquiring that 'know-how' is a capital expenditure. We have already noticed that the 'know-how' is acquired by the assessee was to become its property at the end of the period of agreement. It is not some knowledge acquired merely for the purpose of carrying on the day to day business of the assessee. That knowledge was acquired for manufacturing new types of machines, i.e., to bring into existence new businesses. That knowledge would be available for the assessee for all time to come in the future if the assessee carries out the terms of the agreement.
13. With the above background, let us now proceed to consider whether the 'know-how' supplied by Herbert can be considered as a capital asset. On this question, we have the assistance of the recent decision of the House of Lords in Rolls-Royce Ltd. v. Jeffrey (Inspector of Taxes). Rolls-Royce Limited are manufacturers of motor cars and aircraft engines. Since its formation in 1906, the company had been engaged in metallurgical research and the discovery and development of engineering techniques and secret processes. As a result it acquired in the course of the years a fund of technical knowledge or 'know-how' of which only a comparatively small part was capable of forming the subject-matter of patent right. For some years the company, as a general rule, used its 'know-how' only in its own trade, but during the period 1946 to 1953, as a result of overtures made by certain foreign governments and companies, the company entered into a number of agreements whereby, in consideration of lump sum payments and royalties, it undertook to supply the foreign government or company with technical knowledge, plans, a licence and facilities for the interchange of staff to enable them to manufacture specified types of aircraft engines. The agreements were for periods of from five to ten years with provision for giving full information regarding improvements and the like during that time, and with options to renew on terms. In connection with the assessments to income tax for the years 1948-49 to 1954-55 under Case I of Schedule D, to excess profits levy, profits tax and excess profits tax, the question arose whether, in computing the company's profits or gains, the lump sums paid to it under the agreements should or should not be included. The House of Lords held that the sums in question should be so included as being part of the receipts of the company's trade; the company was not parting with its assets but trading in them as part of the development of its general trade.
14. While deciding the above issue, it became necessary to consider whether the 'know-how' is a capital asset or not. The speech of Lord Radcliffe is of utmost assistance in that regard. We shall quote the relevant portion of his Lordship's speech. It reads :
'My Lords, I think that the issue of this appeal depends upon a right appreciation of just two matters. One is the nature of this asset of the appellants which is conveniently comprehended in the word 'know-how' : the payment of the sums of money which are the subject of this dispute.
First, as to 'know-how'. I see no objection to describing this as an asset. It is intangible : but then so is goodwill. It would be difficult to identify with any precision the sources of the expenditure which has gradually created it and, patents apart, I would not have thought of it as a natural balance sheet item. But it is a really when associated with production and development such as that of Rolls-Royce, and a large part, though not the whole of it, finds its material record in all those lists, drawings and manufacturing and engineering data that are specified in the various licence agreements.
It is fundamental to the appellants' case that we should categorise this asset as being part of their fixed capital. Indeed, their argument proceeds from the premise that it is fixed capital. That, I think, is to start from too assured a base. An asset of this kind is, I am afraid that I must use the phrase, sui generis. It is not easily compared with factory or office buildings, warehouses, plant and machinery or such independent legal rights as patents, copyright or trade marks, or even with goodwill. `Know-how' is an ambience that pervades a highly specialised production organisation and, although I think it correct to describe it as fixed capital so long as the manufacturer retains it for his own productive purposes and expresses its value in his products, one must realise that in so describing it one is proceeding by an analogy which can easily break down owing to the inherent differences that separate 'know-how' from the more straight-forward elements of fixed capital. For instance, it would be wrong to confuse the physical records with the 'know-how' itself, which is the valuable asset : for, if you put them multiplied your asset in proportion. Again, as the facts of the present appeal show, 'know-how' has the peculiar quality that it can be communicated to or shared with others outside the manufacturer's own business, without in any sense destroying its value to him. It becomes, if you like, diluted, and its value to him may be affected, though, in my view, it begs the question to say that value is necessarily reduced because the asset is used for outside instruction.
This considerations lead me to say that, although 'know-how' is properly described as fixed capital by way of analogy, it is the kind of intangible entity that can very easily change its category according to the use to which its owner himself decides to put it. I am not sure that it is too much to say that it is his use of it that determines the category. It is not like a single physical entity which must be employed for production or else broken up : it is more like a fluid in store which can be pumped down several channels.'
15. The above decision clearly established that 'know-how' primarily is a capital asset and the price received on its sale a capital receipt. But moneys received for systematic and repeated exploitation of 'know-how' would be on revenue account.
16. Applying the ratio of the above decision to the facts of the present case, it becomes evident that 'know-how' supplied by Herbert in the hands of the assessee is a capital asset, but the price realised for the sale of that 'know-how' by Herbert is a revenue income. From that conclusion, it follows that the 'know-how' acquired by the assessee during the assessment year is an acquisition of a capital asset and, consequently, the price paid for that acquisition is a capital expenditure.
17. In support of his contention that the expenditure in question is a revenue expenditure, Mr. Venkatesa Iyer, the learned counsel for the assessee, relied on the decision of the Bombay High Court in Commissioner of Income-tax v. Ciba Pharma Private Ltd. Therein the assesses company under an agreement dated June 18, 1948, was to pay to the Swiss company 8 per cent. of its net sales by way of consideration : (1) for the use of the rights under the patents of Ciba Basle, (2) for acquiring the extensive knowledge and practical experience in the pharmaceutical field that Ciba Basle commands by reason of its long and extensive research work and scientific and practical experience in so far as it relates to the products which were manufactured or processed or sold by Ciba Pharma, and (3) for obtaining scientific and technical assistance. It may be noted that the payment stipulated was payment of 8 per cent. of the net sale proceeds received by the assesses company. The agreement was to last only for a period of five years. The benefit received by the assesses company was the use of the rights under the patents of Ciba Basle and the 'know-how' supplied to it in the matter of improving its production by utilising the practical experience gathered and the scientific and technical assistance given by it. Taking into consideration the duration of the agreement and the nature of the 'know-how', the High Court came to the conclusion that the expenditure incurred by the Ciba Company is a revenue expenditure. Dealing with that aspect, this is what Tambe J. (as he then was), speaking for the court, observed :
'It is indeed true that the payment of 8 per cent. of the net sale price, though referred to under various heads in clauses (a) and (b) of paragraph I of article III as contributions, is on an analysis of the agreement, a consideration paid for acquiring the extensive knowledge and practical experience of Ciba Basle constitutes acquisition of an asset of an enduring nature. In other words, whether the expenditure incurred for acquiring the technical 'know-how' of the business, Ciba Pharma had acquired an asset of an enduring benefit. Having regard to paragraph 2 of article I and paragraph 5 of article V of the agreement, there can hardly be any doubt that Ciba Pharma had acquired no asset in obtaining the 'know-how' of the business. No right in the results of the scientific research has been acquired by Ciba Pharma. These two paragraphs make it clear that the confidential information received by Ciba Pharma from Ciba Basle about the conduct of the business and all data connected with the manufacturing processes was not to be divulged by Ciba Pharma during the currency of the agreement. On the termination of the agreement Ciba Pharma is required to return to Ciba Basle or to such other persons Ciba Basle may appoint, all copies of information, scientific data or material sent to it by Ciba Basle under this agreement. Further, Ciba Pharma is expressly refrained from communication such information, scientific data or material received by it hereunder to any person, firm or company whomsoever, other than Ciba Basle. The use of the knowledge or 'know-how', is thus limited only for the purpose of the conduct of the business during the period of the agreement, which is of a duration of five years. Payments made for acquiring the said knowledge cannot, in our opinion, be said to have brought into existence an asset of an enduring nature. On the other hand, payment has been made to get the technical 'know-how' only for the purpose of running the business during the period of the agreement with a view to earn profits. In the payment, therefore, in our opinion, no expenditure of a capital nature is involved.'
18. From the above observations, it is clear in that case the High Court came to the conclusion that the 'know-how' in question is not a capital asset because of the fact that its use is limited for a short period of 5 years and further that the technical knowledge supplied is essentially one that is connected with the day to day business of the company. It must be remembered that a great deal of research is going on in the matter of manufacture of drugs. Technical knowledge in that field becomes ante-dated within the course of months and years. We do not think that the ratio of that decision is applicable to the facts of the present case.
19. For the reasons mentioned above, our answer to the question referred to is that on the facts and in the circumstances of the case, the sum of Rs. 26,713 was properly disallowed as a capital expenditure.
20. The assessee to pay the costs of this reference. Advocate's fee Rs. 250.