The last few decades have witnessed an influx of many international consumer brands in India. These multinational corporations license their intellectual property to regional organizations, which can subsequently become franchisees of the International brand. International brands license their trademarks and patents to regional organizations that pay fees in the form of royalties. The Delhi High Court passed judgement in an interesting case concerning the taxation of such royalties of the following companies: McDonald’s (the Appellant), Bikanerwala, GlaxoSmithKline Asia and Sagar Ratna (the Petitioners).

            The abovementioned companies owned trademarks and licensed their brands in franchise agreements. GSK Asia had issued trademark licenses of their powdered beverage, ‘Horlicks’, to SmithKline Beecham Consumer Healthcare Ltd. for sale in India, Nepal and Bhutan. All licenses were non-exclusive, and the Petitioners received royalties made up from a percentage of the revenue earned from the sale of the trademark-bearing products, namely burgers, health drinks, biscuits, etc.

            The Constitution states laws related to Sales tax and Service tax in the Articles 246, 268A and the Seventh Schedule. The Union List (a list of items given in the Seventh Schedule on which the Parliament has exclusive power to legislate) provides for ‘92C. Taxes on services’, while the ‘54. Taxes on the sale or purchase of goods other than newspapers, subject to the provisions of Entry 92A of List I.’ is included in the State List. Generally, according to the stated excerpts, an IP transaction would be taxed ‘Service Tax’ by the Union if it is taken as a rendering of a service and would be taxed ‘Sales tax or VAT’ by the State if it is taken as a sale of goods.

            There have been several situations wherein organizations tried to bypass either of the taxes by reasoning that the nature of their IP transaction was not taxable by the concerned authority. After several litigations and constitutional amendment, the law related to IP transactions can be summarized as follows:

1. Composite contracts that include elements of both sale and service cannot be taxed twice. (State of Madras v. Gannon Dunkerley). Sales tax (or VAT) and Service tax are mutually exclusive taxes.
2. Transfers of the right to use goods (TRUGs) are considered sales. IP is considered as goods.
3. A mere permission to use IP is not considered to be a sale.

Now, it is to be noted that when an IP transaction is considered to be a sale, the respective State(s) may levy sales tax on the resulting royalties. Hence, it is not a surprise that time and again, several States claimed that IP licenses are considered as TRUGs, due to which the States can levy sales tax on the transaction.

The main question here was to identify the circumstances where the licensing of IP rights amount to a sale of goods, and the circumstances in which they would amount to the rendering of a service. In BSNL v. Union of India (2006), Justice Lakshmanan delivered five criteria that had to be fulfilled for a transaction to qualify as a TRUG:

1. There must be goods available for delivery;
2. There must be a consensus ad idem as to the identity of the goods;
3. The transferee should have a legal right to use the goods – consequently all legal consequences of such use including any permissions or licenses required therefore should be available to the transferee;
4. For the period during which the transferee has such legal right, it has to be the exclusion to the transferor -this is the necessary concomitant of the plain language of the statute – viz. a “transfer of the right to use” and not merely a licence to use the goods;
5. Having transferred the right to use the goods during the period for which it is to be transferred, the owner cannot again transfer the same rights to others.

      In this case before the Delhi High Court, the crux of the matter was whether sales tax had to be levied on the royalty payments received by the licensors in the trademark licensing.

            In the assessment year 2005-2006, the Delhi Value Added Tax authorities gave a notice to McDonald’s that royalty payments were to be taxed as they were related to the transfer of rights to use the trade mark "McDonald's". On 17^th March 2006, the Value Added Tax Officer issued a letter alleging that McDonald’s had a sale turnover from trade mark and patents in the form of royalty received from its franchisees; and thus, attracted a levy of sales tax under the provisions of the Delhi Sales Tax on Right to Use Goods Act, 2002 (DSTRTUG Act).

Subsequently, McDonald’s filed a reply wherein it resisted the levy of sales tax under the DSTRTUG Act and submitted a copy of the Master License Agreement (MLA) executed between the Appellant and McDonald’s India. However, the Value Added Tax Officer treated the McDonald’s system as goods and sent McDonald’s an order with a demand of Rs. 13,44,684 charged as Sales tax.

Aggrieved, McDonald’s appealed to the Joint Commissioner of Trade and Taxes, who upheld the order given by the Value Added Tax Officer. In response, McDonald’s appealed to the Appellate Tribunal in September 2008. The Tribunal, however, dismissed the appeal. As a final resort, McDonald’s filed an appeal at the Delhi High Court.

In a similar manner, the petitioner Sagar Ratna Restaurants Private Ltd paid Service tax to the Central Government at a rate of 12.36% for the related fiscal year, but received an order passed by the Value Added Tax Officer stating that its received franchisor fee is subject to DVAT levy. Additionally, Bikanerwala Foods Pvt. Ltd and GlaxoSmithKline Asia Pvt. Ltd. have entered into franchise agreements similar to that of McDonald’s and Sagar Ratna Hotels, earn royalty for rendering such services and accordingly pay service tax on the same. They were also served notices regarding the payment of VAT.

McDonald’s argued that the franchise agreement only confers the right to use the McDonald’s systems in a restaurant, and royalty is paid as a percentage of gross sales. Further, according to one of the clauses in the licensing agreement, the licensee is not allowed to use any name, mark or other related intellectual property except in connection with the operation of the restaurant.

McDonald’s applied the five-point criteria of BSNL stated above, and stated that there were no goods which were deliverable at any stage and there was no transfer of right to use any trade mark. Thus, they argued that the levy of sales tax/VAT was without jurisdiction and contrary to the relevant statutory provisions

The franchise agreements signed between the Petitioners and their respective franchisee parties were drafted in a similar manner, wherein the licensees were not given the exclusive right to use the respective trademarks and were only permitted to use the trademarks for the limited purposes provided in the franchise agreements. Thus, the Petitioners gave an argument similar to that of McDonald’s.

When the Delhi High Court examined the McDonald’s Master License Agreement, it found that the agreement was a composite franchise agreement which included trade secrets, know-how, recipes, training, etc. along with the trademark to the franchisee. The High Court determined that a limited right to use the composite system of a business is not a transfer of the right to use goods. Subsequently, the Court held that any such composite contract that non-exclusively provided a bunch of services could not be levied Sales tax.

The Delhi High Court’s judgement in this case cleared the confusion caused by several contradictory judgements passed in prior cases. However, it seems to be too little, too late, considering the introduction of the Goods and Services Tax (GST) from 1^st July 2017, which is bound to change the game altogether.

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