Variable license fee: whether capital or revenue expenditure?

In yet another major setback for telecom companies, the Supreme Court held on October 16, 2023, that payment of annual variable license fees shall be classified as capital expenditure and not revenue expenditure.

Supreme Court’s decision in the present case

The decision made by the Supreme Court is underpinned by the idea that making license fee payments in installments does not change the fundamental nature of the payment. It was observed that the nature and purpose of the expenditure should dictate its classification, while the source and method of payment should have no consequence.

History of the litigation

In 1999, the National Telecom Policy of 1994 was substituted by the New Telecom Policy of 1999. In accordance with the new policy, licensees were required to pay a one-time entry fee up to July 31, 1999, and additionally, an annual license fee on a percentage share of gross revenue which was temporarily fixed at 15%.

The Delhi High Court noted that the license encompassed not only the initial establishment of cellular telephone services but also their continuous maintenance and operation throughout the license period. Furthermore, it was highlighted that subsequent payments were determined as a percentage of the gross revenue generated.

In view of the above, it was held that the payment of license fee was capital in part and revenue in part and that it would not be correct to hold that the whole fee was capital or revenue in nature in its entirety.

When it came to apportionment between capital and revenue expenditure, it was held appropriate and proper to divide the license fee into two periods i.e., before and after July 31, 1999. The license fee paid or payable for the period up to July 31, 1999, i.e., the date set out in the new policy should be treated as capital and the balance amount payable on or after the said date should be treated as revenue.

With this current ruling  however, the apex court has over-ruled the Delhi High Court’s decision and put an end to a decade-old litigation between the income tax department and the telecommunication companies. The judgments of Bombay and Karnataka High Court following the Delhi High Court ruling are also set aside.

Nature of Original Obligation Test

It was highlighted 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.

The Supreme Court underscored the significance of the original obligation test and ruled that if subsequent payments serve a purpose distinctly separate from the taxpayer's initial obligation, they would be considered as revenue expenditure.However, where each of the successive instalments relate to the same obligation or purpose, the cumulative expenditure would be capital in nature.  

In the present case, the successive instalments related to the same obligation, i.e., payment of license fee as consideration for the right to establish, maintain and operate telecommunication services as a composite whole. Hence, the cumulative expenditure was held to be capital in nature.

Principles for determining the nature of expenditure: whether capital or revenue

In distinguishing between capital and revenue expenditure, the courts have applied different tests in different cases. Nonetheless, it is acknowledged that none of the tests by themselves are conclusive and the determination in one way or the other must be made on the facts and circumstances of each case. Some of these tests are:

1. The enduring benefit test: Capital expenditure is one met with a view to bringing into existence an asset for the enduring benefit of the trade.
2. Initial expenditure test: Where 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.
3. Fixed and circulating capital test: Where the expenditure is to bring into the hands of the taxpayer a necessary ingredient of their existing business, which is important but still ancillary to the business, the expenditure is to be debited to the circulating capital (revenue account) rather than to the fixed capital (capital account).
4. Business structure v. process test: The question as to whether an expenditure is capital or revenue in nature is to be judged in every case in the context of business necessity or expediency. The most important aspect to be considered is whether the expenditure is a part of the taxpayer’s working expenditure or a part of profit earnings.
5. The once and for all test: Whether the expense is a recurring expense or a one-off payment.

Impact of the Supreme Court decision on payment of license fees

The Supreme Court has made it clear that splitting a payment into installments does not alter its nature from capital to revenue. What truly matters is the inherent nature of the initial obligation and whether the installment payments are linked to that original obligation or not.In several instances payment of license fee for purchase of right to manufacture and sell products, obtain rights for broadcasting, using technology, subscription of software licenses, subscription fee for accessing databases and portals, etc. is structured in a composite manner of lump-sum and/or variable periodic payments. In view of the above decision, taxpayers would be required to revisit the tax treatment of such license fees in their books of accounts. Reclassifying revenue expenditure as capital expenditure would increase the tax liability to a substantial extent.

The Hyderabad Tribunal, in 2018, held that one-time consolidated fees paid by the taxpayer to its holding company for use of trademark shall be treated as capital expenditure since it had an enduring benefit, whereas the amount of annual recurring license fee shall be classified as revenue expenditure.

In light of the Supreme Court's ruling, tax authorities may scrutinize these decisions and potentially reclassify the annual variable license fees.

Impact of the Supreme Court decision on the Telecom Sector

The telecom sector is currently grappling with the challenge of settling their outstanding AGR (Adjusted Gross Revenue) dues with the Central Government. Complicating matters further, Vodafone Idea filed a curative petition on October 9, 2023, in response to the Supreme Court's rejection of telecom companies' petitions seeking corrections to their AGR dues.

In addition to these concerns, the Supreme Court's decision is poised to have far-reaching implications for the financial strategies and tax planning of telecom operators throughout India, notably affecting Vodafone Idea and Airtel. These companies now face the necessity of reassessing their financial structures and potentially incurring higher tax liabilities as they contend with the classification of license payments as capital expenditures.

The Indian telecom industry, already grappling with numerous challenges, now faces an additional burden due to this development.

Author- Rahul Charkha, Partner and Afrin Shaikh, Associate at Economic Laws Practice