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(1) Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.

(2) However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State but if the recipient is the beneficial owner of the royalties, the tax so charged shall not exceed ... per cent (the percentage is to be established through bilateral negotiations) of the gross amount of the' royalties. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of this limitation.

(3) The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, or films or tapes used for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial, or scientific equipment, or for information concerning industrial, commercial or scientific experience.

(4) The 'provisions of paragraphs (1) and (2) shall not apply if the beneficial owner of the royalties, being a resident of a Contracting State carries on business in the other Contracting State in which the royalties arise, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the right or property in respect of which the royalties are paid is effectively connected with (a) such permanent establishment or fixed base, or with (b) business activities referred to under (c) of paragraph (1) of Article 7. In such cases the provisions of Article 7 or Article 14, as the case may be, shall apply.

(5) Royalties shall be deemed to arise in a Contracting State when the payer is that State itself, a political sub-division, a local authority or a resident of that State. Where, however, the person paying the royalties, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the liability to pay the royalties was incurred and such royalties are borne by such permanent establishment or fixed base, then such royalties shall be deemed to arise in the State in which the permanent establishment or fixed base is situated.

(6) Where by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the royalties, having regard to the use, right or information for which they are paid, exceeds the amount which would have been agreed upon by the payer arid the beneficial owner in the absence of such relationship, the provisions of. this Article shall apply only to the last-mentioned amount. In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State due regard being had to the other provisions of this Convention.

68. Scope
The Article deals with taxability of royalty income arising from the use of intangible properties such as' copyrights, patents, and of the tangible properties such as industrial, commercial or scientific equipment, or of information concerning industrial, commercial or scientific experience. In the era of industrialisation the real wealth consists in holding intangible assets, in contradistinction to traditionally holding of tangible assets, such as houses, chattels, and money. Now intellectual property has been becoming more and more important than the tangible and the physical assets. Consideration for the use of these assets (royalties or fee for technical services) is taxed both in the country in which it arises and in the country in which the recipient resides. What is taxed is the royalty or fee in its character of remuneration for the assets and not the latter in themselves. In the absence of a treaty each country would assert its jurisdiction to tax the income arising from the use of the industrial asset.

It has now been well recognised that royalties from licensing of technology is having their source where the licensed property is put to use. For taxing income from the exploitation of industrial asset the attention is focussed to the country where the asset is used to generate income and not to where it is formed and developed. Though the source country has jurisdiction to tax income in regard to royalty income, the claim of country of residence cannot be ignored. The OECD Model Convention, however, has given an exclusive right to residence State. The UN Model departs substantially from the OECD Model. in recognising the principle of taxation at source. This Model recognises that the taxing jurisdiction depends on the nexus between it and economic activities producing income on the one hand as also on the relationship between it and the taxpayer on the other. The Model, however, limits the rights of the source country to tax royalty income at a certain agreed upon percentage of the gross amount. Royalty has been defined exhaustively as representing consideration for the use or right to use copyright, patents, industrial equipment or information. Income, however, if it could be refused to a permanent establishment or a fixed base becomes taxable as business, or professional income, irrespective of its source being the copyright, etc.

69. Taxability in the source country
Paragraph (1) of Article 12 of the UN Model states that royalties arising in a Contracting State and ‘paid’ to a resident of the other Contracting State shall be taxable only in that other State. Paragraph (2) is a corollary of paragraph (1) extending the right of the source State to tax royalty income but only to a limited extent confined only to the rate of tax as mutually agreed upon.

The jurisdiction of the source country to tax royalty income being not in doubt, the question arises about the taxable base, whether and to what extent or whether not at all, the expenses associated with the royalties be allowed deduction. Such expenditure must have been incurred outside the jurisdiction of the source country and may involve different years. Since allocation of expenditure relating to the royalty income is pregnant with some inherent uncertainties and difficulties, taxing it by the source country by the use of the method of applying a withholding tax on the gross amount is advantageous. Such advantage is recognised world over because of the certainty in result, and simplicity in administration. But the rate of deduction of tax at source be such so as to approximate overall relationship of the expenses to gross royalty, so that overall revenue will approximate to the results that would be reached through the application of regular rate of tax to the net royalty income. In the case of non-residents, the tax treatment of royalty income is provided in section 30 read with section 31(4) and rule 23. These are produced as under:

"Sec. 39. Income from other sources. - (1) Income of every kind which may be included in the total income of an assessee under this Ordinance shall be chargeable under the head "Income from other sources", if it is not included in his total income under any other head.

(2) In particular, and without prejudice to the generality of the provisions of sub-section (1), the following incomes shall, save as otherwise provided in this Ordinance, be chargeable under the head "Income from other sources", namely -

(a) dividend;
(b) interest, royalties and fees for technical services;
(c) ground rent;
(d) income from the hire of machinery, plant or furniture belonging to the assessee and also of buildings belonging to him if the letting of the buildings is inseparable from the letting of the said machinery, plant or furniture; and
(e) any income to which sub-section (12) of section 12 or section 13 applies.

Sec. 31. Deductions. - (1) In computing the income under the head "Income from other sources", the following allowances and deductions shall be made, namely -

(a) in the case of dividends, any sum paid by way of commission to a banking company realising such dividends on behalf of the assessee;

(b) any expenditure (not being in the nature of capital expenditure or personal expenses of the assessee) laid out or expended wholly and exclusively for the purpose of earning such income; and

(c) in the case of income to which clause (d) of sub-section (2) of section 30 applies, any allowance or deduction computed in accordance with the provisions of clauses (iii), (iv) and (v) of sub-section (1) of section 23.

Sec. 31(4) Notwithstanding anything contained in sub-section (1) or sections 22 and 23, in the case of an assessee, being a foreign company or a foreign association, the income by way of royalty received from a Pakistani concern in pursuance of any agreement made by the foreign company or the foreign association, as the case may be, with the Pakistani concern shall be computed in such manner as may be prescribed.

Rule 23. Income from royalties or fees for technical services. - For the purpose of sub-section (4) of section 31, the income of a foreign company by way of royalty or fees for technical services received from a Pakistani concern in pursuance of any agreement made by the foreign company with the Pakistani concern shall be computed in the following manner, namely :-

(1) In case the said income is by way of royalty ,-

(a) when received in pursuance of an agreement made before the 8th day of March, 1980, or an agreement made on or after the said date the proposal in respect of which was approved by the Government before the said date, the deductions admissible under section 31 shall be allowed in accordance with the provisions of the said section; and

(b) when received in pursuance of any agreement made on or after the 8th day of March, 1980, no deduction in respect of any expenditure or allowance shall be made under the said section 31 from the gross amount of royalty.

(2) In case the said income is by way of fees for technical service -

(a) when received in pursuance of an agreement made before the 8th day of March, 1980, or an agreement made on or after the said date the proposal in respect of which was approved by the Government before the said date, the deduction admissible under section 31 shall be allowed in accordance with the provisions of the said section;

(b) when received in pursuance of an agreement made on or after the 8th day of March, 1980, but before the 4th day of May, 1981, the deductions admissible under section 31 shall not exceed in the aggregate twenty per cent of the gross amount of such fees; and

(c) when received in pursuance of an agreement made on or after the 4th day of March, 1981, no deduction in respect of any expenditure or allowance, except the following expenditure, shall be made under section 31 from the gross amount of such fees, namely -

(i) expenditure incurred in Pakistan on the provision of services of technical or other personnel, including their salaries earned in Pakistan wherever paid;

(ii) expenditure incurred in Pakistan in respect of any work done in pursuance of such agreement; and

(iii) expenditure incurred outside Pakistan in respect of any work done in pursuance of such agreement not exceeding ten per cent of the gross amount of such fees."

69.1. Inter-relationship between the taxation by the countries of source and recipient - The source country has exclusive tax jurisdiction in regard to royalty income, yet the claim of country of residence cannot be ignored. In the absence of a treaty each country would assert its jurisdiction to tax the income arising from the use of the industrial asset. The country of residence would tax the income in terms of its tax laws normally applicable to an assessee, unless tax relief is provided unilaterally by exempting foreign income which has already been subjected to tax or by providing deduction of tax thus paid from the amount found payable on determination of normal tax liability so that income is not doubly taxed.

Unilateral relief provided, if achieved through bilateral agreements, the conflict between the claims of jurisdiction of the country of source and of residence disappears. This could be done by laying the rate of withholding tax at a level as at of the residence country rate so that the source country tax gets amount entirely absorbed in any residence country credit. This explains reasons that mostly the double taxation agreement fixes the rate of withholding tax at a lower rate than the rate normally applicable. Reduction in rate is also sought on account of another reason. The source country should not get any unwanted advantage over the interest of the country of residence, by fixing the effective rate of withholding tax on the gross amount (which reflects the element of expense) at a higher level than the regular rate applicable to the net amount (gross amount minus the permissible deduction) in the country of residence, i.e., in excess of the allowable credit. Thus, the method of taxation by the source country and the general desirability of applying withholding rate to the gross royalty payments, requires the rate to be determined at a level which is appropriate to overall relationship of the expenses to the gross royalty, so that there could be a close relationship of taxation at source and taxation in the country of the recipient and that the source country tax involves the aspect of 'sharing' of the revenue.

70. Arising or deemed arising in a country
The source State right to tax royalty income would be operative when the income arises or is deemed to arise in that State. The expression 'arise' has been discussed in detail in para 63.1. As regards ‘deemed to arise' paragraph (5) states, inter alia, that when the payer is the State itself, a political sub-division, or a local authority or resident of that State, royalties shall be deemed to arise in that State. This expression has been discussed in para 63. 1-1. In its meaning and contents it accords substantially with section 12(4)(a) & (b) of the Income Tax Ordinance, 1979.

70.1. Royalty - A non-resident taxpayer is chargeable to tax in Pakistan in respect of income by way of royalty which is received or is deemed to be received in Pakistan or which accrues or arises or is deemed to accrue or arise in Pakistan. The Income Tax Ordinance, 1979 did not contain clear cut source rule specifying the circumstances in which royalty income could be regarded as accruing or arising in Pakistan. Further, lump sum payments made for the supply of know-how were not chargeable to tax where such know-how was supplied from abroad and the payment therefor was made outside Pakistan, even though the know-how is used in Pakistan, if no part thereof was attributable to any services rendered in Pakistan.

Section 12(4)(a) & (b) deals with this subject which says:

"Sec. 12(4) Any income by way of royalty payable by -

(a) a person who is a resident, except where the royalty is payable in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on by such person outside Pakistan or for the purposes of making or earning any income from any source outside Pakistan; or

(b) a person who is a non-resident, where the royalty is payable in respect of any Fight, property or information used or services utilised for the purposes of a business or profession carried on by such person in Pakistan or for the purposes of making or earning any income from any source in Pakistan,

shall be deemed to accrue or arise in Pakistan."

In view of the aforesaid royalty income consisting of lump sum consideration for the transfer outside Pakistan of, or the imparting of information outside Pakistan in respect of any data, documentation, drawings or specifications relating to any patent, invention, model, design, secret formula or process or trade mark or similar property, is ordinarily become chargeable to tax in Pakistan.

70.2. Fees for technical services - As in the case of royalty, the circumstances in which the income by way of 'fees for technical services' is deemed to accrue or arise in Pakistan, .in the same manner.

Under section 12(5) of the Income Tax Ordinance, 1979, income by way of 'fees for technical services' of the following types will be deemed to accrue or arise in Pakistan:

"Sec. 12(5) Any income by way of fees for technical services payable by -

(a) a person who is a resident, except where the fees are payable in respect of services utilised in a business or profession carried on by such person outside Pakistan or for the purposes of making or earning any income from any source outside Pakistan; or

(b) a person who is a non-resident, where the fees are payable in respect of services utilised in a business or profession carried on by such person in Pakistan or for the purposes of making or earning any income from any sources in Pakistan,
shall be deemed 'to accrue or arise in Pakistan."

The expression 'fees for technical services' is defined in Explanation to section 2(5) to mean any consideration (including any lump sum consideration) for the rendering of managerial, technical or consultancy services (including the provision of services of technical or other personnel). It is defined as under:

"Sec. 12(5) Explanation - For the purposes of this sub-section, clause (b) of section 24, sub-section (2) of section 30, sub-section (3A) of section 50 and section 80AA, "fees for technical services" means any consideration (including any lump-sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of the services of technical or other personnel) but does not include consideration for any construction, assembly or like project undertaken by the recipient or consideration which would be income of the recipient chargeable under the head "Salary"."

Applicability of Section 80AA of the Income Tax Ordinance, 1979

Fees for technical services accruing or arising to a non-resident are chargeable to tax under section 80AA of the Income Tax Ordinance, 1979, which reads as follows:-

80AA. Tax on income of non-residents from fees for technical services.-(1) Notwithstanding anything contained in this Ordinance, where any consideration by way of fees for technical services referred to in the Explanation to sub-section (5) of section 12 is received or is deemed to be received by, or accrues or arises or is deemed to accrue or arise to, a non-resident, the whole of such consideration shall be deemed to be income of the non-resident and tax thereon shall be charged at the rate of fifteen per cent of such income.

(2) A non-resident referred to in sub-section (1), or an agent authorised by him in this behalf, shall prepare and furnish to the Deputy Commissioner within thirty days from the last day of each period of six months in every financial year, that is to say, the thirty-first day of December and the thirtieth day of June, respectively, a return, in respect of each such period of six months as aforesaid, showing therein full particulars of the income referred to in the said sub-section:

Provided that, where such non-resident is likely to leave Pakistan in any six month period as aforesaid or shortly after its expiry and he has no present intention of returning to Pakistan, the provisions of section 81 shall, so far as may be, apply as if references to financial year, the return of total income, the income year, the order of assessment, the assessment year and rate of tax were references to the corresponding provisions of this section.

(3) On receipt of such return, the Deputy Commissioner may, after calling for such Particulars, accounts or documents as he may require, determine the income referred to in sub-section (2) and charge tax thereon in accordance with the provisions of this section.

(4) Nothing contained in this Ordinance shall be so construed as to allow any expense against the income determined under sub-section (3).

(5) The tax paid under this section shall, to the extent that the income of the non-resident is chargeable under this section, be deemed to be the final discharge of his tax liability under this Ordinance, and he shall not be required to file the return of total income under section 55 or be entitled to claim any refund or adjustment on the basis of such return.

(6) The provisions of this section shall not apply to a non-resident in respect of any consideration referred to in sub-section (1) for rendering technical services under an agreement entered into on or before the thirtieth day of June, 1987.]

The provisions of section 50(3A) are also relevant for the purpose of Section 80AA. Section 50(3A) reads as follows:

50(3A) Any person responsible for paying to a non-resident any sum by way of fees for technical services shall, unless such person is himself liable to pay tax thereon as an agent, deduct, at the time of payment, tax at the rate specified in the First Schedule [:]

Provided that, where on an application of an assessee the Deputy Commissioner gives a certificate in writing that the assessee is liable to pay tax under any treaty or convention for avoidance of double taxation, entered into between the Government of Pakistan and the country of residence of the assessee, at a rate which is lower than the rate specified in the First Schedule, the person responsible for paying any sum as fees for technical services to such assessee shall, until such certificate is cancelled by the Deputy Commissioner, deduct tax at such lower rate.

It is evident that section 80AA would come into operation only when fee for technical services "is received or is deemed to be received by, or accrues or arises, or is deemed to accrue or arise, to a non-resident" in Pakistan. In a case reported as 1993 68 Tax 91 Trib, it is held: "it is well established that the sea-vices were predominantly performed in Switzerland and that the payments (except for reimbursements) were received in Switzerland. Moreover, it is pertinent, the assessing officer has nowhere specifically held that the remuneration was received or is deemed to have been received/accrued in Pakistan. Again we have already reversed the finding that the Appellant had a permanent establishment in Pakistan. As a consequence, they would be liable for income received/accrued (or deemed to have been received/accrued) in Pakistan as could be said to be covered by the provisions of clause 'b' of sub-section (1) of section 11 of the Ordinance. But, there is neither any definite evidence or categorical finding by the assessing officer in this behalf, hence the Appellant nonresident cannot be burdened with any tax liability on an income which accrued abroad, was earned abroad and also was received outside Pakistan. Even if it were so received/accrued, the operation of the terms of the Convention provides an umbrella for its exemption from Pakistani taxes".

71. Royalty
The term 'royalty' has been defined in paragraph (3) of Article 12 of the UN Model as to mean payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films or films or tapes used for radio or television broadcasting any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use industrial, commercial or scientific equipment or for information concerning industrial, commercial or scientific experience.

The scope of the' income from royalty has not been confined to industrial royalties arising out of patents and know-how, copyright royalties but also extended to cover rentals within its scope such as film rentals, rentals of certain equipment and current technical assistance. Rentals of tangible assets such as commercial or scientific equipment should normally have been taken as business income, but since these are .to be taken royalty income as per paragraph (3) of Article 12 of the UN Model, these may, therefore, create confusion. This confusion could be dispelled if the tangible assets referred to in aforesaid paragraph be understood as those which represent technical know-how in the tangible form.

71.1. Royalty generally defined - Defined generally, the word 'royalty' means a share of the product or profit reserved by the owner for permitting another to use the property; the share of the production or profit paid to the owner; a share of the product or proceeds therefrom reserved to the owner for permitting .another to use the property; the share of the produce reserved to the owner for permitting another to exploit and use the property; a share of the profit, reserved by the owner for permitting another to use the property; the amount reserved or the rental to be paid to the original owner of the whole 'estate. ‘Royalty proper' is a share of product or profits reserved by the owner for permitting another to use or develop his property, and a case of one of the American Courts is referred to in support of this proposition in Corpus Juris Secundurn.

'Royalty' (except in the expression 'tonnage royalty') includes a dead rent and any periodical or other payment for minerals got under a mining lease, and 'tonnage royalty' means a royalty calculated by reference to the amount of minerals so got from time to time, or of manufactured Articles produced from such minerals, or by any similar method.

The royalty is a payment made to the owners of certain types of rights by those who are permitted by the owners to exercise the rights. The rights concerned are literary, musical and artistic copyright, rights in inventions and designs, and rights in mineral deposits, including oil and natural gas. The term originated from the fact that in Great Britain for centuries gold and silver mines were the property of the Crown; such 'royal' metals could be mined only if a payment ('royalty') were made to the

Crown. An individual inventor without capital or plant must licence others to manufacture his invention. When owners of rights make arrangements for such exploitation by others, the remuneration they receive in exchange is often in the form of a royalty, usually based on the actual extent of the exploitation. As to inventions, a royalty may be said to be a compensation paid under a licence granted by the owner of a patent ('the licensor') to another person ('the licensee') who wishes to make use of the invention, the subject of the patent. The patent remains the property of the licensor. A licence may be exclusive, in which case the patent owner precludes himself from granting licences to third parties, or non-exclusive, in which case the patent owner may grant licences to as many persons as he wishes. The granting of licences and the payment of royalties thereunder are purely a matter of contract between licensor and licensee. It is essential that all relevant matters be provided for in the contract, especially the amount of royalties, and the precise method of computing them. A licence may be limited or not, according to the intentions of the parties. It may be limited to certain purposes or to geographical areas or in any other way permissible under the national laws having jurisdiction over the transaction. It will normally be for the full term of the patent. A royalty may be a single payment covering the whole use of the patent for the whole term, but the more usual practice is to make periodic payments and to relate the amounts of those payments to the actual use of the patent by the licensee. It is common to charge royalties on the basis of a percentage of the price for which the licensee sells the Articles or on the basis of the number of the Articles made under the patent. Although the amount of royalties is generally a matter of free bargaining between licensor and licensee, in some countries governments preclude their nationals from paying royalties to foreign patent owners in excess of a certain maximum fixed by the Government. Some Governments also reserve the right to approve the entire licence contract concluded between their nationals and aliens.

Royalty payments may be in exchange for something in addition to the mere use of the invention. The most common example is that wherein the licensor not only grants the right to use the invention but also undertakes to supply the licensee with technical 'know-how', that is to say, information from his own experience on the most efficient and economical way of working the patent. It is estimated that more than 50 per cent of licence contracts include 'know-how' provisions.

When applied to industrial designs, the meaning of the word 'royalty' is roughly the same as in the case of patented inventions. Designs, depending on their nature or the various national laws, may be protected by patents, copyright or registration. The form of legal protection, however, does little to change the system of royalty payment as described in regard to patents.

It is thus clear that in the case of secret processes, patents, special inventions, when right of exploitation is given by the owner of the inventions, patents, etc., to a third party, instead of outright sale, then, for the fight to exploit these inventions, secret processes, some amount may be paid and the amount paid may be co-related to the extent of exploitation. It is in this sense, that licence agreements for the exploitation of patents, inventions, etc., are being entered into in modern commercial world and as part of such agreements, even knowledge derived from his own experience and technical know-how for the most economical and efficient user of the patents inventions, etc., are parted with by the licensor to the licensee.

71.1.1 Royalty from mine, quarry, etc., to be taxed as income from immovable property or as business - Under some agreements income earned as royalty is taxed as arising from immovable property, if it is derived from the operation of mine, quarry or any other extract/on of natural resources. As for an illustration reads as follows:

- "(1) Income from immovable property may be taxed only in the territory in which the property is situated. [(2)..........Royalty or other income derived from the operation of a mine, quarry or any other extraction of natural resources shall be regarded as income from immovable property."

For a limited purpose 'royalty' derived from mine, quarry or any other extraction of natural resources is taken to be emanating as if from an immovable property along with rent or other income. This Article only classifies that the nature of receipt derived from that Particular source as royalty. It, thereafter, states that receipt designated as royalty should be taxed as income from immovable property.

Nothing can in this Article lead to interpretation that the general meaning which is to be attributed to 'royalties' as occurring in Article III(3) requires to be limited to royalties derived from mines, quarries, or any other extraction of natural resources.

In fact income referable to mine or a quarry or any other place of extraction of natural resources, is to be assessed as business income, as the UN Model Convention defines, inter alia, to include these to mean permanent establishment. The nomenclature of a receipt as 'royalty, would not be decisive as characterising it to be so, if the receipt is having reference to the permanent establishment. In that case it is to be taxed as business income, and not as royalty convertible Under Article 12 or as arising from immovable property taxable under Article 6.

71.2. Royalties as defined in double taxation agreements - Royalty has been defined in double taxation agreements, Pakistan has entered with Hungary, Denmark, Norway, Finland. Austria Indonesia, France, Belgium to mean any royalty or the likeamount received as consideration for the right to use copyright, models or artistic designs, plans, secret processes, formulae and other like property. In almost all agreements the definition and concept of royalty as per OECD/UN Model, has been incorporated. The modern international usage in the commercial field accepts this very meaning of the word 'royalty’ in the sense of consideration paid from time to time or, may be outright, for the exploitation of the rights, inter alia, to the knowledge regarding secret process, patents, registered trade marks, etc., and also the right to market the products as a result of those exploitations. These agreements were arrived at in the field of taxation and the word 'royalty’ is thus understood by the contracting parties, namely, the respective countries.

71.3. Royalty as defined under the income Tax Ordinance, 1979 - The word 'royalty, has now been defined in Explanation to section 12(4). This definition lends support that in the international commercial usage that the word 'royalty, has now come to acquire a particular meaning. In the case of secret process, patent, special inventions, when right of exploitation is given by the owner of the inventors, patents, etc., to a third party, instead of outright sale, then for the right to exploit these inventions, secret processes some amount may be paid and the amount paid may be co-related to the extent of the exploitation. Licence agreements for the exploitation of patents, inventions are being entered into in the modern commercial world and as part of such agreements, even knowledge derived from his own experience and technical know-how for the most efficient and economical user of the patents, inventions, etc., are parted with by the licensor to the licensee. Payments of this kind are known as royalties.

71.3-1 Whether receipt of technical fee could be taxed on the basis of its arising because of business connection, or as royalty - Section 12(2) refers to -all income accruing or arising whether directly or indirectly, through or from any business connection in Pakistan or through or from any property in Pakistan, or through or from any asset or source of income in Pakistan or through the transfer of capital asset situated in Pakistan. Section 12(5) refers to income by way of fees for technical services payable by Government or a resident company or non-resident company in certain circumstances. Section 12(2) is a general provision, whereas section 12(5) is a special provision which refers to a particular type of income dealing with fees for technical services rendered by the foreign company. The technical services may be rendered as a result of the business connection or otherwise. But whether or not there is a business connection any income by way of fees for technical services should be taken to have been covered by the provision in section 12(5) because when there is a special provision dealing with a special type of income, such a provision could exclude a general provision dealing with the income accruing or arising out of any business connection. If the nature of an income. is such as it falls under a specific provision, but on account of something in that provision or proviso or Explanation thereto, it cannot be subjected to tax, it cannot be brought within tax net by circumventing the general provision and extending its sweep to embrace it within its folds. When it is not possible to tax amount under section 12(5) on account of the proviso thereto, the income received by a person by way of fee for technical services rendered irrespective of whether it arises out of business connection, cannot be taxed under section 12(2). Two provisions cannot operate in the same field in respect of fees for technical services.

71.4. Royalty as defined in the Model Convention - 'Royalty' has been defined to mean payments of any kind received.

(a) as consideration for the use or the right to use:
(i) any copyright of literary, artistic or scientific work including cinematograph films, or films or tapes used for radio or television broadcasting; or
(ii) any patent, trade mark design or model, plan, secret formula or process; or
(iii) industrial, commercial or scientific equipment;

(b) as consideration for information concerning industrial, commercial or scientific experience.

71.4-1 Receipt of consideration for the use or right to use of technical knowledge - What is taxed as royalty is the amount received as consideration for the use or the right to use technical knowledge, etc. If, however, the consideration does not so represent but represents the price for outright sale of technical knowledge, the amount received is on capital account and taxable as capital gains.

There are different ways of imparting technical know-how, e.g., (i) outright sale of designs, know-how, etc., (ii) lending the services of foreign technicians, (iii) giving technical assistance, (iv) royalty or licensing agreements or (v) foreign capital participation. Sale of technical know-how or imparting of technical knowledge and information results in transfer or parting with the property or asset or any special knowledge or skill which would ripen into a form of property, and after such transfer, the transferor is deprived of using the asset. In all other cases where no asset is parted with and the transaction is merely permitting the use or granting the right to use the asset, the amount received would represent royalty.

The tax problems arising under technical collaboration agreements are broadly of two kinds, viz, those relating to the admissibility of the expenditure incurred in the assessments of the Paidstahl Participants (whether be taken as capital or revenue) and those relating to the taxation of amounts in the hands of the non-resident collaborators. As regards the former, the law has been well settled that if the expenditure has been incurred for acquiring or bringing into existence an asset or advantage of enduring nature, the expenditure will have to be regarded on capital account, and if, for running the business and working it with a view to providing profits, it will have to be regarded on revenue account.

The nature of the expenditure in relation to the payer is not determinative of the nature of the corresponding receipt in the hands of the recipient. If to the recipient the amount received represents rental for the mere user of technical knowledge or information, it would be regarded royalty income in his hands.

Know-how can be put to use so as to produce revenue in two ways. The manufacturer can use it himself to make things for sale and make profit in that way; or he can teach it to others, so that they can make their own things, in that case he gets paid for the knowledge and information which imparts to them. His fees and rewards are the revenue in his hands. The manufacturer although teaching it to others, still retains the knowledge himself and intends to go on using it himself and .making things from it. So long as he does this, he retains the capital asset himself and is using it to produce revenue. But know-how can be used to produce a capital receipt. It can be sold outright and bring in a capital fund. This happens when a trader or manufacturer sells his know-how outright to a purchaser and agrees not use the know-how to the prejudice of the purchaser. The purchase price he receives is capital in his hands. In Rolls Royce Ltd. v. Jeffrey (Inspector of Taxes) the House of Lords held that the lump sum received for the know-how was revenue receipt. This decision was followed in Musker v. English Electric Co. Ltd. as well as in Murray (Inspector of Taxes) v. Imperial Chemical Industries Ltd. In Imperial Chemical industries' case, Lord Denning, M.R., held that the lump sum for 'know-how' may be a revenue receipt as the capital remained with the owner and all he did was to put it to use.

Thus, whether receipts from the provision of know-how are of capital or revenue nature would essentially depend upon the transaction out of which receipts would arise and the context in which the receipts are received. If the imparting of know-how is really in the nature of services rendered without anything more the receipt must be treated as revenue receipt. But when consideration is received for imparting know-how in association with disposal of a capital asset, then the receipt will have to be treated capital receipt.

71.4-2 Industrial properties and technical know-how- Transfer of revenue receipt or capital gains - Technology is embodied in various forms, such as machinery, human capital and written documents. Transfer of technology involves industrial properties like patents and trade marks, human skills and of equipment. In general, contractual agreements can be divided into two broad types. The first includes what are generally known as licensing agreements, and involves the transfer of the right to use certain properties such as patents, trade mark, design, model, plan, secret formula or process industrial, commercial and scientific equipment. The second involves the transfer of skills, experiences and knowledge which are already in the public domain, for example, turnkey contracts, service and engineering contracts. Technology transfer agreements cover licence rights over specific processes, formula or manufacturing technology, other knowledge or expertise necessary for the setting up of a plant and provision of various technical assistance and supporting services.

The UN Model Convention covers both kinds of transfer and defines the consideration for the use or the right to use of industrial asset, as also the consideration for transfer of information concerning industrial, commercial or scientific experience, as royalty. A licensing agreement may also include technical assistance; and a technical assistance agreement may include the right to use the industrial asset. The consideration received in respect of both is royalty. But under certain circumstances transfer may involve the outright transfer as giving rise to capital gains. Having incurred heavy expenditure on research and development before a manufacturing enterprise or an inventor develops a patent or a process, he may desire to be compensated, as also to be somewhat profited. He, therefore, permits the licensee to use the patent, invention or process for a lump sum payment apart from the current royalty. However, whether the lump sum consideration or even the subsequent amount to be received annually represents royalty or the capital gain, depends upon the facts and circumstances of each case. Under the Ordinance, the distinction between the two is well demarcated, when the expression 'royalty' is defined in Explanation to section 12(4) as to mean consideration including lump sum consideration but excluding any consideration which would be the income of the recipient chargeable under the head 'Capital gains' for transfer of all or any right (including the licence) or any information concerning with, or permitting the use of industrial assets as a patent, invention, model, design, secret formula or process or trade mark or similar property, or a copyright, literary or scientific work, etc. Thus, transfer of technology or know-how may involve capital gain or it may be for a consideration which is taxed as royalty.

The Madras High Court in Fenner Woodroffe & Co Ltd. v. CIT held that agreement was a sale of technical know-how. References were made to Lord Radcliffe's speech in Rolls Royce Ltd. v. Jeffrey decided by the House of Lords and to other English cases. It was held that 'know how' is an intangible asset. Quoting from Lord Denning's speech in Muskar v. English Electric Co. Ltd. it was observed that 'know-how' could be sold to others and could also be used to produce an enduring result by utilisation in manufacture.

The principles, on which foreign collaboration agreements have to be examined are well settled, whether such agreements provide for the sale or the use of the know-how. There can be an agreement by which the utilisation of the technical know-how is transferred, there can be an agreement by which know-how is to be utilised in a restricted manner, there can be an agreement in which know-how is to be transmitted as a part of the larger agreement of collaboration. There may conceivably be other types of agreements in which a question can arise as to whether the know-how has been acquired as a capital asset by the assessee. Collaboration agreements and other agreements are full of complex questions peculiar to the agreements in question. Each agreement, therefore, requires critical examination.

The distinction between capital and revenue expense is sometimes difficult to ascertain although the two things are distinct and yet they tend to overlap at particular points. If an entrepreneur has to manufacture anything he must get the necessary machinery and plant for making the Article. He must also get the information as to how that machinery is to be utfiised in the making of the goods that he wants to market. The expense on the manufacturing machinery and plant is most definitely a capital expenditure. The question is as to whether the information obtained for running that machinery is a capital expense or revenue expense becomes a problematic question. For instance, the manufacturer may buy the know-how from another party or he may engage the services of another expert who knows how to do the manufacture. If he gets expert managerial staff, the expense could be of revenue in nature except to the extent utilised for setting up the machinery. If information is given by way of plans and drawings for making the Article, it could be considered to be capital. But if the utilisation is limited to manufacturing the goods for a limited period, it has to be treated as revenue expenditure.

71.5. Speeialised knowledge or service yields royalty - The term royalty connotes payment periodic or at a time for user of one person of certain exclusive rights belonging to another person. The examples of such exclusive rights are in the nature of a patent, mineral rights, or right in respect of publications. It appears that the person who grants the user of the exclusive right might have the sanction of law which guarantees exclusiveness. Such sanction may be obtained by taking out a patent in respect of an invention. In other cases, such exclusive rights would arise from the ownership of mineral rights, protected by the laws relating to property. In respect of books and publication the exclusive right of the author is protected and sanctioned by the laws of the copyright. It is possible that a person who invents may not take out a patent for his invention but unless some other inventor independently and by his own efforts comes to duplicate the invention the original invention remains exclusive to the inventor and it is conceivable that such an inventor might exploit his invention permitting some other person to have the user thereof against the payment. Similarly, it is possible for a person carrying out operations of manufacture and production of a particular produce to acquire specialised knowledge in respect of such manufacture and production which is not generally available. A person having such specialised knowledge can claim exclusive right to the same as long as he chooses to make such specialised knowledge to public. It is also conceivable that such a person can exploit and utilise such specialised knowledge in the same way as a person holding a patent or owning a mineral right or having the copyright of a publication to allow limited user of such specialised knowledge to others in confidence against payment. There is no reason why payment for the user of such specialised knowledge, though not protected by a patent, should not be treated as royalty or in the nature of royalty. The nomenclature used by the parties in respect of a particular service would not b.. decisive of the matter but such nomenclature has to be construed on the basis of commercial principles.

Technical assistance may be rendered by supply of information although such information by way of technical assistance would be information of general nature; but supply of exclusive and specialised information on the basis of which production and manufacture is possible, goes beyond the concept of assistance and falls into the category of right of user of an exclusive property right. If, therefore, information agreed upon to be supplied in respect of working methods and manufacturing processes of the product are exclusive information and knowledge available to the assessee and not generally disseminated, the payment in respect thereof would bear the character of royalty. Industrial assets are held in the form of copyright, patent, design, trade mark, model; or technical information concerning industrial, commercial and scientific experience, which expressions are discussed in the following paras:

71.6. Copyright - Copyright is one of the intangible assets whose value is limited by the rights and anticipative benefits that possession confers upon the owner. It is an exclusive legal right to reproduce, publish, and sell the matter, and form of a literary, musical or artistic or scientific work, a right conveyed by a statute. Other forms of intangible assets are patents, design, trade marks, model, plan, secret formula or process.

71.7. Patent - Patent is a grant by the Government to an inventor, giving him the exclusive right to make, produce, use and sell his invention, for a term of years, it is an official document conferring a right or privilege, the monopoly of the right or privilege so granted.

71.8. Design - Design means only the nature of shape, configuration, pattern or ornament applied to any Article by an industrial process or means.

71.9. Trade mark - It is a distinctive identification of a manufactured produce or of a service taking the form of a name, sign, motto, device or emblem'. It is thus a distinctive mark attached to goods or services to identify them with a particular trader or with his successor as the owner of the particular business.

71.10. Model - A pattern, system; or postulational set of functional relations, including definitions, between variables and parameters, the purpose of which is to conceptualize empirical findings and to plan, design and analyze the results of systematic investigations. Sometimes models may take physical form (e.g, scale models of ships or buildings) as an aid to planning or analysis, but more frequently they retain the form of abstract constructs. Often thought of as being confined to investigations in mathematical and developed sciences, models are essential to systematic work in any field dealing with complex problems involving relations between facts and objectives.

71.11. Technical know-how and information concerning industrial, commercial and scientific experience - All these rights in the form of copyright, patent, design, trade mark, models, secret formula or process emanate from research and investigation and may be grouped as technical knowledge or technical know-how. Information relating to industrial, commercial or scientific experience is also known technical knowledge and any consideration received for providing it is taxed as royalty.

71.12. Technical know-how - 'Technical know-how' is a term of wide connotation and includes several kinds of technical knowledge, assistance and services. There are several ingredients constituting technical know-how, such as (i) the design of the product to be manufactured, (ii) the design of the process for manufacture, (iii) the design and engineering of the plant, (iv) the erection and commission of the plant, etc., etc.

Know-how is a peculiar kind of asset. It is the accumulated fund of knowledge acquired by years of observation, research, experimentation and experience. Though it is an intangible asset, the whole of it, however, is not in an intangible form, as it grows in the shape of formulae, drawings, patterns, blueprints, specifications and so on. The material form it takes not only facilitates preservation, collation and nearly reference, but also makes it perceptible and visible and easily capable of being transmitted to others. When it assumes such a concrete shape, it ceases to be an intangible entity and becomes in a sense of corporeal asset which can be bought and sold, lent or borrowed, exchanged or stolen or imparted gratuitously to others. Though physical records of know-how such as lists, drawings, engineering and manufacturing data is imparted to another person, know-how is not lost to the owner thereof who still continues to retain it for his own use, and, therefore, income arising from an agreement under which such record is parted with cannot properly be termed as capital receipt. The technical-know-how in the shape of drawings, designs, charts, plants, processing data and other literature falls within the meaning of plant and is, therefore, a depreciable asset. Technology is a science or a body of' knowledge applicable to the production of goods. Modern machinery is the product of technology. The concept of transfer of technology is a complex phenomenon involving rights, obligations, privileges and commitments of the parties concerned. The transaction permits access to advanced means of production and control over the means of production. Such control, however, is not always accompanied by control over technology. This is only when the skill, information and technical excellence that make up technology, is transferred to the national managers, supervisors and workers of enterprises from where it can eventually be permeated into the economy of the developing country, technology could be said to have been transferred. Such transfer is possible if access and use of commercial and scientific equipment is permitted.

71.13. Equipment, use of or sale of, distinction - Royalty has been defined as the consideration for the use or the right to use of, inter alia, industrial, commercial or scientific equipment. Such a right is imparted as a part of technology transfer, or sometimes as part of business activity of leasing of machinery or equipment, or is granted for such time till the transaction ripens into sale. A distinction has, therefore, to be made between the consideration paid for the use of equipment, whether it could be taken royalty under Article 12, or business income under Article 7, or capital gains under Article 13, or professional income under- Article 14, or other income under Article 21.

Normally technology could be had through package deals which include comprehensive transfer of equipment, industrial properties like patents and trade marks, skill, etc. Transfer and dissemination takes place through collaborations, joint ventures, turnkey projects, purchase of machineries, sale of technologies, hiring of expertise. The collaboration agreements are of two types: (1) licensing arrangements, (2) transfer of skills, experience and knowledge. The first relates to permitting the use of patents and trade marks; and the second to transfer 'of experience and skills such as service and engineering agreements. In practice, these are not mutually exclusive. A licensing agreement may also include technical assistance. A technical assistance may include right to use trade marks. In rendering technical assistance, the aid of machinery or equipment is necessary, and therefore, agreement includes licensing of such machinery or equipment. The consideration received for such licensing is taken to be 'royalty' income. If equipment is given on hire by a person in the normal course of business, the consideration received is taken as business income.

When an equipment has been leased for a consideration, the lessor retains the ownership of an asset but conveys the right to use it to the lessee for an agreed period of time in return for the payment of specified rentals. A lease consists of a right to the possession and the use of the property owned by some other person. It is an outcome of the separation of ownership and possession. Thus the basic characteristic of the concept of leasing is the divorce between 'ownership' and 'use' of the asset. But some contracts contain hire element and the sale element, as in the hire-purchase agreement. It is the nature of a contract of bailment with an element of sale added to it. It, however, differs from sale transaction. In a sale where price is payable by instalments, property nonetheless passes on the date of the contract, while in a hire-purchase agreement, it passes when the option is finally exercised by the intending purchaser after complying with all terms of the agreement. Hire-purchase contract is often used to describe contract which are in reality agreements to purchase chattels by instalments, subject to the condition that the property in them is not to pass until instalments have been paid. The hire-purchase agreement contract fixes the total amount payable by the hirer-cum- purchaser which exceeds the original price of the asset by an amount which may be called hire charges. Thus instalments paid by the purchaser/hirer do not in principle constitute royalties and the gain is taxable as capital gains' under Article 13. In the case of land lease, and leasing in particular, the principal purpose of contract is normally that of hire, even if the hirer ultimately exercises an option to purchase it. Article 12, therefore, applies in the normal case to the rentals paid by the hirer, including all rentals paid by him upto the date he exercises any right to purchase.

In the know-how contract, generally one of the parties agree to impart to the other, his special knowledge or experience, so that the other can use it for his own account. The grantor is not required to play any part himself in the application of the formula granted. This differs from contracts for the provision of services, in which one of the parties undertakes to use his skills and expertise to execute work himself for the other party. Such Participation is ensured through many ways.

There are a number of modes open to business organisations to pool their resources. These are:
- Franchising
- Licensing
- Sale of turnkey plants
- Co-production agreements
- Joint ventures

71.13-1 Franchising - In franchising, the ownership of enterprise remains with the supplier of the patent. There is a privilege granted by the owner of the technology to an individual or a corporation by which the grant is permitted to operate a business under certain conditions. It means granting of an exclusive right to another corporation. The features of franchise are:
-Duration of the issue
-Rates charged for services
- Services to be conducted
- Capitalisation

In return the grantee companies generally agree to pay a fixed percentage of the gross sale. The ownership of the enterprise remains with the corporation and all taxes are borne by its owner. Management is conducted locally with the experts from the foreign companies available on request and on fee.

71.13-2 Licensing - In a licensing agreement, the arrangement usually entails a form with sophisticated technical expertise in a specific industry which sells package of technology to another for consideration.

71.13-3 Turnkey plants - In turnkey plants the foreign companies provides machinery, supervising the assembling of production line for the product which it has licensed, besides offering expertise to the host company.

71.13-4 Co-production agreements - In co-production agreements, there is a joint manufacturing of a product generally for an extended period of time One partner usually supplies components to be integrated into the equipment produced by the other partner. The final product then is marketed by both the parties in and outside the respective home States. Occasionally this form of corporation combines both the licensing agreements and the turnkey plant sale.

71.13-5 Joint ventures - As association of individuals or firms formed to carry out a specific business project although a joint venture is very similar to the partnership. It differs in that it is limited to the success or failure of the specific project for which it is formed. As in the case of partnership, a joint venture is formed by a contract agreement in which each partner assumes unlimited liability for the organisation debts.

Income arising as a result of co-production agreements or joint ventures is essentially income from business, and the one arising from franchising licensing, turnkey projects is partly business and partly royalty. The payments obtained 'as consideration for after-sales service, for services rendered by a seller to the purchaser under a guarantee, for pure technical assistance, for professional services given by a professional such as an engineer, an advocate, or an accountant, do not constitute royalty. Such income generally falls under Article 7 or 14. The cases where the contracts are of mixed nature, consisting of imparting technical know-how and business venture, the appropriate course is to apportion the receipt between its components as to ascertain how much of it could be referable to technical know-how and how much to business or professional activity so that each component is appropriately dealt with under the respective Article, unless where one component constitutes by far the principal purpose and other is only ancillary and largely unimportant character when the whole amount of the consideration is to be attributable to the principal part. If, however, income is of such a nature that it could fall equally under any of the Articles, it should be covered under that Article which specifically so provides in respect of that income.

An almost similar question arose before the Madras High Court, whether the amount received by a non-resident collaborator be taxed as an income arising or accruing in India by reason of business connection in India in terms of section 9(1)(i) of the Indian Income Tax Act [corresponding to section 12(2)(a) of the Income Tax Ordinance, 1979] or as the technical fee for services rendered in terms of section 9(1)(vii) corresponding to section 12(5)(a) of the Income Tax Ordinance, 1979 in CITv. Copes Vulcan Inc. The Court held that if the nature of income is such as it falls under a specific provision, it has to be taxed under that provision and not under the general provision.

72. Article 12 vis-a-vis Article 11
The provisions relating to royalties in respect of property which is effectively connected with permanent establishment or a fixed base, deal with in paragraph (4), the fictional provisions about arising of income deal with in paragraph (5) and the determination of income at arm's length deal with in paragraph (6) are not discussed here, as these paragraphs are almost in pari materia with the similarly numbered paragraphs of Article 11. Discussion relating to them under that Article is also relevant for this Article.

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