The Supreme Court(1) recently held that, for the purpose of central excise duty, royalty charges payable by distributors and copyright owners to artists and production houses could not be included in the assessable value of compact discs (CDs) which had been duplicated by workers using master CDs supplied to them.

Facts

The appellant manufactured copied CDs from a master CD issued by a distributor which owned the copyright. The artist who owned the copyright sold it for a certain consideration to a music producer; the music and images were then captured on CD. The producer then sold its copyright to a distributor, which had the CDs duplicated by the appellant. The distributor sold the CDs to end customers.

The appellant was given the master CD, from which further CDs were duplicated onto blank CDs owned by the appellant and then sold to the distributor. On receipt of the CDs, the distributor added (proportionately) part of the royalty paid to the music producer to the price of each CD, which were then sold to end customers. The entire stock of duplicate CDs could be sold only to the distributor.

Apart from the cost of the raw material and other expenses, the appellant levied a RS1 royalty on each CD.

For the CDs sold between November 2000 and October 2001, the tax authorities confirmed the demand for differential excise duty on account of the royalty payable to the distributor, which was calculated at Rs54.81 per CD.

On appeal, the commissioner held that royalty charges incurred by the distributor were liable to be included in the assessable value of the CDs. The case was accordingly remanded to the assistant commissioner to quantify the demand after taking into consideration the amount of royalty to be apportioned (according to the methodology prescribed under Circular 619/10/2002-CX, February 19 2002).

The Customs, Excise and Service Tax Appellate Tribunal (CESTAT) confirmed the commissioner's order. The order passed by CESTAT was appealed before the Supreme Court.

Decision

The Special Tax Bench of the Supreme Court held that the royalty payable by the distributor should not be included in the assessable value of the duplicated CDs.

Section 4(1)(a) of the Central Excise Act 1944 did not apply, since price was not the sole consideration for the sale, as a master CD had to be handed over by the distributor to the appellant. Since Section 4(1)(b)applied, the Central Excise Valuation (Determination of Price of Excisable Goods) Rules 2000 also applied. Both sides agreed that Rule 6 of the Valuation Rules applied to the case.

On an examination of Clause 4, Explanation to Rule 6 of the Valuation Rules,(2) the Supreme Court observed that where the master CD was supplied by the distributor to the appellant, whether free or at a reduced cost, the master CD must be used in connection with the production and sale of the goods by the assessee. What is clear from the present transaction is that the master CD contained music and pictures in digital form.

There is no doubt that the music and pictures supplied on the master CD ought to be valued and were valued as additional consideration that flowed from the buyer to the assessee, and their value was accepted at Rs1 per CD.

Insofar as the royalty payable for the music and artwork were concerned, even though it was agreed that this royalty was inextricably connected with the music and therefore would be used in connection with the production of the duplicate CDs, the explanation requires that such use be not merely in connection with the production, but also in connection with the sale of the duplicate CDs.

The duplicate CDs were sold only to the distributor, which was the copyright holder. The copyright value in the duplicate CDs was therefore not used in connection with the sale of such goods and no part of the copyright could be passed on by the distributor to the assessee to be used by the assessee in selling the duplicate CDs to the distributor, which owned the copyright.

On the assumption that the music and images embedded in the master CD were inextricably associated with the copyright, the copyright was not used by the appellant while selling the duplicate CDs to the distributor. The distributor, having paid a lump-sum royalty to the music producer, sold the duplicate CDs with the cost of the royalty included.

On the assumption that the music and images were the artwork of the master CD, this would be taken into account, as they was necessary for the production of the duplicate CDs. However, the royalty payable for such music and pictures could not extend to artwork which was necessary for the production of duplicate CDs, as this was not taken into account by either the distributor or the appellant.

The Supreme Court relied on its earlier judgments in Joint Secretary to Government of India v Food Specialities Ltd(3) and Sidhosons v Union of India.(4) According to the law, the value of goodwill contained in a brand name would not form part of the assessable value of goods produced and sold only for the owner of the goodwill. The Supreme Court observed that in the present case, the appellant also sold duplicate CDs to the distributor who was the owner of the copyright, and this enhancement could not be added as part of the value of goods sold.

In Associated Cement Companies Ltd v Commissioner of Customs,(5) the Supreme Court observed that what was imported by the appellant was not merely paper, but drawings and designs on paper whose value had to be added for the reason that the importers were themselves going to exploit the intellectual content of the imported goods. In the present case, the appellants did not exploit the intellectual content in the duplicate CDs by way of sale, as any sale could be made only to the copyright owner.

Given that no part of the royalty can be added to the duplicate CDs, the 2002 circular which deals with the apportionment of royalties would not apply in the present case.

The decision will have a significant impact on, among others, the music, software and automotive industries, where workers are engaged to mass produce goods containing intellectual input (eg, music, software and design).

Under customs law, in terms of the position set out by the Supreme Court in Commissioner v Living Media (India) Ltd,(6) the licence fee and royalty paid by an importer to a licensor should be included in the value of goods purchased from the duplicator of CDs. Living Media (supra) was rendered in the context of Rule 9(1)(c) of the Customs Valuation (Determination of Value of Imported Goods) Rules 2007, which requires the inclusion in assessable value of:

"royalties and licence fees related to the imported goods that the buyer is required to pay, directly or indirectly, as a condition of the sale of the goods being valued, to the extent that such royalties and fees are not included in the price actually paid or payable".

There is no comparable rule under the valuation rules in excise law.

The 2002 circular clarified that the cost of the master CD (supplied for duplication) would include the royalty amount paid or payable by the music company for acquiring the exclusive rights for the music and images and the cost incurred in getting the original score recorded in a studio (if this had been incurred by the copyright owner).(7) The circular specifically clarified that duty must be paid on this royalty amount. However, the Supreme Court held that the circular had no application to the facts before it.

For further information on this topic please contact Ranjeet Mahtani or Divya Jeswant at Economic Laws Practice by telephone (+91 22 6636 7000) or email (ranjeetmahtani@elp-in.com or divyajeswant@elp-in.com).

Endnotes

(1) M/s KRCD (I) Pvt Ltd v Commissioner of Central Excise, Mumbai, Civil Appeal 6709, 2004 (April 23 2015).

(2) Explanation to Rule 6 of the Valuation Rules:

"Explanation – For the removal of doubts, it is hereby clarified that the value, apportioned as appropriate, of the following goods and services, whether supplied directly or indirectly by the buyer free of charge or at reduced cost for use in connection with the production and sale of such goods, to the extent that such value has not been included in the price actually paid or payable, shall be treated to be the amount of money value of additional consideration flowing directly or indirectly from the buyer to the assessee in relation to sale of the goods being valued and aggregated accordingly, namely: (i)…(iii)… (iv) value of engineering, development, art work, design work and plans and sketches undertaken elsewhere than in the factory of production and necessary for the production of such goods."

(3) [1985 (22) ELT 324 (SC)].

(4) [1986 (26) ELT 881 (SC)].

(5) [2001 (128) ELT 21 (SC)].

(6) [2011 (271) ELT 3 (SC)]. The review petition against Living Media was dismissed by the Apex Court in Sony Music Entertainment India Pvt Ltd v Commissioner [2012 (284) ELT A58 (SC)].

(7) In such cases, the 2002 circular has clarified that the most reasonable method would be to ascertain the royalty amount and studio hire charges contained in the wholesale price of the CDs at which the copyright owner sells, to its dealers, at arm's length. This could be done by determining the royalty amount plus the studio hire charges as a percentage of the net sale value (gross sale minus central excise duty element) of the music company or copyright owner in respect of the recorded media. The figures of net sales and royalty payments are normally available in the balance sheets of these companies. This percentage will be used to determine the element of royalty cost attributable to each CD.

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