CONTRACTS AND THE DOCTRINE OF EFFICIENT BREACH

CONTRACTS AND THE DOCTRINE OF EFFICIENT BREACH

Snehal Bade

Introduction

The notion of contracts is an ancient one dealing with law, society, economics and business. The concept of capacity to contract led to recognition of concepts of ownership, possession, transfer, etc. Contracts have now become a way of living. The principles of contract and laws of contract are the backbone of commerce, industry, agriculture and economy of every country. A contract entails both rights and obligations. These obligations may not only be legal but also include those backed by social and moral sanctions. We have studied and applied innumerable principles of contract in different circumstances with a view to achieve varied desirable results. Some of these principles relate to “breach of contract”.

               This article proposes to discuss the concept of “breach of contract” in the light of the said doctrine of efficient breach. It has been discussed at length by many judges and jurists in England and the United States of America. This term needs to be explored in the Indian context.

I. Definition and Meaning

               The development of contracts law with regard to economics and business methods is still in its nascent stage.

               To begin with, the term “efficient breach” is employed in cases of breaches that are socially and economically beneficial. It refers to an international “breach of contract” and payment of damages by a party who would incur greater economic loss by performing under the contract.[1] Efficient breach theory is “the view that a party should be allowed to breach a contract and pay damages, if doing so would be more economically efficient than performing under the contract.”[2] Basically, efficient breach theory is the common law remedy of expectation damages. This remedy requires a party who breaches a contract to pay damages in an amount that would make the victim of breach as well off as he would have been had the breach not occurred. In principle, this gives each contracting party an incentive to perform when performance is efficient, but not otherwise. Parties will therefore complete those contractual projects that are valuable and abandon those that are wasteful.[3]

               Indian law does not define the term ‘breach’. Breach means a failure to do something that must be done by law.[4] ‘Effiecient’ cannotes the doing of something well and thoroughly with no waste of time, money or energy.[5] Thus on a combined reading we can conclude that when the avoidance of a contract becomes more beneficial and economical than its performance, then such a breach is called an ‘efficient breach’. Contract law and efficiency theory both asserts that society benefits from the non-performance of some promises.

II. Application

               The application of the Efficient Breach Theory can be demonstrated with the help of some illustrations.

Illustration 1

               The owner of a land makes an agreement with a building contractor for construction of a building within 6 months. The total cost of the contract is set as Rs. 25 lakhs. Out of this amount, Rs. 20 lakhs is the actual cost for construction accounting for the material used, labour employed and other related factors. He does work worth Rs. 5 lakhs. In the meantime the cost of construction goes up by Rs. 10 lakhs owing to an inflating market. The contractor thus has to suffer a loss of Rs. 10 lakhs because the term of the contract cannot be altered subsequently.

               A term in the contract reads that in case of breach committed by the contractor, he shall be liable to pay the contract price in addition to Rs. 5 lakhs as damages i.e. Rs. 30 lakhs in total. During this time he gets an offer from another owner of some other land to construct a building for Rs. 75 lakhs. This owner is under an obligation to get the work of construction within a specified period. If he fails, he will have to pay huge amounts of money as damages for breach. The actual cost of construction comes out to be 30 lakhs (the same amount which he would have spent had he performed his earlier contract post inflation) taking into consideration the fluctuating market. He thus has an option to efficiently breach his first contract. If it does so, under the second contract he will gain a profit of Rs. 45 lakhs. After deducting the amount of damages and Rs. 5 lakhs i.e. the amount that he has already spent while performing his earlier obligation, the contractor will still earn a profit of Rs. 10 lakhs.

               In this way, what was his loss earlier now becomes his profit. At the same time, the aggrieved party is getting damages due under the contract and the amount is enough for it to get the work done by some other person. Even if the aggrieved party goes to the court, there would not be much interference with the measure of damages since the parties have themselves provided for it on their own violation. In addition, the case does not qualify to be one of specific performance, since damages are measurable. Also, the owner in the second contract is in no way affected by these transactions. This can be termed as a win-win situation for every party.

               Most importantly, the contract will still be entitled to get the value of materials, although not the amount for working, for whatever amount of work done in pursuance of the prior contract.[6] Professor Craswell explains the purpose of efficiency breach:

“If a breaching seller must pay damages equal to the value of the goods to the first buyer, the seller will find it profitable to breach the contract only if the second buyer is willing to pay more than that amount. This will be possible only if the second buyer values the goods more than the first buyer does, and in that case the breach will be efficient because it will move the goods to a more highly valued use.”[7]

               In economic terms, this kind of breach is Pareto Efficient. In a given a set of alternative allocations of, say, goods or income for a set of individuals, the contract in the present case, a movement from one allocation on to another that can make at least one individual better off without making any other individual worse off is called a Pareto improvement.[8] In Law and Economics, Robert Cooter and Thomas Ulen describe the Pareto Superior event: “A transaction is said to be Pareto efficient if it is possible to change it so to make at least one person better off (in his own estimation) without making another person worse off (again, in his own estimation).”[9] With facts in the above illustration, no party in being subjected to financial loss.

Illustration 2

               Let us now consider the centrepiece illustration of the theory of efficient breach in the first edition of Posner’s Economic Analysis of Law:[10]

“…I sign a contract to deliver 1000,000 custom-ground widgets at $0.10 a piece to A, for use in his boiler factory. After I have delivered 10,000, B comes to me, explains that he desperately needs 25,000 custom-ground widgets at once since otherwise he will be forced to close his Pianola factory at great cost, and offers me $0.15 apiece for 25,000 widgets. I sell him the widgets and as a result do not complete timely delivery to A, who sustains $1000 in damages from my breach. Having obtained an additional profit of $1250 on the sale to B, I am better off even after reimbursing A for his loss. Society is also better off. Since B was willing to pay me $0.15 per widget, it must mean that each widget was worth at least $0.15 to him. But it was worth only $0.14 to A--$0.10, what he paid, plus $.04 ($1000 divided by 25,000), his expected profit. Thus the breach resulted in a transfer of the 26,000 widgets from a lower valued use to a higher valued use.”

               These are two ideal illustrations of the application of the doctrine of efficient breach.

III. Conditions for the application of the doctrine

               Studying the above two illustrations, we can summarize that the following are the possible conditions necessary for the application of this doctrine:

-       There should be demand of the goods or the service in the market.

-       It should be valued at a higher price.

-       The seller should be able to convert his loss into profit because of the breach.

-       The seller should pay to the first buyer damages and the quantum of such damages should justify the buyer’s expectation losses.

-       The seller should be in position to avoid any kind of litigation claims in the nature of specific performance.

-       The third party should be immune from any litigating claims from the first buyer.

The legal remedies available to a buyer are vital to determine whether the contract is fit for efficient breach. However, as stated earlier, in a contract specifying liquidated damages, efficient breach is possible.

IV. Applying the Doctrine under Indian Law

               An anticipatory breach occurs when the promisor absolutely repudiates the contract before the promised date of performance.[11] It is an announcement by a contracting party of his intension not to fulfil the contract, or that he will no longer be bound by it.[12] Number of reasons may compel or influence the promisor in deciding to breach the contract before the date fixed for performance. The extent of liability to pay damages can be foreseen by a reasonable man, as arising naturally in the course of things. Since economic and financial aspect is a major factor influencing the adherence of contracts, a party can breach the contract if the performance of a contract is patently uneconomical for either of the parties.

               Contract law contemplates many kinds of damages viz. nominal, liquidated, exemplary, penal, damages for pain and suffering, etc. The doctrine of efficient breach can be seen best to apply to a contract which contains a clause specifying liquidated damages. Parties can predict the loss they might suffer and in case of breach, the amount of damages is well within the contemplation of the parties. It can thus be decided whether the breach will be efficient or not. When the amount has not been mentioned and if a suit is filed as a result of the breach, then the decision as to the measure of damages is at the discretion of the Court. In such a case, the party who is planning for an efficient breach will have to start from scratch, calculate the amount of damages arising in the usual course of things, as well as amount for unexpected situations. Thus a clause specifying for liquidated damages acts as an advantage to use the doctrine of efficient breach. However, this does not mean that every contract that specifies for liquidated damages is bound to be efficiently breached.

               Many Indian judgments explain various aspects of award of damages, measure of damages, etc. However, there is no reported judgment expressly recognising this doctrine.

V. Issue of Morality

               This doctrine is criticised as being against morality and principles of equity. To quote Oliver Wendell Holmes, “[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it,- and nothing else.”[13] This has generally been interpreted to mean that a contracting party has a lawful option to perform or not. Clerk Remington wrote, “[t]he law has come to regard the obligation to perform a contract as being generally equivalent to an option to perform or pay damages.”[14] Sir Frederick Pollock says “Mr. Justice Holmes…suggests that every legal promise is really in the alternative to perform or to pay damages: which can only be regarded as a brilliant paradox. It is inconsistent not only with the existence of equitable remedies, but with the modern common law doctrine that premature refusal to perform may at once be treated as a breach.”[15]

VI. Conclusion

               Parties make contracts with an expectation of performance, of their own, and that of the other party. Promises are made to be kept as far as possible. If the Court imposes any exemplary damages as a penalty for the breaching party, then such a penalty can be treated as a charge for choosing to breach the contract. The law as it stands today provides parties an option of performance or breach. In such a case a party choosing the latter option should not be regarded acting against the law. There is a nexus between the conduct of a breaching party and the doctrine of estoppel, because promising first and then breaching it is against the principle of estoppel. However, the option for efficient breach is given by law and its exercise cannot be termed immoral.

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[1] ‘Efficient Breach’, http://en.wikipedia.org/wiki/Efficient_breach, last visited on 21/02/2009

[2] Bryan A. Garner (Editor-in-Chief), Black’s Law Dictionary, 8^th Ed., Thomson West Publication, p. 555

[3] Barry E Adler, ‘Efficient Breach Theory through the Looking Glass’, Law and Economics workshop, University of Berkeley, 2007, available at http://repositories.cdlib.org/be_law_econ/Fall2007/18

[4] A S Hornby, Oxford Advanced Learner’s Dictionary of Current English, 6^th Ed., Oxford University Press, p. 141

[5] Id. At p. 402

[6] Stumper v. Hedges (1898) 1 QB 673 C.A.

[7] Melvin Eisenberg, ‘The theory of Efficient Breach And The Theory Of Efficient Termination’, Law and economics Workshop, University of California, Berkeley, Paper 14, 2004, available at http://repositories.cdlib.org/berkeleylaw econ/spring2004/14 quoting Richard Craswell, ‘Contract Remedies, Renegotiation, and the Theory of Efficient Breach’, 61 S. Cal. L. Rev. 630 at pp. 634-35 (1988) –“…seller will find it profitable to breach the contract only if the second buyer is willing to pay more than that amount”, where ‘that amount’ refers to damages. This will be possible only if the second buyer values the goods more than the first buyer does, where ‘this’ apparently refers to Seller’s willingness to pay enough to make the breach profitable to Seller.”

[8] ‘Pareto Efficiency’, http://en.wikipedia.org/wiki/Pareto_Efficiency. Last visited on 21/02/2009; The term Pareto Efficient is used after the name of Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.

[9] Robert Cooter & Thomas Ulen, Law and Economics, Pearson Education Publication, 2004, pp. 16, 17

[10] Supra note 8

[11] Avtar Singh, Law of contracts and Specific Relief, 8^th Ed. (2002), Eastern Book Company, p. 372; quoting ‘A Suggested Revision of the Contract Doctrine of Anticipatory Repudiation’, (1954), Yale Law Journal 85

[12] Id. At p. 372

[13] Dawinder S Sidhu, ‘The Immorality and Inefficiency of an Efficient Breach Transactions’, The Tennessee Journal of Business Law, vol. 8, p. 4; available at http://ssrn.com/abstract=936223

[14] Joseph M. Perillo, ‘Misreading Oliver Wendell Holmes on Efficient Breach and Tortious Interference’, 2000 Fordham Law Review, Vol. 68, p. 2; quoting Clark Remington on ‘International Interference with Contract and the Doctrine of Efficient Breach: Fine Tuning the Notion of the Contract Breacher as Wrongdoer

[15] Id. At p.3; quoting Holmes-Pollock Letters, ‘ The Correspondence of Mr. Justice Holmes and Sir Frederick Pollock’, 1874-1932

ROYALTIES AND FEES FOR TECHNICAL SERVICES IN INTERNATIONAL TRADE

SILP100032

ROYALTIES AND FEES FOR TECHNICAL SERVICES IN INTERNATIONAL TRADE*

Snehal Bade

Introduction

International trade is the exchange of capital, goods, and services across international borders or territories. While international trade has been present throughout much of history, its economic, social, and political importance has been in the rise in recent centuries. Industrialization, advance transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. International trade is a major source of economic revenue for any nation that is considered as a world power.

I. Bird’s eye view

In the late 1980’s, the more progressive developing countries, particularly in Latin America, began to give up their isolationist policies and to loosen the controls over trade and investment.

Today they are trying to attract large sources of new capital for investment, new technologies, new manufacturing techniques and business know-how, improve training for their labour force and organizational and managerial expertise. Some countries are lowering taxes on royalties paid to foreign companies under licensing agreements for modern technology and technical assistance. Government “Red-tape” is being cut allowing a faster and easier flow of paper work through government bureaucracies, and Government agencies are applying laws and regulations to foreign firms in a fairer and more consistent manner.[1]

India still has some of the most severe restrictions in the world. They have high tariffs and quotas on imports, import licensing requirements a ban on the import of practically all consumer goods and strict control over the import of commodities. Since 1976, India has applied the rule of taxation of royalties and fees for technical services. This has resulted into more foreign collaboration and Indian importers asking for advanced technology and services from other source countries.

II. Meaning of Royalty and Fees for Technical Services

Royalty- A payment made to an author on invention for each copy of a work or article sold under a copyright or patent.[2] In the Income Tax Act, 1961 (hereinafter referred to as the Act), royalty is not specifically defined its provided in the Explanation 2 of section 9(1)(vi). The meaning of royalty is not to be restricted to what is mentioned in the Act, even Double Taxation Avoidance Agreements (hereinafter referred to as DTAA) entered with other nations are inclusive of the definition of royalty.

Madras High court in the case of CIT v. Neyveli Lignite Corp.Ltd.[3] has expressed that the term cannotes “royalty” which normally connotes the payment made by a person who has exclusive right over a thing for allowing another to make use of that thing which may be either physical of intellectual property or thing.

Fees for technical services- fee mean a charge for labour or services, especially for professional services.[4] In the Act meaning for fees for technical services is provided in Explanation 2 of Section 9(1)(vi). Only services of technical nature are taxable as fees for technical services are not personal, what is technical has to be determined from facts and circumstances of every transaction. Most of the DTAA’s do not provide for the meaning of fees for technical services specifically but it is either included under the term royalty or distinguished from the term personal services.

III. Basis of Charge

According to Sec. 4 of the Act, income tax shall be chargeable on every person whose income in previous year is taxable in the assessment year at any rate or rates. Income tax at that rate or those rates shall be charged for that year in accordance with, and subject to provisions of the Act. Sec 4 charges every person in respect of his ‘total income’, and Sec. 5 defines the gamut of total income. The principal underlying Sec. 5 is to take the changeability of income depending upon the locality of accrual of receipt.[5]

IV. Rate of Taxation

Sec. 115A deals with determination of tax on dividends, royalties and fees for technical services in the case of foreign companies. In certain cases this section provides, a special rate of tax on dividends, royalties and fees for technical services, interest, incomes from units and computer software fees received by non-resident or non-corporate assesses or foreign company.

The tax rates mentioned in the Act will not be applicable where a lower rate of tax is prescribed under an agreement for the avoidance of double taxation entered into by the Central Government, under S. 90 with any other country or payment made in pursuance of the agreement approved by the Central Government.

V. Payment of Income Tax by Assessees in Different Form

A.    RESIDENT:

              A resident who pays for the use of royalty does not directly come under the purview of taxation under Sec. 115A of the Act. The resident merely has to deduct tax at source for such payments made by him to a non-resident. Sec. 195 provides hat when any person pays to a non-resident, not being a company or to a foreign company ant interest or any other sum chargeable under the provisions of the Act, not being income chargeable under the head ‘salaries’, shall at the time of such payment by any mode deduct income tax thereon at the rates in force.

B.    NON-RESIDENT:

               Royalty or fees for technical services paid to a non-resident is always taxable and more so under Sec. 9(1)(vi) & (vii) in respect of its use for business purposes carried on in India. DTAA would also entitle royalty as mentioned in respective DTAA’s to be taxed in the country where it arises.

               Sec. 44DA provides that the income by way of royalty or fees for technical services receives from government or an Indian concern in pursuance of an agreement made by a non-resident (not being a company) or a foreign company with government of the Indian concern after 31^st March, 2003, shall be computed under the head “profits and gains of business of professions” in accordance with the provisions of the Act.

C.     FOREIGN COMPANY:

              Sec 44D(a) of the Act provides that in case of foreign company, the deductions admissible under section 28 to 44C of the Act in computing the income by way of royalty or fees for technical services received from an Indian concern is pursuance of an agreement made with the Indian concern before 1^st April, 1976, shall not exceed 20 percent of the gross amount of such income. Where such agreement is made after 31^st March, 1976, Sec. 44D(b) provides that no deduction will be allowed in respect of any expenditure or allowance under any of the said sections in computing such income.

VI. A Magnified View over the Intellectual Property Right- Software’s

There are three categories of software that may be distributed, namely, specialist bespoke programs, general commercial software and mass marketed software. The first is an unlikely candidate for distribution, while commercial programs with a general application are more suited for distribution. Mass marketed software has been beleaguered by the greater number of problems and is subjected to the same affliction that plagues the music industry- copyright infringement on commercial scale. For the purposes of copyright law, computer programs are treated as “literary works”.

Notwithstanding all of these hazards, the efficiently and technical advances underlying licensing makes it a rapidly expanding and highly profitable form of doing business abroad. It is, however, an endeavor that must be pursued cautiously.

             

One of the questions faced by the foreign companies which supply the Intellectual property or advanced technology such as software is whether the payment made thereof takes the character of ‘royalties’ or leads to business profits?

             

In view of Tata Consultancy Services v. State of A.P[6], computer software put in the medium of disk are “goods” and its purchase constitutes the “Purchase” of a tangible asset and the assessee becomes the “owner” thereof, though the content on such medium is intangible asset. The fact that the computer software is obtained by way of “ownership” or on “license” is not determinative. The functional test is more important. If the tests of ownership and enduring benefit are satisfied, the question whether expenditure incurred on computer software is capital or revenue has to be seen from the point of view of its utility to a businessman and how important an economic or functional role it plays in his business.[7]

             

Under the Act, right to use software is ‘royalty’ irrespective of the fact that it is on a CD. Treating payments to acquire software as royalties could imply more revenues for the tax department in India. However, revenues may not be guaranteed for the tax department if they are treated as business profits due to ‘permanent establishment’ issues for multinational software companies.

             

The high-profile Microsoft case, involving about Rs. 700 crore, is an example of differing interpretations on the “characterization’ of the payments made for software. Transfer of all or any rights of software including granting of a license in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property would fall under the term royalty. Thus, to conclude, only those transactions wherein there is a transfer of all or any rights of the computer software would fall within the definition of royalty under explanation 2 of Sec 9(1) (vi) and not those transactions of commercial nature.

VII. Interpretation- is it Complex?

             

Controversies relating to international taxation are about the provisions of domestic law, the treaties and the conventions concerning double taxation avoidance. Tax treaties may give rise to various tax disputes, which domestic tax forums and courts have to deal with. The main problem before such courts would be that there are often no precedents to be followed, since international tax law is still in its infancy. Most of the cases are being decided keeping the law aside and depending upon facts and circumstances of the case.

             

In interpreting a section in a taxing statute, according to Lord Simons, “the question is not at what transactions the section is according to some alleged general purpose aimed, but what transaction its language according to its natural meaning fairly and squarely hits.”[8] It is, therefore, not the function of a court of law to give to words a strained and unnatural meaning to cover loopholes through which the evasion tax-payer may find escape or to tax transactions which, had the legislature thought of then, would have been covered by appropriate words.[9] If there is any ambiguity in respect of the subject of the tax, person liable to pay the tax and the rate at which the tax is levied,[10] and such ambiguity is not removable by reasonable construction then there will be no tax in law till the defect is removed by legislature.[11]

VIII. Conclusion

             

With respect to the Act, Sec 115A where it provides concessional rate of tax for royalty where the agreement is in respect of industrial policy or approved by the Central Government. It is an option available that if the subject is not included in the industrial policy then the person who makes such payment shall try and get the approval of the Central Government for a concessional rate of tax. The situation is not very clear on what basis the Government grants approval for such agreement, whether it is being based on industrial policy or it is a matter administrative policy. And when such payments are made by the Government itself the rule is not much clear whether it has to be presumed that it is approved by the Central Government.

             

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*Awarded Second Best Paper at the 4^th Nani A. Palkhivala Memorial Research Paper Competition,2009. This is an abridged version of the same.

[1] Richard Schaffer, Berverley Earle& Filiberte Agusti, International Business Law and its Environment, 4^th Ed. (1999), West Education

[2] Bryan a. Garner, Black’s Law Dictionary, 7^th Ed. (1999), West Group

[3] CIT V. Neyveli Lignite Corp. Ltd. 243 ITR 459

[4] Supra note 2

[5] Kanga Palkhivala; Vyas, The Law and Practice of Income tax, 9^th Ed. (2004), LexisNexis   Butterworths

[6] Tata Consultancy Services v. State of AP 271 ITR 401 (SC)

[7] Amway India Enterprises v. DCIT 301 ITR 1 (Delhi)

[8] St. Aubhya (LM) v. A.G. (1951) 2 ALL ER 473

[9] IRC v. Wolfson (1949) 1 ALL ER 865

[10] State of Kerala v. Alex George (2005) 1 SCC 299

[11]Mathuram Agarwal v. State of Madhya Pradesh AIR 2000 SC 109