India’s drone industry is taking flight, with immense potential across a multitude of sectors. From revolutionizing agriculture and logistics to enhancing surveillance and disaster management, drones are transforming how we work and live. But navigating this dynamic landscape requires a deep understanding of the opportunities, challenges and crucial regulatory, tax and financial considerations.

Against this backdrop, FCA Amit Aggarwal (Associate Partner, Dhruva Advisors LLP) and CA Hemant Agarwal (Senior Executive) explore the key tax issues faced by the sector and the need for a positive tax policy framework in the future. Stating that, as the drone industry grows, optimizing the operational model and ensuring tax compliance is essential, the authors conclude by remarking that “By prioritizing tax structuring & regulatory compliance, drone companies can achieve sustainable growth and success in this dynamic market. Regularly consulting with legal and tax professionals is highly recommended to stay abreast of evolving regulations and best practices.”

“Indian Drone Industry - Tax Issues in Business Model!”

Introduction

India's drone industry is experiencing rapid growth driven by government initiatives and increasing adoption across sectors. The government's push to establish India as a global drone hub by 2030 is evident in policies like the Unmanned Aircraft System (UAS), Unmanned Traffic Management (UTM) policy framework and the promotion of drone corridors. Drones are revolutionizing sectors like agriculture, logistics, healthcare and defence, promising optimized resource allocation and enhanced operational efficiency in both rural and urban areas.

In this article, FCA Amit Aggarwal and CA Hemant Agarwal will explore the key tax issues faced by the sector for a robust tax compliance function covering crucial areas.

Production Linked Incentive (PLI) scheme for Drones

The PLI scheme, with a financial outlay, aims to boost domestic drone manufacturing and enhance competitiveness. Manufacturers, including those producing drone components, can benefit from incentives based on value addition, provided they meet specific criteria. The scheme encourages local sourcing and manufacturing of drone components, promoting self-reliance in the sector. The specific details of the PLI scheme, including incentive percentages and eligibility criteria, should be regularly reviewed as they may be subject to change.

It is important to examine the nature of the PLI and analyze whether it should be categorized as a capital receipt or revenue receipt as explained below:

• Government Assistance as Income: Section 2(24)(xviii) of the Income Tax Act includes government assistance like subsidies and grants as income. However, it excludes incentives.
• Conditional vs. Unconditional: Assistance is generally unconditional and supportive, while incentives are conditional and tied to achieving specific goals.

While a conservative view will be to offer the PLI receipts to tax, technical arguments exist to claim non-taxability of PLI incentives in appropriate cases. This can be explored further to delve upon suitable tax strategy for tax returns to be filed including revisiting past returns and claiming tax refunds, wherever possible.

Drone as a Service (DaaS) and tax considerations

DaaS offers businesses cost-effective access to drone technology through rental or subscription models. This model is gaining popularity in sectors like surveying, inspection and delivery. Taxation of DaaS presents complexities, particularly in income classification. Payments for drone services can be categorized as rental income, royalties, or professional fees, each with different tax implications.

One key income-tax Issue in DaaS (in case of hardware with embedded functional drone utility software, and incapacity to apply predominant nature test to hardware/ software) is the characterisation of income as mentioned below:

• Rental of equipment/ drone
• Royalty for use of drone software 
• Automated equipment/ portal constituting technical / managerial services
• Technical services involving human assistance or support
• Cloud services like analysing drone data for third parties, etc.

The tax treatment of DaaS income can also vary based on the service provided and whether it's for a resident or non-resident entity. Compliance with domestic tax laws and Double Taxation Avoidance Agreements (DTAA) for payment to non-resident vendors/ service providers is essential.

Drone Intellectual Property (IP) and Tax Issues

Intellectual Property is crucial for drone manufacturers, with patents, trademarks and designs protecting innovations. The tax treatment of IP income depends on its nature.

Proceeds from selling IP assets like patents or trademarks are treated as capital gains. The classification as capital gains or royalty depends on the transaction structure, including whether the transfer involves full or partial rights. For manufacturers transferring technology or IP, the agreement terms (e.g., exclusivity, regional rights) are relevant in determining income classification.

Taxability of royalty income under section 115BBF:

• Royalty income from patents developed and registered in India is taxable at concessional rate of 10%.
• No deduction is allowed for any expenditure or allowance while calculating royalty income under section 115BBF.
• Eligible assessee must opt for this tax treatment on or before the due date for filing the return for the relevant year.
• If assessee has availed benefit of concessional rate of 10% in any assessment year then, he must opt for the same for at least five consecutive assessment years otherwise, he will not be able to take the benefit for next five year starting from the assessment year in which he doesn’t opt.
• At least 75% of the expenditure must be incurred in India for the invention and development of such patent.

Benefits under section 80-IAC of the Income-tax Act

It offers a 100% profit deduction for three consecutive years to eligible startups.  This deduction can be claimed within a ten-year window from incorporation.  To qualify, the startup must not be formed by splitting or reconstructing an existing business and must not be formed by transferring previously used machinery (with exceptions for imported machinery and cases where transferred machinery value is less than 20% of the total machinery value). 

The startup must be engaged in innovating, developing, or improving products, processes, or services, or have a scalable business model with high employment generation or wealth creation potential. It must be a company or LLP incorporated after April 1, 2016 and before April 1, 2030 with a turnover not exceeding INR 100 crore in the relevant previous year and must possess a certificate of eligible business from the Inter-Ministerial Board of Certification.

Focus on R&D: Benefits under section 35 of the Income-tax Act

There is a strong emphasis on research and development (R&D) in drone technology and new initiatives designed to foster innovation in areas such as autonomous systems, precision mapping, etc.

Section 35 of the Income-tax Act provides deductions for both revenue and capital expenditures related to scientific research.

• Revenue Expenditure: Revenue expenditures include the everyday costs involved in running a business, such as wages, rent and maintenance. These expenses are fully deductible in the year they are incurred. Additionally, if expenses are incurred within the three years before a business begins operations for scientific research, such as salaries for research personnel or the purchase of materials, they are deductible in the year the business commences.
• Capital Expenditure: Capital expenditures related to scientific research are also deductible, provided the expenses occur in the same year as the spending. However, land acquisitions are not eligible for deductions. Also, any capital expenses incurred within three years before the business starts operations are treated as expenses for the year the business begins.

TDS on Payments to Residents and Non-Residents

Understanding TDS implications for payments to residents and non-residents is crucial. Payments for pilot training, technical training, or software usage may attract different TDS rates. For non-residents, withholding tax applies to royalties, fees for technical services and IP usage, subject to DTAA.

For non-residents, documents for claiming reduced or NIL withholding tax rates include the Tax Residency Certificate (TRC), Form 10F and a No Permanent Establishment (PE) certificate. Determining the existence of a PE or otherwise on account of drone components, equipment in India for assemble or visits of employees is crucial for tax liability in India.

Failure to correctly apply the appropriate withholding tax rate and maintain proper documentation could result in shortfall in tax deposits, disallowance of expenses and potential interest or penalties.

Industry expectations into the future

The Indian drone industry has high hopes and are seeking government support to accelerate its growth and establish India as a global drone hub. Key expectations include:

• Increased PLI Scheme Allocation: A substantial increase in the Production Linked Incentive scheme outlay to incentivize domestic manufacturing and attract investment.
• Dedicated R&D Fund: A dedicated fund to support research and development of advanced drone technologies, including AI-enabled drones and autonomous navigation.
• Focus on Component Manufacturing: Incentives and policies to encourage local production of critical drone components and reduce reliance on imports.
• Skill Development and Training: Investing in programs to ensure a skilled workforce for drone operation, maintenance, and development.
• Financial Support and Access to Capital: Measures to improve access to funding for drone businesses, especially startups, through easier loans, venture capital funding, and tax benefits.

Way Forward: Need for Tax Evaluation

As the drone industry grows, optimizing operational model and ensuring tax compliance is essential.  Key focus areas are:

• Undertaking statutory tax compliances like filing tax returns, advance tax payments, tax audit, transfer pricing, TDS and GST compliance
• R&D and technology related tax issues
• International tax and tax treaties and transfer pricing
• Review of applicable customs duties and regulatory compliances for drone imports and exports.
• Ensuring compliance with the Foreign Exchange Management Act for foreign transactions.

Conclusion

The Indian drone industry offers significant potential, driven by government support and technological advancements. However, navigating the regulatory, tax and funding landscape is crucial. By prioritizing tax structuring & regulatory compliance, drone companies can achieve sustainable growth and success in this dynamic market. Regularly consulting with legal and tax professionals is highly recommended to stay abreast of evolving regulations and best practices.