Bombay HC upholds non-taxability of deferred consideration on transfer of shares in the absence of accrual

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1 18 April 2016 EY Tax Alert Bombay HC upholds non-taxability of deferred consideration on transfer of shares in the absence of accrual Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarizes a recent ruling of the Bombay High Court (HC) in the case of Mrs. Hemal Raju Shete [1] (Taxpayer) on the issue of taxability of capital gains on transfer of the shares of the company where part of the consideration was receivable in the future, subject to occurrence of contingency. Under the agreement to sell, the Taxpayer and her family members (sellers) transferred shares of the company to the purchaser against payment of consideration, payable upfront. The agreement also contemplated the entitlement of the sellers to additional consideration payable over a period of four years, based on the profitability of the company whose shares were the subject matter of transfer, subject however, to the covenant that the aggregate consideration was not to exceed INR200m. The Tax Authority levied capital gains with respect to the consideration of INR200m, rejecting the Taxpayer s claim to compute capital gains with respect to the amount actually due and received in the year of transfer. The HC held that deferred consideration, which is linked to the future performance of the company, is dependent upon uncertain events, which is contingent and has not accrued in the year of execution of the agreement. No part of the deferred consideration is, therefore, chargeable to tax in the year of execution. Furthermore, the HC also accepted taxability of deferred consideration as capital gain income in the respective year of accrual. [1] CIT v Hemal Raju Shete (ITA No 2348 of 2013)

2 Background The Indian Tax Laws (ITL) provide for taxation of capital gains income. It provides that any profits or gains arising on transfer of capital asset is taxable in the year in which the transfer takes place. Furthermore, capital gains are calculated with reference to the full value of the consideration received or accruing as a result of the transfer. Thus, taxability of capital gains triggers in the year of transfer and with respect to the amount of consideration which accrues as a result of the transfer. The ITL provides for certain exceptions where capital gains are taxed on receipt basis, even if the transfer in relation to the asset may have been effected in the earlier year. Facts The Taxpayer, along with her family members (sellers), were shareholders of a closely-held company. The sellers entered into an agreement, dated 25 January 2006, with the purchaser for transfer of all the shares in their company. The transfer appears to be irrevocable. Part of the consideration was receivable as initial consideration upon execution of the agreement. The sellers were also entitled to deferred (additional) consideration for four subsequent years (up to 31 March 2010), based on the performance of the underlying company whose shares were transferred. The deferred consideration was based on a certain formula which took into consideration average profits of two years, together with adjustment for cash and debt as at balance sheet date. However, the aggregate consideration payable would not exceed INR200m. For tax year , the Taxpayer offered capital gains on transfer of her shares in the year of execution of the agreement. Capital gains were computed, basis the initial consideration received. The Tax Authority, however, assessed the Taxpayer with reference to her share in the total consideration of INR200m viz., the initial consideration and the deferred consideration. The First Appellate Authority accepted the Taxpayer s claim. It noted the terms of the agreement and held that no part of the deferred consideration accrued to the sellers in tax year The deferred consideration was contingent upon the profitability of the company and, thus, its accrual was dependent upon the performance of the company. In support, the First Appellate Authority noted that for the immediate subsequent year, the Taxpayer did not receive any consideration, as the company did not meet with the expected profitability. Being aggrieved by the First Appellate Authority s order, the Tax Authority appealed before the Mumbai Income Tax Appellate Tribunal (Tribunal) which endorsed the order of the First Appellate Authority. On being aggrieved, the Tax Authority filed further appeal against the Tribunal s order before the HC. By the time of the Tribunal s ruling, the Taxpayer group had already received the deferred consideration to the extent due as per the agreement. As it appears, these sellers had offered the deferred consideration to tax on receipt basis, in respective tax years. The Tax Authority raised a question of law before the HC that the Tribunal s order, accepting the Taxpayer s mode of offering capital gains on deferred consideration on receipt basis in various tax years, was contrary to provision of law which requires taxation in the year of transfer. Taxpayer s contentions: Deferred consideration is contingent and dependent upon the future performance of the company. No part of the deferred consideration accrued in the year of execution of the agreement. The Taxpayer had offered to tax the capital gains in the year/s in which the deferred compensation accrued to or was received by the Taxpayer.

3 Tax Authority s contentions: Capital gain is chargeable to tax in the year of transfer and is basis accrual of the consideration as a result of transfer, regardless of whether and when the consideration is actually received. Wherever capital gain is required to be taxed on receipt basis, the ITL has provided for a specific provision. The Tax Authority was justified in bringing to tax the entire amount of the share of the Taxpayer in consideration of INR200m in tax year , being the year of transfer. HC s ruling The HC rejected the Tax Authority s appeal and held that, in the facts of the case, the question raised before it does not give rise to any substantial question of law. The HC upheld the Tribunal s order to the effect that no part of the deferred consideration accrued during the tax year , for the following reasons: The HC referred to various Supreme Court (SC) rulings [2] and noted the wellsettled principles of accrual of income. It reiterated that income can be said to have accrued only when a taxpayer gets the right to receive it. Such right must be represented by the debt owed by somebody in favor of the taxpayer. There can be no taxation of hypothetical income which does not accrue to the taxpayer. Applying these principles to the facts of the case, the HC held as under: In terms of the agreement, the deferred consideration is dependent upon the profits of the company for each of the four subsequent years. In the absence of profit for any year, nothing is payable to the seller. In tax year , the Taxpayer had no right to claim any part of the deferred consideration; no such right vested in the Taxpayer. The consideration of INR200m does not represent assured consideration, but reflects the outer limit up to which the consideration could be received. Thus, no part of the deferred consideration, that is dependent upon uncertain events and is contingent, can be said to have accrued to the Taxpayer and other sellers in tax year The HC noted that the sellers had offered the deferred compensation as capital gains income in the respective year of accrual of income, in terms of the agreement. The HC also noted the SC s observations in the case of K.P. Varghese [3] to the effect that computation of capital gains starts with the full value of the consideration received or accruing. The HC, accordingly, held that, on the facts of the case, no part of the deferred consideration was received by or accrued to the Taxpayer during tax year so as to trigger taxation. Basis this, the HC rejected the Tax Authority s contention that the Taxpayer s mode of offering capital gains on the deferred consideration on receipt basis in various tax years was contrary to the provisions of the ITL, which require the taxation in the year of transfer. [2] Morvi Industries Limited v. CIT [(1971) 82 ITR 835], E.D.Sassoon & Co Limited v. CIT [(1954) 26 ITR 27], CIT v. M/s Shoorji Vallabhdas and Co [(1962) 46 ITR 144] [3] K P Varghese v. ITO & Anr. [(1981) 131 ITR 597]

4 Comments In a share acquisition deal, it is not unusual that, besides upfront payment of fixed consideration, parties may commercially agree to payment of additional consideration basis the future performance of the underlying company. From the seller s perspective, while there may be no dispute on taxation of the fixed consideration received in the year of transfer of shares, a dilemma persists with regard to the point of time at which capital gains tax liability triggers in relation to the additional or the deferred consideration receivable in subsequent years and the year in which it is taxable. This HC ruling lays down that the general concept of accrual of income is also embedded in the provisions dealing with taxation of capital gains. Accordingly, even capital gain income cannot be said to have accrued until a taxpayer gets the right to receive the same. In relation to the deferred consideration which is linked to the future performance of the company, the HC held that the deferred consideration did not accrue in the year of execution of the agreement and no part of the deferred consideration is, therefore, chargeable to tax in that year. Furthermore, the HC also accepted taxability of the deferred consideration as capital gain income in the respective subsequent year of accrual, basis determination of the consideration on the performance of the company. The year of taxation of the deferred contingent compensation for transfer of capital asset is not free from doubt. While the present HC ruling favors the taxpayer, since it relieves the burden of retrospective taxation of the deferred consideration with reference to the year of transfer of the asset, one will need to watch further judicial/statutory developments in the matter.

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