Workshop on Practical Problems of Tax Treaty Interpretation and Application

Transcription

1 Workshop on Practical Problems of Tax Treaty Interpretation and Application TERMINATION PAYMENTS FOR NON-COMPETE CLAUSE BIJAL AJINKYA Partner, Khaitan & Co

2 Facts Mr A, resident of R, works as a lawyer in State P in a law firm. Employment contract terminated when he turns 65. An additional payment equivalent to 1 year s salary is payable if he agrees not to work for a competitor for 1 year. Taxation under Indian domestic law Under the Indian Income Tax Act, 1961 (IT Act), such termination payments can be categorised as either of the following: Income under the head salary. More specifically as profits in lieu of salary under Section 17 (3) of the IT Act; or Business income under Section 28(va) of the IT Act

3 Taxation under the head Salary For the non-compete fees to be taxed as salary, the following conditions need to be satisfied: There should be an employeremployee relationship between the law firm and Mr A; and The termination payment should flow from this employer-employee relationship However, language of Section 17(3) is wide enough to include any compensation due or received by the taxpayer from any person after cessation of his employment with that person

4 Taxation under the head Business Income Section 28(va) of the IT Act (introduced by Finance Act, 2002) states as follows: The following income shall be chargeable to income-tax under the head Profits and gains of business or profession (va) any sum, whether received or receivable, in cash or in kind, under an agreement for (a) not carrying out any activity in relation to any business The provision seems to cover the situation at hand

5 What takes precedence? Salary or business income Strictly speaking, the termination payment of non-compete fees are not related to employment (as also noted by the OECD) Section 28(va) is a more specific provision and it is a canon of statutory interpretation that specific overrides general Ref: Delhi HC judgment in CIT v Prasar Bharti ([2007] 292 ITR 580), If, on the same date, two provisions are introduced in the Act, one specific to the activity sought to be taxed and the other is more general terms, resort must be had to the specific provision which manifests the intention of the legislature

6 What takes precedence? Salary or business income ITAT, Delhi Bench inthe case of Kanwaljit Singh v ACIT ([2009] 29 SOT 43) Facts Taxpayer, a former employee of an airline company, due to his proximity with it, was in a position of acquiring the sole selling agency for cargo and air tickets of the said airline company Agency agreement executed in favour of a partnership firm formed by taxpayer s daughter and wife The assessee in status of an employee was receiving income from the said firm Due to certain disputes which arose between the taxpayer and the partners of the firm, he made efforts to transfer the agency from the firm to himself On settlement of the disputes, the taxpayer agreed to the continuation of the agency with the firm and entered into a Non-compete Agreement with the partners of the firm and was paid a non-compete Commission Issue Whether the non-compete commission received by taxpayer was taxable as salary or business income

7 What takes precedence? Salary or business income ITAT, Delhi Bench inthe case of Kanwaljit Singh v ACIT ([2009] 29 SOT 43) Ruling of the Tribunal The Tribunal observed that the non-compete agreement executed between the taxpayer and the partners of the firm was on principal-to-principal basis and did not flow from the employer employee relationship It was further observed that the commission received could be taxable either under the head of Salary Income or Business income Section 28(va), being a specific provision, the income earned by assessee under the noncompete agreement was taxable as Business income.

8 What takes precedence? Salary or business income ITAT, Bangalore Bench in the case of Sasken Communication Technologies Ltd v ITO ([2011] 48 SOT 86) Facts Non compete fees were paid by the employer company (taxpayer) to its employees at the commencement of their employment The payment was made for not competing with the taxpayer in case of the said employees terminating their services with it Theemployees were residents of USA and were rendering services inusa Ruling of the Tribunal The Tribunal held that the non-compete fees paid would be remuneration or compensation paid in relation to employment and therefore, would fall under the term salary or profit in lieu of salary Further held that the income arose outside India as provided under Article16 of the India USA Tax Treaty as the recipients are residents of USA and are also rendering services in USA

9 International Aspects If State R is a treaty country If it is concluded under the domestic tax provisions that the termination payment is in the nature of business income and Mr A, then he would be taxable only if he has a PE in India Otherwise, if regarded as salary, would fall within dependent personal services and Mr A would be taxable in India only if his presence in India in the relevant tax year exceeds 183 days (taking the example of Article 16 of India US Treaty) Can it be treated as Other Income? In such a case, India can still exercise its right to tax the payment under most treaties

10 International Aspects If State R is a non- treaty country If it is concluded under the IT Act that the termination payment is in the nature of business income and Mr A, then he would be taxable in India if the same arises from a business connection Business connection is a wider term as compared to PE Possible to argue that the non-compete fee is in relation to the operations that Mr A will not carry in State R and therefore there is no business connection in India If treated as salary, would be taxable in India if it is held to be earned in India (i.e. for services rendered in India) Arguable that the payment is not in relation to services rendered in India

11 If Mr A was a partner of the law firm Since there would be no employeremployee relationship, hence the termination payment would only fall under Section 28(va) of the IT Act as business income In such a case, if State R is a treaty country, the payment wouldn t be taxable in India unless Mr A has a PE in India In case State R is a non-treaty country the payments would be taxable in India if the same arises from a business connection Possible to argue that the noncompete fee is in relation to the operations that Mr A will not carry in State R and therefore there is no business connection in India Applicability of Section 10(2A) of the IT Act which exempts in the hands of the partner income which forms part of his share of income in the form and which has already been assessed to tax in the hands of the firm

12 Relevance of OECD Commentary and Reports in India There are cases which have placed reliance on OECD Reports (Factset Research Systems Inc, In re ([2009] 317 ITR 169 (AAR), Standard Chartered v DDIT ([2011] 45 SOT 494 (Mum)) However, contrary rulings also exist which state that no reliance can be placed on OECD Reports (New Skies Satellite NV v ADIT ([2011] 12 taxmann.com 9 (Delhi), Linklaters LLP v ITO [2010] 132 TTJ 20 (Mum)) Similarly, divergent judicial views exist on whether or not OECD Commentary should be relied upon