www.pwc.com/in Sharing insights News Alert 17 October, 2011 Taxability of non-compete fee as business income or capital gains In brief The Mumbai Income-tax Appellate Tribunal (the Tribunal ) in two separate decisions, namely, Ramesh D Tainwala 1 and Savita N Mandhana 2 explained the law relating to the taxability of non-compete fees. In the case of Ramesh D. Tainwala ( assessee 1 ), the Tribunal held that a non-compete fee separately agreed in the share transfer agreement, would be taxable under the head Profits or gains under business and professions. In the case of Savita N Mandhana 1 Ramesh D Tainwala v. ITO [TS-594-ITAT-2011(Mum)] 2 ACIT v. Savita N Mandhana [TS-593-ITAT-2011(Mum)] ( assessee 2 ), the Tribunal concluded that when a non-compete fee is embedded in the share price according to the share transfer agreement, the entire consideration for shares would be taxed under the head capital gains. Ramesh D. Tainwala v. ITO Facts Assessee 1 was one of the promoters in Tainwala Polycontainers Ltd. (the Company ). The company was engaged in the business of manufacturing and marketing of blow moulded high molecular, high density polyethylene containers, Time Packaging Ltd (the Acquirer ), another company engaged in 1
a similar business to that of the company, approached assessee 1 for purchase of shares in the company and consequently acquiring a controlling interest in the company. Assessee 1 entered into an agreement to transfer the shareholding as well as the operations of the company in good and running condition to the acquirer. According to clause 6 of the agreement, assessee 1 and other promoters ( sellers ) agreed not to engage in any business, directly or indirectly, which competes with that of the company for a period of 11 years. A separate consideration of INR 40 million was agreed as non-compete amount according to clause 6.2 of the agreement. The consideration was to be paid in equal proportion to assessee 1 and Rakesh Tainwala. Issue Whether the receipt of the non-compete fee amounting to INR 20 million by assessee 1 according to clause 6 of the agreement was taxable as a revenue receipt or a capital receipt. Assessee s contentions Assessee 1 claimed that the sum of INR 20 million, being compensation for agreeing not to engage in the business in which he had sole expertise and knowledge, was compensation received for giving up a source of income. Hence, this sum is a capital receipt and not chargeable to tax. Alternatively, assessee 1 submitted that the receipt, if at all held to be taxable, has to be taxed as a capital gains under section 45 of the Act by treating it as part of the sale of shares and not as income from business under section 28(va) of the Act. As a result, the receipt in question should be subject to a lower rate of tax. Revenue s contentions The assessing officer ( AO ) pointed out that the controversy regarding the taxability of non-compete fees was put to rest by insertion of clause (va) in section 28 of the Act with effect from 1 April, 2003 by bringing non-compete fees within the purview of section 28 of the Act. According to the AO, the receipt in question was a fee for not carrying out any activity in relation to any business and therefore, chargeable to tax under section 28(va) of the Act. The AO did not deal with the alternate contention put forth by assessee 1 regarding taxability of the fee as capital gains. Tribunal ruling Section 28(va)(a) of the Act provides for the taxability of receipts in the nature of non-compete fees. In terms of proviso (i) to section 28(va)(a) exceptions were given to cases where such receipts are taxable as capital gains, viz., where any sum is received for transfer of a right to carry on any business which is chargeable to tax as a capital gains. If a receipt is considered as payment of compensation with the source remaining intact, it would be revenue receipt covered by section 28(va)(a) of the Act. If the receipt is a payment for sterilisation of the source of income, then it would be a capital receipt covered by section 45 of the Act. The Tribunal held that the provisions of section 45 of the Act would be attracted only when there is capital gains arising as a result of transfer of a capital asset as defined in section 2(47) of the Act. In the present case, the agreement by which assessee 1 agrees to refrain from indulging in a business competing with another is independent by itself, though it is included in the agreement for transfer of shares. If the agreement to refrain from indulging in competition is part and parcel of the agreement for 2
transfer of a business and the transferor agrees not to indulge in competition, then it can be said that the right to carry on the same or similar business was transferred along with the business. In the present case what was transferred was the shareholding by the promoter. In such a situation, there is no question of transfer of a right to carry on business. Accordingly, the receipt was held to be chargeable to tax under section 28(va) of the Act. ACIT v. Savita N Mandhana: Facts Assessee 2 was a shareholder in Mandhana Exports Pvt Ltd - a closely held company owned and managed by the Mandhana family. In the year 1996, the name of the company was changed to Mandhana Boremann Industries Pvt. Ltd. ( Mandhana Boremann ), pursuant to a joint venture with Bornemann and Bick GmbH. In financial year 2005-06, all the shareholders in the Mandhana family ( transferors ) entered into an agreement with Paxar BV for transfer of their shareholding for a consideration of INR 570 per share, which worked out to INR 456 million in total. The agreement also had a clause providing for non-competition by the transferors in any business that competes with the business of Mandhana Boremann. Assessee s contentions Assessee 2 submitted that the consideration for transfer of shares was mutually agreed between the transferors and Paxar BV and no separate consideration was agreed for a non-compete fee. The consideration, if any, even if allocated towards a non-compete fee, would be covered by the exception provided by proviso (i) to section 28(va) of the Act and be taxed under the head capital gains. In view of this, the entire consideration was offered to tax under the head capital gains. Revenue s contentions The AO held that a part of the total consideration of INR 570 per share was towards the non-compete fee and taxable under section 28(va) of the Act as a revenue receipt. Accordingly, he used a break-up value method to determine INR 205 per share to be a receipt in the nature of a non-compete fee. The CIT(A) upheld the action of the AO, and held that only INR 41 per share could be attributed to non-compete fees. Tribunal ruling While determining the taxability of the receipt, the Tribunal relied on the decision of a co-ordinate bench in the case of Hami Aspi Balsara 3 wherein it was held that even when there was a specific non-compete obligation in the agreement, no part of the sale consideration of shares could be attributed to be taxed in the hands of the assessee as business income under section 28(va) of the Act. 3 Hami Aspi Balsara 3 v. ACIT [2009] 30 DTR 576 (Mum) 3
In Hami Aspi s case, the coordinate bench held that the consideration towards the restraint clause was embedded in the price of the shares, and hence the basis adopted for assigning the consideration towards non-compete fees was not correct. Furthermore, even if a part of the consideration is to be allocated towards non-compete fees, this part should be computed having regard to the provisions of section 55(2)(a) of the Act. Section 28(va) of the Act would be attracted only where the particular assessee was carrying on business and not where the assessee only had a right to carry on business in the form of a capital asset. Further, Circular No.8 dated 27 August, 2002 explaining the provisions of Finance Act, 2002, by which clause (va) was inserted in section 28 of the Act, clarifies that receipts for transfer of right to manufacture, produce or process any article or thing or right to carry on any business which are chargeable to tax under the head capital gain would not be taxable as profits and gains of business. Thus, the difference between the sale consideration and true value of shares was chargeable as capital gains. Accordingly, the Tribunal, relying on the above decision of the coordinate bench, held that the entire consideration received on sale of shares by the transferor is taxable under the head capital gains. The exercise of bifurcation between the consideration attributable to sale of shares and for non-compete obligations was rendered academic and infructuous. Conclusion The terms agreed to and the manner of receipt are key to determining the tax liability in the hands of the recipient. The take away from these decisions are: Where shares are transferred pursuant to an agreement which also contains a non-compete clause, the consideration for shares should not be split-up into two components, viz. price of shares and the non-compete fee, so as to tax the component attributable to the non-compete obligation as business income. The entire gain on share transfer would be taxable under the head capital gains. The non-compete provision is attracted if a taxpayer is carrying on business and agrees to a non-compete obligation for a separate consideration. 4
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