By Darryl Paul Barretto Overview Payment received as non compete fee was treated as a capital receipt till the assessment year 2003 04. Through the Finance Act, 2002, the said receipt were made taxable under section 28(va) of the Income Tax Act, 1961 with an exception is found under proviso clause (i) to section 28(va)(a), which provides that any sum, whether received or receivable, in cash or kind, on account of transfer of the right to manufacture, produce or process any article or thing or right to carry on any business, which is chargeable under the head Capital gains would not be taxed under section 28(va). Further the Finance Act, 2002 also amended section 55(2)(a) to provide for cost of acquisition in case of transfer of right to manufacture, produce or process any article or thing or right to carry on any business. These amendments have brought about a dichotomy in the taxability of non compete fees, with regards to taxability as Business income under section 28(va), or as Capital gains covered by the proviso (i) to Section 28(va)(a). From the decisions of the Income Tax Appellate Tribunal ( ITAT ) and the High Courts it can be seen that the taxability of non compete fee would depend on the factors such as the position of the recipient of the non compete fee with regards to the business before and after the non compete covenant coming to operation, his relation with the payer of non compete fee, the type of asset transfer taking place, and the terms of the non compete covenant. Some of these factors influencing the taxability of non compete fee have been discussed below: 1. Where the recipient of the non compete fee is shareholder who was not actively engaged in the business The position of the recipient of the non compete fee with the business in question, has played a decisive role in deciding the taxability of the non compete fee, as it can be seen in Mrs. Hami Aspi Balsara v. ACIT 1. In this case, the ITAT held that, since the assessee on her own was not carrying on business and it was the company in which she was shareholder which was carrying on the business, section 28(va) would not be attracted. In this case, the Assessing Officer ( AO ) treated the difference between book value of shares and the sales consideration received for the share transfer, towards non compete fee, bringing the same fee under the purview of section 28(va). The ITAT observed that section 28 (va) would be attracted where the assessee was carrying on business and not where assessee only had right to carry on business in the form of a capital asset. The view taken in Mrs. Hami Aspi Balsara 2 has been followed by the ITAT in ACIT v Savita N. Mandhana 3, where the AO had bifurcated the share sale consideration amount into two components, one in respect of sale of shares and the other towards non compete fee to be taxed under section 28(va). The ITAT had held that in view of the fact that the assessee was not actively engaged in business, and the agreement did not specify payment towards non compete obligation, the entire amount of consideration received by the assessee would be treated as capital gains. 2. Where the recipient of the non compete fee is a shareholder who is actively engaged in the business (as in case of a promoter) 1 [2010] 126 ITD 100 (Mum). 2 Ibid. 3 2012 TIOL 63 ITAT MUM. 1
In the case of Ramesh D. Tainwala v ITO 4 the ITAT ruled that the non compete fee received by the assessee who was a promoter and director of the company being acquired, was taxable under section 28(va)(a). With regards to the assessee s contention that the non compete fee falls within the proviso (i) to Section 28(va)(a), the ITAT had observed that for the said proviso to apply there must be transfer of the right to carry on any business, whereas in the case at hand what was transferred was shareholding by the promoters and therefore there was no question of transfer of a right to carry on any business. The ITAT maintained that assessee was not carrying on any business on his own but was the promoter and director of the company whose shares were purchased by the Acquirer. The facts of in the case of ACIT v R.K.B.K Fiscal Services 5 were very similar to Ramesh D. Tainwala 6 where the promoters of a company had received a specific amount under an agreement towards non compete, which was held by the ITAT to be taxable under section 28(va)(a). Another case in this series was Nayan C Shah v DCIT 7. Here the assessee, being the Managing director and promoter of a Joint Venture ( JV ) entered into a Non compete Agreement ( NCA ) with the non resident JV partner. Under the NCA the assessee was to receive a lump sum amount along with commission (within a set limit) payable after a period of 5 years, based on the annual success of the JV during the 5 year period. The case before the ITAT was the issue of taxability of one such receipt of annual commission. The ITAT observed that, the assessee had continued to do his activity in the same line (for the non resident JV partner) even after entering into this NCA and therefore it cannot be said that the assessee has transferred completely the right to carry on any business. ITAT explained that an agreement not to compete with a third party in the business would not encompass totality of right to carry on any business. The ITAT further stated that right to carry on any business was larger in scope and range, and an agreement not to compete with the business of a particular person is only a part of it. The agreement not to compete with a particular person in his business does not prevent a person from carrying on the same business in a manner which would not compete with the business of that particular person. Consequently, the ITAT held that commission can be considered either as compensation to the assessee for agreeing not to carry out any activity in relation to any business attracting section 28(va)(a), or the payment is for the services rendered by the assessee for the non resident JV partner computed on the basis of the profitability of the venture for the 5 years, and that either ways it would be a revenue receipt. 3. Non compete fee is being paid along with consideration for transfer of all the assets of the business The ITAT, in Ramesh D. Tainwala 8 had observed that if the agreement to refrain from indulging in competition is part and parcel of the agreement for transfer of a business and the transferor agrees not to indulge in competition, then it can be said that right to carry on same or similar business was transferred along with the business. Further the ITAT s observed in DCIT v. Max India Ltd. 9, that when an assessee signed a negative covenant not to carry on manufacture or trade in product for certain period of time, it amounted only to self imposed restriction and not a transfer. There is 4 [2011] 48 SOT 324 (Mum). 5 [2011] 138 TTJ 1 (Kol.) 6 Ramesh D. Tainwala (n 4). 7 [2011] 48 SOT 77 (Mum)(URO). 8 Ramesh D. Tainwala (n 4). 9 [2007] 112 TTJ 726 (Asr), although this decision deals with a year prior to Assessment Year 2003 04 the same was been cited and accepted by ITAT in Nayan C Shah (n 7). 2
neither a sale or exchange or relinquishment of an asset, nor any right therein, which is extinguishable, the right to manufacture or trade remaining intact after the period for which the negative covenant was signed. 10 From the combined reading of these observation what comes out is that for the non compete fee to be brought under the purview of the proviso (i) to Section 28(va)(a), the non compete obligation has to be part of the transaction where there is a transfer of capital assets of the business (amounting to a transfer of business). The non compete covenant on its own cannot amount to a transfer of any right. A mere refrainment from carrying on an activity would be taxed under section 28(va) as can be seen from the decision of the Bombay High Court in the case of John D souza v. CIT and Anr 11. In this case the assessee had entered into an agreement with a company which had purchased a certain plot on which the assessee was carrying on fish farming. By the agreement, the assessee had agreed to stop fish farming in in the said ponds, for which he had received a certain sum from the said company. The High Court was of the view that the assessee had received the said sum for not carrying on any activity in relation to fish farming, the same being taxable under section 28(va)(a). Assessee contended that the said sum be taxed under section 45 as capital gains. To this the High court held that for the application of section 45 there should be a transfer of capital asset which was absent in the case. If the non compete covenant is a part of a transaction involving transfer of capital assets amounting to transfer of the business, the non compete fee received would be covered under the proviso (i) to section 28(va)(a) and would be taxed as a capital receipt. This stand was further clarified in the case of DCIT v Mediworld Publications (P) Ltd. 12 In this case, the assessee, through a Specified Asset Transfer Agreement', had sold all its rights, titles and interests in the specified assets of its Healthcare Journals and Communications business which included all the intangible assets being trademarks, brands, copyrights and the associated goodwill. The aforesaid agreement also relinquished for six years the assessee s right to carry on any business involving or relating to or competing with the transferred specified assets. The assessee treated the whole receipt as long term capital gains. The AO contended that the said receipt was towards non compete fee and was to be taxed under section 28(va) as Business income. The ITAT ruled in favour of the assessee and held the entire receipt is to be treated as capital gains. The ITAT relied on the following facts as mentioned in the order of Commissioner of Income Tax (Appeals) ( CIT(A) ), for holding that the assessee had wholly given up its right to carry on the Healthcare Journals and Communications business for a specified period: The assessee had sold all its intangible assets like trademarks, brands, copyrights and goodwill which constituted the assets of the business or the profit earning apparatus meaning thereby that the appellant, on selling the entire business apparatus, had deprived itself of any earnings in the subsequent years. No income had been generated by the assessee company after sale of intangibles to and consequent to such sale, and the assessee company had relieved the entire workforce from their duties/jobs since the entire business with its data base, networks, goodwill, trademark, copy right clientele etc. had been transferred to the buyer. 10 [2007] 112 TTJ 726 (Asr). 11 [2009] 226 TTJ 540 (Bom). 12 2010 TIOL 523 ITAT DEL. 3
The ITAT further observed that the consideration received was not only for giving up the right to carry on the business but was mainly for the transfer of all intangible assets being trademarks, brands, copyrights and the associated goodwill of the business and even the consideration as may be allocated to the giving up of right to carry on Healthcare Journals and Communications business was also taxable as long term capital gain by virtue of section 55(2)(a) read with clause (i) of the proviso to section 28(va)(a). One of the objections of the tax department was that the assessee had not transferred to the buyer, the total business, and the assessee was carrying on the business of clinical trial even after the sale. To this the assessee placed the defence that both the businesses were independent, and the same was accepted by the ITAT. The department appealed to the Delhi High Court 13 against the decision of the ITAT. The High Court also decided in favour of the assessee. The High Court accepted the ITAT and CIT(A) s reasoning as mentioned above and additionally relied on the following fact while ruling in favour of the assessee: That the assessee had sold and transferred permanently and forever all its existing assets and contracts of the Healthcare journals and Communication business in terms of an agreement. That the main part of the agreement was the transfer of all intangible assets being trademarks, brands, copyrights and the associated goodwill of its Healthcare Journals and Communication business. That the consideration was not received only for giving up the right to carry on the Healthcare Journals and Communication business but was mainly for the transfer of all intangible assets being trademarks, brands, copyrights and the associated goodwill of the Healthcare journals and communication business. That the consideration for the transfer of intangible assets being trademarks, brands, copyrights and the associated goodwill of Healthcare journals and communication business was taxable as long term capital gain. That for the purpose of the journals etc. published by the assessee company it had to go through the statutory procedures and clearances which proved the authenticity of the assessee's claim of the assets being in the nature of intangible capital assets of business. One common point which can be seen from the facts in the case of Mrs. Hami Aspi Balsara 14 and Mediworld Publications (P) Ltd. 15, though adjudicated on different grounds is that there was no specific amount assigned towards the non compete obligation and the consideration was towards transfer of assets. In ACIT v Dr. B.V. Raju 16, the special bench of the ITAT had discussed that there are two categories of persons: (1) the transferor carrying on the business himself, and (2) persons associated with the transferor. With regards to the first category, if the transferor sells his business and agrees not to carry on the business the consideration so received would fall under section 55(2)(a) right to carry on business. But in case of the second category, the same would fall under section 28(va)(a). Now from the facts of Mediworld Publications (P) Ltd. 17 it can be seen that the entire transaction of the specified assets including the non compete obligation was between the acquirer and the company, 13 CIT v Mediworld Publications (P) Ltd [2011] 337 ITR 178 (Delhi). 14 Mrs. Hami Aspi Balsara (n 1). 15 Mediworld Publications (P) Ltd (n 13). 16 [2012] 14 ITR (Trib) 387 (Hyd)(SB), at para 39, this decision deals with a year prior to Assessment Year 2003 04 but the decision had explained the position of law dealing with taxability of non compete fees as applicable from Assessment Year 2003 04. 17 Mediworld Publications (P) Ltd (n 13). 4
and not with its promoters. Therefore it can be said that the same would fall under first category as explained in Dr. B.V. Raju 18, and taxed as capital gains under section 55(2)(a). Whereas where the non compete fee was paid to the promoter as in the case of Ramesh D. Tainwala 19 the same would fall in the second category and would be taxed under section 28(va). In Dr. B.V. Raju 20, the Special bench of ITAT had also explained the terms set out in the proviso (i) to section 28(va)(a) and section 55(2)(a). It had observed that what is sought to be covered by the expression a right to manufacture, produce or process any article or thing found in section 55(2)(a) is intangible asset in the form of a patent or similar right and that the expression a right to manufacture, produce or process any article or thing and the expression a right to carry on business as appearing in section 55(2)(a), have definite and different connotations. 4. Where the non compete fee is being paid to an employee In Sasken Communication Technologies Ltd v ITO 21, the ITAT held that where non compete fees were paid by the assessee company to its employees at the commencement of their employment, for not competing with the assessee company in case of the said employees terminating their services with it, the same would be remuneration or compensation paid in relation to employment and therefore, would fall under the term salary or profit in lieu of salary. An interesting case is that of Kanwaljit Singh v ACIT 22, where on the basis of peculiar facts it was held that the non compete fee paid to an employee would be taxed under section 28(va)(a). The facts of the case were that the assessee 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. The assessee got the agency agreement executed in favour of a partnership firm formed between his 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 assessee and the partners of the firm, the assessee made efforts to transfer the said agency from the firm to himself. On settlement of the disputes, the assessee agreed to the continuation of the agency with the firm and entered into a NCA with the partners of the said firm. As per the NCA, the partners agreed to pay the assessee a commission, at an agreed rate till a certain period. The AO contended that the said noncompete commission was to be taxed as Salary Income, whereas the assessee contended that the same should be taxed under section 28(va) as Business income. The ITAT observed that the NCA executed between the assessee 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. The ITAT held that section 28(va), being a specific head, the income earned by assessee under the NCA was assessable under the head Business income. The Special bench of the ITAT had observed that for the provisions of section 55(2)(a) to apply, the transferor should have already been carrying on the business, and if the transferor is not already carrying on business then the consideration received would be considered to be for not carrying out 18 Dr B V Raju (n 16). 19 Ramesh D. Tainwala (n 4). 20 Dr B V Raju (n 16). 21 [2011] 15 taxmann.com 51 (Banglore Trib). 22 [2009] 29 SOT 43 5
any activity in relation to any business, and the provisions of section 28(va)(a) would apply. 23 Applying the above in case of employees, it can be said that if non compete fee is paid to an employee for not competing with the employer after termination of his services the provisions of section 55(2)(a) would not apply. 5. Where the non compete fee is being paid to a sister concern In Pentamedia Graphics Ltd v DCIT 24, the assessee company had transferred its software technology division to its sister concern. There was interlacing of activities and interlocking of funds between these two concerns. They both had a common CEO and management, and were not working as competitors. In these circumstances, the ITAT held that the amount attributed to non compete fee was a colourful arrangement of the accounts to shadow over the reality of the transfer of goodwill. Concluding remarks The decisions discussed above, have cleared the air surrounding the issue of taxability of noncompete fee, but some would argue that greater clarity would be required with respect to concept of right to carry on any business as provided under section 55(2)(a). A news report in 2008, stated that the Income Tax department had asked the Central Board of Direct Taxes ( CBDT ) for clarification with regards to right to carry on any business as provided under section 55(2)(a) 25. The report also mentioned that the Department favoured an amendment to Section 28(va) to exclude non compete fee from the list of capital transactions, thereby making it taxable as Business income only. 26 Disclaimer: The contents of this document are solely for informational purpose. It does not constitute professional advice or a formal recommendation. While due care has been taken in preparing this document, the existence of mistakes and omissions herein is not ruled out. Neither the author nor itatonline.org and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any inaccurate or incomplete information in this document nor for any actions taken in reliance thereon. No part of this document should be distributed or copied (except for personal, noncommercial use) without express written permission of itatonline.org 23 Dr B V Raju (n 16), para 40. 24 [2012] 22 taxmann.com 216 (Chennai Trib). 25 Anindita Dey, I T Dept asks CBDT to clarify non compete fee (Business Standard, 25 February 2008) <http://www.business standard.com/india/news/i t dept asks cbdt to clarify non compete fee/314899/> accessed on 26 June 2012 26 Ibid. 6