{"id":1183,"date":"2012-06-26T18:16:52","date_gmt":"2012-06-26T18:16:52","guid":{"rendered":"http:\/\/www.itatonline.org\/articles_new\/?p=1183"},"modified":"2012-06-26T18:17:35","modified_gmt":"2012-06-26T18:17:35","slug":"the-law-on-taxability-of-non-compete-fees-explained","status":"publish","type":"post","link":"https:\/\/itatonline.org\/articles_new\/the-law-on-taxability-of-non-compete-fees-explained\/","title":{"rendered":"The Law On Taxability Of Non-Compete Fees Explained"},"content":{"rendered":"
\n
\"Darryl<\/div>\n

The Law On Taxability Of Non-Compete Fees Explained<\/p>\n

Darryl Paul Barretto<\/p>\n

\t\t\t The question whether fees received for granting a non-compete covenant is a capital receipt or a revenue receipt depends on a bewildering array of circumstances. While there are a plethora of judgements on the point, the principles are not clear. The author has done a commendable job of carefully analyzing the judgements and systematically identifying their core principles in a concise and clear manner\n<\/p><\/div>\n

\n
Link to download this article in pdf format is at the bottom<\/a><\/span><\/div>\n<\/p>\n

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:\n<\/p>\n<\/div>\n

<\/p>\n

\n
\n
<\/div>\n<\/div>\n
\n

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 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<\/p><\/div>\n

1. Where the recipient of the non-compete fee is shareholder who was not actively engaged in the business<\/h2>\n<\/p>\n

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.<\/em> Hami Aspi Balsara v. ACIT<\/em> (1)<\/a>. 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.<\/p>\n<\/p>\n

The view taken in Mrs.<\/em> Hami Aspi Balsara(2)<\/a> <\/em>has been followed by the ITAT in ACIT v<\/em> Savita N. Mandhana<\/em>(3)<\/a>, 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. <\/p>\n<\/p>\n

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)
\n<\/h2>\n<\/p>\n

In the case of Ramesh D. Tainwala v ITO<\/em>(4)<\/a> 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<\/em>(5)<\/a> were very similar to Ramesh D. Tainwala<\/em>(6) <\/a>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).<\/p>\n<\/p>\n

Another casein this series was Nayan C Shah v DCIT<\/em>(7)<\/a>. 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.<\/p>\n<\/p>\n

3. Non-compete fee is being paid along with consideration for transfer of all the assets of the business
\n<\/h2>\n<\/p>\n

The ITAT, in Ramesh D. Tainwala<\/em>(8)<\/a> 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.<\/em>(9)<\/a>,<\/em> 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 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)<\/a> 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). <\/p>\n<\/p>\n

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<\/em> v. CIT and Anr<\/em>(11)<\/a>. 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. <\/p>\n<\/p>\n

\n

what is sought to be covered by the expression \u2018a right to manufacture, produce or process any article or thing\u2019 found in section 55(2)(a) is intangible asset in the form of a patent or similar right and that the expression \u2018a right to manufacture, produce or process any article or thing\u2019 and the expression \u2018a right to carry on business\u2019 as appearing in section 55(2)(a), have definite and different connotations<\/p>\n<\/div>\n

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.<\/em>(12)<\/a> 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.’ <\/p>\n<\/p>\n

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:<\/strong><\/p>\n<\/p>\n

– 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. <\/p>\n<\/p>\n

– 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. <\/p>\n