Payment received as  non- competition fee is taxable in Income Tax u/s 28(va)- Supreme Court

Introduction

Section 28 of the Income Tax Act pertains to incomes which shall be chargeable to income-tax under the head “Profits and gains of business or profession” According to Section 28(ii)(a) any compensation or other payment due to or received by any person, by whatever name called, managing the whole or substantially the whole of the affairs of an Indian company, at or in connection with the termination of his management or the modification of the terms and conditions relating thereto will be chargeable to income-tax under the head “Profits and gains of business or profession”

According to Section 28(va), any sum, whether received or receivable, in cash or kind, under an agreement for:-

1. not carrying out any activity in relation to any business or profession; or
2. not sharing any know-how, patent, copyright, trade-mark, licence, franchise or any other business or commercial right of similar nature or information or technique likely to assist in the manufacture or processing of goods or provision for services

will be chargeable to income-tax under the head “Profits and gains of business or profession”

Whether the non- compete fees received were taxable or whether the same is exempt as capital receipt?

The above issue was given light in the present appeal relating to assessment year 1995-96 is by Shiv Raj Gupta, who was the Chairman and Managing Director of M/s Central Distillery and Breweries Ltd. (CDBL), which had a unit in Meerut manufacturing beer and Indian Made Foreign Liquor (IMFL).

Facts of the Case:-

1. The appellant, his wife, son, daughter-in-law and two daughters were the registered holders of equity shares constituting 57.29% of the paid-up equity share capital of CDBL.
2. A Memorandum of Understanding (MoU), was made between the appellant and three group companies of M/s Shaw Wallace Company Group (SWC group)
3. The MoU refers to a Supreme Court Order, which made it clear that the company’s manufacturing activity at the plant at Meerut was suspended until a secondary effluent treatment plant was installed and made operative by the company.
4. This led to the sale of this controlling block of shares, which was sold at the price of INR 30 per share.
5. It is stated in the said MoU that the entire sale consideration had been paid by the SWC group to Shri Gupta, as a result of which Shri Gupta has irrevocably handed over physical possession, management and control of the said brewery and distillery of CDBL to a representative of the SWC group
6. It was also made clear that the nominees of the SWC group would be made directors, so that they will constitute an absolute majority on the board of the company.
7. Both Shiv Raj Gupta and his son Shri Jayant Gupta (who, together with his wife, is the major shareholder of the family) would resign as Chairman and Managing Director and as Joint Managing Director respectively of CDBL
8. According to the MoU, personal guarantees given by the appellant and his son to UCO Bank, IFCI, ICICI and IREDA for loans will be indemnified against all claims, actions, etc. in respect thereof.
9. A deed of Covenant was entered and non-competition fee of Rs. 6,60,00,000 was decided
10. Mr. Gupta agreed that he will not start or engage himself directly or indirectly or provide any service, assistance or support of any nature, whatsoever, to or in relation to the manufacturing, dealing and supplying or marketing of Indian Made Foreign Liquor (IMFL) and/or Beer.
11. This covenant shall remain in full force and effect for a period of 10 years and it would be irrevocably binding on Mr. Gupta.

Order of Assessing Officer (AO)

1. AO held that despite the fact that the appellant owned a concern, named, M/s Maltings Ltd, which also manufactured IMFL, being a loss making concern, no real competition could be envisaged between a giant, namely the SWC group and the loss making company, as a result of which the huge amount paid under the Deed of Covenant cannot be said to be an amount paid in respect of a restrictive agreement of non-competition.
2. Also the son of the appellant was not paid any such non-compete fee despite the fact that he also resigned from his position as Joint Managing Director.
3. It was also held that this was a lump sum payment with no reason as to why such a huge amount of INR 6.6 crores was being paid.
4. It was also found that there was no penalty clause to enforce the performance of obligations under the aforesaid Deed of Covenant, as a result of which, the Deed of Covenant was held to be a colourable device to evade tax that is payable under Section 28(ii)(a) of the Income Tax Act, 1961.
5. As a result thereof, the amount was then brought to tax under the aforesaid provision
6. An appeal from the AO to the Commissioner of Income Tax (Appeals) was also dismissed.

Appeal to Income Tax Appellate Tribunal (ITAT)

1. When it came before the ITAT the Accountant Member differed with the Judicial Member.
2. The Accountant Member held that there was no colourable device involved, and as a result, non-compete fee payable under the Deed of Covenant was not taxable under Section 28(ii)(a) or any other provision of the Income Tax Act, 1961.
3. The Judicial Member on the other hand agreed with the AO, as a result of which he decided in favour of the revenue.
4. A reference was then made to a third Member, who was also a Judicial Member. The third Member emphasised the fact that a share worth INR 3 was sold for INR 30 under the MoU as a result of transfer of control of the CDBL.
5. It cannot be said that these shares have been undervalued, neither can it be said that there was any collusion or other sham transaction, as a result of which the amount of INR 6.6 crores has escaped income tax.
6. He pointed out that, a “penalty clause” was provided for and out of the amount received by the assessee an amount of INR 3 crore was to be deposited with the SWC group for two years under a public deposit scheme
7. In case there is any breach of the terms of the MoU resulting in loss, the amount of such loss would be deducted from this deposit.
8. The result, therefore, was that the appeal stood allowed by a majority of 2:1 in the ITAT.

Appeal to High Court (HC)

1. The revenue preferred an appeal to the High Court.
2. Appeal to the Delhi HC stood on the issue whether, the amount of Rs. 6.6 crores received by the assessee from SWC is on account of handing over management and control of CDBL (which were earlier under the management and control of the assessee) to SWC as terminal benefit and is taxable u/s 28(ii) of the Income-tax Act or whether the same is exempt as capital receipt being non-competition fee by executing deed of covenant?
3. Disagreeing with the AO and the minority judgment of the Tribunal, the HC went on to state that the said sum of INR 6.6 crores could not be brought to tax under Section 28(ii)(a), but would have to be treated as a taxable capital gain in the hands of the appellant, being part of the full value of the sale consideration paid for transfer of shares.

Appeal to Supreme Court (SC)

Observations of SC regarding Deed of Covenant

1. Each member of the family was paid for his/her shares in the company, the lion’s share being paid to the assessee’s son and wife as they held the most number of shares within the said family.
2. The non-compete fee of INR 6.6 crores was paid only to the assessee.
3. This was for the reason stated in the Deed of Covenant, namely, that Shiv Raj Gupta had acquired considerable knowledge, skill, expertise and specialisation in the liquor business as he had been Chairman and Managing Director of CDBL for about 35 years.
4. He also owned a concern, namely M/s Maltings Ltd., which manufactured and sold IMFL and beer and that he was the President of All India Distilleries Association and H.P. Distilleries Association.
5. It was further recorded in the judgment of the Accounting Member that the amount of INR 6.6 crores was arrived at as a result of negotiations between the SWC group and the appellant
6. That the restrictive covenant for a period of 10 years resulted in the payment of INR 66 lakhs per year so that the appellant would not start or engage himself, directly or indirectly, or provide any service, assistance or support of any nature, whatsoever, to or in relation to the manufacturing, dealing and supplying or marketing of IMFL and/or Beer
7. Given the personal expertise of the assessee, the perception of the SWC group was that Gupta could either start a rival business or engage himself in a rival business, which would include manufacturing and marketing of IMFL and Beer at which he was an old hand, having experience of 35 years.
8. It was also clear that the withholding of INR 3 crores out of INR 6.6 crores for a period of two years by way of a public deposit with the SWC group for the purpose of deduction of any loss on account of any breach of the MoU, was akin to a penalty clause, making it clear thereby that there was no colourable device involved in having two separate agreements for two entirely separate and distinct purposes.
9. According to the SC, stating that there was no rationale behind the payment of INR 6.6 crores and that the assessee was not a probable or perceptible threat or competitor to the SWC group is the perception of the AO, which cannot take the place of business reality from the point of view of the assessee.
10. The fact that M/s Maltings Ltd. had incurred a loss in the previous year is again neither here nor there. It may in future be a direct threat to the SWC group and may turn around and make profits in future years.
11. Besides, M/s Maltings Ltd. is only one concern of the assessee. It is the assessee’s expertise in this field on all counts that was the threat perception of the SWC group which cannot be second guessed by the revenue.
12. The fact that there was no penalty clause for violation of the Deed of Covenant, was found to be incorrect by the SC.
13. The fact that the respondent-assessee in his letter in reply to the show cause notice had stated that the SWC group had gained substantial commercial advantage by the purchase of shares in CDBL as the turnover increased from Rs 9.79 crores to Rs 45.17 crores in 4-5 years is again neither here nor there.
14. As a matter of fact, the SWC group, due to its own advertisement and marketing efforts, may well have reached this figure after a period of six years.

Reference to Judgment in Guffic Chem (P) Ltd. v. CIT (2011) 4 SCC 254

1. In this case, the question set out by the Court was whether a payment under an agreement not to compete (negative covenant agreement) is a capital receipt or a revenue receipt.
2. Here, the Court was dealing with an amount of INR 50 lakhs received by the appellant-assessee from Ranbaxy as a non-compete fee under an agreement.
3. The Court in negating the application of Section 28(ii)(a) to such receipt, held that the position in law is clear and well settled.
4. There is a contrast between receipt of compensation by an assessee for the loss of agency and receipt of compensation attributable to the negative/restrictive covenant.
5. The compensation received for the loss of agency is a revenue receipt whereas the compensation attributable to a negative/restrictive covenant is a capital receipt

Reference to Judgment in Gillanders case [(1964) 53 ITR 283 (SC)]

1. The assessee in that case carried on business in diverse fields besides acting as managing agents, shipping agents, purchasing agents and secretaries.
2. Assessee also acted as importers and distributors on behalf of foreign principals and bought and sold in its own account.
3. Under an agreement which was terminable at will, the assessee acted as a sole agent of explosives manufactured by Imperial Chemical Industries (Export) Ltd.
4. That agency was terminated and by way of compensation Imperial Chemical Industries (Export) Ltd. paid for first 3 years after the termination of the agency two-fifths of the commission accrued on its sales in the territory of the agency of the appellant and in addition in the third year full commission was paid for the sales in that year.
5. Imperial Chemical Industries (Export) Ltd. took a formal undertaking from the assessee to refrain from selling or accepting any agency for explosives
6. The first question which arose was whether the amounts received by the appellant for loss of agency was in normal course of business and therefore whether they constituted revenue receipt.
7. The second question which arose was whether the amount received by the assessee (compensation) on the condition not to carry on a competitive business was in the nature of capital receipt.
8. It was held that the compensation received by the assessee for loss of agency was a revenue receipt whereas compensation received for refraining from carrying on competitive business was a capital receipt.

Observations of the SC pertaining to receipt by the assessee under noncompetition agreement

1. The HC had misinterpreted the judgment of this Court in Gillanders case [(1964) 53 ITR 283 (SC)].
2. In the present case, the Department had not questioned the genuineness of the transaction.
3. SC was of the view that the HC had erred in interfering with the concurrent findings of fact recorded by CIT(A) and the Tribunal.
4. Also, the payment received as non-competition fee under a negative covenant was always treated as a capital receipt till Assessment Year 2003-2004.
5. The Finance Act, 2002 itself indicates that during the relevant assessment year compensation received by the assessee under noncompetition agreement was a capital receipt, not taxable under the 1961 Act. It became taxable only with effect from 1-4-2003.
6. It is well settled that a liability cannot be created retrospectively.
7. In the present case, compensation received under the non-competition agreement became taxable as a capital receipt and not as a revenue receipt by specific legislative mandate vide Section 28(va) and that too with effect from 1-4-2003. Hence, the said Section 28(v-a) is amendatory and not clarificatory.

Reference to Judgment in CIT v. Rai Bahadur Jairam Valji [(1959) 35 ITR 148 (SC)]

1. It was held by the SC that if a contract is entered into in the ordinary course of business, any compensation received for its termination (loss of agency) would be a revenue receipt.
2. In the present case, both CIT(A) as well as ITAT, came to the conclusion that the agreement entered into by the assessee with Ranbaxy led to loss of source of business
3. The payment was received under the negative covenant and therefore the receipt of Rs. 50 lakhs by the assessee from Ranbaxy was in the nature of capital receipt.
4. In fact, in order to put an end to the litigation, Parliament stepped in to specifically tax such receipts under the non-competition agreement with effect from 1-4-2003.

Therefore payment recevied as non- competition fee is taxable in Income Tax u/s 28(va).

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