India: Madras High Court Attributes Part Consideration To Non-Compete Covenant Having Regard To The ‘Form' Of The Transaction

Last Updated: 11 January 2017
Article by SKP  

In a recent case1, the High Court of Madras (Court) attributed part of the composite consideration received to a non-compete covenant. The court held that where the agreement itself provided for total consideration to include consideration for negative covenant as well, the question of whether the activity of the non-compete was incidental or dominant was irrelevant.

Provisions of the Income Tax Act, 1961 (ITA) on taxability of payment for non-compete covenant

Prior to the insertion of subsection (va) in section 28, the taxability of non-compete receipts was a matter of substantial litigation with taxpayers adopting a view that these receipts were in the nature of capital receipts and accordingly not subject to tax. To put a rest to this controversy, subsection (va) was introduced in Section 28 vide Finance Act 2002 providing for taxability of non-compete receipts as income under the head 'profits and gains of business or profession'.

However, the provisions of the ITA also provide for the taxability of a sum received or receivable on account of the transfer of the right to manufacture, produce or process any article or thing or right to carry on any business or profession under the head 'capital gains'. It is pertinent to note that the tax rate for long-term capital gains is 20% whereas the tax rate for business income is 30%. Hence, whenever any business is transferred, the taxpayer will want to treat the receipt as a transfer of a right to do business and the tax authorities will want to treat the same as business income. This makes the decision of the Court quite relevant.

Brief facts of the case

  • Chemech Laboratories Ltd (taxpayer) was engaged in the business of manufacture and marketing of pharmaceuticals.
  • It entered into a transaction with Solvay Pharma (I) Ltd (SPIL) for transfer of brand, consultancy and non-compete agreements (through 3 different agreements) for a composite consideration of INR 60 million. A reference to non-compete agreements was given in the brand acquisition agreement.
  • The consideration was to be discharged in three instalments – INR 40 million upon the execution of the agreement, INR 10 million upon the transfer of registration under the Drug Laws and the balance INR 10 million upon the completion of one year from the date of execution of the agreement.
  • The taxpayer considered the entire sum of INR 60 million as consideration towards the transfer of business under the brand acquisition agreement without allocating any sum towards the non-compete covenant.
  • During the revenue audit, the tax officer allocated INR 40 million towards the non-compete covenant by holding the first instalment as an upfront payment towards the same. He thus made INR 40 million taxable under section 28.
  • On appeal, the Commissioner of Income Tax (Appeals) (CIT(A)) agreed with the view of the tax officer that part of the consideration was attributable to the non-compete. However, he modified the amount to 50% of the consideration (INR 30 million) holding that both non-compete and brand acquisition were equally important components in the transfer of an undertaking.
  • The taxpayer filed an appeal before the Income Tax Appellate Tribunal (ITAT) contending that the transaction was one of transfer of a right to carry on any business falling within the purview of the exclusion in the proviso to section 28(va) of the ITA.
  • The ITAT accepted the contention of the taxpayer on a finding that the dominant purpose of the transaction was to enforce the enjoyment of rights by exploitation of the brands and not to formulate a restrictive covenant, which was incidental.
  • Thus, the ITAT held that the entire sum of INR 60 million would constitute a capital receipt and nothing would be attributable to the negative covenant of non-compete.

Issue before the Court

  • Whether on the facts and circumstances of the case, the Tribunal was right in attributing the entire consideration to the sale of brand name, when the contracts in question covered both; sale of brand name and non-competition agreements?

Taxpayer's contentions

  • The entire consideration of INR 60 million related solely to the transfer of business under the brand acquisition agreement and no part thereof was attributable to non-compete.
  • The transaction was about the transfer of the rights to carry on any business falling within the purview of the exclusion in the proviso to section 28(va) of the ITA.
  • The business transferred was highly specialised and exclusive which involved cutting-edge technology inaccessible to it in the absence of the brands transferred. Products it sold constituted hormones utilised for infertility treatment under prescription, close monitoring and in controlled conditions.
  • These products were manufactured by three companies worldwide and the third entity which was under an exclusive agreement with the taxpayer now stood transferred to SPIL under the brand acquisition agreement. Its re-entry was just wishful thinking and impossibility.

Tax authority's contentions

  • The contracts covered the sale of a brand name as well as non-competition agreements.
  • Thus, the consideration should also be attributed to non-compete covenant taxable as business income.

Madras High Court's observation and ruling

  • The Court observed that the clauses in the brand acquisition agreement contained that the consideration of INR 60 million is for all transactions put together (i.e. after taking the restrictive covenants into account).
  • The Court explained that the legislature itself has made a conscious and clear distinction between the positive right to carry on a business or the activity of manufacture, production or process, the consideration for the transfer of which would be chargeable under the head 'capital gains' and a negative right, being a covenant against the carrying on of any activity in relation to a business, the consideration for which would be taxable as business income.
  • It held the ITAT's observation that the dominant purpose of the transaction was not to formulate a restrictive covenant, which was incidental, but to enforce the enjoyment of rights by exploitation of the brands was of no relevance.
  • The Court also referred to the specified clause of the non-compete agreement which mentions "........the consideration for all matters has been agreed after taking all such restrictive covenants into account". However, the agreement was silent on the attribution.
  • The Court recognised the merits in the arguments of the appellant that the business transferred was highly specialised and exclusive, but in view of the specific clauses in the agreement evidencing the apparent intent of the parties to attribute some of the amount towards non-compete fees, it ruled that the same had to be reconciled.

In view of the above, the taxpayer suggested that a sum of INR 10 million might be adopted as a reasonable valuation towards non-compete fee. Giving due regard to the taxpayer's submission, the Court accepted the INR 10 million attribution as proper and reasonable.

SKP's comments

Post insertion of sub-section (va) in section 28, taxpayers have been structuring transactions in a manner whereby the non-compete component was not being separately agreed for but is being camouflaged in a composite consideration and applying the dominant intention principle (rule of substance over form), the same is not being subject to tax at the highest rate. This is a classic case whereby placing reliance on the clauses of the agreements entered into by the parties, the court has held that part consideration was attributable to the non-compete covenant.

The key takeaways from this ruling are given below.
  • The rule of 'substance over form' cannot be applied blindly by ignoring the form altogether: It is crucial that the parties to the transaction must pay due consideration to the form i.e. the way in which the transaction is recorded or presented.
  • Attributing values to various rights/transactions: Non–allocation of consideration can certainly invite several rounds of litigation as well as commercial hassles in future. The agreements involving the transfer of various rights should be tested for after-effects before hand. The necessity of valuation/allocation of consideration should be considered at the time of executing the agreement itself in order to avoid any ambiguity and absurd attributions in the course of a revenue audit.

Footnote

[1] CIT vs. Chemech Laboratories Ltd

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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