Saurabh
Srivastava
v.
Deputy
Commissioner of Income-tax, Circle 46(1), New Delhi
Section 28(i) read with
sections 17(2), 17(3), 28(ii), 28(iv), 28(va), 45 and 56 of Income-tax
Act, 1961 – Business income-chargeable
as – Assessment year 1998-99 – Whether where compensation is received for
composite partly for transfer of capital assets, incidental to carrying on
business and partly for undertaking restrictive covenant of not competing with
business of assessees, compensation relatable to such activity would be a
capital receipt – Held, yes – Assessee,
a Computer Engineer and
associated with Software and Information Technology, was promoter and founder
of as well as Managing Director of a company ‘H’ and held certain shares of
said company – Company ‘H’ was agreed to be taken over by a U.K. company and as
per shares purchase agreement dated 4-12-1997 entered into by U.K. company with
shareholders of ‘H’ including assessee, 76 per cent of subscribed equity
capital was agreed to be transferred in favour of U.K. company by shareholders
in order to effect said taken over – In terms of said agreement, assessee sold
his all shares of company ‘H’ to U.K. company – In addition to share transfer
agreement, U.K. Company also entered into a non-compete agreement with assessee
on same date, i.e., 4-12-1997, whereby assessee was restrained from carrying
out any software development activity for any other person who directly
competed with U.K. company and its associate and subsidiary companies for a
period of 18 months – In meantime, assessee also entered into yet another new
service agreement with company ‘H’ on 24-2-1998 whereby assessee was employed as Managing Director of said company –
Therefore, shares purchase agreement was completed on 26-2-1998 and 76 per cent
of shares of company ‘H’ stood owned and vested in U.K company on that date –
During previous year relevant to assessment year 1998-99, assessee received
certain amount from U.K company as non-compete fees and claimed same to be
exempt being in nature of a capital receipt – Assessing Officer rejected claim
of assessee and held that amount in question was a revenue receipt liable to
tax under section 28(ii) – Whether even though on date of payment of
non-compete fees by U.K company to assessee an employer and employee
relationship existed between company ‘H’ and assessee, since restrictive
covenants stipulated in non-compete agreement were in nature of restrictive
covenants for not doing something to compete with business of U.K. company and
associate companies upto a period of 18 months from date of agreement dated
4-12-1997 to 31-5-1999 and further since non-compete agreement was an
independent, distinct and separate agreement from service agreement and it was
not dependent on assessee continuing in employment with company ‘H’ and further
since restrictions accepted by assessee adversely affected his income earning
potential by exploiting entrepreneur skill, knowledge etc., non-compete fees
received by assessee was in nature of a capital receipt – Held, yes – Whether
since entering into a non-compete agreement for restrictive covenant could not
be considered and treated as part of rendering services to employer company ‘H’
would bring such compensation in nature and ambit of profits in lieu,
non-compete fee was not taxable under head ‘salary’ under section 17(3)(i)/17(2)(v)
– Held, yes– Whether since assessee continued to be Managing Director of
company ‘H’ even after take over, payment of non-compete fees was not in any
way directly or indirectly linked to termination of management and, therefore,
non-compete fees was not covered under section 28(ii) – Held, yes –
Whether since non-compete fees did not arise to assessee from carrying on of
business or profession, it would also be not be taxable under section 28(iv) –
Held, yes – Whether since legislature, in their wisdom, has specifically made
taxable receipt of a non-compete fees under an agreement under clause (va) of
section 28 inserted by Finance Act,
2002 with effect from 1-4-2004, non-compete fees in question could not
be brought to tax under amended section also – Held, yes – Whether since
assessee had not transferred any capital asset, non-compete fees was also not
liable to capital gains under section 45 -Held, yes – Whether since non-compete
fees received by assessee was for undertaking restrictive covenants of not
undertaking or engaging himself in business of assessee or joining employment
with any other concern, same was also not liable to tax under head ‘income from
other sources’ – Held, yes – Whether, in view of aforesaid, it could be
concluded that non-compete fees for undertaking restrictive covenants was in
nature of capital receipt and hence, not liable to tax under any head of income
mentioned under section 14 – Held, yes
FACTS
The assessee a Computer Engineer and associated with Software and Information Technology, was the promoter founder as well as the Managing Director of a software company ‘H’. He held certain shares of the said company. The said company was agreed to be taken over by a U.K. company and as per the shares purchase agreement dated 4-12-1997 entered into by the U.K. company with the shareholders of ‘H’, including the assessee, 76 per cent of the subscribed equity capital was agreed to be transferred in favour of the U.K. company by the shareholders in order to effect the said take over. In terms of the said agreement, the assessee sold his all shares of the company ‘H’ to the U.K. company. In addition to the share transfer agreement, the U.K. company also entered into a non-compete agreement with the assessee on the same date, i.e., 4-12-1997, whereby the assessee was restrained from carrying out any software development activity for any other person who directly competed with the U.K. company and its associate and subsidiary companies, for a period of 18 months. In the meantime, the assessee also entered into yet another new service agreement with the company ‘H’, on 24-2-1998 whereby, the assessee was employed as the Managing Director of the said company. Further the shares purchase agreement was completed on 26-2-1998 and 76 per cent of the shares of the company ‘H’ stood owned and vested in the U.K. company on that date. During the previous year relevant to the assessment year 1998-99, the assessee received a sum of Rs. 1,07,36,570 certain amount from the U.K. company as non-compete fees and claimed the same to be exempt being in nature of a capital receipt. The Assessing Officer taking notice of the service agreement dated 24-2-1998 entered into between the assessee and the company ‘H’ and the non-compete agreement dated 4-12-1997 held that the only limitation undertaken by the assessee was not to harm the business interest of the U.K. company. He also held that the very fact that the assessee received a lump sum payment did not make the receipt as that of a capital nature. He further having noticed that the assessee was not running or carrying on any business and was working in the capacity of Managing Director of the company ‘H’ before entering into non-compete agreement with U.K company and continued to work in that capacity after its takenover by the U.K. company held that the assessee’s capacity to work or earn income was not affected adversely because of the non-compete agreement and there was no loss of source of income to the assessee. The Assessing Officer, therefore, rejected the claim of the assessee that the non-compete fees of Rs. 1,07,36,570 was a capital receipt and held that the amount in question was a revenue receipt liable to tax under section 28(ii).
On appeal, the Commissioner (Appeals) upheld the action of the Assessing Officer.
On second appeal
HELD
In the light of catena of decisions it is evident that whether particular receipt is capital or revenue in nature would depend on the facts of each case. However, the payments received for impairment of income earning apparatus, sterlisation of source of income or transfer of a capital asset would generally fall in the category of capital receipts. Further, the compensation received for undertaking restrictive covenants of not competing with the business of the assessee also generally fall in the nature of capital receipt until the same is incidental to the carrying on of business. Thus, the receipts which are incidental to carrying on the business and which do not affect the source of income would generally fall in the category of revenue receipts. Therefore, where the compensations received for composite partly for transfer of capital assets, incidental to the carrying on the business and partly for undertaking restrictive covenant of not competing with the business of assessees, the compensation relatable to such activity would be a capital receipt. [Para 8]
In the instant case, the non-compete agreement became effective simultaneously with the completion of the transaction of sale and purchase of the shares under the share purchase agreement. On reading the shares purchase agreement dated 4-12-1997 it was clear that the shareholders of the company ‘H’ had agreed to sell 76 per cent of their holding to the U.K. company on the condition that the four directors of the company ‘H’, namely, R, the assessee, D and M, would have entered into a contract of employment with the company ‘H’ in the agreed form and remained in employment of the company ‘H’ on terms and conditions stipulated therein. The contract for employment was also to be in the agreed form and was to be entered into on or prior to the completion date i.e., 26-2-1998. In fact, the assessee entered into the service agreement on 24-2-1998 and received the non-compete fees of Rs. 1,07,36,750 on 26-2-1998 alongwith consideration for sale of shares. It was also a fact that the assessee was the Managing Director of the company ‘H’ right from its inception and continued in the same position after taking over by the U.K. company without any break. The only difference was that earlier the ownership, control and management of the company ‘H’ vested with the persons holding 76 per cent shares and after take over, the ownership, control and management vested with the U.K. company. The Non-compete fees agreement was also dependent upon the completion of the share purchase agreement. However, the payment of non-compete fees to the assessee and three other Directors was not dependent on their continuing in employment with the company ‘H’ after takeover. If it were so, ‘R’ who had quite the employment of the company ‘H’ after takeover would have not received the non-compete fees. It was also a fact that there were other directors of the company ‘H’ who had not been paid non-compete fees and the sellers were under an obligation to procure their resignations. Therefore, even though the date of the agreements, i.e., for sale of shares and non-compete fees was 4-12-1997, yet the date when these became effective was the completion date of the share purchase agreement, i.e., 26-2-1998. No doubt, there were certain obligations cast on the sellers between the dates of the agreement, i.e., 4-12-1997 to the completion date, i.e., 26-2-1998, yet these were to become effective only on the date of taking over by the U.K. company. Therefore, on the date of payment of non-compete fees to the assessee, the shares of the company ‘H’ were substantially owned by the U.K. company and, therefore, an employer-employee relationship existed between the company ‘H’ and the assessee. Now, the question arose whether the non-compete fees received for undertaking restrictive covenants was a capital or a revenue receipt even though the employer and employee relation stood established between the company ‘H’ and the assessee on the completion date that is, 26-2-1998. Further bare reading of the restrictive convenants stipulated in the non-compete agreement dated 4-12-1997 showed that the assessee alongwith other three directors had undertaken for the period of 18 months upto May 31, 1999, directly or indirectly, either alone or jointly with or on behalf of any person, firm, company or entity, to solicit or interfere with or endeavour in the relevant territory to entice away from the U.K. company any person, firm, company or entity who was a client or customer of the U.K. company in respect of business in the 12 months prior to the completion date, or who would becomes a client after the said period prior to 3 l-5-1999. The assessee was also not to supply of the services of products in the specified territory to any person which is or was a client or a customer of the U.K. company during the period of 12 months prior to the completion date or would become a client prior to May 31,1999. The assessee had accepted similar restrictions in respect of persons who were supplier of services or goods to the company H for the above mentioned period. The assessee was also estopped from employing or engaging or soliciting the employment of any person who was an employee of the company H except of the category of persons mentioned therein. The assessee was also restrained from representing himself as being in any way connected with or entrusted with the business of the covenantee group. Thus, all these stipulations were in the nature of restrictive covenants for not doing something to compete with the business of the U.K. company and associate companies upto a period of 18 months from the date of agreement dated 4.12.1997 to 31.5.1999. [Para 9]
Now the question arose since the assessee had continued with the company ‘H’ as the Managing Director, whether the non-compete fees, received by him for accepting the restrictive covenant would be liable to tax under the head 'salary' as profit in lieu of salary. On going through the decisions of the various Benches of the Tribunal and the High Courts, where a similar issue came up for consideration, it was evident that compensation received for undertaking restrictive covenant falls in the category of a capital receipt. In the instant case, the non-compete agreement with the four directors including the assessee was an independent, distinct and separate agreement from the service agreement and it was not dependent on their continuing in employment with the company ‘H’. In fact, ‘R’ had quit the employment as Director of the company ‘H’ after take over. Still, he was paid non-compete fees of the same amount as paid to other three directors. Likewise, there were other directors of the company ‘H’ before take over. They were also not paid non-compete fees. Therefore, the payment of non-compete fees was neither dependent upon these directors continuing in the employment of the company ‘H’ after take over, nor it arose/sprung from their employer-employee relationship. Therefore, the non-compete fees received by the assessee could not be brought to tax under the head 'Income from salary' or profits in lieu of salary. The assessee, by accepting the terms and conditions of the non-compete agreement, had restrained himself from setting up any business, joining the employment; becoming the Director of some other concern to compete with the business of the U.K. company. Such restrictions accepted by the assessee adversely affected the income earning potential by exploiting his entrepreneur skill, knowledge, experience etc. Therefore, the non-compete fees was in the nature of a capital receipt. [Para 10]
It is no doubt true that under the law, a company is a legal entity separate and distinct from its directors. It is also a fact that the business of the company is being run through the persons who own, man, control and manage the business of the company. The success and failure of the company depends on the quality, capability and skills of the persons who manage, control and run the company. Therefore, there was no merit in the contention of the revenue that since the business carried on by the company ‘H’ belonged to the U.K. company, the assessee and other directors could non-compete with the said business having accepted the employment of company ‘H’. [Para 11]
Earlier, the assessee was not only the Managing Director, but was also the founder, promoter and major shareholder of the company ‘H’. The same gave a feeling of belongingness, partnership in addition to his being the Managing Director. But after its take over by the U.K. company, he ceased to be the shareholder of the company ‘H’. His relationship with the company ‘H’ after take over, was only of Managing Director i.e. the employee. The ownership and management vested with the U.K. company. Thus, the feeling of belongingness to the company ‘H’ would not exist and the loyality to the organisation would be no more than an employee. If the assessee would get better terms and conditions from some other company, he might like to quit the company ‘H’. It was precisely for these reasons that the company ‘H’ after its take over, offered attractive/better terms and conditions for continuing in employment. Since the scope of new services agreement was different from the agreement for non-compete fees, all payments received under the new services agreement would be taxable under the head salary. However, the payments received under the non-compete agreement being independent in nature for accepting restrictive covenants, would fall in the category of a capital receipt. [Para 11.1]
Further in the instant case, the face value of the shares of the company ‘H’ was Rs. 10 per share. The shares were quoted in the market and the average quoted price during the 26 weeks was at Rs. 45 per share. Shares had been sold at the rate of 100.90 per share. This only showed that the company ‘H’, before its take over, was doing very well. Therefore, the purpose of entering into a non-compete agreement was to restrain such person from undertaking such business or engaging themselves in activities which were detrimental to the business of the employer-company. Therefore, entering into a non-compete agreement for restrictive covenant could not be considered and treated as part of rendering services to the employer company ‘H’ while being in employment which would bring such compensation in the nature and ambit of profits in lieu of salary. Therefore, the non-compete fees was not taxable under the head salary either under section 17(3)(i)/17(2)(v). Further clause (iii) of sub-section (3) of section 17 has been inserted by the Finance Act, 2001 with effect from 1-4-2002, under which, any amount due to or received, whether in lump sum or otherwise by an assessee from any person before his joining any employment with that person, or after cessation of his employment with that person, has been included in the nature of profits in lieu of salary. But this amendment has been made applicable with effect from 1-4-2001 and, therefore, the non-compete fee could not be brought to tax under the amended section also. [Para 11.2]
Now the question arose, whether the non-compete fees could be brought to tax under section 28(ii). In the instant case, the assessee was himself not carrying on any business. The amount received by way of non-compete fees did not arise to the assessee in the course of business carried on by the assessee. The case of the Revenue was that the non-compete fees was covered under sub-clause (a) of clause (ii) of section 28. However, the said clause deems compensation which is received by any person managing wholly or substantially the affairs of the Indian company at the time of termination of his management or on modification of the terms and conditions relating thereto as income liable to tax under the head 'profits and gains from ‘business or profession’ . In the instant case apart from four directors, namely, the assessee, ‘R’, ‘D’ and ‘M’ the remaining directors had to resign. The assessee continued to be the managing director even after take over. Therefore, there was no termination of the powers of the management of the assessee. The payment of non-compete fee was not in any way, directly or indirectly linked to termination of management. Therefore, the non-compete fee was not covered under section 28(ii). [Para 12]
The revenue had also argued that the non-compete fees would be taxable under section 28(iv) because the expression ‘Profession’ was again of the widest amplitude. The non-compete fees did not arise to the assessee from carrying on of business or profession. Since the assessee was not carrying on any business or profession, the impugned receipt would neither be taxable under section 28(ii) or 28(iv). [Para 12.1]
Now the question arose, whether, the non-compete fees received by the assessee a capital receipt being in the nature, was liable to tax as capital gains. Section 45 deals with the income calling in the nature of capital gains. The same can be brought to tax only if there is transfer of a capital asset. In the instant case, the assessee had not transferred any capital asset. On the contrary, the assessee had undertaken restrictive covenants for not doing something. Therefore, the same did not amount to transfer of a capital asset. Thus, the non-compete fees was not liable to capital gains. [Para 13]
Further since the non-compete fees received by the assessee was for undertaking restrictive covenants of not undertaking or engaging himself in the business of the assessee or jointing employment with any other concern, the same was also not liable to tax under the head ‘income from other sources’. [Para 14]
Conclusion
Therefore, the non-compete fees received by the assessee was for undertaking restrictive covenant to compete with the business of the assessee directly or indirectly. These were not at all linked with the services rendered in the past or to be rendered in future. Such payments did not spring from relationship of an employer and employee. The nature and scope of activities spelt out in the new services agreement was different and independent from the non-compete agreement. Therefore, the payment could not be linked directly or indirectly with the employment of the assessee as Managing Director of the company ‘H’. Therefore, the non-compete fees was not taxable under the head ‘Income from salary’. The non-compete fees was also not taxable under section 28(ii) and 28(iv) because the assessee was not carrying on any business or profession. Such receipt was also not liable to tax under the head ‘Capital Gains’ or ‘Income from other sources’. The non-compete fees for undertaking restrictive covenants was capital in nature and, hence, not liable to tax under any head of income mentioned under section 14 of the Act. The receipt of a non-compete fees under an agreement has been specifically made taxable under clause (va) of section 28 inserted by the Finance Act, 2002 with effect from 1-4-2003. The legislature, in their wisdom, has thought of making such amendment applicable from assessment year 2002-2003. Therefore, the same was not applicable to the assessment year under consideration. [Para 16]
Therefore, the non-compete fees received by the assesse from the U.K. company being in the nature of a capital receipt was not liable to tax. [Para 17]