In a recent judgment (CIT vs. Chemech Laboratories Limited), the Madras High Court has held that where consideration is paid for all aspects of a transaction (with non‑compete covenants), some portion of the consideration is to be attributed towards non-compete covenants, even in the absence of an express provision in the transaction agreements.
Facts of the case
Chemech Laboratories Limited (CLL), a company engaged in the business of manufacture and marketing of pharmaceuticals, entered into 3 separate agreements with Solvay Pharma (India) Limited (SPIL) for transfer of its business namely, (i) a brand acquisition agreement (BAA), (ii) a consultancy agreement (CA) and (iii) a non‑compete agreement (NCA). While the NCA was made an integral part of the BAA, the entire consideration for the transfer of business was set out in the BAA only and there was no specific attribution to the NCA or the non-compete covenants in the BAA. The consideration was payable in 3 instalments. In its tax assessment, CLL did not attribute any part of the consideration specified in the BAA towards the NCA. However, the Assessing Officer (AO) allocated the first instalment of consideration towards the NCA. As a result, the first instalment of consideration was taxed as business income.
The first appellate authority (CIT(A)), while agreeing in-principle with the AO that some amount must be attributed towards the NCA, provided some relief to CLL by reducing the quantum of such attribution. On further appeal, the second appellate authority (ITAT) reversed the orders of the AO and the CIT(A) and passed an order in favour of CLL. It held that the whole sum of consideration would only constitute a capital receipt (i.e. no attribution towards non-compete covenant) on the basis that, (i) the dominant purpose of the transaction was not to formulate a restrictive covenant, and (ii) such restrictive covenant was merely incidental to the enjoyment of the rights of the brand.
Madras High Court Ruling
On further appeal, the Hon’ble Madras High Court held that the ITAT misdirected itself in addressing the question of whether the activity of non-compete was incidental or dominant. It observed that the 3 agreements (connected to the business transfer) depict a composite transaction in respect of which the consideration has been paid and accordingly, some part of the consideration would have to be attributed towards the activity of non-compete as well. With respect to the quantum of attribution, CLL itself suggested an amount to be attributed towards non-compete activity, which was then accepted by the High Court.
Even though there is a specific provision in the Income-tax Act, 1961 to tax consideration received for non-compete restrictions, the differential tax rates between long term capital gains (20%) and business income (30%) has always lead to disagreements between the taxpayers and the tax authorities as far as non-compete covenants are concerned. This ruling is indicative of the tax authorities’ and the judiciary’s perception of transactions (involving non-compete covenants, whether drafted in the main agreement or provided for in a separate agreement), especially where the transaction documents do not expressly attribute any portion of the consideration towards the non-compete covenants. Going forward, the implications of this ruling would need to be carefully evaluated from both a direct and indirect tax standpoint. Finally, this ruling also has wider ramifications as it may cast withholding tax obligations upon investors.