Non-Compete Fees and Book Profits: Court Upholds Tax Exemption

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Case Name: 

Commissioner of Income Tax vs. Bisleri Sales Ltd. (High Court of Bombay)

Income Tax Appeal No. 1436 of 2013

Date: 30th June 2015

Key Takeaways:

• Non-compete fees received before April 1, 2003, are considered capital receipts and not taxable as capital gains.
• For amounts to be added to book profits under Section 115JA (of Income Tax Act, 1961), they must first be debited to the Profit and Loss account.
• The court relied on precedents from the Supreme Court, including Apollo Tyres Ltd. and National Hydroelectric Power Corp. Ltd., to support its decision.

Issue: 

Should non-compete fees be taxed as capital gains and included in book profits under Section 115JA (of Income Tax Act, 1961)?

Facts: 

Bisleri Sales Ltd. received a non-compete fee of Rs. 5 crores from an agreement with Hindustan Coca-Cola Bottling North West Pvt. Ltd. The Assessing Officer wanted to tax this fee as capital gains and include it in book profits. However, Bisleri argued that the fee was a capital receipt and not taxable before 2003.

Arguments:

• Revenue’s Argument: The non-compete fee should be taxed as capital gains due to the amendment in Section 55(2)(a) (of Income Tax Act, 1961) and included in book profits under Section 115JA (of Income Tax Act, 1961).
• Bisleri’s Argument: The fee is a capital receipt, not taxable before 2003, and should not be included in book profits as it was not debited to the Profit and Loss account.

Key Legal Precedents:

• Apollo Tyres Ltd. vs. CIT: The court held that the Assessing Officer cannot alter the book profits declared in audited accounts unless specified by the law.
• National Hydroelectric Power Corp. Ltd. vs. CIT: For amounts to be added to book profits under Section 115JA (of Income Tax Act, 1961), they must be debited to the Profit and Loss account.

Judgement: 

The court dismissed the Revenue’s appeal, ruling that the non-compete fee was not taxable as capital gains before 2003 and should not be added to book profits as it was not debited to the Profit and Loss account. The decision followed the Supreme Court’s rulings in Apollo Tyres Ltd. and National Hydroelectric Power Corp. Ltd.

FAQs:

Why was the non-compete fee not taxed as capital gains?

• The fee was considered a capital receipt and not taxable before the introduction of Section 28(va) (of Income Tax Act, 1961) in 2003.

Why wasn’t the fee included in book profits?

• It wasn’t debited to the Profit and Loss account, a requirement for inclusion under Section 115JA (of Income Tax Act, 1961).

What is the significance of this case?

• It clarifies the treatment of non-compete fees and the conditions for including amounts in book profits under Section 115JA (of Income Tax Act, 1961).

1. This Appeal filed by the Revenue under Section 260A(Act) (of Income Tax Act, 1961) challenges the order dated 30 November 2012 passed by the Income Tax Appellate Tribunal (the Tribunal). The impugned order disposes of cross appeals as well as cross objections relating to the Assessment Year 1999-­2000.

2 Although numerous questions have been formulated Mr. Pinto, learned counsel for the Revenue at the time of admission urges that two issues arise in this Appeal as under:­

“1 Whether on the facts and circumstances of the case and in law, the Tribunal was justified in holding that non-compete consideration received by the assessee is not liable to tax as capital gains even after the amendment to Section 55(2)(a) (of Income Tax Act, 1961) w.e.f. 1.4.1998 which introduced the words 'or a right to manufacture, produce or process any article or thing'?

2 Whether on the facts and circumstances of the case and in law, the Tribunal was correct in holding that the non­compete consideration taken as Reserves to the Balance sheet cannot be added to the Book Profit under Section 115JA (of Income Tax Act, 1961) even in terms of clause (b) of the Explanation thereto?.

3 Question No.1­

(a) An agreement dated 27 November 1998 was entered by the

Respondent / Assessee into with M/s Hindustan Coco Cola Bottling

North­West Pvt. Ltd which prohibited the Respondent / Assessee

from utilising its business knowhow i.e. carrying on its business at

a consideration of Rs.5 crores i.e. non­compete consideration. The

Assessing officer was of the view that the non­compete fee received

by the Respondent / Assessee is taxable under the head Capital

gains w.e.f. 1 April 1998 in view of amendment to Section 55(2)(a) (of Income Tax Act, 1961)

of the Act which included within its ambit right to manufacture,

produce or process any article.

(b) On Appeal, the Commissioner of Income Tax (Appeals)

allowed the appeal of the Respondent / Assessee. It held that even

the amendment to Section 55(2)(a) (of Income Tax Act, 1961) on 1.4.1998 will not

take within its scope a negative / restrictive covenant. This

negative / restrictive covenant was taxable after the introduction of

Section 28(va) (of Income Tax Act, 1961) in the Act w.e.f. 1.4.2003.

(c) Being aggrieved the Revenue carried the issue in appeal to

the Tribunal. By the impugned order the Tribunal held that the

entire issue of restraint of right to carry on business would be

taxable only with effect from Assessment Year 2003­2004

consequent to the introduction of Section 28(va) (of Income Tax Act, 1961) into the Act. The

impugned order relies upon the decision of the Supreme Court in

Guffic Chem Pvt.Ltd. v/s CIT,1 wherein it has been observed as ­

“The position in law is clear and well settled. There is a

dichotomy between receipt of compensation by an Assessee for

the loss of agency and receipt of compensation attributable to

the negative/restrictive covenant. 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.

One more aspect needs to be highlighted. Payment received as

non-competition fee under a negative covenant was always

treated as a capital receipt till the assessment year 2003-04. It

is only vide Finance Act, 2002 with effect from 1.4.2003 that

the said capital receipt is now made taxable [See: Section

28(va)]. The Finance Act, 2002 itself indicates that during the

relevant assessment year compensation received by the

Assessee under non-competition agreement was a capital

receipt, not taxable under the 1961 Act. It became taxable only

with effect from 1.4.2003. It is well settled that a liability

cannot be created retrospectively. In the present case,

compensation received under Non-Competition Agreement

became taxable as a capital receipt and not as a revenue

receipt by specific legislative mandate vide Section 28(va) (of Income Tax Act, 1961) and

that too with effect from 1.4.2003. Hence, the said Section

28(va) is amendatory and not clarificatory. Lastly, in

Commissioner of Income-Tax, Nagpur v. Rai Bahadur Jairam

Valji reported in : 35 ITR 148 it was held by this Court 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. In the present case, both CIT (A) as

well as the Tribunal, came to the conclusion that the agreement

entered into by the Assessee with Ranbaxy led to loss of source

of business; that payment was received under the negative

covenant and therefore the receipt of `50 lakhs by the Assessee

from Ranbaxy was in the nature of capital receipt. In fact, in

order to put an end to the litigation, Parliament stepped in to

specifically tax such receipts under non-competition agreement

with effect from 1.4.2003.”

(d) Moreover Section 55(2)(a) (of Income Tax Act, 1961) would have no

application in the present circumstances, as it deals with the cost of

acquisition in relation to a capital asset which includes a right to

manufacture or carrying on business. In the present case, the

Agreement prohibits the assessee in as much as it amounts to giving

up its right to carry on business i.e. a restrictive covenant. It held

that such restrictive covenant stands covered only w.e.f. 1.4.2003

on introduction of Section 28(va) (of Income Tax Act, 1961).

(e) In view of the above, the impugned order having merely

followed the decision of the Apex Court in Guffic Chem Pvt. Ltd.

no substantial question of law arises for our consideration.

Accordingly question 1 as proposed is not entertained.

4 Regarding Question No.2­

(a) For the subject Assessment year, the Assessing officer by order

dated 21 March 2002 recomputed the book profit under Section

115JA of the Act (MAT provision) by adding the amounts received

on account of goodwill and non­compete fees which were directly

taken to the Balance sheet by the Respondent­Assessee. This was

inter alia on the basis of clause (b) of the Explanation to Section

115JA of the Act. The Assessing officer had also held that the

above amounts had to be routed through the Profit and Loss

account for the purpose of computing profits under the Companies

Act, 1956.

(b) Being aggrieved, the Respondent­Assessee filed an appeal to

Commissioner of Income Tax (Appeals) (the Commissioner). By

order dated 16 September 2002, the Commissioner allowed the

appeal by relying upon the decision of the Supreme Court in the

case of Apollo Tyres Ltd. V/s CIT,2 wherein it is held in the

context of MAT provisions that the Assessing officer has to accept

the authenticity of the accounts maintained in accordance with the

provisions of Companies Act, 1956, which are duly audited and

passed in the general body meeting of shareholders. It was held

that the Assessing Officer has no power to disturb the profits in the

Profit and Loss account as except to the extent provided in the

explanation to Section 115JA (of Income Tax Act, 1961).

(c) On further appeal by the Revenue the Tribunal by the

impugned order dismissed the Revenue's appeal. The impugned

order places reliance upon the decision of the Apex Court in Apollo

Tyres Ltd., wherein it was held that it is not open to the Assessing

officer to question the correctness of the Profit and Loss account

when the same have been prepared in accordance with the

provisions of the Companies Act, duly scrutinised by the Auditors,

approved by the general body of shareholders and filed with the

Registrar of Companies. The Apex Court held that the Assessing

officer has limited power to make additions and reductions as

provided in the Explanation to Section 115JA (of Income Tax Act, 1961). The

impugned order further held that the provision for Reserve made

by the Respondent­Assessee cannot be added to arrive at book

profits in terms of clause (b) of the Explanation to Section 115JA (of Income Tax Act, 1961) of

the Act. This is so as the Explanation presupposes that the amounts

received should have been debited to the Profit and Loss account

before the same can be added in terms of the Explanation.

Accordingly the impugned order dismissed the Revenue's appeal.

(d) The grievance of the Revenue before us is that even though

the Assessing officer is bound by the audited accounts, made in

accordance with the provisions of the Companies Act, and cannot

be disturb the profits so arrived, yet in terms of explanation to

Section 115JA (of Income Tax Act, 1961), the Assessing officer in the present facts ought to

have applied clause (b) of the Explanation to Section 115JA (of Income Tax Act, 1961) of the

Act. Therefore it is submitted that the amount carried to Reserves

had to be added in terms of the Explanation to Section 115JA (of Income Tax Act, 1961) of the

Act.

(e) We find that for the Explanation to Section 115JA (of Income Tax Act, 1961)

to be invoked it is necessary that the amount which has been

carried to the reserves should have necessarily been first debited to

the Profit and Loss account resulting in a reduction in the profit

declared by the Respondent / Assessee Company. This issue stands

settled in view of the Apex Court decision National Hydroelectric

Power Corpn. Ltd. Vs Commissioner of Income Tax ­ 3 wherein it

has been held that to invoke clause (b) of the Explanation below

Section 115JB (of Income Tax Act, 1961) (identical to Section115JA (of Income Tax Act, 1961)) of the Act, two

conditions must be satisfied cumulatively viz. there must be a debit

of the amount to the Profit and loss account and the amount so

debited must be carried to Reserves. Admitted position in this

case is that there is no debit to the Profit and loss account of the

amount of Reserves. The impugned order has in view of the self

evident position taken a view that in the absence of the amount

being debited to Profit and Loss account and taken directly to the

reserve account in the balance sheet, the book profits as declared

under the Profit and Loss account cannot be tampered with. In view

of the fact that the impugned order has followed the decisions of

the Apex Court in Apollo Tyres and is in accordance with the

decision in National Hydroelectric, the Explanation to Section

115JA of the Act would not be triggered. Thus question­ 2 raises

no substantial question of law for consideration.

Accordingly Appeal dismissed. No order as to costs.

(N.M.Jamdar, J.) (M.S.Sanklecha, J.)