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TheLawOnTaxabilityOfNonCompeteFeesExplained ByDarrylPaulBarretto Overview Paymentreceivedasnoncompetefeewastreatedasacapitalreceipttilltheassessmentyear2003 04.

4. Through the Finance Act, 2002, the said receipt were made taxable under section 28(va) of the Income Tax Act, 1961 with an exception is found under proviso clause (i) to section 28(va)(a), which providesthatanysum,whetherreceivedorreceivable,incashorkind,onaccountoftransferofthe righttomanufacture,produceorprocessanyarticleorthingorrighttocarryonanybusiness,which is chargeable under the head Capital gains would not be taxed under section 28(va). Further the Finance Act, 2002 also amended section 55(2)(a) to provide for cost of acquisition in case of transfer of right to manufacture, produce or process any article or thing or right to carry on any business. These amendments have brought about a dichotomy in the taxability of noncompete fees, with regards to taxability as Business income under section 28(va), or as Capital gains covered by the proviso (i) to Section 28(va)(a). From the decisions of the Income Tax Appellate Tribunal (ITAT) and the High Courts it can be seen that the taxability of noncompete fee would depend on the factors such as the position of the recipient of the noncompete fee with regards to the business before and after the noncompete covenant coming to operation, his relation with the payerofnoncompetefee,thetypeofassettransfertakingplace,andthetermsofthenoncompete covenant. Some of these factors influencing the taxability of noncompete fee have been discussed below: 1. Where the recipient of the noncompete fee is shareholder who was not actively engaged in thebusiness The position of the recipient of the noncompete fee with the business in question, has played a decisive role in deciding the taxability of the noncompete fee, as it can be seen in Mrs. Hami Aspi Balsara v. ACIT 1. In this case, the ITAT held that, since the assessee on her own was not carrying on business and it was the company in which she was shareholder which was carrying on the business, section28(va)wouldnotbeattracted.Inthiscase,theAssessingOfficer(AO)treatedthedifference between book value of shares and the sales consideration received for the share transfer, towards noncompetefee,bringingthesamefeeunderthepurviewofsection28(va).TheITATobservedthat section 28 (va) would be attracted where the assessee was carrying on business and not where assesseeonlyhadrighttocarryonbusinessintheformofacapitalasset. The view taken in Mrs. Hami Aspi Balsara2 has been followed by the ITAT in ACIT v Savita N. Mandhana3, where the AO had bifurcated the share sale consideration amount into two components, one in respect of sale of shares and the other towards noncompete fee to be taxed under section 28(va). The ITAT had held that in view of the fact that the assessee was not actively engaged in business, and the agreement did not specify payment towards noncompete obligation, theentireamountofconsiderationreceivedbytheassesseewouldbetreatedascapitalgains. 2. Where the recipient of the noncompete fee is a shareholder who is actively engaged in the business(asincaseofapromoter)
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[2010]126ITD100(Mum). Ibid. 3 2012TIOL63ITATMUM.

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In the case of Ramesh D. Tainwala v ITO4 the ITAT ruled that the noncompete fee received by the assessee who was a promoter and director of the company being acquired, was taxable under section 28(va)(a). With regards to the assessees contention that the noncompete fee falls within the proviso (i) to Section 28(va)(a), the ITAT had observed that for the said proviso to apply there must be transfer of the right to carry on any business, whereas in the case at hand what was transferredwasshareholdingbythepromotersandthereforetherewasnoquestionoftransferof a rightto carry on anybusiness.TheITAT maintained that assessee was notcarrying onany business onhisownbutwasthepromoteranddirectorofthecompanywhoseshareswerepurchasedbythe Acquirer. The facts of in the case of ACIT v R.K.B.K Fiscal Services5 were very similar to Ramesh D. Tainwala6 where the promoters of a company had received a specific amount under an agreement towardsnoncompete,whichwasheldbytheITATtobetaxableundersection28(va)(a). Another case in this series was Nayan C Shah v DCIT7. Here the assessee, being the Managing director and promoter of a Joint Venture (JV) entered into a Noncompete Agreement (NCA) with the nonresident JV partner. Under the NCA the assessee was to receive a lump sum amount along withcommission(withinasetlimit)payableafteraperiodof5years,basedontheannualsuccessof the JV during the 5 year period. The case before the ITAT was the issue of taxability of one such receipt of annual commission. The ITAT observed that, the assessee had continued to do his activity in the same line (for the nonresident JV partner) even after entering into this NCA and therefore it cannotbesaidthattheassesseehastransferredcompletelytherighttocarryonanybusiness.ITAT explainedthatanagreementnottocompetewithathirdpartyinthebusinesswouldnotencompass totality of right to carry on any business. The ITAT further stated that right to carry on any business was larger in scope and range, and an agreement not to compete with the business of a particular person is only a part of it. The agreement not to compete with a particular person in his business does not prevent a person from carrying on the same business in a manner which would not compete with the business of that particular person. Consequently, the ITAT held that commission can be considered either as compensation to the assessee for agreeing not to carry out anyactivityinrelationtoanybusinessattractingsection28(va)(a),orthepaymentisfortheservices rendered by the assessee for the nonresident JV partner computed on the basis of the profitability oftheventureforthe5years,andthateitherwaysitwouldbearevenuereceipt. 3. Noncompete fee is being paid along with consideration for transfer of all the assets of the business The ITAT, in Ramesh D. Tainwala8 had observed that if the agreement to refrain from indulging in competition is part and parcel of the agreement for transfer of a business and the transferor agrees notto indulge in competition, then it can be said that right to carry on same or similar business was transferred along with the business. Further the ITATs observed in DCIT v. Max India Ltd.9, that when an assessee signed a negative covenant not to carry on manufacture or trade in product for certain period of time, it amounted only to selfimposed restriction and not a transfer. There is
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[2011]48SOT324(Mum). [2011]138TTJ1(Kol.) 6 RameshD.Tainwala(n4). 7 [2011]48SOT77(Mum)(URO). 8 RameshD.Tainwala(n4). 9 [2007]112TTJ726(Asr),althoughthisdecisiondealswithayearpriortoAssessmentYear200304thesame wasbeencitedandacceptedbyITATinNayanCShah(n7).

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neither a sale or exchange or relinquishment of an asset, nor any right therein, which is extinguishable, the right to manufacture or trade remaining intact after the period for which the negativecovenantwassigned.10Fromthecombinedreadingoftheseobservationwhatcomesoutis thatforthenoncompetefeetobebroughtunderthepurviewoftheproviso(i)toSection28(va)(a), the noncompete obligation has to be part of the transaction where there is a transfer of capital assetsofthebusiness(amountingtoatransferofbusiness). Thenoncompetecovenantonitsowncannotamounttoatransferofanyright.Amererefrainment fromcarryingonanactivitywouldbetaxedundersection28(va)ascanbeseenfromthedecisionof the Bombay High Court in the case of John Dsouza v. CIT and Anr11. In this case the assessee had entered into an agreement with a company which had purchased a certain plot on which the assessee was carrying on fish farming. By the agreement, the assessee had agreed to stop fish farming in in the said ponds, for which he had received a certain sum from the said company. The High Court was of the view that the assessee had received the said sum for not carrying on any activity in relation to fish farming, the same being taxable under section 28(va)(a). Assessee contended that the said sum be taxed under section 45 as capital gains. To this the High court held that for the application of section 45 there should be a transfer of capital asset which was absent in thecase. Ifthe noncompetecovenant isapartof atransaction involvingtransfer ofcapital assets amounting totransferofthebusiness, thenoncompete feereceived wouldbecoveredunderthe proviso (i)to section 28(va)(a) and would be taxed as a capital receipt. This stand was further clarified in the case of DCIT v Mediworld Publications (P) Ltd.12 In this case, the assessee, through a Specified Asset Transfer Agreement', had sold all its rights, titles and interests in the specified assets of its Healthcare Journals and Communications business which included all the intangible assets being trademarks, brands, copyrights and the associated goodwill. The aforesaid agreement also relinquished for six years the assessees right to carry on any business involving or relating to or competingwiththetransferredspecifiedassets.Theassesseetreatedthewholereceiptaslongterm capital gains. The AO contended that the said receipt was towards noncompete fee and was to be taxedundersection28(va)asBusinessincome. The ITAT ruled in favour of the assessee and held the entire receipt is to be treated as capital gains. The ITAT relied on the following facts as mentioned in the order of Commissioner of Income Tax (Appeals) (CIT(A)), for holding that the assessee had wholly given up its right to carry on the HealthcareJournalsandCommunicationsbusinessforaspecifiedperiod: The assessee had sold all its intangible assets like trademarks, brands, copyrights and goodwill which constituted the assets of the business or the profit earning apparatus meaning thereby that the appellant, on selling the entire business apparatus, had deprived itself of any earnings inthesubsequentyears. No income had been generated by the assessee company after sale of intangibles to and consequent to such sale, and the assessee company had relieved the entire workforce from their duties/jobs since the entire business with its data base, networks, goodwill, trademark, copyrightclienteleetc.hadbeentransferredtothebuyer.
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[2007]112TTJ726(Asr). [2009]226TTJ540(Bom). 12 2010TIOL523ITATDEL.

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The ITAT further observed that the consideration received was not only for giving up the right to carry on the business but was mainly for the transfer of all intangible assets being trademarks, brands,copyrightsandtheassociatedgoodwillofthebusinessandeventheconsiderationasmaybe allocatedtothegivingupofrighttocarryonHealthcareJournalsandCommunicationsbusinesswas also taxable as long term capital gain by virtue of section 55(2)(a) read with clause (i) of the proviso to section 28(va)(a). One of the objections of the tax department was that the assessee had not transferredtothebuyer,thetotalbusiness,andtheassesseewascarryingonthebusinessofclinical trial even after the sale. To this the assessee placed the defence that both the businesses were independent,andthesamewasacceptedbytheITAT. The department appealed to the Delhi High Court13 against the decision of the ITAT. The High Court also decided in favour of the assessee. The High Court accepted the ITAT and CIT(A)s reasoning as mentionedaboveandadditionallyreliedonthefollowingfactwhilerulinginfavouroftheassessee: That the assessee had sold and transferred permanently and forever all its existing assets and contractsoftheHealthcarejournalsandCommunicationbusinessintermsofanagreement. That the main part of the agreement was the transfer of all intangible assets being trademarks, brands, copyrights and the associated goodwill of its Healthcare Journals and Communication business. That the consideration was not received only for giving up the right to carry on the Healthcare Journals and Communication business but was mainly for the transfer of all intangible assets being trademarks, brands, copyrights and the associated goodwill of the Healthcare journals andcommunicationbusiness. Thattheconsiderationforthetransferofintangibleassetsbeingtrademarks,brands,copyrights and the associated goodwill of Healthcare journals and communication business was taxable as longtermcapitalgain. That for the purpose of the journals etc. published by the assessee company it had to go through the statutory procedures and clearances which proved the authenticity of the assessee'sclaimoftheassetsbeinginthenatureofintangiblecapitalassetsofbusiness. One common point which can be seen from the facts in the case of Mrs. Hami Aspi Balsara14 and Mediworld Publications (P) Ltd.15, though adjudicated on different grounds is that there was no specific amount assigned towards the noncompete obligation and the consideration was towards transferofassets. InACITvDr.B.V.Raju16,thespecialbenchoftheITAThaddiscussedthattherearetwocategoriesof persons: (1) the transferor carrying on the business himself, and (2) persons associated with the transferor. With regards to the first category, if the transferor sells his business and agrees not to carry on the business the consideration so received would fall under section 55(2)(a) right to carry on business. But in case of the second category, the same would fall under section 28(va)(a). Now from the facts of Mediworld Publications (P) Ltd.17 it can be seen that the entire transaction of the specified assets including the noncompete obligation was between the acquirer and the company,
CITvMediworldPublications(P)Ltd[2011]337ITR178(Delhi). Mrs.HamiAspiBalsara(n1). 15 MediworldPublications(P)Ltd(n13). 16 [2012]14ITR(Trib)387(Hyd)(SB),atpara39,thisdecisiondealswithayearpriortoAssessmentYear2003 04butthedecisionhadexplainedthepositionoflawdealingwithtaxabilityofnoncompetefeesasapplicable fromAssessmentYear200304. 17 MediworldPublications(P)Ltd(n13).
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and not with its promoters. Therefore it can be said that the same would fall under first category as explained in Dr. B.V. Raju18, and taxed as capital gains under section 55(2)(a). Whereas where the noncompete fee was paid to the promoter as in the case of Ramesh D. Tainwala19 the same would fallinthesecondcategoryandwouldbetaxedundersection28(va). InDr.B.V. Raju20,theSpecialbenchof ITAThad alsoexplainedthe termssetoutinthe proviso(i)to section 28(va)(a) and section 55(2)(a). It had observed that what is sought to be covered by the expressionarighttomanufacture,produceorprocessanyarticleorthingfoundinsection55(2)(a) is intangible asset in the form of a patent or similar right and that the expression a right to manufacture, produce or process any article or thing and the expression a right to carry on businessasappearinginsection55(2)(a),havedefiniteanddifferentconnotations. 4. Wherethenoncompetefeeisbeingpaidtoanemployee InSaskenCommunicationTechnologiesLtdvITO21,theITATheldthatwherenoncompetefeeswere paidbytheassesseecompanytoits employeesatthecommencementoftheiremployment, fornot competing with the assessee company in case of the said employees terminating their services with it,thesamewouldberemunerationorcompensationpaidinrelationtoemploymentandtherefore, wouldfallunderthetermsalaryorprofitinlieuofsalary. AninterestingcaseisthatofKanwaljitSinghvACIT22,whereonthebasisofpeculiarfactsitwasheld thatthenoncompetefeepaidtoanemployeewouldbetaxedundersection28(va)(a).Thefactsof the casewerethattheassesseea formeremployeeofan airlinecompany,due to hisproximity with it, was in a position of acquiring the sole selling agency for cargo and airtickets of the said airline company. The assessee got the agency agreement executed in favour of a partnership firm formed between his daughter and wife. The assessee in status of an employee was receiving income from the said firm. Due to certain disputes which arose between the assessee and the partners of the firm, the assessee made efforts to transfer the said agency from the firm to himself. On settlement of the disputes, the assessee agreed to the continuation of the agency with the firm and entered into a NCA with the partners of the said firm. As per the NCA, the partners agreed to pay the assessee a commission, at an agreed rate till a certain period. The AO contended that the said non compete commission was to be taxed as Salary Income, whereas the assessee contended that the same should be taxed under section 28(va) as Business income. The ITAT observed that the NCA executed between the assessee and the partners of the firm was on principal to principal basis and didnotflowfromtheemployeremployeerelationship.Itwasfurtherobservedthatthecommission received could be taxable either under the head of Salary Income or Business income. The ITAT held that section 28(va), being a specific head, the income earned by assessee under the NCA was assessableundertheheadBusinessincome. The Special bench of the ITAT had observed that for the provisions of section 55(2)(a) to apply, the transferor should have already been carrying on the business, and if the transferor is not already carryingonbusinessthentheconsiderationreceivedwouldbeconsideredtobefornotcarryingout
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DrBVRaju(n16). RameshD.Tainwala(n4). 20 DrBVRaju(n16). 21 [2011]15taxmann.com51(BangloreTrib). 22 [2009]29SOT43

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any activity in relation to any business, and the provisions of section 28(va)(a) would apply.23 Applying the above in case of employees, it can be said that if noncompete fee is paid to an employee for not competing with the employer after termination of his services the provisions of section55(2)(a)wouldnotapply. 5. Wherethenoncompetefeeisbeingpaidtoasisterconcern In Pentamedia Graphics Ltd v DCIT24, the assessee company had transferred its software technology division to its sister concern. There was interlacing of activities and interlocking of funds between these two concerns. They both had a common CEO and management, and were not working as competitors. In these circumstances, the ITAT held that the amount attributed to noncompete fee wasacolourfularrangementoftheaccountstoshadowovertherealityofthetransferofgoodwill. Concludingremarks The decisions discussed above, have cleared the air surrounding the issue of taxability of non compete fee, but some would argue that greater clarity would be required with respect to concept of right to carry on any business as provided under section 55(2)(a). A news report in 2008, stated that the Income Tax department had asked the Central Board of Direct Taxes (CBDT) for clarificationwithregardstorighttocarryonanybusinessasprovidedundersection55(2)(a)25.The report also mentioned that the Department favoured an amendment to Section 28(va) to exclude noncompetefeefromthelistofcapitaltransactions,therebymakingittaxableasBusinessincome only.26 Disclaimer: The contents of this document are solely for informational purpose. It does not constitute professional advice or a formal recommendation. While due care has been taken in preparing this document, the existence of mistakes and omissions herein is not ruled out. Neither the author nor itatonline.org and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any inaccurate or incomplete information in this document nor for any actions taken in reliance thereon. No part of this document should be distributed or copied (except for personal, noncommercial use) without express written permission of itatonline.org

DrBVRaju(n16),para40. [2012]22taxmann.com216(ChennaiTrib). 25 Anindita Dey, IT Dept asks CBDT to clarify noncompete fee (Business Standard, 25 February 2008) <http://www.businessstandard.com/india/news/itdeptaskscbdttoclarifynoncompetefee/314899/> accessedon26June2012 26 Ibid.
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