Article 19(1)(g) of India’s constitution permits every citizen to practise any profession, or to carry on any occupation, trade or business. This fundamental right means that the purchasers of a business always run the risk of competition from the sellers of the business. To safeguard the purchaser’s interests, the purchaser generally includes a non-compete fee while negotiating the business takeover price to prevent the seller from competing for a stipulated period of time.
Indian income tax law treats the receipt of non-compete fees as business income in the hands of payee. However, its treatment seems to be unclear from the perspective of the payer. Section 37(1) of the Income Tax Act, 1961, permits the deduction of expenses, other than capital or personal expenditures, incurred wholly and exclusively for the purpose of a business or profession. Although non-compete fees are incurred for the purpose of a business or profession, there has always been a debate with respect to their deductibility.
One test which is generally determinative of the deductibility of an expense is whether the expenditure incurred creates enduring benefit for the payer. If there is an enduring benefit, the expenditure is treated as a capital expenditure and therefore not allowable under section 37(1) of the act.
In a recent series of cases, different courts have taken contradictory views on the issue of non-compete fees being treated either as revenue or capital expenditure and the eligibility of depreciation on such expenditure.
Capital versus revenue expenditure: The Mumbai Income Tax Appellate Tribunal (ITAT), in its recent decision in DCIT v Intervet (I) Ltd, held that a non-compete fee paid for a restrictive covenant of five years constitutes revenue expenditure. The non-compete agreement was a standalone agreement entered into with the erstwhile directors of the seller company and was not part of the share purchase agreement.
The ITAT observed that a period of five years could not be said to be of enduring nature and therefore the fee was not a capital expenditure. Further, the payment was to ward off potential business threats and, based on the records, did not result in any augmentation of profit-making assets or contribute to any capital outlay.
This decision relied on the Madras High Court ruling in the case of Carborandum Universal Ltd v JCIT, which had similar facts.
Contrary to the above ruling, Delhi High Court in the case of Pitney Bowes India Pvt Ltd v CIT, upholding the Delhi ITAT special bench ruling in the case of Tecumseh India Pvt Ltd v Addl CIT, had ruled that non-compete expenditure for a restrictive covenant for five years would be capital in nature since the period was sufficient to give an enduring benefit to an assessee.
Even if the expenditure is treated as a capital expenditure, all is not lost from the perspective of a taxpayer, if the expenditure can be claimed as a deduction for amortization or depreciation.
Depreciation or no depreciation on non-compete fees, if held as a capital asset: Delhi High Court, in its recent judgment in the case of Sharp Business Systems v CIT, held that a non-compete right acquired by the assessee was not a depreciable asset and so the assessee cannot claim depreciation on it under section 32(1)(ii) of the act. The court held that to qualify as an “intangible asset”, an intellectual property right must flow from it.
Contrary to the above, the Mumbai ITAT in the case of Ind Global Corporate Finance Private Limited v ITO allowed depreciation on non-compete rights on the premise that the taxpayer can run its business without bothering about competition, and therefore non-compete rights are an intangible asset falling in the category of “any other business or commercial right” under section 32(1)(ii) of the act.
As the Indian courts in the aforementioned recent cases have taken split views on the treatment of non-compete fees, it is critical to have documentation which clearly outlines the objective of the non-compete fee payment and what is intended to be achieved. In certain instances, it may be useful to highlight in the agreement the nature of the business and why the parties believe the non-compete period is reasonable from a commercial standpoint. In addition, other terms such as intent of the management to pay such non-compete fees, the time period of the arrangement, and preconditions to the terms of the sale and purchase arrangement should also be specifically outlined.
It is not just that the single test of enduring benefit must be met in order to qualify as revenue or capital expenditure, but it is also important to have robust documentation in place while entering into a non-compete arrangement in order to minimize any tax litigation.
Economic Laws Practice is a full-service law firm with headquarters in Mumbai and offices in New Delhi, Pune and Ahmedabad. Pranay Bhatia is a partner at the firm and Hardik Choksi is an associate.
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