2007 (12) TMI 240 - AT - Income Tax

Nature of Non-Compete Fee receipt ''Capital Or Revenue'' - Liable to charge tax under the head of salary or Capital Gain or PGBP or income from other sources - salaried employees or the Managing Director or Directors employed with the business concerns - employer-employee relationship existed - HELD THAT - It is also a fact that there were other Directors of the company 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 takeover by the FI Group. Therefore, the revenue is correct in saying that on the date of payment of non-compete fees to the assessee, the shares of IISC were substantially owned by the FI Group, UK and, therefore, an employer-employee relationship existed between them. 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 on the completion date - A bare reading of the restrictive covenant shows that the assessee along with other three directors had undertaken for the period of 18 months up to 31-5-1999, 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 Company any person, firm, company or entity who was a client or customer of the assessee in respect of business in the 12 months prior to the completion date, or who becomes a client after the said period prior to 31-5-1999. The assessee was also estopped from employing or engaging or soliciting the employment of any person who was an employee of the IISC 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 assessee and associate companies up to a period of 18 months from the date of agreement dated 4-12-1997 to 31-5-1999. whether the non-compete fee received by the assessee for accepting the restrictive covenant would be liable to tax under the head 'Salary' as profit in lieu of salary - In this case also, the face value of the shares 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 have been sold at the rate of Rs. 100.90 per share. This only shows that the company, before its takeover, was doing very well. Therefore, what has been stated about Reliance Industries would equally hold good to this case, with a difference of degree. Therefore, the purpose of entering into a non-compete agreement is to restrain such person from undertaking such business or engaging themselves in activities which are detrimental to the business of the employer-company. Therefore, entering into a non-compete agreement for restrictive covenant cannot be considered and treated as part of rendering services to the employer while being in employment which would bring such compensation in the nature and ambit of profits in lieu of salary. Thus, we are of the considered opinion that the non-compete fees is not taxable under the head 'Salary' either under section 17(3)(i)/17(2)(v) . It is pertinent to mention that 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 cannot be brought to tax under the amended section also. Therefore, it is clear that the nature and character of the non-compete fee received by the assessee was for undertaking restrictive covenant to compete with the business of the assessee directly or indirectly. These are 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 cannot be linked directly or indirectly with the employment of the assessee as Managing Director of the Company. Therefore , the non-compete fees is not taxable under the head 'Income from salary' . The non-compete fee is also not taxable under section 28(ii) and 28(iv) of the Act because the assessee was not carrying on any business or profession. Such receipt is 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 2002-03. Therefore, the same is not applicable to the assessment year under consideration. Thus, we hold that the non-compete fees received by the assessee from F.I. Plc., UK being in the nature of a capital receipt not liable to tax. Accordingly, the question referred to the Special Bench is decided in favour of the assessee and against the revenue after setting aside the orders of authorities below. These grounds of appeal arc allowed. In the result, the appeal filed by the assessee is allowed.

Summary

Issues Involved:
1. Taxability of the non-compete fee received by the assessee.
2. Validity of the reopening of the assessment under section 147.

Issue-wise Detailed Analysis:

1. Taxability of the Non-Compete Fee:

Facts and Background:
The assessee, a Computer Engineer and Managing Director of M/s. IIS Infotech Ltd., sold his shares to FI Group Plc., UK. Alongside the share transfer, the assessee entered into a non-compete agreement with FI Group, receiving Rs. 1,07,36,570 as non-compete fees. The assessee claimed this amount as a capital receipt, exempt from tax. However, the Assessing Officer (AO) treated it as a revenue receipt taxable under section 28(ii) of the Income-tax Act, 1961.

Assessing Officer's View:
The AO argued that the non-compete fee was a revenue receipt because:
- The restrictions were for a limited period (18 months).
- The assessee continued as Managing Director post-takeover, indicating no adverse effect on his income-earning capacity.
- The lump sum payment did not inherently qualify as a capital receipt.

CIT(A)'s View:
The CIT(A) upheld the AO's decision, stating:
- The non-compete agreement did not significantly restrict the assessee's earning potential.
- The nomenclature of 'non-compete agreement' did not alter the receipt's nature as revenue.

Arguments by the Assessee:
The assessee contended that:
- The non-compete agreement was a separate, independent contract, not linked to his employment.
- The restrictive covenants significantly affected his potential to earn from other sources.
- The payment was for sterilizing a potential source of income, thus a capital receipt.

Tribunal's Analysis:
The Tribunal examined various judicial precedents and the nature of the non-compete agreement. Key observations included:
- The restrictive covenants were substantial, preventing the assessee from engaging in competitive activities for 18 months.
- The non-compete fee was not linked to the employment agreement, as evidenced by another director receiving the fee despite not continuing employment.
- The payment was for undertaking restrictive covenants, affecting the assessee's income-earning potential.

Judicial Precedents:
The Tribunal referred to several cases, including:
- Best & Co. (P.) Ltd. v. CIT: Compensation for restrictive covenants was held as a capital receipt.
- Saroj Kumar Poddar v. CIT: Non-compete fees were considered capital receipts despite the assessee continuing as non-executive chairman.
- A.S. Wardekar v. CIT: Similar compensation was held as capital receipts.

Conclusion:
The Tribunal concluded that the non-compete fee was a capital receipt, not liable to tax under any head of income mentioned under section 14 of the Act. The fee did not arise from the employer-employee relationship and was not taxable under sections 28(ii), 28(iv), or as capital gains or income from other sources. The amendment in section 28(va) by the Finance Act, 2002, applicable from 1-4-2003, was not relevant for the assessment year in question.

2. Validity of the Reopening of the Assessment under Section 147:

Facts and Background:
The AO initiated proceedings under section 147, issuing a notice under section 148, on the grounds that the non-compete fees were a revenue receipt liable to tax.

Assessee's Argument:
The assessee challenged the reopening of the assessment, arguing that the AO did not have sufficient information to form a belief that income had escaped assessment.

CIT(A)'s View:
The CIT(A) upheld the AO's action, stating that the information available was sufficient to entertain a belief that income chargeable to tax had escaped assessment.

Tribunal's Decision:
At the hearing, the assessee's counsel did not press these grounds. Consequently, the Tribunal dismissed these grounds as not pressed.

Conclusion:
The Tribunal allowed the appeal, holding that the non-compete fee received by the assessee was a capital receipt not liable to tax. The grounds challenging the reopening of the assessment under section 147 were dismissed as not pressed.