TREATMENT OF COMPENSATION ATTRIBUTABLE TO A NEGATIVE COVENANT UNDER INCOME TAX ACT, 1961

[Mr. M. GOVINDARAJAN]

The question whether the receipt is capital or revenue is to be determined by drawing the conclusion of law ultimately from the facts of the particular case and it is not possible to lay down any single test as infallible or any single criterion as decisive.   Ordinarily compensation for loss of an office or agency is regarded as capital receipt, but this rule is subject to an exception that payment received even for the termination of agency agreement would be revenue and not capital in the case of where the agency was one of many which the assessee and its termination did not impair the profit making structure of the assessee but was within the framework of the business, it being a necessary incident of the business that existing agencies may be terminated and fresh agencies may be taken.

In ‘Gillanders Arbuthnot and Co. Limited V. Commissioner of Income Tax’ – 1964 (5) TMI 5 - SUPREME Court the Supreme Court has brought  out a dichotomy between receipt of compensation by an assessee for loss of agency and receipt of compensation attributable to the negative/restrictive covenant.   If the compensation is received for the loss of agency, it is to be treated as a revenue receipt, whereas, if the compensation is attributable to a negative/restrictive covenant then it would amount to a capital receipt.

In ‘Commissioner of Income Tax V. TTK Health Care Limited’ – 2016 (6) TMI 302 - MADRAS HIGH COURT  London International Group PIC (‘LIG’ for short) was carrying on business of manufacturing and sale of rubber contraceptives all over the world apart from other businesses.  The company carries on its business on its own and also through its subsidiaries or joint venture companies.  TTK Bio-Med Limited is engaged in the business of manufacturing and marketing rubber contraceptives and also gloves.   TTK Bio-med was, at the time, in the process of merging with TTK Pharma Limited.  It had agreed to discontinue the business of manufacturing and marketing rubber contraceptives and not compete with LIG or other subsidiaries or associates including the joint venture TTK-LIG.  It is also agreed to surrender all the know-how received from LIC and undertake that it shall not in any manner whatsoever compete with the business of LIC or its associates.  Further it also undertakes not to engage in the said business directly or indirectly and in case it receives any further enquiries or other information relating to the said business, it shall pass on the same to LIG for further exploitation.  In consideration of the above covenants not to compete with LIG or its associates, LIG paid a sum of 4,99,000 pounds to Bio-med Limited.

The compensation paid is for the assessment year 2000 – 01.  The assessee company claimed the said amount as not taxable treating it as capital receipt.  The Assessing Officer assessed the non compete fee as revenue receipt.  The Commissioner of Income Tax upheld the order of the assessing Officer.  The Tribunal reversed the findings of the Assessing Officer, as upheld by Commissioner (Appeals).  Against this order the Revenue filed appeal before the Madras High Court.  The Revenue submitted the following-

• The assessee has not lost the entire source of income by virtue of agreement entered into with LIG and on the other hand, it had gained freedom to concentrate all its energy and time in manufacturing and marketing its other products, including gloves;
• The impairment suffered by the assessee is not a complete denial of its source of income;
• What has been paid by the LIG is for rendering certain service to it by the assessee, when it has agreed to direct all enquiries and other information relevant to the rubber contraceptive business which the assessee might receive to enable LIG to further exploit the same;
• The payment made by LIG cannot be treated as a compensation towards non compete agreement, inasmuch as, a non compete agreement requires stoppage of the activity completely;
• On the other hand TTK Bio-med Limited agreed to cease to engage in the business of rubber contraceptives from a future date namely 01.02.2001 and thus coupled with the obligation undertaken to forward all further enquiries and information to LIG, the payment made by LIG is liable to be treated only for the service with TTK Bio-Med Limited agreed to render to LIG and hence, amounts to a revenue receipt.

The assessee contended the following-

• As per clause (5) of the agreement entered into by and between TTK Bio-med and LIG, LIG has agreed to pay a sum of 4,99,000 pounds so that, TTK Bio-Med would not compete with LIG or its associates in so far as rubber contraceptive business is concerned;
• Covenant 5 of the agreement is clear, unambiguous and leaves no room to entertain a different opinion thereof;
• It is plainly a negative covenant agreed to by the TTK Bio med to refrain itself from manufacturing and marketing rubber contraceptives and also not to associate itself with regard to the said business with any other third parties at any later point of time;
• TTK Bio-med has agreed to cease from engaging itself in the business of manufacture and marketing of rubber contraceptives with effect from 01.02.2001, a subsequent date of the agreement;
• TTK Bio-med has agreed to forward all trade information and trade enquiries with regard to rubber contraceptive business to LIG, to enable it to exploit it;
• Such forwarding the trade enquiries is only an obligation more towards those who approached the TTK Bio-med, as, the failure to forward any such trade enquiries to LIG does not bring about any consequences much less penal ones with regard to agreement entered into by and between the parties.

The question considered by the High Court is whether this receipt of money by the assessee is liable to be treated as a capital receipt or revenue receipt.  The High Court held that the amount equivalent to 499000 pounds paid by the LIG is to be treated as a measure of compensation towards the negative covenant of non compete entered into by and between Bil-med limited and LIG.  It is not necessary that the assessee need to shelve all his other sources of income as well, for the receipt of compensation to amount to a capital receipt.

The litmus test is whether the impairment is one of its sources of income or not and if the answer is that the injury has been caused to one of its sources of income, then it is enough to render the compensation received in that process as a capital receipt, the High Court held.

With effect from 01.04.2003 Section 28(va) was introduced by which all monies received pursuant to a negative covenant become liable for the incidence of taxation. .  According to this newly inserted section any sum, whether received or receivable, in cash or kind, under an agreement for-

• not carrying out any activity in relation to any businessor profession; or
• not sharing any know-how, patent, copyright, trade-mark,  licence, franchise or any other business or commercial right of similar nature or information or technique likely to assist in the manufacture or processing of goods or provision for services

shall be chargeable to income-tax under the head "Profits and gains of business or profession".

The proviso to this section provides that sub-clause (a) shall not apply to-

• any sum, whether received or receivable, in cash or kind, on account of transfer of the right to manufacture, produce or process any article or thing or right to carry on any business,or profession which is chargeable under the head "Capital gains";
• any sum received as compensation, from the multilateral fund of the Montreal Protocol on Substances that Deplete the Ozone layer under the United Nations Environment Programme, in accordance with the terms of agreement entered into with the Government of India.