By TIOL News Service

HYDERABAD, FEB 17, 2012: THE Whether when assessee receives payments not for transfer of any intangible right or relinquishment of any right but only for 'not carrying out any activity in relation to any business', such sum is not taxable as capital gains. And the Special Bench verdict goes against the Revenue.

Facts fo the case

Assessee is an individual who set up RCL and SVCL cement companies but was not having controlling interest in these companies. ICL took over these companies. After the takeover, the assessee lost his business and died. Meanwhile a search was conducted in the case of RV a close relative of the assessee who also worked as chairman of VCL. A document of non-compete agreement was found during search which was entered between the assessee and ICL whereby a sum of Rs. 11 crores was agreed to be paid by ICL to the assessee for agreeing not to participate either directly or indirectly in the business of cement/industry. Assessee declared income of Rs. 2.04 lacs beside agricultural income. Since this amount of Rs.11 crores was not disclosed by the assessee, a notice u/s 148 was issued which was duly served but the assessee died after one month without complying the said notice. AO issued fresh notices u/s 148 to the legal heirs of the assesse and initiated reassessment proceedings.

The ICL took over RCL and SVCL and with a view to ward off competition, the assessee was restrained from starting a fresh cement unit by entering in the non compete agreement. During the assessment proceedings, the legal heirs of the assessee expressed their ignorance of the said transaction. On enquiry from ICL, ICL confirmed that the sum was payable to the assessee but was not paid to him and adjusted against the sum which were due to RCL by some of the customers known to the assessee as per the authorization given by the assessee. Based on this information, AO concluded that there was a transfer by the assessee by way of relinquishment of his right to manufacture or involve in activities connected with the cement line of business to ICL for a period of five years and taking the cost of acquisition of the said right at NIL as per the provisions of S 55(2)(a) of the Act as amended by the Finance Act, 1997, he worked out the capital gains chargeable to tax in the hands of the assessee at Rs.11 crores and completed the assessment u/s 143(3) r.w.s. 147.

In appeal before the CIT (A) it was contended by the legal heirs of the assessee that it was not known as to for what reasons the entire agreement was made. As per the letter authorizing the adjustment an annexure was referred but as per the title of the annexure, it was a part of the non compete agreement. Annexure referred to various parties but it did not refer the parties to the non-compete agreement. Thus, the annexure could not be considered to be a part of the non-compete agreement. In the letter produced originally ICL referred only two debtors, but subsequently it claimed to had squared off accounts of 8 parties. These parties were never informed by ICL of such write off of dues. Therefore, the agreement could not be considered to be complete in respect of right and duties of contracting parties. AO’s justified the claim on the basis of the audited books of ICL but not considered the confirmations produced from the parties which were alleged to had dues payable to M/s. RCL. AO had not examined the books of accounts of these parties denying the liabilities, nor had given them any opportunity to prove their case. ICL stated that the amount paid to the assessee was debited to the investment account and the recoveries of advances had been credited to the profit and loss account as the advances were nil. Assessee contended that ICL had accepted that the dues in the name of the above parties were nil. If the facts of the ICL was accepted then there was no case for ICL to say that they had paid Rs. 11 crores to assessee and adjusted the same against the nil dues. If ICL had not claimed any expenditure for Rs. 11 crores, no such monies were paid to the assessee. Thus, the ICL made an effort to create a false reserve in their books of account. If at the time of amalgamation, ICL had given a nil value of all these parties, the same should had been reduced from their liability side or some other asset should had been created. AO had not examined this aspect. Even if the agreement was considered as genuine, no amount was ever received either in cash or indirectly from the so called debtors of RCL and the AO had not brought any evidence for receipt of the money by the assessee. The alleged adjustment related to dues of RCL for which the takeover was complete long back.

CIT(A) observed that the non-compete agreement was validly entered into between the assessee and the ICL and a sum of Rs.11 crore was to be paid. The said amount due to him was foregone by the assessee for the reasons best known to him. The assessee voluntarily did not want the true nature of the transactions to be examined and although there were some adjustments made settling the pending transactions, the exact details thereof or the facts relevant thereto were not known. The assessee could not with conviction be said to had received the sum of Rs.11 crores and AO was not justified in bringing to tax the said amount in the hands of the assessee. CIT (A) further observed that even after the hostile takeover of his company, ICL was apprehensive that the assessee was always capable and competent to start his business afresh and give tough competition to it. The assessee had personal skills and abilities which were placed under restraint in the non-competition agreement, and the said personal abilities and skills not being in the nature of capital asset, as defined under S.2(14) of the Income-tax Act, there was no question of any capital gain arising as a result of non-compete agreement, which could be brought to tax in the hands of the assessee. There was only a restraint on the use of personal skills and abilities of the assessee for a period of five years and there being no cessation or relinquishment or extinguishment of any right, there was no transfer within the meaning of S.2(47) of the Act. The amount was in the nature of a capital receipt not chargeable to tax, before the insertion of provisions of S. 28(va) of the Income-tax Act, with effect from 1.4.2003. Accordingly, the addition made by the AO was deleted.

In appeal before ITAT, the revenue contended that the scope of the question before the Special Bench was as to whether the amendment made to Sec.55(2)(a) of the Act by the Finance Act 1997 w.e.f. 1/4/1998 would apply or whether the amendment made to the aforesaid provisions by the Finance Act of 2002 w.e.f. 1/4/2003 whereby “right to carry on business” when transferred would have nil cost of acquisition and improvement for computing capital gains, would apply. The issue of non receipt of Rs. 11 crores by assessee was not before the Special Bench.

Revenue further contended that the CIT(A) had accepted the fact that there was an accrual of income but had come to the conclusion that it could not be said with conviction that the assessee had received a sum of Rs. 11 crores, without any basis. If there was a doubt or want of corroboration, the CIT(A) could not leave the matter as it is and was duty bound to make further investigation. CIT(A) had not given positive finding that the assessee did not receive a sum of Rs. 11 crores as non-compete fee. Once there was evidence to show that sum of Rs. 11 crores had accrued as income in the hands of the assessee under the non-compete agreement, the burden was on the assessee to show that there was no accrual of income.

Revenue contended that it is not correct to say that it is only when the person is already manufacturing a product that he can give up the right to manufacture. Right to manufacture and manufacturing rights are akin to right of occupancy and right to occupy. A right to manufacture will also take within its fold a right of manufacturing in the sense capacity to indulge in manufacturing. A right to manufacture takes into its compass a right that has been generated in any other way, or is self-acquired. ICL recognized the same and paid the amount for this. The amendment to Sec.55(2)(a) of the Act by the Finance Act, 1997 whereby cost of acquisition of “Right to Manufacture, produce or process any article or thing” was specifically fixed by the legislature. Assessee had the expertise to manufacture cement and had the right of manufacturing, though he was not manufacturing cement himself. RCL and SVCL were promoted by the assesse and right of manufacturing could be said to be with the assessee and against this right the assessee received a sum of Rs. 11 crores.

The definition of capital asset u/s 2(14) includes even right of management which can be called a capital asset. When the agreement says that right to manufacture was being transferred, it was not possible for anybody to say that such an undertaking could not have been given by the assessee.

Assessee contended that it was only for undertaking not to compete in similar business as carried on by ICL and there was no right to manufacture that was given up by the assessee. The question was that whether the assessee was the owner of such right. SVCL and RCL had a right to manufacture but not the assessee. Therefore, the assessee could not have transferred a right which he did not possess.

After hearing both the parties, the ITAT held that,

++ the legal heirs of the assessee pleaded complete ignorance of the transaction and the AO called for the details of the transaction and the accounting treatment from ICL. ICL claimed that it paid a sum of Rs.11 crore to the assessee by way of adjustment of debts due to RCL supported by the annual report of RCL. It is found that the monies have flown out of RCL and the same are reflected as debtors in their audited accounts. When RCL was taken over by ICL, the said debts were assigned Nil value. There exists an authorisation of the assessee, that the debts were to be adjusted by ICL against the Non-Compete fee payable to the assessee. Therefore, the conclusion of the AO that the assessee was paid Rs 11 Crores by ICL as Non-Compete fee, is proper. The letters given by two debtors stating that no amount is payable to RCL as per their books of account cannot be the basis to hold that there was no constructive payment of Rs.11 crores by ICL to the assessee;

++ in the light of the evidence available on record, amount of Rs.11 crores accrued to the assessee under the Non competent agreement and that was enough to attract the provisions of Sec.45 of the Act to tax capital gain on transfer of a capital asset. There were certain debts due to RCL to the extent of Rs. 11 crores. These debts were considered at nil value when ICL took over RCL. Thus these amounts were treated as paid to RCL. ICL when it took over RCL had duly taken into consideration the discharge of these debts by the debtors to RCL. Thus there was an adjustment of the monies payable by ICL to assessee by treating the debts payable by debtors of RCL to RCL, as discharged. The discrepancies pointed out by the CIT(A) will not stop accrual of income in the hands of the assessee;

++ ICL took over RCL as well as SVCL which were public limited companies whose shares were widely spread out in the market and nobody had controlling block of shares. Ultimately the promoters of RCL and SVCL sold their share in a negotiated deal to ICL. In the case of one of the promoters of the RCL and SVCL, regarding the taxability of receipts, the ITAT held that the receipts were not taxable on two counts (1) The payment in question was a payment as consideration for not indulging in competition (which was chargeable to capital gains tax only w.e.f 1-4-2003 by virtue of amendment to Sec.55(2)(a) of the Act by the Finance Act, 2002) and was not a payment made for a right to manufacture, produce or process any article or thing (which was chargeable to capital gains tax w.e.f 1-4-1998 by virtue of amendment to Sec.55(2)(a) of the Act by the Finance Act, 1997). (2) it was only SVCL and RCL that were manufacturing cement and, therefore, the amount received by the Assessees who were individuals and promoters of those companies were not engaged in any manufacturing of cement and therefore it cannot be said that the consideration paid for not indulging in competition was a consideration for giving up right to manufacture, produce or process any article or thing. In the case of the assessee, the ITAT had some reservations and hence a reference was made to the Special Bench;

++ for attracting charge to tax under the head capital gain u/s 45 there are certain conditions necessary to be fulfilled, viz., there must be a capital asset, there should be a transfer of the capital asset, the capital asset should be something which can be acquired by paying a cost i.e., it should be capable of determining the cost of acquisition of the capital asset and there must be accrual of consideration for transfer of capital asset;

++ in order to ensure that computation provisions do not fail when there is a transfer of goodwill, the provisions of Sec.55(2)(a) were introduced by the Finance Act, 1988 w.e.f 1-4-1989 which provide that the cost of acquisition for the purposes of sections 48 and 49, in relation to a capital asset, being goodwill of a business, in the case of acquisition of such asset by the assessee by purchase from a previous owner, means the amount of the purchase price and in any other case, shall be taken to be nil. By the Finance Act, 1997 w.e.f 1-4-1998, provisions of Sec.55(2)(a) were again amended by providing that the cost of acquisition in relation to a capital asset, being goodwill of a business, or a right to manufacture, produce or process any article or thing, tenancy rights, stage carriage permits or loom hours, in the case of acquisition of such asset by the assessee by purchase from a previous owner, means the amount of the purchase price and in any other case not being a case falling under sub-clauses (i) to (iv) of sub-section (1) of section 49, shall be taken to be nil. Thus, by these amendments, the difficulty in bringing to tax capital gain on transfer of self generated assets were remedied by the legislature by assigning nil value or actual purchase value as cost of acquisition and nil value as cost of improvement;

++ whether the receipts in the hands of the recipient of consideration under a non compete agreement or clause in any other agreement whereby a person is restrained from carrying on business in competition, would constitute income or not has engaged the attention of Courts. Income is likened to fruits of a tree, while the tree being a source is capital. Income is a periodic return in money or moneys worth coming with some sort of regularity or expected regularity from definite source. When amounts are received with the source being intact, it will be income, while amounts received as compensation for the loss or sterilisation of the source will be capital. When there are receipts by a person as Non-compete fee under an agreement not to carry on particular business, then it was regarded as a capital receipt not chargeable to tax;

++ with effect from 01.04.2003 vide finance Act 2002 a new subsection (va) was inserted in section 28 to bring in the non-compete fess within the preview of section 28 to make it taxable in the hands of the recipient of such income. In the case of Guffic Chem. P. Ltd. v. CIT, the Supreme Court held that 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 the Finance Act, 2002 with effect from April 1, 2003 that receipt by way of non-compete fee was made taxable u/s. 28(va)). The amendment by insertion of clause (a) to section 28(va) was amendatory and not clarificatory;

++ when a business is sold and the purchaser enters into agreements to ensure that there is no competition, he may enter into agreements not only with the transferor of the business but also with persons connected with the transferor. He may also pay consideration to the transferor for transfer of business, for not engaging in competition. He may also pay consideration to persons associated with the transferor not to indulge in competition. The receipts by the transferor or other persons connected with the transferor can be divided into the following categories (i) the consideration paid by the transferee for transfer of the business to the transferor, (ii) consideration paid to the transferor not to carry on same business directly or indirectly not to indulge in manufacturing same or similar products, not to use the trade names etc. and (iii) consideration paid to persons associated with the transferor to ensure that they also do not indulge in competing business. As far as category (a) is concerned the receipt would fall for consideration under the head capital gains as there is a transfer of capital asset in respect of which the machinery provisions of computation of capital gain can be applied. As far as category (b) is concerned the consideration received would fall for consideration under the head capital gain but depending upon the law that prevailed at the time of transfer. As far as category (c) is concerned, the same would fall for consideration to see if it is capital receipt chargeable to tax as on the date of transfer because after 1-4-2003 such consideration even if regarded as capital receipt would be chargeable to tax u/s.28(va)(a) of the Act;

++ if a payment is in the nature of non-compete fee received by the transferor when he sells his business and agrees not to carry on the business which he transfers then that would fall for consideration under category (b) section 55(2)(a) “right to carry on business”. If the non-compete fee is paid to persons associated with the transferor then the same would fall for consideration only under Sec.28(va)(a) of the Act introduced by the Finance Act, 2002, w.e.f 1-4-2003. The words used in Sec.28(va)(a) of the Act are “not carrying out any activity in relation to any business”. The proviso (i) to Section 28(va)(a) provides for exception to cases where such receipts are taxable as capital gain viz., where any sum is received for transfer of a right to carry on any business which is chargeable to tax as capital gain. When the transferor is already carrying on business and agrees not to carry on business transferred, then the same would fall for consideration only under Sec.55(2)(a) of the Act;

++ in the case of the assessee, the assessee was not carrying on business of manufacture of cement. He was associated with two cement manufacturing companies RCL and SVCL in various capacities. With this background, the meaning of the expression ‘a Right to Manufacture, produce or process any article or thing” and “Right to carry on any business” used in Sec.55(2)(a) of the Act is to be seen. To bring to tax capital gain on transfer of goodwill and other self-generated assets like tenancy rights, stage carriage permits or loom hours, Finance Act, 1994 amended Sec.55(2)(a) of the Act w.e.f. 1-4-1995 whereby covered u/s.55(2)(a)of the Act whereby tenancy rights, stage carriage permits or loom hours were also covered and the cost of acquisition and cost of improvement of these capital assets were also to be computed in the same manner as goodwill. By the Finance Act, 1997 w.e.f.1-4-1998, the same principle was also extended to “Right to Manufacture, produce or process any article or thing” by inserting the said expression in Sec.55(2)(a) of the Act and providing method of computing their cost of acquisition and cost of improvement. As per Board Circular No.763 dt. 18.2.1998 the amendment is being brought to bring to tax extinguishment of such a right to manufacture etc., within the ambit of capital gains tax. By the Finance Act, 2001 w.e.f. 1-4-2002, the principle of ascertaining cost of acquisition and cost of improvement of capital asset being “a trademark or brand name associated with a business” was introduced in the form of amendment to Sec.55(2)(a) of the Act. Thus, it is an intangible capital asset that was sought to be covered by the expression “a right to manufacture, produce or process any article or thing”;

++ the preamble to the non-compete agreement refers to the fact that the assessee during the course of his employment with CCI, RCL and SVCL acquired a corpus of knowledge, skill, expertise, and experience related to the production, distribution, marketing, running and managing of cement plants and has also acquired or otherwise come in possession of various secret information, know-how and trade secrets relating to the Cement line of business. As per the preamble the assessee along with other persons entered into an agreement with ICL by which they sold the shares held by them in SVCL. With the acquisition of SVCL, the core family promoters of RCL & SVCL were out of Cement business. ICL with a view to ward off competition desired that the assessee should be restrained from starting a fresh cement unit, lest it should have a bearing on their business and thus entered into a Non-Compete Agreement with the assessee. The consideration received was not for sale of any business nor was it for not carrying on any business which he was carrying on, which he had transferred. It was also not a payment for a “right to manufacture, produce or process any article or thing”. The sum in question was not paid for transfer of any intangible right in respect of manufacture, production or process of cement. The provisions relating to capital gains are therefore not attracted. The amount was paid for “not carrying out any activity in relation to any business” and would fall within the ambit of Sec.28(va)(a) of the Act. The payment falls under the category of a payment for “not carrying out any activity in relation to any business” which at the relevant point of time of accrual in the hands of the assessee, was a capital receipt not chargeable to tax. Such receipts became taxable on and from 1-4-2003. As held by the Suprme Court in the case of Guffic Chemical Industries, the provisions of Sec.28(va)(a) are not clarificatory and were applicable only prospectively from 1-4-2003. Thus, the order of CIT(A) is upheld and the appeal by the Revenue is dismissed.

(See 2012-TIOL-104-ITAT-HYD-SB in 'Income Tax')