By TIOL News Service

NEW DELHI, DEC 22, 2015: THE issue is - Whether compensation received on termination of JV agreement can be said to be in nature of capital receipt, where pursuant to termination, assessee’s income earning apparatus was impaired and its source of income got sterilised. YES is the answer.

Facts of the case

The assessee, HCL Infosystems Ltd. (HIL), which was initially incorporated as HCL Ltd., was engaged in the manufacture, distribution and sale of computers and services in India. At that stage most of the computer products being manufactured by it were designed in-house. On the other hand, Hewlett Packard Inc (HP), a company incorporated in the USA, is engaged in the design, engineering, manufacture, assembly and sale of certain types of computers, along with their components and peripherals. It has substantial experience, expertise and reputation in its area of operations. Hewlett-Packard India Pvt. Ltd. (HPI) is the subsidiary of HP in India and is engaged in the manufacture of computers in India under licences from HP. During concerned A.Y, the HCL Limited, HP, HPI and a majority of its shareholders and certain other individuals, entered into a Joint Venture Agreement (JVA). In terms of the JVA, the parties agreed to combine their respective computer manufacturing, marketing, servicing and sales activities in India of both the assessee i.e., HCL Ltd. and HPI. Therein, 26% equity in the JVA was held by HP, through its wholly-owned subsidiary, Hewlett-Packard Delaware Capital Inc. (HPDC). Although, HIL was permitted to use the name ‘Hewlett Packard’ under the JVA. The joint venture company was accordingly renamed as HCL Hewlett-Packard Ltd (HCL HP Ltd). The basic idea behind the JVA was that instead of both HCL and HPI separately representing HP's interests, it was decided to combine their respective activities into one operation to be conducted by a company in India owned jointly by HP and the shareholders of HCL. Thereafter, a separate Non-Competition Agreement (NCA) was entered into by HP and HCL HP Ltd, which was to continue for five years after commencement of commercial production by HCL HP Ltd or six years from the effective date which was earlier. This NCA provided for licencing of HP transfer products, HP patent rights, HP know-how, HP copyrights and HP trademarks. The idea behind the NCA was that the parties desired to "avoid competition with each other by limiting HP India from entering into any new business activities in respect of products directly competitive with the computers/workstations and related software product range manufactured or distributed by HCL HP". Accordingly, at the request of HCL HP Ltd., HP India released its employees solely engaged in handling business of the said products to HCL HP. In consideration of HP India not agreeing to compete with HCL HP, HCL HP was to pay HP India a sum of Rs. 4.30 crores at a mutually agreed time. The NCA was to be in force for a period of five years from the effective date.

The JVA was however terminated by an agreement. It was acknowledged that since the formation of HCL HP, the competitive landscape had changed significantly "due to increased investment and interest in India by HP’s global competitors." It was accordingly decided that the implementation of HP’s worldwide model for the distribution of personal computers would be in their mutual best interest and the best approach to ensure long term market growth, was to allow HPI the temporary right to establish and manage multiple channels for the distribution and sale of HP personal computer products in India, while retaining HCL HP as a premier channel partner. The HP had, therefore, offered for sale its entire shareholding in HCL HP to the members of the Control Group and in turn obtained the "freedom to implement in India through HPL its worldwide sales, distribution and business models and discontinue manufacturing of HP computers and software in HCL HP under the licensing agreements." Correspondingly, the Control Group agreed to acquire HP’s share in HCL HP "in order to assert more complete ownership and management control over HCL HP’s principal business activities." In the assessment order u/s 143(3), the AO noted that the compensation was indeed a capital income but held that it was nevertheless taxable u/s 55(2). He observed that the extinguishment of these bundle of rights by termination of the JVA resulted in transfer of an asset in terms of Section 2(47)(ii). The AO also rejected the contention of assessee that the said capital receipt was not taxable. Accordingly, the entire sum received by HCL HP was brought to tax u/s 45 r/w/s 55 as 'income from capital gain'. On appeal, the ITAT noted that even prior to entering into JVA, the assessee was engaged in the business of manufacture of computer products as per in-house technology under the trade and brand name of HCL computers. Further, even after termination of the JVA, the assessee continued to manufacture computers under its own brand name. Therefore, it could not be said that the assessee had surrendered the right to manufacture computers and had received compensation for it. The ITAT also held that since at the relevant time there was no provision for subjecting the compensation received pursuant to the termination of the JA, no capital gains tax could be levied u/s 45 in respect of those capital assets for "which no cost of acquisition was incurred by the Assessee."

Having heard the parties, the High Court held that,

++ it is to be noted that section 45 states that any profit or gains arising from the transfer of a capital asset effected in the previous year shall be chargeable to income tax under the head 'capital gains' and shall be deemed to be the income of the previous year in which the transfer took place. In the present case the first question that arises is whether the amount received by the Assessee pursuant to termination of the JVA was compensation for the transfer of a capital asset. It is plain from a reading of the various clauses of the JVA and the other concomitant agreements, as well as the termination agreement, that as a result of the termination of the JVA, the Assessee’s income earning apparatus was impaired and its source of income got sterilised. The Court, therefore, concurs with the ITAT that the amount received by the Assessee upon termination of the JVA was in the nature of a capital receipt;

++ further, in order to determine the capital gains, if any, arising from the transfer of a capital asset, Section 48 provides that from the full value of the consideration received or accruing as a result of the transfer of the capital asset, (a) the expenditure incurred wholly and exclusively in connection with such transfer; and (b) the cost of acquisition of the asset and the cost of any improvement thereto, requires to be deducted. Ascertaining the ‘cost of acquisition’ of a tangible asset might not pose as much difficulty as determining the 'cost of acquisition' of an intangible asset. Section 49 deals with the determination of cost with reference to certain modes of acquisition. This is a deeming provision. U/s 49(1)(i) to (iv), where the capital asset became the property of an Assessee in any of the circumstances outline thereunder, "the cost of acquisition of the asset shall be deemed to be the cost for which the previous owner of the property acquired it." For determining the cost of acquisition of an intangible asset changes were made to Section 55(2). While the words "or a right to manufacture" u/s 55(2) was inserted in clause (a) of sub-section (2) w.e.f 1st April 1998, the words "or a trade mark or brand name associated with a business" was inserted by the Finance Act, 2002 w.e.f 1st April 2002. Prior to the above insertion of "or a trade mark or brand name", 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, or right to carry on any business, the tenancy rights, stage carriage permits or loom hours would be taken to be nil u/s 55(2)(a)(ii) if it did not have a purchase price. The expression 'or right to carry on any business' was inserted w.e.f 1st April 2003. That the above amendments were intended to be prospective, since there is nothing to the contrary stated therein, is fairly well settled. This has also to be viewed in the context of the corresponding amendments to Section 28 as far as the consideration received by the Assessee pursuant to a non-compete agreement is concerned;

++ what emerges from the above amendments is that till 1st April 2003, there was no provision under which the capital gains arising from the transfer of a trade mark or brand name associated with a business could be brought to tax. Likewise till 1st April 2003, the capital gains arising from the transfer of right to carry on business or any negative 'non-compete' right also could not be brought to tax. In terms of the decisions in CIT v. B.C. Srinivasa Setty and PNB Finance Limited v. CIT, the settled legal position is that in the absence of a machinery provision, an item of income cannot be assessed to tax. In the present case what stood extinguished as a result of the termination of the JVA was a bundle of rights of the Assessee. This included the right to manufacture computers using HP knowhow and HP labels, trademarks and patents. At the same time it was not as if the Assessee's right to manufacture its own computers was also taken away by the termination. That stood revived. In any event, there has been no attempt at unbundling the compensation amount, as it were, to determine how much of it pertained to the above constituent rights in the bundle of rights of the Assessee that were extinguished. The AO proceeded on the basis that the entire sum received by the Assessee was for it giving up the right to manufacture HP computers. This overlooked the factual position concerning the extinguishment, as a result of the termination of the JVA, of the entire bundle of rights not limited to the right to manufacture HP computers. The right of HCL HP to revive manufacturing its computers cannot be construed as a 'transfer' of a right. At the same time HP HCL lost its status as an exclusive distributor of HP products. The transfer, if any, of the intangible assets of the kind described under the JVA could not, at the relevant time, be held to fall within the ambit of the kinds of capital assets that were contemplated in Section 55(2)(a) as it then stood. Therefore, their cost of acquisition could not have been deemed to be 'nil' in terms of Section 55(2)(a)(ii) as it stood at the relevant time. This Court, therefore, holds that the receipt of Rs. 6080.95 lakhs by the Assessee as a result of the termination of the JVA during AY 1998-99 was a capital receipt but in light of Section 55(2)(a) as it stood at the relevant time, the said amount cannot be brought to capital gains tax. At the relevant time, there was no provision in regard to determining the cost of acquisition of the above intangible assets for the purposes of computing capital gains tax.

(See 2015-TIOL-2870-HC-DEL-IT)