JULY 16, 2020

By R Subhashree & Dr G Gokul Kishore

CLASSICAL economists believed in 'perfect competition' with complete freedom to all players to enter, market their wares and make profit. The more practical and prevalent condition is 'imperfect competition' where one person restrains the other from certain activities so that he can carry on business. Thus, non-compete is a familiar word and extends to a more active form of cooperation rather than non-disclosure which may be equated to passive silence.

The Income Tax Act, 1961 (the IT Act) contains at least three provisions to tax the fee paid for such non-compete agreement which would seek to restrain a former employee, the vendor of a business or any person connected to the business from disclosing information, taking up similar employment etc.

Section 17(3)(iii) introduced with effect from 1-4-2002 provides that any sum received by an assessee from any person whether before taking up employment with that person or after cessation of employment with that person would be taxable as profits in lieu of salary.

Section 28(va) introduced with effect from 1-4-2003 provides that any sum received under an agreement for not carrying out any activity in relation to any business or profession or not sharing intellectual property rights, technical or commercial information etc., which is likely to assist in the manufacture or processing of goods or provision for services would be taxable unless it is taxable as capital gains.

Section 56(2)(xi) introduced w.e.f. 1-4-2019 provides that any compensation or other payment, due to or received by any person, by whatever name called, in connection with the termination of his employment or the modification of the terms and conditions would be taxable as income from other sources. However, if such sum is received or is due from the employer or former employer, it would be taxable as profits in lieu of salary as per Section 17(3)(1).

However, despite such heavy armoury, the revenue department could not succeed in the recent case of Director of Income-tax v. Sasken Communication Technologies Ltd, [2020] 117 taxmann.com 278 (Karnataka) wherein the High Court of Karnataka has held that sum received by two employees who rendered services in USA was not taxable in India.

Facts of the case and High Court judgment

The foreign subsidiary merged with the Indian entity and two of its employees were offered employment in the merged entity. The non-compete agreement was signed prior to taking up the employment and separate non-disclosure agreement was also signed besides the employment contract. The sum was paid to the employees and no tax was deducted on the payment. Since the non-compete agreements restrained the employees from accepting similar assignments in India in respect of seven identified companies, the revenue department argued that the income arose in India and that since the non-compete agreement would be effective only after termination of employment, it was not 'profit in lieu of salary'.

The High Court held that the sum was in the nature of profits in lieu of salary as per Section 17(3)(iii) since they were paid by the prospective employer.

The ITAT, had earlier ruled that since the payments pertained to the contract of employment, the appropriate head would be salaries and not other income. Also, since the employees were not engaged in business, the payments would not be taxable in terms of Section 28(va).

Various aspects under consideration

The case of Sasken (Supra) appears to be a textbook case of Section 17(3)(iii) though it is a little surprising why an employee should be paid a non-compete fee on joining the entity. Normally the negative covenants apply after cessation of employment because the employer seeks to protect himself from possible competition on account of the employee using the skills, information, experience etc. gained in course of employment.

Competition between employer and employee

Payment of non-compete fee to employee has been subjected to scrutiny by the taxman earlier also. An employee who retired was re-appointed in the same company and was paid a sum and the assessee contended that the fee was in nature of non-compete fee and hence not taxable in the assessment year 2002-2003. However, the Bombay High Court in B.L. Shah v. Assistant Commissioner of Income-tax, Special Range 16(2), Mumbai, - 2016-TIOL-245-HC-MUM-IT held that an employee can hardly be expected to compete with the company and an employee is expected to be dedicated and work in the best interests of the employer. It held that the sum was taxable as profit in lieu of salary.

Section 28(va) may apply even if person is not engaged in business

As noted above, the ITAT in Sasken (supra) had held that if the person is not engaged in business, non-compete fee cannot be business income. However, as per the ruling of the Special Bench in Assistant Commissioner of Income-tax Circle 2(3), Hyderabad v. Dr. B.V. Raju, - 2012-TIOL-104-ITAT-HYD-SB, it is not essential that the recipient should be engaged in business in order to tax the sum as business income. Therein, the competing heads of income were capital gains and business income. The assessee was a promoter of the company and well experienced in cement business and received non-compete fee from acquirer of the company While the assessee contended that it was a capital receipt, the revenue authorities argued that it was in the nature of compensation for transfer of right to manufacture and hence taxable as capital gains even prior to 1-4-2003. The ITAT in this case held that in order to fall within the ambit of Section 28(va) - 'not carrying out any activity in relation to any business', it is not necessary that the person/recipient must have been engaged in the business but since the amount was received prior to 1-4-2003, it was held as not taxable.

Existence of relationship of employer-employee

As per Commissioner of Income-tax- IV v. Pritam Das Narang, - 2015-TIOL-2222-HC-DEL-IT where the employment did not commence and the assessee was paid a fee to compensate him for the same, the sum was not taxable as profits in lieu of salary since the relationship of employer-employee is essential for income to be taxable under the head salary.

However, a receipt in the hands of the employee can also be taxed as business income if the facts so dictate, as was held in Ashish Tandon v. Assistant Commissioner of Income-tax, Circle-1(1)(2), Vadodara, - 2019-TIOL-677-ITAT-AHM, In this case, the employee/director developed a technical concept and allowed his employer to exploit it free of cost but on sale of the developed product, the employee received certain non-compete fee which he claimed was not taxable since it was not possible to ascertain the cost of the asset. The ITAT held, after perusing the contract of employment, the non-compete agreement and sale agreement that, in essence what was received by the assessee was non-compete fee taxable as business income. Though the facts in this were peculiar, the ruling emphasises the relevance of nature of payment and terms of the contract.

Classification as capital receipt

In Guffic Chem (P.) Ltd v. Commissioner of Income-tax, - 2011-TIOL-32-SC-IT-LB the Supreme Court held unequivocally that prior to the amendment in 2003, consideration received for a negative covenant would be a capital receipt and was not taxable but post the amendment it was taxable. However, in M.G. Mohan Kumar v. Deputy Commissioner of Income-tax, Circle-5 (1), Bangalore, - 2016-TIOL-1505-ITAT-BANG the assessee successfully contended that the sum was a capital receipt, since as a professional he could not engage in business and the amount had been received after cessation of employment (from the former employer). Section 56(2)(xi) of the IT Act may now apply since payment received 'in connection' with termination or modification of employment is taxable post 2019.

The view of ITAT Bangalore in M.G. Mohan was followed by ITAT Mumbai in Sunderraj Srinivasan v. ITO 35(3)(4), ITA/7243/Mum/2016, ITAT Mumbai, Order dated 13-1-2020. This is at variance with the judgement of High Court of Bombay in Arun Toshniwal, Mumbai v. Deputy Commissioner of Income-tax 1(3), - 2015-TIOL-929-HC-MUM-IT in which it was held that since the assessee was being compensated for what he could have otherwise earned as a revenue receipt, non-compete fee cannot be a capital receipt. Being a judgment of jurisdictional High Court, this is binding on ITAT Mumbai but it is not clear why the same was not followed.

Thus under income tax law, non-compete fee would be taxable under any one of the heads of income and unless the argument of capital receipt succeeds, it may be difficult to extricate the same from taxability. However, where such payment is received by an employee or non-employee the applicability of GST has to be determined using very different yardstick.

Non-compete fee not taxable in all cases under GST law

In GST law, there appears to be a tendency to consider non-compete fee as liable to tax in all cases and for such purpose, Schedule - II of CGST Act relating to agreeing to the obligation to refrain from an act or tolerate an act is relied on. The argument is incredibly tempting as acceptance of payment for not competing with a particular person or entity can be perceived as a fully eligible candidate for coverage under the above said entry in Schedule - II. Before such candidature is cleared, it merits a gentle reminder that this schedule merely categorises certain transactions as either supply of goods or supply of service. In isolation, this schedule neither intends to nor can be extended to cast liability to tax on a transaction if otherwise the same is absent.

Schedule - III is, as a species, different from Schedule - II as the former contains legislatively blessed transactions which will not get the colour of supply of goods or services so as to effectively oust tax liability. The first entry deals with services by an employee to the employer in the course of or in relation to his employment. It requires no elaboration that if non-compete fee is received by an employee, then it will not be liable to GST as it is in relation to his employment. This will lead to the obvious question - will any employee be paid non-compete fee? An employee may have submitted his resignation, a date for termination of employment contract would have been agreed and during such period, he may receive non-compete fee by entering into non-compete agreement restricting him from taking up similar employment or be engaged in similar business. Neither the status of employee has ceased nor the nexus with employment lost in such case.

Clouds of complication may be around if such non-compete fee is received before employment since the relationship of employer-employee has not yet commenced and the prospective employer has chosen the nomenclature of "non-compete fee" though it may well be joining bonus. But if the person has signed the employment contract with a deferred joining date and in the period before actual joining, his status as employee might have come into existence as per the contract i.e. in form but not in substance. In such a scenario, it may be possible to argue that it is in relation to his employment and the amount termed as "non-compete fee" should not be liable to GST.

Deciphering the implications becomes dangerously uncertain when non-compete fee is received by the employee after termination of employment contract. Parties have, on paper, separated but the amount is received in relation to employment and the service for which such fee is received is not to compete by joining hands with similar persons which gets rendered over a period of time as agreed in the non-compete agreement. Insofar as such service is concerned, the recipient of non-compete fee may be seen as an employee and the person making the payment may continue to retain the status of employer. If such argument gets accepted, no GST applies.

All the above possibilities are relevant only in respect of non-compete fee received by an employee. If it is received by business, the protection offered by Schedule - III is not available and the recipient has to fight the battle against possible launch of Schedule - II read with definition of supply. The argument as available under Income Tax Act based on treatment as capital receipt to ward off any tax demand will not be relevant under GST law. It can, however, be argued that by agreeing not to do competing business, essential condition of supply as to the activity being in course or furtherance of business does not get satisfied. The tax department may adopt the position that this is 'refraining from an act' and Schedule - II will come into play. The final word will be with the judiciary and the ultimate word will be with the tax administration which may push for back-dated amendment if the judicial view does not support it.

[The authors are Advocates practising independently and the views are strictly personal.]