The Hindu Business Line : The guise of contingent payments

IT IS GENERALLY presumed that the salaried taxpayer has no way of avoiding taxes and is, therefore, compelled to be honest. And yet, there have been a number of instances where various devices adopted by companies to save employees from burdensome taxation have led to protracted legal battles, resulting in the law having to be amended.

The Finance Act, 2001 inserted sub-clause 3 (iii) in Section 17 of the Income-Tax Act to bring into the tax net amounts to be received by any assessee from any person before his joining, or after cessation of, employment with that person.

This provision took effect from April 1, 2002. The earlier law held that non-compete payments were capital receipts not taxable as income. With a view to subject such compensation to capital gains tax, Section 55(2)(a) was amended from April 1, 1998.

What happens if the amount is not taxable as capital gains? Sub-clause (va) was inserted in Section 28 with effect from the assessment year 2003-04 to bring to tax sums received or receivable, in cash or in kind, in consideration of a restrictive covenant not to carry out any activity in relation to any business.

The intention was to tax such compensation as business income if not taxable as capital gain.

Is it still possible to escape taxation even after all these amendments to the law? A bold attempt was made by Anurag Jain, an NRI, by manipulating the companies in India and the US that he had interests in.

He entered into an ingenious purchase agreement covering share transactions which stipulated a fixed payment known as closing payment and also contingent payments payable over a three-year period between March 2004 to 2006.

The contingent payment was conditional on the company achieving the prescribed target. The American company, engaged in business process outsourcing, was in the niche area of processing medical bills and insurance claims. The NRI held shares in Vision Health Resoruces India P Ltd, an Indian company involved in BPO services.

The NRI entered into an agreement with certain foreign companies for transferring shares in the Indian companies for a fixed sum of $23,00,000. The agreement also provided for contingent payments for the next three years.

The NRI entered into a non-compete agreement under which he would receive a portion of the purchase price in respect of his ownership interest and also substantial direct and indirect benefits from the transaction contemplated under the agreement, which also stipulated a five-year employment as CEO. The agreement was dated April 15, 2003.

The Department sought to tax the entire amount, including contingent payments, in the assessment year 2004-05.

The balance-sheet value per share of the Indian company was $8 and the agreement stipulated fixed sale consideration of $23 per share and a further consideration of $70 per share payable over a four-year period as contingent payments.

According to the Department, the contingent payments represented non-compete fees taxable under Section 28 (va). It was argued that the NRI attempted to claim the benefit of a lesser rate of tax by linking capital gains with non-compete fees.

The transaction of sale of shares was designed, prima facie, to avoid taxation of non-competition fees. The whole amount represented a composite consideration for transfer of shares, non-compete fees and goodwill.

On behalf of the NRI, it was argued that the contingent payments up to $7 million spread over three years was uncertain since it depended upon the performance of the company. Even if it is considered part of the consideration for transfer of shares, capital gains arising out of such a transfer cannot be ascertained and no liability arose under Section 45.

Investments were made in respect of the fixed sums in Nabard bonds and, therefore, no liability arose under Section 45. The contingent payments were not received in 2003-04 and, therefore, could not be taxed in the assessment year 2004-05.

The Authority for Advance Ruling (AAR) decided the issue on first principles and the final decision had a surprise element, not visualised by either party (2005 277 ITR 1 AAR). It held that the fixed sum alone represented the full value of the consideration for the agreement for purpose of Section 48.

The contingent payment had a nexus with the performance of the NRI for achieving the defined target. It cannot be styled a non-compete fee. The contingent payment will, therefore, not fall under Section 28 (va) of the Act.

The AAR, however, went on to hold that the contingent payments were nothing but in the nature of incentive remuneration for achieving the target taxable under Section 17(1)(iv) as profits in lieu of salary.

The definition of "profits in lieu of salary" in Section 17(3) included payments due or received by an assessee from a current or former employer.

The AAR held in the instant case the fact that contingent payments are disguised as the second part of consideration under the share purchase agreement will not militate against those payments being remuneration within the meaning of salary under Section 17 of the Act.

A curious case where tax planning almost succeeded. But for the intelligent intervention of the court, the NRI would have got away paying nil tax by clever drafting of agreements for purchase of shares in Indian companies.

(The author is a former Chief Commissioner of Income-Tax.)

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