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The nature of non-compete fee

T.C.A.RAMANUJAM | Updated on November 15, 2017 Published on January 15, 2012

A non-compete fee is the outcome of an agreement entered into between two parties and does not represent any intangible assets.

In this age of mergers, demergers and takeovers of business entities, one key area requiring attention of advocates and accountants relates to the importance to be given for non-compete covenant.

The on-going business entity should be protected from competition by the outgoing entity. For this purpose, care has to be taken in drafting the agreement providing for abstinence from competition by one entity against another.

Normally this requires payment of huge sum of money. The nature of non-compete fee is being examined from various angles by judicial authorities. The receipt in the hands of the company agreeing not to compete was often considered capital, not liable for taxation. The Finance Act, 2002 inserted Section 28 (va) in the Income-Tax Act, 1961 providing for the taxation as business receipts of all amounts received or receivable, in cash or kind, for agreeing not to carry on any activity in competition.

This cleared the law and laid down that the non-compete fee is taxable in the hands of the receiver company. What about the company which incurs expenditure? Is the argument still open that the payment is revenue in nature? If it is treated as capital expenditure, can it be treated as deferred revenue or expenditure on which depreciation can be claimed.?

Intangible Assets

Section 32 (1)(ii) provides for depreciation in respect of know-how, patent, copyright, trade mark, licences, franchises or any other business or commercial rights of similar nature being intangible assets acquired on or after first April 1998 and used for the purposes of business or profession.

The assets should be owned wholly or partly by the assessee, it should be intangible, and it should be used for purposes of business or profession. All these conditions are cumulative. The question of allowing depreciation will arise if the expenditure on the asset is considered capital in nature.

Larsen & Toubro (l&T) was engaged in the business of developing, manufacturing and marketing of electronic products in India. It had a well-established countrywide sales network in India. There was a joint venture agreement between L&T and Sharp Corporation of Japan. The Japanese firm was involved in the same business. It paid Rs 3 crore to L&T in lieu of L&T not competing in the same line of trade for seven years. It treated the sum of Rs 3 crore as deferred revenue expenditure to be written over seven years. In the income-tax assessment, the amount was claimed as revenue expenditure.

Sharp pointed out that what is income in the hands of the receiver must be treated as revenue expenditure in the hands of the payer. In the alternative, the company claimed, if it is treated as capital expenditure, depreciation should be allowed.

The Delhi Bench of the Appellate Tribunal rejected all the submissions of Sharp Business Systems India Ltd. The payment of Rs 3 crore was made to avoid tough competition from L&T. The period of seven years is long enough for Sharp to establish its reputation and acquire a reasonable market share. The idea was not to increase profitability but to establish itself in the market and acquire market share. It can establish a reputation in the market. The expenditure, therefore, cannot be treated to have been incurred in the revenue field.

Depreciation



In an earlier ruling, the Madras Bench of the Tribunal had allowed depreciation on non-compete fee treating it as intangible assets. The Delhi Bench pointed out that subsequently the Delhi High Court itself had explained the nature of intangible assets. The meaning of ‘business or commercial right of similar nature' has to be understood in the backdrop of Section 32 (1) (ii).

Any right which is obtained for carrying on business effectively will come within the sweep of the meaning of intangible assets. It should be similar in nature to know-how, patent, copyright, trademark, licence, franchise, etc.

These rights are brought into existence not overnight but by experience and reputation. The Tribunal pointed out that the non-compete fee is the outcome of an agreement entered into between two parties. It does not represent any intangible assets. It would not create an asset of intangible nature eligible for depreciation. Depreciation cannot be allowed on the amount of non-compete fee.

Again, where the expenditure incurred is capital in nature, spread-over cannot be allowed. The Tribunal decided this issue also in favour of revenue.

All types of expenditure are incurred in business. They may be revenue or capital in nature.

All capital expenditure, however, does not result in the creation of an asset entitled to depreciation. This is one aspect of income-tax law that is bewildering. Can we ever hope to simplify the tax law? Easier said than done.

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

Published on January 15, 2012
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