Supreme Court Rules on Taxability of Non-Compete Fee in Income Tax Dispute

The Supreme Court of India, in the case of Shiv Raj Gupta vs. Commissioner of Income-Tax, Delhi-IV, ruled on the taxability of a non-compete fee received by the appellant under the Income Tax Act, 1961. The judgment clarifies whether such payments constitute revenue receipts taxable under Section 28(ii)(a) or capital receipts exempt from taxation.

The dispute arose from a transaction in which the appellant, former Chairman and Managing Director of Central Distillery and Breweries Ltd. (CDBL), sold his controlling interest in the company to the Shaw Wallace Company Group (SWC). As part of the agreement, he received Rs. 6.6 crores under a Deed of Covenant, which restricted him from engaging in the liquor business for 10 years. The Revenue treated this amount as taxable under Section 28(ii)(a), leading to litigation that culminated in the Supreme Court’s ruling.

Background of the Case

The appellant was the majority shareholder in CDBL, owning 57.29% of its paid-up equity share capital. Due to financial constraints and regulatory hurdles, he entered into an agreement with SWC to sell his stake. This agreement comprised two key documents:

• A Memorandum of Understanding (MoU) outlining the sale of shares and transfer of management.
• A Deed of Covenant that barred the appellant from engaging in the liquor business for 10 years in exchange for Rs. 6.6 crores.

The central question before the Court was whether the non-compete fee was a genuine capital receipt or a disguised compensation for loss of management, which would be taxable as business income.

Arguments of the Petitioner

The appellant argued:

• The Deed of Covenant was a separate and valid agreement aimed at preventing competition.
• The payment was for his commitment not to compete, making it a capital receipt and not taxable as revenue income.
• Taxability under Section 28(ii)(a) applies only when compensation is received in connection with termination of management, which was not the case here.
• Similar payments were not made to other shareholders, proving that it was a genuine non-compete fee.

Arguments of the Respondent

The Income Tax Department countered:

• The non-compete fee was a sham, serving as additional compensation for loss of management control.
• The appellant’s son, who was also a shareholder, was not paid any such fee, raising doubts about the transaction’s legitimacy.
• The payment was structured to avoid tax liabilities and should be treated as business income under Section 28(ii)(a).
• The High Court correctly held that the amount should be taxed as part of the sale consideration.

Supreme Court’s Key Findings

1. Distinction Between Capital and Revenue Receipts

The Court emphasized the settled principle that compensation for loss of business is a capital receipt, whereas compensation for loss of management is taxable. It ruled:

“A payment under a restrictive covenant to prevent competition must be assessed based on its true nature and not on Revenue’s speculation.”

2. Lack of Justification for Revenue’s Interpretation

The Court rejected the Revenue’s argument that the payment was a colorable device to evade tax, stating:

“The business perception of the parties must be respected, and the Revenue cannot second-guess commercial wisdom.”

3. Relevance of Section 28(ii)(a)

The Court clarified that Section 28(ii)(a) applies only when compensation is received for termination of management. Since the appellant’s resignation was part of the share sale agreement, the restrictive covenant was distinct.

4. Application of McDowell’s Doctrine

While the Revenue cited McDowell & Co. Ltd. vs. CTO to argue that tax avoidance should be curbed, the Court distinguished between tax evasion and legitimate tax planning.

Final Judgment

The Supreme Court:

• Allowed the appeal.
• Held that the Rs. 6.6 crores received under the Deed of Covenant was a capital receipt and not taxable.
• Overruled the High Court’s judgment treating the amount as taxable consideration.

Key Takeaways from the Judgment

• Non-compete fees, if genuine, are capital receipts and not taxable under business income.
• Section 28(ii)(a) applies only when compensation is linked to termination of management.
• The Revenue cannot question the commercial decisions of businesspersons.
• Tax authorities must distinguish between legitimate tax planning and colorable transactions.

Conclusion

This ruling provides clarity on the tax treatment of non-compete fees, reaffirming that restrictive covenants must be evaluated based on their real substance. The judgment ensures that genuine non-compete agreements are not unfairly taxed as business income.

Petitioner Name: Shiv Raj Gupta.
Respondent Name: Commissioner of Income-Tax, Delhi-IV.
Judgment By: Justice R.F. Nariman, Justice Navin Sinha, Justice B.R. Gavai.
Place Of Incident: New Delhi.
Judgment Date: 22-07-2020.

Don’t miss out on the full details! Download the complete judgment in PDF format below and gain valuable insights instantly!

Download Judgment: Shiv Raj Gupta vs Commissioner of Inco Supreme Court of India Judgment Dated 22-07-2020.pdf

Direct Downlaod Judgment: Direct downlaod this Judgment

See all petitions in Income Tax Disputes
See all petitions in Tax Evasion Cases
See all petitions in Corporate Compliance
See all petitions in Judgment by Rohinton Fali Nariman
See all petitions in Judgment by Navin Sinha
See all petitions in Judgment by B R Gavai
See all petitions in allowed
See all petitions in supreme court of India judgments July 2020
See all petitions in 2020 judgments

See all posts in Taxation and Financial Cases Category
See all allowed petitions in Taxation and Financial Cases Category
See all Dismissed petitions in Taxation and Financial Cases Category
See all partially allowed petitions in Taxation and Financial Cases Category