2002 (10) TMI 72 - HC - Income Tax

Termination compensation deemed capital receipt, not assessable as revenue.

The court held that the amount received by the assessee upon termination of the distributorship agreement was a capital receipt, not assessable as ... 'Whether, Tribunal was right in law in holding that the amount received by the assessee on the termination of distributorship agreement is only a capital receipt and hence not includible in the assessee's total income?' - The reasoning of the authorities below the Tribunal that the compensation has been quantified on three counts, i.e., the cost of trained man-power, compensation for cost of dealers and compensation for loss of profits and thus the payment received by the assessee was only reimbursement of such cost factors is not correct. That was only a method to quantify the lumpsum to be paid. Such method adopted cannot be stretched to the extent of concluding that the assessee had only recouped or reimbursed the expenses incurred in the past nor can it be said that the assessee had been reimbursed the profit that was not available to it, as a result of the termination of the agreement. - we are of the view that the Tribunal is right in its approach in treating the amount received by the assessee as a capital receipt. Hence the question is answered in favour of the assessee and against the Revenue. Issues Involved:1. Whether the amount received by the assessee on the termination of the distributorship agreement is a capital receipt and hence not includible in the assessee's total income.Issue-Wise Detailed Analysis:1. Nature of the Amount Received on Termination of Distributorship Agreement:The core question was whether the amount received by the assessee upon the termination of the distributorship agreement should be considered a capital receipt or a revenue receipt. The assessment years in question were 1986-87 and 1987-88.The assessee, a non-industrial company, had been distributing products of three companies on a principal-to-principal basis since May 1, 1964. The distribution agreement was periodically renewed, with the last renewal dated October 21, 1983, for five years. The agreement was terminated on June 29, 1984, effective June 30, 1984. As compensation for the termination, the assessee received Rs. 42 lakhs, paid in ten equal quarterly installments.2. Assessing Officer's View:The Assessing Officer categorized the compensation into three elements:- Rs. 11 lakhs for the cost of trained manpower.- Rs. 22 lakhs for the cost of the dealership network.- Rs. 9 lakhs for the loss of profits.The entire sum of Rs. 42 lakhs was considered revenue receipts and brought to assessment.3. Appellate Tribunal's Conclusion:The Appellate Tribunal, upon reviewing the distribution and termination agreements, concluded that the amount received should be regarded as a capital receipt, not assessable as revenue receipt. This led to the present reference by the Revenue.4. Tribunal's Findings:The Tribunal found that the termination agreement required the assessee to transfer its employees and dealers to the company and prohibited the assessee from acting as a distributor for similar products for three years. This payment was for the impairment of the profit-making apparatus and the sterilization of the income source.The Tribunal also noted that the assessee's turnover drastically reduced from Rs. 71.14 crores to Rs. 7.17 crores post-termination, indicating significant impairment of the profit-making apparatus.5. Legal Principles Applied:The court noted that to constitute income, there must be a source from which the receipt arises, and a nexus between the receipt and the source. The source is the profit-earning apparatus, and if the amount received is from this apparatus, it is income. However, if the amount is for the transfer of the entire source, it is a capital receipt.6. Relevant Case Laws:- P.H. Divecha v. CIT [1963] 48 ITR 222 (SC): The Supreme Court held that the nature and quality of the payment must be considered to determine if it is a return for loss of a capital asset or income. The payment must have a source and a connection to the source.- CIT v. Seshasayee Brothers P. Ltd. [1999] 239 ITR 471: This court held that compensation received on termination of an agreement affecting the business structure is a capital receipt and not taxable under section 28(ii)(c).7. Section 28(ii)(c) Analysis:Section 28(ii)(c) pertains to compensation received by a person holding an agency in India. The Tribunal found that the assessee was not acting as an agent but was distributing goods on a principal-to-principal basis. Thus, the section was not applicable.8. Conclusion:The court concluded that the assessee had acquired an enduring advantage through the distribution rights since 1964, which was terminated in 1984. The termination agreement transferred the entire establishment and distributorship network, depriving the assessee of its income source and profit-earning apparatus. The compensation was for the impairment of the profit-making apparatus, not merely reimbursement of costs.The Tribunal's approach in treating the amount received as a capital receipt was upheld, and the question was answered in favor of the assessee and against the Revenue.