2006 (1) TMI 191 - AT - Income Tax

Tribunal rules non-compete and goodwill receipts as capital gains, not taxable as revenue income

Deputy Commissioner Of Income-tax, 3(1), Hyderabad. Versus Sr. KSN. Enterprises (P.) Limited.

Deputy Commissioner Of Income-tax, 3(1), Hyderabad. Versus Sr. KSN. Enterprises (P.) Limited. - ITD 105, 375, TTJ 108, 940, [2007] 105 ITD 375 (HYD.) Issues Involved:1. Applicability of Section 28(ii) to the consideration received on termination of contracts.2. Validity of the non-compete agreement and the nature of the receipt.3. Existence and treatment of goodwill in the assessee-company's line of business.4. Treatment of the amount received as a capital receipt or revenue receipt.5. Applicability of Section 50(2) regarding short-term capital gains.Detailed Analysis:1. Applicability of Section 28(ii) to the Consideration Received on Termination of Contracts:The Assessing Officer (AO) contended that the amount received by the assessee for the loss of income/earnings is a revenue receipt and falls under the purview of Section 28(ii) of the Income-tax Act, 1961. The AO argued that the compensation received was for the termination of an agency agreement, which should be treated as revenue income.However, the first appellate authority concluded that the provisions of Section 28(ii) are not applicable as the agreement between the assessee and Spectra was not an agency agreement but a distribution agreement. The Tribunal upheld this view, emphasizing that the agreement was on a principal-to-principal basis and not an agency agreement. Therefore, the receipt does not fall within the ambit of Section 28(ii).2. Validity of the Non-Compete Agreement and the Nature of the Receipt:The AO argued that the non-compete agreement and the agreement for the purchase of goodwill were dubious devices to avoid tax. The AO's position was that the assessee was merely a transporter and not a distributor, thus having no confidential information or goodwill.The Tribunal, however, found that the assessee had a legitimate distribution network and that the agreements were bona fide. The Tribunal noted that the non-compete agreement involved preventing the assessee from engaging in a similar line of business and disclosing confidential information, which constituted a capital receipt. The Tribunal relied on the Supreme Court judgments in Kettlewell Bullen & Co. Ltd. v. CIT and Gillanders Arbuthnot & Co. Ltd v. CIT, which held that compensation for restrictive covenants is a capital receipt.3. Existence and Treatment of Goodwill in the Assessee-Company's Line of Business:The AO's position was that there was no goodwill in the assessee's line of business. However, the first appellate authority and the Tribunal disagreed, noting that the assessee had developed a significant distribution network and had substantial sales, indicating the presence of goodwill.The Tribunal upheld the view that the amount received for goodwill should be treated as a capital receipt and subjected to capital gains tax, allowing the assessee's claim under Section 54EA.4. Treatment of the Amount Received as a Capital Receipt or Revenue Receipt:The AO treated the entire consideration of Rs. 4 crores as a revenue receipt, arguing that the amount received was in lieu of profits and thus taxable. The Tribunal, however, held that the amount received under the non-compete agreement was a capital receipt as it resulted in the impairment of the assessee's profit-making apparatus.The Tribunal emphasized that the restrictive covenant and the goodwill agreement were genuine and that the amounts received were for the loss of the source of income, not merely for the loss of profits.5. Applicability of Section 50(2) Regarding Short-Term Capital Gains:The AO alternatively argued that if the receipt is considered a capital receipt, it should attract short-term capital gains tax under Section 50(2) of the Act. However, the Tribunal noted that Section 50(2) applies to the transfer of depreciable assets forming part of a block of assets, which was not the case here.The Tribunal concluded that the receipt in question did not fall within the purview of Section 50(2) and upheld the first appellate authority's order, treating the amount as a capital receipt not liable to short-term capital gains tax.Conclusion:The Tribunal upheld the first appellate authority's decision, concluding that the amounts received by the assessee under the non-compete agreement and for goodwill were capital receipts. The provisions of Section 28(ii) were found inapplicable, and the receipt was not liable to tax as revenue income. The Tribunal also dismissed the applicability of Section 50(2) for short-term capital gains, confirming the treatment of the receipt as a capital gain. The appeals by the Revenue were dismissed.