The Chennai Income Tax Appellate Tribunal (ITAT) has issued three rulings addressing the contentious issue of whether noncompeting fees paid by the acquirer of a business constitute tax deductible expenditure, and concluding that such fees are tax-depreciable intangible assets (Radaan Mediaworks India Ltd (2007), Real Image Technologies (Pvt.) Ltd (2008) and Medicorp Technologies India Ltd (2009)).
Taxpayers historically have taken the position that non-compete fees paid are revenue expenditure that are deductible for tax purposes, whereas the tax authorities have treated such fees as capital expenditure. These divergent views have led to the matter being referred to the Special Bench of the Tribunal. While the decision of the Special Bench has not yet been issued, the Chennai ITAT has added another dimension to the debate with its holdings in the three rulings treating the fees as intangible assets.
Section 32 of the Indian Income Tax Act, 1961 (ITA) allows depreciation on both tangible and intangible assets. Intangible assets for this purpose include know-how, patents, copyrights, trademarks, licenses, franchises and any other business or commercial rights of a similar nature, acquired on or after 1 April 1998. Depreciation on such intangible assets is allowed at a rate of 25% per annum.
The issue before the Chennai Tribunal was whether non-compete fees fall within the scope of “any other business or commercial rights of a similar nature.” The Tribunal unanimously concluded that non-compete fees are a business or commercial right within the meaning of Indian income tax law and, therefore, may be depreciated for tax purposes.
The facts of the three cases were very similar:
Real Image Technologies (Pvt.) Ltd – In arriving at its conclusion that a non-compete fee is tax depreciable, the Tribunal provided an informative explanation of its rationale in Real Image Technologies (Pvt.) Ltd, separating the issues before it into the following questions:
1. Whether the payment of a non-compete fee can be construed as a commercial right; and
2. If so, whether a non-compete fee is a business or commercial right similar to other rights that may be depreciated.
On the first issue, the Chennai ITAT held that the payment made by the acquirer to the seller was for restraining the seller from competing with the acquirer and, thus, gave the acquirer the right to operate the business without concern over competition. A non-compete fee is generally paid for a limited period of time (usually five years), during which the business becomes more stable and better equipped to withstand competition. As a result, the ITAT held that the non-compete fee is a commercial right.
Having concluded in the affirmative on the first question, the ITAT then examined whether a non-compete fee is a right similar to know-how, patents, copyrights, trademarks, licenses and franchises. The Tribunal applied the ejusdem generis principle for the definition of intangible assets, which requires that words of a general nature following specific and particular words be construed as limited to things that are of the same nature as those specified. The ITAT consequently ruled that, if the business or commercial right of a patent, trademark, license, franchisee, etc., fulfilled the condition of being intangible assets, then a business or commercial right acquired by payment of INR 18.79 million also fulfilled the condition by way of a logical corollary. The non-compete right was therefore held to be eligible for depreciation under ITA section 32(1)(ii).
Medicorp Technologies India Ltd – The Chennai ITAT’s views in Medicorp Technologies were along similar lines. However, responding to the tax authorities’ contention that a non-compete fee was not an “asset” at all because it lacks a market value and it cannot be transferred, sold or licensed, the Tribunal also examined the concept of depreciation in the ITA.
The ITAT considered the difference between the concept of depreciation under the ITA and under normal accounting principles. Under the ITA, depreciation is a statutory allowance, which is not confined to the diminution in value of an asset by wear and tear but also contains an “incentive” element and is governed by fiscal policies and considerations. The ITAT observed that depreciation under the ITA does not reflect purely economic criteria. The ITAT gave as an example items for which the rate of depreciation provided under the ITA is 100% and observed that this does not mean that the effective life of the items is only one year. According to the ITAT, the logic for such differences in treatment could be that the Indian government wanted to encourage the use of certain types of assets.
As another example, the ITAT referred to the fact that depreciation is allowed on computer software, which, once loaded, cannot be resold, loses its assignability and transferability, and has practically no market value. The ITAT noted that the depreciation provisions do not necessarily follow the traditional concept of an “asset” and an accountant’s approach to “depreciation,” reiterating that the tax law sometimes implements the government’s economic and/or fiscal policies.
Through its analyses in the rulings, the ITAT concluded that a non-compete fee is an intangible “asset” that may be depreciated. The rulings should provide a boost to merger and acquisition activities in India, allowing taxpayers and their advisors to better plan for the tax consequences of non-compete fee arrangements in drafting takeover contracts.