Consideration bifurcated for negative covenants in share purchase agreement is not chargeable to tax

Punjab & Haryana High Court held In the case of CIT vs. Smt. Usha Saboo that although the agreement did not bifurcate the consideration towards the various covenants in the agreement, the assessee was entitled to bifurcate the same and apportion a part thereof towards the negative covenants. The matter in our view is covered in the respondents’ favour by the judgment of the Supreme Court in the case of Commissioner of Income Tax, Madras v. Best and Co. (Private) Ltd. 1966 Income Tax Reports (60) 11. This is also the view taken by several other High Courts. On facts we have held that the amount of 100/- out of 400/- apportioned towards the negative/restrictive covenants was infact on the conservative side.

Facts of the Case

Groz Beckert Saboo Ltd. was a joint venture between the assessee i.e. Saboo group and M/s Theodor Groz & Sohne & Ernst Beckert Nadelfabrik Commandit Gesellschaft, a partnership firm in Germany (Groz Beckert group). The Saboo group and Groz Beckert group held 40% and 60% shares of the equity capital of Groz Beckert Saboo Ltd. respectively. Disputes arose between two groups leading to the Saboo group filing a petition for oppression and mismanagement under sections 397 and 398 of the Companies Act, 1956. The petition was dismissed. The Saboo group filed an appeal under section 10F of the Companies Act, 1956 before Delhi High Court. The matter was ultimately settled in terms of a Share Purchase Agreement dated 21.01.1993. Rs. 400/- was stated to be the consideration for the sale of all the shares held by the Saboo group to the Groz Beckert group. The agreement also contained restrictive/negative covenants given by the Saboo group. The respondents contended that they were entitled to apportion a sum of Rs. 100/- out of Rs. 400/- as consideration for the negative covenants. This claim was rejected by the Assessing Officer and the C.I.T. (A) but was allowed by the order of the ITAT.

Contention of Assessee

The ld counsel of the assessee submitted that out of the sum of 400/- per share, a sum of 100/- ought to be apportioned as consideration on account of the negative covenants stipulated in the Share Purchase Agreement. They contended that the said sum of 100/- per share would be on account of capital receipts for agreeing to the negative covenants under the Share Purchase Agreement and the same being capital in nature was not chargeable to tax. To justify the basis and the quantum of this claim for apportionment, the respondent filed a valuation report of the Chartered Accountants M/s Vaish & Associates which valued the shares at 93.12 as per break-up value as on 31.03.1993. He relied on the judgment of a Division Bench of the Bombay High Court in Baijnath Charurbhuj and another v. Commissioner of Income Tax, Bombay City-II, 1957 Income Tax Reports (Bombay) 643 in which it was held that It is difficult to understand how the mere fact that the parties have not apportioned the consideration between the two assets which were being dealt with by this agreement can make any difference to the rights of the parties.

He also relied upon a judgment of the Division Bench of Madras High Court in Parry and Co. Ltd. v. Deputy Commissioner of Income Tax and another 2004 Income Tax Reports 177 and judgment of the Division Bench of Patna High Court in Raghubar Narain Singh v. Commissioner of Income Tax, 1984 Income Tax Reports 447.

Contention of Revenue

The ld counsel of the revenue submitted that there being no bifurcation in the agreement between the value of the share and the value of the negative covenants, the assessee was not entitled to apportionment thereof for the purposes of assessment under the Income Tax Act.

He relied upon the judgment of a Division Bench of Madras High Court in Venkatesh (Minor) and others v. Commissioner of Income Tax 2000 (243) ITR 367 Madras in which it was held that the price paid by the vendee for acquisition of such shares remains the price of those shares though the price so paid is higher than the market price. Controlling interest is but an incidence of the shareholding and has no independent existence. Similar view was taken by the Madhya Pradesh High Court in the case of Smt. Maharani Ushadevi v. CIT [1981] 131 ITR 445, wherein also it was pointed out that the controlling interest in a company is an incident arising from holding of a particular number of shares in the company and that such controlling interest cannot be transferred without transferring shares.

He also relied upon the observations of the Madhya Pradesh High Court in Smt. Maharani Ushadevi v. Commissioner of Income Tax, M.P. 1981 Income Tax Report, Vol. 131, 445 in which it was held that the controlling interest is an incidence arising from holding a particular number of shares in the company and cannot be separately acquired or transferred. It is an incidence or a consequence of the holding of the said shares.

Lastly, he relied upon the observations of the Supreme Court in Vodafone International Holdings BV vs. Union of India (2012) 6 SCC 613 in which it was held that Where the parties have agreed for a lump sum consideration without placing separate values for each of the above items which go to make up the entire investment in participation, merely because certain values are indicated in the correspondence with FIPB which had raised the query, would not mean that the parties had agreed for the price payable for each of the above items. The transaction remained a contract of outright sale of the entire investment for a lump sum consideration.

There was infact no consideration payable in respect of the negative covenants.

In support of this contention, the ld counsel of the assessee contended that the members of Saboo group did not have the technical expertise to carry on such business in competition with the business of Groz Beckert Saboo Ltd. In this regard, she relied upon the order of the Company Law Board dated 22.10.1992 recording the submissions on behalf of the Saboo group inter-alia to the effect that due to non-cooperation of the Groz Beckert group to take effective steps for ‘indigenization of raw material supply and transfer of technology to the company, the proposal of the Saboo group that more manufacturers of raw material should be contacted was defeated. This according to her indicates an admission on behalf of the Saboo group that it was the Groz Beckert group that was in possession of the technology and that the Saboo group did not have the technology necessary to conduct such business. She also relied upon the observations in the order of the Company Law Board to the effect that under section 29 of the Foreign Exchange Regulations Act, 1973, a company in which the non-residents holding is more than 40% (as in the case of Groz Beckert Saboo Ltd. wherein the Groz Beckert group had 60% shares holding) would require the permission of the Reserve Bank of India to carry on business in India. In 1973-74, the Government required the Groz Beckert group to reduce its equity ownership in the company but considering the nature of the technology, the Reserve Bank of India permitted the Groz Beckert group to retain 60% of the equity and the Saboo group supported the same. This according to Ms. Dhugga indicated that the technology was of a high level and valuable and that it is the Groz Beckert group that was in possession of the same.

The order is perverse

There was no further bifurcation and apportionment of the consideration towards each of the covenants/negative covenants contained in the various clauses of the Share Purchase Agreement. She submitted that a value must then be attributed to all the covenants/negative covenants such as in Clauses 5.6, 5.7 and 5.8 set out earlier.

In any event, the consideration for the negative covenants under Clause 5.5 is assessable to tax under section 28 of the Act.

Held by CIT (A)

The CIT (A) held that the respondent was neither a Director nor an employee of the company; that she was not a technical expert; that the sale of the shares could not have an element of managerial control. It was held that as the respondent was not a Director or an employee of the company, she could not have any element of managerial control and that she did not have any expertise to run a venture similar to the one run by the purchaser of the shares i.e. Groz Beckert group. He further concluded that the restrictive covenant was not applicable to the respondent in ITA No. 557 of 2006. It was, therefore, held that the entire amount of 400/- per share was received against the sale of the share and the Assessing Officer had rightly treated the entire amount as a part of the capital receipt liable for capital gains.

.Held by ITAT

ITAT allowed the assessee contention that they were entitled to apportion a sum of Rs. 100/- out of 400/- as consideration for the negative covenants. Accordingly it was held that sum of Rs. 100 per share is capital receipt and not chargeable to tax.

Held by High Court

In our view, an assessee is entitled to seek bifurcation of the consideration mentioned in the agreement. Whether a part of the consideration was paid in respect of a particular promise or not is a question of fact which must necessarily depend on the facts of each case.

Judgment of a Division Bench of the Bombay High Court in Baijnath Charurbhuj and another v. Commissioner of Income Tax, Bombay City-II, 1957 Income Tax Reports (Bombay) 643, is well founded. We agree that the parties not having apportioned the consideration between two or more assets can make no difference to the right of the assessee to seek an apportionment of the consideration in respect of each of them. We see no reason in principle to prevent the assessee from doing so. The value to be ascribed to each transaction must obviously depend upon the evidence and the facts in each case. The tax of whatever nature must be levied on the basis of the true value of the asset of the transaction and not merely on the basis of the value ascribed to it by the assessee.

In the case before us the negative covenant and the shares are independent and distinct assets. It was possible to have a separate and independent agreement in respect of each of them. The agreement in terms of the negative covenant contained in Clause 5.5 did not flow out of the agreement to sell the shares. Each of these agreements could have been arrived at independent of the others. It was therefore not only permissible but necessary to apportion the consideration towards each of the assets provided of course it is possible to ascertain a value of each of the assets. The same views were expressed in a Bench of three learned Judges of the Supreme Court in Commissioner of Income Tax, Madras v. Best and Co. (Private) Ltd. 1966 Income Tax Reports (60) 11 in which it was held that In the present case, the covenant was an independent obligation undertaken by the assessee not to compete with the new agents in the same field for a specified period. It came into operation only after the agency was terminated. It was wholly un-connected with the assessee’s agency terminated. We, therefore, hold that that part of the compensation attributable to the restrictive covenant was a capital receipt and hence not assessable to tax.

As held by the Division Bench of Madras High Court in the case of Venkatesh (Minor) and others v. Commissioner of Income Tax 2000 (243) ITR 367 Madras that the controlling interest is an incidence of the shareholding and has no independent existence. We have already held that the negative covenant was a distinct right independent of the right of ownership of the shares. The case is, therefore, clearly distinguishable from the one before us.

The Observations in the Vodafone International Holdings BV vs. Union of India (2012) 6 SCC 613, cannot be read in isolation. Moreover, even these observations do not support contention of the revenue that merely because the written agreement entered into between the parties does not bifurcate the consideration and apportion the same, the authorities and/or the assessees are precluded from doing so. Indeed, the issue, as it arises before us, was not considered by the Supreme Court. The Supreme Court considered the aspect in an entirely different context. To understand these observations, it would be necessary to read the judgment in Vodafone International Holdings BV vs. Union of India as a whole. The Supreme Court did not hold that even if it had come to the conclusion that the case concerns sale of share and other assets, there could be no bifurcation and apportionment of the consideration stipulated merely because the Share Purchase Agreement did not itself bifurcate the consideration qua the independent components.

We are, therefore, in any event bound by the judgment in CIV v. Best and Co. P. Ltd. 1966 Income Tax Reports (60) 11 . The first contention therefore stands rejected. The Tribunal was right in coming to the conclusion that the consideration ought to be bifurcated and a part thereof apportioned towards the restrictive covenants.

We will assume that the members of the Saboo group did not possess the technical expertise to run a similar business themselves. That does not render clause 5.5 meaningless. It is of vital importance to note that clause 5.5 prevented the members of the Saboo group from directly or indirectly engaging in a similar business or in competition with the business of Groz Beckert Saboo Ltd. The possession of technical expertise required to manufacture a product is not necessary to engage in any business similar to or in competition with the business of another. The term ‘engage’ is of wide import. The members of Saboo group or any one of them could engage in such business merely as investors. They could in turn acquire the technical expertise from another party. They could enter into a joint venture with another party that has the technical expertise to produce similar goods and to engage in similar competitive business. The mere fact that none of the members of the Saboo group had the technical expertise themselves to manufacture the goods is entirely irrelevant. Their ability to engage in such a business is not dependent on their possessing the technical expertise required for running such a business.

This is entirely irrelevant. It does not indicate that clause 5.5 is meaningless or without any value. If there was a breach of clause 5.5, the Groz Beckert group or the company i.e. Groz Beckert Saboo Ltd. could have filed an action to prevent them from doing so by enforcing the negative covenants. They could also have sought damages for the breach of the covenants. The contention that clause 5.5 is meaningless and of no value is, therefore, rejected. Merely because Groz Beckert Saboo Ltd. may not have filed any action to enforce the negative covenants it does not necessarily follow that the covenant was sham and was not intended to be acted upon. They may have refrained from doing so for a variety of valid reasons.

The submission that there was no consideration for the negative covenants is therefore rejected.

There are two reasons for this contention. Firstly, as rightly pointed out by Ms. Suri, this contention was not raised by the Assessing officer. Nor was it raised before the C.I.T. (A) or before the Tribunal. Ms. Dhugga contended that this is a pure question of law and the Department, therefore, ought to be allowed to raise the point before us although it was not raised before the CIT(A) and the Tribunal. Ms. Suri’s objection is well founded. There is no justification for allowing the appellant to raise this point for the first time in the appeal before us. The second reason is that the appellants themselves have not valued the shares infact a Chartered Accountant have made the valuation as per different methods. There is nothing to indicate that the valuation report was dishonest or malafide for any reason. Nor is there anything to indicate that it is unsustainable for any reason. It is important to note that there is no ground of appeal before us against the Tribunal’s acceptance of the valuation report

Section 28 (ii) (a) & (b) are inapplicable to the facts of this case. The members of the Saboo group held only 40% of the equity shares in Groz Beckert Saboo Ltd. Their share holding even together did not give them the right to manage the whole or substantially the whole of the affairs of Groz Beckert Saboo Ltd, therefore it is clear that the Saboo group not managed the whole of the affairs of Groz Beckert Saboo Ltd. In this view of the matter, it is not necessary to consider whether section 28(ii)(a)(b) of the Act applies in view of other certain aspects raised by ld counsel of the revenue.The consideration for the negative covenants in 5.5 of the Share Purchase Agreement is assessable to tax under section 28 of the Act is, therefore, rejected.

Accordingly, appeal of the revenue dismissed.