The Apex Court in the case of Shiv Raj Gupta v. CIT1 held that the compensation attributable to a negative/restrictive covenant is a capital receipt. The Apex Court reiterated that the test of commercial expediency would have to be adjudged from the point of view of the businessman and not of the Income Tax Department.
The Apex Court further held that the High Court’s jurisdiction depends on a substantial question of law being involved in the appeal before it. The High Court cannot answer any question not farmed before it. It must record reasons and give proper and adequate opportunity of hearing to the parties before deciding any other question of law.
Facts of the case :
CDBL is a company engaged in manufacturing beer and liquor. The Appellant was a Chairman and Managing Director of CDBL. The Appellant alongwith his family members held 186,109 no. of shares @ Rs.10/- in CDBL.
On 13/04/1994, the Appellant entered into a MOU with SWC. Vide said MOU, the family members of the Appellant sold their shares for Rs.30/- per share. Accordingly, the Appellant handed over the physical possession of assets, management and control of CDBL to the representatives of SWC.
On the very same date, the Appellant entered into a Deed of Covenant with SWC wherein the SWC agreed to pay Rs.6.60 crores to the appellant towards “non compete fees”. Out of the total Rs.6.60 crores, Rs.3 crores was withheld by SWC for a period of two years by way of a public deposit for the purpose of deduction of any loss on account of breach of the MoU.
The AO treated the amount of Rs.6.60 crores as income of the Appellant by invoking section 28(ii)(a) of the Income Tax Act, 1961 on the following grounds :
1. M/s. Maltings Ltd. owned by the Appellant is a loss making company. Thus, there can be no real competition between the parties.
2. The shares worth Rs.3/- were sold at Rs.30/-.
3. There was no penalty clause to enforce the performance of obligations.
4. The son of the Appellant was not paid any non compete fees despite the fact that he also resigned from the position as Joint Managing Director.
5. Deed of Covenant is a colourable device (McDowell & Co. Ltd. v. CTO2).
The CIT(A) confirmed the addition made by the AO. The members of the ITAT differed and the third member decided against the revenue holding the amount to be non taxable. The High court though held that the amount is not a business income, treated it as part of sale consideration of shares.
1STISSUE BEFORE ALL HIGHER COURTS Question before Higher Courts :
(i) Whether Rs.6.6 crores received by the Appellant from SWC is on account of handing over management and control of CDBL to SWC as terminal benefit and is taxable u/s. 28(ii)(a) of the Income-tax Act ?
(ii) Whether Rs.6.6 crores is exempt as capital receipt being non-competition fee by executing Deed of Covenant ?
Tribunal verdict :
The Third member held that Rs.6.60 crores was not taxable as there was a penalty clause in the Deed of Covenant. Hence, the amount was non compete fee not liable to tax.
High Court verdict :
The High Court held that Deed of Covenant could not be read as a separate document and was not in its real avatar a non-compete fee at all. The sum of Rs.6.60 crores could not be brought to tax u/s. 28(ii)(a). But the same would be taxable as capital gain as a sale consideration for transfer of shares.
Proceedings before Supreme Court :
The following issues were raised before the Supreme Court :
(i) Whether the amount of Rs.6.6 crores was towards “non compete fee” being of capital nature not liable to tax ?
(ii) Whether the High court was right in answering a substantive question of law which was never framed before it ?
(iii) Whether the High Court was right in looking at the commercial expediency from the point of view of the Income Tax Department ?
Revenue’s contention :
1. Relying upon the decision of McDowell (supra) and Vodafone International Holding BV v. UOI3 revenue contended that Rs.6.60 crores has been received for sale of shares.
2. Alternatively, the amount is taxable u/s. 28(ii)(a).
Supreme Court observation :
(i) Share having face value of Rs.10/- and market value of Rs.3/- was sold for Rs.30/- as a result of control premium having to be paid.
(ii) Each member of the family was paid for his/her shares in the company.
(iii) The Appellant had acquired considerable knowledge, skill, expertise and specialisation in the liquor business who had been Chairman and Managing Director for a period of 35 years.
(iv) The non-compete fee of Rs.6.6 crores was paid only to the Appellant. Withholding of Rs.3 crores out of Rs.6.6 crores for a period of two years by way of a public deposit with the SWC group for the purpose of deduction of any loss on account of any breach of the MoU, was akin to a penalty clause, making it clear thereby that there was no colourable device involved in having two separate agreements for two entirely separate and distinct purposes.
(v) The perception of the AO that there was no rationale behind the payment of INR 6.6 crores and that the assessee was not a probable or perceptible threat or competitor to the SWC group cannot take the place of business reality from the point of view of the Appellant. M/s. Maltings Ltd. may in future be a direct threat to the SWC group and may turn around and make profits in future years.
Guffic Chem (P) Ltd. v. CIT4 and Gillanders Arbuthnot & Co. Ltd. v. CIT5 : the compensation received for the loss of agency is a revenue receipt whereas the compensation attributable to a negative/restrictive covenant is a capital receipt.
Supreme Court held :
The amount of Rs.6.60 crores received by the Appellant is a capital receipt not liable to tax.
Acelegal Analysis :
The Apex Court held that where a compensation is attributable to a non compete fee, the said compensation is a capital receipt. However, this verdict is good till AY 2002-03. From AY 2003-04, the non compete fee is specifically made taxable under section 28(va).
Moreover, with effect from 01/04/2019, the Legislature has introduced clause (e) in section 28(ii). As per this section, any compensation or other payment due to or received by any person, by whatever name called, at or in connection with the termination or modification of the terms and conditions, of any contract relating to his business is made taxable. Therefore, whether we state that the amount received is for non compete or whether it is received for a negative covenant, now the amount would be taxable.
2NDISSUE BEFORE SUPREME COURT
The Appellant also questioned the power of the High Court to decide a question under section 260A of the Income Tax Act.
As per the Appellant, Section 260A empowers the High Court to answer those substantial questions which are framed before them. If some other question is to be answered, the Court must first give notice of the same to both sides, hear them, pronounce a reasoned order and thereafter frame another substantial question of law, which it may then answer. As per the Appellant, the High Court has failed to follow this procedure and have answered the following question which was never framed before it :
“whether the assessee can be taxed outside the provisions of section 28(ii)(a)?”
Thus, the Appeal pleaded that the entire judgment is vitiated and must be set aside on this ground alone.
Supreme Court’s verdict :
The Apex Court held that the High Court was not right in answering the above mentioned question without recording reasons and without framing any such substantial question of law.
Rule applied by Supreme Court :
While passing the said verdict the Supreme Court relied on section 260A of the Income Tax Act, 1961 and Section 100 of Code of Civil Procedure which reads as under :
Section 260A of Income Tax Act, 1961 :
(4) The appeal shall be heard only on the question so formulated, and the respondents shall, at the hearing of the appeal, be allowed to argue that the case does not involve such a question.
(6) The High Court may determine any issue which—
(a) has not been determined by the Appellate Tribunal; or
(b) has been wrongly determined by the Appellate Tribunal, by reason of a decision on such question of law as is referred to in sub-section (1).
Section 100 of CPC : Second appeal :
(1) Save as otherwise expressly provided in the body of this Code or by any other law for the time being in force, an appeal shall lie to the High Court from every decree passed in appeal by any court subordinate to the High Court, if the High Court is satisfied that the case involves a substantial question of law.
(2) An appeal may lie under this section from an appellate decree passed ex parte.
(3) In an appeal under this section, the memorandum of appeal shall precisely state the substantial question of law involved in the appeal.
(4) Where the High Court is satisfied that a substantial question of law is involved in any case, it shall formulate that question.
(5) The appeal shall be heard on the question so formulated and the respondent shall, at the hearing of the appeal, be allowed to argue that the case does not involve such question:
Provided that nothing in this sub-section shall be deemed to take away or abridge the power of the Court to hear, for reasons to be recorded, the
appeal on any other substantial question of law, not formulated by it, if it is satisfied that the case involves such question.
On reading of both the provisions, the Apex court observed that the High Court’s jurisdiction depends on a substantial question of law being involved in the appeal before it.
As per sub-section (4) to section 260A, if a High Court wishes to hear the appeal on any other substantial question of law not formulated earlier, it may, for reasons to be recorded, formulate and hear such questions if it is satisfied that the case involves such a question.
As per sub-section (6) to section 260A, the High Court may also determine any issue which, though raised, has not been determined by the ITAT or has been wrongly determined by the ITAT by reason of a decision on a substantial question of law raised.
Decision relied upon by Supreme Court :
(1) Kshitish Chandra Purkait v. Santosh Kumar Purkait6 and Dnyanoba Bhaurao Shemade v. Maroti Bhaurao Marnor7: The Supreme Court referred to section 100 of CPC and held that :
(a) It is a duty cast upon High Court to formulate the substantial question of law involved in the case at initial stage ;
(b) In exceptional cases, formulate the question at a later point of time in exercise of its jurisdiction u/s. 100(5) of CPC ;
(c) On framing substantial question of law, the opposite party should be put on notice thereon and should be given a fair or proper opportunity to meet the point ;
(d) Proceedings to hear the appeal without formulating the substantial question of law involved in the appeal is illegal and is an abnegation or abdication of the duty cast on court.
(e) Even after the formulation of the substantial question of law, if a fair or proper opportunity is not afforded to the opposite side, it will amount to denial of natural justice.
(ii) Biswanath Ghosh v. Gobina Ghosh8 – The Court after referring to section 100 of the CPC held that an appeal shall lie to the High Court from an appellate decree only if the High Court is satisfied that the case involves a substantial question of law. It further mandates that the memorandum of appeal precisely states the substantial question of law involved in the appeal. If such an appeal is filed, the High Court while admitting or entertaining the appeal must record its satisfaction and formulate the substantial question of law involved in the appeal. The appeal shall then be heard on the questions so formulated and the respondent shall be allowed to argue only on those substantial questions of law. However, proviso to this section empowers the court to hear on any substantial question of law not formulated after recording reasons.
The jurisdiction of the High Court depends upon the substantial question of law framed before it. If the High Court desires to answer a substantial question of law which is not framed before it, then it has to first frame the question by giving reasons for the same, thereafter put the said question before the parties and hear the parties by giving them an adequate and proper opportunity of hearing. If this procedure is not followed the order passed by the High Court will be vitiated.
3RDISSUE BEFORE SUPREME COURT
The High Court further observed in its decision that :
(i) The market price of per share was Rs.3/- only whereas the shares were sold at Rs.30/-. The price of Rs.30/- per share is fallacious and off beam.
(ii) The figure of Rs.6.60 crores towards non compete fee being 10 times more than the share price does not appear to be realistic.
Supreme Court’s verdict :
The commercial expediency has to be adjudged from the point of view of the assessee. The Income Tax Department cannot enter into the thicket of reasonableness of amounts paid by the assessee.
Decisions relied upon by the Supreme Court :
(i) CIT v. Walchand & Co.9 and J.K. Woollen Manufacturers v. CIT10 – In applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of the business, reasonableness of the expenditure has to be adjudged from the point of view of the businessman and not of the Revenue.
(ii) CIT v. Panipat Woollen & General Mills Co. Ltd.11 – In order to determine the question of reasonableness of the expenditure, the test of commercial expediency would have to be adjudged from the point of view of the businessman and not of the Income Tax Department.
(iii) Shahzada Nand & Sons v. CIT12 – Factors are to be considered from the point of view of a normal, prudent businessman. The reasonableness of the payment has to be judged not on any subjective standard of the assessing authority but from the point of view of commercial expediency. Commercial expediency must be judged in the context of current socio-economic thinking which places the general interest of the community above the personal interest of the individual and believes that a business or undertaking is the product of the combined efforts of the employer and the employees.
(iv) S. A. Builders Ltd. v. CIT13 and CIT v. Dalmia Cement (B.) Ltd.14 – The Revenue cannot justifiably claim to put itself in the armchair of the businessman or in the position of the Board of Directors and assume the role to decide how much is reasonable expenditure having regard to the circumstances of the case. No businessman can be compelled to maximise its profit. The Income Tax Authorities must put themselves in the shoes of the assessee and see how a prudent businessman would act.
(v) Hero cycles (P) Ltd. v. CIT15 – The expression “for the purpose of business” is wider in terms than the expression “for the purpose of earning profits”. The Court further relied upon the decision in the case of S.A. Builders Ltd. (supra) and Dalmia Cement (B.) Ltd. (supra).
Acelegal Analysis :
The Supreme Court has reiterated the principle laid down in various precedents. It has held that the commercial expediency has to be judged from the point of view of a businessman and not from the point of view of the Income Tax Department. The revenue cannot insist on maximising profits for the assessee. This principle is all very important because often the revenue treads on unreasonable additions to income in their zeal to collect more taxes. The decision by the Apex court is a stark reminder to assessing authorities about the boundaries within which they operate.
1 Civil Appeal no. 12044 of 2016, order dated 22/07/2020
2 (1985) 3 SCC 230
3 (2012) 6 SCC 613
4 (2011) 4 SCC 254
5 (1964) 53 ITR 283 (SC)
6 (1997) 5 SCC 438
7 (1999) 2 SCC 471
8 (2014) 11 SCC 605
9 (1967) 3 SCR 214
10 (1969) 1 SCR 525
11 (1976) 2 SCC 5
12 (1977) 3 SCC 432
13 (2007) 1 SCC 781
14 (2002) 254 ITR 377 (SC)
15 (2015) 16 SCC 359