In the era of globalisation, the world of Mergers & Acquisitions is witnessing rapid growth and the race amongst corporates to expand organically and inorganically is seeing significant momentum across the globe. Strategies that focus on core businesses or diversify into new businesses and markets, or even hive-off non-core businesses, are gaining momentum. This endeavour to gain supremacy and control over technology, trade secrets and intangibles are resulting in complex negotiation terms and innovative deal structures. This facilitates the need to safeguard and protect confidential information against any risk of leakage and ensure that the exiting party does not re-exploit its skill, experience and know-how in the near future. Any attempt by the seller, using its rich experience and know-how, to re-enter the same business again and compete with the buyer may result in loss to the buyer, and accordingly, it is necessary to protect against such eventuality. Commonly, this is achieved by agreeing to a non-compete in the transaction agreement, for which the exiting party demands a specific compensation, called non-compete fees. A non-compete fee is the consideration paid by one person to another under an agreement for restricting such other person from competing with it in a same or similar area of business or profession or trade. At times, non-compete fees is paid for not sharing any know-how, patent, copyright, license, franchise or business or commercial right of similar nature, which is likely to assist someone in the manufacturing or processing of goods or provision for services. Thus, non-compete fees is paid to impose restrictions in one or more of the following areas:
> Starting a competing business or trade or profession;
> Operating in a particular segment/ geographical market;
> Disclosing any confidential information, secret formula, know-how etc.;
The non-compete clause has gained much importance in M&A transactions, joint venture agreements and even employment agreements. The concept of non-compete fees had become controversial in the past in terms of its enforceability, as it was considered a restraint on trade. Although that controversy has been put to rest, the controversy around its taxation aspects remain for the payer, and haunts the parties to the transaction. The tax implications of non-compete agreements in India are discussed as follows.
I. Direct tax implications
The key tax implications relating to non-compete fees is tabulated as follows:
| Particular | Tax implications |
| In the hands of Payer/ Buyer/ Employer | > Tax deductibility of non-compete fees is a vexed issue, since there are no specific provisions under the income-tax regime that govern the tax deductibility of non-compete fees. Thus, two views exist: non-compete fees can either be construed as “capital” or “revenue” expenditure in nature.
> The real determination of the nature of claim depends on the facts of each transaction, such as period of non-compete agreement, nature of payment, timing of payment, etc. > To be treated as capital in nature, the determining factors would be the enduring benefit that such non-compete fees is likely to derive for the buyer. Once it is ascertained that the fees is capital in nature, it needs to be ascertained if it will be eligible for depreciation. The judicial precedents on the issue are split, and thus, claiming depreciation on non-compete is a contentious issue, which needs to be examined considering the facts of the actual transaction. > Withholding tax (WHT) obligation: If any payment is made to an employee, the payer will have to withhold tax on salaries. If payment of non-compete fees results in business income for the payee, the payer will be liable to withhold tax under the head “fees for professional and technical services” at 10% If any payment is being made to a non-resident, the provisions of section 195 of the Income-tax Act, read with the relevant tax treaty will have to be examined. |
| In the hands of Payee/ Seller/ Employee | > In case of an employee: The receipt of consideration from employer for non-compete fees, either at the beginning of employment or at the termination of employment, qualify as payments received in the nature of salary and will be taxed accordingly.
> In other cases, i.e., business acquisition: If any amount is received for not carrying on any business or profession or for not sharing any know-how, patent, copyright, license, franchise or business or commercial right of similar nature, etc., then it will be taxable as income from business and profession for the payee/ seller. An exception to the above is that any sum received for transfer of a right to carry on any business would be chargeable to tax as Capital Gains. > In case a non-resident is receiving the payment, the relevant provisions of the tax treaty will also have to be analysed, while determining the tax implications for the payee/ seller. |
Largely, the taxability of non-compete fees depends on the terms of the agreement. For example, if the transaction document for the transfer of shares/ business does not provide for any specific consideration towards non-compete fees, the taxpayer may seek to claim to tax the entire consideration (including non-compete fees) as capital gains. This treatment may offer a tax arbitrage opportunity to the taxpayer, since the said element would get taxed at 20% (if long-term in nature) instead of 30%. However, this carries the risk of litigation, since the tax authorities can seek to determine a proportion of the sale consideration towards such non-compete fees and levy higher tax by changing the nature of such allocated amount, as income from business and profession.
Further, in one case, it has been laid down that where capital asset is in the nature of the taxpayer’s right to carry on business, the non-compete consideration will be liable for capital gains. However, where the non-compete relates to a taxpayer who is actually carrying on the business and does not merely have a right, the tax may be charged as business income.
Clearly, no single explanation will fit all cases. Hence, while determining the tax implications in case of non-compete fees, it will be necessary to consider various factors, such as deal structure, nature of transaction, parties’ contractual intent, whether the transaction pertains to transfer of a right to carry on business or allowing the payer a right to stop the recipient party from undertaking a competing business, etc.
II. Indirect tax implications
Non-compete fees fall within the ambit of indirect tax laws, since refraining from doing an act, tolerating an act or situation, and doing an act are all construed as a service, i.e., the person receiving non-compete fees will be assumed to be the person providing the services. Hence, the Goods and Service Tax (GST) implications will have to be evaluated in the case of both business and service agreements, including the non-complete clause. Further, in case the service provider (i.e. receiver of non-compete fees) is located outside the taxable territory but the service is being provided in the taxable territory, GST shall be payable by the service receiver (i.e. the person paying non-compete fees) under the reverse charge mechanism.
Conclusion
Non-compete agreements play a prominent role in today’s business environment. Non-compete fees can have far reaching implications under various laws as well as on general business functioning. Both the recipient (i.e. payee) and the payer of non-compete fees should weigh the impact under these regulations, especially under the income-tax laws. While there is sufficient clarity on the tax treatment of non-compete fees in the hands of the recipient of such fees, much needed guidance is still awaited from the tax authorities on its treatment in the hands of payer.
Non-compete fee is an intangible asset in the hands of payer (as it gives rise to benefit to the assessee over a certain period of time) which is liable for depreciation.
Further, TDS is required to be deducted on payment of non-compete fee as per the provisions of section 194J(1)(d).
Now my question is- what shall be the consequences of non deduction of TDS on payment of non-compete fee?
One of the consequences is the levy of interest and penalty on non deduction of TDS…
But what about disallowance u/s 40(a)(i) or 40(a)(ia) of 100% or 30% of payment respectively?
Whether or not 100% or 30% of non-compete fee would be added in ‘Actual cost’ for purpose of claiming depreciation?