INCOME TAX ON COMPENSATION RECEIVED ON CONFIDENTIALITY AND NON COMPETE AGREEMENTS

A confidentiality agreement or non-compete agreement would normally have the following clauses:

(i) Non-disclosure of know-how/data know-how, patent, copyright, trade-mark or such rights of similar nature or information likely to assist in the manufacture or processing of goods or provision of services.

(ii) Not carrying out any activity in relation to any business;

(iii) Future non-employability.

Therefore, the nature of the agreement would be a restrictive one, restraining the Assessee from exercising his certain rights which arise naturally, which form a capital asset of the Assessee.

It is clear from a gamut of cases that any amount received under a restrictive covenant is a ‘Capital Receipt’.

Gillanders Arbuthnot and Co. Ltd. v. The Commissioner of Income-tax, Calcutta, AIR 1965 SC 452:

Para 12: “It cannot seriously be disputed that compensation paid for agreeing to refrain from carrying on competitive business in the commodities in respect of which the agency was terminated, or for loss of goodwill would, prima facie, be off the nature of a capital receipt.”

In Commissioner of Income Tax v. Saroj Kumar Poddar [2005] 279 ITR 573(Cal) , the assessed had acquired considerable knowledge and expertise in the field of manufacture of shaving blades and other products with special reference to the manufacturing process, sources of raw materials and the marketing of the products of Gillette. Gillette entered into a non-compete agreement with the assessed wherein the facts relating to the expertise of the assessed were mentioned and thereafter the assessed undertook, on receipt of consideration of Rs. 18 million, that he would not engage himself in any business relating to the manufacturing, marketing or distribution of razors, razor blade, shaving systems or shaving preparations.

On these facts, the question before the Calcutta High Court was whether the payment under the non-compete agreement is a colourable device to earn some income since the assessed did not sell any assets. After considering the case law, the Calcutta High Court came to the conclusion that the non-compete agreement entered into between the assessed and Gillette resulted in a payment to the assessed which was in the nature of the capital receipt.

In a very recent case of Rohitasava Chand v. CIT, [2008] 306 ITR 242(Delhi), the court after looking into the various case-law precedent and the law as laid down by the legislature in its wisdom, was pleased to hold:

“The restrictive covenant was an independent obligation undertaken by the assessed not to compete with the new agent in the same field and that part of the compensation attributable to the restrictive covenant was a capital receipt, not assessable to tax.”

However, consequent to this, there has been an amendment to the Income-tax Act, 1961 through the Finance Act, 2002 (20 of 2002). Through this provision, section 28(va) has been inserted in the Income-tax Act, which reads as under:-

“(va) any sum, whether received or receivable, in cash or kind, under an agreement for—

(a) not carrying out any activity in relation to any business; or

(b) not sharing any know-how, patent, copyright, trade-mark, licence, franchise or any other business or commercial right of similar nature or information or technique likely to assist in the manufacture or processing of goods or provision for services:

Provided that sub-clause (a) shall not apply to—

(i) any sum, whether received or receivable, in cash or kind, on account of transfer of the right to manufacture, produce or process any article or thing or right to carry on any business, which is chargeable under the head “Capital gains”;

(ii) any sum received as compensation, from the multilateral fund of the Montreal Protocol on Substances that Deplete the Ozone layer under the United Nations Environment Programme, in accordance with the terms of agreement entered into with the Government of India.

Explanation.—For the purposes of this clause,—

(i) “agreement” includes any arrangement or understanding or action in concert,—

(A) whether or not such arrangement, understanding or action is formal or in writing; or

(B) whether or not such arrangement, understanding or action is intended to be enforceable by legal proceedings;

(ii) “service” means service of any description which is made available to potential users and includes the provision of services in connection with business of any industrial or commercial nature such as accounting, banking, communication, conveying of news or information, advertising, entertainment, amusement, education, financing, insurance, chit funds, real estate, construction, transport, storage, processing, supply of electrical or other energy, boarding and lodging;]”

Thus, it is clear that subsequent to this amendment, the judgment of the Courts shall no longer be applicable and a confidentiality agreement or non-compete agreement would be taxable at the hands of the Department.

The provision for taxation of these amounts has been included in the Direct Taxes Code Bill, 2010 vide Clause 33 read with Clause 314(10).