Whether transaction of sale of merchant banking business to an erstwhile global accountancy firm can be considered as colourable device, although payments were made only for transfer of business and contracts - NO: ITAT

THE issues before the Bench are - Whether a transaction of sale of merchant banking business to an erstwhile internationally acclaimed accountancy firm can be considered as a colourable device, although the combined reading of the provisions of the Business Transfer Agreement suggests that the payments have been made only for transfer of business and contracts; Whether only when the document is not bona fide nor intended to be acted upon, but is only used as a cloak to conceal a different transaction, a transaction can be regarded as a sham or colourable; Whether consideration received by the assessee for transfer of its sole merchant banking business, which was discontinued thereafter, is in the nature of capital receipt; Whether
any amount is received as compensation or damages for any wrong done which does not affect any capital asset or the capital structure of the assessee’s business, but causes injury to the assessee in its trade, will normally constitute a trading receipt - Whether it is beyond the purview of the Revenue to question the adequacy of the consideration involved in a transaction; Whether non-compete fee paid consequent to transfer of merchant banking business, which resulted in its discontinuation causing loss of enduring trading assets, is nothing but a capital receipt - Whether when the intangible assets involved no cost of acquisition, the same cannot be taxed under the head capital gains; Whether the non compete agreement is for a limited period or absolute is not a relevant factor for determining the nature of non-compete fee and Whether the claim of deduction towards expenditure incurred in respect of discontinued business of the assessee in the absence of any nexus with the existing business can be allowed. And the verdict partly goes in favour of the assessee.

Facts of the case

A. Compensation received on transfer of merchant banking business

The assessee, M/s. Ind Global Financial Trust Ltd, is a company engaged in merchant banking business. Arthur Andersen & Associates (AA), a partnership firm wanted to invest as strategic investor in a company engaged in the business of merchant banking, and for this purpose, it approached the assessee. Purusant to their mutual understanding, the assessee (Transferor) and Mr. R. Sankaran incorporated a wholly owned subsidiary in the name and style of M/s. Ind Global Corporate Finance Pvt Ltd (Transferee) to induct AA as strategic investor in the company. AA purchased the shares of the Transferee company from the sellers (Transferor and Mr. Sankaran, Managing Director of the Transferor) and to comply with the adequacy requirements to receive SEBI license, AA subscribed million to the new shares issued by the Transferee Company. The assessee/Transferor surrendered its SEBI License on or before the Effective Date i.e. the date on which the Transferee received the SEBI license for merchant banking business. The assessee/Transferor has changed its name to IGFT Ltd from Ind Global Financial Trust Ltd and has ceased to use its trademark and transferred the same to the Transferee. For the transfer of the business, the assessee/transferor received an amount of Rs 25 lakhs from the Transferee for the intangible assets and a non-compete fee of Rs 1 crore according to the terms and conditions set out in the Transfer of Business Agreement signed between the parties. The AO was of the opinion that this amount was revenue in nature and should be taxable. The assessee/Transferor contended that the amount was paid for the transfer of the merchant banking business and was clearly a capital receipt. However, the AO rejected the contention and brought the amount to tax.

On appeal, the CIT(A) confirmed the order of the AO. The CIT(A) held that there was no loss of capital structure at all, and the business of the assessee was going on as usual as evident from the annual accounts of subsequent years. CIT(A) agreed with the opinion of the AO that the said transaction was a colorable device and that it defies all business prudence of the assessee to transfer its business of merchant banking earning more than Rs. 7.50 cr for a negligible sum of Rs 1.25 cr.

Aggrieved with this order, the assessee/Transferor has filed this appeal before the Tribunal.

The counsel for the assessee contended that the transaction was with an unrelated party which was an internationally reputed accountancy firm and hence the transaction was not a sham by any means. He argued that the decisions relied by the AO were distinguishable and in the decision relied upon by the CIT(A), only one of the business was transferred, whereas the sole and main business i.e., merchant banking business of the assessee was transferred. The counsel relied on the decision of the Supreme Court in the case of McDowell & Co., Union of India v. Azadi Bachao Andolan and Vodafone International Holdings B. V. v. UOI, wherein the Supreme Court has held that tax planning within the framework of law is permitted. It was further submitted that after discontinuing the merchant banking activities, assessee company did not have any active source of income and its income consisted of income mainly from dividend from shares and mutual funds, profit on sale of shares, interest income and nominal consultancy charges. Hence, there was a substantial fall in in profit earning of the assessee after entering into non-compete agreement. The counsel also contended that the sum of Rs.25 lakhs was received on transfer of intangible assets having no cost of acquisition, and therefore, the said sum was not liable to tax. Based on all the grounds, the counsel finally submitted that the receipt was of capital in nature and not to be taxed.

The Departmental Representative relied on the reasoning given by the lower judicial authorities.

B. Non compete fees as revenue receipt

The assessee had entered into a non-compete agreement whereby the assessee company was restricted from carrying on the merchant banking activities for a period of three years for which it received a sum of Rs. 1 crores towards non-compete fees. In the assessment framed, the AO treated the impugned receipt as revenue receipts and assessed the tax under the head business income. On appeal, the same was confirmed by the CIT(A).

Aggrieved, the assessee has filed this appeal before the Tribunal.

The counsel for the assessee contended that Supreme Court has in the case of Guffic Chem P. Ltd. V. CIT held that non compete fees received before 1.04.2003 was a capital receipt not liable to tax. The assessee also submitted that on the basis of the very same Transfer of Business Agreement and for the same period of 3 years, the Tribunal has in the case of the Chairman Mr. Sankaran held that the non-compete fee was not liable to tax. Hence, the agreements in the present case which originate from the same Transfer of Business Agreement cannot be considered to be sham.

C. Disallowance on account of pre-paid expenses

The assessee had debited membership & subscription account and credited prepaid expenses being prepaid payment for SEBI fees, insurance, repairs and maintenance etc. The AO disallowed the amount since the business was transferred. The AO also noted that there is no provision in the Act to debit prepaid expenses. Out of the said amount, Rs.1,66,667 pertained to SEBI fees of current year and hence, the AO rectified his order to that effect and allowed relief of Rs.1,66,667. Hence, the disallowance was restricted to Rs.3,86,243.

On appeal, the CIT(A) confirmed the disallowance. Aggrieved by the impugned decision, the assessee has raised this ground in the appeal before the Tribunal.

The counsel for the assessee submitted that that since the business had been transferred and sold off of the intangible assets pertaining to the business, the assessee could no more get the benefit of the expense in the subsequent years. Hence, the amount was allowable as loss in the current year. Since the amounts were incurred in the normal course of business and they ceased to render benefits in future assessment years, the said amount has become a loss of the current year and hence, was allowable u/s 28.

Having heard the parties, the Tribunal held that,

A. Compensation received on transfer of merchant banking business

+ it is pertinent to mention that clause 2.2 of the Transfer of Business Agreement dated 07.12.2000 suggests that the assessee has received Rs.2.5 million (Rs.25 lacs) as consideration for transfer of the business. Clause 1.3 of the definition clause in the said agreement reads ‘business means the Employees (as set out in Schedule 4) and certain know-how related to the merchant banking business of the Transferor but does not include the Excluded assets, Creditors and Liabilities’. Clause 1.8 states that ‘Excluded assets means, the real Estate of the transferor located at 91/92, Bajaj Bhawan, Nariman Point, Mumbai-400 021 and any other tangible assets of the transferor’. A combined reading of the said relevant clauses indicates that the receipt of Rs.25 lakhs is for transfer of business and contracts. The same fact is strengthened by the decision of the Tribunal in ITA No.1258 & 1656/M/08 wherein on the basis of the very Transfer of Business Agreement, Ind Global Finance Pvt Ltd (Transferee) has claimed depreciation considering the amount of Rs 25 lakhs as technical know how, which has been rejected by Tribunal holding that the payment of Rs.25 lakhs was for transfer of business and contracts;

+ the aforementioned discussion clearly establishes that the assessee has received Rs.2.5 million (Rs.25 lacs) as consideration for transfer of the business and contracts. In view of that matter, we do not find any justifiable reason on the part of the authorities below to consider the transaction as sham which involves colourable device;

Compensation towards loss of capital asset is a capital receipt

+ the perusal of the order of the CIT(A) raises various issues which are also to be decided for the sake of completeness. Firstly, whether the amount of Rs. 25 lakh is in the nature of compensation to the assessee received in the course of carrying on business activity and has resulted in no loss of capital structure. It is pertinent to mention that according to the judgement of Calcutta High Court in CIT v. Siewart & Dholakia (P.) Ltd., compensation to the assessee received in the course of carrying on business activity is a trading receipt only if it is received for injury to trade. If any amount is received as compensation for an injury which affects a capital asset of the assessee or the capital structure of the assessee’s business, such amount may normally be considered to be a capital receipt. If, however, any amount is received by an assessee as compensation or damages for any wrong done which does not affect any capital asset or the capital structure of the assessee’s business but causes injury to the assessee in its trade, such amount will normally constitute a trading receipt of the assessee. Considering the fact that the assessee has received Rs.2.5 million (Rs.25 lacs) as consideration for transfer of the merchant baking business to the transferee and the assessee has discontinued its business, we are of the view that the impugned receipt is capital in nature and not in the nature of compensation received during the course of business as has been found by the CIT(A);

Colourable device

+ secondly, whether the entire exercise is a colourable device which defies all business prudence. It is relevant to point out that a transaction can be regarded as a sham or colourable when the document is not bona fide nor intended to be acted upon, but is only used as a cloak to conceal a different transaction or where it is intended to give to third parties the appearance of creating between the parties legal rights and obligations which are different from the actual legal rights and obligations which the parties intend to create. In the facts of the case, the Revenue has not shown as to how the assessee has resorted to a ‘device’, which is otherwise ‘colourable’. Thus, we do not agree with the findings of the CIT(A) on this count;

Adequacy of consideration

+ thirdly, as to the observation of the CIT(A) that there is no basis for arriving at the figure of Rs.25 lacs and Rs. 1 Crore which appears to be completely arbitrary decision which again defies all and it is not understandable why the business was transferred for a negligible sum of Rs 25 lakh while the noncompete fee was worked out at Rs 1 cr, it may be pointed out that it is for the transferor and the transferee to fix the consideration for the subject matter of transfer. In facts and circumstances of the instant case, we are of the opinion that it is beyond the purview of the Revenue to raise any issue on the adequacy of consideration;

B. Non compete fees as revenue receipt

+ fourthly, as to the applicability of the decision of Karnataka High Court in the case of CIT vs Tata Coffee Ltd relied on by the CIT(A), the Karnataka High Court has treated the non-compete fees received by the vendor as a revenue receipt for the reason that the discontinuance of the unit has not resulted in the loss of enduring trading asset. Same is the position with the other cases relied by the CIT(A). However, in the instant case, The perusal of the details clearly reveals that after discontinuing the merchant banking activities, assessee company did not have any active source of income and its income consisted of income mainly from dividend from shares and mutual funds, profit on sale of shares, interest income and nominal consultancy charges Hence, there is a substantial fall in profit earning of the assessee after entering into non-compete agreement. As per the relevant agreement, the assessee has received the impugned receipt for the transfer of its business of merchant banking in the form of employees, contracts in the form of customer and client relationship, a list of ten largest clients and certain know-how related to merchant banking business of the assessee, which in our view necessarily qualify impugned receipt for the transfer of the said intangible assets [though not in terms of section 32(1)(ii) is intangible)] in the category of ‘capital nature’ as the subject matter of transfer has resulted in the loss of enduring trading assets. Regarding the possibility of taxing the said impugned capital receipt under the head of capital gains, we are of the considered opinion that since no cost of acquisition is involved by the assessee for these assets, the same cannot be taxed under the head capital gains also. It is needless to emphasis that the nature of the transfer does not attract the provision of section 50B of the Act in relation to slump sale also as there is no transfer of an undertaking by the assessee. Accordingly, we decide ground no A in favour of the assessee;

+ at the out set, it is relevant to point out that the Supreme Court in the case of Guffic Chem (P.) Ltd. V. CIT has held as follows:

[“Payment received as non-competition fee under a negative covenant was always treated as a capital receipt till the assessment year 2003-04. It is only vide Finance Act, 2002 with effect from 1-4-2003 that the said capital receipt is now made taxable [See : Section 28(va)]. The Finance Act, 2002 itself indicates that during the relevant assessment year compensation received by the assessee under noncompetition agreement was a capital receipt, not taxable under the 1961 Act. It became taxable only with effect from 1-4-2003. It is well-settled that a liability cannot be created retrospectively. In the present case, compensation received under Non-Competition Agreement became taxable as a capital receipt and not as a revenue receipt by specific legislative mandate vide section 28(va) and that too with effect from 1-4-2003. Hence, the said section 28(va) is amendatory and not clarificatory.“];

+ the above judgment of the Apex court makes it clear that the fees received under non-competition agreement is a capital receipt as the amendment does not cover the relevant assessment year under consideration and hence not taxable under the Act. It is also pertinent to mention that on the basis of the very same Transfer of Business Agreement and for the same period of 3 years, the Tribunal has in the case of the Chairman Mr. Sankaran in ITA Nos 4951 & 4952/m/2009 held that the noncompete fee was not liable to tax;

+ we also find merits in the contention of the assessee that the decisions relied on by CIT(A) are not applicable to the facts of the assessee’s case as in the said cases only one of the businesses had been transferred and not the sole and main business. The perusal of the materials indicate that in the case of the assessee, the sole and main business or revenue earner i.e. merchant banking has been discontinued. The reasoning that of the authorities below that since the agreement is only for a period of 3 years and not absolute is not a relevant factor to determine the receipt as revenue in nature as generally all the non-compete agreements are limited in point of time which prescribes the period of non-competition. In view of that matter, we decide this ground in favour of the assessee and delete the impugned addition;

C. Disallowance on account of pre-paid expenses

+ it is an admitted fact that the assessee has discontinued the merchant banking business and has also sold off the intangible assets pertaining to the said business. Since these expenses are pertaining to the said business, the CIT(A) has correctly upheld the impugned addition as there is absolutely no basis for claim of deduction in respect of existing business of the assessee in the absence of any nexus with it. The said decision of the apex court relied by the AR is not applicable to the facts of the assessee. Accordingly, this Ground is dismissed.