Taxation of Deferred Compensation – A Continuing Conundrum

In the world of mergers and acquisitions (M&A), determining the value of a transaction can be complex, especially when involving deferred compensation. This article delves into the taxation challenges surrounding such compensations, highlighting judicial interpretations and the ongoing uncertainties faced by both buyers and sellers.

Valuation and Deferred Compensation: In an M&A deal, the total value may be paid either in a single upfront payment or split into multiple payments based on various business factors. Start-ups often face a gap in valuation between the seller's expectations and the buyer's conservative approach. To bridge this gap, transactions commonly include:

1. Upfront Consideration – paid immediately.
2. Deferred/Earn-out Compensation – paid upon reaching certain performance milestones.

The deferred portion is crucial because it often ties the final transaction value to the future performance of the acquired business. This structure helps mitigate the risk of business underperformance after acquisition.

Taxation Conundrum: A significant challenge for sellers is deciding when to pay taxes on deferred compensation. Should it be taxed in the year the asset is transferred or the year the compensation is received?

According to Section 45(1) of the Income Tax Act, 1961 (IT Act), capital gains from asset transfers are taxable in the year of transfer. Section 48 explains how to compute the gains, i.e., the difference between the transfer value and the acquisition cost. The ambiguity arises in the case of deferred compensation: has it "accrued" in the year of transfer, or should taxation wait until receipt?

Judicial Interpretations: The courts have delivered conflicting judgments on this issue:

1. Mumbai Tribunal (2024, Huntsman Investments): Held that deferred compensation is not taxable during the year of asset transfer, as it had not yet accrued due to its contingent nature.
2. Mumbai High Court (2024, Rajendra Sitaram Goel): Reinforced that deferred compensation, dependent on certain conditions, is taxable only in the year of receipt, when the seller has a legally enforceable right to receive it.
3. Delhi High Court (2012, Ajay Guliya): Took a different stance, ruling that deferred compensation is taxable in the year of transfer if the consideration is fixed and the seller has no right to reclaim the asset in case of non-payment.

The tax authorities argue that deferred compensation should be taxed in the year of transfer unless explicitly exempted by law, as seen in cases like insurance payouts or stock sales.

Implications and Practical Considerations: Even if deferred compensation is taxed in the transfer year, complications arise if the seller receives less than expected or nothing at all in future years, as the IT Act offers no provision for tax refunds or revised returns.

Therefore, careful structuring of the sale-purchase agreement (SPA) is essential. The compensation must have significant contingency elements to ensure it is not taxable until the seller's right to receive the income is clear. Sellers should avoid hypothetical income taxation and focus on real income, which only accrues when there is a legal right to receive it.

Conclusion: The taxation of deferred compensation remains a gray area, with courts divided on the matter. Until the Supreme Court provides a definitive ruling, the onus is on businesses to carefully structure their agreements to navigate these uncertainties. Proper planning can help mitigate tax risks and avoid unnecessary litigation.