Share sale by Passive Shareholder taxable as Long-Term Capital Gains and not Business Income irrespective of non-compete clause in the SPA

 As per Income Tax Laws, any sum received or receivable in cash or kind under an agreement for not carrying business or profession is treated as profit or gain from business or profession, thereby taxable as business income.

In a recent ruling, the Mumbai ITAT held that consideration received under a SPA is taxable as long-term capital gains when the assessee is only a passive shareholder and no separate non-compete consideration is involved.

The assessee, an individual, held approximately 4% stake in a company as a long-term investment. Pursuant to a Share Purchase Agreement (SPA), the assessee, along with other shareholders (including some family members), collectively sold 74% stake in the company to a Japanese acquirer and reported the consideration as long-term capital gains.

The AO noted that SPA involved all the shareholders acting together, resulting in a joint transfer of shares along with management and control. The inclusion of a non-compete clause was also viewed as indicative of a business-driven transaction. Treating the transaction as “an adventure in the nature of trade”, AO reclassified the proceeds as business income and denied capital gains benefits.

Assessee argued that he was merely a shareholder, and had no role in the conduct of the company’s business. The consideration pertained solely to share transfer, with no separate non-compete payment. He also argued that other family members who received similar consideration under the same SPA, were assessed under the head “capital gains,” and therefore he could not be treated differently.

The Revenue contended that collective shareholder sale via SPA resulted in transferring business control and management. Further, the inclusion of non-compete clause in SPA and premium over valuation indicated additional consideration for transfer of control.

The ITAT held that the assessee not being involved in the company’s business, the entire consideration was received solely for the transfer of shares with no element of non-compete fees, to be constituted as long-term capital gains and not business income. It also observed that, since other family members received identical consideration under the same SPA and were assessed under the capital-gains head, the assessee could not be treated differently.

This ruling reaffirms that consideration received by a passive shareholder, having no involvement in company’s business and receives no separate non-compete payment, must be taxed as long-term capital gains and not as business income. The outcome heavily depends on how the SPA is structured, worded, and negotiated. Given the increasing scrutiny by tax authorities, it becomes critical to carefully evaluate and draft SPA terms to mitigate adverse tax exposure.