Whether sum forfeited due to cancellation of contract in excess of agreed liquidated damages for making good of loss of business opportunity amounts to revenue receipt

THE issues before the Bench are - Whether the amount forfeited pursuant to cancellation of contract in excess of agreed liquidated damages, for making good loss of business opportunity amounts to capital receipt; Whether valuation of closing stock of bulk drugs can be brought down to Nil, although the opening stock was valued at Rs 12 crores, when in between the bulk drugs manufacturing unit was sold off and the leftover stock was merely expired drugs having no resale value in the market; Whether amount received by the assessee on a condition not to carry on the competitive business is in the nature of capital receipt; Whether there is any provision to substitute the consideration received with the fair market value of asset sold for computation of capital gains; Whether when assessee has sold shares of its loss making group
company to pay off financial institutions and to avoid any legal action, can amount to colourable device, merely because those shares were sold at reduced value to the Managing Director of such group company; Whether when under a knowhow transfer agreement, non compete fees has been separately paid, the remaining consideration received is only for transfer of knowhow; Whether this consideration amounts to capital receipt or subject to capital gains tax and Whether technical knowhow is an intangible asset, liable to be taxed under the head ‘Capital Gain'. And verdict partly goes in favour of the assessee.

Facts of the case

Compensation for cancellation of contract

The assessee company entered into a lease agreement by virtue of which the assessee leased Bulk Drug Plant to M/s. Tumkur Chemicals Limited ( ‘TCL') on receiving Rs.25,00,000 as security deposit. Later on, the assessee entered into an agreement of sale of very same Bulk Drug Plant for a consideration of Rs.5.75 Crores and the security lease amount was treated as advance amount. Similarly, the assessee also entered into lease agreement for lease of R & D Unit to TCL and received the security deposit of Rs.25,00,000. Subsequently, the assessee entered into an agreement of sale of the said R & D Unit treating the security deposit as a part of sale consideration and also received Rs.4.49 crores as advance. Pursuant to the agreement, the TCL was put in possession. The TCL sub-leased the said two Units to the RIL. However, the said agreements were cancelled. Since the Unit has been used for more than one year, the RIL had agreed to forego Rs.1.10 crores in favour of the assessee. Further, the said two Units were sold for Rs.8.00 crores to HILKAL Limited as against Rs.9.70 crores as agreed between the assessee and TCL. The loss of 1.70 crores was reduced Rs.1.10 crores. The said amount was treated as capital receipt and the same is not liable to be taxed. On appeal, the CIT(A) upheld the assessment order. On further appeal before the Tribunal by the assessee, the Tribunal held that the forfeited amount received by the assessee towards cancellation of agreement of sale is a capital receipt and the same cannot be taxed. Aggrieved, the Revenue has filed an appeal before the High Court.

The DR contended that the amount paid beyond the stipulated liquidated damages from the advance consideration shall be treated as revenue receipts for loss of business. He argued that as per the agreement failure on the part of the purchaser to perform his part of contract, the vendor i.e., assessee shall be entitled to terminate the agreements, and to claim Rs.25,00,000 and Rs.5,00,000 as liquidated damages from the advance consideration, however, the assessee had forfeited Rs.1.10 crores from the amount paid by the TCL. Therefore, any amount in excess of this would be treated as revenue receipt.

On the other hand, the AR contended that due to cancellation of agreement by the purchaser, the said two Units were sold for Rs.8.00 crores as against Rs.9.70 crores as agreed between the assessee and TCL. The loss of 1.70 crores was reduced Rs.1.10 crores and therefore, the said amount cannot be treated as Revenue receipt.

Valuation of closing stock

The assessee had discontinued the manufacture of bulk drug during the previous year ended 31-3-2000. The factory was leased to TCL as per the agreement dated 15-11-1999. The said factory was sub-leased to the RIL as sub-lessee of TCL. The stock of Bulk Drug which was valued at Rs.12.78 crores as on 31-3-2000 was valued at NIL in the account as on 31-3-2001. The AO observed that the said closing stock shall be the opening stock as on 1-4-2000, however, the assessee has shown NIL as on 31-6-2000. The AO assessed the closing stock at Rs.11,56,74,925 deducting a sum of Rs.1,21,000 towards the sale of stock. However, the CIT(A) assessed the value of the closing stock at Rs.1,49,82,784 after deducting the waste stock to an extent of Rs.10,06,92,141. These finding was challenged both by the assessee and the Revenue before the Tribunal. The Tribunal accepted the contention of the assessee and rejected the contention of Revenue. Aggrieved, the Revenue has filed an appeal before the High Court.

The DR argued that Tribunal failed to take note of the fact that the assessee had entered into an agreement of sale of Bulk Drug Unit and R & D Unit with TCL, the closing stock pertaining to the above was retained with the assessee. The assessee valued the stock pertaining to Bulk Drug Unit and R & D Unit as its realizable value at Rs.12.78 crores on 31-3-2000 and NIL on 30-06-2000. The assessee failed to explain as to what was the reason under which, the value of stock got suddenly eroded its value to Rs.3.00 crores, within three months.

On other hand, the AR argued that the assessee had discontinued the manufacture of bulk drug during the previous year ended 31-3-2000. It was submitted that out of Rs.12.78 crores of value of bulk drug, major portion of the stock was WIP, R & D stock, solvent, II crop material, major portions of which carried from many years whose value was reduced year after year on account of non-mobility. Regarding the stock of Unit at Jigani and R & D Unit, it was submitted that after sale of the unit along with all saleable items, stock left were merely unsalable items having no sale value in the market.

Anti competitive fees

The assessee received a sum of Rs.4.00 crores received from M/s.Recon Health Care Ltd pursuant to the agreement dated 30-06-2000. As per the agreement, the assessee and the promoters of the assessee-company were prevented from carrying on certain business activities. The said sum was treated as a revenue receipt by the AO. The Tribunal held that it is a capital receipt not liable to be taxed. Aggrieved, the Revenue has filed an appeal before the High Court.

Computation of long term and short term capital loss

The assessee transferred its Agro Division i.e., M/s.Agro Tech (P) Limited to RAL which is the subsidiary company of the assessee after obtaining the approval of the shareholders of the assessee. Against the net assets transferred, assessee received Rs.3.05 crores and, utilized the same to acquire Rs.25,50,000 equity shares of Rs.10/- each in the financial year 1997-98 and later Rs.1.00 crore in the financial year 2000-01. These shares were sold to Sri.Suresh, Managing Director of RAL at the price of Rs.2.55 lakhs, which was 1% of the value of the share. The assessee indexed the cost of acquisition to Rs.3,12,77,964 and arrived at long term capital loss of Rs.3,10,22,946. The AO came to the conclusion that buying and selling of the shares of RAL were between the interested persons and family members as the assessee failed to adduce evidence that the valuation of the share was done at arm length. The AO rejected the assessee's claim for long term capital loss.

With regard to the short term capital loss, the AO noticed that the assessee invested a sum of Rs.1.00 crore in equity shares of RAL in the financial year 2000-01 which was also later sold to Sri.Suresh, Managing Director of RAL for Rs.1,00,000 within a short duration and claimed a short term capital loss of Rs.99,00,000. The AO disallowed the entire short term capital loss. On appeal, the CIT(A) partially allowed relief. However, on further appeal the Tribunal deleted both the disallowance. The Tribunal held that as per section 48 unless and until it can be proved, that the assessee received something more than the apparent consideration, the AO cannot compute the capital gain artificially by substituting fair market value in place of consideration received. It was further observed that there is no provision to substitute the consideration received with the fair market value of asset sold. The Tribunal held that the transaction was at an arms length and the assessee basically wanted to get rid of the unit as a whole as well as the share of such unit. Aggrieved, the Revenue has filed an appeal before the High Court.

The DR argued that the Tribunal erred in allowing the short term and long term capital loss and the entire transaction of the purchase and sale of the shares between the close relatives and interested parties and family members, was a colourable device.

On the other hand, the AR submitted that RAL was a separate division which was incurring losses. Since the assessee had undertaken a corporate guarantee on behalf of RAL, the shares had to be sold off to pay credit facility availed by RAL from Karnataka Bank It was further submitted that the assessee sold the shares to Mr. Suresh, Managing Director of RAL at Rs.0.10 per share, whereas Sri.Suresh was neither a relative of any of the promoters of the assessee nor Director of any of the Group Company.

Consideration for transfer of knowhow

The assessee through agreement transferred the technical knowhow in respect of certain products to M/s.Recon Health Care Limited and in consideration received a sum of Rs.25.00 crores which was originally offered to tax as a revenue receipt. However, in the revised return, the same was claimed as capital receipt. This was rejected by the AO, but on appeal the CIT(A), it was held that as per the provision of Section 32(1)(ii), the knowhow acquired after 1-4-1998 is a capital asset for the purpose of allowance of depreciation. Therefore, the AO was directed to tax the said amount under the head capital gain. The assessee still aggrieved approached the Tribunal, however, the Revenue has not preferred any appeal. The Tribunal, examined the relevant clauses of the agreement and relying upon the judgment in C.I.T v/s VAZIR SULTAN TOBACOO COMPANY LIMITED held that in view of the agreement, the assessee is prevented from manufacturing goods with respect to Pharmaceuticals which has been sold to the M/s.Recon Health Care Limited, and therefore this amount was in the nature of capital receipt. Aggrieved, the Revenue has filed an appeal before the High Court.

The DR argued that as per the Agreement Rs.40.00 crores, was received i.e. for the sale of technical knowhow, the assessee has received Rs.25.00 crores, Rs.11.00 crores towards sale of brand, and Rs.4.00 crores towards non-competition fee. It was argued that the Tribunal erred in finding that 25 crores was received for not carrying out certain activities of business in Pharmaceutical goods. It was further argued that since technical knowhow is an intangible asset which is a capital asset u/s 32(1)(ii) for the purpose of depreciation and exigible to tax under the capital gain.

On the other hand, the AR argued that the effect of the agreement dated 30-06-2000 was not only for the transfer of knowhow, but also for non-disclosure of technical knowhow to others. He further argued that it is clear that under the Agreement, the assessee not only has to convey certain knowledge to the transferee but also impose restrain on itself on use of such knowledge.

Having heard the parties, the High Court held that,

Compensation for cancellation of contract

+ as per the agreement, if the purchaser fails to perform their part of the contract, the Vendor is entitled to terminate the agreement and claim liquidated damages of Rs.25,00,000/- and Rs.5,00,000/- respectively. However, in the present case, by mutual consent of the parties, the RIL had agreed to forego Rs.1.10 crores in favour of the assessee for loss of earnings due to the cancellation of agreement and the loss sustained in the sale transaction. The amount over and above Rs.30,00,000/- has to be treated as revenue receipts. The Assessing Authority as well as the First Appellate Authority had taken the entire amount of Rs.1.10 crores as revenue receipts and assessed to tax. In the facts and circumstances of the case, we are of the opinion that as per the agreement, the assessee is entitled to forfeit only a sum of Rs.30,00,000/- and the remaining amount of Rs.80,00,000/- has to be treated as revenue receipt and the assessee is liable to pay tax;

Valuation of closing stock

+ the said goods were not saleable items in the market. Unsalable items were kept in the godown. It was accumulated year to year. Subsequently, all the goods were disposed of in the plot No.28 of KIADB Industrial area, Jigani under the technical supervision of Mr.Swaminathan, in November 2001. The life of the bulk drug was expired and it cannot be sold in the market. The Central Excise Records also disclose that the said goods cannot be sold in the market. The Income Tax Appellate Tribunal, taking into consideration all these aspects of the matter and that the manufacturer has been completely stopped the manufacturing of the bulk drug, has taken the value of closing stock of bulk drug as NIL. The assessee has not adopted any colourable devices in order to avoid the tax. Hence, we find there is no infirmity or irregularity in the said finding. However, the judgment relied upon by Sri.H.S.Ramabhadran is not applicable to the facts of the case on hand. Hence, the finding recorded by the Tribunal is purely a question of fact. Accordingly, the second substantial question of law is held against the Revenue and in favour of the assessee;

Anti competitive fees

+ the said issue is fully covered by the judgment of the Supreme Court in the case of GUFFIC CHEMIC (P) LTD. v/s COMMISSIONER OF INCOME TAX wherein the Apex Court has held that the compensation received for restraining the assessee from carrying on competitive business was the capital receipt. The issue before the Supreme Court was whether the amount received by the assessee on a condition not to carry on the competitive business was in the nature of capital receipt. The Supreme Court clearly held that it is capital receipt. In the instant case, Rs.4.00 crores received from M/s. Recon Health Care Limited towards noncompetition to discontinue the business of three years has to be held as capital receipt. Accordingly, the third substantial question of law is answered in favour of the assessee;

Computation of long term and short term capital loss

+ we find that there is no infirmity in the finding recorded by the Appellate Tribunal. Under Section 48 of the Income Tax Act, the capital gain is to be computed after reducing the cost of acquisition of the asset, cost of any improvement thereto and the expenditure incurred in connection with the transfer of capital assets. In order to avoid the stringent action being taken by the financial institution, the assessee sold the shares to its subsidiary company in order to stabilize its financial position. No document has been produced by the Revenue to show that the transaction between the assessee and its subsidiary company is a colourable device. The finding recorded by the Appellate Tribunal is purely a question of fact. The Revenue has not made out a case to interfere with the same. Accordingly, we confirm the finding recorded by the Appellate Authority and the substantial question of law is held against the Revenue;

Consideration for transfer of knowhow

+ the caption of the said agreement is “The Agreement of Sale of Knowhow”. Another agreement was entered into between the assessee and M/s. Recon Health Care Limited. It was captioned as “Non-Competition Agreement”. Pursuant to the said agreement, the assessee has received Rs.4.00 Crores (Rupees four crores only). It was agreed between the parties that the assessee directly or indirectly shall not use the name of trademark “RECON” in any manner whatsoever in respect of any product and, or any business. Further, as per the Memorandum of Understanding entered into between the assessee and M/s.Cadila Health Care Limited, the assessee has transferred all tangible and intangible properties and handed over Pharmaceuticals business with brand name and trade mark. Hence, it is clear that an amount of Rs.25.00 crores received was not for restraining the assessee from carrying on the business, on the other hand, it is only a transfer of knowhow in favour of M/s. Recon Health Care Limited. The assessee has already received Rs.4.00 crores towards non-competition agreement;

+ Under Section 28(v)(a) any sum, whether received or receivable, in cash or kind, under an agreement for not carrying out any activity in relation to any business, or not sharing any knowhow, patent, copyright, trademark, license, franchise or any other business or commercial right of similar nature or information or technique likely to assist in the manufacture or processing of the goods is intangible goods acquired on or after 1-4-1998 is a capital asset and liable to be taxed under the head ‘Capital Gain'. The judgment relied upon by Sri.Ramabhadran reported in CIT v/s VAZIR SULTAN TOBACOO COMPANY LIMITED is not applicable to the facts of the present case. In that case, the compensation has been paid for termination of agency agreement which would be a capital receipt, whereas in the present case, there is a transfer of knowhow;

+ the technical knowhow is an intangible asset, liable to be taxed under the head ‘Capital Gain'. The order passed by the Appellate Tribunal holding that the consideration of Rs.25.00 crores received is also for not carrying out certain activities pertaining to the business in manufacture of Pharmaceutical goods. Any consideration received for not carrying out certain activity in connection with business is not taxable earlier to 1-4-2003. Therefore, the receipt is a capital receipt and not liable for the capital gain is contrary to law. Accordingly, the substantial question of law is answered against the assessee and in favour of the revenue.