Volume 5, Issue 24

1st October, 2012

Tax Alert
Allowability of Depreciation on Non Compete Fees and Business contracts including Clients and Clients Relationship

The Mumbai Bench of the Income-tax Appellate Tribunal (‘Tribunal’) in a recent case of Ind Global Corporate Finance Pvt. Ltd. v Income-tax Officer has considered the allowability of ( a) deduction for non-compete fees and (b ) depreciation on payments made under business transfer agreements.  The relevant findings of this case form the subject matter of this Tax Alert.

Relevant facts of the case:

Regarding Payment of Non Compete Fees

  • The tax payer was engaged in providing corporate advisory and merchant banking services.  It entered into a Business Transfer Agreement (‘BTA’) with another company (‘seller’) to acquire the merchant banking business of the seller.
  • In terms of the BTA, the tax payer paid certain sums as non-compete fees to the seller and the main shareholder of the seller for restricting them from:
    1. carrying out similar business,
    2. soliciting present and past clients,
    3.  enticing of employees,
    4. injuring the reputation of the business and prejudicing the goodwill of the business of the tax payer.
      The duration of the non-competition covenant was 36 months.
  • The tax payer treated the non-compete fee as deferred revenue expenditure in its books of account.  However, for tax purpose, it treated the same as revenue expenditure and claimed the entire amount as deduction in the year in which it was incurred.

Contentions of the Revenue:

Regarding Payment for Transfer of Business contracts including clients and clients relationship

  • A sum of Rs. 25 lacs was paid to the seller for transfer of business and contracts which included transfer of employees, customer and client list and relationship and certain business know-how relating to merchant banking business in the form of a manual which was a compilation of regulations, requirements and procedure relating to merchant banking and advisory services.
  • The payment for purchase of business and contracts was considered as payment for acquisition of know how and depreciation was claimed on the same treating the same as intangible assets.

Tax Payer's Contentions:

On Non Compete Fees

  • Creation of enduring benefit on account of making a particular payment is not a conclusive test to decide the true nature of the expenditure. 
  • The tax payer acquired an enduring benefit in the revenue field; hence the non-compete fees should be considered as revenue expenditure.
  • If the non-compete fees is considered as capital expenditure, the tax payer should be allowed depreciation on the same by considering it as an intangible asset.

On Purchase of Business including clients and clients Relationship

  • The business know-how manual should be considered as an intangible asset eligible for depreciation by placing reliance on a number of decisions
  • If the payment of Rs. 25 lacs is not considered as know how then the same should be considered as goodwill and depreciation should still be allowed on it.
  • If know-how is not considered as intangible asset, it should be considered as revenue expenditure.

Contentions of the Revenue:

On Non Compete Fees

  • By paying the non-compete fee, the tax payer had acquired the right to carry on the business for 36 months and had acquired a benefit of enduring nature.  Hence, the payment of non-compete fee was capital expenditure.
  • The tax payer itself had treated the non-compete fees as deferred revenue expenditure which showed that the tax payer also believed that it was capital expenditure.

On Purchase of Business including clients and clients Relationship

Revenue relied upon the orders of the assessing officer and the Commissioner of Income Tax (Appeals) denying the benefit of depreciation.

Tribunal’s judgment:

On Non Compete Fees

  • The Tribunal relied on the decision of the Special Bench of the Tribunal in the case of Tecumseh India Private Limited (127 ITD 1) where it was held that the non-compete fee was part of the initial outlay for setting up new business and to ward off competition and is hence capital expenditure.  (SKP’s comment: It may be pertinent to note here that as per tax jurisprudence, a decision of the Special Bench of the Tribunal is binding on other benches of the Tribunal.)
  • The time period of 36 months is sufficient to treat the expenditure as capital expenditure.
  • Depreciation will be allowed on non-compete fees

On Depreciation on know-how and Customer contracts

  • The business know-how manual was only a compilation of facts of regulations and procedures which were otherwise available in the market in the form of books.  The same can not be considered as know how.
  • For the purpose of claiming depreciation, know how is defined to mean “any industrial information or technique likely to assist in the manufacture or processing of goods or in the working of a mine, oil well or other sources of mineral deposits”.  In the present case, the seller had not transferred any industrial information or technique which could assist in the manufacture or processing of goods.  Moreover, the business of the tax payer was such that it did not require any industrial information or technique relating to the manufacture or processing of goods.
  • The tax payer has not produced any material before the Tribunal to demonstrate that the payment of Rs. 25 lacs was related to the acquisition of goodwill.
  • Transfer of business contracts including clients and client relationship cannot be considered as intangible assets.
  • Accordingly , depreciation cannot be allowed on the said payment of Rs. 25 lacs.

SKP’s comments:

Non compete fees have been recognized as intangible assets and depreciation has been allowed on the same which is a welcome relief.

However, the Tribunal has held that business contracts; customer and client list and relationship are not intangible assets for claiming depreciation for tax purpose. It appears that the Tribunal has not appreciated the judgments referred to by the tax payer where the Courts and Tribunals have held that business contracts, customer and client list and relationship and business know how are intangible assets and are eligible for depreciation.  The Tribunal has proceeded on the singular footing that the business know how manual was not know how and has not considered whether the same could be considered as “other intangible asset” being business or commercial rights of similar nature . 

It would be relevant to note that the Supreme Court, in a recent judgment in the case of Smifs Securities Limited ([2012] 24 Taxmann.com 222) has held that the excess consideration paid over the net assets of the business acquired is goodwill and is eligible for depreciation.  It appears that since the Supreme Court’s judgment was pronounced after the hearing in the present case was concluded, the Tribunal could not take note of the Supreme Court’s decision to consider the same as in the nature of goodwill. To this effect, the Tribunal’s judgment in the present case is likely to be challenged in the High Court and in which case, one will have to await the High Court’s verdict.