Tax Insights

(1)

1 PwC pwc.in

Tax Insights

24 August 2023

Compensation paid for premature contract termination is deductible revenue

expenditure; non-compete fee paid is a capital expenditure qualifying as an intangible asset eligible for claim of depreciation – Bombay High Court

In brief

The Bombay High Court¹ on perusal of all the facts and the relevant provisions and relying upon the judicial precedents previously pronounced on similar issues, in the case of the taxpayer held that the compensation for premature contract termination is a revenue expenditure deductible under the provisions of the Income-tax Act, 1961 (the Act). It also held that the non-compete fee paid is a capital expenditure in the nature of an intangible asset eligible for claim of depreciation under section 32(1)(ii) of the Act.

In detail

Facts

• The taxpayer was earning income mainly from advertising in the intermittent breaks of various programmes that it was relaying on its radio station. To procure advertisement from various clients, it had entered into an agreement with an Indian company, X Limited.

• A dispute arose between the two companies resulting in the termination of the agreement entered into by the taxpayer with X Limited. Consequently, on account of the said termination, the taxpayer was liable to pay the f ollowing –

- Compensation to X Limited for premature termination under the advertisement and sales termination agreement (ASTA); and

- Non-compete fees restricting X Limited to enter into similar business for two and half years under the restrictive covenant agreement (RCA).

• The Tax Of f icer disallowed the compensation paid by the taxpayer to X Limited under the ASTA and RCA, treating the same as capital expenditure within the meaning of section 28(va) of the Act.

1 ITA No. 675 of 2018

(2)

2 PwC Tax Insights

• Both the Commissioner of Income-tax (Appeals) [CIT(A)] and the Income-tax Appellate Tribunal (Tribunal) passed the order partly in favour of the taxpayer by treating the payment towards premature contract termination as a deductible revenue expenditure while holding the non-compete fees paid to be capital in nature but qualifying as an intangible asset eligible for claim of depreciation under section 32(1)(ii) of the Act.

High Court’s observations and decision

• With respect to the compensation paid for premature contract termination under the ASTA, relying on the ruling of the Supreme Court in the case of Ashok Leyland Limited², the Bombay High Court observed that on account of termination of the agreement and payment of the premature compensation, the taxpayer was relieved of its liability to pay the commission it was required to pay under the agreement for the current and the subsequent years.

• Moreover, as a matter of commercial expediency, it cannot be stated that by terminating the agreement and avoiding the business expenditure, it acquired any enduring benefit or any income yielding asset. Based on the above, the Bombay High Court affirmed the view of the Tribunal and the CIT(A) to hold that the

compensation for premature contract termination was revenue in nature and a deductible business expenditure.

• With respect to the non-compete fees paid under the RCA, it was not disputed before the Bombay High Court that the said expenditure was in fact a capital expenditure since by making such expenditure, the taxpayer had acquired enduring benefits. The question before the Bombay High Court was whether payment of non-compete fees was covered within the definition of an intangible asset under Explanation 3 to section 32(1)(ii) of the Act, and consequently, whether it was eligible to claim depreciation under the provisions of the Act.

• The Bombay High Court, relying on the decision of its Division Bench in the case of Piramal Glass Limited³ and India Medtronic (P) Limited⁴, upheld that the expression ‘or any other business or commercial rights of similar nature’ used in Explanation 3 to section 32(1)(ii) is wide enough to cover non-compete fees since the same provided enduring benefit to the taxpayer and also protected the taxpayer’s business against competition, including a person who had worked closely with the taxpayer.

• Based on the above, the Bombay High Court concluded that the amount paid towards non-compete fees would be eligible for depreciation under section 32 of the Act.

The takeaways

This is a welcome decision as the Bombay High Court has reaffirmed the position on two recurring issues in f avour of the taxpayers. The Bombay High Court, applying the principles laid down by the Supreme Court, in the case of Ashok Leyland Limited² has reaffirmed the characterisation of premature contract termination fee as revenue in nature by confirming that no enduring benefit arises on account of payment of compensation for premature termination of a contract. The Bombay High Court, relying on its coordinate bench decisions, has adopted a consistent view by confirming that the non-compete fees qualify as an intangible asset as per Explanation 3 to section 32(1)(ii) of the Act, and is hence eligible for claim of depreciation under the provisions of the Act.

2 CIT v. Ashok Leyland Limited [1972] 86 ITR 549 SC

3 Pr. CIT v. Piramal Glass Limited [IT Appeal No. 556 of 2017]

4 Pr. CIT v. M/s. India Medtronic (P) Limited [IT Appeal No. 1453 of 2017]

(3)

pwc.in

In this document, “PwC” refers to PricewaterhouseCoopers Private Limited (a limited liability company in India having Corpora te Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers International Limited (PwCIL), each member firm of which is a separate legal entity.

Tax Insights

About PwC

At PwC, our purpose is to build trust in society and solve important problems. We’re a network of firms in 152 countries with over 328,000 people who are committed to delivering quality in assurance, advisory and tax services. Find out more and tell us what matters to you by visiting us at www.pwc.com.

PwC ref ers to the PwC network and/or one or more of its member f irms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details.

Follow us on

Facebook, LinkedIn, Twitter and YouTube.