Direct Tax Alert

BACKGROUND

The issue of the allowability of a non-compete fee as a deductible expenditure has been an area of dispute between the taxpayer and the tax authorities. The tax authorities have often sought to treat the non-compete fee as capital expenditure, often coupled with a denial of depreciation. The Supreme Court¹ has held that payment of non-compete fee does not result in acquisition of a capital asset or alteration of profit-making structure of the business and is allowable as revenue expenditure under section 37(1)² of the Income-tax Act, 1961 (IT Act).

We, at BDO India, have analysed and summarised the key aspects of this judgement and provided our comments on its impact hereunder:

FACTS OF THE CASE

• The taxpayer, a company engaged in the business of importing, marketing and selling electronic office products and equipment in India, is a joint venture between Sharp Corporation and Larsen & Toubro Limited (L&T). Sharp Corporation is engaged globally in designing, manufacturing and marketing electronic products, while L&T is engaged in the same business as that of Sharp in India.

• The taxpayer paid INR 30 mn to L&T as consideration for L&T agreeing not to set up, undertake or assist in any business in India relating to sale, marketing or trading of electronic office products for a period of 7 years. Such amount was claimed as a deductible revenue expenditure in return of income as non-compete fee.

• The tax officer treated the non-compete fee as capital expenditure on the premise that it resulted in an enduring benefit by eliminating competition. Under normal litigation route, this matter reached the Supreme Court with the key issue being allowability of non-compete fee. 

SUPREME COURT JUDGEMENT

The Supreme Court, while holding that non-compete fee is an allowable revenue expenditure under section 37(1) of the IT Act, made following key observations:

• Non-compete fee from the payer’s perspective is paid in anticipation that absence of competition from the other party for specified period or territory secures a benefit in terms of enhancing its profitability. However, there is no certainty that such benefit would accrue, while the payer may still not achieve the desired result, in spite of a non-compete arrangement.

• Such payments merely facilitate carrying on of business more efficiently and profitably, and it neither results in creation of any new asset nor accretion to profit earning apparatus of the payer. The enduring advantage, if any, by restricting a competitor in business, is not in capital field.

• Duration of competitive restraint is not determinative of nature of expenditure and as long as the advantage is not in capital field and leaves fixed assets untouched, such expenditure, would be an allowable revenue expenditure.

• Therefore, the non-compete fee paid by taxpayer only kept a potential competitor out of same business, did not eliminate competition or create any monopoly. Hence, did not amount to acquisition of a capital asset or a new profit-earning structure. Accordingly, the non-compete fee paid to L&T is allowable as revenue expenditure under section 37(1) of the IT Act.

BDO INDIA COMMENTS

This judgment provides long-awaited clarity on the perennial question whether an expenditure incurred by taxpayer is capital or revenue. The Supreme Court has emphasised that mere restriction of competition, without acquisition of a capital asset or expansion of profit-earning structure, does not characterise an expenditure as capital in nature.

The judgement is expected to resolve litigation on non-compete fee, particularly in cases where tax authorities have sought to treat such non-compete fee as capital expenditure solely on basis of duration or perceived enduring benefit. The judgment emphasises that a non-compete fee should be examined in substance and commercial effect, and not merely by reference to the duration of the restraint or the presence of an incidental enduring benefit. The ratio laid down in this judgement should also help in deciding pending cases related to characterisation of a particular business expenditure, whether it is a capital or revenue expenditure.