Non-Compete Covenant Expenditure: Capital or Revenue? - Tax Implications Unveiled

The authors are RR Shree Nikesh and K Vignesh Raj from Tamil Nadu National Law University

Abstract:

The ambiguous realm of classifying the money expended for non-competing covenants has been under scrutiny for decades. It has led to various businesses getting into trouble while filing taxes supposedly causing revenue loss to the government. With no clear distinction provided in the act and courts adopting different methods to determine the nature of the expenditure, it has perpetuated those ambiguities. To solve such ambiguities and to provide a blanket solution, the paper establishes the relevance of the "Test of Enduring Benefit" in determining the type of expenditure, particularly in the context of non-compete agreements, and further attempts to classify the non–compete covenant as an intangible asset, warranting capital treatment and challenging the deductibility of the same under Section 37(1) of the Income Tax Act, 1961.

Keywords:

Non – competing covenant; Enduring benefit; Intangible asset; Capital Expenditure

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1. The test of Enduring Benefit: Outdated?

The issue of whether an Expenditure is Revenue or Capital in nature has been contested before various judicial forums.  In the present context answering this ambiguity is necessary to determine the nature of the money expended for a non-compete covenant.[1] The Court of Sessions in Scotland provided the earliest decisions regarding this issue and held that Capital Expenditure is a type of Expenditure going to be spent once and for all whereas Revenue Expenditure is recurring in nature.[2] The Scottish Court of Sessions in Robert Addie & Sons Collieries Ltd. v. Inland Revenue [3] defined Revenue Expenditure in terms of the company’s working expenses or process of profit earning whereas Capital Expenditure was described in terms of Expenditure made for the acquisition of property or rights of permanent character which are necessary to carry on the business.

This chapter looks into the validity of the test of ‘Enduring Benefit’ that can be applied to determine the nature of an expenditure made to realize a non-compete agreement or clause.

1.1   Application of Enduring benefit in other jurisdictions:

Lord Viscount Cave in Atherton v. British Insulated and Helsby Cables[4] devised the “Test of Enduring Benefit” and held that when an expenditure is made with a view of bringing into existence an asset or an advantage for the enduring benefit of the trade, then such an expenditure would be capital in nature.

Expounding on this aspect, the Australian High Court held that[5] the words “permanent” or “enduring” do not indicate that the advantage will last forever. Rather, the distinction sought to be drawn is between recurrent expenses involved in running a business and expenditures for the benefit of the business as a whole such as the enlargement of goodwill of the company.

1.2   Application of Enduring benefit and Non-compete agreement (Indian Context):

In Commissioner of Income Tax vs. Chapman[6], it was held by the Calcutta High Court that a benefit is seen as enduring in a trade when the advantage gained is not transient but possesses a durability that warrants treating it as a capital asset and the test of Enduring Benefit has been accepted through various judicial decisions in the Indian context. The factor of durability has been further strongly emphasized in the case of  Alembic Chemical Works Co. Ltd. v. CIT[7], the tribunal held that “The expression “asset” or “advantage of enduring benefit” was evolved to emphasize the element of a sufficient degree of durability appropriate to the context”. This can be interpreted in two ways; the first is to adopt the durability test to determine the enduring nature and the other is the one adopted by the Alembic Chemical Works[8] case, that is, the test of enduring benefit is evolved to check the durability of the context. So, it is quite evident that the two concepts are complementing each other. Hence, it can be interpreted either way, the authors for convenience have adopted the former one.

A five Judge Bench of the Supreme Court of India in Assam Bengal Cement vs. CIT[9] held that if the expenditure is made for acquiring or bringing into existence an asset or advantage for the enduring benefit of the business, then it is properly attributable to capital and is of the nature of capital expenditure. It is only when the above test fails one can proceed further with the test of fixed or circulating capital i.e., acquisition or enlargement of assets, and consider whether the expenditure incurred is part of the fixed capital of the business or part of circulating capital. In a similar line, the courts in the following cases CIT v. Hindustan Pilkington Glass Works[10], Gujarat Mineral Development Corpn. Ltd. v. CIT,[11] and Beharilal Beni Parshad v. CIT[12] inter alia, have ruled that non-compete payment is capital in nature if it yields any enduring advantage to the acquirer.

Further, in the case of Neel Kamal Talkies[13], the court elaborated on the use of the enduring benefit test. In this case, the High Court of Allahabad held that the agreement between the assessee and the firm, where a payment was made for its execution, was a capital expenditure. The reason being, that the assessee had entered into an agreement which had the effect of eliminating competition so far as the assessee was concerned. The competitor was prevented from carrying out business activities for 5 years and the court considered such period enduring in nature. 

Commenting on the nature of Expenditure made concerning a Non-Compete Clause, the Supreme Court in CIT v. Coal Shipments[14], acknowledged that payment made to ward off business competition would constitute capital expenditure if the goal is to gain an advantage over some length of time. It was further noted that the outcome might differ if the duration of the advantage is uncertain and can be terminated at any moment. Therefore, the duration of the advantage must be clear and what amount of time would constitute an enduring benefit for the company would depend on the facts and circumstances of the case.

In circumstances where the competition has been restricted for a shorter span of time or there is uncertainty in the duration of restriction which can be rescinded at any time, the courts in CIT v. Bowrisankara Steam Ferry Co[15] have unilaterally decided that the money spent on non-compete agreement is revenue in nature and the same was held in Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd.[16]

From the above observations, it is clear that expenditures that are enduring are capital in nature and to be enduring such expenditures must adhere to the below criteria:

• Not transient in nature.

• The advantage gained should last for some time and not be uncertain. But this will only remain a substantiating factor[17] as “the length of time over which the competition is eliminated/benefit accrues is not the decisive factor in determining whether an expenditure is on capital or revenue account.”[18]

• Further, it is not necessary that there needs to be any addition or enlargement of capital assets of the concerned assessee since the mere existence of an asset or advantage of enduring nature would suffice.

• The amount of time required to qualify it to be enduring or durable in nature is subjective and has to be determined on a case-to-case basis.

1.3   Illustration of ‘Non-compete agreement’ being enduring in nature:

Let’s assume that a television broadcasting company is entering into a Share transfer agreement with one of its directors. The director with whom the agreement so entered has also been the company’s chairman, managing the affairs of the company for 8 years. In the said agreement, the director agreed not to compete with the business of the broadcasting company (transferee) for five years, and in the realization of the same, the company has paid him some amount of consideration.    

This case falls under the scenario of expenditure being capital in nature. This is because the company is deriving an enduring benefit out of the expenditure made for a period of five years which is crucial for a television broadcasting company to grow and establish a firm position in the market. The expenditure made is not transient in nature and it exists for some period of time hence not uncertain.

At this juncture, a question may arise regarding the treatment of 5 years as a crucial period for the case at hand. To substantiate the same, the authors would like to put forward that, according to Television Broadcasting in India - Empirical Growth Analysis, 2011,[19] an analysis of the TV Broadcasting growth trend, more than half of the Indian population has access to television in India. Such a trend would have increased by now. In addition, the TV universe estimates for 2020 from the Broadcast Audience Research Council have shown that TV Homes in India increased by 6.9% to 210 million from the previous 197 million in 2018. TV viewing individuals grew by 6.7% effectively an increase of 56 million. It is to be noted here that such an increase happened within a short period of 2 years.[20]    

Due to the rapidly evolving nature of the television broadcasting company and constant technological advancements, the 5-year period specified in the covenant is essential for the company to capitalize on its full potential and solidify its market position.

1.4   Relevancy of ‘Enduring benefit test’:

The aforesaid precedents point out that expenditures that are enduring, are capital in nature and to be enduring such expenditure should not be transient, the advantage gained should last for some period of time and should not be uncertain. Subsequently, the enduring benefit test stands relevant.

However, one might overlook the precedent laid down in the Empire Jute Mills[21] case and come to the conclusion that the Enduring benefit test is not a binding or conclusive test when it comes to determining the nature of expenditure made since other factors to be considered were established in the case. It includes an examination of whether the expenditure results in the addition of capital for the assessee, the creation of a new asset, the addition or expansion of the profit-making apparatus of the assessee, and whether the assessee acquired a source of profit or income when such spending was made.   

At this point, the authors contend that the court in no manner whatsoever discarded the Enduring Benefit test, instead, it only cautioned against blind and mechanical application of the test without regard to the facts and circumstances of a case.[22] The court itself clarified that there is no all-embracing formula that can provide a ready solution to the problem and every case has to be decided keeping in mind the peculiarity of the facts and circumstances of the concerned case.

Also, if one read that the case indeed discards the test, even then, its ruling is not binding as we already have the precedent of a 5-judge bench which has made the enduring benefit test conclusive. The Empire Jute Mills[23] case was a bench of 3-judge; hence it cannot overrule Assam Bengal’s ruling that came before it.   

The authors would like to assert that the Enduring Benefit Test has been consistently applied in determining the nature of Expenditure by various judicial bodies even after the Empire Jute Mills Case[24]. Commenting on the implications of the Empire Jute Mills case, it was observed by a 2 Judge Bench of the Madras High Court in Chelpark Co vs. CIT[25] that:

“We are unable to read these observations implying, that the test of enduring benefit is hopelessly outdated and would not be applicable, even if the facts and circumstances attract and justify its application.”

Therefore, the authors insist that the Enduring Benefit continues to be relevant and important in determining the nature of Expenditure provided that the facts and circumstances justify the usage of the test.

2.     Classification of ‘Non-compete covenant as Intangible Asset

The authors contend that there exist substantial reasons to consider a non-compete covenant as an Intangible Asset and subsequently the expenditure so made to acquire such asset is Capital in nature. In this chapter, the authors put forth arguments to validate the claim made.

2.1   The amount expended for Non non-competing covenant is a Capital expenditure.

If we observe Section 2(11)(b) and Section 32(1)(ii) of the Income Tax Act, 1961 both remain identical. It goes as follows:

Section 2(11)(b)

“block of assets" means a group of assets falling within a class of assets comprising—

(b) intangible assets, being know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature, [not being goodwill of a business or profession,]”

Section 32(1)(ii)

“(ii)know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature, being intangible assets acquired on or after the 1st day of April 1998, [not being goodwill of a business or profession]”

At this juncture, one needs to notice that the keyword in both these sections relevant to the present context is “similar”. One can use this as a gateway to demonstrate that this section is inclusive in nature thereby bringing non-compete agreements within its scope.

The Delhi High Court's Areva T&D case[26] sheds light on how the principle of ejusdem generis applies. This principle states that when general words follow specific ones, the meaning of the specific words should be limited to things of the same kind. Accordingly, the term “similar” in the above sections doesn't require an exact match. Importantly, the Court highlighted the legislature's intention behind adding "similar," emphasizing that the list of specific assets is not exhaustive and should not be confined solely to those six categories. 

The Karnataka High Court, in the case of CIT v Ingersoll Rand International Ind. Ltd.,[27] highlighted the significance of non-compete agreements as valuable assets. Payment of non-compete fees grants the acquiring party a set of rights, including the ability to restrict the recipient, directly or indirectly, from engaging in a business similar to the paying party's own. The Court found that these rights acquired through a non-compete agreement share similarities with the objectives behind intangible assets like patents, copyrights, trademarks, licenses, and franchises. All these assets aim to enhance business efficiency and success by providing an edge over competitors operating in the same field.

The authors believe that the object of acquiring know-how, patent, copyright, trademark, license, or franchise is to pursue business against rivals in the same business in a more efficient manner. It is pointed out that Non-compete agreements serve a parallel purpose, eliminating competition for a limited time. Therefore, the payment for a non-compete fee establishes the assessee company's acquisition of a commercial or business right, akin to know-how, patents, copyrights, trademarks, licenses, and franchises.

Since the commercial or business right thus acquired by the assessee through the non-competing covenant, runs parallel to the rights acquired by the know-how, patents, copyrights, trademarks, copyright, and licenses, the non-competing covenant too falls in the category of an intangible asset. Hence, the non-competing covenant also gets the color of an intangible asset.

In the case of Blaze and Central v. CIT[28], it was held that “any amount expended for acquiring a business or asset which generates income or for avoiding competition in business has to be treated as capital in nature.” From the above analysis, it was made evident that non competing covenant is an intangible asset, and from the case of Blaze Central[29] it is clear that the amount expended to acquire an asset is a capital expenditure, so it is obvious that non –a competing covenant being an intangible asset and the money expended to enter the non –competing agreement is a capital expenditure. Apart from that, the establishment of intangible assets qualifies the secondary test of capital expenditure propounded in the Assam Bengal case[30]. In addition, it also satisfies the other considerations identified in the Empire Jute Mills case[31] as there is an addition to the capital of the assessee, the creation of a new asset, acquisition of a source of profit through precluding competitors.

2.2   Section 32 of Income Tax Act, 1961: A Wider Interpretation

Section 32 of the Income Tax Act 1961 can be referred to establish that the Benefit obtained by entering into a Non-Compete Clause is an intangible Asset. Section 32 (1) (ii) provides for depreciation in respect of know-how, patents, copyrights, trademarks, licenses, franchises, or “any other business or commercial rights of similar nature being intangible assets”. The Delhi High Court in Commissioner of Income Tax v. Hindustan Coco Cola Beverages Pvt. Ltd[32] held that the provision allows depreciation on both tangible and intangible assets. 

 When categorizing intangible assets under this clause, the Supreme Court emphasized the importance of the word "similar." They clarified that it doesn't necessitate complete identicalness, but rather a substantial degree of correspondence, likeness, or shared characteristics, even if not all are identical.[33]

As mentioned already in, Areva T and D India Ltd vs. Deputy Commissioner of Income Tax (Delhi)[34], the principle of ejusdem generis applies to Section 32(1)(ii) of the Income Tax Act.  The Court clarified that while "business or commercial rights of similar nature" in Section 32(1)(ii) doesn't require an exact match with listed assets like know-how or patents, it does require the rights to be broadly similar in character. Hence, it is evident from the above precedents that Section 32(1) (ii) is not exhaustive and it has a scope to include other intangible assets which satisfy the criteria of “other business or commercial rights”.

It is further observed that interpreting the term “commercial rights” in Section 32(1) (ii), it is defined as “related to or connected with trade and commerce in general”.  As per Black’s Law Dictionary, commerce' is defined as the exchange of goods, productions, or property of any kind; the buying, selling, and exchanging of articles.

The Income Tax Appellate Tribunal, in the Assistant Commissioner of Income Tax v. Real Image Tech.[35] Case interpreted Section 32(1)(ii) of the Income Tax Act as granting businesses a key advantage. The rights conferred by copyrights and trademarks, such as the ability to control their use and exclude others, empower businesses to operate more effectively by leveraging exclusive knowledge or hindering competition.

In Pr. CIT v. Ferromatic Milacron India (P.) Ltd.[36], the High Court held that the payments made by the assessee company to its partner to ward off business competition constitute an acquisition of commercial rights. Also, as this acquisition has resulted in an enduring benefit and protected the business from competition, it qualifies as "business or commercial rights of a similar nature" under Explanation 3 to Section 32(1)(ii) of the Income Tax Act, making the assessee eligible for depreciation on such intangible assets. A similar observation was earlier made in the case of ITO v. Medicorp Technologies India Ltd.[37]

Analysis of the above precedents indicates that a non-competing covenant falls within the scope of section 32(1)(ii) of the IT Act, 1961 making it eligible to claim depreciation under the said section.

2.3   Section 37(1) r/w Section 32 of Income Tax Act, 1961

Section 37 provides for deduction only if the Expenditure is not covered under Sections 30 to 36, is related to the business of the assessee, and is not like Capital Expenditure.

Firstly, the authors have established that if the benefit gained out of the non-compete covenant is enduring in nature, the expense made in the realization of it should be capital in nature. Secondly, the authors have also established that a non-competing covenant is an Intangible asset, thereby, any money spent to realize such a covenant leads to the acquisition of an asset vindicating capital treatment.

As it has been established that the benefit accruing from a Non-Compete Agreement is to be considered as an intangible asset, the Expenditure made to acquire such asset is also capital in nature. Furthermore, the authors have showcased that the non-compete covenant is depreciable as a result of it falling within the ambit of section 32(1)(ii) of the Income Tax Act, 1961. Therefore, the money spent as consideration for the Non-Compete Agreement is not an allowable Deduction under Section 37(1) of the Income Tax Act, 1961.

3.      Conclusion:

The expenditures which are enduring are capital in nature and to determine the enduring nature, the factors such as durability; time (substantiating factor), and the mere existence of an asset or advantage of enduring nature would suffice. From the rulings of supreme courts and various High courts, it is evident that the test of Enduring Benefit is relevant to date and stands essential in resolving the ambiguity of the nature of Expenditure made towards the acquisition of a non-compete covenant.

In addition to the establishment of relevancy of Enduring benefit in resolving the ambiguity through case-to-case analysis, the authors have also come up with a more comprehensible and straightforward solution to resolve this problem. It is done through interpreting Section 2(11)(b) of the IT Act, 1961 along with the ruling of Blaze and Central v. CIT [38] to conclude, that the non-competing covenant is an intangible asset under Section 2(11)(b) and the money expended to acquire the covenant is a capital expenditure. Additionally, the authors have showcased that a non-compete agreement is eligible to claim depreciation under section 32(1)(ii) of the IT Act, 1961.

Further, Section 37 of the Income Tax Act, 1961 provides for deduction only if the Expenditure does not fall under Sections 30 to 36 of IT Act, 1961 and as the non-competing covenant is classified as intangible asset under section 2(11)(b) of IT Act, 1961, and qualifies depreciation under section 32(1)(ii) of IT Act, 1961 it is not an allowable deduction under Section 37 (1) of the IT Act, 1961.

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[1] It is made by one party to another to restrain the second party from competing with the first party (the payer) in a specified territory for a specified period. The second party accepts the negative covenant of not carrying on competing business for a specified number of years in the specified territory.

[2] Vallambrosa Rubber Co. Ltd. v Farmer [1910] SLR 488 (SC)

[3] Robert Addie & Sons Collieries Ltd. v Inland Revenue [1924] 8 TC 671 (SC)

[4] Atherton v British Insulated and Helsby Cables Ltd [1925] 10 TC 155 (HL)

[5] Sun Newspapers Ltd. & Associated Newspapers Ltd. v. Federal Commissioner of Taxation [1938] 61 CLR 337

[6] Commissioner Of Income Tax v Piggot Chapman And Co [1952] AIR 414 (Cal)

[7] Alembic Chemical Works Co. Ltd. v CIT [1989] 177 ITR 377 (SC)

[8] Alembic (n 7) 2.

[9] Assam Bengal Cement v. CIT [1955] AIR 89 (SC)

[10] CIT v. Hindustan Pilkington Glass Works [1983] 139 ITR 581 (Cal.)

[11] Gujarat Mineral Development Corpn. Ltd. v. CIT [1983] 143 ITR 822 (Guj)

[12] Beharilal Beni Parshad v. CIT [1959] 35 ITR 576 (Punj. & Har)

[13] Neel Kamal Talkies vs. CIT [1973] 87 ITR 691

[14] CIT vs. Coal Shipments [1971] 82 ITR 902 (SC)

[15] CIT v. Bowrisankara Steam Ferry Co [1973] 87 ITR 650 (AP)

[16] Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd. [1965] 58 ITR 241 (PC)

[17] CIT v Eicher Ltd [2008] 302 ITR 249 (Del.)

[18] CIT v Madras Auto Service (P) Ltd.[1998] 233 ITR 468 (SC)

[19] Television Broadcasting in India - Empirical Growth analysis since 1959, IMS Manthan - Volume VI, No. 2, Dec 2011

[20] BARC India releases TV Universe Estimates 2020, https://barcindia.co.in/announcement/barc-india releases-tv-universe-estimates-2020.pdf (last visited Nov 28, 2024)

[21] Empire Jute Mills v Commissioner of Income Tax [1980] 124 ITR (SC)

[22] Gujarat Mineral Development Corpn. Ltd. v CIT  [1983] 143 ITR 822 (Guj)

[23] Empire(n. 21) 5

[24] ibid.

[25] Chelpark Co Ltd v CIT  [1991] 191 ITR 249 (HC)

[26] Areva T and D India Ltd v Deputy Commissioner of Income Tax (Delhi) [2012] 349 ITR 127 (Del.)

[27] CIT v Ingersoll Rand International Ind. Ltd [2014] 48 taxamn.com (Kar.)

[28] Blaze and Central v CIT [1980] AIR 186 (Kar.)

[29] ibid

[30] Assam Bengal Cement Co Ltd v CIT [1955] 27 ITR 34 (SC)

[31] Empire (n 21) 5.

[32] Commissioner of Income Tax v Hindustan Coco Cola Beverages Pvt. Ltd [2007] 293 ITR 226 (SC)

[33] Nat Steel Equipment Pvt Ltd. v CCE [1988] AIR 631 (SC)

[34] Areva (n. 24) 7

[35] Assistant Commissioner of Income Tax v Real Image Tech. (P) Ltd [2008] 114 ITD 573 (Mad.)

[36]Pr. CIT v Ferromatic Milacron India (P.) Ltd [2018] 99 taxmann.com 154 (Guj)

[37] ITO v Medicorp Technologies India Ltd [2010] 2 ITR 367 (Trib)

[38] Blaze (n. 26) 8.