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TAXATION Why payments for restrictive covenants should not be taxed. By Narayan Verma & Rajesh Kothari
Restrictive covenants in an agreement between an entity and its employee could preclude the employee from:
Now, the issue is: can such compensation received by a former employee be taxed as "profits in lieu of salary" under Section 17(3) of the Income Tax Act, 1961? Any payment made by an employer to an employee, or a former employee, does not, automatically, qualify for taxation under Section 17(3)(ii) of the Act. But compensation paid for the termination of employment, or for modification of the terms and conditions of employment, come under "profits in lieu of salary." But compensation for a restrictive covenant does not flow from the terms of employment. It is not a remuneration, or return for service. The compensation is not given during the period of employment, but after termination. Moreover, it is paid for the deprivation of future earnings. In Superintendence Co. of India vs Shri Krishan Murgui (1981), the Supreme Court held that the "restrictive covenants," or conditions, contained in the terms of employment could not be extended beyond the date of termination of services. Thus, on termination of employment, the employer-entity cannot enforce the terms restraining the erstwhile employee from divulging the secrets of the entity. The doctrine of "restraint of trade" applies only when the contract of employment ends. Compensation to employees for restrictive covenants is not paid for the loss of employment, but for preventing a person from carrying out certain activities which are prejudicial to the business interests of the employer. Ergo, the compensation paid for a restrictive covenant to a former employee has been held as capital receipt by the Mumbai Tribunal in M.H. Karani vs the Assistant Commissioner of Income Tax (ACIT). A similar view has been taken by the Chennai Income Tax Appellate Tribunal (ITAT) in K.S.S. Mani vs Income Tax Officer (ITO). The Chennai itat held that the compensation received in consideration for all restrictive covenants undertaken by the former employee for loss in profits from the business or profession in which he, or she, could have profitably engaged himself, or herself, is nothing but a capital receipt for the loss of a profit-earning source of income and, therefore, not liable to be taxed. Restrictive covenants in an agreement between an entity and a person engaged in business could restrain the person from carrying on similar business for a certain number of years, and competing. Here, the question is whether the compensation paid is a capital receipt or a revenue receipt. In Kettlewell Bullen & Co. vs Commissioner of Income Tax (CIT), the Supreme Court stated that the compensation would be revenue, and not capital receipt, even if it was received for the termination of an agency agreement, where the agency was one of the many which the person held, and the termination of the agency did not impair the profit-making structure, but was within the framework of the business (that is, it was a necessary incident of the business). But if the termination of the agreement impaired the profit-making structure of the person concerned, any compensation thus paid will constitute capital receipt. The decisions, therefore, establish that compensation for giving up a right to a source of income, or for the surrender of an income-yielding asset, is a capital receipt not taxable in the hands of the recipient. In arrangement with the Bombay Chartered Accountants' Society |
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At times, a person is compensated monetarily for agreeing to refrain from
carrying out certain activities, or agreeing not to part with certain information. Such
compensation is termed "payment for restrictive covenants." The payment may be
made by an employer to an employee who agrees not to divulge certain secrets of the
business, or even to a competitor to ward off competition. 