Retention in Escrow Account – Liability to Capital Gains

In most merger and acquisition transactions involving sale of a business or controlling interest in a company, a certain part of the sale consideration is not directly paid to the seller but is kept aside to meet certain contingencies which may arise in the next few years, such as contingent liabilities. This amount is retained in an escrow account with an escrow agent, with instructions as to how the amount is to be utilized and paid out to the seller, depending upon the happening of certain events. Similar contingent payments may prevail in ordinary non-merger cases, too.

An Escrow Arrangement is a monetary instrument whereby a third-party, i.e. an Escrow Agent, holds liquid assets for the benefit of two parties who have entered into an exchange/transaction, and disburses the liquid assets upon the fulfilment of a specific set of obligations on the part of both the parties under a contract i.e. on happening or non-happening of the contingent event.
 
The issue has arisen before the courts whether, in a situation where the monies kept in escrow are not released to the seller, pending the contingency, at all or released in a year subsequent to the year of transfer of the capital asset, the amount until certain obligations or conditions are fulfilled, would form a part of the consideration accruing or arising to the seller on transfer of the capital