Depreciation on Non-Compete Fees

Issue for Consideration

Depreciation is allowable u/s. 32(1) on buildings, machinery, plant or furniture, being tangible assets, and on know-how, patents, copyrights, trade marks, licences, franchises or any other business or commercial rights of similar nature, being intangible assets acquired on or after 1^st April 1998. At times, under an agreement for acquisition of shares or acquisition of a business or on cessation of employment of an employee, the seller, its promoters or the employee may be paid a non-compete consideration, in addition to the sale consideration. The agreement for such non-compete would generally provide that the payee shall refrain from carrying on a competing business for a certain number of years.

The issue has arisen before the High Courts as to whether such non-compete fee constitutes an intangible asset of the payer, which is eligible for depreciation u/s. 32(1). While the Delhi High Court has held that such non-compete fee is not an intangible asset eligible for depreciation, the Karnataka and the Madras High Courts have held that the rights acquired on payment of a non-compete fee are intangible assets eligible for depreciation.

Sharp Business System’s case

The issue had come up before the Delhi High Court in the case of Sharp Business System vs. CIT 211 Taxman 576.

In this case, the assessee was a joint-venture between Sharp Corporation and L & T. It used to import, market and sell electronic office products and equipments in India. During the relevant year, it paid Rs. 3 crore to L & T as consideration for the latter not setting up or undertaking or assisting in setting up or undertaking any business in India of selling, marketing and trade of electronic office products for a period of 7 years. In the accounts of the assessee, this amount was treated as a deferred revenue expenditure and written off over the period of 7 years. In the return of income, the entire sum paid was claimed as a revenue expenditure, on the ground that the payment facilitated its business and did not enhance or alter the fixed capital.

The assessing officer disallowed the deduction on account of non-compete fee, on the ground that it conferred a capital advantage of enduring value. The Commissioner(Appeals) rejected the assessee’s appeal, and also rejected the alternative contention of the assessee for allowance of the depreciation on such payment.

On further appeal, the Tribunal also rejected the contention that the non-compete fee constituted revenue expenditure, holding that the payment made by the assessee was not to increase the profitability, but to establish itself in the market and acquire market share, as the period of 7 years was quite long, during which any new company could establish its reputation and acquire a reasonable market share. It held that by keeping L & T away from the same business, the assessee hoped to acquire a good market share. The Tribunal also rejected the assessee’s claim for depreciation on intangible asset.

Before the High Court, on behalf of the assessee, besides arguing that the expenditure was of a revenue nature, it was argued that the Tribunal was wrong in concluding that the right to trade freely in the market was not an asset, and did not qualify for depreciation u/s. 32. Reliance was placed on section 32(1)(ii) for the proposition that intangible assets used for the business were eligible for depreciation. It was argued that once it was held that the assessee had acquired an advantage in the capital field, denial of depreciation amounted to an inconsistent approach.

Reliance was also placed on behalf of the assessee on the decision of the Supreme Court in the case of Techno Shares and Stocks Ltd vs. CIT 327 ITR 323, where the Supreme Court had held that holding of a membership card of the stock exchange amounted to acquisition of an intangible asset, which qualified for depreciation u/s. 32(1)(ii). On a similar reasoning, it was argued that the right acquired by the assessee for itself after payment of the non-compete fee was akin to a license or other similar rights, on which depreciation had to be given. Reliance was also placed on the decision of the Delhi High Court in the case of CIT vs. Hindustan Coca-Cola Beverages (P) Ltd 331 ITR 192, where it was held that intangible advantages all assets in the form of know-how, trade style, goodwill, etc. were depreciable assets.

On behalf of the revenue, it was argued that the question of allowability of depreciation did not arise at all, because the business or commercial rights of similar nature could not be said to arise overnight on account of payment of non-compete fee. Besides, the payment did not result in any intangible asset akin to a patent or intellectual property right. Therefore, it was claimed that the non-compete agreement did not create an asset of intangible nature or kind which qualified for depreciation.

While holding that the payment amounted to a capital expenditure, given the fact that the arrangement was to endure for a substantial period of 7 years, the Delhi High Court considered whether an expenditure conferring a capital advantage was necessarily depreciable. It observed that as was evident from section 32(1)(ii), depreciation could be allowed in respect of intangible assets. Parliament had spelt out the nature of such assets by explicit reference to know-how, patents, copyrights, trademarks, licences and franchises. It noted that so far as patents, copyrights, trademarks, licences and franchises are concerned, though they were intangible assets, the law recognised through various enactments that specific intellectual property rights flowed from them.

According to the Delhi High Court, licences were derivatives and often were the means of conferring such intellectual property rights. The enjoyment of such intellectual property right implied exclusion of others, who did not own or have license to such rights, from using them in any manner whatsoever. Similarly, in the matter of franchises and know-how, the primary brand or intellectual process owner owns the exclusive right to produce, retail and distribute the products and the advantages flowing from such brand or intellectual process owner, but for the grant of such know-how rights or franchises. In other words, the species of intellectual property like rights or advantages led to the definitive assertion of a right in rem.

Referring to the Supreme Court decision in the case of Techno Shares and Stocks(supra), the Delhi High Court was of the view that the Supreme Court had clearly limited its scope while holding that the right to membership of the stock exchange was in the nature of any other business or commercial right, which was an intangible asset, by clarifying that the judgement of the court was strictly confined to the right to membership conferred upon the member under the BSE membership card during the relevant assessment years. According to the Delhi High Court, that ruling was therefore concerned with an extremely limited controversy, i.e. depreciability of stock exchange membership. In the view of the Delhi High Court, the membership rights of a stock exchange was held to be akin to a license, because it enabled the member to access the stock exchange for the duration of the membership, and therefore it conferred a business advantage, which was an asset and clearly an intangible asset.

While analysing the question of whether the non-compete right of the kind acquired by the assessee against L&T for 7 years amounted to a depreciable intangible asset, the Delhi High Court observed that each of the species of rights spelt out in section 32(1)(ii), i.e. know-how, patent, copyright, trademark, license of franchise or any other right of a similar kind conferred a business or commercial right, which amounted to an intangible asset. The nature of these rights clearly spelt out an element of exclusivity, which enured to the assessee as a sequel to the ownership. In other words, if it was not for the ownership of the intellectual property or know-how or license or franchise, it would be unable to either access the advantage or assert the right and the nature of the right mentioned spelt out in the provision as against the world at large, in legal parlance, in rem.

According to the Delhi High Court, in the case of a non-compete agreement or covenant, the advantage was a restricted one in point of time. It did not necessarily, and in the facts of the case before the Delhi High Court, according to the court, did not confer any exclusive right to carry on the primary business activity. The right could be asserted in the present case only against L&T, and was therefore a right in personam.

The Delhi High Court further observed that another way of looking at the issue was whether such rights could be treated or transferred, a proposition fully supported by the controlling object clause, i.e. intangible asset. Every species of rights spelt out expressly by the statute, i.e. of the intellectual property right and other advantages such as know-how, franchise, license, et cetera and even those considered by the courts, such as goodwill, could be said to be transferable. Such was not the case with an agreement not to compete, which was purely personal.

The Delhi High Court therefore held that the words “similar business or commercial rights” had to necessarily result in an intangible asset against the entire world, which could be asserted as such, to qualify for depreciation u/s. 32(1)(ii). Accordingly, it was held that the non-compete payment made by the assessee did not result in an intangible asset eligible for depreciation.

Ingersoll Rand International Ind Ltd.’s case

The issue came up again before the Karnataka High Court in the case of CIT vs. Ingersoll Rand International Ind. Ltd. 227 Taxman 176 (Mag).

In this case, the assessee was engaged in the business of security and access control systems integration. During the relevant year, it entered into a business purchase agreement with another company, Dolphin, whereby it purchased the business of Dolphin for a consideration of Rs. 11.71 crore. The purchase consideration included a sum of Rs. 54.43 lakh paid to the promoter as non-compete fees, and a sum of Rs. 43.55 lakh paid to him for purchase of patents. The promoter was also appointed as the Vice President and Company Head of the assessee through a contract of employment.

Out of the total consideration of Rs. 11.71 crore, non-compete fees and patents were shown as assets in the books of account of the assessee, and the balance amount was shown as goodwill. The payment of non-compete fee was treated as a revenue expenditure in the computation of total income, though capitalised in the books of account. The assessee also claimed depreciation on the patents in the computation of its income, though it did not claim depreciation on goodwill.

The assessing officer held that the non-compete fee was capital in nature and disallowed it. The Commissioner(Appeals), while holding that the non-compete fee was in the nature of capital expenditure, also held that it was not eligible for depreciation. The Tribunal, while upholding the view that the non-compete fee was in the nature of capital expenditure, held that it was in the nature of a business or commercial right, and that depreciation was allowable on such an asset.

Before the Karnataka High Court, on behalf of the revenue, it was argued that non-compete fee did not constitute a commercial or a business right for allowing depreciation u/s. 32(1)(ii). It was argued that in order to claim depreciation, the assessee should own and use the asset in the business, and that this user test was not satisfied in this case. It was therefore argued that non-compete fee could not be classified as an asset, and now depreciation could be allowed thereon.

On behalf of the assessee, it was argued that by virtue of payment of the non-compete fee, the assessee could carry on business without any competition for the limited period, which in turn resulted in an advantage to the business, and as that advantage conferred on it a commercial and business right, once it was held to be of the nature of capital expenditure, the assessee was entitled to depreciation u/s. 32(1)(ii).

The Karnataka High Court referred to the decisions of the Delhi High Court in the case of Hindustan Coca-Cola Beverages (P) Ltd. (supra) and Areva T & D India Ltd.vs. Dy CIT 345 ITR 421 to understand the meaning of the term “any other business or commercial rights of a similar nature”. It further referred to the decision of the Madras High Court in the case of Pentasoft Technologies Ltd vs. Dy CIT 222 Taxman 209, where the Madras High Court had held that a non-compete fee amounted to an intangible asset eligible for depreciation, and the decision of the Delhi High Court in the case of Sharp Business System (supra).

The Karnataka High Court, while analysing the provisions of section 32(1)(ii), noted that in the definition of intangible assets, any  other business or commercial rights of similar nature were included. Therefore, such rights need not answer the description of know-how, patents, copyrights, trademarks, licenses, or franchises, but must be of similar nature as those assets, namely know-how, etc. According to the Karnataka High Court, the fact that after the specified intangible assets, the words “business or commercial rights of similar nature” had been additionally used, clearly demonstrated that the legislature did not intend to provide for depreciation only in respect of specified intangible assets, but also to other categories of intangible assets, which were neither feasible nor possible to exhaustively enumerate.

The Karnataka High Court noted that the words “similar nature” carried a significant expression. The Supreme Court, in the case of Nat Steel Equipment (P) Ltd vs. Collector of Central Excise AIR 1988 SC 631, had held that the word similar did not mean identical, but meant corresponding to resembling to in many respects, somewhat like or having a general likeness. According to the Karnataka High Court, therefore, what was to be seen was what the nature of intangible assets was, which would constitute business or commercial rights to be eligible for depreciation.

The Karnataka High Court noted that the intangible assets enumerated in section 32(1)(ii) effectively conferred a right upon an assessee for carrying on of business more efficiently, by utilising an available knowledge or by carrying on a business to the exclusion of another assessee. A non-compete right represented a right, under which one person was prohibited from competing in business with another for a stipulated period. It would be the right of the person to carry on the business in competition, but for such agreement of non-compete. The right acquired under a non-compete agreement was a right for which a valuable consideration was paid. The right was acquired to ensure that the recipient of the non-compete fee did not compete in any manner with the business with which he was earlier associated.

According to the Karnataka High Court, the object of acquiring a know-how, patent, copyright, trademark, license, or franchise was to carry on business against rivals in the same business in a more efficient manner, or in the best possible manner. The object of entering into a non-compete agreement was also the same, i.e., to carry on business in a more efficient manner by avoiding competition, at least for a limited period of time. On payment of non-compete, the payer acquired a bundle of rights, such as restricting the receiver directly or indirectly from participating in the business, which was similar to the business being acquired, from directly or indirectly suggesting or influencing clients or customers of the existing business or any other person either not to do business with the person to whom he has paid the non-compete fee, or the person receiving the non-compete fee is prohibited from doing business with the person who was directly or indirectly in competition with the business, which was being acquired. The right was acquired for carrying on the business, and therefore it was a business right.

The right by way of non-compete was acquired essentially for trade and commerce, and therefore qualified as a commercial right. Such a right could be transferred to any other person, in the sense that the acquirer got the right to enforce the performance of the terms of agreement under which a person was restrained from competing. When a businessman paid money to another businessman for restraining the other businessman from competing with the assessee, he got a vested right, which would be enforced under law, and without that, other businessmen could compete with the first businessman. By payment of non-compete fee, the businessman got a right which was a kind of monopoly to run his business without bothering about the competition.

The Karnataka High Court noted that the non-compete fee was paid for a definite period. The idea behind this was that, by that time, the business would stand firmly on its own footing, and could sustain later on. This clearly showed that a commercial right came into existence, whenever the assessee made a payment of non-compete fee. Therefore, according to the Karnataka High Court, the right which the assessee acquired on payment of non-compete fee conferred in him a commercial or business right, which was similar in nature to know-how, patents, copyrights, trademarks, licenses and franchises, which unambiguously fell within the category of an intangible asset. The right to carry on business without competition had an economic interest and a money value.

In the view of the Karnataka High Court, the doctrine of ejusdem generis would come into operation. The non-compete fee vested right in the assessee to carry on business without competition, which in turn conferred a commercial right to carry on a business smoothly. Once such expenditure was held to be capital in nature, consequently, the assessee was entitled to the depreciation provided u/s. 32(1)(ii). The Karnataka High Court therefore held that the assessee was entitled to depreciation on the non-compete fee.

A similar view was taken earlier by the Madras High Court in Pentasoft Technologies’ case (supra), though in that case the non-compete payment was for restraint on use of trade mark, copyright, etc.

Observations

One makes a payment, in the course of business either for meeting an expenditure or for acquiring an asset or a right. An expenditure can be either in the revenue field or in the field of capital. Where a revenue expenditure is incurred, no asset can be said to have been acquired and hence no depreciation is allowable. When a capital expenditure results in acquisition of an asset that is eligible for depreciation, the payer will be entitled to depreciation. Besides, being an owner of the asset, it is essential that the owner uses the asset and such user is for the purposes of business. On satisfaction of these tests, a valid claim for depreciation is made that cannot be frustrated for ambiguous reasons.

Any payment made, in the course of business, not resulting in acquisition of a tangible asset generally should be for acquiring some right or removing some disability and when seen to be resulting in to a business or commercial right should, without hesitation, be classified as an intangible asset, in view of the two landmark decisions of the apex court in the case of Techno Shares and Smifs Securites. It is inconceivable that a businessman would make a payment that does not endow him with business rights or, in the alternative, saves him from some disability that facilitates the conduct of his business efficiently.  Looked at from this angle, any non revenue payment results in acquiring a business right, provided it does not result in acquisition of a tangible asset.

The principle of user of an asset, in the context of an intangible asset, will have to be viewed differently. In the context, it will also include a case of preventing another person from using it against the assessee and therefore a non-user by the others, on payment, should be viewed as the user by the assessee. The authorities or the courts should appreciate this aspect or the character of the intangible asset while dealing with the concept of user.

A business or commercial right of a similar nature is vast enough to cover a good number of cases, where the payer, on payment, is seen to be facilitating the efficient conduct of business, by use or by non-user by the payee. A know-how, license, franchise, etc. are cases where the payer is enabled to carry on business with the protection of law or of the payee. Similarly, on payment of non-compete consideration, the payer acquires a protection from the payee for carrying on his business without competition. 

Both the Delhi and Karnataka High Courts seem to have adopted the principle of ejusdem generis, to arrive at diametrically opposite views. While the Delhi High Court was of the view that a right obtained under a non-compete agreement was not akin to trademarks, copyrights, licences, etc., the Karnataka High Court was of the view that such right is similar in nature, as both facilitate carrying on of business more smoothly.

The distinction between the right in rem and in personam perhaps is not relevant or conclusive in deciding the issue whether an asset is depreciable or not. Neither the law nor the courts require that a right in an asset should be against the world before a valid depreciation is allowed. In the case of Techno Shares & Stocks (supra), while the Bombay High Court had earlier held that the membership rights of the Bombay Stock Exchange was not an intangible asset eligible for depreciation, not being similar to other rights specified in section 32(1)(ii), the Supreme Court took a contrary view on the same principle of ejusdem generis, holding that such membership right was similar to a licence, since it permitted a member to carry on trading on the exchange. This was notwithstanding the fact that such right was a personal permission granted to the member under the bye-laws of the exchange, and therefore not transferable. In a similar manner, a right of non-compete, though not strictly transferable, can still be an intangible asset.

Therefore, though the Supreme Court may have observed that the ratio of its decision applied only to a case of membership rights of the Bombay Stock Exchange, the principles on the basis of which the case was decided, would apply equally for other payments under which a right to carry on a business is acquired, though non transferable. Interestingly, the Karnataka High Court has found such rights to be transferable by the payer for a consideration and has noted that the transferee should be in a position to enforce such rights against the payee.

Similarly, in the case of CIT vs. Smifs Securities Ltd 348 ITR 302 (SC), the Supreme Court held that goodwill arising on amalgamation of companies was an intangible asset eligible for depreciation. This was notwithstanding the fact that such a goodwill arose only to the amalgamated company, and was not on account of any transferable asset which can be put to any specific use.

From the two decisions of the Supreme Court on the subject of depreciable intangible assets, it is therefore clear that the Supreme Court has taken a broader view of the term, by permitting depreciation on business and commercial rights, in cases where the payment  permitted smoother functioning of the business, holding that such rights were similar to the specified rights, such as trademarks, copyrights, licences, etc.