Introduction:
The income chargeable under the head ‘salaries’ is one of the heads of incomes which covers exhaustively, ‘payments’ made between persons in the capacity of employer and employee. The term ‘Salaries’, ‘perquisites’ and ‘profits in lieu of salary are defined under Section 17 of the Income Tax Act, 1961 (‘the Act’). Of the items that Section 17 of the Act covers, profits in lieu of salary is of special interest for the purposes of this Article.
At present, (after amendment vide Finance Act, 2001) Section 17 of the Act which defines the term ‘profits in lieu of Salary’ is so wide that it is capable of covering any payments made between the employer and employee (including payments received from the former or prospective employer). Through this Article the author attempts to analyze, taxability of the receipt pursuant to a contract entered into (not forming part of employment contract) by a person from former employer towards non-compete fee or other restrictive covenants’ few months or years after he was terminated from the rolls of employment.
Income chargeable under the head ‘Salaries’:
Income tax is a tax on ‘income’. The term ‘income’ is defined under Section 2 (24). Clause (iii) of Section 2 (24) includes “the value of any perquisite or profit in lieu of Salary taxable under Clauses (2) and (3) of Section 17” as income. Clause (3) defines the term ‘profit in lieu of Salary’ in the following words:
"profits in lieu of salary" includes—
(i) the amount of any compensation due to or received by an assessee from his employer or former employer at or in connection with the termination of his employment or the modification of the terms and conditions relating thereto;
(ii) any payment (other than any payment referred to in clause (10), clause (10A), clause (10B), clause (11), clause (12), clause (13) or clause (13A) of section 10), due to or received by an assessee from an employer or a former employer or from a provident or other fund, to the extent to which it does not consist of contributions by the assessee or interest on such contributions or any sum received under a Keyman insurance policy including the sum allocated by way of bonus on such policy.
(iii) any amount due to or received, whether in lump sum or otherwise, by any assessee from any person—
(A) before his joining any employment with that person; or
(B) after cessation of his employment with that person.
It is a settled principle that only revenue receipts are taxable under the Act, while capital receipts are exempted unless specifically mentioned in the Act. Payment received by an employee as compensation for loss of employment before the Amendment to Section 7 vide Finance Act, 1955 of the 1922 Act, was held to be a ‘capital receipt’ by the Apex Court in the case of Commissioner of Income Tax v. E.D. Sheppard [1963] 48 ITR 237 (SC)] and various other decisions. To overcome this, the Income Tax Act, 1922 was amended to include even payments received as compensation for loss within the ambit of Section 7. In the same way, to understand if ‘payment received by an employee from former employer towards non-compete fee or other restrictive covenants are liable to be taxed under Act’, it is first necessary to understand the nature and scope of the receipt in the hands of the employee. i.e. whether it is a capital receipt or revenue receipt.
In Kettlewall Bullen and Co. [(1964) 53 ITR 261], the Hon’ble Apex Court laid down the following broad principle in determining whether a payment is in the nature of capital or revenue receipt “Where on a consideration of the circumstances, payment is made to compensate a person for cancellation of a contract which does not affect the trading structure of his business, nor deprive him of what in substance is his source of income, termination of the contract being a normal incident of the business, and such cancellation leaves him free to carry on his trade (freed from the contract terminated) , the receipt is revenue: Where by the cancellation of an agency the trading structure of the assessee is impaired, or such cancellation results in loss of what may be regarded as the source of the assessee’ s income, the payment made to compensate for cancellation of the agency agreement is normally a capital receipt”.
The Hon’ble Apex Court in the case of Commissioner of Income Tax v. Best and Company (Private) Limited [AIR 1966 SC 1325] held that compensation received to refrain from selling or accepting any agency for explosives or other commodities competitive with those covered by the agency agreement now being terminated in the assessment year 1951-52 & 1952-53 as ‘capital receipt’ and therefore not assessable to tax under the head Salaries.
The Delhi High Court recently in the case of CIT v. Pritam Das Narang (2015) 61 taxmann.com 332 (Delhi) held as follows “The words 'from any person' occurring in section 17(3)(iii) have to be read together with the following words in sub-clause (A): 'before his joining any employment with that person'. In other words, section 17(3)(iii)(A) presupposes the existence of an employment, i.e., a relationship of employee and employer between the assessee and the person who makes the payment of 'any amount' in terms of section 17(3)(iii). Likewise, section 17(3)(iii)(B) also presupposes the existence of the relationship of employer and employee between the person who makes the payment of the amount and the assessee. It envisages the amount being received by the assessee 'after cessation of his employment'. Therefore, the words in section 17(3)(iii) cannot be read disjunctively to overlook the essential facet of the provision, viz., the existence of 'employment', i.e., a relationship of employer and employee between the person who makes the payment of the amount and the assessee”. Similar interpretation was assigned in the case of ITO v. Kuwait Airways Corporation (2017) 78 taxmann.com 187 (Mumbai Tribunal).
Relying on the above proposition, the Bangalore Tribunal in the case of MG. Mohan Kumar v. DCIT, (2016) 73 taxmann.com (Bangalore Tribunal) held as under “For assessment year 2007-08 amount received by assessee after cessation of employment for not sharing knowledge and secrets of trade of ex-employer to competitors would be capital receipt and could not be taxed as profit in lieu of salary under section 17(3)(iii)”
The author is of the view that as per the above decisions, the payment received by Mr. X could not be covered under the head ‘income chargeable under the head Salaries’ even though Clause (iii) to Sub-Section (3) to Section 17 is comprehensive enough and that payments that are due to or received by the employee for the past services rendered or compensation received on termination of employment till the Notice period of the employee, is only eligible to be taxed under this head.
Transfer of a Capital asset:
Section 12B of the 1922 Act and the present Section 45 states that “profits and gains arising from transfer of a capital asset effected in the previous year shall be chargeable to income-tax under the head “capital gains” and shall be deemed to be the income of the previous year in which the transfer took place.
Section 2 (47) defines transfer in relation to capital asset includes “(i) the sale, exchange or relinquishment of the asset or (ii) the extinguishment of any rights therein or (iii) the compulsory acquisition thereof under any law or (iv) ….(iva)….(v)…(vi)……”.
Section 2 (4A) of the 1922 Act defined the term ‘capital asset’ in a similar way as it stands today. Section 2 (14) of the Act defines the term ‘Capital asset’ to mean (a) a property of any kind held by an assessee, whether or not connected with his business or profession (b) any securities held by a foreign institutional investor which has invested in such securities in accordance with the regulations made under the Securities Exchange Board of India Act, 1992 but does not include…………”.
Applying the above provisions, in the case of Commissioner of Income tax, Punjab v. Prabhu Dayal (Decd. By Legal representatives) [1971] 82 ITR 804 (SC) the Hon’ble Apex court held that “the assessee possibly by some fortuitous circumstances discovered kankar in some places in the Jind State. This circumstance gave him an opportunity to bring about an engagement between the State of Jind and Shanti Prasad Jain and when Shanti Prasad Jain transferred his right to a new company, in the formation of which that assessee had a hand, he was promised certain yearly commission on net profits earned by the company. None of these activities of the assessee can be considered as a business activity but yet he did acquire an income yielding asset as a result of his activities. But the compromise decree destroyed that asset and in its place he was given Rs. 70,000 as compensation. This payment was neither in respect of the services rendered in the past nor towards the accumulated commission due to him. It was paid as compensation to him because he gave up his right to get commission in future to which he was entitled under the agreement. It was a price paid for surrendering a valuable right which, in our opinion, was a capital asset. Therefore, that receipt must be considered as a capital receipt”.
As rightly pointed out by the Hon’ble Apex Court in the decision of Prabhu dayal (supra), right to join any office of employment could be considered as capital asset as the definition under Section 2(14) is wider to include anything under its ambit and ‘extinguishment of such right’ for a consideration would amount to transfer as per Section 2 (47).
However, there is lack of clarity on the aspect of method of ascertaining cost of acquisition (as it is extinguishment of inherent right of a person) for the purpose of computation of profits or gains under this head and therefore, as per the decision of the Commissioner of Income Tax v. B.C. Srinivasa Shetty [(1981) AIR (SC) 972] one may say that computation mechanism fails and therefore not purported to be covered under Section 45”.
Profits and gains of business or profession:
An analysis under this head may not be required, as it is evident that Mr. X is not a person in the business of ‘entering into agreement to not compete or other restrictive covenants’.
In this regard, however, it is interesting to note that, Section 28 which deals with income taxable under the head ‘profits and gains of business of profession”, in sub-section (ii) Clause (va) includes “any sum whether received or receivable, in cash or in kind, under an agreement for
(a) Not carrying out any activity in relation to any business; or
(b) Not sharing any know-how, patent, copyright, trade-mark, license, franchise or any other business or commercial right of similar nature or information or technique likely to assist in the manufacture or processing of goods or provision for services
A clause such as the one available under the head “income chargeable under the head profits and gains of business or profession” is not explicitly present in Section 17 of the Act. Clause (ii) to Section 17(3) appears to be very wide however its interpretation has to be confined to cover only such payments as have some connection with employment, as held in Lachhman Das v. CIT, 124 ITR 706 (Del). As regards clause (i) of the said Section, the same can apply only if the compensation is either at or in connection with termination/medication of employment. The expression ‘in connection with something’ means intrinsically related to that thing as held in V.A. Vasumathi v. CIT, 123 ITR 94(Ker). In this decision, the court accepted the argument that the phrase is wide enough to cover transactions occurring either prior to or after the event with which they otherwise have a connection. This decision was followed in Stumpp Schuele v. CIT 190 ITR 152. The author is of the view that the payment of non-compete fee arises from an agreement entered into for that and does not necessarily arise on account of termination of employment.
As already stated the payment can be better described as a capital receipt and for a capital receipt to be taxable under the Act it must be specifically mentioned in the Act, otherwise it is understood that the same is not subject to taxation.
[The author is a Senior Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, Chennai]