The question that often arises is whether the payment of compensation under a restrictive covenant, entered into with a rival not to carry on business either in the same area or in the same business, is taxable as income.

Restrictive covenants represent a sophistic way of carrying on near-monopolistic business. To eliminate competition in the market, an agreement is entered into with a rival not to carry on business either in the same area or in the same business. The agreement entails payment of compensation to the party that agrees to such a restriction.

Such agreements are frowned upon under the Indian Contract Act. Yet, it is the flavour of the day in Indian business circles, bifurcating the business, which hitherto was a single entity, among relations and family members. The question that often arises is whether the payment of such compensation under a restrictive covenant is taxable as income. This is a fascinating subject under the income-tax law.

In this case (2007 165 Taxmann 85 Karnataka), TTP Guruva Reddy entered into an agreement with TTP Guruva Reddy Constructions (P) Ltd that with effect from March 17, 1993, he will not compete with the company in the local limits of Tumkur for a period of five years in consideration of a sum of Rs 8 lakh paid by the company by way of compensation.

The question was whether the Rs 8 lakh was a capital receipt in his hands not liable for taxation. With the Income-Tax Appellate Tribunal (ITAT) having decided the matter against him, Reddy went in appeal before the Karnataka High Court. The court observed that restrictive covenant may not always be a negative factor.

Yet, the facts of the case showed that the Rs 8 lakh was nothing but income for purposes of levy of income-tax.

Details with regard to construction were not forthcoming in the agreement, which showed that Reddy himself had created the company.

It cannot strictly be construed a restrictive covenant as understood in law. Several rulings of the Supreme Court and various High Courts were cited in support of Reddys case. The Karnataka High Court was not convinced. It held that a reading of the agreement showed that it is not compensation as understood in terms of the material documents available on record. The payment made was nothing but an income and not a capital receipt in terms of law.

The assessment year involved was 1993-94. Finance Act, 2002 inserted sub clause (va) in Section 28 making such receipts under the non-compete agreement taxable as business or professional income. This amendment was cited before the Karnataka High Court to plead that in the assessment 1993-94, there was no such law to tax the non-compete fees as income. Yet, the High Court thought that the argument would be of no avail. It chose to treat the Rs 8 lakh as taxable income.

Does this mean that the amendment is retrospective? Not at all. The court clarified that each case has to be decided on its own facts.

In this case, Kwality Caf and Restaurant P Ltd (294 ITR AT 298) case, the assessee-family was carrying on the business of manufacture of the well-known Kwality brand of ice-creams for many generations in places such as Delhi, Mumbai and Kolkata.

Differences arose between the various groups in the family. In 1982, an agreement was entered into, under which, the company was allowed to use three trademarks. A memorandum of understanding (MoU) was reached under which the company agreed to terminate w.e.f June 1, 1995, all activities relating to manufacture of ice-cream under the name Kwality.

It received Rs 55 lakh for giving up the claim in respect of trademarks as well as for stopping the manufacture of ice-cream under the name Kwality. The question for consideration was whether the Rs 55 lakh was assessable to income-tax.

The ITAT held that the amount was received on account of surrender of user rights/goodwill as well as for giving up the right to manufacture under the brand name Kwality. The amount received for transfer of goodwill and trademarks should be treated as capital receipt.

The Bench apportioned Rs 55 lakh into two parts. Rs 15 lakh was treated as relatable to goodwill and trade name. The balance Rs 40 lakh was treated as relating to surrender of right to manufacture ice-creams under the brand name Kwality. The Tribunal did not accept the argument that the compensation was in the nature of damages not liable to tax.

The essence of the Tribunal order is that the sum estimated as relatable to goodwill and trademark was liable for capital gains tax. Transfer of goodwill became liable for capital gains tax w.e.f April 1, 1995. The amount considered by the Tribunal in the Kwality case related to the assessment year 1996-97. Non-compete fees became taxable from the assessment year 2003-04.

All these only show that great care is required in drafting restrictive covenants.