Merger and acquisition (M&A) activity has dropped off considerably due to the current economic slowdown. The deal cycle has lengthened and there is prolonged negotiation on valuation issues and other commercial considerations such as non-compete arrangements.
Often, in any acquisition, the buyer pays “non-compete” fees to prevent the seller from undertaking the same/similar business activities. The payment may be significant under certain circumstances; in that context, the tax treatment of non-compete fees paid by the buyer is very important.
There are several issues surrounding the tax implications of payment of non-compete fees in the hands of the buyer. Some of the key issues are:
• whether payment of non-compete fees is revenue expenditure or capital expenditure (although in the hands of the seller it is revenue income);
• if it is revenue expenditure, whether it can be amortized in its entirety in the first year and be considered as allowable tax deductible expenditure or whether it should be amortized over a period of years for tax purposes; or
• if regarded as capital expenditure, whether tax depreciation it could be claimed.
Under the provisions of the Income-tax Act, tax depreciation at 25% is available on certain intangible assets: know-how, patents, copyrights, trademarks, licences, franchises, or any other business or commercial rights of similar nature. Given this provision, can it be possible for the buyer of the business to classify the non-compete consideration paid by it to the seller as an acquisition of “right” being in the nature of “business or commercial rights” eligible for tax depreciation at 25%?
Recently, the Madras tribunal, in a decision dated 16 January in the case of ITO v. Medicorp Technologies India Ltd (2009-TIOL-203-ITAT-MAD), granting relief to the assessee held that non-compete fees paid by Medicorp Technologies under an agreement for non-competition is in the nature of business or commercial right eligible for tax depreciation.
These are the facts:
• Medicorp is in the business of manufacture and distribution of bulk drugs and intermediaries, and exporting these products to the US, Canada, Europe and Australia.
• Another company, Medispan Ltd (MS), was engaged in the business of development and production of medical and pharmaceutical formulations. MS had been exporting these pharmaceutical products to various South American, African and South-East Asian countries.
• MS agreed to transfer the business and activities of its export division to Medicorp. The business transfer agreement among other things provided that out of the total consideration of Rs5.33 crore, Rs2 crore was payable as a consideration towards acceptance of a non-compete obligation for 10 years, in respect of exports of bulk drugs, pharmaceutical products and formulations.
• Medicorp, in its tax return, claimed the payment of non-compete fees of Rs2 crore as revenue expenditure. However, another claim was also made before the assessing officer (AO) to grant tax depreciation on the non-compete fee. The AO rejected both claims.
• The commissioner of income–tax (appeals) or CIT(A) held that non-compete fees were intangible assets, eligible to tax depreciation.
• A bundle of rights had been acquired, which included a consideration of Rs2 crore for acquiring the non-compete obligation. By agreeing to a non-compete obligation, the seller—MS—was restricted for a period of 10 years from selling, marketing, registering products in foreign markets, conducting business outside India on its own or with a partner in bulk drugs, pharmaceutical products and formulations.
• The non-compete obligation acquired was a business/commercial right, to be used as a tool for business.
• The non-compete right acquired was similar to other intangible assets on which tax depreciation is available under the Act.
• By relying on the definition of an “asset” in the Advanced Law Lexicon, the revenue authorities contended that “non-compete obligation” was not an asset as it has no market value and is not non-transferable, nor it could it be sold or assigned.
• Without prejudice to the above, even if the non-compete obligation is treated as an asset, it is not of a similar nature as “know-how, patents, copyrights, trademarks, licences, franchises” to be eligible for tax depreciation.
• There is no diminution in the value of such an asset.
• Reliance was placed on certain decisions where it was held that depreciation on “goodwill” was not eligible, as it was not similar to other intangible assets specified in the Act, so depreciation should not be granted even on non-compete fees.
The tribunal, in its decision, has held that the non-compete fee is an asset and qualifies as an intangible asset, eligible for tax depreciation. The decision of the tribunal is summarized as under:
• Allowance for “depreciation” under the Act is a statutory allowance, and it is not confined, necessarily, to the diminution in value of the asset by wear and tear. To demonstrate this, the tribunal noted that there are certain class of assets which either enjoy accelerated tax depreciation or no tax depreciation at all. For example, there are items of assets for which depreciation is allowed at 100%; but it could not mean that the effective life of these items was only one year. Conversely, cars manufactured outside India and acquired between 28 February 1975 and 31 March 2001 were not eligible for tax depreciation.
However, this did not mean that such motor cars did not undergo wear and tear. This shows that the provisions of tax depreciation do not necessarily follow the traditional concept of an asset, and an accountant’s approach to depreciation. The tribunal in fact held that the taxation laws are known to have been used as a tool for implementing the economic/fiscal policies of the state.
• The tribunal also noted that computer software is eligible for tax depreciation from fiscal 2002-03. The tribunal held that computer software generally once loaded on a computer cannot be resold, and loses its assignability and transferability. Hence, though practically it could have no market value, it still remains eligible for tax depreciation.
• Accordingly, the tribunal held that capability to have a market value, assignability, transferability or diminution in value are no more the touchstones on which the admissibility for depreciation under the Act has to be tested.
• Based on reasoning and the fact that Medicorp had made a payment of Rs2 crore as non-compete consideration to MS to ward off competition in the export business acquired by it from MS, it concluded that “non-compete right” is an asset in the nature of “business or commercial right”.
• It further held that such right is in the nature of other intangible assets such as copyright, trademark, licence or franchise, being eligible for tax depreciation at 25%, on the premise that the non-compete right was acquired on an exclusive basis and in case of breach the assessee could sue, similar to a case of copyright, trademark, licence or franchise, where too the owners have exclusive business/commercial rights and where they can sue if there is a breach.
• Thus, the tribunal held that the non-compete right acquired by Medicorp was eligible for tax depreciation under the Act at 25%, upholding the order of the CIT(A).
By upholding the grant of tax depreciation on non-compete consideration, which could possibly constitute a significant component of the entire deal value, a buyer would be able to reduce its acquisition cost.
In a broad sense, this decision provides guidance on tax treatment of non-compete fees in the hands of the buyer of the business.
It is important, however, that the amount of non-compete fees is commercially justifiable and defensible.
This is a welcome decision and will provide impetus to the M&A story of Indian companies.
Ketan Dalal is executive director and Manish Desai is associate director, PricewaterhouseCoopers. Your comments and feedback are welcome at email@example.com