TAXABILITY OF DEFERRED CONSIDERATION IN CAPITAL GAINS

Section 45 provides for the charge of tax in respect of capital gains. It provides that any profits or gains arising from the transfer of a capital asset 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. Entire capital gains is chargeable to tax in the year of transfer of the capital asset, irrespective of the year in which the consideration for the transfer is received.

Section 48 provides for the mode of computation of the capital gains. It provides that the income chargeable under the head “Capital gains” shall be computed by deducting from the full value of the consideration received or accruing as a result of the transfer of the capital asset, the expenditure incurred wholly and exclusively in connection with such transfer, and the cost of acquisition and the cost of improvement of the asset.

In many business restructuring transactions, it is common that a certain consideration is paid at the time of transfer of the shares and additional amount is agreed to be payable subsequent year or years (“deferred consideration”).  The deferred payment is dependant upon achievement of certain turnover or profitability targets or happening of certain events.  Therefore, receipt of deferred consideration is contingent. 

The issue has arisen before the courts as to whether such contingent consideration is chargeable to tax as capital gains in the year of transfer of the capital asset or in the year of receipt of consideration.  These cases are discussed below:

Cases where it is held that deferred payment is taxable in year of receipt:

CIT v Mrs. Hemal Raju Shete 239 Taxman 176 (Bom HC) – The assessee filed her return of income for AY 2006-07 showing LTCG arising out of the sale of shares of M/s. Unisol Infraservices Ltd. (M/s. Unisol) to M/s.Radha Krishna Hospitality Services (RKHS) in terms of Agreement dated 25.01.2006.  As per agreement, the assessee alongwith other co-owners of the shares of M/s.Unisol were to receive Rs.2.70 crores as initial consideration.  Agreement also provided for deferred consideration which was capped at Rs.20 crores, which had to be paid in terms of formula prescribed in the agreement and was payable over a period of four years.  The Assessee had offered initial consideration to tax in her return.  The payout was depended on profits made by Unisol.  The amounts received on the application of formula (save AY 2007-08 for which there is no deferred consideration on application of formula) was offered to tax in the respective year.

The AO considered the deferred consideration for capital gains computation.  CIT(A) and ITAT deleted the addition.  The Revenue filed appeal before HC.

The HC observed that deferred consideration was depended on profits made by Unisol.  The HC observed that deferred consideration is not an assured consideration but is only the maximum that could be received.  The HC held that it is not a case where any consideration out of Rs.20 crores or part thereof (after reducing Rs.2.70 crores) has been received or has accrued to the assessee during the instant year.  The HC concluded that in the subject AY no right to claim any particular amount gets vested in the hands of the assessee and deleted the addition.

Universal Medicare (P.) Ltd. v. Dy. CIT [2020] 119 taxmann.com 377 (ITAT Mumbai) – During AY 2012-13, the Assessee sold its marketing division to another company through Business Purchase Agreement (BPA) by way of slump sale.  As per BPA, gross consideration was agreed at Rs. 567.07 crores. Out of which, Rs. 477.62 crores accrued and became payable upon transfer. Balance consideration of Rs. 89.44 crores was placed in an Escrow Account and would accrue to assessee annually in five equal instalments of Rs. 17.89 crores each. While filing its return for AY 2012-13, the assessee offered to tax lump-sum consideration of Rs. 477.30 crores as well as Rs. 17.89 crores which accrued to the assessee during the relevant previous year. The balance amount of Rs,71.56 crores was offered in four subsequent assessment years and accepted by Revenue in assessment. The AO held that the entire consideration including deferred consideration to tax in AY 2012-13 itself.  CIT(A) confirmed the findings of the AO.

The Tribunal noted that the Escrow account was executed in furtherance of BPA and the amount in Escrow Account would accrue to the assessee only on fulfilment of certain conditions and therefore deposit in Escrow Account was intrinsic and integral to transfer of marketing division under BPA and without it, sale would be incomplete. Based on these facts the Tribunal held that the income which did not accrue to assessee was not liable to tax during the said year.

The Tribunal held that the income for the year under consideration of Rs. 447.30 crore and further Rs. 17.89 crore was accrued to the assessee. The assessee offered the same under the head Capital Gain and no other income which is not accrued to the assessee is not liable to tax in the year under consideration. The remaining income was accrued only in subsequent Assessment Year i.e. A.Y. 2013-14 to 2016-17 that is an amount of Rs. 17.89 Crore each in four subsequent years, and the same has been offered for taxation under the head Capital Gain. The Tribunal upheld the approach of the Assessee and deleted the addition.

Cases where it is held that deferred payment is taxable in year of transfer of asset:

Ajay Guliya v. ACIT [2012] 24 taxmann.com 276 (Delhi HC) – The assessee shareholder of Orion Dialog Pvt. Ltd, divested its shareholding through a Share Purchase Agreement (‘SPA’) dated 15.2.2006. The Assessee offered a sale consideration of Rs. 60 lakhs to (being the price of 1500 shares at Rs. 4,000/- per share).  As per the SPA, the total consideration agreed upon in respect of each share was Rs.5750/-, of which Rs. 4000/- became payable on the execution of SPA and the balance was payable over a period of two years.  The AO held that the entire consideration income accruing to the assessee was to be considered for capital gains computation. CIT(A) allowed the appeal of Assessee. 

However, the ITAT held in favour of Revenue.  The ITAT held that Section 45 is the charging section and ordinarily acquires primacy whereas Section 48 is merely computing mechanism. The ITAT observed that shares were transferred on the date of execution of the SPA by the Assessee. There is no material on the record or in the agreement suggesting that even if the entire consideration or part is not paid, the title to the shares will revert to the seller.  The ITAT held that the controlling expression of “transfer” in the present case is conclusive as to the true nature of the transaction.  The fact that the assessee adopted a mechanism in the agreement that the transferee would defer the payments would not in any manner detract from the chargeability when the shares were sold. 

On appeal by Assessee, the HC held that no substantial question of law arises for consideration and upheld the Order of the ITAT.

T.A. Taylor (P.) Ltd v ACIT [2018] 66 ITR(T) 146 (Chennai – Trib.) / [2018] 98 taxmann.com 366 (Chennai  ITAT) – The Assessee-company entered into a slump sale agreement with PKAPL for transfer of its business division for total sale consideration of Rs. 18.31 crores.  As per agreement, assessee received Rs. 16.02 crores in relevant AY and balance sum of Rs. 2.29 was kept in Escrow Account and same was received in subsequent FY.  The Assessee computed capital gains for impugned AY considering sale consideration at Rs. 16.02 crores. The AO held that date of actual receipt of consideration was irrelevant and computed capital gains for impugned assessment year taking Rs. 18.31 crores as sale consideration.

The ITAT held in favour of revenue observing that profits or gains arising from a slump sale can be correctly computed only if the total consideration arising to an assessee on account of sale is reckoned. There is no provision which allows the assessee to segregate the consideration as per slump sale agreement in accordance with the year of receipt. 

In the instant case, there was no deferred consideration mentioned in the slump sale agreement. The ITAT observed that no doubt, release of the escrow amount, is dependent on satisfaction of various responsibilities undertaken by the assessee in relation to the slump sale. However, this by itself would not be a reason to hold that consideration for the slump sale was not Rs. 18.31 crs. Since consideration was clearly mentioned in slump sale agreement, segregation of consideration into two parts could not be a reason to say that capital gain arose only with reference to first part.  The ITAT held that entire sale consideration was to be taxed as capital gain.

Coming to the judgment of Hon’ble Bombay High Court in the case of Hemal Raju Shete (supra), the ITAT observed that in that case the agreement considered clearly divided the consideration to initial consideration and deferred consideration. The ITAT observed that it is for this reason the HC directed the exclusion of the deferred consideration for computing the capital gains. The ITAT held that in the instant case , there is no deferred consideration mentioned in the slump sale agreement and depositing a part of the consideration in an escrow account will not be equivalent to a deferred consideration.

T.V. Sundaram Iyengar & Sons Ltd. v CIT [1959] 37 ITR 26 (MAD HC) – The assessee was carrying on business in the purchase and sale of motor cars, spares and accessories.  The Assessee had on hand certain lorries taxies and delivery vans.  The assessee was the managing agent of the Southern Roadways Ltd.  In November, 1946, the assessee sold its entire fleet of 15 lorries, six taxies and four vans to the Southern Roadways Ltd. for a sum of Rs. 2,20,250. Subsequently, on 18th December, 1946, the Southern Roadways Ltd. wrote to the assessee asking it to reduce the price to Rs. 1,92,834. This was done in view of the fact that the State Government at that stage proposed to nationalise road transport. By a letter dated 17th January, 1947, the assessee agreed to this reduction. Subsequently, the Government again changed their policy and as a consequence the Assessee agreed to accept Rs. 48,800 being the WDV of the vehicles and to accept sale consideration in the form of paid up shares in Southern Roadways Ltd.

The HC held that to attract liability to tax under section 12B it is sufficient if profits have arisen, that is to say, if the assessee has a right to receive the profits.  The HC observed that it is not necessary that the assessee should have actually received the profits.  The HC held that undoubtedly the assessee had the right to receive the price and, therefore, the profits are taxable during the relevant AY.  The HC observed that if it subsequently happens that the money is not actually received, that would be a capital loss arising in the year when the money became irrecoverable and that cannot be considered in relevant AY. 

Anurag Jain v. AAR [2009] 183Taxman383 (Madras HC) – The Assessee, a NR, was shareholder in private Indian company.  He decided to transfer all the shares held by him in said company to via SPA.  As per the SPA, the consideration for sale of shares was split in two consideration, i) an amount equal to 2.3 million USD payable at the time of transfer of shares; and (ii) balance constituting the contingent payments to be made in first year, second year and third year after the closing payment.  The manner of determination of the contingent payment was provided in the SPA which was supported by other documents like the employment agreement.  The Assessee filed application seeking advance ruling on its liability of capital gains tax in respect of the said transfer of shares.

The AAR (reported as Anurag Jain, In re [2005] 277 ITR 1/145 Taxman 413 (AAR – New Delhi)), on a combined reading of the employment agreement, non-competition agreement and the SPA, concluded that contingent payments payable under the SPA were in substance and reality payment for ensuring performance under the employment agreement to achieve the desired object of exceeding EBITDA and had no real nexus to the consideration for the sale of the shares, etc.  The AAR ruled that (i) the gains arising to the petitioner from the transfer of shares were chargeable to tax under the head ‘Capital gains’; (ii) (a) initial lump sum payment received in AY 2004-05 represented the full value of the consideration under the SPA and, therefore, gains arising to the petitioner from the transfer of shares covered by the SPA would be computed by taking the initial lump sum payment as the true value of the consideration; and (b) contingent payments as could be determined at the end of the first year, second year and third year could not be taken into account in computing the capital gains but they would be taxable under the head ‘Salaries’ based on the associate employment agreement. The Assessee filed writ petition to HC.  The HC held that it was not factually in dispute that the said associated employment agreement formed part of the share purchase agreement.  The HC observed that, the entire issue had been considered in a threadbare manner and there was absolutely no reason for the Court to come to a conclusion that the finding was either perverse or totally opposed to law.  The HC upheld the AAR order.

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