No capital gains tax on contingent payments if neither accrued nor received
Recently, the Bombay High Court has rendered an important ruling in the context of taxation of deferred consideration which are contingent in nature and are payable on transfer of assets. The Court held that deferred consideration contingent on uncertain events does not accrue in the hands of the transferor in the year of the transfer. Such consideration is only be taxable if it actually accrues or is received by the transferor.1
In case of exit by promoters / investors, etc., very often the consideration receivable is composed of two components – a fixed amount and a performance / other formula based contingent amount. The taxability of such deferred consideration in the year of transfer has been a debated issue. In the year of transfer, if the deferred consideration is not received / has not accrued to the transferor, taxation of the same could be very onerous. Further, in a cross-border context where the seller is a non-resident and subject to tax on capital gains in India (i.e., in situations where there is no relief under an applicable tax treaty), the buyer is required to withhold applicable taxes from the transfer consideration and often, there is a lot of disagreement between the parties as to whether deferred consideration is taxable (and consequently subject to withholding tax obligations on the buyer). This becomes particularly significant considering the fact that failure to withhold can result in consequences such as interest at the rate of 1% per month until the withholding is made, and 1.5% per month until the withheld tax is deposited with the government. A penalty equal to the amount of tax that should have been withheld may also be levied.
Mrs. Hemal Raju Shete (“Taxpayer”), an Indian resident individual, along with her family members (together the “Sellers”) held shares in M/s. Unisol Infraservices Ltd. (“Target Company”). They entered into an agreement on January 25, 2006 (“Agreement”) with M/s Radha Krishna Hospitality Services (p) Ltd. (“Buyer”) for the sale of shares in M/s. Unisol Infraservices Ltd. Pursuant to the Agreement, the Sellers were to receive INR 27 million (approx. USD 0.4 million) as initial consideration. The Agreement also provided for deferred consideration capped at INR 200 million (approx. USD 30 million). This deferred consideration was receivable over a period of 4 financial years subsequent to the year of transfer (i.e., 2006-07, 2007-08, 2008-09 and 2009-10) and contingent on the Target Company’s performance during that period. It was to be calculated as per a formula outlined in the Agreement. As per the formula, no part of the deferred consideration accrued or was received in financial year 2005-06, (which was the year in which the shares were transferred as per the Agreement).
In her income tax returns with respect to financial 2005-06, the Taxpayer declared capital gains computed on the basis of her share of the initial consideration. With respect to subsequent financial years (except one financial year in which no deferred consideration accrued on application of formula), the Taxpayer offered to tax the amounts which were received on the application of the formula provided in the Agreement.
With respect to financial year 2005-06, the tax authorities were of the view that the entire deferred consideration of INR 200 million was also taxable in the hands of the Taxpayer.
Therefore, the key issue before the Bombay High Court was whether the deferred consideration of INR 200 million was taxable in the hands of the Taxpayer with respect to the financial year 2005-06.
The High Court held that the deferred consideration of INR 200 million was not received or accrued with respect to financial year 2005-06 and therefore, cannot be taxed in the hands of the Taxpayer in that year on any notional or hypothetical basis.
Based on precedents laid down by the Supreme Court2 the High Court in this case re-iterated that income can be said to accrue to a taxpayer only when the taxpayer acquires a right to receive such income.
In the present case, the High Court examined the terms of the Agreement wherein it was clear that the sum of INR 200 million was only the maximum amount that could be paid to the Sellers. The actual sum of deferred payment was contingent on the performance of the Target Company in a financial year. Therefore, the High Court held that, in financial year 2005-06, the Taxpayer did not have a vested right to receive the deferred consideration of INR 200 million or any part thereof.
Thus, the High Court found that the entire sum of INR 200 million could not be viewed as deferred income accruing to the Taxpayer in financial year 2005-06.
The disagreement with respect to taxation of deferred consideration (in the context of transfer of capital assets) stems from the manner in which capital gains are taxed. According to the charging provisions dealing with capital gains, “any profits or gains arising from the transfer of a capital asset” shall be deemed to be the income of the year in which the transfer takes place. Further, in order to compute the gains subject to capital gains tax, the computation provisions provide that capital gains shall be computed as the full value of “consideration received or accruing” to the transferor as reduced by the original cost of acquisition of the asset and any expenditure incurred in connection with transfer of the asset. Thus, capital gains is to be calculated using the total consideration accruing to the transferor, and is subject to capital gains tax in the year the asset is transferred, regardless of when payment is actually received by the taxpayer.
The issue, brought to light in the present case, arises when the total consideration is not a fixed amount guaranteed to be received in the year of transfer or at a later date, but rather an amount calculated pursuant to a formula based on uncertain events. In such a case, calculating the total amount of consideration that may eventually accrue to the assesse becomes impossible in the year of transfer. It is important to note at this point that the income tax law specifically provides that when consideration accruing to a taxpayer as a result of a transfer of a capital asset cannot be ascertained, the fair market value of the asset on the date of transfer should be used for the purposes of computing the amount of income chargeable to capital gains tax. However, Revenue Authorities use the maximum possible amount of consideration receivable in order to calculate a taxpayer’s capital gains tax liability.
This issue has been dealt with by other High Courts in the past. For example, in 2012 the Delhi High Court3 held that pursuant to section 45(1), the entire amount of consideration must be offered to tax in the year of transfer even if part of such considerations is a deferred payment based on future contingencies. The High Court also held, relying on a Madras High Court4 decision, that in the event that that the entire consideration is not received by the assesse in subsequent years, such non-payment would be considered a capital loss in the year when the consideration becomes irrecoverable.
Interestingly, in the present case the Bombay High Court has approached the issue from a different perspective. Unlike the previously mentioned Delhi High Court and Madras High Court decisions, the Bombay High Court rightly does not start with the assumption that the entire amount of consideration has accrued to the taxpayer at the time of transfer. Instead, it relies on the decision of the Supreme Court to hold that income accrues to a taxpayer only when the he or she has the right to receive such income.
Although this position of law seems sound, and is a welcomed relief, taxpayers are likely to face difficulties till the matter is addressed by the Supreme Court in light of the existence of conflicting judgments of different High Courts. Further, this ruling leaves open the question of taxation of deferred consideration accrued or received in years subsequent to the transfer. One view could be that such consideration is taxable in the year it is accrued or received. However, such a view does not fit within the scheme of taxation of capital gains, which mandates that capital gains are taxable in the year of transfer of capital asset. Alternatively, after accrual or receipt of deferred consideration, it could be offered as income with respect to the year the transfer took place by revising previously filed income tax returns. However, this option would only be viable to the extent that such consideration accrues or is received within the time limit available for revising previous tax returns5. Of course, a taxpayer may also choose to follow the precedent laid down in the above-mentioned Madras and Delhi High Court decisions by offering the entire consideration to tax and claiming a capital loss (for any amount not actually accrued or received) in the year that the consideration becomes irrecoverable. With respect to the year of transfer, this may be very important from a liquidity perspective, particularly, where the proportion that the deferred consideration bears to the fixed consideration is very high. As none of these options provide a comprehensive solution to the tax treatment of deferred consideration contingent on uncertain events, litigation on the subject is likely to continue until required amendments to the ITA are made.
The uncertainty around this issue and the resulting risk of litigation can also have a significant impact on M&A involving earn-out payments, which are very common6. Parties often strive for tax certainty, and in doing so, generally tend to have long-drawn negotiations of the terms of earn outs.
1 CIT v Hemel Raju Shete, High Court of Judicature at Bombay, Ordinary Original Civil Jurisdiction, Income Tax Appeal No. 2348 of 2013
2 E.D. Sassoon & Co. Ltd. vs. CIT (1954) 26 ITR 27 and Morvi Industries Ltd. vs. CIT (1971) 82 ITR 835.
3 Ajay Guliya v ACIT TS 520 HC 2012 (Del)
4 T.V. Sundaram Iyenger & Sons Ltd. v CIT (1959) 37 ITS 26 (Chennai)
5 Pursuant to section 139(5) of the ITA a taxpayer can file a revised tax return at any time before the expiry of one year from the end of the relevant assessment year or before the completion of the assessment, whichever is earlier.
6 Earn out payments are typically payments calculated on the profits of the target company, and are made to the seller in years subsequent to the transfer of the target company.