May 12, 2022
Withdrawal of amount deposited in escrow account by buyer deductible from sale consideration
The Bombay High Court (“the Court”) held amount of consideration for sale of shares deposited by the seller (“Taxpayer”) in an escrow account, but subsequently withdrawn by the buyer from such account towards payment of contingent liabilities (i.e., for specific indemnity obligations of the seller as provided for in the SPA) will be allowed to be deducted from the full value of consideration (“FVC”) paid to the Taxpayer for computing tax on capital gains under section 45 of the Income-tax Act, 1961 (“the ITA”).1
The Taxpayer, along with other promoters of a company (“Target”) (holding 100% shares in the company) simultaneously entered into two share purchase agreements (“SPA”) to sell 100% shareholding of the Target. The SPAs provided that the consideration payable to the Taxpayer would be in two tranches as under:
Accordingly, the Taxpayer filed his income tax return (“ITR”) in the year of closing, and disclosed long-term capital gains by taking into account both the tranches of consideration (i.e., including the funds parked in the escrow account). The assessment was selected for scrutiny under section 143(3) of the ITA and the income disclosed by the Taxpayer was accepted as final.
Subsequent to filing of the ITR, certain liabilities (for which specific seller indemnity obligations existed as per the SPA) arose within the stipulated 2-year period, therefore, the consideration payable to the Taxpayer as per the second tranche (which was parked in the escrow account) was reduced to the extent of paying off such liabilities. As a consequence, the tax on capital gains that had already been computed and paid by the assessee, was more than the actual consideration received from the sale of shares of the Target.
The Taxpayer, with this reduction in income receivable from the sale of shares of Targer, filed an application under Section 264 of the ITA and pleaded that the quantum of capital gains computed previously in the ITR must be reduced. This request was refused by the Principal Commissioner of Income-tax (“the Revenue”).
The Revenue observed that in the absence of any provision in the ITA which allows for the deduction of contingent liabilities while computing capital gain, no deduction will be permissible. Further, as per section 240 of the ITA, the Revenue contended that once an assessment has been annulled, no refund will be granted on the returned income.
The Taxpayer preferred a Writ Petition before the Court against this order of the Revenue.
Ruling by the Court
The Court on appeal set aside the order of the Revenue and held the following:
The decision by the Court is welcome in context of M&A transactions. The Court has clarified the contours of computing capital gains under section 48 of the ITA and reiterated the real income theory. The Court has clarified that in case where the amounts deposited in the escrow account are subsequently withdrawn by the buyer, the same should not be included in the FVC while computing capital gains.
The usage of escrow accounts to provision for contingent liabilities of the target company or the seller, is quite common across M&A transactions. Taxability of amounts deposited in escrow account (including timing of taxation) has been frequently litigated.
Further, while the Court has elucidated on relief to claim refund by taxpayers on excess payment of taxes even after the filing of income tax returns and the closing of assessments, a number of questions with respect to when contingent or conditional payments should be offered to tax (in the absence of specific provisions) remains unanswered.
Recently, the High Court of Madras in case of Caborandum Universal Ltd. v. ACIT3held thatthe amount parked in the escrow account will be treated as accrued income and hence will be taxed under section 45 of the ITA. The High Court of Madras while arriving at this conclusion noted that the assessee actually received the full consideration (including the amount deposited in the escrow account) without any deduction of liabilities envisaged under the agreement. To this extent the decision of the Court is in line with the decision by the Madras High Court. In relation to the timing, the Madras High Court held that the entire amount had accrued to the assessee upon execution and thus was subject to tax in the same year itself (despite a certain amount from the consideration having been agreed to be retained in escrow to pay for any exigencies). However, the Madras High Court noting the language in the agreement, further goes on to hold that even if certain payoffs were to be made from the retention money, it will not in any manner alter the full and total consideration received by the assessee. Consequently, it held that even assuming certain payments were made from the amount retained in the escrow account, it would still not in any manner reduce the cost of acquisition.
The key principle noticeable from both rulings is that this determination of taxability of amounts deposited in escrow account needs to be a fact-specific exercise including review of the contours of the agreement, which may grant guidance on whether or not the amount parked in the escrow forms part of the full and final consideration. Therefore, it is important for taxpayers to carefully word the escrow / retention related provisions in the SPA to avoid any future litigation on this account.
Lastly, the Court has also importantly clarified the obligation of the tax authorities to levy tax only on the actual income chargeable under the ITA and if a higher tax is paid, re-emphasised the duty of tax authorities to compute the correct tax liability and grant refund of the excess tax paid by the taxpayers.
(We acknowledge and thank Nikunj Maheshwari, Student Nirma University, Ahmedabad for his assistance on this hotline.)
You can direct your queries or comments to the authors
1 Writ Petition No. 2475 of 2015
2 Reliance was placed to the Supreme Court decision in case of CIT vs. Shoorji Vallabhdas Co (1962) 46 ITR 144 (SC)
3  130 taxmann.com 133 (Madras).
The contents of this hotline should not be construed as legal opinion. View detailed disclaimer.