Can compensation escape tax net?

The issue whether compensation for breach of contract is taxable or not was recently considered by AAR in the case of Upaid Systems Limited, UK in AAR/885/2010. In the fact of the case Satyam India and Upaid, a UK resident company entered into an agreement by virtue of which Satyam was to develop a software for Upaid. Satyam developed the software but it was alleged that Satyam had given the software to two other companies also, which was not permitted under the agreement between Satyam and Upaid. Therefore, certain disputes arose between Satyam and Upaid and Upaid demanded compensation and the matter was taken to Courts in UK.

To reconcile the differences, parties entered into a Settlement Agreement. It provided for the parties to severe all ties with each other forever and for settlement of all the claims of the Upaid, Satyam agreed to pay an amount of $ 70 million.

Settlement agreement also provided that Upaid will grant a perpetual worldwide royalty free license on all of its patents, pending patents and any future patents to Satyam and its affiliates. The royalty free license was not assignable.

In short, the question posed before the Authority for Advance Rulings (“AAR”) is whether the amount receivable by Upaid from Satyam is a capital receipt and whether the said amount can be treated as income under any of the specified heads provided in the Income-tax Act, 1961.

Upaid claimed that the compensation is in the nature of capital receipt and not revenue receipt. Revenue took the position that it is a capital receipt but contended that it has to be taxed under the head Capital Gains and that the gain has accrued in India. Revenue also contended that a part of the payment had to be attributed to the grant by Upaid of a license to Satyam to use the patent for all times to come and that that part was liable to be taxed as royalty.

Authority ruled that “(i) The answer is that (subject to taxability of a portion as royalty) the compensation of the $ 70 million paid by Satyam to the applicant would be capital receipt in the hands of the applicant.

(ii) In the light of the ruling on question no. (i) and the finding that no capital gain is involved, the ruling is that the amount less that portion attributable to royalty, cannot be treated as income under any of the specified heads under the Income-tax Act.”

As for taxability of royalty the settlement agreement recites that grant of perpetual worldwide perpetual right is without consideration. It was submitted by Upaid that the recital is conclusive and the Revenue cannot go behind it. Authority, however, ruled that “on going through the settlement deed, it is clear that the rights acquired and secured by the applicant over the software, a literary work, and according to the Revenue, a process as well, is acknowledged and reaffirmed. In turn, the applicant gives a right to Satyam to use that right in perpetuity. The recital that it is done for no consideration can only be viewed as an attempt to avoid payment of tax on that part of the transaction.” However, the provisions of clause (iii) to the proviso to section 245R(2) which prohibits Authority to allow the application where the question raised in the application relates to a transaction or issue which is designed prima facie for the avoidance of income-tax were not raised by the Revenue.

On this aspect, Authority referred the quantum of royalty included in the consideration to be determined by the Assessing Authority.

It is important to note that no reference was made to the Double-taxation Avoidance Agreement between India and UK in arriving at the conclusion that the compensation for breach of contract receivable by a foreign resident is not taxable in India. AAR held that such compensation is not taxable under the Income-tax Act itself. Therefore, it appears that such compensation is not taxable in India irrespective of tax residence of the assessee.

H P Agrawal
(Author is a Sr. Partner in S S Kothari Mehta & Co.)

hp.agrawal@sskmin.com