Non-Compete Fee Qualifies as Allowable Revenue Expenditure

The Hon’ble Supreme Court (Supreme Court), while adjudicating a batch of appeals, wherein assessees had made payments of non-compete fees restricting the competing activities of their respective counterparts, resolved the common key issue regarding the nature of such payments specifically, examined whether such non-compete payments made by Assessees are classified as revenue expenditure deductible under Section 37(1) of the Income tax Act (ITA) or a capital expenditure.

In the case, the Revenue characterized the underlying payments as capital expenditure, on the reasoning that it provided the assessee with an advantage of an enduring nature by restricting competition for a specified period and thus would not an allowable expense. Alternatively, it was proposed that such payments have no apparent justification, these were not for the purpose of business of the assessee, thus not representing an allowable expense.

The Supreme Court delved into the essence and rationale of non-compete payments:

1. Non-compete fee is paid by one party to another to restrain the latter from competing with the payer in the same line of business.

2. It may be by way of a written agreement or by an oral understanding.

3. The restriction may be limited to a specified territory or otherwise; similarly, it can be for a specified period or otherwise.

4. Purpose of non-compete payment is to give a head start to the business of the payer. It can also be for the purpose of protecting the business of the payer or for enhancing the profitability of the business of the payer by insulating the payer from competition.

The Supreme Court spelt out the framework of residuary provisions of Section 37 of the ITA, i.e. such expenditure should not be an expenditure described in Sections 30 to 36 and should not be in the nature of capital expenditure or personal expenses of the assessee. The Court relied on landmark judgments to elucidate the classical tests for distinguishing between revenue and capital expenditures:

1. Alembic Chemical Works Co. Ltd. ([1989] 43 Taxman 312 (SC)): wherein it was observed that the idea of ‘once for all’ payment and ‘enduring benefit’ are not to be considered with a rigid approach and there is no single definitive criterion which by itself is determinative as to whether a particular outlay is capital or revenue. Further, it was held that the ‘once for all’ payment test is also inconclusive and what is relevant is the purpose of the outlay and its intended object and effect considered in a commonsense way having regard to the business realities. On this basis, one time payment for technical know-how was allowed on the premise that the same was for the better conduct and improvement of the existing business

2. Assam Bengal Cement Company Ltd. v. CIT ([1955] 27 ITR 34 (SC)) and CIT v. Bharti Hexacom Ltd. ([2023] 155 taxmann.com 322 (SC)/[2023] 458 ITR 593 (SC)): if the expenditure is made for acquiring or bringing into existence an asset or advantage for the enduring benefit of the business, it is properly attributable to capital and is of the nature of capital expenditure. If on the other hand, if it is made for running the business or working it with a view to produce profits, it is revenue expenditure.

3. Coal Shipments case ([1971] 82 ITR 902 (SC)) wherein similar payments to refrain from export was held to be related to actual shipment of coal in the course of the trading activities of Coal Shipments Pvt. Ltd. and had no relation to the capital value of the assets.

4. Empire Jute (Empire Jute Co. Ltd. v. CIT,[1980] 3 Taxman 69 (SC)) case wherein it dealt with amount paid by the assessee for purchase of loom hours and it was held where an advantage facilitates the operations of the assessee or enables it to make more profits without impacting its fixed assets, there the expenditure is revenue in nature.

5. CIT v. Madras Auto Service (P.) Ltd. ([1998] 99 Taxman 575 (SC)/[1998] 233 ITR 468 (SC)) case wherein even in the case of expenditure incurred by the tenant on construction of a new building which was to vest in the landlord was held to be allowable revenue expenditure on account of gaining business advantage in the form of lease of new building on lower rent.

The Supreme Court applied the judicial interpretations in the above landmark judgement to the nature of non-compete fees in the present case to characterize non-compete payments as revenue expenditures on the premise that the said payments do not create any new asset and  they merely restrict anticipated competition, with no certainty that intended benefit will materialize and doesn’t create any monopolistic situation for the assessee. 

Conclusion

The ruling reinforces established principles for characterizing an expense as revenue or capital in nature and should serve a precedent for future positions and assessments for characterization of non-compete fees and other transactional/business payments on similar footing.