Published Editorial

‘Look at’ or ‘look through’?

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The Hindu Business Line


Ravi Mehta
Tax Partner

Contributed by:

Sriram Krishna
Senior Tax Professional

Can a strategic sale of shares be classified as a sale of business because the sellers also handed over management responsibilities to the buyer? Can the inclusion of a non-compete clause from the sellers in the share purchase agreement (SPA) re-characterize the consideration as a business income, instead of capital gains? These questions arise subsequent to a recent judgment of the Punjab and Haryana High Court. This is expected to step up the level of controversy/ litigation between taxpayers and authorities.

Recently, the HC in the case of Sumeet Taneja, Supneet Kaur affirmed the ruling of the Income Tax Appellate Tribunal that sale of equity shares is effectively a sale of business and taxable as business income. The taxpayers, in this case, were promoters and directors of an Indian company, and they had, as part of the share transfer, agreed to (a) relinquish supervision and management of the Indian company; (b) hand over product database, customer support contracts, new client proposals, and so on; and (c) enter a two-year non-compete covenant restraining themselves from engaging in a similar activity. The HC eventually held such a transfer of shares as transfer of a business that resulted in business income. Generally, the domestic base tax rate for business income is 30 per cent, which is higher than the 20 per cent applicable to long-term capital gains.

The ruling seems at variance with several others, leading to uncertainty over the correct position in law. To begin with, it’s a settled position that company and shareholders are distinct from each other. Secondly, the HC ruling seems to have overlooked the general principles laid down by the Supreme Court in Vodafone’s case, which held that in the absence of abuse of corporate form, the Revenue Department/ Court should ‘look at’ the entire transaction as a whole and not adopt a ‘look through’ approach when ascertaining the legal nature of the transaction.

The apex court also held that, as a general rule, a transaction involving transfer of shares cannot be split into individual components, assets or rights such as the right to vote, right to participate in company meetings, management rights, controlling rights, control premium, brand licenses and so on, as shares constitute a bundle of rights. The HC ruling does not seem to provide strong reasons for ignoring the legal form of the transaction (that is, transfer of shares). Lastly, even assuming that the transfer was business, it could be classified only as a capital asset resulting only in capital gains. But here the share sale has been re-characterized as business income.

The ruling also seems to have arisen from the inclusion of the non-compete element. A couple of Mumbai ITAT judgments involving similar transfer of shares together with a non-compete clause did not allow splitting the composite consideration between sale and non-compete covenant. However, the HC seems to hold the entire consideration towards non-compete.

Strategic share transfer deals are generally likely to have covenants in their agreements similar to those listed in the HC ruling. Hence, the ruling (unless reversed by the Supreme Court) could increase the controversy/ litigation between taxpayers and authorities.

Several tax controversies related to merger-and-acquisition deals have been making headlines in recent times. These developments appear to suggest that the tax authorities are going beyond conventional approaches in assessing taxpayers. As laws in India undergo reforms, it is imperative that clarity, consistency and certainty emerge in the overall tax regime.