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A recipe that didn't cook up

T. C. A. Ramanujam

T. C. A. Ramanujam on a case where entering into non-compete covenant failed to serve as a tax-planning tool.

TAX avoidance is the minimisation of one's tax liability by taking advantage of legally available tax planning opportunities. This is contrasted with tax evasion, which entails the reduction of tax liability by using illegal means. The American tax system has perfected the technique of tax shelters, a device used by taxpayers to reduce or defer payment of taxes.

The Tax Reforms Act, 1986 limited the benefit of tax shelters significantly by classifying losses from such shelters as passive and ruling that passive losses can only offset passive incomes in arriving at taxable income. Tax planners have to device subtle methods to escape the clutches of the law. One such method used to be the entering into a non-compete covenant.

Damodaraswamy Naidu and Brothers happened to be a firm carrying on business of running a chain of hotels under the name Annapoorna and Gowrishankar in Coimbatore.

In July 1994, the brothers formed a new company, Shree Annapoorna Gowrishankar Hotels (P) Ltd. The business of the hotel was leased to the newly formed company for an annual rent of an over Rs 40 lakh. The company also entered into an agreement with the four brothers, styling it as a deed of compensation, under which, the company agreed to pay a further Rs 20 lakh in five equal instalments to the four brothers as consideration for the promise not to carry on the business of running hotels in or around Coimbatore for five years.

The four brothers to whom compensation was to be paid were also the shareholders and directors of the company. It was claimed by the brothers that the amount paid to them under the deed of compensation was a capital receipt not liable to tax.

Negativing the claim of the brothers, the Madras High Court pointed out that despite the formation of the company and the lease agreement, the fact remains that the persons who ran the business in reality were the same both before and after the formation of the company.

Instead of running the business of the hotels as partners of the firm, the same persons controlled and directed the hotel business as shareholders and directors of the company. The participation of the brothers in running the hotel business continued even after the formation of the company. The position of the brothers, therefore, did not change in substance after the company was formed and the company was given a right to run the business.

For deciding the true character of the payment made by the company to the brothers, one must take note of the aforementioned facts. Having regard to the totality of the circumstances, lifting the veil of the company was a permissible exercise which the Tribunal undertook. It is well settled that the formation of the company and registration under the Companies Act did not preclude the lifting of the veil, particularly where matters of taxation are concerned, if the circumstances of the case so warrant.

The finding that the payment made by the company to these brothers is in the nature of revenue receipt in the hands of the brothers would not negate the separate juristic existence of the company. The company continues to remain a legal entity with a right to hold property, contract, and so on. The true character of the payment made by it to the brothers who are shareholders and directors and who, as partners of the firm, own the building and the equipment used by the company for running the hotel, has to be judged by looking at the reality after removing or piercing the veil of the company, as the circumstances of the case justify such an exercise. The purpose of the deed of compensation in reality was only to screen the payment made under that deed from liability to income-tax in the hands of the assessee.

It was argued for the brothers that the company was a genuine legal entity, the lease date was genuine and the consideration for the payment was real. It was also argued that the payment was warranted by genuine business considerations. The High Court repelled these arguments observing that in exceptional cases the court is entitled to lift the corporate veil and to pay due regard to the economic realities behind a legal façade.

Non-compete covenant used to be a favourite tax-planning tool. The law, however, caught up with the tax planners when an amendment was inserted in Section 55 of the Income-Tax Act, 1961, first in 1997 and then in 2002 bringing to capital gains tax monies received for transfer of the right to manufacture or right to carry on business. It will indeed be a Herculean task to utilise this tax-planning tool hereafter.

It will be worthwhile to ponder over the failure of the tax planning scheme resorted to by the Coimbatore hoteliers. Probably, they would have succeeded if the scheme had been drafted in a more deft and subtle manner.

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