The Gujarat High Court (Ahmedabad Bench) has held that payments for gratuity and leave encashment, even when made upon an employee’s exit under a Voluntary Retirement Scheme (VRS), are not considered part of the VRS compensation. They are terminal benefits related to the employee’s service, fully deductible as business expenses in the year of payment, and are not subject to amortization over five years under Section 35DDA of the Income Tax Act.
On transfer of self-generated trademarks, the High Court observed that the consideration received from the transfer of self-generated trademarks prior to Assessment Year 2002-2003 is a capital receipt that is not chargeable to tax under the head ‘capital gains’. This is because such assets have no conceivable cost of acquisition, which causes the computation machinery under Section 48 of the Act to fail. The amendment to Section 55(2)(a) of the Act, which deems the cost of such assets as ‘Nil’, is prospective in nature and does not apply to transactions before its effective date.
On transfer of marketing rights, the Court observed that the compensation received for the transfer and extinguishment of exclusive marketing rights, which function as an income-earning apparatus, is a capital receipt and not a revenue receipt. When the transfer of such rights severs the appellant’s connection to a source of profit, the consideration received is on the capital account.
The Division Bench comprising Justice A.S. Supehia and Justice Pranav Trivedi observed that the VRS had two distinct components: compensation paid to employees for opting for the scheme, and terminal benefits like gratuity and leave encashment. It held that gratuity and leave encashment are post-retirement benefits that accrue to an employee based on the service already rendered and are governed by the terms of employment. These payments are what an employee is entitled to upon retirement, whether voluntary or on superannuation, and are therefore ancillary to the VRS, not a part of the VRS compensation itself.
The Bench found the appellant’s bifurcation of these amounts to be correct and the AO’s approach of clubbing them together to be erroneous. The Bench also noted that the CIT(A) and ITAT wrongly confirmed the disallowance based on the non-production of employment contracts, which the AO had never requested in the first place. Further, the reliance on the prospective insertion of Section 43B(f) (w.e.f. 01.04.2002) to disallow leave encashment was deemed incorrect, as the provision only added a condition of actual payment for an already allowable expenditure.
On the nature of receipt for transfer of trademarks of Rs. 25 crores, the Bench observed that the transfer of trademarks is a transfer of a ‘capital asset’ as defined under Section 2(14) of the Act. The central issue was the taxability of the consideration received. For a gain to be taxed under ‘capital gains’, the computation machinery under Section 48 must be workable, which requires a quantifiable ‘cost of acquisition’. Whereas, for self-generated assets like goodwill and trademarks, where no cost of acquisition can be conceived, the computation mechanism fails.
The Bench noted that the amendment to Section 55(2)(a) of the Act by the Finance Act, 2001, which specifically deemed the cost of acquisition for self-generated trademarks as ‘Nil’, was prospective and effective only from Assessment Year 2002-2003. Since the transaction occurred in AY 2001-2002, prior to the amendment, the receipts were rendered as non-taxable as capital gains. The fact that many trademarks were unregistered was considered immaterial, as an unregistered trademark is still an intangible asset to which the same principles apply.
On the nature of receipt for transfer of marketing rights of Rs. 20 crores and Rs. 2 crores, the Bench observed that the exclusive marketing rights held by the appellant constituted an ‘income earning apparatus’. By transferring these rights, the appellant was stripped of a source of revenue, which was substantiated by the significant drop in its turnover and profit in the subsequent year.
The Bench held that when an income-earning apparatus is transferred or extinguished, the compensation received for it is a capital receipt, not a revenue receipt. It affirmed that when the ties with a profit-earning apparatus are snapped, the resulting consideration is on the capital account. Thus, the Bench concluded that the appellant was precluded from exploiting this source of income, and therefore the compensation received was a capital receipt, not assessable to tax under the prevailing law, similar to the treatment of self-generated trademarks.
Briefly, the appellant entered into a transaction to form a 50:50 Joint Venture (JV) Company named ‘Sarabhai Zydus Animal Health Ltd.’ with Cadila Health Care. Through a Deed of Assignment, the appellant transferred its veterinary/animal health business to this JV, and the total consideration for this transfer was Rs. 73 crores, which was allocated as follows: (a) Rs. 25 crores for the assignment of 46 veterinary trademarks/brand names ‘along with goodwill of the business’, which the appellant claimed as a capital receipt; (b) Rs. 20 crores for the assignment of marketing rights, also claimed as a capital receipt; (c) Rs. 28 crores for the transfer of know-how, which the appellant declared as a revenue receipt; and (d) Rs. 2 crores for a five-year transfer of marketing rights for products of ABIC, Bomac, and Bristol Myers Squibb, which was also claimed as a capital receipt.
The Assessing Officer (AO) treated the aggregate amount of Rs. 47 crores as revenue receipts, by observing that the trademarks were largely unregistered, they were indistinguishable from know-how, and the transfer of marketing rights did not amount to giving up the income-earning apparatus. The Commissioner of Income Tax (Appeals) and subsequently the Income Tax Appellate Tribunal (ITAT) partly allowed the appeals.
A separate issue involved payments made to employees under a Voluntary Retirement Scheme (VRS). The appellant paid a total of Rs. 6.86 Croes which included Rs. 1.77 Crores for Gratuity and Rs. 30.93 Lakh for Leave Encashment. The appellant claimed the gratuity and leave encashment amounts as fully deductible business expenses for the year, while seeking to amortize the remaining VRS compensation of Rs. 4.77 Lakh over five years under Section 35DDA of the Income Tax Act. The AO, however, aggregated the entire payment and allowed only a 1/5th deduction on the total amount under Section 35DDA.
Appearances:
Senior Advocate Saurabh Soparkar and Advocate B.S. Soparkar, for the Appellant/ Taxpayer
Advocate Maunil G. Yajnik, for the Opponent/ Taxpayer
