Non-Compete Fees Paid to Employees is Salary Income Not Business Income: Karnataka HC

Karnataka HC rules that non-compete fees paid to key employees at the time of joining is in the nature of “salary income”.

BRIEF FACTS:

In the case of Sasken Communication Technologies Ltd  (Taxpayer), the issue before the HC was.

1. whether non-compete fees paid to two key-employee rendering services outside India, i.e., in the US, would be regarded as taxable in  India and;
2. whether there was an obligation on the Taxpayer to withhold the taxes thereon.

The Taxpayer, an Indian company, has its subsidiary company in the US (US Co).

The US Co merged with the Taxpayer and subsequently, the  Taxpayer offered employment to Mr. and Mr. B who were  in employment with the US Co as they were in key strategic position of the US Co. Pursuant to this.

The Taxpayer  entered into three contracts with these two employees viz., 

1. Employment agreement;
2. Non-disclosure agreement (NDA) and
3. Employee non-compete agreement (NCA).

Employment agreement and NDA were generally entered  by the Taxpayer with all of its employees, whereas NCA was  entered with only these two employees as they were key employees of the company. The Taxpayer paid non-compete  fee to the employees after they became employees of the  Taxpayer. The Taxpayer did not deduct tax on non-compete  fees as the same was claimed to be salary income not  taxable in India pursuant to the India-US Treaty.

However,  the Tax Authority contended that since the NCA prohibited  employment with other Indian competing companies, the  rights and obligations of the parties under the NCA were to take effect in India, and hence, the non-compete fees arose  in India and was liable to withholding tax in India. The Tax  Authority also contended that the non-compete fees was in the nature of business income in the hands of employees in India.

The High Court upheld the ruling of the tribunal  considering that the facts noted by the tribunal were not perverse and ruled  that no taxes were required to be withheld as the income  was not taxable in India. 

Briefly, the HC approved the  following ruling of the tribunal:

1. The non-compete fees in the hands of the employees was in the nature of salary income as the same was  related to employment with the Taxpayer and prohibited the employees from taking up competitive employment upon termination of current employment with the  Further, as employees did not carry out any  business in India, the same was not in the nature of business income.
2. As the employees are residents of the US and are also rendering services in the US, the income is taxable  in the US as per Article 16 of the India-US Treaty.

Accordingly, there was no obligation on the taxpayer to withhold taxes.

CONCLUSION:  the non-compete fees paid by an employer to his employees for not competing with the company will be treated as salary income of the employees. Since non-compete fees arises from the employment of employees. In above case since employees are worked in US and they are receiving salary in US and hence employer is not liable to withhold tax in India.

Citation: Sasken Communication Technologies Ltd vs ITO; I.T.A. No. 241 of 2011 dated 10 June 2020; Karnataka High Court

DISCLAIMER: the case law produced here is only for information and knowledge of readers. In case of necessity do consult with tax professionals.