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M&A transactions oftentimes adopt a ‘deferred consideration’ mechanism, to fulfil the purchase consideration payable on such transactions. Deferred consideration refers to consideration, which is/ will be payable in the future, rather than at the time of disposal of an asset, depending on the fulfilment of conditions agreed upon between the buyer and seller. These include conditions such as the company’s performance indicators including turnover, profits, earnings before tax, etc. in the future years. Deferred consideration may also be preferred when uncertain events such as the outcome of high value litigations, continuation of employment of key company personnel, and other such uncertain events exist. Deferred consideration or earn outs as they are also known, may be of a fixed amount and payable on a specified future date, or it may be contingent upon the completion of milestone events. The exact consideration amount to be paid may be ascertainable, or unascertainable, at the time of disposal (i.e., of a known or unknown value). While such an arrangement may be desirable for both parties and match valuation expectations, deferred consideration also gives rise to a plethora of issues from the perspective of the Income tax Act, 1961 (“IT Act”) in India.
- Year of taxability
Section 45 of the IT Act lays down the general rule that capital gains on transfer of a capital asset shall be deemed to be taxable in the year in which the transfer takes place, with no specific exceptions to exclude deferred consideration from taxation in the year of transfer. This has resulted in ambiguity and protracted litigation on the timing of taxation of deferred consideration.
Given the lack of clarity under the IT Act, there have been conflicting court rulings on the timing of taxation, which have led to multiple views. The first view is that the right to receive the deferred consideration arises in the future years, subject to fulfillment of certain conditions; hence, income neither accrues nor is received in the year of transfer and therefore should be taxed only in the year of receipt. The alternative view is that as per the deeming fiction in Section 45(1), the entire consideration must be taxed in the year of transfer itself, irrespective of the year in which income is received. Yet another view is that the deferred consideration is taxable as ‘income from other sources’ in the year of receipt, and not as capital gains. A rather controversial view is that since the IT Act does not provide for any mechanism to compute additional consideration received in a subsequent year, the gain cannot be taxed at all given that in the year of transfer, no consideration was received. Thus, the lack of clarity has predictably resulted in divergent judicial views.
Taxable in the year of accrual / receipt
In the landmark Hemal Raju v. CIT case, there was an agreement entered into for the transfer of shareholding of a private limited company, under which a deferred consideration was payable over a period of 4 years, depending upon the profits of the company in each year. There was a cap of Rs.20 crores fixed as the maximum deferred consideration payable. The Bombay High Court held that Rs.20 crores is not an assured consideration, but only the maximum amount that the taxpayer was eligible to receive. The amount was dependent on uncertain events, and therefore could not be said to have accrued to the taxpayer, in the absence of a right to the claim. Since the taxpayer had offered to tax the deferred consideration in the year of receipt, the Bombay High Court held that in the absence of any right to receive consideration in the year of transfer, no real income had accrued to the taxpayer, and the deferred consideration could not be taxed in the year of transfer.
In the case of Universal Medicare Pvt Ltd v. DCIT, a business purchase agreement (“BPA”) was entered into for a gross consideration of Rs.567.07 crores, out of which Rs.477.62 crores was payable on transfer, and the balance of Rs.89.4 crores was placed in an escrow account by the purchaser, payable to the taxpayer in five equal installments of Rs.17.89 crores each, depending on the achievement of performance targets each year. The tax officer alleged that the BPA and escrow were independent of each other, and the escrow could not be linked to the agreement. Hence, the entire consideration was taxable in the year of transfer itself. It was held that the escrow account was executed in furtherance of the BPA, and the amount in the escrow account would accrue to the taxpayer only on the fulfilment of certain conditions, in the subsequent years. Hence, the income was offered to tax in subsequent years only upon accrual without deducting any cost.
In a recent ruling of Dinesh Vazirani v. PCIT, the taxpayer entered into a share subscription and purchase agreement (SPA) and sold 100% of his company’s share capital. Part of the consideration amount was kept in an escrow account for two years, to meet future liabilities. The taxpayer filed his return of income showing long term capital gain on the sale of shares including the escrow amount, which in fact was not received when the return was filed. Later, certain liabilities arose, which were paid directly from the escrow account and thus, the taxpayer never received the entire amount which he had offered to tax. Hence, the taxpayer filed for a claim of refund of the excess tax paid. It was held that the full consideration amount had neither been received nor accrued to the taxpayer and hence, it could not be taken as the full value of consideration in computing capital gains. The tax officer had not appreciated that income should be chargeable to tax based on real income earned, and here the real income can be computed by taking the real consideration i.e., consideration after reducing the escrow amount. There is neither accrual nor receipt, even though an entry had been made in the books. The taxpayer had paid more capital gains tax than what should have been paid, and hence, was entitled to the refund of excess tax paid.
While these favourable rulings support the position that in case of deferred consideration, income will accrue on fulfillment of certain conditions, there are several rulings to the contrary too.
Deferred consideration taxable in the year of transfer
In the case of Ajay Guliya v. ACIT, the taxpayer had transferred his shareholding in a company for a consideration of Rs.86.25 lakhs, out of which only Rs.60 lakhs were received by the taxpayer. The balance was to be received in three succeeding years subject to fulfillment of certain conditions. It was held that as per the deeming fiction laid down in Section 45(1), the entire consideration is taxable in the year of transfer of shares, irrespective of whether it was accrued or received in different years. Further, there were no clauses in the agreement, which indicated that if the entire or part consideration is not paid then the title will revert to the seller. Merely because the agreement provides for payment upon the occurrence of a certain event, it cannot be said that income had not accrued to the taxpayer.
In the Caborandum Universal Ltd v. ACIT case, the taxpayer had sold plant and machinery for a total consideration of Rs.31.14 crores. Though the entire consideration was received, only Rs.27.89 crores was offered under the head capital gains. The taxpayer submitted that the difference of Rs.3.25 crores was kept in an escrow account to meet contingent liabilities. It was held that the amount kept in escrow is only an application of income and the whole consideration is deemed to accrue on the execution of the sale agreement. Even assuming that certain payments were made from an escrow account, it will still not reduce the cost of acquisition.
In the T.A Taylor v. ACIT case, the taxpayer transferred its business undertaking through a slump sale agreement for a lumpsum consideration of Rs. 18.31 crores. In the year of transfer, the taxpayer received only Rs. 16.02 crores, and the balance amount was kept in an escrow account, to be paid in the subsequent year, on satisfaction of various responsibilities cast upon the taxpayer in relation to the slump-sale. The Chennai Tribunal held that where part of the consideration was parked in an escrow account, it will not be equivalent to a deferred consideration and therefore, the entire consideration was liable to be taxed in the year of transfer itself.
Given the above discussions, a view on whether consideration is taxable in the year of transfer, or the year of accrual / receipt should be taken after thoroughly examining the terms of agreement, based on which the deferred consideration is dependent. Further, the receipt or the accrual of deferred consideration also needs to be determined. The test of accrual requires that there should be a right to receive the consideration, which is legally enforceable even though it may be received later. It cannot be said that income has accrued until the debt is owed to the taxpayer, and a right to claim the amount vest in the taxpayer.
Moreover, tax is levied on real income and not hypothetical income. As observed in Shoorji Vallabhdas and Co, the IT Act considers the two points of time at which the liability to tax arises viz., the accrual of the income, or its receipt. But ultimately, the key aspect is the existence of income itself. If there is no income, there can be no tax, even though an entry may have been made in the books. Merely passing an entry in the books of accounts does not mean there is real income; it may as well be just a hypothetical income that has not yet materialized.
- Mode of computation
Let’s assume, Rs.100 is the fixed consideration to be received upfront by the seller on sale of shares, and Rs.30 is the deferred consideration, which may be received after a period of 3 years on satisfaction of certain performance indicators (i.e., deferred consideration). The cost of acquisition was Rs. 30.
If the view taken is that consideration is taxable only on actual receipt, the fixed consideration component will be offered to tax in the year of transfer, and the entire deferred consideration, which will be received in installments, will be offered to tax in the year of accrual / receipt without deduction of any cost. Considering the above, the computation in the first view would appear as under:
Having said the above, it is worthwhile to highlight the ratio laid down by Hon’ble Apex Court in the case of B.C. Srinivasa Shetty wherein it was held that where the capital gains computation mechanism fails, no capital gains can be levied on such transfer. Arguably, one may contend that in the absence of the cost of acquisition in the year of accrual / receipt of deferred consideration, the computational mechanism fails, and no capital gains ought to arise on deferred consideration.
In case the alternative view is adopted, the general computation mechanism as laid down in Section 48 of the IT Act would prevail. In this case, the entire consideration including the deferred consideration would be taxable in the year of the transfer itself. In this scenario, the computation would appear as under:
(Year of transfer)
|Full value of consideration||130|
|(-) Cost of acquisition||30|
|Taxable Capital Gains|
- Return of income (“ROI”)
In a scenario where the first view is adopted, there ought to be no practical challenges with respect to filing of the ROI as the deferred consideration will be offered to tax in the year of accrual / receipt under the head capital gains, though timing aspect may be raised as an issue by the authorities. Further, no deductions (such as cost, transaction expenses etc) may be available.
However, where the second view is adopted and the entire consideration on transfer (including deferred consideration) is offered to tax in the year of transfer itself, a practical challenge may arise when the actual deferred consideration received in the subsequent year(s), differs from what has already been offered to tax in the initial year. In such a case, where in the unlikely event the due date for filing a revised return of income has not lapsed, one may consider revising the original ROI itself. However, where such time-limit has lapsed, the taxpayer may face challenges in claiming tax refund or payment of the additional tax liability, on the differential amount in which case, litigation cannot be ruled out. The Bombay High Court has reaffirmed in the Dinesh Vazirani case that tax is levied only on income chargeable to tax and if more tax is paid, the taxpayer is entitled to claim a refund. However, the taxpayer may still face practical challenges with respect to filing of tax refund claim, as the income-tax authorities, especially at lower levels, do not entertain refund claims unless it is claimed by way of filing a revised ROI.
- Applicability of Section 50D of the IT Act
Section 50D of the IT Act provides that where the consideration received or accruing because of the transfer of a capital asset is not ascertainable or cannot be determined, then, for the purpose of computing income chargeable to tax as capital gains, the Fair Market Value (“FMV”) of the said asset on the date of transfer shall be deemed to be the full value of the consideration received or accruing upon such transfer.
On careful reading of the above, it can be inferred that the following three preliminary conditions ought to be satisfied to trigger the provisions of Section 50D:
- the consideration must be received or accrued;
- there must be a transfer of capital asset; and
- such consideration should not be ascertainable or determinable
As discussed in previous paragraphs, where the first view is adopted, deferred consideration will accrue only when a right to receive is established, on fulfillment of certain conditions, or on completion of relevant milestones. In this scenario, one may contend that as the consideration has neither accrued nor been received by the taxpayer in the year of transfer, the primary condition fails and therefore the provisions of section 50D ought not to be triggered.
It is also pertinent to note that the Memorandum to the Finance Act, 2012, which explains the legislative intent for introducing Section 50D into the statute, states that the said section will be invoked only in cases where in the absence of any determinable consideration, the machinery provisions fail resulting in a no tax payable situation. Thus, one may contend that since per the terms of the agreement, the quantum of consideration is clearly determinable and quantifiable, albeit payable at a later point in time, the exchequer was not at a loss for capital gains tax revenue, and hence, the provisions of section 50D ought not to apply.
In the case of Gujarat Flurochemicals v. DCIT, the taxpayer had sold its entire wind energy business under slump sale to a buyer, for a sum of Rs. 1 crore. The tax officer observed that two days after the transaction, the buyer revalued the assets to Rs.437.80 crores. The tax officer invoked section 50D and computed the capital gains by adopting the FMV of the assets. The Ahmedabad Tribunal held that section 50D can be invoked only when the consideration received is not ascertainable or cannot be determined. Since the consideration was clearly determined at Rs 1 crore, section 50D cannot be invoked. Similar view was held by Hon’ble Delhi Tribunal in the case of Analjit Singh v. DCIT.
Considering the above, one can argue that in case of deferred payments, the consideration is clearly provided for in the agreement, or it may be determinable / ascertainable as per the prescribed mechanism provided for in the agreement, even though the mechanism may be triggered only on the occurrence of certain future events and therefore, section 50D ought not to apply in the year of transfer.
- Earnout Payment to Promoters
Where post-acquisition, existing promoters are retained by the company on its payroll, and are offered earnout payments, the additional issue that may arise is whether such payments ought to be linked towards ‘sale of shares’ or ‘employment services’. This may impact taxability as either ‘capital gains’ or ‘salary’.
In the case of Anurag Jain v. AAR, the taxpayer had entered into a share purchase agreement to transfer shareholding in a company to a third party buyer, and the consideration for sale was bifurcated into two components i.e., (i) a fixed amount payable at the time of transfer of shares; and (ii) balance constituting the contingent payments, depending on the earnings of the company, to be made for the three consecutive years after the closing. The SPA was complemented by an employment agreement that set out performance matrices and earn-out payouts for the individual, linked to profitability of the company. In this case, the Madras High Court held that where contingent earn-out components were linked to the employment agreement, which was linked to future performance of the company, such earn-out payments were taxable as ‘salary’, and not as capital gains.
Considering the above, and the lack of clarity on this aspect, one may have to verify the facts and circumstances of each case and the relevant terms of the agreement, to determine whether the earn-out payment pertains to the sale of shares or employment service.
- Concluding Remarks
Clearly, there are contrary views on the taxability of deferred consideration and a position must be taken, keeping in view the facts of each case. The onus is on the taxpayer to establish that deferred consideration has neither accrued nor been received in the year of transfer, so that it can be taxed in the year of accrual / receipt. The situations may also have to be appropriately distinguished depending on whether the consideration is determinable or is merely an application of income. Moreover, in an escrow arrangement, transfer of consideration into an escrow account may be merely considered as an application of income, and the seller may be liable to tax on the entire consideration in the year of transfer itself. However, one can also contend that mere transfer of an amount to an escrow account does not determine whether such amount has accrued to the seller, and therefore the escrow amount may be taxed in the year in which a right to receive is established.
In any case, till such a time that there is clarity in the law, the taxability of deferred consideration is likely to be a vexed matter, given the contrary judgments on this issue.
Authors: Shruti K.P, Partner, Gaurav Goyal, Senior Associate, Nupur Jain, Associate
 CIT v. Mrs. Hemal Raju Shete,  68 taxmann.com 319 (Bombay)
 Universal Medicare Pvt Ltd v. DCIT,  119 taxmann.com 377 (Mumbai – Trib.)
 Dinesh Vazirani v. PCIT,  140 taxmann.com 581 (Bombay)
 Ajay Guliya v. ACIT,  24 taxmann.com 276 (Delhi)
 Caborandum Universal Ltd v. ACIT,  130 taxmann.com 133 (Madras)
 T.A. Taylor (P.) Ltd v. ACIT,  98 taxmann.com 366 (Chennai – Trib.)
 E.D. Sassoon & Co Ltd v. CIT  26 ITR 27 (SC)[14-05-1954]
 CIT v. Shoorji Vallabhdas & Co.  46 ITR 144 (SC)[27-03-196t2]
 CIT v. B.C. Srinivasa Shetty  5 Taxman 1 (SC)
 Gujarat Fluorochemicals Ltd v. DCIT,  97 taxmann.com 10 (Ahmedabad – Trib.) [13-08-2018]
Analjit Singh v. DCIT,  92 taxmann.com 310 (Delhi – Trib.) [01-12-2017]
Anurag Jain v. AAR,  183 taxmann.com 383 Madras)