Commissioner of Income Tax vs T.I. and M. Sales Ltd.

K. Raviraja Pandian, J.—In the above two tax cases, the common question referred to us for our opinion is as follows :

Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the amount received by the

assessee on the termination of distributorship agreement is only a capital receipt and hence not includible in the assessee''s total income ?

The assessment years are 1986-87 and 1987-88, respectively.

The brief facts of the case are that the assessee is a non-industrial company and has been distributing on principal to principal basis, the products

of three companies, viz., (1) Tube Investments of India Limited, (2) T. I. Miller Limited, and (3) T. I. Diamond Chain Ltd., from May 1, 1964, by

means of a distribution agreement entered into between them. The distribution agreement so entered into was periodically renewed and the last one

was dated October 21, 1983, renewed for a period of five years from that date. The said distribution agreements were terminated by an

agreement called termination of distribution agreement dated June 29, 1984, with effect from June 30, 1984. Consequent to the termination of the

distribution agreement, the assessee agreed to receive a lumpsum amount of Rs. 42 lakhs and the same was agreed to be paid in ten equal

quarterly instalments commencing from the quarter ending September 30, 1984. The said amount of Rs. 42 lakhs has to be paid by the three

companies as follows :

Rs.

(1) Tube Investments of India Ltd. 40.00

(2) T. I. Miller Ltd. (since amalgamated with Tube Investments of India Ltd.) 0.50 lakhs

(3) T. I. Diamond Chain Ltd. 1.50 lakhs

The Assessing Officer was of the view that the compensation so accrued to the assessee consisted of three elements, i.e., (1) compensation for the

cost of trained manpower transferred (162 nos.) computed on the basis of salary and travelling expenses incurred by the assessee during the

training period in a sum of Rs. 11 lakhs. (2) The compensation for the cost of dealers/customers network (2,700 nos.) computed on the basis of

expenses incurred by the assessee in establishing the dealership network in a sum of Rs. 22 lakhs. The aggregate of the above two elements in a

sum of Rs. 33 lakhs represented recouping of revenue expenditure incurred by the assessee. As regards the balance amount of Rs. 9 lakhs, the

Assessing Officer was of the view that the said amount has accrued to the assessee towards compensation of loss of profits. In that view, the entire

amount of Rs. 42 lakhs which accrued to the assessee under the termination agreement was regarded as representing revenue receipts. On the said

reasoning, the Assessing Officer brought the said amount to assessment.

On appeal, the Commissioner of Income Tax (Appeals) confirmed the view of the Assessing Officer. The Appellate Tribunal on further appeal,

on consideration of the covenants contained in the distribution agreement and in the termination agreement had come to the conclusion that the

amount accrued to the assessee should be regarded as a capital receipt in nature and hence the said amount cannot be assessed to tax treating the

same as a revenue receipt. Therefore, at the instance of the Revenue, the present reference is made.

It is evident from the records that the assessee was distributing the products of the three companies, viz., Tube Investments of India Ltd., (2) T.

I. Miller Ltd., and (3) T. I. Diamond Chain Ltd., under the distribution agreement from May 1, 1964, onwards till the termination of the same with

effect from June 30, 1984. One of the conditions of the distribution agreement was that the assessee should maintain adequate sales organisations

at various centres and offices for carrying on the said business at such places and the assessee also further covenanted with the companies that the

assessees were not entitled to any charge or claim against the company any sum by way of expenses or otherwise in respect of the sales provided

by the assessee through such organisations and offices established. In tune with the covenants, the assessee had established sales organisations and

other establishments at different places and also developed dealership networks in different centres. At the time of the termination of the agreement

in the year 1984, as found by the Tribunal, the assessee had sales organisations with 126 trained personnel.

The assessee also had a dealership network of 1,200 sub-dealers, 1,200 industrial chain dealers and as many as 3,300 engineering division

customers. The above said network has been established and built up by the assessee for the past 20 years, during which the assessee was in the

field of distribution of the products of the above companies.

As per the termination agreement dated June 29, 1984, which came into force with effect from June 30, 1984, the assessee had to arrange with

their employees directly connected with the marketing and selling and other supporting staff to become the employees of the company on and from

July 1, 1984. Further the assessee also had to place all the dealers appointed by them for marketing the companies products at the disposal of the

company on the same terms and conditions, which the assessee had with the dealers and sub-dealers. Further the assessee also was prohibited for

a period of three years from the date of termination from acting as distributor, stockist, dealer or agent of any other manufacturer or dealer of

products similar to or competing with the companies products.

Thus it is evident from the termination agreement that the assessee was paid a lump sum of Rs. 42 lakhs for having agreed to transfer the staff,

dealership network, brand image and other marketing infrastructures and also for the loss arising out of the termination of the distributor agreement

with a further restrictive condition that the assessee should not for a period of three years immediately after the date of termination act as

distributor, stockist, dealer or agent of any other manufacturer or dealer of products similar to or competing with the companies products. Thus the

amount paid to the assessee was a compensation for the impairment of the profit-making apparatus of the assessee and for the sterilisation of the

very source of its income.

It is also found as a fact by the Tribunal that because of the transfer of the entire establishment including the dealership network established by

the assessee, the turnover of the assessee had dwindled down to Rs. 7.17 crores from Rs. 71.14 crores. The damage caused to the profit-making

apparatus of the assessee has been manifest from the turnover statistics made available before the Tribunal prior to and subsequent to the

termination. Prior to the termination, the turnover for the year ending with June 30, 1984 was Rs. 71,14,44,058. However, the turnover of the

immediate accounting year ending with June 30, 1985, has reduced to Rs. 7,17,84,514. For the subsequent years also the turnover has reduced

considerably.

It is well settled that to constitute income, profits or gains, there must be a source, from which the particular receipt has arisen and there must be

a nexus between the receipt and source. The source is the profit-earning apparatus and if the amount received is from the profit-earning apparatus

then the amount so received would necessarily amount to an income, profit or gain. When the entire source of the income earning apparatus of the

assessee has been transferred to the companies, pursuant to the termination agreement, the amount received for such transfer would be in the

nature of a capital receipt only. If the amount accrued is to compensate the assessee for cancellation of the distributors agreements, which does not

affect or impair the trading structure of the assessee''s business or does not deprive the assessee of the very source of income, then the termination

of the contract being an incident of business and leaves the assessee to carry on his trade, then the receipt would be regarded as a revenue receipt.

When the termination of the distribution agreement impaired the trading apparatus or trading structure of the assessee and the prohibitory clause

contained in the termination agreement totally sterilised the assessee from gaining any income then the payment received by the assessee for such

impairment and sterilisation would be characterised only as capital receipt.

In P.H. Divecha and Another Vs. Commissioner of Income Tax, Bombay I, , the Supreme Court held as follows (headnote) :

In determining whether a payment amounts to a return for loss of a capital asset or is income, profits or gains liable to Income Tax, one must have

regard to the nature and quality of the payment. If the payment was not received to compensate for a loss of profits of business the receipt in the

hands of the recipient cannot properly be described as income, profits or gains as commonly understood. To constitute income, profits or gains,

there must be a source from which the particular receipt has arisen, and a connection must exist between the quality of the receipt and the source.

If the payment is by another person it must be found out why that payment has been made. It is not the motive of the person who pays that is

relevant. More relevance attaches to the nature of the receipt in the hands of the person who receives it though in trying to find out the quality of the

receipt one may have to examine the motive out of which the payment was made. Generally, the fact that the amount involved was large or that it

was periodic in character has no decisive bearing upon the matter. A payment may even be described as ''pay'', ''remuneration'', etc., but that does

not determine its quality, though the name by which it has been called may be relevant in determining its true nature, because this gives an indication

of how the person who paid the money and the person who received it viewed it in the first instance. The periodicity of the payment does not make

the payment a recurring income because periodicity may be the result of convenience and not necessarily the result of the establishment of a source

expected to be productive over a certain period.

This court in the case of Commissioner of Income Tax Vs. Seshasayee Bros. (P) Ltd., has held that the compensation received by the assessee on

termination of the agreement was not taxable even under the provisions of Section 28(ii)(c). That was a case in which under the agreement entered

into by the assessee with one SA the assessee was entitled to a remuneration of Rs. 20,000 per annum from January 1, 1965, to the date of

commencement of the production by SA and Rs. 30,000 thereafter. The agreement also provided that in the event of termination of the agreement

by SA for any reason whatsoever, the assessee was to be paid a remuneration for the unexpired portion of the ten years contracted for. As SA felt

that the consultancy service agreement of the asses-see was no longer required, as such there was a mutual agreement and ultimately it was

decided that SA was to pay a sum of Rs. 60,000 in lieu of Rs. 1,42,500, which would have been otherwise payable by the said company to the

assessee as per the agreement entered into on January 1, 1965. The Income Tax Officer proceeded on the basis that it was a capital receipt, but

he held that the amount of all compensation received was taxable under the provisions of Section 28(ii)(c). The Tribunal held that the compensation

amount paid for the termination of the agreement was a capital receipt and that the amount was not taxable even under the provisions of Section

28(ii)(c). On a reference the High Court held that in view of the factual finding recorded by the Tribunal that the termination of contract affected the

business structure of the assessee and considering the unexpired period, which was quite a long period the amount received towards the

compensation was a capital receipt and this court further held that the prerequisite for the applicability of the Section 28(ii)(c) is that there must be

an agency agreement. The agreement of the assessee with SA envisaged assistance in securing foreign collaborations, technical assistance in its

productions, assistance in discussion with the Government etc., and in the context of the said agreement, this court concurred with the finding of the

Tribunal that there was no principal and agent relationship between the parties and hence the compensation received by the assessee on

termination of agreement was not taxable even under the provisions of Section 28(ii)(c).

Section 28(ii)(c) provides that if any compensation or other payment was received by any person, by whatever name called, holding an agency

in India, for any part of the activities relating to the business of any other person at or in connection with the termination of the agency or the

modification of the terms and conditions relating to it, the amount received would be regarded as profits and gains of business carried on by it. The

section refers to ""holding an agency in India"" which requires an agency agreement. The assessee in this case was not acting as agent of the principal

company, but was distributing the goods of the companies on principal to principal basis. The Tribunal recorded a finding that the agreement was

not an agency agreement, which finding is not disputed by the Revenue.

Applying the above ratio decidendi, we are of the view that the assessee had acquired an advantage of enduring nature by way of distribution

rights from three companies since 1964. The advantage was continuing to the assessee for more than 20 years by virtue of periodical renewal of

the distribution agreement till it was terminated in the year 1984 and by virtue of the agreement the assessee had developed a pucca establishment

and a large marketing network and had been earning very good profit in all these years till the date of the termination agreement. Under the

termination agreement, the entire establishment, the man-power along with the distributorship network, which earned profits to the assessee has

been transferred to the companies thereby the assessee was deprived of its source of income and profit-earning apparatus. Further the assessee is

also impaired from doing any distribution business as done earlier because of the prohibitive covenant in the termination agreement. All these

factors would clearly indicate that by virtue of the termination agreement, the structure of the assessee''s profit-making apparatus has been

considerably crippled. The reasoning of the authorities below the Tribunal that the compensation has been quantified on three counts, i.e., the cost

of trained man-power, compensation for cost of dealers and compensation for loss of profits and thus the payment received by the assessee was

only reimbursement of such cost factors is not correct. That was only a method to quantify the lumpsum to be paid. Such method adopted cannot

be stretched to the extent of concluding that the assessee had only recouped or reimbursed the expenses incurred in the past nor can it be said that

the assessee had been reimbursed the profit that was not available to it, as a result of the termination of the agreement.

For the forgoing reasons stated above, we are of the view that the Tribunal is right in its approach in treating the amount received by the

assessee as a capital receipt. Hence the question is answered in favour of the assessee and against the Revenue.