In secondary transactions, deferred consideration, milestone-based payments or earn-out payments are often used when the seller expects a higher valuation for the target, but the buyer believes the valuation should be justified based on future performance or achievement of specific milestones. As a result, the buyer may agree to pay an additional amount to the seller for the transfer of the asset, provided certain conditions are met, typically linked to the performance of the underlying business.
One key issue in structuring these payments is determining when they should be taxed—at the time of transfer or when the income is actually received. Indian tax law generally taxes gains on the transfer of capital assets in the year of transfer, irrespective of when the payment is made. However, if the realisation of the deferred pay-outs is uncertain, it raises the question of whether tax should be applied only when the right to receive such income is established.
The Huntsman Case: A Closer Look
In a recent ruling, the Income Tax Appellate Tribunal (ITAT), Mumbai addressed this issue in the case of Huntsman Investments Netherlands BV. Huntsman sold shares of Huntsman Advanced Materials Solution Private Limited (HAMSPL) to Pidilite Industries for approximately USD 285 million. While 90% of the sale price was paid immediately, 10% was contingent upon HAMSPL achieving agreed revenue thresholds. Huntsman reported the 90% in the year of sale and the deferred amount in the subsequent year when the relevant conditions were satisfied. The tax authorities, however, sought to tax the deferred consideration as well in the year of sale.
The ITAT ruled in favour of Huntsman, holding that capital gains tax applies in the year of transfer only to the extent that the gains have accrued to the seller. Since the deferred payment was dependent on HAMSPL achieving agreed revenue thresholds, , it was considered contingent in nature. If these targets were not met, Huntsman would not be entitled to any deferred payment. Thus, the ITAT concluded that the deferred consideration should only be taxed in the year when the revenue thresholds are met.
The Way Forward
The ITAT ruling underscores the accrual basis of taxation in cases where the receipt of consideration is contingent on future events, following the decision of the Bombay High Court in the case of Hemal Shete. However, it is noteworthy that neither the ITAT nor the Bombay High Court addressed the view taken by the Delhi High Court ruling in the case of Ajay Gulliya, where the taxability of contingent consideration was affirmed in the year of transfer itself. As a result, the debate on the taxability of deferred consideration could continue and may require clarification through legislative amendments or a higher court ruling.
Nonetheless, the ITAT provided sound reasoning in its judgment by placing emphasis on the fundamental provisions under the Income Tax Act, 1961, which state that the income is taxable either on an accrual or receipt basis. Shareholders and investors may consider this ruling when negotiating deferred consideration and assessing the associated tax positions, potentially adopting a balanced approach to mitigate risks.
