Parties must take care not to have unreasonable or one-sided non-compete clauses in agreements, as these can be rendered ineffective by the courts, writes Kunal Mehta
It is well-settled law that a non-compete obligation in an employment contract in India is unenforceable after termination of the employment. However, an acquirer in an M&A transaction can require a promoter to not compete with the business that he is selling. Such non-compete obligations are now an integral part of M&A transactions involving change of control.
In the past few years, control deals have gained popularity in India. Both private equity and strategic investors are now favouring control deals so that they have the ability to control the management. Similarly, many family-run businesses that face succession issues are willing to sell their entire business. In such a scenario, where the sellers of a business possess valuable customer relationships, intellectual property, knowhow or skills, acquirers are insisting on non-compete obligations from the sellers. Strong non-compete clauses can be a source of significant value for businesses.
Non-compete obligations in India derive their enforceability from the exception to section 27 of the Indian Contract Act, 1872, which allows a person who sells the goodwill of a business to agree with the acquirer to refrain from carrying on a similar business, within reasonable limits. Various judicial precedents have also held that negative covenants such as non-compete, non-solicit and non-disclosure would not generally be regarded as being in restraint of trade, unless they are unreasonable or completely one-sided.
The reasonability of such non-compete obligations has been tested in the past by courts and the Competition Commission of India (CCI). In the case of Affle Holdings Pte Limited v Saurabh Singh & Others, Delhi High Court in 2015 upheld the legal validity of a non-compete obligation, which required the outgoing promoters to not compete with the business for a period of 36 months after the completion date in a 100% share acquisition scenario.
In Arvind Singh & Another v Lal Pathlabs Private Limited & Ors, in the same year, Delhi High Court differentiated between profession and business, and held that the non-compete obligation in a share purchase agreement shall restrict the selling shareholders of a company in running a pathology lab or diagnostic centre by forming a venture that has the essential attributes of a business (i.e., employing workers, laboratory technicians, paramedics etc.) but allowed the selling shareholders to continue professional activities as a pathologist and radiologist.
The CCI has also analyzed the scope and term of non-compete obligations in various instances. In the case of a transfer of a business, Orchid Chemicals, to Hospira Healthcare, the CCI observed that non-compete obligations should be reasonable, particularly in respect of the duration over which such restraint was enforceable, business activities, geographical areas and person(s) subject to such restraint, so as to ensure that such obligations did not result in appreciable adverse effect on competition.
Pursuant to these observations by the CCI, the parties modified the term of the non-compete obligation, from eight years (on the seller company) and five years (on the promoter) to four years. The parties also revised the scope of non-compete to exclude activities regarding research, development and testing of certain new active pharmaceutical ingredients (APIs).
Similarly, in another case in the pharmaceutical sector (Mylan Inc and Strides Acrolab Limited), after the CCI’s observations, the parties revised the scope of non-compete to cover only those products that were either being made, sold or were under development by the target company and its subsidiary. The sellers were allowed to continue to conduct research and development of new APIs or molecules, which were non-existent at that time. The parties also reduced the duration of the non-compete obligation from six years to four years.
In a case relating to acquisition of Crompton Greaves Consumer Electricals, the CCI approved the combination transaction only after the parties agreed to reduce the term of the non-compete obligation from five years to three years.
In 2017, the CCI also issued the Guidance on Non-Compete Restrictions, in line with international best practice. The guidance states that only “ancillary restriction”, i.e., a restriction directly relating and necessary to the implementation of the combination, shall be approved by the CCI. The guidance also lays down standards for determining the necessity and reasonability of a non-compete obligation. These standards include the duration, geographical limits and scope of application of a non-compete restriction.
However, in May 2020, slightly deviating from its earlier stance, the CCI issued a press release stating that prescribing a general set of standards for assessment of non-compete restrictions may not be appropriate in modern business environments, and proposed certain amendments to its regulations that do away with the requirement for parties to disclose non-compete restrictions while seeking CCI approval for combinations.
Although these proposed amendments would reduce the information burden on the parties, they will still be required to make sure that the non-compete restrictions in the agreements are compliant with competition law.
Taxation of non-compete fee
There has been a lot of debate around direct and indirect taxes applicable to non-compete fees. The Finance Act, 2002, had added section 28(va) to the Income Tax Act, 1961, to tax as business income any sum received for: (1) not carrying out any activity in relation to any business or profession; or (2) not sharing any knowhow, patent, copyright, trademark, licence, franchise or any other business or commercial right of similar nature.
This would include the non-compete fee received by the sellers of a business. However, the proviso to section 28(va) provides that any sum received on account of transfer of the right to manufacture, produce or process any article or thing, or right to carry on any business or profession that is chargeable under the term “capital gains”, shall not be liable to be taxed as business income.
The interpretation of section 28(va) has resulted in varying decisions on the taxation of non-compete obligations. In a couple of decisions, like Ramesh Tainwala v Income Tax Officer and Anurag Toshniwal v Deputy Commissioner of Income Tax, it has been held that payments on account of non-compete fees shall be taxable under section 28(va) as business income, and not under the term of capital gains. However, in Commissioner of Income Tax v Mediworld Publications Pvt Ltd, the entire consideration for the sale of a business under a specified asset transfer agreement (which had a non-compete clause) was held to be liable to be taxed as capital gains, and not as business income. The taxability will ultimately depend on the factual matrix of each case.
Non-compete fees also fall within the ambit of indirect taxes. A non-compete obligation may also be treated as a service of refraining from doing an act (i.e., refraining from competing) provided by the seller of a business to the buyer. Several private equity firms and other investors who had non-compete arrangements with sellers of the businesses have been receiving notices from the tax authorities demanding them to pay 18% goods and services tax (GST) on the non-compete fee.
Advice for companies
Considering the above-mentioned precedents, parties should be extremely careful when drafting, negotiating or agreeing to non-compete obligations. They should keep in mind the following aspects:
- First, the business being transferred must have a genuine proprietary interest that requires non-compete protection. If the transferred business has no, or low, recent activity, it may mean there is no current business interest to protect. Moreover, the restrictions should not be such that the seller is not left with any source of livelihood. A non-compete clause should not prevent the seller from purchasing or holding a small stake in a competing company solely for investment purposes, as long as he/she has no material influence in the operations and management of the company;
- The scope of the non-compete activities should be clearly defined, i.e., the term “business” in acquisition agreements should be clear and unambiguous. A vague scope of non-compete will reduce the chances of a court enforcing non-compete restrictions;
- A non-compete obligation must be restricted to the products and services that comprise the main activity of the transferred business;
- The acquisition agreement should state that the goodwill of the business is also being transferred, along with the shares or the business;
- The restrictions should be reasonable. From past precedents, it seems that a term restriction for more than three or four years may not be acceptable to the CCI. The geographical limits should also be reasonable, for example, a worldwide restriction of non-compete may not be reasonable when the parties operate in a very small geography (only two or three states in India). At the same time, parties will have to be careful in drafting non-compete clauses if they operate in areas like e-commerce or fintech, where geographical boundaries are blurry; and
- Parties should carefully consider the tax implications of non-compete obligations. These will depend on a lot of factors – nature of transaction, contractual intent of the parties, period of non-compete, identity of the seller, etc. Some key tax implications that parties should analyze are: (i) should a specific amount be assigned towards non-compete fees over and above the consideration for the business/shares; (ii) whether non-compete fees shall be taxed as capital gain or as business income in the hands of the seller; (iii) will the non-compete fees be subject to withholding tax implications; and (iv) the implications of GST on the seller and the buyer, depending on where they are located, and where the service is being provided.
Kunal Mehta is a legal counsel at JSW Group, Mumbai. The views expressed by the author are personal. This article is only for information purposes and should not be considered as legal advice.