It is common practice for a part of the sale consideration of businesses/shares/capital assets to be kept in an escrow account, to meet any contingent events or liabilities arising post closure of the deal. In most cases, the year in which the escrow amount is paid to the seller, if at all, differs from the year in which the deal was closed.
Typically, sellers take a view that the sale consideration kept in the escrow account is taxable only in the year in which it actually accrues/is received. However, this is a vexed issue as income-tax authorities seek to tax the full sale consideration (including the amount kept in escrow account) in the year of sale itself, on accrual basis even if part of it is received later.
This interpretation may be tax neutral across the years if the sale consideration kept in the escrow account is ultimately received in full – however, where the amount paid out from the escrow account is adjusted for liabilities or not paid at all (where liabilities exceed the sale consideration), it requires the seller to revise its taxable income. Revision of income can have practical challenges for the seller if the date for revising the tax return has passed. Also, the possibility of a tax scrutiny being initiated on account of revising the taxable income to a lower amount cannot be ruled out.
Hence, in the year of sale itself, the sellers would prefer to exclude the sale consideration kept in the escrow account from its taxable income and offer the same to tax only in the year in which it actually accrues/is received.
In this context, a recent decision of the Delhi Bench of the Income Tax Appellate Tribunal (“ITAT”) in the case of Modi Rubber Limited v. Dy. Commissioner of Income Tax[1] has provided much needed clarity on this issue. After analysing the facts of the case in detail, it was held by the ITAT that the sale consideration kept in the escrow account was neither received, nor was it likely to be received, and hence, was to be excluded while computing taxable capital gains. Such consideration/amount ought to be taxed in the year which such amount actually accrues/is received.
Facts of the case
The taxpayer company was engaged in the business of automotive tyres, tubes and flaps. The taxpayer company sold its shareholding in a wholly owned subsidiary to Continental India Limited for an agreed consideration of ~ INR 1.18bn. As per the SPA, out of the total sale consideration an amount of INR 254.8mn was kept aside in an escrow account as it was contingent on certain events. The escrow account was held under the joint instructions of the taxpayer and Continental India and was to be first utilized towards future liabilities.
The taxpayer company initially filed its tax return and offered the capital gains on sale of shares by considering the full amount of sale consideration of ~ INR 1.18bn. Subsequently, a revised tax return was filed reducing the sale consideration to INR 921.4mn i.e. after excluding the amount kept in the escrow account. Thereafter, the principal amount of INR 19.19mn received from the escrow account in subsequent year was offered to tax in the year of its receipt along with interest earned on that amount.
The tax officer did not accept the reduction in the amount of taxable income on the ground that the entire sale consideration had accrued to the taxpayer company in the year of sale. The first appellate authority confirmed the action of the tax officer. Accordingly, the taxpayer company approached the ITAT for relief in the matter.
Arguments of the taxpayer
It was contended that the escrow agreement entered by the parties laid down that the taxpayer company shall receive the release of the escrow amount up to the expiry of 2 years, 4 years, and 8 years. Such release was subject to adjustment of claims arising on account of unascertained liabilities. The amount kept in the escrow account was neither received in year of sale, nor it was likely to be received in the future. Hence, the full value of sale consideration was to be reduced to the extent of unrealisable sale consideration kept in the escrow account.
Reliance was placed on the judgement of the Bombay High Court in the matter of Dinesh Vazirani v. Pr CIT[2] wherein it was held that the amount in escrow account which was not received by the sellers cannot form part of consideration for the purpose of computation of capital gains. The Bombay HC referred to the observations made by the Supreme Court in the issue of CIT v. Shoorji Vallabhdas & Co. [3] that only real income should be considered for taxation.
Arguments of the tax authorities
It was contended that the incidence of taxation arises under the head of ‘capital gains’ on the full value of consideration that stands accrued as a result of transfer of capital asset. The law does not provide any form of deduction for money kept aside in an escrow account. Even if the entire sale consideration was not received at the time of the sale, it would not mean that the consideration has not accrued. Also, there is no provision of law that permits the deferment of taxation to a later year.
Reliance was placed on the judgement of the Madras High Court in the case of Carborundum Universal Limited v. ACIT[4] where it was observed that the entire consideration, including the escrow amount, was taxable in the year of transfer/sale. It was observed that it was not necessary that the whole amount of lumpsum consideration should have been received in the year of transfer/sale and subsequent actions of the parties would have no bearing on the liability of tax.
Decision of the ITAT
The ITAT analysed the facts of the taxpayer’s case in detail i.e. the covenants and conditions of business sale agreement, escrow agreement and overall factual matrix and observed that the same were similar to those in the case of Dinesh Vazirani, as against the facts in the case of Carborundum Universal Limited.
The ITAT observed that in the Carborundum case, the amount kept in escrow was eventually returned to the taxpayer without any deduction or reduction of sale consideration. Therefore, the question of amendment of full value of consideration did not arise. However, in Dinesh Vazirani’s case, there was actually a deduction from the amount placed in escrow and the amount of consideration underwent a significant change. The amount kept in escrow account was ultimately never received as income by the seller as the amount was returned to the buyer.
While the amount retained in escrow forms part of the agreed consideration, such amount does not necessarily form part of ‘full value of consideration received or accruing’ as result of transfer of capital asset. The realisation of escrow amount in the instant case is contingent upon fulfilment of wide ranging conditions which had been demonstrated to be substantially higher than the amount earmarked in escrow. When subsequent events after the filing of tax return are factored, the amount earmarked in escrow cannot be regarded as sale consideration accrued to the taxpayer company in the year of sale. The amount received from escrow in the later years shall be liable to taxation in the respective years of accrual/ receipt.
Our comments
This is a welcome decision which should provide certainty to both the taxpayer and the acquirer of the business/shares/capital asset in terms of withholding tax. The decision highlights the importance of the careful drafting of the provisions of the sale agreement along with escrow agreement, especially covenants, representations, warranties, conditions precedent and subsequent, indemnities, etc. It is important to ensure that the escrow account is set up appropriately and the amounts kept therein do not give the impression of having been accrued to the seller at the time of deal closure and are merely being applied subsequently against liabilities.
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[1] TS 81 ITAT 2024 (DEL).
[2] TS 274 HC 2022 (BOM).
[3] 46 ITR 144
[4] S-6597-HC-2021(Madras)-O
AUTHORS: Abbas Jaorawala (Senior Director and Head-Direct Tax) | Yukta Kamra (Associate)