Non-Compete Fee Can Be Deducted As Revenue Expenditure Under Section 37(1) Income Tax Act: Supreme Court Clarifies Long-Standing Controversy

Introduction

The Indian Supreme Court has recently delivered a landmark judgment that has far-reaching implications for corporate taxation in the country. In Sharp Business System v. Commissioner of Income Tax-III N.D. [1], the Court addressed a question that has long troubled tax practitioners and businesses alike: whether non-compete fees paid to prevent competition should be treated as capital expenditure or revenue expenditure under the Income Tax Act, 1961. The two-judge bench comprising Justice Manoj Misra and Justice Ujjal Bhuyan conclusively held that non-compete fees qualify as revenue expenditure deductible under Section 37(1) of the Income Tax Act, thereby settling a controversy that had seen conflicting decisions across various High Courts in India.

This judgment carries significant importance because it directly impacts how businesses structure their commercial agreements and claim tax deductions. Non-compete agreements have become standard practice in mergers, acquisitions, joint ventures, and business reorganizations. Companies routinely pay substantial sums to ensure that competitors or former business partners do not enter the same market for a specified period. The tax treatment of such payments has always been contentious, with revenue authorities often contending that these payments create an enduring benefit and should therefore be treated as capital expenditure not eligible for immediate deduction.

Understanding Section 37(1) of the Income Tax Act, 1961

Section 37(1) of the Income Tax Act serves as a residuary provision that allows deduction of business expenditure not specifically covered under Sections 30 to 36 of the Act. The provision states that any expenditure, not being expenditure of the nature described in Sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession” [2].

This section embodies the principle that legitimate business expenses incurred for earning profits should be deductible while computing taxable income. However, the provision explicitly excludes capital expenditure from its ambit, which creates the central question in cases involving non-compete fees. The Explanation to Section 37(1) further clarifies that any expenditure incurred for purposes which constitute an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession [3]. This safeguard ensures that businesses cannot claim tax benefits for illegal or prohibited activities, but it does not address the capital versus revenue distinction that lies at the heart of non-compete fee disputes.

Factual Background of the Sharp Business System Case

The case before the Supreme Court arose from a joint venture between Sharp Corporation of Japan and Larsen & Toubro Limited. Sharp Business System, the assessee company, paid Rs. 3 crores to Larsen & Toubro as consideration for a non-compete agreement that prevented L&T from entering the business of selling, marketing, and trading electronic office products in India for seven years. This payment was made during the assessment year 2001-02 and claimed as revenue expenditure deductible under Section 37(1) of the Income Tax Act.

The Assessing Officer rejected this claim, holding that the payment created an enduring benefit for the assessee by warding off competition and should therefore be treated as capital expenditure. This decision was upheld by the Commissioner of Income Tax (Appeals) and subsequently by the Income Tax Appellate Tribunal, New Delhi. The assessee then approached the Delhi High Court, which also ruled against the company, holding that the expenditure was capital in nature and did not result in a depreciable intangible asset under Section 32(1)(ii) of the Act.

The Legal Framework: Capital Versus Revenue Expenditure

The distinction between capital and revenue expenditure has been one of the most litigated issues in Indian tax jurisprudence. There exists no statutory definition of these terms in the Income Tax Act, and courts have developed various tests and principles over decades to determine the true nature of an expenditure. The fundamental principle remains that capital expenditure relates to the acquisition of assets or advantages of an enduring nature that form part of the profit-making apparatus itself, while revenue expenditure relates to the day-to-day operation of that apparatus.

The Supreme Court in Empire Jute Co. Ltd. v. Commissioner of Income Tax [4] laid down seminal principles for this distinction. The Court observed that there exists no all-embracing formula to provide a ready solution to this problem, and every case must be decided on its own facts keeping in mind the broad picture of the whole operation in respect of which the expenditure has been incurred. The celebrated “enduring benefit” test propounded by Lord Cave in British Insulated and Helsby Cables Ltd. v. Atherton has been applied by Indian courts but with important caveats. As Lord Radcliffe clarified, it would be misleading to suppose that in all cases, securing a benefit for the business would be prima facie capital expenditure so long as the benefit is not so transitory as to have no endurance at all.

The critical question is not merely whether an advantage of enduring nature is acquired, but whether that advantage is in the capital field or the revenue field. If the advantage consists merely in facilitating the assessee’s trading operations or enabling the management and conduct of the business to be carried on more efficiently or more profitably while leaving the fixed capital untouched, the expenditure would be revenue in nature. Conversely, if the expenditure results in the acquisition of a capital asset or brings into existence a new profit-earning apparatus, it would be capital expenditure.

The Supreme Court’s Analysis and Reasoning

In the Sharp Business System judgment, the Supreme Court conducted a thorough analysis of the legal principles governing the capital versus revenue distinction and their application to non-compete fees. Senior Advocate Ajay Vohra, appearing for the assessee, argued that the expenditure was incurred wholly and exclusively for business purposes to enable the company to run its business more efficiently. He contended that the payment did not result in the acquisition of any capital asset or creation of a new profit-earning apparatus, but merely facilitated the carrying on of the existing business without the distraction of immediate competition.

The Additional Solicitor General S. Dwarakanath, representing the Revenue, supported the Delhi High Court’s view that the payment brought an enduring benefit to the assessee and should be treated as capital expenditure. He further argued that non-compete rights constitute negative covenants that cannot be owned or used like patents or trademarks and therefore do not qualify for depreciation under Section 32 of the Act.

The Supreme Court analyzed these contentions in light of established legal principles and observed that non-compete fees only seek to protect or enhance the profitability of the business, thereby facilitating the carrying on of the business more efficiently and profitably. The Court emphasized that such payments neither result in the creation of any new asset nor accretion to the profit-earning apparatus of the payer. The enduring advantage, if any, by restricting a competitor in business is not in the capital field but operates in the revenue field.

The Court specifically held that payment was made to Larsen & Toubro only to ensure that the appellant operated the business more efficiently and profitably. Such payment could not be considered to be for acquisition of any capital asset or towards bringing into existence a new profit-earning apparatus. The Court further clarified that as long as the enduring advantage is not in the capital field, where the advantage merely facilitates carrying on the business more efficiently and profitably while leaving the fixed assets untouched, the payment made to secure such advantage would be an allowable business expenditure irrespective of the period over which the advantage may accrue.

Regulatory Framework Governing Non-Compete Agreements

Non-compete agreements in India are subject to various regulatory frameworks beyond taxation. The Competition Act, 2002 governs anti-competitive practices and agreements that cause or are likely to cause an appreciable adverse effect on competition within India. However, non-compete clauses ancillary to legitimate transactions such as sale of business, transfer of intellectual property rights, or exit from partnership are generally recognized as reasonable restraints. The Competition Commission of India evaluates such agreements to ensure they do not violate Section 3 of the Competition Act, which prohibits anti-competitive agreements.

The Indian Contract Act, 1872 also has a bearing on non-compete agreements. Section 27 of the Contract Act declares that every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind is to that extent void. However, courts have carved out exceptions to this general rule, particularly in cases involving sale of goodwill of a business where reasonable restraints on the seller are permissible. The key is that the restraint must be reasonable in terms of duration, geographical scope, and business activities covered.

Divergent High Court Decisions Prior to the Supreme Court Ruling

Before the Supreme Court’s decision in Sharp Business System, various High Courts had taken divergent views on the treatment of non-compete fees. The Delhi High Court in the present case had held that non-compete fees constituted capital expenditure but did not result in a depreciable intangible asset under Section 32(1)(ii) because it was a right in personam rather than a right in rem. This created a particularly harsh situation for taxpayers where the expenditure was neither deductible as revenue expenditure nor eligible for depreciation as capital expenditure.

In contrast, the Madras High Court had taken a more favorable view toward assessees in several cases. In Asianet Communications Ltd. v. CIT [5], the Madras High Court treated non-compete fees as revenue expenditure in a case where the non-compete agreement was for five years, holding that it did not result in any enduring benefit to the assessee. Similarly, in Carborundum Universal Ltd. v. Joint Commissioner of Income-tax [6], the same Court recognized such expenditure as revenue in nature.

The Bombay High Court in Pr CIT-3 v. Six Sigma Gases India Pvt. Ltd. [7] also treated non-compete fees as allowable revenue expenditure. These divergent decisions across different High Courts created uncertainty for businesses and tax professionals, making the Supreme Court’s intervention necessary to provide uniform guidance across the country.

Implications of the Supreme Court Judgment

The Supreme Court’s decision in Sharp Business System has several significant implications for corporate taxation and business planning. First and foremost, it provides legal certainty to businesses that non-compete fees paid to facilitate efficient business operations without creating new assets or profit-earning apparatus will be treated as revenue expenditure deductible under Section 37(1). This allows for immediate tax deduction rather than spreading the benefit over multiple years through depreciation or amortization.

For mergers and acquisitions, this ruling clarifies that payments made to ensure that sellers do not compete with the business being acquired can be structured as revenue expenditure if they meet the criteria laid down by the Supreme Court. The judgment emphasizes that the test is not merely the duration for which the benefit accrues, but whether the expenditure creates a new asset or merely facilitates more efficient operation of the existing business. This distinction is crucial for tax planning in corporate restructuring exercises.

The judgment also has implications for past assessments where non-compete fees were disallowed. The Supreme Court remanded the matter back to the Income Tax Appellate Tribunal to decide all appeals and cross-appeals afresh in accordance with the principles laid down in the judgment. This opens the door for taxpayers who have been denied deductions for non-compete fees in previous years to seek relief through appropriate appellate proceedings.

Practical Considerations for Businesses

While the Supreme Court’s judgment is favorable to taxpayers, businesses must ensure that their non-compete arrangements genuinely meet the criteria established by the Court. The payment must be made to facilitate more efficient and profitable operation of the existing business rather than to acquire a new business or create a new profit-earning apparatus. The non-compete agreement should be structured and documented in a manner that clearly demonstrates its purpose and commercial rationale.

Documentation becomes critical in substantiating the claim that non-compete fees constitute revenue expenditure. Businesses should maintain contemporaneous records explaining the business necessity for the non-compete arrangement, how it facilitates the existing business operations, and why it does not create a new asset or advantage in the capital field. The agreement should clearly specify the scope of the non-compete obligation, the duration, and the geographical area covered.

Tax professionals advising on such matters must carefully analyze whether the specific facts of each case align with the principles laid down by the Supreme Court. While the judgment provides favorable guidance, it does not create a blanket rule that all non-compete fees will automatically qualify as revenue expenditure. The factual matrix of each case remains important, and assessees must be prepared to demonstrate that their situations fall within the parameters established by the Court.

Conclusion

The Supreme Court’s decision in Sharp Business System v. Commissioner of Income Tax-III N.D. represents a significant development in Indian tax jurisprudence regarding the treatment of non-compete fees. By holding that such payments constitute revenue expenditure deductible under Section 37(1) when they facilitate efficient business operations without creating new assets or profit-earning apparatus, the Court has resolved a long-standing controversy and provided much-needed clarity to businesses and tax professionals.

The judgment reinforces the principle that the enduring benefit test must be applied pragmatically and that not every advantage of enduring nature automatically constitutes capital expenditure. The critical inquiry is whether the advantage is in the capital field or merely facilitates revenue operations. This approach aligns with commercial reality and ensures that legitimate business expenses incurred for operational efficiency receive appropriate tax treatment. As businesses continue to structure their operations and commercial arrangements, this judgment will serve as an important reference point for determining the tax treatment of non-compete and similar restrictive covenant arrangements.

References

[1] Sharp Business System v. Commissioner of Income Tax-III N.D., Civil Appeal No. 4072 of 2014, Neutral Citation: 2025 INSC 1481, Supreme Court of India. Available at: https://www.livelaw.in/top-stories/supreme-court-judgment-non-compete-fee-revenue-expenditure-section-37-income-tax-act-514058 

[2] Section 37 of the Income Tax Act, 1961. Available at: https://www.taxmann.com/post/blog/critical-analysis-of-section-37-of-the-income-tax-act 

[3] Section 37(1), Explanation, Income Tax Act, 1961. Available at: https://www.tataaig.com/health-insurance/section-37-of-income-tax-act 

[4] Empire Jute Co. Ltd. v. Commissioner of Income Tax, (1980) 124 ITR 1 (SC), Supreme Court of India. Available at: https://www.legitquest.com/case/ms-empire-jute-company-limited-v-commissioner-of-income-tax/2AB1 

[5] Asianet Communications Ltd. v. CIT, Chennai, (2012) 257 Taxman 473, Madras High Court. Available at: https://bcajonline.org/journal/section-371-business-expenditure-capital-or-revenue-non-compete-fee-allowable-as-revenue-expenditure/ 

[6] Carborundum Universal Ltd. v. Joint Commissioner of Income-tax, Special Range-I, Chennai, [2012] 26 taxmann.com 268, Madras High Court. Available at: https://bcajonline.org/journal/section-371-business-expenditure-capital-or-revenue-non-compete-fee-allowable-as-revenue-expenditure/ 

[7] Pr CIT-3 v. Six Sigma Gases India Pvt. Ltd., ITA No. 1259 of 2016, dated January 28, 2019, Bombay High Court. Available at: https://bcajonline.org/journal/section-371-business-expenditure-capital-or-revenue-non-compete-fee-allowable-as-revenue-expenditure/ 

[8] Sharp Business System – Non-Compete Fee as Revenue Expenditure, Law Trend India. Available at: https://lawtrend.in/non-compete-fee-as-revenue-expenditure-allowable-under-section-371-of-income-tax-act-supreme-court/ 

[9] Tax Weekly Round-Up: December 15-21, 2025, LiveLaw. Available at: https://www.livelaw.in/amp/tax-cases/tax-weekly-round-up-december-15-december-21-2025-514174