Kiran Raj 

The Delhi High Court has dismissed appeals filed by the Income Tax Department challenging the deduction of a license fee paid for the use of goodwill by a law firm. The court upheld the Income Tax Appellate Tribunal’s (ITAT) ruling that the expenditure incurred for the license fee was a legitimate business expense under Section 37 of the Income Tax Act, 1961. The court rejected the contention that the transaction amounted to a diversion of revenue or was prohibited under the Bar Council of India Rules, ruling that the payment was solely for the use of goodwill and did not constitute an unlawful revenue-sharing arrangement.

The appeals were filed by the Principal Commissioner of Income Tax, Delhi against the law firm Remfry & Sagar, challenging the ITAT’s decisions regarding Assessment Year (AY) 2009-10 and AY 2011-12. The primary issue before the court was whether the license fee paid by the law firm to a private entity, Remfry & Sagar Consultants Private Limited (RSCPL), for the use of its goodwill was allowable as a business expenditure.

The dispute originated from an assessment order wherein the Assessing Officer (AO) disallowed the deduction claimed under Section 37 on the grounds that the payment was a colorable device aimed at diverting revenue for the personal benefit of the children of Dr. V. Sagar, a legal practitioner who had previously owned the firm’s goodwill. The AO further argued that since RSCPL was not engaged in the legal profession, it could not claim or license goodwill associated with a law practice.

The Commissioner of Income Tax (Appeals) (CIT(A)), however, overturned the AO’s findings, holding that the goodwill in the name “Remfry & Sagar” was a legitimate asset that had been validly gifted by Dr. Sagar to RSCPL. The CIT(A) concluded that the license fee was a necessary expense for the law firm to continue using the well-established name and reputation of the firm, which had been built over several decades.

The Income Tax Department appealed this ruling before the ITAT, arguing that the license fee arrangement violated the Bar Council of India Rules, which prohibit fee-sharing between advocates and non-lawyers. The department also contended that the goodwill of a legal practice was inseparable from the individual lawyer and could not be transferred to a corporate entity. The ITAT rejected these arguments, ruling in favor of the taxpayer. Aggrieved by this decision, the department filed appeals before the Delhi High Court.

The Delhi High Court examined the nature of goodwill and its transferability, the applicability of Explanation 1 to Section 37, and the alleged violation of the Bar Council of India Rules.

1. Legitimacy of Goodwill Transfer

The court recorded that goodwill was a valuable asset that could be monetized and transferred, stating: "The goodwill in the name ‘Remfry & Sagar’ had been acquired over several decades and was validly gifted to RSCPL. The license fee paid for its continued use was a legitimate expenditure."

The court noted that four unrelated partners joined the firm after the goodwill was transferred to RSCPL and agreed to pay a license fee for its continued use. This, the court observed, undermined the department’s argument that the arrangement was a ruse for tax avoidance.

2. Applicability of Explanation 1 to Section 37

The Income Tax Department argued that the transaction was prohibited by law, invoking Explanation 1 to Section 37, which disallows expenses incurred for an unlawful purpose. The court, however, rejected this contention, stating: "For disallowance under Explanation 1 to Section 37, the expenditure must be incurred for the commission of an offense or a purpose prohibited by law. A payment made for the use of goodwill cannot be classified as an illegal purpose."

The court stated that the mere fact that the fee was calculated as a percentage of revenue did not convert it into an unlawful revenue-sharing arrangement.

3. Bar Council of India Rules on Fee Sharing

The department relied on Chapter III, Rule 2 of the Bar Council of India Rules, which states: "An advocate shall not enter into a partnership or any other arrangement for sharing remuneration with any person who is not an advocate."

The court, however, held that the license fee was a consideration for the use of goodwill and not a sharing of legal fees, observing: "The Bar Council Rules prohibit advocates from sharing their professional fees with non-lawyers. However, the use of goodwill in a firm’s name is a separate commercial transaction and does not amount to fee sharing."

The court further stated that the reference to 25% of revenue as the basis for calculating the license fee was only a method of computation and did not indicate profit-sharing with non-lawyers.

4. Reliance on Apex Laboratories Case

The department cited the Supreme Court’s ruling in Apex Laboratories Pvt. Ltd. v. Deputy Commissioner of Income Tax (2022), where expenses on freebies to doctors were disallowed under Explanation 1 to Section 37 as they violated the Medical Council of India (MCI) Regulations. The Delhi High Court distinguished the two cases, stating: "Unlike the MCI Regulations, which expressly prohibit medical practitioners from accepting gifts or incentives, the Bar Council Rules do not prohibit payment for the use of goodwill. Therefore, Apex Laboratories does not apply."

The Delhi High Court dismissed the department’s appeals and issued the following rulings:

1. The ITAT’s decision allowing the deduction of the license fee was upheld.

2. The license fee was held to be a legitimate business expenditure under Section 37 of the Income Tax Act.

3. The transaction did not violate the Bar Council of India Rules, as it was for the use of goodwill and not an unlawful fee-sharing arrangement.

4. The challenge based on Explanation 1 to Section 37 was rejected, as the payment was not for an unlawful purpose.

5. The court found no basis to question the validity of the gift of goodwill to RSCPL.

Case Title: Principal Commissioner of Income Tax v. Remfry & Sagar
Case Number: ITA 199/2017 & ITA 449/2022
Bench: Justice Yashwant Varma, Justice Ravinder Dudeja

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