Payment for Use of Goodwill is Not Illegal or Against Public Policy: Delhi High Court

Delhi High Court dismissed the Revenue’s appeal, upholding the Income Tax Appellate Tribunal’s (ITAT) decision that license fees paid for goodwill usage constitute a valid business expenditure under Section 37 of the Income Tax Act, 1961. The Bench, comprising Justice Yashwant Varma and Justice Ravinder Dudeja, held that goodwill is a legally recognized and transferable asset, and its monetization by the law firm did not violate the Bar Council of India Rules or Explanation 1 to Section 37(1).

The Revenue had argued that the arrangement violated professional ethics under the Advocates Act, 1961 and the Bar Council of India Rules, making the expenditure impermissible. The Court, however, ruled that the payment was for goodwill usage and not an illegal revenue-sharing arrangement.

The case arose from a challenge by the Principal Commissioner of Income Tax against the ITAT’s orders concerning tax deductions claimed by M/s. Remfry & Sagar, a reputed law firm. The firm had entered into an agreement to pay license fees to Remfry & Sagar Consultants Pvt. Ltd. (RSCPL) for the right to use the goodwill associated with the firm's name. The Revenue contended that this amounted to an impermissible sharing of legal fees with non-lawyers, violating the Bar Council Rules and, therefore, was disallowable under Explanation 1 to Section 37(1).

The Assessing Officer (AO) initially disallowed the deduction, considering the transaction a colorable device to divert profits to non-lawyers. The Commissioner of Income Tax (Appeals) [CIT(A)] reversed this, holding that goodwill is a legitimate business asset that can be monetized. The ITAT upheld the CIT(A)'s ruling, leading the Revenue to appeal to the Delhi High Court.

The High Court began by reaffirming that goodwill is a recognized business asset, capable of being transferred, monetized, or licensed. The firm Remfry & Sagar had earned substantial goodwill over decades, which was gifted by Dr. V. Sagar (its former owner) to RSCPL through a registered gift deed. The new partnership of Remfry & Sagar then entered into a license agreement with RSCPL, paying a fee (linked to 25% of its billed revenue) for continued use of the name and goodwill.

Rejecting the Revenue's argument that this constituted revenue-sharing, the Court held:

"A payment made for use of goodwill cannot possibly be viewed as being an illegal purpose or one prohibited by law. A person would be obliged to part with consideration for the use of goodwill if it seeks to derive benefit and advantage therefrom."

The Court found that the Revenue wrongly sought to challenge the legitimacy of the gift deed transferring goodwill from Dr. Sagar to RSCPL. It ruled that the validity of the gift was irrelevant to the tax deduction dispute, as the only issue was whether license fees paid for goodwill usage were allowable under Section 37.

No Violation of Bar Council Rules: Court Rejects Revenue’s Interpretation
The Revenue contended that since the license fee was linked to 25% of the firm's revenue, it amounted to an impermissible sharing of legal fees under 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 or legal practitioner who is not an advocate."

The Court rejected this argument, clarifying that the Bar Council Rules prohibit direct sharing of legal fees, but do not bar payments for goodwill usage. It emphasized that the license fee was computed as a percentage of revenue only to establish a reasonable valuation for goodwill, not to share fees from legal practice.

"The linking of the consideration for the aforesaid purpose to the revenue earned by the firm only constituted a basis and a measure to determine the consideration that was to be paid. The arrangement was clearly not driven by a motive to share revenues earned by the legal firm. It was purely consideration paid for use of the goodwill attached to the name ‘Remfry & Sagar.’"

Thus, the Court concluded that no violation of professional ethics had occurred, and the expenditure was legally valid.

Explanation 1 to Section 37(1): "Purpose Test" Decisive
The Revenue relied on the Supreme Court’s decision in Apex Laboratories Pvt. Ltd. v. DCIT (2022 SCC OnLine SC 2286) to argue that expenses violating professional ethics are disallowable under Explanation 1 to Section 37(1), which prohibits deductions for expenses incurred for an "illegal purpose or an act prohibited by law."

The Court, however, distinguished the present case from Apex Laboratories, where pharmaceutical companies provided illegal "freebies" to doctors in violation of statutory medical ethics. In contrast, the Court found that goodwill is a legitimate, monetizable asset, and its licensing does not constitute an unlawful act.

The Court emphasized that the "purpose" of an expenditure determines whether it is barred under Explanation 1. The license fee was paid exclusively for goodwill utilization, not for revenue-sharing or fee-splitting, making it a valid business expenditure.

"It is thus manifest that it is principally the purpose for which the expenditure is incurred which would be decisive of whether it is liable to be disallowed. Regard must also be had to the fact that the expression ‘prohibited by law’ is coupled to the commission of an offense."

Since there was no offense or illegal act involved, the expenditure did not fall within the ambit of Explanation 1.

The Delhi High Court dismissed the appeals, holding that:

•    Goodwill is a legitimate business asset that can be transferred and monetized.
•    The license fee paid for goodwill usage is a valid business expenditure under Section 37.
•    The Bar Council Rules were not violated since the payment was for goodwill usage and not an illegal fee-sharing arrangement.
•    Explanation 1 to Section 37(1) does not apply because the expenditure was not for an illegal purpose or against public policy.
•    The Revenue’s attempt to challenge the gift deed was irrelevant to the core issue of tax deductibility.
•    The ruling reaffirms the principle that business expenditures must be analyzed based on their purpose, and payments for goodwill—if commercially justified—are legally deductible. This decision sets a crucial precedent for law firms and other professional entities regarding the monetization of goodwill and tax deductions for associated payments.

Date of Decision: January 31, 2025