The article specifically revolves around the question whether capital gains can be charged on deferred consideration that is neither received nor accrued to the taxpayer in the initial year of transfer of the capital assets?
Problem: To understand this concept, let us begin with a hypothetical situation where a sale agreement for a property is executed in March 2015, between Mr. A (Seller) and Mr. B (Purchaser) and the total consideration is mutually agreed to be Rs. 10,00,00,000/-, however, Mr. B decides to retain a sum of Rs. 1,00,00,000/- in an escrow account for indemnity against any potential claims, future warranties or, liabilities that may arise until a period of 15 months. The arrangement lays down that Mr. A would be entitled to redeem the retained sum only after the completion of the holding period of 15 months, which is May 2017 and upon deducting the said claims if and when they arise. Therefore, to what extent should Mr. A admit capital gains in the A.Y. 2016-17?
Understanding the Real Income Theory
The guiding factor for the above question is laid down in the landmark judgment of CIT v. Shoorji Vallabhdas and Co., (1962) 46 ITR 144 (SC) wherein the Apex Court observed that, “Income tax is a levy on Income” that is, it is taxed on real income. Real income, as held by the Supreme Court in Poona Electricity Supply Company Limited v. CIT, [1965] 57 ITR 521 (SC), “means profits arrived at on commercial principles, subject to the provisions of the Act. Profits and gains should be true and correct profits and gains, neither under nor over stated”.
There are two methods of accounting – the mercantile system of accounting and the cash system of accounting, wherein the former requires the income and expenses to be accounted as and when the right to receive or the right to pay arises and the latter requires the income and expenses to be accounted on actual receipt or payment. Thus, the system determines the manner of accounting, consequently, the taxability of transactions shall vary from case to case. It is a settled principle that even if an individual follows the mercantile system, tax can be imposed only if there is real income and income tax cannot be imposed on hypothetical income.
The above query shall be examined in the light of the following provisions of the Income Tax Act, 1961 (“Act”) being Section 45 which lays down:
“any profits or gains arising from the transfer of a capital asset effected in the previous year, shall be chargeable to income tax under the head “Capital gains” and shall be deemed to be the income of the previous year in which the transfer took place.”
The provision clearly sets out that, if the period of transfer and period of receiving the consideration are distinct, the capital gains shall be admitted in the period relevant to the “transfer” of such capital asset. In an instance where the asset is transferred but the consideration is yet to be received then, the transferor shall be liable to admit capital gains in the year of effecting the transfer, as the consideration has accrued to him at the time of the transfer even if it is not realised yet.
The above proposition is further engrained under Section 48 of the Act, which provides for the mode of computing capital gains. According to sec. 48, capital gains are calculated by deducting from the full consideration, received or accrued on the transfer of the capital asset, the transfer costs incurred solely in connection with such transfer and the cost of acquisition and improvement of such capital asset. The provision takes into account two points of time at which the liability to tax is attracted, that is, the accrual of the income or its receipt. The Act recognises accrued income while considering the taxability of the transactions for computing capital gains, however the term “accrued” has various connotations, which have been considered and settled by the Courts vide landmark judgements. The interpretation of the term is necessary to determine if the income has really accrued to the Assessee in the year of transfer, or is merely hypothetical in nature.
Accrual of Income – Meaning
The Apex Court in the case of Morvi Industries Ltd. v. CIT, (1972) 4 SCC 451;- considered the dictionary meaning of the term “accrue” to mean, “to come as an accession, increment, or produce; to fall to one by way of advantage; to fall due.” The income can thus be said to accrue when it becomes due. The postponement of the date of payment has a bearing only in so far as the time of payment is concerned, but it does not affect the accrual of income. The moment the income accrues, the Assessee gets vested with the right to claim that amount, even though it may not be payable immediately. There also arises a corresponding liability of the other party from whom the income becomes due to pay that amount. The further facts that the amount of income is not subsequently received by the Assessee would also not detract front or efface the accrual of the income, although the non-receipt may, in appropriate cases, be a valid ground for claiming deductions. The accrual of an income is not to be equated with the receipt of the income.”
From the above case, it is ample clear that income may accrue to an Assessee without the actual receipt of the same. Accrual of income has less to do with the date of receipt and more with when the individual acquires the right to claim it. The Courts have further laid down that the existence of a corresponding liability of the other party to pay the amount forms a vital ingredient to determine if the income has accrued. Thus, income accrues when it becomes due but it must also be accompanied by a corresponding liability of the other party to pay the amount, only then can it be said that for the purposes of taxability that the income is not hypothetical and it has really accrued to the Assessee.
Judicial Pronouncements – A Conflict
The issue, brought to light in the present case, arises when the total consideration is not a fixed amount guaranteed to be received in the year of transfer or at a later date, but rather an amount calculated pursuant to a formula or based on uncertain events. In such a case, calculating the total amount of consideration that may eventually accrue to the Assessee becomes impossible in the year of transfer, thus posing difficulties in ascertaining “full consideration” according to the sec. 48 of the Act. There are conflicting views of the High Courts in this matter, wherein the Madras and the Delhi High Court observed that the entire amount of consideration must be offered to tax in the year of transfer even if part of such considerations is a deferred payment based on future contingencies. However, the Mumbai High Court has approached the issue by relying on the principles of the Supreme Court, to hold that income accrues to a taxpayer only when the he or she has the right to receive such income, and specifically laid down that accrual of any capital gains on consideration which is receivable in future, and contingent upon a prospective event, cannot be chargeable to tax in the initial year of transfer of capital asset.
A. Taxable in the year of Transfer
In the case of Ajay Guliya v. ACIT [2012] 24 taxmann.com 276 (Delhi HC) – The Assessee shareholder of Orion Dialog Pvt. Ltd, divested its shareholding through a Share Purchase Agreement (‘SPA’) dated 15.2.2006. The Assessee offered a sale consideration of Rs. 60 lakhs to (being the price of 1500 shares at Rs. 4,000/- per share). As per the SPA, the total consideration agreed upon in respect of each share was Rs.5750/-, of which Rs. 4000/- became payable on the execution of SPA and the balance was payable over a period of two years. The AO held that the entire consideration income accruing to the Assessee was to be considered for capital gains computation. CIT (A) allowed the appeal of Assessee. However, the ITAT held in favour of Revenue. The ITAT held that Section 45 is the charging section and ordinarily acquires primacy whereas Section 48 is merely computing mechanism. On appeal, the HC observed that the Tribunal’s findings were based upon its understanding about the characterization of the receipt and it has not dealt with the deeming fiction about the accrual which is dealt with by Section 48. The tenor of the Tribunal’s order is that the entire income by way of capital gains is chargeable to tax in the year in which the transfer took place. This is what is stated in Section 45(1). Merely because the agreement provides for payment of the balance of consideration upon the happening of certain events, it cannot be said that the income has not accrued in the year of transfer. The HC upheld the Order of the ITAT.
In the case of T.A. Taylor (P.) Ltd v ACIT [2018] 66 ITR(T) 146 (Chennai – Trib.) / [2018] 98 366 (Chennai ITAT) – The Assessee-company entered into a slump sale agreement with PKAPL for transfer of its business division for total sale consideration of Rs. 18.31 crores. As per agreement, assessee received Rs. 16.02 crores in relevant AY and balance sum of Rs. 2.29 was kept in Escrow Account and same was received in subsequent FY. The Assessee computed capital gains for impugned AY considering sale consideration at Rs. 16.02 crores. The AO held that date of actual receipt of consideration was irrelevant and computed capital gains for impugned assessment year taking Rs. 18.31 crores as sale consideration. The ITAT held in favour of the Revenue observing that profits or gains arising from a slump sale can be correctly computed only if the total consideration arising to an assessee on account of sale is reckoned. There is no provision which allows the assessee to segregate the consideration as per slump sale agreement in accordance with the year of receipt. In the instant case, there was no deferred consideration mentioned in the slump sale agreement. The ITAT observed that no doubt, release of the escrow amount, is dependent on satisfaction of various responsibilities undertaken by the Assessee in relation to the slump sale. However, this by itself would not be a reason to hold that consideration for the slump sale was not Rs. 18.31 crs. Thus, the entire amount of consideration must be offered to tax in the year of transfer even if part of such considerations is a deferred payment based on future contingencies. Since consideration was clearly mentioned in slump sale agreement, segregation of consideration into two parts could not be a reason to say that capital gain arose only with reference to first part. The ITAT held that entire sale consideration was to be taxed as capital gain.
B. Not taxable in the year of Transfer
The principle ruling of the Bombay High Court in the case of CIT v. Hemal Raju Shete, Income Tax Appeal No. 2348 of 2013 where the Assessee transferred 100% shares in a company named Unisol, for a total consideration of 200 million, out of which an initial consideration of 27 million was made and the remainder, 173 million was decided to be settled as a deferred payment which was to be computed on the basis of earnings of the company for each of subsequent four years. The HC observed that since the deferred consideration was dependent on profits to be made by the company in future, in absence of profits of the company, no consideration would be receivable by the taxpayer; thereby the deferred consideration was not an assured consideration and could not be said to have accrued. Since the amount had neither been received nor had it accrued to the taxpayer, on account of the consideration being contingent upon future profits of the company, it could not be said that any right to receive such income had accrued to the taxpayer in the initial year.
Further in the recent case of Universal Medicare (P.) Ltd. v. Dy. CIT [2020] 119 377 (ITAT Mumbai) the Assessee sold its marketing division to another company through Business Purchase Agreement (BPA) by way of slump sale. As per the BPA, gross consideration was agreed at Rs. 567.07 crores out of which, Rs. 477.62 crores accrued and became payable upon transfer, and the balance consideration of Rs. 89.44 crores was placed in an Escrow Account and would accrue to Assessee annually in five equal instalments of Rs. 17.89 crores each only upon the fulfilment of a pre-determined condition. The AO held that the entire consideration including the deferred consideration was taxable in the year of initial transfer as the agreement and the escrow account were independent of each other. Upon Appeal, the Tribunal noted that the Escrow account was executed in furtherance of BPA and the amount in Escrow Account would accrue to the Assessee only on fulfilment of the condition and therefore, there was no certainty that the Assessee would receive the amount in the future. Furthermore, it was observed that the deposit in Escrow Account was intrinsic and integral to transfer of marketing division under BPA and without it, sale would be incomplete, thus the agreement and the escrow account were not independent of each other. Accordingly, the Tribunal held that the entire consideration did not accrue to Assessee in the initial year of transfer and the same was not liable to tax during the said year.
Conclusion: From the principle rulings of the Supreme Court and the various High Courts, one may gather the vital ingredients that have to be present, in order to tax any deferred consideration in the initial year of transfer;-
The deferred payment must be an assured consideration and not contingent upon future uncertain events, a formula or, any conditions;
The taxpayer should have been vested with the right to receive such assured consideration, even though not immediate;
A corresponding liability of the other party to pay the amount should arise;
Solution: In the instant case, by relying on the most recent judgement of the Bombay High Court, one could state that the amount retained in the Escrow account for the purpose of indemnities is contingent, as the retained amount shall be released only after the expiry of a specific period after deducting any and all expenses that may arise in the holding period. There is no certainty that Mr. A shall receive any amount in the future since the receipt of the retained amount is not fixed, rather it is contingent upon the happening of uncertain events. Furthermore, there arises no corresponding liability in the hands of Mr. B to pay or release the funds held in the escrow account in the A.Y 16-17. In the absence of all the essential ingredients to bring the retained amount to tax in the initial year of transfer, it may be concluded that,what amount has to be brought to tax is the amount which has been received and/or accrued to Mr. A in the year of transfer and not any notional or hypothetical income. In the given situation, maximum cap in the Agreement being Rs. 10,00,00,000/- cannot be equated with sale consideration or full value of consideration as provided u/s 48 of the Act, since the maximum cap is neither received nor accrued to the Assessee in the relevant assessment year. Therefore, at the time of computing capital gains in the A.Y. 16-17, Mr. A shall admit the amount that he received in the previous year, being Rs. 9,00,00,000/-.
Opinion: The ruling of the Bombay High Court leaves open the question of taxation of deferred consideration accrued or received in years subsequent to the transfer. We are of the opinion that:
One view could be that such consideration is taxable in the year it is accrued or received. However, such a view does not fit within the scheme of taxation of capital gains, which mandates that capital gains are taxable in the year of transfer of capital asset;
Alternatively, after accrual or receipt of deferred consideration, it could be offered as income with respect to the year the transfer took place by revising previously filed income tax returns. However, this option would only be viable to the extent that such consideration accrues or is received within the time limit available for revising previous tax returns;
A taxpayer may also choose to follow the precedent laid down in the above-mentioned Madras and Delhi High Court decisions by offering the entire consideration to tax and claiming a capital loss (for any amount not actually accrued or received) in the year that the consideration becomes irrecoverable;
As none of these options provide a comprehensive solution to the tax treatment of deferred consideration contingent on uncertain events, litigation on the subject is likely to continue until required amendments to the Act are made.
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