[Hardeep Singh Chawlais an Advocate practicing in the M&A & PE Tax Department of a Big4 in Gurgaon, Haryana. Views expressed are his own. The author may be reached at [email protected]]
“…… in a taxing Act one has to look merely at what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to a tax. Nothing is to be read in, nothing is to be implied. One can only look fairly at the language used.”
– Rowlatt J. in Cape Brandy Syndicate vs. IRC (1921) 1 KB 64 (KB)
Section 5(1) of the Income tax Act, 1961 (“IT Act”)which deals with scope of total income, inter alia, provides that income is taxable in the hands of the assessee only if it ‘accrues or arises’ or is ‘deemed to accrue or arise’ to the assessee during the relevant previous year.
The Supreme Court of India in E.D. Sassoon & Co. v. CIT held that income is said to ‘accrue’ or ‘arise’ when the following two conditions are satisfied:
(a) when the right to receive the income vests in the assessee; and
(b) corresponding debt is created in favour of the assessee.
Further, it is a well settled by the Supreme Court in Hindustan Housing & Land Development Trust Ltd. that where the compensation is under dispute, it is only on the final determination of the amount of compensation that such income would accrue or arise in the hands of the assessee.
Taxability under the provisions of section 115JB of the IT Act
Section 115JB of the IT Act provides for an alternative mechanism to tax companies on their ‘book profits’ (being net profit adjusted by prescribed inclusions / exclusions). In case the tax as per normal provisions is less than 18.5% of the ‘book profits’, then ‘book profits’ are deemed as total income and Minimum Alternate Tax (“MAT”) at the rate 18.5% is payable on such ‘book profits’.
Scenario 1: Liquidated damages are not credited in the P&L (due to uncertainty of receipt)
The Supreme Court in the case of Apollo Tyres Limited vs. CIT held that section 115JB is a self-contained code and, for computation of book profits, only the items prescribed under that section could be added to or excluded from net profit disclosed in the profit and loss account where the accounts are prepared in accordance with Part II of Schedule VI of the Companies Act, 1956.
Accordingly, liquidated damages (not credited to the profit and loss account) should not form part of book profits for the purposes of section 115JB of the IT Act for and thus would not be liable to MAT. Further, the treatment of liquidated damages for MAT purposes would need evaluation in the year in which it is credited to the profit and loss account
Scenario 2: Liquidated damages are to be treated as a capital receipt in the hands of the assessee company and hence not part of “book profits” as per section 115JB of the IT Act
This scenario encompasses two limbs, one, that liquidated damages are capital receipt(s) and, second, that capital receipts are not to be included while computing MAT.
Liquidated damages are Capital Receipts
As a general rule for income tax, all revenue receipts (unless specifically exempted by the IR Act) are taxable under the provisions of the IT Act and all capital receipts (unless made specifically taxable by the Act) do not constitute income chargeable to tax.
The terms ‘capital’ and ‘revenue’ have not been defined in the IT Act and various courts have held that the nature (capital or revenue) of compensation for breach of contract / liquidated damages would depend on the facts of each case.
In CIT vs. Saurashtra Cement Ltd. the assessee was engaged in the business of cement and had entered into an agreement with the supplier for purchase of additional cement plant. As per the terms of the agreement, in the event of delay caused in the delivery of the machinery, the assessee was to be compensated by the supplier @0.5% of the price of the respective portion of the machinery for delay of each month by way of liquidated damages. The supplier defaulted and failed to supply the plant and machinery on the scheduled time and, therefore, as per the terms of the contract, the assessee received certain amount from the supplier by way of liquidated damages.
The Court observed that the delay in supply could be of the whole plant or a part thereof, but the determination of damages was not based upon the calculation made in respect of loss of profit on account of supply of a particular part of the plant.The damages to the assessee were directly and intimately linked with the procurement of a capital asset, i.e., the cement plant, which would lead to delay in coming into existence of the profit-making apparatus, rather than a receipt in the course of profit-earning process.
Thus, the Court held that compensation paid for the delay in procurement of capital asset amounted to sterilization of the capital asset of the assessee as supplier had failed to supply the plant within time as stipulated in the agreement. Accordingly, it was held that the amount received by the assessee towards compensation for sterilization of the profit-earning source and not in the ordinary course of its business, was a capital receipt in the hands of the assessee.
The Delhi High Court had an opportunity to consider taxability of compensation for breach of contract in the case of Khanna & Annadhanam vs. CIT wherein the assessee had a long-term service contract which was abruptly terminated by the customer and the assessee received one-time compensation for the same. The High Court upheld the nature of compensation as capital receipt.
In light of the aforesaid principles and jurisprudence, a position could be adopted that liquidated damages are in the nature of capital receipt and thus not taxable under the normal provisions of the IT Act on account of the following reasons:
– Liquidated damages are a pre-determined amount, computation of which is not linked to any portion of profits of the company. Thus, it can be argued that the same is not towards compensation for loss of future profits; and
– Liquidated damages are not on account of the ordinary course of business, but a one-time event.
Capital receipts to not form part of MAT computation
The inclusion or exclusion of a capital receipt for computing book profits has been a matter of significant litigation in India with contradictory court rulings. In this regard, the Special Bench of the Hyderabad Tribunal in the case of Rain Commodities, while dealing with the issue as to whether capital gains arising from a transfer which is exempt from tax should form part of book profits under section 115JB, held that since the capital gains was credited to the profit and loss account (prepared in accordance with schedule VI to the Companies Act, 1956), such gains should also form part of the book profits under section 115JB. The Tribunal further held that the entire mechanism for computation of book profits has been laid down in sub-section (1) of section 115JB read with the explanation thereto and the mere fact that capital gains is exempt under the normal provisions of the Act would not have any impact on the computation of book profit. In this regard, the following remarks by the Tribunal on the intention behind introduction of section 115JB are of significance:
…By again importing deductions allowed under the normal provisions of income-tax into computation of book profits, one would be negating the very purpose for which these sections were introduced.
The Mumbai Tribunal in the case of Shivalik Ventures Pvt. Ltd. differed in their view while dealing with the same issue of whether capital gains not regarded as transfer should form part of book profits under section 115JB of the Act, held that such gains should not form part of book profits under section 115JB of the Act. While noting that the assessee had disclosed in its notes to accounts that it has taken a view that such capital gains should not form part of the book profits, the Tribunal distinguished the Special Bench judgment in Rain Commodities primarily based on two arguments:
(a) Capital gains arising on transactions not regarded as transfer does not fall within the definition of ‘income’ under section 2(24) and since the same does not enter into the computation provisions at all, there is no question of including the same in book profits under section 115JB;
(b) The profit and loss account has to be read along with the notes to accounts and thus the net profit should be adjusted by the disclosures made in the notes to accounts. Since the assessee had made relevant disclosures in its notes to accounts regarding such a position, the net profit has to be adjusted to nullify the effect of capital gains.
The above decision of the Mumbai Tribunal has been followed by other recent tribunal decisions as well. However, the above decision of Mumbai Tribunal has been distinguished by the Bangalore Tribunal in the case of B&B Infotech Ltd, wherein the assessee in this case had credited remission of the principal portion of the loan liability (being capital in nature) to the profit and loss account and, relying on the decision of Shivalik Ventures, took a view that such remission should also not form part of the book profits. The Bangalore Tribunal, relying on the decision of Supreme Court in the case of Apollo Tyres,held:
…Once P&L A/c is admittedly prepared as per Schedule VI of the Companies Act, then neither the AO has any power to tinker with it nor the assessee is permitted to claim exclusion or inclusion of any item of income or expenditure as the case may be, for the purpose of computing book profits u/s 115JB except the permissible adjustment provided under the Explanation to sec.115JB of the Act itself…
While it may be possible to claim that liquidated damages being in the nature of capital receipt do not fall within the definition of ‘income’ and thus should not be subjected to tax under MAT provisions, however, in the light of differing views by various Tribunals, the jury is still out.
– Hardeep Singh Chawla