While taxing of long term capital gains and insertion of the Income Computation and Disclosure Standards (ICDS) have been some of the major talking points post presentation of Budget this year, the apparently innocuous insertion in Section 28 has not received much attention. ‘A rose by what other name called would smell as sweet’. It is usually difficult to find lyrical beauty or logic in a levy. Since the income tax law would be incorporating these words in Section 28, it is worth taking a closer look at the proposed amendment.
Finance Bill, 2018 proposes to insert new sub-clause (e) in Clause (ii) of Section 28 of Income Tax Act, 1961 (‘the Act’) as follows:
Section 28 (i) Any compensation or other payment, due to or received by …
‘(e) any person, by whatever name called, at or in connection with the termination or the modification of the terms and conditions, of any contract relating to his business’ (emphasis supplied))
As per the Memorandum to the Finance Bill (‘the memorandum’), the amendment will enable the tax authorities to tax compensation received or receivable in connection with the termination or modification of the terms of any contract shall be taxable as business income. Thus, by way of this amendment, compensation, even if capital in nature, is sought to be taxed if it arises on termination or modification of a contract relating to business.
What is sought to be taxed?
The liberal interpretation of the term ‘income’ and ’business’ has not been wide enough to bring into the tax net certain receipts like compensation on termination of managing agency, profit from transfer of DEPB scrip, non-compete fee, etc., and a number of such items were inserted in the Act specifically as being taxable.
In respect of sum received on termination of contract due to breach, non-performance, deficiency in performance, etc., an argument that has often been taken is that the sum received is a capital receipt and hence is not taxable as income. Though there is no express exclusion from the definition of income, the courts have generally held that capital receipts to be outside the scope of the term ‘income’.
In Navinchandra Mafatlal, (1955) 1 SCR 829, the Supreme Court held that the word ‘income’ had to be given the broadest connotation and hence the levy on capital gains was valid and within the powers of the government. It stated that (Entry 82 in List I) ‘Taxes on income other than agricultural income’) is wide enough to cover capital gains. However, in Navnit Lal Jhaveri v. K K Sen, (1965) 1 SCR 909, though the Supreme Court held in favour of the Revenue Department that the deemed dividends could be subject to income tax, it was observed that ‘there must be some rational connection between the item taxed and the concept of income liberally construed’.
Another argument against taxation of such compensation is that it is not ‘profits or gains from business’ but is only a compensation for injury caused to the other party. The obligation to compensate the other party may arise out of the terms of contract itself or under other laws like the Contract Act, 1872. Since the sum received as compensation or liquidated damages etc., could not be described as income falling under any of the heads, such sums were claimed to be not taxable under the Act. In Commissioner of Income Tax, Gujarat v. Saurashtra Cement Ltd, 2010 192 Taxmann 300 (SC), the Apex Court held that where amount received by the assessee is towards compensation for the sterlisation of the profit-making apparatus rather than a receipt in the course of the profit-earning process, it would be a capital receipt and hence not taxable. The Apex Court also observed that there cannot be a single infallible test to decide between capital and income. There have been other cases where it has been held that compensation received on termination of a contract (of agency) is a revenue receipt [CIT v. Best & Co. (P) Ltd., (1966) 60 ITR 11, Gillanders Arbuthnot And Co., Ltd v. The Commissioner Of Income-Tax, 1965 AIR 452]. The reasoning in these cases was that as part of normal operations of a business some contracts may be terminated and new ones entered into, but the assessee continues to do business unaffected by such cancellations.
Is the clause wide enough to cover every payment in connection with contracts?
If we analyse the various parts of the proposed insertion, it is clear that it appears to be very wide and may include not just capital receipts but a host of other payments which may not be income.
Any compensation or other payment, due to or received by [Section 28(ii)]; ‘any person, by whatever name called’ [sub-clause (e)]
This provision seeks to cover any compensation or payment received or due to a person. ‘By whatever name called’ - these words are wide enough to include payments due and actual receipts and compensation and any payment irrespective of nomenclature given to it by parties, treatment in books and so on.
At or in connection with
It is interesting to note that sub-clause uses the word ‘at termination’ rather than on termination/modification or for termination/modification. It appears that any payment at the time of termination even if it is not a consideration to terminate the contract will be taxable. The ambit of the provision is made wider with the use of ‘in connection with’. Thus, even if some payment arises after termination but can be said to be in connection with the termination/modification, the sum may be taxable.
Termination or the modification of the terms and conditions
The provision seeks to tax any payment or compensation arising on modification of the terms of the contract. If a contract relating to business is modified by mutual consent, it is presumed that the business continues though rights and obligations under the contract are varied. Any income arising out of such modification may be taxable even without this amendment. Perhaps the intention is to tax those receipts which may have a character of changing the profit-making apparatus or source of income.
The terms may also be varied by unilateral action of one party which is later accepted by the other in consideration of additional payment. Such payments which are not in fact income from business - sale of goods or services - may also fall within the ambit of this sub-clause.
Parties to a contract may be discharged from their obligations under the contract by mutual consent, by breach of either party or by frustration, impossibility of performance etc. The use of word ‘termination’ implies that the contract comes to an end by action of one or both the parties. The contract itself may provide for payment of compensation, damages etc. However, if a contract becomes void, impossible to perform due to factors beyond the control of the contracting parties like war or destruction of property etc., any party who has obtained some benefit under the contract is bound to return it. Such payments flowing from principle of equity cannot be rightly described as income of the other party. For instance, a party may return the advance received from the other goods, or a party avoiding a voidable contract may return any sum received by it.
Any contract relating to his business
The payment received in connection with any contract – agreement enforceable by law - ‘relating to’ the business of the assessee is proposed to be covered. The word ‘relating to’ has been held to be one of comprehensiveness and equivalent to ‘pertaining to’ and ‘in relation to’ [Doypack Systems (Pvt) Ltd v. UOI, 1988 (36) E.L.T. 201 (S.C.)]. The words presuppose a different subject matter and can have direct and indirect significance depending on the context. It would thus appear that if a contract has some kind of nexus with the business of the assessee though it may not be in course of the profit-earning activity or the main business of the assessee.
Implications on certain payments
It is not possible to draw up an exhaustive list of payment which may arise in course of business and attract the proposed sub-clause. Let us look at certain receipts which may arise at termination or breach of a contract and their taxability in terms of the proposed sub-clause (e).
Coverage under proposed sub-clause (e)
|Receipt of sums pursuant to Arbitration (award and interest)
||Interest received on arbitration award has generally been held to be revenue in nature but there are contrary rulings on whether the award itself is capital receipt [(2010) 42 SOT 1 (Mumbai), (2010) 123 ITD 153 (Mumbai)]||Being an amount received ‘in connection with’ and ‘at termination of a contract’ relating to business, the award might be taxable as a business receipt|
|Court awarded damages||Where the Court awarded damages after specific performance of contract to transfer factory land was denied, the receipt is not taxable as capital gains [(2015) 58 taxmann.com 199 (Bombay)]||This could be an amount received at termination of a contract relating to business|
|Compensation for loss without contractual obligation to do so||Where the parent company compensated the subsidiary for loss sustained without any contractual obligation, the amount represented causal no recurring receipts and was not taxable as business income [(1987) 165 ITR 416]||The amount is received as a measure of restitution. It does not arise out of the contract between the subsidiary and the other party and the payment is made by a third party.|
The proposed amendment seeks to overrule many judicial rulings, particularly the concept of capital receipts being outside the ambit of income tax. Though the amendment is pretty wide in its scope, there is still a need to closely examine the taxability of compensation/ amounts received under different circumstances in the light of existing jurisprudence.
The author is a Principal Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, New Delhi]