Analysis of Section 41(1) of Income Tax Act, 1961

CA Manish J. Sheth

The caption heading of section 41(1) is ‘Profits Chargeable to tax’. The section falls under Chapter IV –Computation of Income from Business or Profession.

In business there are circumstances where a person might have incurred a liability but later on he need not have to pay it for one or other reason. The Income Tax Act brings to tax such liabilities which are no more payable.

The section brings in to its ambit benefit in cash or in kind obtained by a person by remission or cessation of liability. The only condition is that the person must have obtained a deduction or allowance in his computation of income for the said liability in any previous years.

To tabulate the same one needs to consider the following mandatory points:

1. There has to be a remission or cessation of a liability or
2. There has to be recovery of any loss or
3. There has to be recovery of any expenditure
4. The liability must be a trading liability and not on capital account
5. The person is allowed deduction or allowance for the same in any previous year

Many a times a liability is written back in books of accounts for some or other reasons for which a person might not have claimed any deduction from income in previous years in such cases income tax department take recourse to section 28(iv) which brings to tax the value of any benefit or perquisite, whether convertible into money or not, arising from business or profession.

So the income tax department takes recourse to two sections to bring to tax any loss, expenditure or liability which might have been waived or not payable or obtained.

Please note that a person may write back liability in his books of accounts unilaterally, i.e. without consent of the payee or many a times a liability remains in existence continuously over reasonably long time and the payee does not write it back in his books of accounts then also section 41(1) comes in to operation and benefit is brought back to taxation by income tax department.

Given below are some case studies which will clarify how the modalities of these two sections operate in real life situations:

Case Study 1:-

A person has some liability towards acquisition of fixed assets and due to some reason the same is not payable in full or in part at a later date.

In such cases though the person has gained an advantage by not paying the liability, the second test which is regarding claim or any allowance or deduction is not satisfied. The acquisition of fixed asset is never allowed as a deduction. Hence the amount written back cannot be brought to tax. Secondly it also cannot be brought to tax u/s 28(iv) because 28(iv) refers to benefit in kind and not in cash. [Solid Containers Ltd. 308 ITR 407 (BOM)]

Someone may ask a question as to the depreciation claimed on such fixed assets in the past years. As per my point of view, the allowance of deprecation in previous years cannot be brought to tax because cessation of liability only pertains to the principal amount of fixed assets and not the depreciation on it. These two are different and have independent accounting and tax treatment. But the Hyderabad ITAT in the matter of Binjrajka Steel Tubes Ltd. v. ACIT 130 ITD 46 has taken a different view and observed that the assessee has obtained benefit of tax to the extent of depreciation allowance and brought such depreciation to tax.

Case Study 2:-

An assessee has borrowed a loan for purchasing a fixed asset and later on loan is waived or not paid.

Such cases are also not covered u/s 41(1) because though there is remission or cessation of a liability, a person has not claimed any deduction for the same in income tax in past. Hence section 41(1) is not applicable.

Case Study 3:-

An assessee gets waiver of Working Capital loan.

Waiver of working capital loan falls in the trap of section 41(1) and the waived amount is brought to tax. During the year 2004-05 till 2006-07 there were many such instances of loan waiver. The lender financial institutions and banks were asking their defaulting borrowers to accept OTS (one time settlement scheme) to recover its dues. The borrowers were offered reduction in principal payment, reduction in interest and complete waiver of penalty and interest.

In case the reduction is of term loan then section 41(1) does not apply as said earlier. However if the interest on term loan is reduced or waived then to that extend it is taxable. [Refer Mahindra and Mahindra Ltd 261 ITR 501 (BOM)]

In case reduction or waiver is of working capital loan then the whole amount waived is brought to tax. Reason being, in Cash Credit and debtors credit limits the interest is accumulated with the loan amount every quarter and is not separable from original credit limits.

Case Study 4:-

Liability outstanding for a very long period of time and not written back in account.

Many a times, there are instances where the person has standing liability in his books of accounts year after year. The person neither receives any payment against it nor writes it back in books of accounts. In such a situation, the Assessing officer takes the stand that the liability which is outstanding for a very long period ceases to be in existence either because the creditor is not demanding it or by operation of law it becomes barred by time. There are contradictory judgements of different courts, some in favour of the assessee and few against.

In recent times, an interesting case came up before the Mumbai Tribunal- ITO v/s Shailesh D. Shah ITA 7012/M/10 wherein it was held that the assessee has just continued the entry in his books of accounts without any intention to pay back the same and relied on Chipsoft Technology 210 Taxman 173 (Del) and confirmed addition of liability u/s 41(1).

It referred to Vardhaman Overseas Ltd. 343 ITR 408 (Del) wherein it was held that section 41(1) does not apply if the amount is not written back in the books of accounts.

Contrary to this, in CIT v/s Bhogilal Ramjibhai Atara (Guj) held that even if there is unclaimed liability of earlier years where even creditors are untraceable and liabilities are non-genuine, then also the addition cannot be made u/s 41(1) since assessee has not written it back in books of account.

Case Study 5:-

Net Present Value (NPV) of future liability is paid at a discounted rate.

This interesting case has come up before Mumbai special bench in the case of Sulzar India Ltd. v. JCIT ITA No. 2944/Mum-2007 wherein the assessee was enjoying sales tax deferral scheme from Maharashtra Government and it accumulated sales tax for 12 years for about 7.52 Crs. In the meanwhile sales tax dept had come out with an early repayment scheme wherein Suzlar was asked to pay Rs. 3.37 Crs. as onetime payment at NPV calculated at fixed interest rate. The IT Department treated this difference due to early repayment at NPV of Rs. 4.15 Crs. as remission of liability. The matter went upto the Special Bench and the Hon’ble Special Bench observed that in paying NPV the assessee has paid the equivalent value of the sum and hence there is no remission of liability.

Usually in every case, where there is a possible disallowance u/s 41(1), the Department surely takes support from the Hon’ble Supreme Court decision in the case of CIT vs. T.V. Sundaram Iyengar & Sons Ltd. reported in 222 ITR 344 SC (11/09/1996)

In this case trade security deposit received by the assessee and not payable later on was routed through Profit & Loss a/c. This case has gone against the assessee due to 3 reasons:

1. It was a trade security deposit from debtors.
2. It was reversed by crediting Profit & Loss a/c.
3. It was a trade liability.

If any of these 3 components are present then it is not covered u/s 41(1).

In the case of Bombay Gas Co. Ltd. v/s ACIT (MUM) ITA no. 646 and 1188 of 2009, the Hon’ble High Court has observed that it is settled law that if the loan was taken for acquiring the capital asset, waiver thereof would not amount to any income eligible to tax. On the other hand, if this loan was for trading purpose and was treated as such from the very beginning in the books of account, as per T.V. Sundaram Iyengar & Sons Ltd.’s case, the waiver thereof may result in the income more so when it was transferred to Profit and Loss account.

The High Court also distinguished T.V. Sundaram Iyengar & Sons Ltd. (SC) and Solid Containers Ltd. (BOM).

Some of the recent case laws on Section 41

1. Surplus resulting from assignment of loan at present value of future liability was not cessation or extinguishment of liability as loan was to be repaid by the third party and therefore could not be brought to tax in the hands of the assessee under section 41(1). [Cable Corporation of India Limited Vs DCIT (ITAT Mumbai)]

2. It is well settled through series of judgements that merely because a debt has not been repaid for over three years, would not automatically imply cessation of liability. Exhaustion of period of limitation may prevent filing of recovery proceedings in a Court of law, nevertheless it cannot be stated by itself that the liability to repay the amount had ceased. Going by this logic itself, the Assessing Officer, in our opinion, committed an error invoking Section 41(1) of the Act. Further the assessee had produced additional evidence on record before the Appellate Authority after following the procedure and pointed out that substantial portion of the debt was cleared in later assessment years.[ PCIT Vs Pukhraj S. Jain (Bombay High Court)]

3. Tax cannot be levied on Loan Waived under one time settlement – Now considering the facts and circumstances of the case, though, the loan was taken for the purpose of business but the same was never taken in the course of business or to say that the loan sourced was not linked to the trading receipts or the like. Similarly the waiver of the loan amount was not in the course of business or in exercise of a profession. A part of the amount was waived by the bank in a one-time settlement because there were little chances of recovery of the entire amount. This one-time settlement was not done as part of the business activity of the assessee, rather, the transaction of the loan and waiver was a separate transaction. Under the circumstances, the waiver of part of the loan amount cannot be said to be a benefit or perquisite arising from business or profession to the assessee. [ Jai Pal Gaba Vs ITO (ITAT Chandigarh)]

4. Unclaimed creditors to be added to Income u/s 41, even if the same is not written back in Income statement [M/s. West Asia Exports & Imports Vs. ACIT (Madras High Court)]

5. Addition U/s. 41(1) cannot be made for Amount not paid due to long pending dispute [Pyramid Consulting Engineers (P.) Ltd. Vs DCIT (ITAT Mumbai)]

6. No Cessation of liability if Amount forfeited is subject matter of civil suit and cannot be taxed [Bharat Enterprises Vs ACIT (ITAT Mumbai)]

7. Waiver of loan for acquiring capital assets not amount to cessation of trading liability [Commissioner Vs Mahindra And Mahindra Ltd. (Supreme Court of India)]

In the light of above discussions and various judicial pronouncements, one should be very careful in giving treatment of unclaimed trade or otherwise long term liability in the books of accounts.

(Author may be contacted at E-mail: [email protected])

Republished with Amendments