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Bonds, that mature in future, issued against services provided for a project, does not convert them into capital assets

In the cited case, Delhi High Court held that the Iraqi Government’s inability to pay due to sanctions imposed by it and the subsequent Central Government’s negotiating an arrangement for its payment through bonds that were to mature in future with interest did not in any way alter their character

Brief of the Case: In the cited case, Delhi High Court held that the Iraqi Government’s inability to pay due to sanctions imposed by it and the subsequent Central Government’s negotiating an arrangement for its payment through bonds that were to mature in future with interest did not in any way alter their character or convert them into capital assets. The assessee’s claim of capital loss, based on indexed treatment of capital gain is therefore insubstantial and unfounded on any principle.

Facts of the Case: In the year 1983-84, the Government of Iraq expressed inability to pay the US Dollar Component to the assessee who had provided services under contract to it due to its involvement in war with Iran. Protocol Agreements were signed between the Government of India and Government of Iraq. Banking arrangements were also worked out between Exim Bank of India and Central Bank of Iraq. In consideration of the appellant assigning debt receivables for the work done in US$ entered in the books of Central Bank of Iraq by executing Deed of Assignment dated 10.3.1995, the Government of India, pursuant to its notification dated 24.3.1995 issued Compensation Bonds-2001 governed by the provisions of the Public Debts Act, 1944 and the Public Debt Rules, 1945.

By computing the value of such bonds, on indexed cost of acquisition the assessee claimed loss in its return for A.Y. 1995-96. The loss under the head “Capital Gains” was stated at Rs.1,48,22,66,649/-. The Assessing Officer (AO) was of the view that the head “Capital Gains” was not attracted to the deduction claimed by the assessee for AY 1995-96. The AO held the said amount to be taxable under the head “Income from business and profession”.

The Assessee preferred appeal to the High Court questioning the correctness of the view taken by the ITAT. The question of law arose for consideration was “Whether the assessee’s claim that there was a loss and/or it was a capital loss is legally tenable”.

Contention of the Assessee: Assessee submitted that the terms and stipulations contained in the Deed of Assignment executed in favour of the Government of India entitled the assessee to receive the value in the form of Compensation Bonds in 2001 and was not considered properly. The Iraqi Government’s debts, recoverable by the assessee, were in the nature of blocked/sterilized debts or money. In terms of the Government to Government protocol agreements, the banking arrangements between the Exim Bank of India and the Central Bank of Iraq and the relative developments vis-a-vis the debts detailed in the Deed of Assignment, had to be determined under the IT Act. The assessee was not entitled to and was in fact barred from using the receivables from the Iraqi Government in any manner, much less in the course of, or in carrying on its business activities. This was due to the supervening impossibility caused by entirely extraneous circumstances. The effect, however, was that the amounts could never be said to have been the main part of its entitlement. The acceptance of compensation bonds under these circumstances upon assigning of the Iraqi debts (to the Central Government) was not a part of the assessee’s business or trading activities. Therefore, faulted the ITAT’s findings on this aspect.

The assessee relied upon the judgment of the Supreme Court in Sutlej Cotton Mills v. CIT, West Bengal, 116 ITR 1 (SC) and highlighted the distinction between fixed capital and circulating capital. The former is what the owner turns into profit by keeping it in his possession and the latter is what makes profit by parting with and letting it change masters. Circulating capital consequently means amounts employed in trading operations of the business and dealings with it comprise “trading receipts” and “trading disbursements”.

The assessee also relied upon the judgment of the Supreme Court in CIT, Mysore v. Canara Bank Ltd., AIR 1967 SC 417, wherein the question that the Supreme Court had to deal with related to the foreign exchange fluctuation difference which had accrued to the assessee on account of an embargo placed due to difficulties in remittances from the foreign branch of an Indian Bank. The devaluation of the foreign currency led to an increase in the value of the Indian Rupee and enhanced the amounts lying in the assessee’s account at its overseas branch. The SC upheld that the increment which arises in such eventuality was not due to trading operations in the carrying on of banking business and that the assessee’s amount was a blocked or sterilized balance for the period or duration it could not be utilized until it was finally remitted to India. The SC opined that “the money changed its character “of stock-in-trade” when it was “blocked” and “sterilized” and the increment in its value owing to the exchange fluctuation must be treated as a capital receipt”.

Assessee argued that the amount received upon debt assignment could not be treated as income under Section 2(24) but was receipt in value, in consideration of assignment, in the form of compensation bond. The receipt was the consideration in transfer of a capital asset under Section 2(47) of the Income Tax Act. Hence, the assessee’s contentions were well founded and could not have been rejected by the ITAT.

Contention of the Revenue: Revenue submitted that the amount shown as receivable from the Iraqi Government was under the head of “sundry debtors” and could by no stretch of imagination be termed as a “capital asset”. It was highlighted that the assessee was like any other project exporter to Iraq who had suffered a blockage of its debt receipts, (due to extraneous factors such as US sanctions), and was the recipient of the hardship mitigation measures by the Central Government, which took over such debts and issued equivalent rupee bonds. It was argued that there was no profit element due to the taking-over of the debts by the Central Government and issuing bonds in return. In fact, no profit accrued to the assessee from the Central Government. On the other hand, profit was an intrinsic element of the debts which would have accrued in the event the Iraqi Government was capable and permitted to discharge its debt obligations. That the assessee was able to realize its debts through a third agency, i.e. the Central Government did not mean that the character of the amount transformed and the transaction became one of transfer of capital asset.

Revenue relied upon the AO’s order who had drawn an analogy with Section 36(1)(vii), where assessees are allowed deduction in respect of bad debts or part thereof written off as irrecoverable. The AO observed that bad debts are treated as revenue expenditure, and the business income to the extent of those debts is reduced. Conversely, if debts are recovered above the book value, such amount would have to be taxed as income. Analogically, exchange gain in respect of debts would fall in the same category, and would be liable to be taxed as business income. Further argued that the intervening development of the Central Government taking over the debt and issuing bonds for a particular value did not in any way disturb the character of the amounts received or receivable from the Iraqi Government which would have also shown exchange gain. Further submitted that debts were not the assessee’s investment as understood in common parlance in the sense that a profit was intended to be earned on their sale or transfer.

Revenue highlighted that the debt in the present case due from the Iraqi Government was an incident of the assessee’s business and its settlement by the Central Government, (which allotted compensation bonds) could not on the date of such transfer, result in transfer of capital asset. Consequently, the assessee’s claim for entitlement to the benefit of indexation on the compensation bonds received (for which the value of the bonds at US$ 59,967,085/- was shown to be – after indexing at US$ 107,173,029/-) and a corresponding rupee equivalent loss upon conversion claimed at Rs.1,48,22,66,649/- was unacceptable either in the commercial sense of the term or based upon application of any legal principle.

Held by CIT (A): The CIT (Appeals) rejected the contention of the Assessee on the ground that since the Government of India issued compensation bonds to the assessee in lieu of debts due from Government of Iraq, this receipt was nothing but “Profit & Gain of business” taxable under Section 28 of the Income Tax Act.

Held by ITAT: ITAT rejected the appeal of the assessee upholding the concurrent findings of AO and CIT (A) and held that “…………………the amounts receivable were as a result of project so executed. The amount has arisen directly from carrying on the aforesaid business. But for the UN sanction as imposed, the amount would have been repatriated to India as was the case before UN sanction and employed in the trading operation of the business. In such a situation it would constitute a circulating capital as it is intended to be utilized in the course of business or for trading purpose or for effecting a transaction on revenue account. The amount retained abroad was on account of factor beyond the assessee’s power. The latter is however, not material for determining the character of the receipt. The amount as retained was not for utilising it for purchase of any capital asset”.

Held by High Court: The High Court noted that the way in which entries are made by the assessee in its books of accounts is not determinative of the character of the income which has to be determined on the facts and circumstances of each case. Nevertheless the conduct of the assessee cannot be completely ignored. The accounting entries as made have relevance while deciding the issue. At this juncture it would be relevant to mention that even before the Board of Direct Taxes this has never been the stand of the assessee. We would also like to mention that under Section 36 of the Act deduction in respect of any bad debt has been specifically allowed under clause (vii) of sub-sec. (1) of Sec. 36 of the Act. Under the aforesaid section the deductions have been provided for items which are of revenue nature. Deductions in respect of the items of capital nature have been specified as such as is the case in sec. 35(A). 35 AAB in distinction to sec. 35AB of the Act.

The High Court opined that the holding of amounts in foreign currency for diverse reasons by itself cannot be determinative of its character. The appreciation or depreciation in foreign currency value upon conversion would be either trading profit or trading loss. However, the exception to this is that if foreign exchange currency is kept as capital asset or fixed capital – in such event, the gain or loss would be of capital nature. In the instant case, the amounts were payable for services provided by way of projects executed by the assessee in Iraq. The Iraqi Government’s inability to pay due to sanctions imposed by it and the subsequent Central Government’s negotiating an arrangement for its payment through bonds that were to mature in future – with interest did not in any way alter their character or convert them into capital assets. The analogy of bad debts and their reduction from the revenue receipts in a given year and its converse treatment – by virtue of Section 36(1)(vii) is apt to the circumstance of the case. The assessee’s claim of capital loss, based on indexed treatment of capital gain is therefore insubstantial and unfounded on any principle.

After examining the facts and circumstances, the High Court decided that the ITAT order does not suffer from any infirmity. The question of law was answered against the assessee and in favour of the Revenue. The appeal thus failed and dismissed.

Categories: Income Tax
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