This article summarizes a recent ruling of the Special Bench (SB) of the Mumbai Income Tax Appellate Tribunal (ITAT) [ITA No. 7315/Mum/2007] in the case of DCIT vs. Manjula Shah (Taxpayer) which held that, in the case of gifted capital asset, indexation benefit is available to a donee from the year of its acquisition by the previous owner. The SB adopted a purposive construction of the definition of ‘Indexed Cost of Acquisition’ (ICOA) by looking at the scheme of the Indian Tax Law (ITL), which seeks to grant the benefit of cost and holding period of the previous owner to the donee.
Background and facts of the case
- As per the provisions of the ITL, profit or gains arising from the transfer of a capital asset, effected in a tax year, is computed by deducting Cost of Acquisition (COA) of the capital asset from the full value of the consideration, received or receivable. Where the asset is a long-term capital asset, i.e. held for more than 1 year for financial assets like shares, securities etc. and 3 years for other assets, the ITL permits deduction of the ICOA instead of the COA.
- The ICOA is computed by enhancing the COA by cost inflation index (CII), as per the following formula :
ICOA = COA x CII of the year of transfer
CII of the first year in which the asset was held by the taxpayer
 CII is notified every year on the basis of average rise in Consumer Price Index for urban non-manual employees.
- In case of capital asset acquired by a taxpayer by way of a gift, the ITL provides that the COA of the previous owner is to be treated as that of the taxpayer. The holding period of the previous owner is also included in determining whether the asset is a long-term capital asset for the taxpayer.
- The Taxpayer, an individual, earned long-term capital gains (LTCG) in the tax year 2003-04 (assessment year 2004-05) from the sale of residential flat in Mumbai. She had received the flat as a gift from her daughter (the donor) in the tax year 2002-03. The donor had purchased the flat in the tax year 1992-93.
- There was no dispute that the gain was LTCG, as the flat was held for more than 3 years, considering the aggregate of the holding period of the donor and the Taxpayer.
- The Taxpayer computed the LTCG, by calculating the ICOA applying the CII for 1992-93, being the year in which the flat was acquired by her daughter.
- The Tax Authority, however, recomputed the LTCG, by applying the CII for 2002-03, being the year in which the flat was acquired by the Taxpayer under gift from her daughter.
- Being aggrieved, the Taxpayer appealed to the first appellate authority who upheld the Taxpayer’s contention. The Tax Authority appealed further to the ITAT.
In view of conflicting rulings of different benches of the ITAT on the identical issue, an SB was constituted to adjudicate the issue in the case of the Taxpayer.
Contentions of the Taxpayer
In case of a capital asset acquired under gift, the ITL specifically provides for substitution of the COA of the previous owner and inclusion of the holding period of the previous owner, in the hands of the taxpayer. The definition of the ICOA refers to the first year in which the capital asset is held by the taxpayer. The holding by the taxpayer needs to be construed as inclusive of the holding period of the previous owner.
- For the purpose of computing the LTCG, when the date of acquisition and the COA of the previous owner are treated as the date and cost of acquisition of the taxpayer, there is no reason or logic in not adopting the same while computing the ICOA.
Contentions of the Tax Authority
- The definition of the ICOA under the ITL specifically provides that the benefit of indexation shall be available from the first year in which the capital asset was held by the taxpayer. The benefit of indexation would, therefore, be available only from the year in which the taxpayer becomes the owner of the asset. The definition of the ICOA is plain and clear and, hence, needs to be applied literally.
- The inclusion of the holding period of the previous owner on the strength of the specific provision is for the limited purpose of determining whether the capital asset is a longterm or a short-term capital asset. It has no relevance in the computation of the ICOA.
- In the present case, the Taxpayer held the flat from the tax year 2002-03, being the year in which she received the flat as a gift from her daughter. Hence, the indexation benefit would be available from that year only.
Ruling of the SB
The SB ruled in favor of the Taxpayer and held that the Taxpayer was entitled to indexation benefit from the year of acquisition by the previous owner, for the following reasons:
- The transfer of a capital asset under a gift is not charged to capital gains, in terms of the provisions of the ITL. However, where such an asset is subsequently transferred by the successor, the date of acquisition and the COA of the previous owner are adopted, for computing the capital gains in the hands of the successor. The capital gains, which would have been chargeable in the hands of the previous owner, is thereby shifted and made chargeable in the hands of the successor. This is the scheme of the ITL, as borne out by the relevant provisions.
- The definition of holding period of capital asset, which provides for inclusion of the holding period of the previous owner in case of gifted asset, applies to all the provisions of the ITL and, hence, needs to be read into the definition of the ICOA as well. So, read contextually, in the definition of the ICOA, the reference to the first year in which the asset was held by the taxpayer needs to be construed as inclusive of the holding period of the previous owner.
- The position adopted by the Tax Authority, based on literal interpretation, would result in denial of the benefit of indexation for the holding period of the previous owner. As explained in CBDT Circular No. 636 dated 31 August 1992, the current system of enhancing the COA by applying the CII is intended to grant relief from inflationary effect. The relief is linked to the holding period of the capital asset. Exclusion of the holding period by the previous owner, while computing capital gains in the hands of the successor, will lead to absurdity and an unjust result. The SB placed reliance on the ruling of the Supreme Court in the case of K.P. Varghese vs. ITO (131 ITR 597) which held that literal interpretation, leading to absurdity, should be avoided.
- Since the COA and the holding period of the previous owner are adopted for the computation of capital gains in the hands of the taxpayer, denial of the indexation benefit for the holding period of the previous owner does not stand to any reason or logic.
- The SB preferred to adopt a rule of purposive construction, under which the words in the statute are interpreted in a manner in which they best harmonize with the subject matter of the enactment and the object of the legislature.
An SB is generally constituted when there are conflicting decisions of the Tribunals or the matter pending for adjudication is of considerable importance. It is also a well-settled convention to consider the SB’s decision as binding on the division benches of the Tribunal.
The current ruling provides guidance that in the case of a gifted asset, indexation benefit is available from the year of acquisition of the previous owner. It also provides guidance that where literal interpretation leads to absurd result, a purposive construction of the legislature must be adopted in a manner in which they best harmonize with the subject matter of the enactment and the object of the legislature.