Adv. Bharat Agarwal
The legislature has been intending to plug leakages of such incomes which the judiciary treats as non taxable for varied reasons. Charging section 4 of the Act has left doors open from where certain gains and incomes escape chiefly because they are in the nature of capital receipt. It is common knowledge that all revenue receipts are taxable unless exempt and all capital receipts are exempt unless taxable. Therefore, the capital receipts which are not included within the provisions of Capital Gain are not liable for tax under any other head.
To ensure that the receipts do not go untaxed, the legislature brought in amendments to section 28 from time to time. For instance, non compete fee received by an assessee was treated as capital receipt until in 2003 an amendment was made by introducing section 28(va) to specifically tax such non compete fee. Inspite, of these attempts by the legislature the courts have been passing judgments treating certain kinds of receipts as capital receipts not liable for tax.
With effect from 1.4.2018 (AY 2019-20) a new sub clause (e) has been added to section 28(ii) to bring into tax net gains / receipts in the nature of compensation arising out of termination / modification of a contract related to business of the assessee. In this article we try and analyze whether the attempt of the legislature to tax all capital receipts has been successful with the enactment of the said sub clause.
CBDT has vide CIRCULAR No.8/2018 dated 26th December, 2018 explained the purpose and objective of enacting the additional provision. It states as under:
“13. Taxability of compensation in connection to business or employment
13.1 Before amendment by the Act, the provisions of section 28 of the Income-tax Act provided that certain types of compensation receipts shall be taxable under the head “Profits and gains of business or profession”. However, the scope of thissection was restrictive since it did not cover a large segment of compensation receipts in connection with business and employment, leading to base erosion and revenue loss.
13.2 Accordingly, section 28 of the Income-tax Act has been amended to provide that any compensation received or receivable, by any person, whether revenue or capital, in connection with the termination or the modification of the terms and conditions of any contract relating to his business shall also be taxable under the head “Profits and gains of business or profession”. Further, section 56 of the Income-tax Act has also been amended to provide that any compensation received or receivable by any person, whether in the nature of revenue or capital, in connection with the termination or the modification of the terms and conditions of any contract relating to his employment shall be taxable under the head “Income from other sources”. Consequential amendment has also been made in clause (24) of section 2 of the Income-tax Act.
13.3 Applicability: These amendments takes effect from 1st April, 2019 and will, accordingly, apply in relation to assessment year 2019-20 and subsequent assessment years.”
Section 28 clause (ii) sub clause (e) states as under:
“any compensation due or received by any person, by whatever name called, at or in connection with the termination or the modification of the terms and conditions, as the case may be, of any contract relating to his business shall be chargeable to tax under the head “Profits and gains of business or profession”
A perusal of the above provision reveals that with the inclusion of the phrases like “by whatever name called”, “due or received” and “at or in connection with” the said section is widely worded. The language of the section barely keeps anything out and the legislature
has bolted almost all doors which could have allowed an escape from taxability.
Let us try and break up the said provision by analyzing some of the keywords / phrases used in the provision so as to understand what can be the intent of legislature in enacting the provision and whether still there are transactions which are not covered in the said amendment:
1. Compensation by whatever name called: The essential ingredient of the said provision is that the amount received must be a “compensation” by whatever name called. Any receipt which does not fall within the definition of the term “compensation” is not liable for tax. Even the phrase “by whatever name called” is linked to the term “compensation” and hence cannot engulf within itself any other receipt. The said compensation could have been received in the form of onetime amount or periodical payments, whether as liquidated damages or interest or salary or remuneration or non compete or any other nomenclature. Therefore, the said provision cannot be avoided merely by terming the compensation as anything else.
2. Due or Received : The use of the phrase shows that the said amount is taxable on accrual basis irrespective of whether the assessee has actually received it. This phrase would be contentious as regards the year in which the amount of compensation would be taxable. Often the compensation is linked to the performance of the business in future like percentage of turnover achieved or the recovery made. Neither the amount is quantified in such cases nor the enforceability has arisen. Yet the department would like to prepone the taxability.
3. At or in connection with: This phrase is again widely worded. The phrase does not use the words “compensation for termination”. Hence the compensation received even in connection with the termination of contract is covered. Remote connection, if pleaded by the assessee may not bear fruits now as courts would not interpret the phrase restrictively. The words “in connection with” has been judicially interpreted in the case of Renusagar Power Company Ltd. v. General Electric Company AIR 1985 SC 1156 wherein the apex court has held that expressions such as ‘arising out of” or “in respect of” or “in connection with” or “in relation to” or “in consequence of” or “concerning” or “relating to” the contract are of the widest amplitude and content.
4. Termination of contract- Earlier the compensation received for breach of contract was being treated as capital in nature and hence was outside the taxable net for the reason that the receipt was for compensating the loss of source of income. Now the compensation received or receivable in connection with termination of contract would become taxable irrespective of whether it is capital or revenue in nature. The apex court has in the past laid down that compensation received which is revenue in nature is taxable as business income and hence to that extent the provisions of the amended section is a mere reiteration. However, now even the compensation which is in capital field would become taxable.
5. Modification of terms and conditions – Where the compensation is received for modification of any term or condition of a pre-existing contract, such compensation would now be taxable. Therefore any amount received by a partner for reduction in profit sharing ratio or restructuring of partnership terms would be taxable even if it falls within capital field.
6. Any contract- Existence of a contract is a sine qua non for invoking this clause. As per Indian Contract Act the contract can be in writing or verbal. The question is whether entering into a fresh contract would be covered in this clause or not since the provision mentions “termination and modification” of a contract. Obviously termination and modification can only be of an existing contract. If a fresh contract is made where there was no previous agreement and accordingly some compensation is paid then whether this section come into force? I await a judicial finding on this aspect.
7. Relating to his business – this is the only limitation / boundary created around the section. Personal contracts or contracts unrelated to business of the recipient of compensation is not covered in the clause. The section doesn’t say that the recipient should be having income taxable under the head PGBP. It’s sufficient if he is having a business and the contract is entered in the course of such business. However, if there is no business or if the said compensation is not linked to the business then the compensation received due to termination / modification of any other contract would not result into this section being invoked.
So lets see which past precedence have lost their precedence value due to the amendment in the Act.:
1. Baroda Cement and Chemicals Ltd (1986) 158 ITR 636 (SC): This was a case where the assessee agreed to buy a second hand mill for an agreed price. The vendor committed a breach of contract. The assessee received damages for not suing the vendor. The court held that this compensation was a capital receipt since “right to sue” was given up which is not a transferable right and hence not chargeable to capital gain tax. Now with the amendment in place it being a contract entered in relation to business, compensation is for termination of contract. Even if such compensation is in capital field it is covered under section 28(ii)(e) of the Act. The important point to consider is that compensation is payable “at or in connection with the termination of contract”. It’s not “for termination of contract” and therefore the field is much wider.
2. CIT vs. Prashant S. Joshi (2010) 324 ITR 154 (Bom.): compensation received over and above capital balance on retirement of the partner is now taxable. The partnership agreement is a contract between the partners. Retirement of a partner is a termination of such contract and is connected with the business of the partner. Hence now any excess amount received could become taxable under the amendment provision.
3. CIT vs. Parle Soft Drinks (2018) 400 ITR 108 (Bom.) approved by Supreme Court (2018) 97 taxmann.com 136 (SC): Compensation for breach of contract resulting in loss of source of income if emanating from termination of a business contract would also become taxable. Therefore where an agreement for setting up a bottling plant was breached and accordingly damages paid for loss of source of income was treated as capital receipt would now become taxable under the amended provision. Similar reference can be made to the decision of Supreme Court in the case of CIT vs. Oberoi Hotel (P.) Ltd. (1999) 236 ITR 903 (SC).
What still escapes: So whether all compensation are taxable now or whether still some compensation would be capital receipt. Some instances where the amended provision would not apply are:
1. Compensation for any personal injury or for an asset not related to the business asset is not covered in the amended provision. For instance, a flat purchaser gets compensation from a builder for delayed or default delivery and he gives up his right to sue. This is not connected to the business of the recipient and hence, the amended provision would not apply.
2. Compensation received for entering into a contract. Since the provision talks of termination / modification it presumes a pre-existing contract. I leave the issue to the imagination of the readers to figure out how and which compensation is received for entering into an agreement.
3. ACIT v. Jackie Shroff (2018) 97 Taxmann.com 277 (Mum) – Here the compensation was received by the assessee for withdrawing criminal case. The said matter was personal in nature and not connected to business. Hence the compensation would not be taxable.
Key Issues Emerging:
The above amendment is not free from interpretational pangs. It has its share of pains and agony. Some of the key interpretational issues that would arise before the courts are discussed hereunder :
1. Whether the original contract and revised contract has to be with the same party or could be with different parties. For instance, if a contract to acquire property with A but relinquishment in favour of C results in compensation to B whether it can be brought under this section. Whether it can be said that the compensation is for cancellation of contract between A and B or whether the compensation is for assignment of rights by B to C.
2. Similarly, where a partner retires from the firm, it’s treated as a termination of contract between the partners inter se under the Indian Partnership Act, 1932. The question is whether it can be argued that such contract is not connected with the business of partner but the business is in fact that of the firm. Whether we have to apply the law that a firm is nothing but a compendium of partners and hence the termination of contract between partners inter se would also mean termination of contract in relation to “his” business. Also, we have to consider the fact that the income earned by the partner from the firm is taxable as business income under section 28(v) of the Act. Thus, the Act recognize that partner is involved in a business and hence the amount received as compensation could now be taxed under the amended provision of sec. 28.
3. Whether compensation received on giving up “right to sue” is now taxable. The hon’ble Gujarat High Court in the case of Baroda Cement and Chemicals Ltd. (supra) has held that such compensation is a capital receipt not taxable. Now if such compensation is receivable as the right to sue in relation to a business contract then the said sum could become taxable. However, if such compensation is received devoid of a business contract then would continue to be non taxable capital receipt.
The amended provision provides that compensation received will be taxed under the head “Profits and gains of business or profession” .This seems to be in line with the decision of the Apex Court in the case of CIT v. Raj Bahadur Jairam (1959) 35 ITR 148(SC) wherein the court held that money received as a compensation for termination of a business contract is taxable as business income provided such termination does not result in giving up of source of income. The amended provision goes a step further and provides for taxability of all compensation connection with business and therefore even the giving up of source would now become taxable.