Some fundamental tax questions never seem to go out of fashion, irrespective of numerous judicial precedents on the matter. One such matter is the taxability of income from renting of immovable properties (Land and Buildings). The Income can broadly fall under the following two heads of income in the Income Tax Act:
Taxability as HP provides (or limits) a standard deduction of 30% of the income along with a deduction on interest paid on borrowed capital for the purposes of acquisition, construction, repair, reconstruction, etc. (subject to limitations provided under the Act).
On the other hand, when taxed as PGBP, any expenditure laid out or expended wholly and exclusively for the business of leasing shall be allowed as a deduction for tax purposes.
As there are no limits or restrictions on deductions under the head PGBP, taxpayers veer towards classifying rental income received from lease of immovable property as PGBP. Obviously, this requires the support of facts in every case. The tax authorities, on the other hand, argue that rental income should be chargeable to tax as HP Income, perhaps the ease (and limitation) of deductions under HP being the driving force.
This is the genesis of the tussle between taxpayers and the department on taxability of rental income from lease of immovable property. However, thanks to the judiciary, over time and after many cases, certain key principles have emerged as cornerstones or templates for characterisation of rental income under the head PGBP.
Some of the salient ones are as follows:
1. Intent of the taxpayer – this intention can be gathered from the agreement for lease, Memorandum of Association and subsequent conduct of the parties.
2. Active ownership of property – if a property yields rental income by virtue of its own legal existence it would be classified as passive ownership and may be classified as HP.
3. Constitution documents of the taxpayer provide that the main object is to hold the properties (presumably not for gains) and let them out to earn rental income – the activities carried out by the taxpayer should be in line with the constitution documents.
The trend of judicial precedents and directions released by the Central Board of Direct Taxes (CBDT) reveal that the authorities are now accepting that ownership of property and leasing it out may also be done as part of a “business,” apart from as a mere owner. Some of these judicial precedents and directions are as follows:
The Apex court in Chennai Properties & Investments Limited v. CIT, Karanpura Development Co. Limited and Rayala Corporation (P.) Limited v. ACIT, held that the deciding factor is not the ownership of the land or leases, but the nature of the activity of the taxpayer and the nature of the operations in relation to the same. Further, the Apex court has emphasised that for income to be characterised as “business income,” the activities actually carried out by the taxpayer need to be in line with its main object, according to its constitution documents.
Further, the CBDT has issued circular no. 16/ 2017 dated 25 April, 2017, wherein it has been clarified that the income from letting out of premises/ developed space along with other facilities in an industrial park/ SEZ is to be charged to tax under the head PGBP and has guided the department in not filing any appeals on this issue and to withdraw/ not press upon appeals already filed.
In the case of Raj Dadarkar & Associates v. ACIT, the Apex court has held that apart from relying on the object clause, the taxpayer would be required to produce or refer any other material to show the conduct of activities as per its constitution documents. Based on the material produced by the taxpayer, the Apex court held that the taxpayer was unable to establish that he was engaged in any systematic or organised activity of providing services to the occupiers of the shops to constitute receipts from them as business income.
Therefore, when taxpayers are able to provide factual material to substantiate that their activities are in the nature of business and in line with their constitution documents, we hope to see reduced litigation on this issue. Needless, judicial precedents also seem to test the substance over form of transactions. Risk of litigation and related cash tax outflows could impact transaction values in the real estate sector.
(Views expressed are personal to the author. Article includes inputs from Janardhan Rao Belpu – Director – M&A Tax, PwC India, Kunal Singhaniya – Assistant Manager – M&A Tax, PwC India and Soumya Rastogi – Associate – M&A Tax, PwC India.)
  373 ITR 673 (SC)
  44 ITR 362 (SC)
  386 ITR 500 (SC)
 Civil Appeal Nos 6455-6460 of 2017
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(Republished with Amendments by Team Taxguru)