August 31 2010
Supreme Court decision
The distinction between revenue and capital under the income tax law is fundamental. Ordinarily, tax is levied on income, but not on capital profits. The issue of whether a particular receipt is capital or income derived from business is frequently presented to the courts and depends on the particular facts and circumstances of each case.
The assessee, a cement manufacturer, entered into an agreement with the supplier for the purchase of an additional cement plant for a total consideration of Rs17 million. The agreement contained a condition with regard to the manner in which the machinery was to be delivered and the consequences of delay in such delivery. Specifically, Clause 6 in the agreement stipulated that in the event of delay in the delivery of the machinery, the assessee was to be paid compensation at a rate of 0.5% of the price of the respective portion of the machinery for each month of delay by way of liquidated damages from the supplier, without proof of actual loss. In addition, the clause provided that the total amount of damages be capped at 5% of the total price of the plant and machinery. The supplier defaulted on its obligations under the contract by delaying the supply of the plant and machinery. Accordingly, the assessee received Rs850,000 from the supplier by way of liquidated damages under the terms of the agreement.
During the course of the assessment proceedings for the relevant assessment year, a question arose regarding whether the amount received by the assessee as damages was a capital or revenue receipt. The assessing officer, as well as the commissioner of income tax (appeals), denied the assessee's claim that the amount should be treated as a capital receipt and included the amount under the assessee's total income. The assessee carried the matter further in an appeal to the Income Tax Appellate Tribunal, which concluded in favour of the assessee, determining the amount as a capital receipt.
Law on compensation
Compensation paid for delay to the procurement of capital assets amounts to compensation for sterilisation of the assessee's profit-earning source and cannot be said to have been incurred in the ordinary course of business.Thus, such compensation must be treated as a capital receipt in the hands of the assessee.
The Supreme Court(1) held that on account of the supplier having failed to supply the plant within the time stipulated in the agreement, Clause 6 (providing for the remedy of liquidated damages) came into play. The court observed that it was evident that the damages to the assessee were directly and intimately linked with the procurement of a capital asset (ie, the cement plant). The damages would obviously lead to a delay in the establishment of the assessee's overall profit-making business and could easily be perceived as a receipt in the course of the profit-earning process (ie, a revenue receipt). However, the court concurred with the observations of the Income Tax Appellate Tribunal that the incoming receipt was not a revenue receipt: it had no connection with any loss or profit, as the source of income (ie, the machinery itself) was yet to be installed. Accordingly, the court held that the amount received by the assessee towards compensation for sterilisation of its profit-earning source was not received in the ordinary course of its business and thus was a capital receipt, not a revenue receipt.
In arriving at its finding, the court observed that it has frequently considered the question of whether a particular receipt is capital or revenue, and that there has never been a single decisive criterion in determination of this question. The court referred to its observations in Commissioner of Income Tax v Rai Bahadur Jairam Valji ((1959) 35 ITR 148 (SC)) that the question of whether a receipt is capital or revenue will ultimately depend on the facts of the particular case, and that the authorities on the question are valuable only as indicators of the factors that must be taken into account in reaching a decision.
The court also relied on the general principle enunciated in Kettle Bullen and Co Ltd (AIR 1965 SC 65), that where the agency is cancelled and the assessee's trading structure is impaired or such cancellation results in loss of what may be regarded as the source of the assessee's income, the payment made to compensate for such cancellation of the agreement is normally a capital receipt.
This general declaration of law laid down in Kettle Bullen still presides and its binding force and authority have not been undermined by subsequent decisions. In the present case, the court reaffirmed the Kettle Bullen principle and appreciated that while an inherent difficulty remains in ascertaining whether what is received in a given case is compensation for loss of a source of income or profit in a trading transaction, each instance of receipt must be assessed on its particular facts, be it a cancellation of agency, compensation for loss of an office or compensation for breach of contract by delaying payment of the balance amount. The court reaffirmed the principle that when no income is received for a settlement of rights under a trading contract, and instead injury is inflicted on the assessee's impending capital asset resulting in a loss of income, the receipt will be a capital receipt and not a revenue receipt.
For further information on this topic please contact Manu Nair or Saanjh Purohit at Amarchand & Mangaldas & Suresh A Shroff & Co by telephone (+91 11 2692 0500) or by fax (+ 91 11 2692 4900) or by email (email@example.com or firstname.lastname@example.org).
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