Issue for Consideration
Section 45 provides for the charge of tax in respect of
capital gains. It provides that any profits or gains arising from the transfer
of a capital asset shall be chargeable to income-tax under the head “Capital
Gains”, and shall be deemed to be the income of the previous year in which the
transfer took place.Entire capital gains is chargeable to tax in the year of
transfer of the capital asset, irrespective of the year in which the
consideration for the transfer is received.
Section 48 provides for the mode of computation of the
capital gains. It provides that the income chargeable under the head “Capital
gains” shall be computed by deducting from the full value of the consideration
received or accruing as a result of the transfer of the capital asset, the
expenditure incurred wholly and exclusively in connection with such transfer,
and the cost of acquisition and the cost of improvement of the asset.
In many transactions, particularly transactions of
acquisition of a company through acquisition of its shares, it is common that a
certain consideration is paid at the time of transfer of the shares, while an
additional amount is agreed to be
payable, the payment of which is deferred to a subsequent year or years, and is
dependant upon the happening of certain events, such as achievement of certain
turnover or profitability targets or obtaining of certain business or approvals
in the years subsequent to sale. Such receipt is contingent, in the sense that
it would not be payable if the targets are not achieved or the contemplated
event does not occur. Such payments are commonly referred to as “earn-outs”,
when they are linked to achievement of certain targets.
Given the fact that such payment may or may not be
receivable, the issue has arisen before the courts as to whether such
contingent consideration is chargeable to tax as capital gains in the year of
transfer of the capital asset. While the Delhi High Court has taken the view
that such contingent consideration is chargeable to income tax in the year of
transfer of the shares, the Bombay High Court has taken the view that such
contingent consideration does not accrue in the year of transfer of the shares,
and is therefore not taxable in that year.
Ajay Guliya’s case
The issue first came up before the Delhi High Court in the
case of Ajay Guliya vs. ACIT, 209 Taxman 295.
In this case, the assessee sold 1500 shares held by him
through a share purchase agreement dated 15 February 2006. The total
consideration agreed upon was Rs. 5,750 per share, out of which Rs. 4,000 was
payable on the execution of the share purchase agreement and the balance was
payable over a period of 2 years. The balance amount of Rs. 1750 per share
depended upon the performance of the company, and fulfilment of the specified
parameters. The assessee considered the sale consideration at Rs. 4,000 per share, while computing the capital gains in
his return of income for assessment year 2006-07.
The assessing officer held that the entire income accruing to
the assessee was chargeable as capital gains, and accordingly considered the
entire consideration of Rs. 5,750 per share for computation of capital gains.
The Commissioner (Appeals) allowed the appeal of the assessee, holding that
such part of the consideration which was payable in future did not constitute
income for the relevant assessment year and that the assessee would become
entitled to it only on the fulfilment of certain conditions, which could not be
predicated.
The Tribunal on being asked to examine the applicability of
the decision of the Authority for Advance Ruling held that the ratio of the
advance ruling in the case of Anurag Jain, in re, 277 ITR 1, was not
applicable, as in that case, the payment for consideration of shares was
interlinked with the performance of the assessee employee, and not the company
whose shares were transferred, and the question before the authority was
regarding the taxation of the capital gains and contingent payments under the
head “Salaries”. According to the tribunal, in the case before it, the issue
was one of transfer of shares simpliciter, and the payment of additional
consideration did not depend upon the performance of the assessee. The Tribunal
further noted that there was no provision for cancellation of the agreement in
case of failure to achieve targets. Considering the deeming fiction of section
45(1), the tribunal held that the whole of the consideration accruing or
arising or received in different years was chargeable under the head capital
gains in the year in which the transfer of shares had taken place. The tribunal
therefore held that the entire consideration of Rs. 5,750 per share was
chargeable to capital gains in the relevant year of transfer.
Before the Delhi High Court, on behalf of the assessee,
reliance was placed on the decision of the Supreme Court in the case of CIT
vs. B. C. Srinivasa Setty 128 ITR 294, for the proposition that the
provisions of the charging section, section 45 were not to be read in
isolation, but had to be read along with the computation provision, section 48.
It was argued that the entire consideration of Rs. 5,750 per share was not
payable at one go, and that the parties had specified conditions which would
have to be fulfilled before the balance of Rs. 1,750 per share became payable.
Even though the valuation had been agreed upon, much depended on the
performance of the company whose shares were the subject matter of the sale.
The balance amount of Rs. 1,750 per share could never be said to have arisen or
accrued during the relevant assessment year, as the assessee became entitled to
it only upon fulfilment of these conditions. The assessee could not claim the
balance amount unless the essential prerequisites had been fulfilled. It was
argued that the Supreme Court in Srinivasa Setty’s case, had held that though
section 45 was the charging section and ordinarily acquired primacy, while
section 48 was merely the computation mechanism, at the same time, in order to
arrive at chargeability of taxation, both the sections had to be looked into
and read together.
The Delhi High Court observed that the reasoning of the
tribunal was based upon the fact that capital assets were transferred on a
particular date, i.e., on the execution of the agreement. It noted that there
was no material on record or in the agreement, suggesting that even if the
entire consideration or part thereof was not paid, the title to the shares
would revert to the seller. According to the High Court, the controlling
expression of “transfer” was conclusive as to the true nature of the
transaction. In the opinion of the Court, the fact that the assessee adopted a
mechanism in the agreement that the transferee would defer the payments, would
not in any manner detract from the chargeability when the shares were sold.
Dealing with the argument that the tribunal’s had not dealt
with the deeming fiction about the accrual required by section 48, the High
Court was of the view that the tenor of the tribunal’s order was that the
entire income by way of capital gains was chargeable to tax in the year in
which the transfer took place, as stated in section 45(1). According to the
High Court, merely because the agreement provided for payment of the balance
consideration upon the happening of certain events, it could not be said that
the income had not accrued in the year of transfer.
The Delhi High Court therefore held that the entire
consideration of Rs. 5,750 per share was to be considered in the computation of
capital gains in the year of transfer.
Mrs. Hemal Raju Shete’s case
The issue again recently came up before the Bombay High Court
in the case of CIT vs. Mrs. Hemal Raju Shete 239 Taxman 176.
In this case, the assessee sold shares of a company under an
agreement, along with other shareholders of the company. Under the terms of the
agreement, the initial consideration was Rs. 2.70 crore. There was also a
deferred consideration which was payable over a period of 4 years following the
year of sale, which was linked to the future profits of the company whose
shares were being sold, and which was subject to a cap of Rs. 17.30 crore.
The assessee filed her return of income, computing the
capital gains by taking her share of only the initial consideration of Rs. 2.70
crore. The assessing officer was of the view that under the agreement, the
shareholders were to receive in aggregate, a sum of Rs. 20 crore, and therefore
proceeded to tax the entire amount of Rs. 20 crore in the year of transfer of
the shares in the hands of all the shareholders.
The Commissioner (Appeals) deleted the addition made by the
assessing officer on the ground that it was notional. He observed that the
working of the formula agreed upon by the parties for payment of the additional
consideration could lead, and in fact had led to a situation, where no amount
on account of deferred consideration for the sale of shares was receivable by
the assessee in the immediately succeeding assessment year. There was no
guarantee that this amount of Rs. 20 crore, or for that matter, any amount,
would be received. The amount to be received as deferred consideration was
contingent upon the performance of the company in the succeeding year.
Therefore, according to the Commissioner (Appeals), no part of the deferred
consideration could be brought to tax during the relevant assessment year,
either on receipt basis or on accrual basis.
The Tribunal upheld the findings of the Commissioner
(Appeals), holding that, as there was no certainty of receiving any amount as
deferred consideration, the bringing to tax of the maximum amount of Rs. 20
crore provided as a cap on the consideration, was not tenable. The Tribunal
further held that what had to be brought to tax was the amount which had been
received and/or accrued to the assessee, and not any notional or hypothetical
income.
Before the Bombay High Court, on behalf of the revenue, it
was argued that transfer of capital asset would attract capital gains tax in
terms of section 45(1), and that the amount to be taxed u/s. 45(1) was not
dependent upon the receipt of the consideration. Attention of the court was
drawn to sections 45(1A) and 45(5), which in contrast, brought to tax capital
gains on amounts received. It was therefore submitted that the assessing
officer was justified in bringing to tax the assessee’s share in the entire
amount of Rs. 20 crore, which was referred to in the agreement as the maximum
amount that could be received on the sale of shares of the company by the
shareholders from the purchaser.
The Bombay High Court noted the various clauses in the
agreement in relation to the deferred consideration, and observed that the
formula prescribed in the agreement itself made it clear that the defer
consideration to be received by the assessee in the 4 years was dependent upon
the profits made by the company in each of the years. Thus, if the company did
not make a net profit in terms of the formula for the year under consideration
for payment of deferred consideration, then no amount would be payable to the
assessee as deferred consideration. The court noted that the consideration of
Rs. 20 crore was not an assured consideration to be received by the selling
shareholders. It was only the maximum that could be received. According to the
High Court, this was therefore not a case where any consideration out of Rs. 20
crore or part thereof (other than Rs. 2.70 crore), had been received or had
accrued to the assessee.
The Bombay High Court noted the observations of the Supreme
Court in the case of Morvi Industries Ltd vs. CIT 82 ITR 835, as under:
“The income can be said to
accrue when it becomes due………. The moment the income accrues, the assessee gets
vested right to claim that amount, even though not immediately”
According to the Bombay High Court, in the relevant
assessment year, no right to claim any particular amount of the deferred
consideration got vested in the hands of the assessee. Therefore, the deferred
consideration of Rs. 17.30 crore, which was sought to be taxed by the assessing
officer, was not an amount which had accrued to the assessee. The test of
accrual was whether there was a right to receive the amount, though later, and
whether such right was legally enforceable. The Bombay High Court noted the
observations of the Supreme Court in the case of E. D. Sassoon & Co.
Ltd. 26 ITR 27:
“it is clear therefore that
income may accrue to an assessee without the actual receipt of the same. If the
assessee acquires a right to receive the income, the income can be said to have
accrued to him, though it may be received later on its being ascertained. The
basic conception is that he must have acquired a right to receive the income.
There must be a debt owed to him by somebody. There must be as is otherwise expressed
debitum in presnti, solvendum in futuro…”
The Bombay High Court noted that the amount which could have
been received as deferred consideration was dependent/contingent upon certain
uncertain events, and therefore it could not be said to have accrued to the
assessee. The Bombay High Court also noted the observations of the Supreme
Court in the case of CIT vs. Shoorji Vallabhdas & Co. 46 ITR 144:
“Income tax is a levy on
income. No doubt, the income tax Act takes into account two points of time at
which liability to tax is attracted, viz., the accrual of its income or its
receipt; but the substance of the matter is income. If income does not result,
there cannot be a tax, even though in bookkeeping, an entry is made about a
hypothetical income, which does not materialise.”
The Bombay High Court also noted the observations of the
Supreme Court in the case of K. P. Varghese vs. ITO 131 ITR 597, to the
effect that one has to read capital gains provision along with computation
provision, and the starting point of the computation was the full value of the
consideration received or accruing. In the case before it, the Bombay High
Court noted that the amount of Rs. 17.30 crore was neither received, nor had it
accrued to the assessee during the relevant assessment year. The Bombay High
Court also stated that it had been informed that for subsequent assessment
years, other than the year in which there was no deferred consideration on
account of the formula, the assessee had offered to tax the amounts which had
been received pertaining to the transfer of shares.
The Bombay High Court also rejected the argument of the
revenue that by not bringing it to tax in the year of transfer on the ground
that it had not accrued during the year, the assessee was seeking to pay tax on
the amount on receipt basis. The High Court observed that accrual would be a
right to receive the amount, and the assessee had not obtained a right to
receive the amount in the relevant year under the agreement.
The Bombay High Court accordingly held that the deferred
consideration of Rs. 17.30 crore could not be brought to tax in the relevant
assessment year, as it had not accrued to the assessee.
Observations
There is not much of a debate possible in cases where the
consideration for transfer is agreed but the payment thereof is deferred. The
facts of Ajay Gulati’s case seemed to suggest that. In that case, a lump sum
consideration was defined and was agreed upon but the payment thereof was
deferred based on happening of the event. The case perhaps could have been
better in cases where the lump sum is not agreed upon at all, but a minimum is
agreed upon, and the additional payment, if any, is made contingent as to
quantum and the time, on the basis of certain deliverables.
Besides ‘transfer’, the most important thing, for the charge
of capital gains tax, is that there should arise profits and gains on transfer
and it is that profits that has arisen as a result of the transfer that can be
brought to tax. A profit that has not arisen or the one that has yet to arise
may not be termed as having arisen so as to bring it to tax. Another equally
important requirement is that the consideration must have been ‘received or
accrued’ for it to be treated as the ‘full value of consideration’ in terms of
section 48 of the Act. It is only such consideration that can enter in to the
computation of the capital gains. In the case of the additional payments, that
can accrue only on happening of the event and can be received only thereafter.
No right to receive accrues till such time the events happen.
A clause for cancellation may help in minimising the damage
for the assesseee as had been observed by the Delhi high court in Ajay Gulati’s
case. A transfer expressly providing for cancellation, not of the transfer, but
of the right to receive additional compensation, may help the case of the
assessee.
“Full Value of Consideration” is a term that has not been
defined in section 48 of the Act. Its meaning therefore has to be gathered from
a composite reading of the provisions of section 48 of the Act. The term is
accompanied with the words ‘received or accruing’, which words indicate that it
is such a consideration that has been received or has accrued in the least,
failing which it may not enter in to the computation for the time being for the
year of the transfer.
There is a possibility that the additional consideration
would be taxed as income for the independent performance by the transferor in
the subsequent year and be taxed independently in a case where the transferor
is required to perform and deliver certain milestones, subsequent to the
transfer of shares. In such a case, the additional payment accrues to him for
delivering the milestones based on his performance and in such a case the
payment would be construed to be the one for the performance, and not for
transfer of the shares; it would accrue only on performance, and cannot be
taxed in the year of transfer. Please see Anurag Jain’s case (supra).
An alternative to the issue is to read the law in a manner
that permits the taxation of capital gains in different years; ascertained
gains in the year of transfer and the contingent ones only on accrual in the
year thereof and yet better in the year of receipt. It is not impossible to do
so. The charge of section 45 should be so read that it fructifies in two years
instead of one year. There does not seem to be anything that prohibits such a
reading of the law. In taxing the business income, it is usual to come across
cases wherein the additional payments contingent on happenings in future years
are taxed in that year on the ground that they accrue on happening of an event.
It is for this reason that the Bombay high court in Shete’s case has relied
upon the decisions delivered in the context of the real income.
The logic of the Bombay High Court decision does seem
appealing, as a notional income or income, which has not accrued, can never be
taxed under the Income Tax Act. Taxation of such a potential income under the
head “Capital gains” in the year of transfer of the capital asset, merely on
the ground that the charge is linked to the date of transfer, does not seem
justified, where such consideration has not really accrued and there is a
possibility that it may not be recieved.
The peculiar nature of this controversy is on account of the
fact that the charge to capital gains is in the year of transfer, while the
computation is on the basis of accrual or receipt. In the case of earn outs,
there is no accrual in the year of transfer, but in the year of accrual, there
is no transfer of a capital asset.
Therefore, if one follows the Delhi High Court decision, one
may end up paying tax on a notional income which one may never receive. On the
other hand, if one follows the Bombay High Court decision, it may result in a
situation where the deferred consideration is never taxed, as it does not
accrue in the year of transfer, and in the subsequent year when it accrues, the
charge to tax fails on account of the fact there is no transfer of the capital asset.
From the facts of the Bombay High Court decision, it is not
clear as to under which head of income the deferred consideration was offered
to tax in subsequent years when it accrued. However, to a great extent, the
decision of the Bombay High Court may have been influenced by the fact that
such deferred consideration was taxed in subsequent years. Again, the
substantial amount of deferred consideration as against the initial
consideration, and the direct linkage of the formula for determination of
deferred consideration with the profits of the company, may have impacted the
decision of the Bombay High Court.
Therefore, while on principles, the Bombay High Court
decision seems to be the better view of the matter, it is essential that the
law should be amended to bring clarity to the taxation of such deferred
consideration which does not accrue on the transfer of the asset. There are
already specific provisions in the law in the form of section 45(5) in relation
to enhanced compensation received on compulsory acquisition of a capital asset
by the Government, where such enhanced compensation is taxable in the year of
receipt, and is not taxable in the year of transfer of the capital asset.
Pending such amendment to the law, the only option available
to an assessee is to initially offer the capital gains to tax on the basis of
the initial consideration, and subsequently revise the return of income to
reflect the enhanced consideration on account of the deferred consideration as
and when it accrues. Even here, this is not a happy situation, as the time
limit for revision of a return of income under the provisions of section
139(5), is now only one year from the end of the relevant assessment year. If
this time limit has expired, by the time the deferred consideration accrues,
even such a revision would not be possible. Rectification u/s. 154 is yet
another possibility whereunder the additional payment on happening of an event
and on receipt be tagged to the original consideration and be taxed in the year
of transfer.