Deemed business income u/s 41(1)(a) – Remission or cessation of liability – Scope of section 41(1)(a) – Amount obtained mentioned in provision refers to actual amount obtained – Royalty payment claimed as expenditure in A.Y. 1990-91 – Tax deducted at source on such payment and interest paid to treasury – Royalty amount written back in accounts in A.Y. 1995-96 – Tax deducted at source and interest not refunded – Such amounts not includible u/s 41(1)(a)

Deemed business income u/s 41(1)(a) – Remission or cessation of liability – Scope of section 41(1)(a) – Amount obtained mentioned in provision refers to actual amount obtained – Royalty payment claimed as expenditure in A.Y. 1990-91 – Tax deducted at source on such payment and interest paid to treasury – Royalty amount written back in accounts in A.Y. 1995-96 – Tax deducted at source and interest not refunded – Such amounts not includible u/s 41(1)(a)

The assessee claimed a deduction of Rs. 53,71,650 for the A.Y. 1990-91 as expenditure, being royalty payable to a foreign collaborator. Though the deduction was allowed, the amount was not actually remitted outside India. In the meantime, an amount of Rs. 13,65,060 was paid towards tax deducted at source on the royalty amount and a further amount of Rs. 9,38,438 towards interest, under orders passed u/s 201(1A). Thus, a total amount of Rs. 23,03,498 was paid by the assessee towards tax and interest due to the Department against the deduction claimed towards royalty payable to the foreign collaborator. In the A.Y. 1995-96, the amount claimed as deduction for the A.Y. 1990-91, excluding the tax deducted at source and interest paid, was written back by the assessee into its accounts on account of the cessation of liability. Thus, in the return filed for the A.Y. 1995-96, the assessee had written back only Rs. 30,68,152 u/s 41(1). The A.O. held that the entire amount of Rs. 53,71,650 ought to be treated as a deemed profit u/s 41(1)(a) due to cessation of liability with the foreign collaborator.

The Tribunal upheld the addition.

On a reference by the assessee, the Kerala High Court allowed its claim and held as under:

‘i) A reading of section 41(1)(a) indicates that a legal fiction is created to treat the amount which was once deducted as an expenditure, if received back in another assessment year, as income from profits and gains of business. For the purpose of attracting section 41(1) it is necessary that the following conditions are satisfied: (i) the assessee had made an allowance or any deduction in respect of any loss, expenditure, or trading liability incurred by him; (ii) any amount is obtained in respect of such loss or expenditure or any benefit is obtained in respect of such trading facility by way of remission or cessation thereof; and (iii) such amount or benefit is obtained by the assessee in a subsequent year. Once these conditions are satisfied, the deeming provision enacted in the closing part of section 41(1)(a) gets attracted and the amount obtained becomes chargeable to Income-tax as profits and gains of business or profession.

ii) The purpose behind creating a fiction u/s 41(1)(a) is to tax the amount, earlier deducted but subsequently received back, to the extent recouped. It is a measure of taxing the amount recouped. Though a legal fiction must be given full effect, it should not be extended beyond the purpose for which it is created. It is true that Income-tax is a portion of the profits payable to the State and the tax payable is not a permissible deduction. Section 198 provides that all sums deducted for the purpose of computing income of an assessee, including the tax deducted at source, shall be treated as income received. However, this principle cannot be applied while determining the amount to be deemed as profits and gains u/s 41(1)(a). Such an interpretation, if adopted, will in fact be expanding the fiction created and even transform the chargeability.

iii) The words employed in section 41(1)(a) are “amount obtained by such person or the value of benefits accruing to him”. The “amount obtained” can only mean the actual amount obtained. The fiction created under the provision cannot be expanded to include amounts that may be obtained in the future. The legal fiction is intended to deem the actual amount obtained as profits and gains from business and to tax the actual amount. Section 41(1) employs, on the one hand, words such as “allowance” or “deduction”, and on the other hand “loss”, “expenditure”, or “trading liability”. These words are of general import and are understandably employed to take care of several fluid dynamics. These expressions are relatable to words used in section 41(1)(a), i. e., “the amount obtained by such person or the value of benefit accruing to him shall be deemed to be profits, gains, etc.” Therefore, an entry made in one previous year as an allowance or deduction towards “loss”, “expenditure” or “trading liability” when written back in a subsequent previous year, on account of the cessation of such liability, becomes taxable as profit or gains of business. But the tax liability should be commensurate with the actual amount received or the value of benefit accrued to the assessee in that financial year and not on the unrecovered amount or unacknowledged benefit by the assessee. The unrecovered amount becomes taxable only in the previous year when it is recovered or actually obtained.

iv) The amount of tax deducted at source and interest could be deemed to be profits and gains and chargeable to tax only on refund. The amounts paid as tax had not been obtained in 1995-96 as they had not been refunded. Until the amount of tax deducted at source was refunded, that amount could not be treated as an amount obtained by the assessee. The addition made by the A.O. was not justified.’