THE GHOST OF B.C. SRINIVASA SETTY IS NOT YET EXORCISED IN INDIA

DECISION IN B.C. SRINIVASA SETTY’S CASE AND INSERTION OF SECTION 55(2)(a)
The question as to whether ‘goodwill’ generated in a newly commenced business can be described as an ‘asset’ for the purposes of Section 45 came for consideration before a 3-judge bench of the hon’ble supreme court in the case of B.C. Srinivasa Setty’s case (supra).

While concluding that the self-generated goodwill was undoubtedly an asset of the business, the court, however held that self-generated goodwill was not an asset within the contemplation under Section 45.

The court took note of the provisions relating to capital gains and laid down the important principle that the charging section and the computation provisions together constitute an integrated code. When there is a case to which the computation provisions cannot apply, it is evident that such a case was not intended to fall within the charging section. The court observed that Section 48(ii) required deduction of the cost of acquisition from the full value of consideration in computing the capital gains chargeable under Section 45. Thus, the court held that what is contemplated under the provisions of Section 45 and 48 is an asset for which it is possible to envisage a cost of acquisition. Taking note of the fact that in case of goodwill of a new business acquired by way of generation, no cost element can be identified or envisaged, the court reached the conclusion that the goodwill of a new business, though an asset could not be regarded as an asset within the contemplation of the charge under Section 45.

In paragraph 12 of the said judgement, the court has observed that in the case of internally generated goodwill, it is not possible to determine the date when it comes into existence. It has been observed that the date of acquisition of the asset is a material factor in applying the computation provisions pertaining to capital gains. It has been held that the ‘cost of acquisition’ mentioned in Section 48 implies a date of acquisition.

To overcome the above decision in B.C. Srinivasa Setty’s case (supra), Section 55(2)(a) was inserted vide Finance Act, 1987 with effect from 1st April, 1988. The said section originally contained two clauses. Clause (i) dealt with capital asset being goodwill of a business acquired by purchase from a previous owner, and clause (ii) dealt with the residual clause.

However, a reading of the memorandum to Finance Bill, 1987 would indicate that the amendment sought to deal with two classes of goodwill being – a) purchased goodwill and b) self-generated goodwill.

Section 55(2)(a)(ii), which dealt with the latter, i.e.  self-generated goodwill, provided that for the purposes of Sections 49 and 50, the cost of acquisition of such self-generated goodwill would be taken to be nil.

The said section has been amended from time to time to include various classes of intangible assets.

PERIOD OF HOLDING AND LEVY OF TAX IN CASE OF SELF-GENERATED GOODWILL AND INTERNALLY GENERATED INTANGIBLE ASSETS

However, while making such an amendment, the legislature has not made any amendment to the provisions of the act to provide for the manner of computation of the period of holding in case of such assets.

As discussed earlier, it was observed by the Supreme Court that the date of acquisition in case of self-generated goodwill cannot be determined. The court has also observed that the date of acquisition is a material factor in applying the computation provisions relating to capital gains. It has also been held that the ‘cost of acquisition’ mentioned in Section 48 implies a date of acquisition.

The date of acquisition is a material factor in applying computation provisions considering that 2nd proviso to Section 48 replaces the ‘cost of acquisition’ in Section 48(ii) with ‘indexed cost of acquisition’ in case of gains arising from transfer of a long-term capital asset. The determination of whether a capital asset is a long-term capital asset would entail the determination of the period of holding in the hands of the assessee, which would, in turn, require the date of acquisition. Since the date of acquisition in the case of self-generated goodwill cannot be determined, the computation under Section 48 would not be possible.

By providing that the cost of acquisition in case of self-generated goodwill and other internally generated intangible assets as referred to in Section 55(2)(a) would be nil, the legislature may overcome the issue relating to the benefit of indexation under 2nd proviso to Section 48. However, this is not the end of the matter.

It would be pertinent to note that once the capital gains under Section 48 are computed and the charge under Section 45 is attracted, the tax payable on such capital gains would have to be determined based on whether such capital gain is a ‘short-term capital gain’ under Section 2(42B) or a ‘long-term capital gain’ under Section 2(29B). This exercise would, in turn, involve the determination of whether the capital asset is a ‘short-term capital asset’ under Section 2(42a) or a ‘long-term capital asset’ under Section 2(29AA).

A combined reading of sub Sections 42A, 42B, 29AA and 29B of Section 2 would indicate the following:

•    The period of holding of a capital asset will have to be determined in the hands of the assessee. In determining the same one will have to reckon the actual period for which the capital asset has been held by the assessee.

•    Having determined the period of holding in respect of the capital asset in the hands of an assessee, one will have to examine whether the capital asset would fall within the definition of ‘short-term capital asset’ under Section 2(42A) read with the provisos thereto based on such period of holding.

•    If such capital asset meets the definition of ‘short-term capital asset’, the gain arising from the transfer of the same would amount to short-term capital gain by virtue of Section 2(42B).

•    If such capital asset does not meet the definition of ‘short-term capital asset’ under section 2(42A), it will become a ‘long-term capital asset’ by virtue of  Section 2(29AA). Thus, in order to invoke the residuary provision of Section 2(29AA), such a capital asset must clearly not be a ‘short-term capital asset’ within the meaning of Section 2(29AA). Thus, where it cannot be conclusively concluded that a capital asset is not a ‘short-term capital asset’, it cannot, by virtue of the residuary provision under Section 2(29aa), become a ‘long-term capital asset’.

•    This is clear from the fact that ‘long-term capital asset’ has been defined to mean a capital asset that is not a ‘short-term capital asset‘. Firstly, the use of the word ‘means’ in Section 2(29AA) indicates that the definition given under Section 2(29aa) to the term ‘long-term capital asset’ is exhaustive. In this regard, reliance is placed on Kasilingam vs. P.S.G. College of Technology [1995] SUPP 2 SCC 348 (SC), wherein it has been held that the use of the term ‘means’ indicates that the definition is a hard and fast definition. Secondly, Section 2(29AA) defines a ‘long-term capital asset’ to mean a capital asset which is not a short-term capital asset. Thus, only where a capital asset is conclusively found not to be a ‘short-term capital asset’ within the meaning contemplation of Section 2(42A), it would fall within the purview of Section 2(29AA), and any gain arising from the transfer of the same would be a ‘long-term capital gain’ by virtue of Section 2(29B).

Since the period of holding of self-generated goodwill and other internally generated intangible assets cannot be determined, it would not be possible to conclusively rule out that such capital assets are not ‘short-term capital assets’ under Section 2(42A). Resultantly, such assets cannot be ‘long-term capital assets’. As a result, it would not be possible to determine whether the capital gains arising from the transfer of such assets are ‘short-term capital gains’ or ‘long-term capital gains’.

A fortiori, the applicable tax rates in respect of such capital gains cannot be determined as the nature of capital gains is unknown.

It may be noted that the impossibility in determination of the period of holding would further impact an assessee who acquires it from such previous owner who generated the goodwill or other intangible assets, under any of modes provided in clauses (i) through (iv) of Section 49(1).

In such case, by virtue of explanation 1(b) to Section 2(42A), in determining the period of holding in the hands of such assessee, the period of holding of the previous owner is required to be included. Since, the period of holding in the hands of the previous owner cannot be determined, the period of holding in the hands of the assessee would also be
indeterminate.

Can one argue that where the period of holding in the case of the previous owner is indeterminate, such period will have to be ignored for the purposes of explanation 1(b) to Section 2(42A)? However, such a view is clearly contrary to the mandate of the said explanation which provides that the period of holding of the previous owner ‘shall be included’.

Such being the case, it would also not be possible to determine the tax rates applicable to an assessee who acquires self-generated goodwill or internally generated intangible assets under the modes mentioned in Section 49(1)(i) to (iv), upon subsequent transfer of such assets by him.  In Govind Saran Ganga Saran vs. CST, 1985 SUPP SCC 205 : 1985 SCC (Tax) 447 at page 209:

‘6. The components which enter into the concept of a tax are well known. The first is the character of the imposition known by its nature which prescribes the taxable event attracting the levy, the second is a clear indication of the person on whom the levy is imposed and who is obliged to pay the tax, the third is the rate at which the tax is imposed, and the fourth is the measure or value to which the rate will be applied for computing the tax liability. If those components are not clearly and definitely ascertainable, it is difficult to say that the levy exists in point of law. Any uncertainty or vagueness in the legislative scheme defining any of those components of the levy will be fatal to its validity.’

From the above extract, it can be observed that there are four components of tax:

•    The first component is the character of the imposition,
•    The second is the person on whom the levy is imposed,
•    The third is the rate at which tax is imposed, and
•    The fourth is the value to which the rate is applied for computing tax liability.

Further, the court has held that if there is any ambiguity in any of the above four concepts, the levy would fail.

In the following cases, the ratio laid down in Govind Saran Ganga Saran’s case (supra) has been  followed:

•    CIT vs. Infosys Technologies Ltd. [2008] 297 ITR 167 (SC) (para 6);
•    CIT  vs. Vatika Township (P.) Ltd. [2014] 367 ITR 466 (SC) (para 39);
•    Commissioner of Customs (Import) vs. Dilip Kumar & Co. [2018] 95 taxmann.com 327 (SC) (para 42);
•    CIT vs. Govind Saran Ganga Saran [2013] 352 ITR 113 (Karnataka) (para 15);
•    CIT vs. Punalur Paper Mills Ltd. [2019] 111 taxmann.com 50 (Kerala) (para 9).

Thus, it is clear that the rate of tax is one of the important components of tax and any uncertainty in the legislative scheme in defining it will be fatal to the levy.
Thus, in case of self-generated goodwill and other intangible assets, the charge under Section 45 in respect of capital gains upon transfer of the same would fail as the rate of tax cannot be determined. The charge would fail not only in respect of the assessee who acquired it through self-generation but also another assessee who acquires it from the former under modes provided in Section 49(1).

COMPARISON WITH SECTION 45(4) AS RECAST BY FINANCE ACT, 2021
Section 45(4), as inserted by Finance Act, 2021 with effect from 1st April, 2021, creates a charge in respect of profits or gains arising from a receipt of any money or capital asset or both by a specified person from a specified entity in connection with the reconstitution of such specified entity. It also provides the formula for the determination of such profits
or gains.

The said section provides that such profits or gains shall be chargeable to income tax as income of such specified entity under the head ‘capital gains’ and shall be deemed to be the income of such specified entity of the previous year in which the specified person received such money or capital asset or both.

It may be noted that in a given case, a specified person may receive two or more capital assets from the specified entity, comprising of a combination of short-term and long capital assets. In such a case, it would not be possible to apportion the aggregate profits or gains between short-term and long-term capital gains as no such mechanism has been provided in Section 45(4).

Further, there may be cases where only cash is received by the specified person from the specified entity. In such case, there is no transfer of a capital asset (be it long-term or short-term) by the specified entity to the specified person.

However, irrespective of the above situations, the entire profit or gain as determined by applying the provisions of Section 45(4) would be chargeable to tax in the hands of the specified entity under the head ‘capital gains’.

Thus, Section 45(4) is indifferent to whether there is actually a transfer of a capital asset, let alone whether such capital asset is long-term or short-term. Likewise, it is indifferent to the classification of the gains as ‘short-term capital gains’ or ‘long-term capital gains’. The trigger point in Section 45(4), unlike Section 45(1), is not the transfer of a short-term or long-term capital asset, but is rather the receipt of any money or capital asset or both by a specified person from a specified entity in connection with the reconstitution of such specified entity.

Further, Section 45(4), unlike Section 45(1), provides the mechanism for the computation of the profits and gains. The said computation is independent of the existence of any capital asset or, if it existed, the nature of such capital asset (i.e. short-term or long-term), unlike the computation under  Section 48.

At this juncture, the question that would arise is what rate of tax would apply to the capital gains under Section 45(4). This is for the reason that the tax rate is dependent on the classification of the gains as ‘short-term capital gains’ or ‘long-term capital gains’ as discussed earlier.

According to the authors, the normal tax rates applicable to the assessee as per the first schedule to the relevant finance act would be applicable. This would be similar to the case of short-term capital gains other than those referred to in  Section 111A.

A reference may be made to Section 2(1) of the Finance Act, 2021. The said Section, subject to exceptions under Sections 2(2) and 2(3) of the said Act, provides for charge of income-tax at the rates specified in part I of the first schedule. In other words, the tax rates mentioned in Section 2(1) read with part I of the first schedule of the Finance Act, 2021 would generally apply for computing the tax chargeable subject to the exceptions provided in Sections 2(2) and 2(3) of the said Act. One of the exceptions under Section 2(3) of the Finance Act, 2021 is with respect to cases falling under Chapter XII of the Income Tax Act where the said Chapter prescribes a rate. In such a case, the rate provided in the said Chapter would be applicable and not the rates provided in Part I of First Schedule to the Finance Act, 2021.

It may be noted that Section 111A, falling within Chapter XII, deals with short-term capital gains arising from transfer of certain capital assets and provides the rate of tax in respect of the same. Sections 112 and 112A deal with long-term capital gains and provide the tax rates in respect of the same. However, with regard to short-term capital gains other than those covered under Section 111A, no rate of tax is provided either in Chapter XII or any other provisions of the Income Tax Act. Thus, by virtue of Section 2(1) read with Section 2(3) of the Finance Act, 2021, with respect to such short-term capital gains, the rates provided  in Part I of First Schedule to Finance Act, 2021 would apply.

The capital gains under Section 45(4) are not covered by Sections 111A, 112 and 112A. Such gains, therefore, form part of normal income and would suffer normal rates of tax as provided in Part I of First Schedule to Finance Act, 2021.

From the above, it can be observed that wherever the legislature has sought to do away with the requirement of the classification of the gains as short-term or long-term, it has done so.

However, the above would not apply in the case of self-generated goodwill and other internally generated intangible assets. Unless the period of holding of these assets is found, it cannot be determined whether they are ‘long-term capital assets’ or ‘short-term capital assets’ and the gains arising from the transfer thereof as short-term capital gain or long-term capital gain. In the absence of such determination, it would not be known whether such gain would fall under Section 112 and hence covered by Section 2(3) of the Finance Act. Unless its case is conclusively excluded from Section 2(3) of the Finance Act, Section 2(1), which provides for the normal rate cannot be pressed into service. Thus, the determination of the correct rate of tax becomes impossible, thereby frustrating the very levy.

CONCLUSION
Based on the foregoing analysis, it would not be unreasonable to take a stand that the charge under Section 45 and the subsequent levy of tax in respect of capital gains arising from transfer of capital assets, being self-generated goodwill and other intangible assets, would fail, despite the amendment under Section 55(2)(a). Thus, it would not be wrong to state that the ratio laid down by the Hon’ble Supreme Court in the case of B.C. Srinivasa Setty’s case (supra) is still good law, and the same continues to hold the field.