Sections – 4, 5, 9, 45, 48 of the Act –Settlement amounts received by FIIs pursuant to waiver of right to sue for damages caused by fraud in financial statements was compensation for not pursuing the suit and involved surrender of capital asset (viz., “right to sue”); though it was a capital receipt, as the computation provisions failed, capital gains could not be calculated; hence, it was not taxable as capital gains.
Facts
Several FIIs were holding American depository shares and equity shares of an Indian listed company (“IndCo”). There was public disclosure by the CEO of the Indian company about manipulation of financial results of IndCo. As a result, the price of securities of IndCo dropped steeply and the FIIs were forced to dispose of the securities, suffering huge losses. Several investors initiated class action litigation against IndCo. While initially claims of FIIs were also consolidated with those of the other investors, subsequently, the FIIs filed request for exclusion with the Court. The FIIs then separately negotiated the terms of settlement with IndCo and its auditors pursuant to which IndCo and its auditors agreed to pay settlement amount to FIIs.
The issue before the AAR was whether the settlement amount received by FIIs from IndCo and its auditors was taxable in terms of the Act.
The FIIs contended as follows.
As regards sections 4, 5 & 9 of the Act
Since the settlement amounts were not received in the ordinary course of business of the Applicant, and the Applicant is not engaged in the business of suing and seeking settlement from third parties, they would not qualify as “income” for the purposes of the Act.
Since section 9 of the Act refers to only specific streams of income the settlement amounts cannot be said to be deemed to accrue or arise in India in terms thereof.
The settlement amounts were linked to a law suit that arose outside India and was not determined on the basis of value of the underlying shares of IndCo. The suit was linked to allegation of fraud/negligence. The settlement amounts were not sourced in India. Hence, the territorial nexus principle was not fulfilled. This was established from the fact that the FIIs had sold the shares prior to initiation of the action.
Therefore, the settlement amounts cannot be brought to tax u/s. 9 read with Section 4 and Section 5 of the Act. This is on the basis that the settlement amounts were not connected with the Applicant’s business in India but for release of claims of FIIs against IndCo and its auditors. Therefore, the settlement amounts have no territorial nexus with India.
As regards section 45 of the Act
The settlement amounts were received on account of destruction of capital assets (i.e. the right to sue IndCo and its auditors).
Assuming that the settlement amounts were subject to Section 45 of the Act cost of acquisition and cost of improvement of a right to sue cannot be computed. Hence, owing to failure of computation mechanism no Capital Gains could arise under Section 48 and Section 55 (3) of the Act2.
The settlement amounts were received as compensation for the injury inflicted on capital asset of the trading (Equity and ADS shares held FIIs) and therefore not subject to Section 45 of the Act.
A ‘right to sue’ is property (and thus Capital Asset as defined under Section 2 (14) of the Act). Inherently, as a matter of public policy, a ‘right to sue’ is not transferable. Thus, there cannot be any transfer of a right to sue under Indian law. Consequently, any capital receipt arising from a right to sue cannot be considered capital gains u/s. 45 of the Act. The Gujarat High Court has accepted this proposition in Baroda Cement and Chemicals vs. C.I.T. (158 ITR 636). Also, in Vania Silk Mills Pvt. Ltd. vs. C.I.T. (191 ITR 647), the Supreme Court has laid down that receipt on account of destruction of capital assets is not subject to capital gains.
The tax authority contended as follows.
The FIIs were pass-through entities engaged in the business of trading in securities and the loss was incurred by them in the course of that business. The recipients of the settlement amounts were the FIIs (and not participating investors) who were in the business of purchase and sale of securities.
Unlike an investor, Mutual Funds change their portfolios frequently and sometimes prefer even booking losses. The FIIs decide to move out of a market on local as well as international factors. The buying and selling of shares is done very regularly and frequently. These are characteristics of a trader and not of an investor. Merely because in order to attract investments the Government has decided to treat the gains of FIIs as capital gains, the same does not alter the basic character of the activity but only changes the matter of taxability.
Any fall in price of share cannot be regarded as destruction of asset. Rise and fall in prices of securities, be it for one reason or the other, is a normal business incidence and neither the rise in price creates an asset nor the fall in price destroys an asset. Capital receipt arises only when receipt is for destruction of the profit making apparatus or crippling of the recipient’s profitmaking apparatus. However, when the structure of the recipient’s business is so fashioned as to absorb the shock as one of the normal incidents of business activity the compensation received is no more than a surrogatum for the future profits surrendered. Hence, it should be treated as a revenue receipt and not a capital receipt.
The settlement amounts received were not for relinquishment or extinguishment of the right to sue but as a compensation for the loss of potential income suffered in the course of their business operations.
Held
In Union of India vs. Raman Iron Foundry, AIR 1974 SC 265, the Supreme Court has held that the only right which the party aggrieved by the breach of the contract has, is the right to sue for damages, which is not an actionable claim and it is amply clear from the amendment in section 6(e) of the Transfer of Property Act, which provides that a mere right to sue for damages cannot be transferred.
However, in CIT vs. Mrs Grace Collis and other 2001 248 ITR 323, the Supreme Court has held that the expression “extinguishment of any rights therein” does include the extinguishment of rights in a capital asset independent of and otherwise than on account of transfer. Hence, the right to sue can be considered for the purpose of capital gains u/s. 45 of the Act.
In CIT vs. B.C. Srinivasa Setty (1981 128 ITR 294), the Supreme Court has held that the charging section and the computation provisions together constitute an integrated code and a case to which the computation provisions cannot apply was not intended to fall within the charging section. It was further held that none of the provisions pertaining to the head ‘capital gains’ suggests that they include an asset in the acquisition of which no cost of acquisition at all can be conceived. It is clear that if right to sue is considered as a capital asset covered under the definition of transfer within the meaning of section 2(47) of the Act, its cost of acquisition cannot be determined. In the absence of such cost of acquisition, the computation provisions failed and capital gains cannot be calculated. Therefore, right to sue cannot be subjected to income tax under the head ‘capital gains’.
Since the settlement amounts have been received against surrender of right to sue, it cannot be considered for the purpose of capital gains u/s. 45 of the Incometax Act.
The settled legal position is that FIIs are not engaged in trading business. The facts also show that the shares were purchased as investors and not as traders and in the books of accounts also they were treated as capital investment.
While the settlement amounts were relatable to shares (i.e., if shares would not have been purchased the question of class action or right to sue would not have arisen), they were received not as part of business profit or to compensate the future income but as a result of surrender of the claim against IndCo and its auditors. Hence, even in accordance with the principle of surrogatum, such amounts were not assessable as income because they did not replace any business income.
