As we enter the seventh month living with
the coronavirus in India, with each passing day we come across new issues and
manage to find ways to skip / survive them. The virus has not only affected
one’s physical well-being, it has also had an impact on one’s mental, social
and economic health!
Talking of the impact on economic health,
every individual, whether in business or employed, is grappling with liquidity
issues. With the entire payment chain affected, no one in the cycle is left
untouched. Needless to say, the domino effect of salary cuts and layoffs has
only multiplied people’s woes.
This article deals with the consequences
under the Income-tax Act, 1961 (‘the Act’) arising out of one of the many
issues which most people will come across or are already experiencing. It is
now common to hear about people defaulting on their monthly rental payments.
Apart from this, a lot of people are seeking reduction in rent or are prematurely
terminating their existing agreements in order to obtain the benefit of
competitive market rates. Whatever may be the reason, what could ensue, inter
alia, is the forfeiture of the security deposit placed by the licensee with
the licensor.
An attempt will be made in this article to
explain the nature of security deposits and the taxability on their forfeiture
by the licensor and / or waiver by the licensee.
UNDERSTANDING THE NATURE OF SECURITY DEPOSITS
In general terms, a security deposit is
(a) a sum of money
(b) taken from the licensee
(c) to secure performance of contract, and
(d) to protect the licensor from the damage, if
any, caused to the property.
In a typical leave and license agreement,
the licensor takes a security deposit from the licensee. This is done to ensure
due performance by the licensee of his obligations under the contract and, more
particularly, as the name suggests, the deposit acts as a security to make sure
about the safe return of the property at the end of the license period. It is
usually refundable by the licensor to the licensee upon termination of the
license period. The amount of security deposit is not fixed and is mutually
agreed upon by the parties involved. The amount of security deposit is held in
trust for the licensee and is repayable to him. Therefore, the security deposit
represents the liability of the licensor / owner of the premises which has to
be repaid to the licensee at the end of the license period, provided no damage
is caused to the property.
The Supreme Court in Lakshmainer and
Sons vs. CIT (23 ITR 202) (SC) held that a security deposit is in the
nature of a loan and observed as follows:
‘The fact that one of the conditions is
that it is to be adjusted against a claim arising out of a possible default of
the depositor cannot alter the character of the transaction. Nor can the fact
that the purpose for which the deposit is made is to provide a security for the
due performance of a collateral contract invest the deposit with a different
character. It remains a loan of which the repayment in full is conditioned
by the due fulfilment of the obligations under the collateral contract.’
Generally, in
most leave and license agreements security deposit is refundable upon
termination of the agreement. The question being considered is whether
forfeiture / waiver of security deposit constitutes ‘income’ chargeable to tax
or whether it is a capital receipt not chargeable to tax.
SECURITY DEPOSIT AND ITS FORFEITURE – WHETHER ‘INCOME’
UNDER THE ACT?
Section 4 of the Act deals with the charge
of income tax. As per this section, income tax shall be charged in respect of
the total income of every person.
‘Income’ is defined u/s 2(24). A security
deposit is not specifically covered within any of the specific sub-clauses under
this section. However, since the definition of income is an inclusive
definition, a particular item could still be treated as the income of the
assessee if it partakes the character of income even though it is not expressly
included in the definition of income. The scope of income is therefore not
restricted to the receipts mentioned in the specific sub-clauses of the
definition, but also includes the receipts which could generally be understood
as income.
The term ‘income’ has been judicially
interpreted in the case of Shaw Wallace 6 ITC 178 by the Privy
Council to mean:
‘Income… in this Act connotes a
periodical monetary return “coming in” with some sort of regularity, or
expected regularity from definite sources. The source is not necessarily one which
is expected to be continuously productive but must be one whose object is the
production of a definite return, excluding anything in the nature of a mere
windfall.’
Further, receipts which are generally
capital in nature are not chargeable to tax unless there is a specific
provision in the Act which requires taxing such an item.
There are specific provisions under the Act
to bring certain capital receipts to tax, for example, capital gains u/s 45 and
gifts u/s 56(2); subsidy received from the Central or State Government, though
generally capital in nature, is specifically included in the definition of
income u/s 2(24) and hence chargeable to tax. However, there is no such
specific provision which treats a security deposit or its forfeiture as income in
the hands of the assessee.
Security deposit is a liability and cannot,
therefore, be regarded as income.
However, a question arises as to whether the
security deposit becomes taxable if the same is no longer required to be repaid
to the licensee and is forfeited for breach of the agreed terms of contract
between the licensor and the licensee, or if the licensee defaults in the
payment of rent to the licensor.
Like security deposit, forfeiture of
security deposit is also not specifically covered within the definition of
income. Further, forfeiture of security deposit also cannot be construed as
being a regular activity, nor is it expected to have any regularity and hence
is also out of the scope of income as judicially interpreted by the Privy
Council.
Besides, since security deposit itself does
not constitute income and is not chargeable to tax, its forfeiture also cannot
be brought to tax as income.
BURDEN OF PROOF
If the Department seeks to tax the same as
income, then the burden lies on it to prove that it falls within the taxing
provisions. The Supreme Court in Parimisetti Seetharamamma vs. CIT [1965]
57 ITR 532 (SC) has observed as follows:
‘By
sections 3 and 4 the Act imposes a general liability to tax upon all income.
But the Act does not provide that whatever is received by a person must be
regarded as income liable to tax. In all cases in which a receipt is sought to
be taxed as income, the burden lies upon the Department to prove that it is
within the taxing provision. Where however a
receipt is of the nature of income, the burden of proving that it is not
taxable because it falls within an exemption provided by the Act lies upon the
assessee.’
A similar view has been taken by the Courts
in the following cases:
i) Udhavdas vs. CIT
[1965] 66 ITR 462 (SC);
ii) Dr. K. George Thomas
vs. CIT [1985] 156 ITR 412 (SC);
iii) Amartaara Ltd. vs. CIT
[2003] 262 ITR 598 (Bom.);
iv) CIT vs. Rajkumar Ashok
Pal Singh Ji [1977] 109 ITR 581 (Bom.).
Therefore, if the Revenue authorities seek
to tax the security deposit, the onus will be on them to establish that the
same is covered within the taxing provisions and hence chargeable to tax. The
Department may also, inter alia, look into the terms of the agreement
and the conduct between the parties so as to determine the taxability of the
forfeiture of security deposit.
The following paragraphs deal with the
taxability or otherwise of forfeiture of security deposit under different
scenarios. For the sake of clarity and ease of understanding, the scenarios are
broadly classified depending upon whether the rental income is offered by the
assessee / licensor under the head ‘Profits and Gains of Business or
Profession’, or under the head ‘Income from House Property’.
IF THE ASSESSEE OFFERS RENTAL INCOME UNDER THE HEAD PROFITS
AND GAINS FROM BUSINESS OR PROFESSION
In this case, the licensor would primarily
be regarded as engaged in the business of renting of properties and would,
therefore, be offering the rental income under the head Profits and Gains from
Business or Profession.
Termination of agreement and consequent
forfeiture is a rare exception and can never be contemplated as a method of
profit-making by the assessee. Premature termination of a long-term contract
is not, by any means, a feature of business activity. Upon forfeiture of
security deposit, the amount received by the assessee in the past which
undisputedly was capital in nature at the time of receipt, is now partly not
payable or is waived by the creditor, i.e., the licensee, and the amount
forfeited / waived continues to retain the same character as it held at the
time of receipt.
However, the same may not hold true in a
case where the security deposit is adjusted against dues. Where a person
defaults on payment of rent, the dues are adjusted against the security deposit
placed with the licensor. In such cases, the taxability will differ and the
same is dealt with in later paragraphs.
If the forfeiture of security deposit is
considered to be a revenue receipt chargeable to tax, the same would have to be
taxed u/s 28 which provides for items chargeable to tax under the head ‘Profits
and Gains of Business or Profession’, or u/s 41 which deals with taxing of
expenditure or trading liability upon its remission or cessation.
In CIT vs. Mahindra & Mahindra Ltd.
[2018] 404 ITR 1 (SC), the Apex Court considered the question whether
waiver of loan and interest thereon is a benefit or a perquisite arising from
the business of the assessee so as to be chargeable to tax under clause (iv) of
section 28. On this issue, the Court remarked that for applicability of section
28(iv), the income which can be taxed shall arise from the business or
profession. It also observed that the benefit which is received has to be in
‘some form other than money’. In the said case, the assessee procured equipment
from a US company. The supplier provided the said equipment on loan bearing
interest which was repayable after a period of ten years. Subsequently, another
US entity acquired the supplier company from whom equipment was purchased and
the loan was waived. In these facts, the Supreme Court held that the assessee
had received an amount due to waiver of loan and therefore the very first
condition of section 28(iv) which requires benefit or perquisite in the shape
of any form other than money, was not satisfied and in no circumstances could
it be said that the amount so received could be taxed u/s 28(iv). The Court therefore categorically laid down that waiver of loan is not income.
The ratio laid down by the Court in Mahindra
& Mahindra (Supra) will also apply to a case of forfeiture of
security deposit since it is similar to that of loan and forfeiture of security
deposit, not being a benefit in any form other than money, section 28(iv)
cannot apply.
It is worthwhile to note that in the Mahindra
& Mahindra case, the loan was taken for acquiring a capital asset
and the waiver was considered to be a capital receipt. Therefore, one may argue
that the ratio laid down in this case will apply only in cases where the
licensor holds the property as a capital asset and not where it is held as
stock-in-trade. However, for the purposes of section 28(iv) what is relevant is
that the benefit must be in some form other than money. Now, whether the
property is held as capital asset or stock-in-trade, the condition of section
28(iv) of benefit being in some form other than money still does not get
satisfied and therefore, even if the property is held as stock-in-trade, the
decision of the Supreme Court in this case (Mahindra & Mahindra)
will still apply and the forfeiture of security deposit will not be chargeable
to tax.
In continuation to the question of
taxability of forfeiture of security deposit u/s 28, a question arises as to
whether the same can be brought to tax as a normal business receipt. The
Department may tax forfeiture of security deposit u/s 28(i) rather than u/s
28(iv). For this, reliance may be placed by the Department on the decision of
the Bombay High Court in the case of Solid Containers Ltd. vs. DCIT
[2009] 308 ITR 417 (Bom.) wherein it has been held that loan taken for
business purposes and subsequently waived is ultimately retained in business by
the assessee and since the same is directly arising out of the business
activity, it is liable to be taxed. With utmost respect, this ruling of the
Bombay High Court may not be correct in light of the following decisions
wherein it has been held that the character of the receipt is determined
initially at the time of receipt and if the receipt is not a trading receipt
initially, then subsequent events cannot turn it into a trading receipt. The
Courts, therefore, held that if a loan / security deposit is not repaid, then
it cannot be treated as income.
i) Morely vs. Tattersall
7 IR 316 (CA);
ii) British Mexican
Petroleum Company Ltd. vs. Jackson 16 TC 570 (HL);
iii) CIT vs. P. Ganesh
Chettiar 133 ITR 103 (Madras);
vi) CIT vs. Sesashayee Bros.
(P) Ltd. 222 ITR 818 (Madras).
To contest the abovementioned decisions, the
Department generally resorts to the decision of the Supreme Court in the case
of CIT vs. T.V. Sundaram Iyengar & Sons Ltd. [1996] 222 ITR 112 (SC).
In this case, the assessee received deposits from its customers in the course
of carrying on its business and these were treated as capital receipts. Since
the balances remained to be claimed by the customers, the assessee transferred
the amounts credited in the accounts of the customers to the Profit & Loss
Account. The Court held that though the amounts were not in the nature of
income when they were received, they subsequently became income and the
assessee’s own money since the claim of the customers became barred by
limitation. However, the Supreme Court categorically held that it was not a
case of security deposit and held as follows:
‘We are unable to uphold the decision of
the Tribunal. The amounts were not in the
nature of security deposits held by the assessee for performance of contract by
its constituents…
…The
amounts were not given and retained as security to be retained till the
fulfilment of the contract. There is no finding to that effect. The deposits
were taken in course of the trade and adjustments were made against these
deposits in course of trade. The unclaimed surplus retained by the assessee
will be its trade receipt. The assessee itself treated the amount as its trade
receipt by bringing it to its profit and loss account’ (paras 18 & 19).
In fact, after considering the decision of
the Supreme Court in T.V. Sundaram Iyengar & Sons (Supra),
the Mumbai Tribunal in ACIT vs. Das & Co. [2010] 133 TTJ 542 (Mum.)
held that forfeiture of security deposit on premature termination of agreement
is a capital receipt in the hands of the assessee. The question to be decided
by the Tribunal was regarding the taxability of forfeiture of security deposit.
The relevant facts in the said case were as follows:
i) The assessee was engaged in the business of
leasing of properties, warehouses, etc., and offered the income from leasing of property as its business income;
ii) The assessee had entered into a leave and
license agreement to sub-lease its property. However, the licensee terminated
the agreement prematurely and upon termination of the lease, the assessee
forfeited the security deposit of Rs. 1.5 crores and received an amount towards
compensation. The assessee treated the said forfeiture of security deposit as a
capital receipt.
iii) The A.O. as well as the Commissioner of
Income-tax (Appeals) [CIT(A)] held that the receipts were revenue receipts and
were taxable as income;
iv) The Tribunal allowed the appeal of the
assessee and held as follows:
* Perusal of the terms of agreement showed that
security deposit was capital receipt and was treated as such by the assessee
and the same was accepted by the Department. The deposit was neither in the
nature of advance for goods nor could it be treated as part of the rental
component;
* From the clauses of the termination agreement
it was clear that the forfeiture of security deposit was not in lieu of
the rental payments;
* The quality and nature of receipt is fixed
once and for all when the same is received and its character cannot be changed
subsequently.
In the aforesaid case, the assessee was
engaged in the business of leasing of properties, warehouses, etc., and offered
the income from leasing of property as its business income.
A similar view has been taken by the Mumbai
Tribunal in the case of Samir N. Bhojwani vs. DCIT ITA No. 4212/Mum./2006
which has been relied upon and considered in the aforementioned decision of the
Mumbai Tribunal in the Das & Co. case (Supra).
Even in this case, the assessee was engaged, inter alia, in the business
of renting of its properties and offered rental income from leasing of flats
under the head business income.
However, the Mumbai Tribunal, in Anand
Automotive Systems Ltd. vs. Addl. CIT (ITA No. 1343/Mum./2012)(Mum) order dated
3rd June, 2013, after considering the decision of the
coordinate bench in Das & Co. (Supra) has, in a subsequent
decision, held that forfeiture of security deposit on termination of lease
agreement was a receipt in lieu of the rents and hence liable to
be taxed as revenue receipt. The facts in the said case were as follows:
(a) The assessee had given premises on rent to one
of its group concerns and received a security deposit of Rs. 10.58 crores for
the same;
(b) Pursuant to sealing of the assessee’s premises,
the lessee requested the assessee to discontinue the agreement;
(c) The matter went into arbitration and the
Arbitrator, inter alia, ordered the lessee to forego the security
deposit to the extent of Rs. 5.8 crores and directed the assessee to refund the
balance security deposit to the assessee;
(d) The assessee regarded the said forfeiture of
security deposit as a capital receipt not chargeable to tax.
(e) The A.O. as well as the CIT(A) held the receipt
to be in the nature of revenue.
(f) The Tribunal held that it was evident from the
order of the Arbitrator that the amount of Rs. 5.8 crores was nothing but
compensation received for loss of rent as a result of early termination of the
agreement. The amount so received by the assessee was on revenue account and
not capital account which constituted the business income of the assessee as
the rental income received from the property earlier was offered to tax as
business income by the assessee.
In the Das & Co. case (Supra),
the assessee had not forfeited the security deposit but was directed to adjust
it against the compensation due to it for loss of rent. The Tribunal
categorically observed that compensation received by the assessee from the
licensor was nothing but a payment in lieu of rent and since the
assessee offered rental income as its business income, the Tribunal held that
the compensation received was also chargeable to tax as business income of the
assessee.
However, the Mumbai Tribunal, in the Anand
Automotive Systems Ltd. case (Supra), while dealing with
the case of the coordinate bench in Das & Co. (Supra), has
relied on the part of the judgment which deals with the taxability of
compensation to hold that the amount of security deposit forfeited was
chargeable to tax in the hands of the assessee. In this case, the security
deposit was forfeited by the assessee pursuant to an order of the Arbitrator
which also required the assessee to adjust the same towards the compensation
for early termination of the license agreement. In the peculiar facts of the
case, it was held by the Tribunal that the forfeiture of deposit was nothing
but compensation for loss of rent and therefore chargeable to tax as business
income of the assessee.
This decision of the Mumbai Tribunal in the
case of Anand Automotive Systems Ltd. vs. Addl. CIT (ITA No.
1343/Mum./2012)(Mum) has been challenged by way of an appeal before the
Bombay High Court which has been admitted and the same is pending till date.
The matter has, therefore, not attained finality.
Insofar as taxability u/s 41(1) is
concerned, it provides for taxing of loss, expenditure or trading liability in
respect of which allowance or deduction has been made in the past and,
subsequently, the assessee obtains any benefit in respect thereof by way of
remission or cessation. Therefore, what is necessary is that loss, expenditure
or trading liability in respect of which the assessee obtains benefit must have
been allowed as a deduction in the past.
When the licensor takes a security deposit,
there is no deduction whatsoever claimed by the licensor in respect thereof and
therefore there is no question of obtaining any benefit by the remission or
cessation and hence the provisions of section 41(1) cannot apply irrespective
of the fact whether the property is held by the licensor as a capital asset or
as a stock-in-trade.
This view also draws support from the
following decisions:
i) CIT vs. Compaq
Electric Ltd. [2019] 261 Taxman 71 (SC), SLP dismissed by the Supreme
Court against the decision of the Karnataka High Court reported in CIT
vs. Compaq Electric Ltd. [2012] 204 Taxman 58 (Kar.);
ii) CIT vs. Gujarat State
Fertilizers & Chemicals Ltd. [2013] 217 ITR 343 (Guj.);
iii) Pr. CIT vs. Gujarat
State Co-op. Bank Ltd. [2017] 85 taxmann.com 259 (Guj.).
The views expressed in the above
paragraphs apply to cases where the security deposit is forfeited.
Where the forfeiture is treated as
compensation for damages or adjusted towards the rent, it no longer remains a
security deposit and its colour changes to rent and will therefore be a revenue
receipt chargeable to tax in the hands of the licensor.
It is, therefore, necessary to determine
from the fine print of the agreement between the licensor and the licensee as
to whether the deposit is compensatory or in lieu of rent
and if that be the case, then the same will be chargeable to tax.
IF THE LICENSOR OFFERS RENTAL INCOME UNDER THE HEAD
INCOME FROM HOUSE PROPERTY
In this scenario, the licensor offers rental
income under the head Income from House Property, i.e., the income of the
licensor is charged u/s 22. As per section 22, the annual value of the property
consisting of any buildings or land appurtenant thereto of which the assessee
is the owner is chargeable to tax. Section 23 provides how the annual value of
any property is determined.
Now, in a case where the licensor offers
income under the head House Property and the licensee makes a default in
payment of rent or prematurely terminates the agreement, the licensor may either:
(a) Adjust the dues from the security deposit and
return the balance to the licensee:
In this situation,
the colour of deposit changes to rent to the extent it is adjusted. It is
nothing but an amount received by the licensor as rent and therefore taxable
under the head Income from House Property. The charge u/s 22 is on the annual
value and for the purpose of computing annual value the rent receivable has to
be considered.
OR
(b) Adjust the dues from the security deposit and
forfeit the balance security deposit:
In this case, the
taxability of the adjusted security deposit remains the same as mentioned at
point (1.) above. However, so far as the forfeited deposit is concerned,
the same cannot be brought to tax. This is based on the reasoning that what is
taxed u/s 22 is the annual value and any receipt other than annual value cannot
be brought to tax under the head Income from House Property.
OR
(c) Entire
security deposit is forfeited:
In such a scenario as well, nothing will be
chargeable to tax in the hands of the licensor since it is only the annual
value which is chargeable to tax.
The Pune Tribunal in Datar & Co.
vs. ITO [2000] 67 TTJ 546 (Pune) held that compensation received by the
owner from the lessee for premature termination of tenancy agreement was a
revenue receipt. However, such compensation was held not taxable as property
income. This was held so on the basis that it is only the annual value which is
assessable under the head Income from House Property and any other receipt
other than annual value cannot be computed as income under this head.
The Tribunal observed that the agreement was
terminated with effect from September, 1988 and there was a loss of future
rents for 20 months which amounted to Rs. 1,50,000. The compensation of Rs.
1,00,000 received by the assessee was nothing but the discounted present value
of the future rent for the unexpired period of the agreement. Plus, the
assessee was free to let out the bungalow to any party. Based on these facts,
the Tribunal held the compensation to be revenue receipt. However, as regards
the taxability of the compensation, the Tribunal held that it is only the
annual value which is assessable under the head Income from House Property as
follows:
‘In the present case, the compensation arises out of the agreement of
letting out immovable property and therefore, assumes the nature of the income
from house property. Therefore, in our opinion, such receipt would fall under
the head “income from house property”. However, it is only annual
value which can be assessed under the head “income from house
property”. Any other receipt other than the annual value cannot be
computed as income under this head. Therefore, following the decision of the
Bombay High Court in the case of T.P. Sidhwa (Supra) and the decision of Supreme
Court in the case of N.A. Mody (Supra), it is held that the compensation received by the assessee cannot
be taxed.’
Further, the Mumbai Tribunal in Addl.
CIT vs. Rama Leasing Co. (P) Ltd. [2008] 20 SOT 505 (Mum.), following
the decision of the Pune Tribunal in the Datar & Co. case
(Supra) held that compensation received by the assessee on premature
termination of the lease agreement is not chargeable to tax though it is a
revenue receipt.
A similar view has also been taken in one
more decision of the Mumbai Tribunal in ITO vs. Nikhil S. Goklaney in ITA
No. 2542/Mum/2017 order dated 6th September. 2019.
Though the aforementioned decisions of the
Pune and Mumbai Benches of the Tribunal deal with the receipt of compensation
due to premature termination of tenancy agreement and not forfeiture / waiver
of security deposit, the principle laid down by the Tribunal that it is only
the annual value which can be taxed under the head Income from House Property
still applies. In fact, a case of forfeiture of security deposit stands on a
better footing than receipt of compensation.
CONCLUSION
To conclude, forfeiture of security deposit,
to the extent the forfeited amount is adjusted towards rent, in my view, will
be chargeable to tax irrespective of the fact whether rental income is offered
as business income or income under the head House Property. Therefore, it is
essential to determine from the terms of the agreement whether or not the
deposit forfeited is compensatory. To the extent that the forfeited amount is
not adjusted or is not compensatory in nature, forfeiture will not be
chargeable to tax u/s 28(iv) or section 41(1) even if the assessee offers
rental income as business income. If rental income is offered as business income
and the property is held as stock-in-trade, the same could be taxed as regular
business income of the assessee u/s 28(i). If, however, the assessee offers
rental income under the head House Property, forfeiture of security deposit
will be a capital receipt not chargeable to tax. However, even if the same is
held to be a revenue receipt, nothing will be charged to tax as annual value
under sections 22 and 23. In my view, one must first determine from the terms
of the agreement between the parties the exact nature of deposit and then
determine the taxability in view of the provisions contained as well as the
decisions laid down by the Courts.
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