Use of Borrowed Funds for Reinvestment

A benefit of exemption from tax on capital gains tax, is conferred on certain specified persons, subject to reinvestment of the capital gains or the net sales consideration, as the case may be, in specified assets, particularly vide sections 54, 54B, 54EC, 54ED and 54F of the Income-tax Act.

The reinvestment in the specified assets is required to be made within the time prescribed under the respective sections. The prescribed amount is required to be deposited in a designated bank account maintained under the Capital Gains Scheme. In a case where the reinvestment is not made by the due date of filing return of income for the year of capital gains, to be utilised for ultimate reinvestment in specified asset within the stipulated time.

It is common to come across cases, where an assessee has, for the purposes of reinvestment, utilised the funds other than the funds realised on sale of capital assets, borrowed or otherwise, leading to a question about his eligibility for exemption from tax for not having used the sale proceeds directly for reinvestment in specified asset. Conflicting decisions, delivered on the subject, require consideration by the taxpayers and their advisors to enable them avoid any unintended hardship in matters of daily recurrence.

 2. V. R. Desai’s case

The issues recently came up for consideration before the Kerala High Court in the case of CIT v. V. R. Desai, 197 Taxman 52. An appeal in this case was filed by the Revenue u/s.260A of the Act for challenging the order of the Tribunal under which an exemption u/s.54F was granted from paying tax on long-term capital gains. In the peculiar and interesting facts of the case, the assessee was the managing partner of a firm, namely, M/s. Desai Nirman, which was engaged, among other things, in real estate business, including construction and sale of flats. During the previous year relevant to the A.Y. 1995-96, the assessee transferred 12.876 cents of land to the said partnership firm treating it as his contribution to the capital of the firm. The firm in turn credited the capital account of the assessee with an amount of Rs.38,62,800, being the full value of the land brought into the firm by him as his share of capital contribution. The assessee availed a loan from HDFC Bank for the construction of a house and within three years from the date of transfer of land to the firm, he got a new house constructed by another firm of M/s. Desai Home, in which also he was a partner.

There was no dispute that the transfer of the land by the assessee to the partnership firm towards his capital contribution to the firm was a transfer within the meaning of section 2(47) resulting into long-term capital gains as per section 45(3) of the Act. In the return filed for the A.Y. 1995-96, the assessee had in fact offered tax on capital gains on the very same transaction of contribution of the above land towards his capital contribution as managing partner, subject however, to his claim for exemption from capital gains tax u/s.54F of the Act, for investment made in the construction of the new building, out of the loan from HDFC Bank, within three years from the date of transfer of the land to the firm.

The AO noticed that the assessee had not invested the sale consideration in full or part in any of the designated bank accounts maintained under the Capital Gains Scheme prior to the date of filing return in terms of section 54F(4) of the Act. He therefore, completed the assessment and issued intimation u/s.143(1)(a) of the Act, holding that the assessee was not entitled to exemption u/s.54F of the Act. The intimation u/s.143(1)(a) was challenged by the assessee before the first Appellate Authority, who dismissed the appeal. In the second appeal filed by the assessee, the assessee took the contention that disallowance of exemption u/s.54F could not be made while issuing an intimation u/s.143(1)(a) of the Act. In the alternative, the assessee contended that the facts established the construction of a new house within three years from the date of sale of land, and so much so, the assessee was entitled to exemption in terms of section 54F of the Act. The Tribunal upheld the claims of the assessee on both the grounds raised.

The Revenue filed an appeal before the Kerala High Court, challenging the order of the Tribunal. The Revenue contended that in order to qualify for exemption u/s.54F, the assessee should have purchased a residential house within one year before or two years after the date of transfer or should have constructed a residential house within a period of three years from the date of transfer, in either case, by utilising the sale proceeds of land; that, for qualifying for exemption, the assessee should have, before the date of filing return, deposited the net sale consideration received in a nationalised bank in terms of section 54F(4) and the receipt should have been produced along with the return filed.

The assessee on the other hand, contended that in order to qualify for exemption, there was no need to directly utilise the sale consideration in constructing the house and it was enough if during the period of three years, an equivalent amount was invested in the construction of the house, from whatever sources; that the assessee admittedly had constructed a new house within three years from the date of transfer of the property and therefore was eligible for exemption.

The Court observed that the assessee allowed the firm to which the property was transferred to retain and use it as a business asset and towards consideration he got only credit of land value in his capital account and as a result the sale consideration was not received by the assessee in cash, nor could it be deposited in terms of clause 4 of section 54F with any nationalised bank or institution; that the assessee did not have the sale proceeds available for investment in the account under the scheme u/s.54F(3) of the Act. The Kerala High Court, on going through the provisions of section 54F, particularly sub-section (4), held that in order to qualify for exemption from tax on capital gains, the net sale consideration should have been deposited in any bank account specified by the Government for this purpose, before the last date for filing of the return and the assessee should have produced along with the return, a proof of deposit of the amount under the specified scheme, in a nationalised bank.

The Court further observed and held that in order to qualify for exemption u/s.54F(3), the assessee should have first deposited the sale proceeds of the property in any specified bank account, and the construction of the house, to qualify for exemption u/s.54F, should have been completed by utilising the sale proceeds that also were available with the assessee; that in the case before them, though the assessee constructed a new building within the period of three years from the date of sale, it was with the funds borrowed from HDFC. By allowing credit of value of transferred property in the capital account of the assessee in the firm, the assessee conceded that the sale proceeds was neither received, nor was going to be utilised for construction or purchase of a house.

The Court finally held that the assessee was not entitled to exemption u/s.54F, because the assessee neither deposited the sale proceeds for construction of the building in the bank in terms of s/s. (4) before the date of filing return, nor was the sale proceeds utilised for construction in terms of section 54F(3) of the Act and that the assessee was not entitled to claim exemption from tax on capital gains u/s.54F of the Act, which the AO had rightly declined.

3.    P. S. Pasricha’s case

The Bombay High Court vide an order dated 7th October, 2009 passed in ITA 1825 of 2009 in the case of CIT v. Dr. P. S. Pasricha, dismissed the Revenue’s appeal against the order of the Tribunal reported in 20 SOT 468 (Mum.). The facts in the Revenue’s appeal before the Tribunal were that;

•     the assessee had acquired a residential flat in the building known as ‘Dilwara’ at Cooperage, Mumbai at cost of Rs.3,22,464. The said flat was sold during the year relevant to A.Y. 2001-02 for a total consideration of Rs.1,40,00,000. After claiming deductions for the expenses incurred for sale and the cost of acquisition of the said flat, the long-term capital gains was worked out by the assessee at Rs.1,24,02,738,

•    subsequent to the sale of the said flat, the assessee purchased a commercial property at Kolhapur out of the sale proceeds of the said flat for a total consideration of Rs.1,25,28,000 and gave the said property on rent to Hughes Telecom Ltd.,

•     thereafter, within the period specified u/s.54(1) of the Act, the assessee purchased two adjoining residential flats at Mumbai for a total consideration of Rs.1,04,78,750, on the strength of which the assessee claimed exemption u/s.54(1) of the Act from tax on capital gains on the sale of the said flat,

•    the assessee claimed an exemption u/s.54(1) of the Act to the extent of Rs.1,04,78,750 and returned the taxable capital gains at Rs.19,23,988,

•     the AO disallowed the claim of deduction u/s.54 on two grounds; that the sale proceeds from original asset were not deployed fully in the new asset and that the assessee had not purchased one single property, but, two units,

•     the assessee preferred an appeal before the CIT(A) and submitted that he had purchased the residential property within the specified period, as such, he was entitled to the exemption u/s.54(1) of the Act. With regard to two residential flats, it was contended that these flats were adjoining flats and they could be used as a single unit, and

•     the CIT(A) held that the assessee was entitled to exemption u/s.54(1) of the Act, even where the capital gains was invested in more than one flat and with regard to investment of sale proceeds, he further held that since the entire sale proceeds was utilised for purchase of both the flats in question, as such, exemption was to be allowed at Rs.1,04,78,750 as claimed by the assessee.

The Revenue, in the context of the discussion here, contended that the sale proceeds received on account of sale of flat in the building known as ‘Dilwara’ was utilised in purchase of commercial properties at Kolhapur; that the assessee had later on, purchased two residential flats in Lady Ratan Tower, Worli, Mumbai for a sum of Rs.1,04,78,750 out of the funds received from different sources; that to avail the benefit of section 54(1), the assessee was required to invest the sale proceeds received on transfer of long-term capital asset in purchase of another residential house, but, in the instant case, the said sale proceeds from earlier capital asset, were utilised to purchase the commercial property; that a residential house was purchased out of the funds obtained from different sources; that alternatively, the identity of the funds should not be changed and in the instant case, the identity was lost once the sale proceeds were exhausted in purchase of a commercial property; as such, the assessee was not entitled for deduction u/s.54(1) of the Act.

On behalf of the assessee, in the context, it was contended that no doubt the sale proceeds received on sale of residential flat in the building known as ‘Dilwara’ were utilised to purchase a commercial property at Kolhapur, but the assessee had purchased another residential house within the period specified u/s.54(2) of the Act; that the provisions of section 54 nowhere provided that the same sale proceeds, received on transfer of long-term capital asset, must be utilised for the purchase of another residential house; that the assessee was simply required to acquire the residential house within a period of one year before or two years after the date on which the transfer took place and in the instant case, the assessee had purchased the residential flat before the due date of filing of the return and as such, his claim was not hit by ss.(2) of section 54 of the Act and that the proposition propounded by the Revenue about the identity of the funds was without any basis as it could not be applied where the assessee acquired/purchased the residential house before the transfer took place.

The Tribunal observed that the Revenue’s main dispute was about the utilisation of the sale proceeds for purchase of a commercial property and the purchase of residential house out of the funds obtained from different sources, as such, losing the identity of funds. On an analysis of section 54, the Tribunal did not find much force in the Revenue’s contention as, in the opinion of the Tribunal, the requirement of section 54 was that the assessee should acquire a residential house within a period of one year before or two years after the date on which transfer took place and that nowhere, it had been mentioned that the same funds must be utilised for the purchase of another residential house, only that the assessee should purchase a residential house within the specified period, and source of funds was quite irrelevant. Since the assessee had purchased the residential house before the due date of filing of the return of income, his claim was found to be not hit by sub-section (2) of section 54 of the Act and the Tribunal therefore was of the view that assessee was entitled for deduction u/s.54(1) of the Act.

4.    Observations

The wording of the section makes it clear that the law does not insist that the sale consideration obtained by the assessee itself should be utilised for the purchase of house property. The main part of section 54 provides that the assessee has to purchase a house property for the purpose of his own residence within a period of one year before or two years after the date on which the transfer of his property took place or he should have constructed a house property within a period of three years after the date of transfer. A reading of clauses (i) and (ii) of section 54 would also make it clear that no provision is made by the statute that the assessee should utilise the amount which he obtained by way of sale consideration for the purpose of meeting the cost of the new asset.

The assessee has to construct or purchase a house property for his own residence in order to get the benefit of section 54. The statutory provision is clear and does not call for a different interpretation.

There is no ambiguity in understanding the provisions of section 54 and section 54F. The purpose of these provisions is to confer exemption from tax on investment in residential premises. The Legislature itself has appreciated the fact that it would not always be possible to invest the sale proceeds immediately after the sale transaction and therefore, two years’ or three years’ time is given for reinvestment. Neither it is expected, nor is it prudent to keep the sale proceeds intact and keep the said proceeds unutilised till such time.

The fact that these provisions permit the invest-ment in residential premises even before the date of sale, within one year before the sale, and such an investment qualifies for exemption puts it beyond doubt that the Legislature does not intend to have any nexus between the sale proceeds and the investment that is made for exemption. For the purposes of section 54E, even the earnest money or advance is qualified for exemption as clarified by the CBDT’s Circular No. 359, dated 10th May, 1983.

The provisions of sub-sections (2) of section 54 and (4) of section 54F do not, anywhere mandate that there should be a direct nexus between the amount reinvested and the amount of sale consideration or a part thereof, in any manner. A bare reading of these provisions confirm that they use the same language as is used by the sub-section (1) and therefore to infer a different meaning form reading of these provisions, as is done by the Revenue, to obstruct the claim for exemption in cases where the reinvestment was made out of the borrowed funds or funds other than the sales proceeds, is unwarranted and not desirable.

The issue had first arisen before the very same Kerala High Court in the case of CIT v. K. C. Gopalan, 162 CTR 566 wherein, in the context of somewhat similar facts, the Court in principle held that in order to get benefit of section 54, there was no condition that the assessee should utilise the sale consideration itself for the purpose of acquisition of new property. The ratio of this decision was not brought to the attention of the Kerala High Court in V. R. Desai’s case, neither was this case cited. We are of the view that the decision of the Court would have been quite different had this decision and its ratio been brought to the attention of the Court.

In Prema P. Shah v. ITO, 100 ITD 60 (Mum.), the assessee’s claim for benefit of exemption u/s.54 was allowed by the Tribunal, following the said decision of the Kerala High Court in the case of K. C. Gopalan (supra) by rejecting the argument of the Revenue that the same amount should have been utilised for the acquisition of new asset and holding that, even if an assessee borrowed the required funds and satisfied the conditions relating to investment in specified assets, she was entitled to the exemption.

The decision in the case of K. C. Gopalan (supra), though cited, was erroneously distinguished and not followed by the Tribunal in the case of Milan Sharad Ruparel v. ACIT, 121 TTJ 770 (Mum.) wherein it was held that for exemption u/s.54F, utilisation of borrowed funds for purchase of house was detrimental and that the exemption u/s.54F was not available where the assessee purchased a residential house out of funds borrowed from bank. It was held that for the purposes of section 54F, residential property should either be acquired or constructed by the assessee out of his personal funds or the sale proceeds of the capital asset on which the benefit was claimed. Even here, the Tribunal has agreed that the assessee would be entitled to the exemption, which could not be denied to him on the ground of use of borrowed funds, if he is otherwise in possession of his own funds. Once this is conceded, the reference to sub-sections (3) and (4) and reliance thereon for denial of the exemption appears to be incongruous. Either they prohibit the use of other funds or they do not — there cannot be a third meaning assigned to the existence of these provisions.

Similarly, the claim for exemption was denied by the Tribunal in the case of Smt. Pramila A. Parikh in ITA No. 2755/Mum./1997, in which case the assessee had constructed a residential house out of the loans and thereafter the sale proceeds of shares of M/s. Hindustan Shipping & Weaving Mills were utilised for repayment of loans raised for the construction of a residential house. The assessee claimed exemption u/s.54F of the Act. The Tribunal had held that the assessee was not entitled to exemption u/s.54F as she had constructed the house by taking loans from other persons for the purpose of construction of the house and there-after sold the capital asset and repaid the loan out of the sale proceeds of the same.

The Ahmedabad Tribunal, when asked to exam-ine a similar issue in the context of section 54E, in the case of Jayantilal Chimanlal HUF, 32 TTJ 110, held that for claiming exemption u/s.54E, it was sufficient if sale proceeds were invested in Rural Bonds and that the source of funds was immaterial. Similar was the view in the case of Bombay Housing Corporation v. ACIT, 81 ITD 545, wherein it was held that the condition relating to investment in specified assets u/s.54E was satisfied even where the investment was made by the assessee by borrowing funds instead of a direct investment out of consideration received by it for transfer of capital asset. In that case, it was held that the exemption u/s.54E was available for investment in specified assets out of borrowed funds and that the requirement of section 54E was only that the assessee must invest an amount which was arithmetically equal to the net consideration in the specified assets and that no distinction could be made between an assessee who was forced to borrow for the purpose of making the investment and another assessee who effected the borrowing, not because of forced circumstances, but because he consciously or deliberately used the sale consideration for a different purpose. The fact that instead of making a direct investment in the bonds, the borrowed amount was invested in the bonds should not make any difference. These decisions are sought to be distinguished by the Revenue as was done by the Tribunal in the case of Milan Ruparel (supra) on the ground that the said section 54E did not contain a provision similar to section 54F(4) which required an assessee to deposit the sale proceeds in a designated bank account failing the reinvestment before the due date of return of income.

The provisions in any case are meant to be interpreted liberally in favour of the assessee, being incentive provisions, even where it is assumed that there is some doubt in their interpretation. The Courts have always adopted such liberal interpretation of sections 54 and 54F when there is substantial compliance with the provisions of the section.

Even if one looks at the object of sections 54 and 54F, the intention clearly is to encourage investment in residential housing. So long as that purpose is achieved, the benefit of the exemption should not be denied on technical grounds that the same funds should have been utilised.