Advances converted into reserves not cessation of liability u/s 41(1). Pre-conditions / Tests to be applied

Advances converted into reserves not cessation of liability u/s 41(1). Pre-conditions / Tests to be applied for applicability of the deeming provisions as laid by Supreme Court

cessation of liability

ABCAUS Case Law Citation:
ABCAUS 2034 (2017) (08) HC

Assessment Year :  2000-01

Important Case Laws Cited/relied upon by the parties:
Commissioner of Income Tax Vs. T.V.Sundaram Iyengar and sons Ltd (222 ITR 344).
Commissioner of Income Tax Vs. Kesaria Tea Company (254 ITR 434)
Polyflex (India) Pvt. Ltd vs. Commissioner of Income Tax (257 ITR 343)

Brief Facts of the Case:

The appellant company was part of global group of companies and had been set up completely with investment from the parent company. The  parent company had also advanced money towards business needs and the advances were to be adjusted against future supplies to the parent company.

The prevailing foreign direct investment policy imposed a cap of 74% in the mining sector. The company approached private sources for their participation in the equity and as a pre-condition to their investment, the resident investor required the company to dilute the losses incurred by equal investment to be made by the foreign parent company.

Accordingly, the parent company directed the appellant company to convert the advances made by it into capital and the appellant complied with the direction converting the advances, of an amount of Rs. 10,77,49,601/- as capital and transferring the same to general reserves.

During the re-assessment proceedings, the Assessing Officer (AO) was of the view that the provisions of section 41(1) of the Income Tax Act, 1961 (the Act) relating to cessation of liability were attracted and that the amount of advances converted into reserves were liable to be brought to tax as income. Accordingly the AO completed the assessment in terms of section 143(3) read with section 147 of the Act observing that the aforesaid amount ought to have been taken to the profit and loss account instead of to general reserves.

The CIT(A) noted that the provisions of section 41(1) of the Act stood attracted only in a situation where the amount in question, in respect of which liability had ceased, had been claimed as an allowance or a reduction in any previous year, which fact had not been established in the present case. He noted that there was no nexus between the allowance/reduction in the previous years and the amount in question to invoke the provisions of section 41(1). He thus concurred with the submission of the assessee that the said amount constitued a capital receipt.

The matter travelled in appeal to the Income Tax Appellate Tribunal (ITAT).  The ITAT found that the amount was originally received as an advance against supply/export of garnet. Subsequently the claim over the amount was waived and in such circumstances the tribunal was of the view that the amount partook the character of a revenue receipt. Thus, according to the tribunal, the subsequent transfer of the amount to general reserve would constitute only an application that would not change the nature of the taxability of the amount at a stage anterior thereto.

In the present case, the company challenged the aforesaid conclusion of the tribunal before the High Court.

Observations made by the High Court:

The Hon’ble High Court noted that the circumstances in which the infusion of capital was made and the findings relating thereto were undisputed. The CIT(A) had  found that there was nothing on record to lead to the conclusion that the advances from parent company had been claimed as an allowance or reduction in any previous year. This finding of fact had not been disturbed by the tribunal in any way.

The Hon’ble High Court observed that in order for the provisions of Section 41(1) to stand attracted, the benefit obtained by the assessee in the relevant year should have a direct nexus with an allowance or deduction for any previous year as a claim of loss, expenditure, or trading liability which had not been established in the present case.

The Hon’ble High Court distinguished the decision of the Supreme Court relied by the ITAT and clarified that in the said case, the amounts received had depleted by adjustments made by the assessee from time to time and the resultant balance had been transferred by the assessee to the profit and loss account whereas this was not the case in the present matter. The advances received in the present case had remained static without depletion of any sort and more importantly, not been claimed in the previous years. Thus, the pre-condition to the application of section 41(1) of the Act had not been satisfied in the instant case.

The Hon’ble High Court referred to a later decision of the Supreme Court which decided a matter relating to the write back by an assessee in its accounts, of a provision made for the earlier years towards purchase tax liability. The question before the Hon’ble Supreme Court was whether the circumstances contemplated by section 41(1) existed so as to enable the Revenue to take back what has been allowed earlier as business expenditure and to include such amount in the income of the relevant assessment year.

The Hon’ble Supreme Court concluded that the following points were critical in the event the provisions of section 41(1) are to apply:

(1) In the course of assessment for an earlier year, allowance or deduction has been made in respect of trading liability incurred by the assessee;

(2) Subsequently, a benefit is obtained in respect of such trading liability by way of remission or cessation thereof during the year in which such event occurred;

(3) in that situation the value of benefit accruing to the assessee is deemed to be the profit and gains of business which otherwise would not be his income; and

(4) such value of benefit is made chargeable to income tax as the income of us’.

The Hon’ble High Court noted that the Hon’ble Supreme Court in another decision had occasion to consider the application of section 41(1) of the Act to excise duty refunded to the assessee. The Hon’ble Court held that:

(i) The first step would be that in relevant assessment an allowance or deduction has been made of any loss, expenditure or trading liability incurred by the assessee.

(ii) the assessee must have subsequently

(a) obtained any amount in respect of such loss or expenditure or

(b) obtained any benefit in respect of such trading liability by way of remission or cessation thereof.

In case either of these events happen, the deeming provision enacted in the closing part of subsection (1) comes into play. Accordingly, the amount obtained by the assessee or the value of benefit accruing to him is deemed to be profits and gains of business or professions and it becomes chargeable to income-tax

Held:
Following the above tests/criterions laid down by the Supreme Court, the applicability of deeming provisions of section 41(1) ruled out and the appeal was allowed.

cessation of liability

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