Comprehending the provisions of capital gains can be a very tedious job, even for professionals who regularly navigate their way through these provisions. To understand these provisions in their entirety, merely comprehending the language of the statute is not enough, which can in itself be a difficult task. It is important for us to gain familiarity with the object of the original provisions, its short comings and limitation, which will help us to understand the need and object for subsequent amendments. This article attempts to explain, a few provisions of capital gains in Income Tax Act, 1961, in the light of their objects and interpretation given by the courts to reduce some strain on any reader cluttered up with these provisions.
Any profits or gains arising out of transfer of capital asset are chargeable to income tax under the head capital gains [1] . The two terms worth taking cognizance in the above statute are “capital asset” and “transfer”. This two series installments aims to determine 1) what are capital assets, 2) what is “transfer” of a capital asset 3) How “transfer” is distinguished from “distribution” of capital asset and 4) Short comings and subsequent amendments
CAPITAL ASSET [SEC 2 (14)]
The definition of “Capital Asset” is set out in section 2 (14) of the Income Tax Act, 1961 which means “property of any kind held by the assessee”. The meaning of the word “property” is a term of widest import and signifies every possible interest which a person can enjoy or hold. [2] Consequently, the definition of Capital asset encompasses every kind of interest held by the assessee. Even if a property is held in the course of business or profession, the property is said to be a capital asset.
However this definition is subject to specific exclusions which include:
a) stock-in-trade , consumable stores or raw material held for business and profession. Stock In trade means property held for sale in normal course of business including goods which are in the production process and raw material used in the production process including consumable stores item. [3] The meaning of stock in trade has to be understood in contradistinction to terms plant and machinery [4] and investments [5] . Whether the property held by the assessee is held as investment or stock in trade, has to be gathered from the intention of the assessee. eg if assessee buys some shares, then the shares can be classified as stock in trade only when shares are held for trading purposes, in absence any such intentions the shares may be classified as investment.
b) moveable property , which is held for personal use by the assessee or any other family member are also specifically excluded from the ambit of capital asset except for jewelery, archaeological collections, drawings, paintings, sculptures or any work of art.
c) Agricultural land also finds its name mentioned in the list of exclusion, but for all practical purposes only rural land is excluded from the scope of capital asset, the criteria for determining which is mentioned in the section.
The above list is not exhaustive and other items are also excluded from the ambit of capital asset although they arise much less frequently.
TRANSFER
Capital gains tax was brought in the Income Tax Act, 1922 via Excess Profits Amendment Act, 1947 which inserted section 12B according to which the tax net caste by capital gains tax was limited to exchange or transfer of capital asset. As can be seen clearly, this definition had a very narrow scope because this definition was limited to the meaning of the word “transfer” as understood in common parlance and did not include profits and gains arising out of a property otherwise.
Subsequently to remedy the profits escaping out of certain transactions, the net casts by the word “TRANSFER” has been expanded throughout its legislative history. Section 12B as it stood then did not include relinquishment meaning extinguishment of rights in lieu of money, compulsory acquisition under any law, conversion of capital asset to stock in trade etc. An assessee who had relinquished (extinguished) his right in a capital asset for a consideration could not be taxed under this section, as it is not transfer in ordinary usage of the word. A transfer presupposes existence of a property and in this case the rights in the property are extinguished. [6]
In the Income Tax Act, 1961 as it stands now, the word “transfer” has a separate and exclusive definition. The meaning of the word “transfer” has been extended beyond its ordinary signification by legal fictions. Transfer in relation to capital asset includes the sale, exchange or relinquishment of the asset or extinguishment of any rights in the asset or compulsory acquisition under any law or conversion of capital asset of the business to stock in trade of the business or obtaining possession of an immovable property in consideration of part performance of the contract. [7]
In the present act the scope of transfer has been expanded exponentially and the then section 12B is split into eleven sections, namely, Sections 45 to 55 . [eight]
In drafting section 2 (47) and Section 45 (1), the legislator toiled hard to bring in every transactions resembling sale, transfer or even extinguishment of rights under tax net. However even with such wide amplitude, this definition found itself short of fixing many leakages, some of which continues even to this date. The subsequent installment to this article will explain some of the new improvised ways designed to get around the capital gains tax net and subsequent amendments brought by legislature to fix these leakages.
This article is in reference to the previously published article on capital gains and is second installment to the “Plugging in Capital Gains” series. The scope of word transfer evolved a long way from being limited to exchange or transfer of capital asset in 1947 to including relinquishment, compulsory acquisition and conversion of capital asset to stock in trade amongst other things. However even with such wide amplitude, this definition as it stood in 1961, fell short of fixing many leakages. This installment will explain some of the new improvised ways that emerged to get around the capital gains tax net and subsequent amendments brought by legislature to fix these leakages.
Some of the controversies that arose in the context of then existing definition were
“Whether the distribution of assets by a company to its shareholder or by a partnership firm to its partners at the time of liquidation or dissolution respectively would amount to transfer or not”
And
“Whether a partner bringing in personal asset, as capital contribution to the firm would be regarded as transfer” in consideration of the fact that a partnership firm does not have a separate legal identity
DISTINCTION “TRANSFER AND DISTRIBUTION”
In relation to the first controversy, while transfer entails sale, exchange and relinquishment of rights in the asset, distribution of the assets of the companies at the time of dissolution or liquidation does not amount to any of such transactions. When a shareholder or partner in a partnership firm, on recieves money on account of liquidation or dissolution, he receives that money in satisfaction of the right which belonged to him by the virtue of holding the shares and not by the operation of any transaction which amounts to sale, exchange or relinquishment to transfer. [one]
This is because of the reason that interest of the shareholders or partners over the assets exists before dissolution. What a partner or a shareholder gets upon dissolution or liquidation is the realization of the pre-existing right or interest and there is neither any new creation of right in favor of the shareholder or the erstwhile partners.
PERSONAL ASSET TO CAPITAL CONTRIBUTION
In view of the second controversy, at the time of the admission, when a person hands over a capital asset to a partnership firm as contribution to its capital to become a partner in the firm, he loses his exclusive interest in the property, as it gets shared between all the partners. Such transfer of rights in the asset to other partners can be said to be “transfer” as defined under the act, owing to the wide net caste by this definition as discussed above. [2]Though the transaction of converting personal asset to business asset as capital contribution is transfer as defined in the act, the Supreme Court found that such a transaction would still fall out of the scope of capital gains as the consideration to be received by the partner in lieu of extinguishment of the rights of the partner would be indeterminable.
The consideration which is received by the person for such transfer of rights in the asset to other partners is the rights and liabilities accruing out of the subsistence of the firm. The Supreme Court found that at the time of transfer of personal asset there can be no reckoning of liabilities and losses which the firm may suffer in its lifetime and since calculation of such consideration is fundamental for the computation of the tax. Hence no capital gain could arise out of transfer of personal asset to the partnership owing to the unascertainable value of consideration.
PLUMBING THE LEAKAGES
This position of law however created loopholes and an escape routes emerged. A person “A” could enter into a partnership with a person “B” and transfer his personal asset in the partnership firm. The person “A” could have brought his personal asset in the firm as capital contribution. They could then dissolve the partnership firm and distribute the profits among themselves. As read above, the capital gain would neither arise to the partners at transfer of personal asset in the firm and nor it would arise at the point of distribution of sale proceeds, effectively evading tax on any gains arising out of sale of capital asset.
With a view to block this escape route, sub section (3) was inserted in section 45 via finance Act, 1987 which fixed the problem of uncertainty in determining the value of consideration. Section 45 creates a legal fiction and deems the value of rights and liabilities as the amount at which the value of personal asset was recorded in the books of accounts of the firm at the time of transfer of asset to the firm. Due to advent of section 45 (3), the transfer of asset to a firm by partner as contribution to capital of the firm is made taxable.
Further a partnership could also be used as a device to evade tax on dissolution by way of conversion of a partnership asset into an individual asset at accelerated prices. A and B could form a partnership where A has brought a capital asset worth Rs 10 lakhs as capital contribution. At the time of dissolution, the partnership firm could sell the asset at over 10 lakhs and “distribute” the sale proceed to A in satisfaction of his interest in partnership firm which is well above Rs 10 lakhs. Since “distribution” of assets is not transfer as envisaged in Income tax Act, no capital gain would arise at the time of dissolution, hence effectively selling the property at higher value, without any capital gains tax implication.
With a view to block this escape route, sub section 4 to section 5 was inserted. It is pertinent here to mention that while the supreme court (as discussed above) held that bringing a capital into a partnership is extinguishment of right. The distribution of assets at the time of dissolution is not “transfer” as there is no distribution of rights. Hence subsection 4 solves dual problem, firstly it creates a legal fiction that distribution at the time of dissolution is “transfer” of the asset to partners and secondly it removes the uncertainty regarding the cost of consideration by creating another legal fiction that fair market value of the asset at the time of dissolution shall be deemed as a cost of consideration. Due to subsection 4, the deemed transfer of partnership asset to an individual asset can be made taxable.
The loopholes discussed above are far from being the only leakages in Capital gains Tax net, but these are amongst those which drove the legislature to bring forward amendments in section 45. The legislature has constantly turned to creating legal fiction as a tool to plumb these leakages. Hence, it becomes imperative for us to understand the rules of interpretation regarding legal fictions, which will be dealt with in the forth coming articles.
[1] Section 45 (1), Income Tax Act, 1961
[2] CWT v. Vidur V. Patel [1995] 79 Taxman 288/215 ITR 30
[3] Accounting Standards Issued by ICAI, AS-2 (Valuation of Inventories), Definitions (pg 3-4)
[4] Jayasingrao Piraji Rao Ghatge vs Commissioner Of Income-Tax, [1962] 46 ITR 1160 Bom
[5] Masks Investment Ltd. vs ACIT [2012] 25 taxmann.com 21 (Ahd.)
[6] Provident Investment Co. Ltd. vs Commissioner Of Income-Tax [1953] 24 ITR 33 Bom
[7] Section 2 (47), Income Tax Act, 1961
[8] Commissioner Of Income-Tax vs Vania Silk Mills (P.) Ltd. [1977] 107 ITR 300 Guj
Bình luận