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It is an Income but not taxable

February 13, 2017[2017] 78 149 (Article)


1. The word income is defined in clause 24 of section 2 of the Income Tax Act, 1961. The word 'Income' has widest and broadest connotation and means what would constitute Income in the law and otherwise declared as Income in the different sub clauses of clause 24 to section 2. Being an inclusive definition, the meaning of the word "income" is undoubtedly very wide. The word "Means" have narrow impact whereas "includes" have bigger space to be covered as much as it can.

There can be no doubt that any receipt is liable to tax under the Income-tax Act, it must be "income" except such of the types, though not income in the real sense of the term, as are specifically included in the definition. A receipt which is income does not cease to be income even if exempted from income-tax, and a receipt which is not income, does not become income just because it is included as one of the items exempted from income-tax Before we jump on income, first we need to see what is chargeable to tax under the Act. If it is not chargeable then it may be come under the arena of income but still it would be out of purview from taxability under Income Tax Act.

As per section 4 of the Act,

"(1)   Where any Central Act enacts that income-tax shall be charged for any assessment year at any rate or rates, income-tax at that rate or those rates shall be charged for that year in accordance with, and subject to the provisions (including provisions for the levy of additional income-tax) of, this Act in respect of the total income of the previous year of every person.
  Provided that where by virtue of any provision of this Act income-tax is to be charged in respect of the income of a period other than the previous year, income-tax shall be charged accordingly.
(2)   In respect of income chargeable under sub-section (1), income-tax shall be deducted at the source or paid in advance, where it is so deductible or payable under any provision of this Act."

As per Section 56(1) of the Act, Income of every kind which is not to be excluded from the total income under this Act shall be chargeable to income-tax under the head "Income from other sources", if it is not chargeable to income-tax under any of the heads specified in section 14, items A to E.

If any income which is explicitly not covered under the four heads of income, i. e, Salary, House-property, Business or profession and Capital Gain, it will be covered under the head of income from other sources.

But moot question arises here that if any income is not chargeable to tax at all, whether even if at is under the umbrella of this head or not, it is to be taxed or not? Reply would be negative. It cannot be chargeable to tax.

Hon'ble Supreme Court had taken same stand in the case of CIT v. D.P. Sandu Bros. Chembur (P.) Ltd. [2005] 273 ITR 1/142 Taxman 713 wherein it has been held that it would be illogical and against logic of section 56 of the Act to hold that which is not chargeable to capital gain, could be taxed as income under section 56 of the Act. Though this judgement was in reference to an item under capital gain but under holistic view Hon'ble Apex Court said even section 56 should be applied with due caution.

Revenue Receipt or Capital Receipt

2. As per Section 10 of the Act, there are certain incomes which are exempt and not chargeable to tax like agricultural income, partner's share in net profit, etc. Income under the head Capital Gain, is taxable in case of any gain on transfer of a capital asset. Capital receipts are different from capital gain. All capital receipts are not taxable under the head. Only gain arising on transfer of a capital asset, has to be charged to tax. The issue relating to distinction between capital and revenue receipts has engaged the attention of courts in a large number of cases. However, in order to decide whether or not a payment is capital or revenue receipt, it is necessary to look into its true nature and substance. It is well settled that if the payment is received in the ordinary course of the business for loss of trading item, it is revenue receipt and if, on the other hand, the receipt is towards compensation for extinction or sterilization partly or fully of profit earning source (capital assets), such receipt not being in the ordinary course of the business, it must be construed as capital receipt.

Just because a certain receipt is not exempt under section 10, it doesn't follow that it is a revenue receipt and hence income. It is a common law that every receipt by the assessee is not chargeable to tax. Therefore, it follows that unless the receipt represents income chargeable to tax, the question of attracting taxability on such receipt does not arise. No strait-jacket set of principles have been enshrined in the Act for drawing a distinction between a capital and revenue receipt. One of the recognized criteria, in the absence of transfer of a capital asset, is to ascertain whether the receipt is on account of loss of income or source of income. It is trite law that any receipt in the nature of compensation, costs, damage, etc., by whatever name called, towards loss of income is a revenue receipt. However, any receipt to compensate for the loss of source of income is a capital receipt.

Here we analyse some of the items which are income in nature, but not chargeable to tax. Either these are treated as capital receipt or having element of non-earning of such as income.

(i) Interest on Margin Money linked with setting of a plant or project

After having a judgement of Hon'ble supreme court in case of Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT [1997] 227 ITR 172/93 Taxman 502, it was understood that source or purpose of fixed deposits into banks is not a factor for deciding the interest income whether it is capital or revenue item. The principle being that if the capital of a company is fruitfully utilised instead of keeping it idle, the income thus generated, will be of a revenue nature and not accretion of capital.

But we have some of the judgements even of Apex court, after afore mentioned decision and all of them categorically said that if the amount deposited in fixed deposits is intricately linked with setting up of plant or project, then interest earned on such fixed deposits would be on capital account item. Total cost of plant or project should be reduced by such amount of interest. The test that is required to be employed is whether the activity which is taken up for setting up of the business and the funds which are garnered are inextricably connected to the setting up of the same

The Apex court in case of CIT v. Bokaro Steel Ltd. [1999] 102 Taxman 94 said that in case money is borrowed by a newly-started company which is in the process of constructing and erecting its plant, the interest incurred before the commencement of production on such borrowed money can be capitalised and added to the cost of the fixed assets created as a result of such expenditure. By the same reasoning if the assessee received any amounts which were inextricably linked with the process of setting up its plant and machinery, such receipts would go to reduce the cost of its assets. These were receipts of a capital nature and could not be taxed as income.

Again, Apex court in case of CIT v. Karnal Co-operative Sugar Mills Ltd. [2001] 118 Taxman 489, held that the deposit of money in the instant case was directly linked with the purchase of plant and machinery. Hence, any income earned on such deposit was incidental to the acquisition of assets for the setting up of the plant and machinery. Thus, the interest was a capital receipt which would go to reduce the cost of asset.

In case of NTPC Sail Power Company (P.) Ltd. v. CIT [2012] 25 401/210 Taxman 358 (Delhi), it is held that funds invested by assessee-company for earning of interest on temporary deposits of surplus fund and interest on margins/advances made for purposes of expansion, such interest earned were inextricably linked with setting up of new power plant and, therefore, interest earned was to be treated as capital receipt, not liable to tax.

In case of Principal CIT v. Facor Power Ltd. [2016] 66 178/237 Taxman 613 (Delhi), Hon'ble Delhi High Court held that when interest on FDRs which were placed with bank as margin money for procurement of various capital goods for setting up of power project, no business activity was carried out by company because project was under implementation and money placed in fixed deposit was inextricably linked with setting up of power plant, then interest on such fixed deposits would be on capital account and not chargeable to tax.

(ii) Sale of Carbon Credit

Carbon Credits (CERs) are awarded to the member countries under KYOTO PROTOCOL for capping emission of carbon dioxide or other greenhouse gases. These carbon credits are, in turn, awarded as incentives to the industry for using alternative fuel in place of fossil fuel (petrol, diesel, kerosene, coal, oil,) in the manufacture of power, cement, steel, textiles or fertilizers. The allocation of carbon credits depends upon size of the industry and production target. It is calculated as per prescribed formula. The industry which is allocated carbon credits is expected to limit the emission of CO2 and GHG to the extent of allotted credits. If they are able to save credits or CERs by using alternate fuels such as bio-mass or high technology, they can sell their savings (credits) to an industry which has exhausted its allocated credits and still requires CERs to continue production

In case of CIT v. Subhash Kabini Power Corporation Ltd. [2016] 69 394/240 Taxman 514 (Kar.) it was held that since carbon credit was generated out of environmental concerns and it was not having character of trading activity, receipt from sale of carbon credit was capital receipt and not business Income.

In case of My Home Power Ltd. v.Dy. CIT [2012] 27 27/63 SOT 227 (Hyd. - Trib.) it is held that carbon credits is in the nature of 'an entitlement' received to improve world atmosphere and environment reducing carbon, heat and gas emissions. The entitlement earned for carbon credits can, at best, be regarded as a capital receipt and cannot be taxed as a revenue receipt. It is not generated or created due to carrying on business but it is accrued due to 'world concern'. It has been made available assuming character of transferable right or entitlement only due to world concern. The source of carbon credits is world concern and environment. Due to that the assessee gets a privilege in the nature of transfer of carbon credits. Thus, the amount received for carbon credits has no element of profit or gain and it cannot be subjected to tax in any manner under any head of income. Carbon credits are made available to the assessee on account of saving of energy consumption and not because of its business. Further, in our opinion, carbon credits cannot be considered as a bi-product. It is a credit given to the assessee under the Kyoto Protocol and because of international understanding. Thus, the assessees, who have surplus carbon credits, can sell them to other assessees to have capped emission commitment under the Kyoto Protocol. In our opinion, carbon credit is entitlement or accretion of capital and hence, income earned on sale of these credits is capital receipt. Carbon credit is not an offshoot of business but an offshoot of environmental concerns. No asset is generated in the course of business but it is generated due to environmental concerns. credits for reducing carbon emission or greenhouse effect can be transferred to another party in need of reduction of carbon emission. It does not increase profit in any manner and does not need any expenses. It is a nature of entitlement to reduce carbon emission, however, there is no cost of acquisition or cost of production to get this entitlement. carbon credit is not in the nature of profit or in the nature of income. Thus, sale of carbon credits is to be considered as capital receipt.

Further, in case of Ambika Cotton Mills Ltd. v. Dy. CIT [2013] 40 171/[2014] 61 SOT 31 (Chennai - Trib.) (URO), Chennai Tribunal approved the views of aforesaid Hyderabad Tribunal's judgement and said that it is capital receipt.

Later on, Andhra Pradesh High Court has also approved tribunal's views in aforesaid case of CIT v. My Home Power Ltd. [2014] 46 314/225 Taxman 8. The court confirmed the view of the Tribunal that carbon credit is not an offshoot of business, but an offshoot of environmental concerns. No asset is generated in the course of business, but it is generated due to environmental concerns. It was also found that the carbon credit is not even directly linked with the power generation and the income is received by sale of the excess carbon credit. One cannot accept the submission for the simple reason that earning of carbon credit is not the business of the assessee nor the same is generated as a by-product on account of business activity of power generation, but it is generated on account of employment of good and viable practices by the assessee. Then the carbon credit is generated out of environmental concerns and it is not having the character of trading activity, the Tribunal has rightly held that receipt from sale of carbon credit is capital receipt and it is not income out of business and hence not liable to income tax.

(iii) Transfer of right to sue

Section 2(24) specifically includes '(vi) any capital gains chargeable under section 45' within the ambit of income. Thus a capital receipt would be chargeable to tax only if it falls under section 45 (as capital gains), though capital receipt as such is not taxable. Whether right to sue, is a property and a capital asset as defined under section 2(14) of the Act and whether it is chargeable to tax.

Section 2(14) defines Capital Asset to mean 'property of any kind held by an assessee, whether or not connected with his business or profession'. Section 6 of the Transfer of Property Act states that 'property of any kind may be transferred, except as otherwise provided by this Act or by any other law for the time being in force.' Section 6(e) notes that 'a mere right to sue cannot be transferred'. Therefore, a 'right to sue' is a property and thus Capital Asset as defined under section 2(14) but is not transferable.

There cannot be any transfer of a right to sue under Indian law and any capital receipt arising from a right to sue, cannot be considered capital gains under section 45. Moreover, even if right to sue is considered as capital asset covered under the definition of transfer within the meaning of section 2(47), its cost of acquisition cannot be determined. In the absence of 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

Section 56(1) primarily brings to charge income of every kind. Income is defined in section 2(24) and it has been concluded, after elaborate discussions, that the settlement amount cannot be brought within the purview of income under the Act. Further, section 56(1) contemplates only such source which does not specifically fall under any one of other four heads of income i.e. salaries, income from house property, profit or gains of business or profession, or capital gains. To come within the ambit of section 56, the following conditions have to be fulfilled: -

  There has to be an income (under section 2(24), read with sections 4 and 5 of the Act).
  That income should not be exempt under sections 10 to 13A of the Act
  That income is not covered under any of the preceding four heads of income, like salary income, income from house property, income from business/profession and capital gains

In case of Aberdeen Claims Administration Inc., In re [2016] 65 246 (AAR - New Delhi) Hon'ble AAR held that settlement amount received for surrender of right to sue is not taxable since (a) it is capital receipt but cannot be charged to capital gain tax as its cost of acquisition cannot be determined; (b) it is not income and even in accordance with principle of surrogatum, such amount does not replace any business income.

(iv) Compensation for termination of contract

Compensation is taxable under following two sections: -

Section 17(3)(i)- 'profits in lieu of salary. " the amount of any compensation due to or received by an assessee from his employer or former employer at or in connection with the termination of his employment or the modification of the terms and conditions relating thereto

Section 28(va)- any sum, whether received or receivable, in cash or kind, under an agreement for-

(a)   not carrying out any activity in relation to any business or profession; or
(b)   not sharing any know-how, patent, copyright, trademark, licence, franchise or any other business or commercial right of similar nature or information or technique likely to assist in the manufacture or processing of goods or provision for services

Where compensation is received by a businessman for surrendering a contractual right leading to a loss or deprivation of a source, it is by its nature capital receipt not amounting to income. When compensation is given for the exchange of capital or property or a source of income, it is capital receipt, i.e., receipt for termination of a service agreement, or for loss of office or employment or termination of an agreement or cessation of business.

In case of Arunbhai R. Naik v. ITO [2015] 64 216/[2016] 236 Taxman 190 (Guj.), it is held that where ex gratia compensation paid to assessee on his discharge from services was voluntary in nature, it would not amount to compensation in terms of section 17(3)(i). The employer, voluntarily at its discretion, agreed to pay the amount in question to the assessee with a view to bring an end to the litigation. There was no obligation cast upon the employer to make such payment and, therefore, the same would not take the colour of compensation as envisaged under section 17(3)(i). The amount in question would, therefore, not fall within the ambit of the expression 'profits in lieu of salary' as contemplated under section 17(3)(i).

In case of CIT v. Sharda Sinha [2016] 65 153/237 Taxman 111 (Delhi), Hon'ble Delhi high court said that compensation paid to assessee, a journalist, by a foreign publisher upon termination of contract for performance of authorship/professional services for a continuous period of 23 years, was to be regarded as capital receipt not liable to tax. First, that the Assessee was a journalist by profession and was appointed as the foreign correspondent in India of a German news magazine Der Spiegel. The second is that the German publisher was paying a lump sum amount upon termination as sign off compensation for performance of authorship/professional services for a continuous period of 23 years". Thirdly, the letter written by the publisher acknowledges that the compensation was being paid "Due to the loss of his work place and in consideration of his long time association". These factors have a bearing on the character of the receipt in the hands of the Assessee. Indeed, this was compensation for loss of an income-generating asset.

The Court further said that the sum paid to the Assessee was "to compensate for the abrupt loss of source of income" and that the termination of contract had fatally injured the appellant's only source of income for the last 20 years. The mere fact that the Assessee was free to earn through other sources would not make a difference to this position. If the receipt represents compensation for the loss of a source of income, it would be capital and it matters little that the assessee continues to be in receipt of income from its other similar operations.

The main criteria to judge as to whether the compensation is capital or revenue is to ascertain the purpose for which such compensation is awarded. If the compensation is to recoup the loss suffered by the assessee in its business or professional activity, then it will be a revenue receipt. If, however the purpose is unrelated to the trading activity/profession of the assessee, it would be in the nature of a capital receipt. Loss of source of income does not necessarily mean that it must absolutely extinguish. If the source of income has been severely beaten thereby causing serious damage to the income-earning apparatus itself, it will also be construed as the loss of source of income. Such indentation to the source can be caused in different ways. One of such ways may be maligning the name of the business, resulting in tarnishing the reputation and causing damage to the goodwill of business. So if goodwill of the business is damaged and later on some compensation is awarded in lieu of that, it will also fall in the same category of loss to the source of income and, consequently, such a receipt will also qualify to be characterized as a capital receipt. If such a receipt cannot be identified with the loss in a particular transaction(s) but to make good the injury caused to the reputation of business which had the effect of impairing the source of income, it will be a capital receipt

(v) Mesne Profits

Section 2(12) of the Code of Civil Procedure provides that: "Mesne profits" of property means those profits which the person in wrongful possession of such property actually received or might with the ordinary diligence have received therefrom, together with interest on such profits but shall not include profits due to improvement made by the person in wrongful possession. According to Section 2(12) a person becomes entitled to mesne profits only when he has right to obtain possession but another person whose occupation is unauthorized keeps him deprived of that possession. The first and foremost condition for awarding mesne profits is unlawful possession of the occupant of the property

In simple words, Mesne Profits means the profits of an estate received by a tenant in wrongful possession and recoverable by the landlord. Therefore, mesne profits correspond to the profits which the person in wrongful possession is receiving or might receive with due diligence for the wrongful occupation of property.

In case of CIT v. Mrs. Annamma Alexander [1991] 191 ITR 551/158 Taxman 47 (Ker.) it is held by Hon'ble Kerala High court that mesne profits awarded by the decree, are only damages for loss of property or goods and are only a capital receipt and not a revenue receipt.

The same issue came before the Special Bench of the Tribunal in case of Narang Overseas (P.) Ltd. v. Asstt. CIT [2008] 111 ITD 1 (Mum.) for determining the character of mesne profits being either capital or revenue in nature. The Special Bench also held that the same is capital in nature and not chargeable to tax. In this case, the amounts were received by the Respondent-Assessee from a person in wrongful possession of its property i.e. after the relationship of landlord and tenant has come to an end.

Not only mesne profits are capital receipts, but in some cases courts have held that the amount of interest received on mesne profits also cannot be treated as a revenue receipt. Mesne profits themselves being award of compensation in the nature of damages and not taxable, interest thereon which is an integral part of the mesne profits, is also not a revenue receipt and will not be taxable as income. The fact that mesne profits are estimated with reference to the profits which the person- in wrongful possession of such property actually received or would have ordinarily received for the purpose of compensation or determination of the compensation will not in any way render them an "income" or a revenue receipt. Interest up to the date of award of mesne profits is nothing but damages for deprivation of use and occupation of the property and thus receipt is in the nature of capital not chargeable to lax.

(vi) Interest on Compensation, when it is paid along with compensation amount.

If the interest is paid for deprivation of use of money fallen due to them, it is revenue receipt chargeable to tax. On the other hand, if the interest is paid on account of the injury to the capital i.e., deprivation of use and occupation of the property then it is capital receipt not chargeable to tax.

If the quality of the claim for interest is compensation, for this reason that the claimant has been deprived of the use of the money and has not had his money at the due date, it would be income in his hands. It may be regarded either as representing the profit he might have made if he had the use of the money in time, or, conversely, the loss he had suffered, because he had not have that use. If on the other hand, the claim is for loss of property or loss of goods, or some other injury to capital and the element of interest comes in by way of estimating the compensation to be granted for such capital loss or capital injury, then, the receipt would be capital. There is a difference between "interest proper" and "damages by way of interest". It is in the nature of damages which the court may mould according to the justice of the case.

In case of Urvi Chirag Sheth v ITO [2016] 70 33/159 ITD 199 (Ahd. - Trib.) it is held that Interest awarded by Court on compensation for motor accident, accounts for fall in value of compensation money from day, when compensation becomes payable to day when it is actually paid, is a capital receipt not liable to tax. In this case Interest was paid along with compensation.

(vii) Alimony from her husband in terms of decree of divorce

In case of Shrimati Roma Sengupta v. CIT [2016] 68 177/238 Taxman 682 (Cal.) it is held that amount realised by assessee from sale of a property received as alimony from her husband in terms of decree of divorce, was to be regarded as capital receipt not liable to tax.

In case of Princess Maheshwari Devi of Pratapgarh v. CIT [1983] 12 Taxman 220 (Bom.), it is held that lump sum alimony is a capital receipt but monthly is not.

(viii) Award Money from Third person

In case of Aroon Purie v. CIT [2015] 56 80/231 Taxman 349 (Delhi) it is held that amount received by assessee as an award from B.D. Goenka Trust for Excellence in Journalism would be a capital receipt and hence not taxable under Act. As award money had been paid by a third person, who was not concerned with activities or associated with 'vocation' of assessee and payment was not of a periodical nature. Cause of giving award was not directly relatable to carrying on of vocation as a journalist or as a publisher - Prize money had been paid by a third person, who was not concerned with activities or associated with 'vocation' of assessee - Payment was not of a periodical or repetitive nature, payment being of a personal nature, it should be treated as capital payment being akin to or like a gift which does not have any element of quid pro quo. Whether, just because a certain receipt is not exempt under section 10, it doesn't follow that it is a revenue receipt and hence income.

If a person performs an action unaware that the other person would reward him, the receipt may not be towards or for a service rendered, unless there is an element of quid pro quo. On applying the aforesaid test to the present receipt, it has to be held that the said amount would be a capital receipt, being purely in the nature of a testimonial. The causa causans in the instant case is not directly relatable to the carrying on of vocation as a journalist or as a publisher. It is directly connected and linked with the personal achievements and personality of the person i.e. the appellant. Further, it is to be noted that the payment in this case was not of a periodical or repetitive nature. The payment was also not made by an employer; or by a person associated with the 'vocation' being carried on by the appellant; or by a client of his. The prize money has in the instant case been paid by a third person, who was not concerned with the activities or associated with the 'vocation' of the appellant. It being a payment of a personal nature, it should be treated as capital payment, being akin to or like a gift, which does not have any element of quid pro quo. The aforesaid prize money was paid to the assessee on a voluntary basis and was purely gratis.


3. For charging tax on any receipt, it must be an income and that should be chargeable to tax as per provision of section 4 of the Act. Even an income which is not exempt as per the provisions of section 10 to 13, same cannot be charged to tax until it doesn't have character of taxable income. Aforementioned examples are just some of the cases which already cleared judicial test.

* Please refer this before giving effect to Proposals of Union Budget-2017.


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