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Taxability of damages for breach of contract
January, 19th 2008

It is in the case of transactions relating to immovable property that controversies generally arise about the taxability of compensation money.

T. C. A. Ramanujam

When agreements are entered into for purchase of property, rights are created in favour of the parties to the agreement. Failure to honour the agreement can lead to breach of contract and claims for damages or specific performance.

Quite often, such breach of contract ultimately results in a compromise settlement of the dispute and monies are paid as quits. Will the receipt of such compensation for breach result in tax consequences?

This matter has been engaging the attention of courts all over the country. Section 51 of the Income-Tax Act, 1961, provides that any advance or other money received and retained by the owner of the property shall be deducted from the cost of the asset, wherever the transaction does not end in transfer of the property.

This effectively means that the advance or other money received by the owner of the property will go to reduce the cost of the property for him. The other party to the agreement is not involved in this interpretation of Section 51 of the Act.

The MP Ruling

Courts are divided on the question of bringing in the compensation money to tax. In the latest case on the subject, the Madhya Pradesh High Court considered a contract entered into by Lakshmi Devi Ratani and Indian Pharmaceuticals.

The lady agreed to sell immovable property to the firm for Rs 1,05,000 as per agreement dated September 25, 1970.

The agreement was not honoured. The firm filed a suit for specific performance of the contract.

The matter was compromised in 1986. The owner of the property agreed to pay to the prospective buyer a sum of Rs 14,85,000 as damages. The I-T department stepped in and taxed the same as capital gains. On appeal, the Income-Tax Appellate Tribunal (ITAT) ruled that no capital gains tax accrued in the transaction.

The Revenue went to the Madhya Pradesh High Court. The court held that the receipt of Rs 14,85,000 was exigible to capital gains tax as it involved transfer of property within the meaning of Section 2(47) of the Act. It pointed out that the expression property of any kind in Section 2(14) is of wide import.

Giving up of the right to claim specific performances to get conveyance of immovable property in lieu of monetary compensation results in extinguishment of rights in property thereby attracting the rigour of Section 2(14) read with Section 2(47). This is a clear case of relinquishment of a right in the property resulting in transfer.

The court upheld the action of the department in bringing the compensation amount to charge as capital gains (CIT vs Lakshmidevi Ratani 296 ITR 363).

The court was echoing the views of the Bombay High Court in several cases, including the CIT vs Tata Services Ltd (122 ITR 594) case. The Madras High Court also took the same view in K. R. Srinath vs Assistant CIT (268 ITR 436).

Contrarian view

The Calcutta and Gujarat High Courts have, however, taken a contradictory stance on the subject. Compensation for breach of contract gives rise to damages. Such damages, according to the Calcutta and Gujarat High Courts, are not assessable to tax.

There is no cost element involved and the Supreme Court ruling about goodwill in the Srinivasa Shetty (128 ITR 294) case should govern the law on the subject. The Calcutta High Court specifically cited the Supreme Court ruling in its judgment in CIT vs Asoka Marketing Ltd (164 ITR 664).

In all these cases, the receipt of compensation money is considered at great length and decisions are rendered about taxability or otherwise of the money compensation. Nothing is said about the person who pays the compensation.

Damages for breach of contract can be considered as business expenditure in commercial transactions. If a contract is not executed because its execution would result in loss, damages paid for its breach are deductible as business expenditure. It is only in matters concerning immovable property that such damages give rise to acrimonious debate about the nature of the receipt. Such damages are not like earnest money which is forfeited.

Commercial expediency

When the matter falls under Section 37 of the Act, the test of commercial expediency will be applied. Damages paid for breach of contract in purchase of machinery will always be considered as capital expenditure not deductible under Section 37. On the other hand, compensation paid for delay in completion of a building contract is considered deductible. It is only in the case of transactions relating to immovable property that controversies have arisen about the taxability of compensation money.

Since serious differences of opinion have arisen among various High Courts, it is necessary that the matter be settled by an appropriate ruling of the Supreme Court. In the alternative, the law can be amended and Section 51 can be recast to settle the issue finally.

(The author is a former Chief Commissioner of Income-Tax.)
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