Indian tax laws have various provisions whereby certain notional items are deemed to be income for the purpose of taxation, though, in the normal sense, one may not regard these as incomes.

One such notional income is the annual value of a house property. The fair rental value of a house is supposed to be its annual value, if the house is self-occupied or vacant. In case of a property let out on rent, while the rent is an actual income, one has to compare the fair rental value with the actual rent received, and the higher of the two is taxable. One of the issues is whether the municipal rateable value, or in the alternative, the standard rent of the property, can be taken as the fair rental value, or whether the tax authorities can adopt rental rates fetched by similar properties in the vicinity as the fair rental value.

The other issue relates to notional interest being imputed on a rent deposit. When a house is let out, typically, a deposit is also taken by the landlord. Normally, the deposit is of a few months’ rent. But at times, the deposit is a fairly large amount, with a corresponding reduction in the monthly contractual rent. Over the past few years, the tax authorities have been seeking to create another deeming fiction, by adding notional interest on such deposit to the actual rent, thereby taxing a higher income than the actual rent. While there have been earlier decisions in this regard, a recent Bombay High Court decision has comprehensively analyzed and decided the issue.

The Bombay High Court observed that the tax authorities can reject the actual rent, only if the rent has been deflated due to fraud, emergency, relationship or other considerations. The municipal rateable value, which is a safe guide to the fair rental value, cannot be discarded by the tax authorities, without cogent and reliable material to show that it is not a fair indicator, and that too only in suspicious cases, where the contractual rent is doubtful.

Market rental in the same locality for similar properties can be adopted in such suspicious cases. However, the tax authorities have to first compare those properties and the terms of those agreements with the property and terms of agreement of the taxpayer, to ascertain whether these are similar in nature. They then have to share the information in their possession with the taxpayer, and give her an opportunity to prove why the rent for such other properties is not comparable to the rent received by the taxpayer.

The Bombay High Court noted that merely because an interest-free refundable security deposit has been taken by the taxpayer, it does not mean that interest on such deposit, computed at the bank rate, can be added to her income.

The Court held that if the rent control laws apply to the let out premises, the standard rent has to be necessarily adopted, and cannot be ignored by the tax authorities. The tax authorities should either get the rent determined by the relevant Tribunal or Court from the parties, or should themselves undertake the exercise of determination of the standard rent.

This decision of the Bombay High Court will be useful in quite a large number of cases, particularly in the context of interest on security deposit. Very often, the demand for a large security deposit is not driven by tax reasons, but to ensure that the tenant does not default in vacating the premises for fear of forfeiting the large deposit. Another aspect is that the deposit is generally invested by the landlord, very often in a fixed deposit, and the interest on this is taxable as the income of the landlord. Therefore, imputation of a notional interest on the security deposit would amount to a double taxation—one of the actual interest income, and the other of the notional interest.

The high court’s restriction on annual value not exceeding the standard rent may, however, not apply in a large number of cases of leave and licence, as most landlords prefer to contract only in a manner whereby the rent control laws do not apply. Similarly, the concept of municipal rateable value is now gradually being replaced by the concept of capital value for municipal taxation purposes, and many new properties may not have a rateable value.

It is perhaps time now for the government to rethink the concept of taxing a notional annual value of a property, particularly in cases where the property has not been let out, in order to reduce the disputes as to the fair rental value of a property. Taxation of income from property should be restricted to the rent actually received, so that taxpayers are taxed only on their real income, and not on a notional income, which the government thinks they should have received.