Loss can be clubbed and carried forward like income – SC

The Income-tax Act has specified certain cases where income of one person is statutorily required to be included in the income of another person if some conditions are satisfied. This inclusion is known as “Clubbing of Income”. As the term suggests, clubbing of income means adding or including the income of another person (mostly family members) to one’s own income. This is allowed under Section 64 of the IT Act. However, certain restrictions pertaining to specified person(s) and specified scenarios are mandated to discourage this practice.

Let us refer to the case of CIT v. J. H. Gotla (1985), where the issue under consideration was whether the income of the wife and/or minor children of the assessee from a partnership firm in which the wife is a partner and/or minor children have been admitted to the benefits of partnership carried on with the assets transferred by the assessee in any year subsequent to the year of transfer could be set off against any loss brought forward by the assessee in respect of a business carried on by the assessee?

The sections mentioned here pertain to Section 16(3) and 24(2) of Income-tax Act, 1922 which were substituted by Sections 70, 71 and 72 of Income Tax Act 1962.

Provisions of Income-tax Act, 1922

According to Section 16(3), In computing the total income of any individual for the purpose of assessment, there shall be included:

1. so much of the income of a wife or minor child of such individual as arises directly or indirectly:
2. from the membership of the wife in a firm of which her husband is a partner
3. from the admission of the minor to the benefits of partnership in a firm of which such individual is a partner
4. from assets transferred directly or indirectly to the wife by the husband otherwise than for adequate consideration or in connection with an agreement to live apart; or
5. from assets transferred directly or indirectly to the minor child, not being a married daughter, by such individual [otherwise than for adequate consideration]; and
6. so much of the income of any [person or association of persons] as arises from assets transferred [otherwise than for adequate consideration to the person or association] by such individual [for the benefit of his wife or a minor child or both].

According to Section 24(2), where any assessee sustains a loss of profits or gains in any year, being a previous year not earlier than the previous year for the assessment for the year ending on the 31st day of March, 1940, in any business, profession or vocation, and the loss cannot be wholly set off under sub-section (1), so much of the loss as is not so set off or the whole loss where the assessee had no other head of income shall be carried forward to the following year, and

1. where the loss was sustained by him in a business consisting of speculative transactions, it shall be set off only against the profits and gains, if any, of any business in speculative transactions carried on by him in that year;
2. where the loss was sustained by him in any other business, profession or vocation, it shall be set off against the profits and gains, if any, of any business, profession or vocation carried on by him in that year: provided that the business, profession or vocation in which the loss was originally sustained continued to be carried on by him in that year; and
3. if the loss in either case cannot be wholly so set off, the amount of loss not so set off shall be carried forward to the following year and so on [but no loss shall be so carried forward for more than eight years

Facts of the Case:

• The assessee was carrying on the business of purchase and sale of ground-nut oil and was also running an oil mill. He was also an abkari contractor.
• On 1st June, 1957, he had gifted away a part of the oil mill machinery, viz., a solvent extraction plant, to his wife and three minor children.
• A firm was constituted by the assessee’s wife and another person to the profits of which the three minor sons of the assessee were also admitted.
• The mill premises as well as the remaining machinery of the assesses were leased out to this firm which carried on the business of the manufacture and sale of ground-nut oil.
• The assessee himself continued to carry on business in purchase and sale of ground-nut cake and oil on a small scale. The assessee also continued his business as abkari contractor.
• The assessee had incurred huge losses in his individual business in the earlier years which were being carried forward from year to year up to AY 1958-59.
• The loss carried forward from AY 1958-59 was Rs. 7,88,734.
• The assessee’s profit from his own business for 1959-60 were Rs 14,324.
• The share income of the assessee’s wife and minor children from the firm for the AY 1959-60 was Rs. 24,592.
• The said income was included in the computation of the total income of the assessee for AY 1959-60.
• The assessee claimed set off of the loss carried forward from AY 1958-59 against the profits of his own business as also the share income of his wife and minor children.
• The ‘AO’ rejected the claim for set off in so far as it related to the share income of his wife and minor children.
• Similar claims for set off were made in the AY’s 1960-61 and 1961-62 but were rejected.

Proceedings of Appellate Authorities and the High Court (HC)

• On appeals preferred by the assessee, the Appellate Assistant Commissioner allowed the set off claimed on the ground that the assessee himself is deemed to be carrying on the business from which the share income was derived by his wife and minor children.
• The revenue appealed to the Income Tax Appellate Tribunal (ITAT).
• ITAT held that although the assessee was not carrying on the business of manufacture and sale of oil during the years under appeal, he was continuing to carry on the business of oil in general.
• ITAT also held that the firm did carry on the same business as carried on by the assessee but there was no connection between the assessee and the business carried on by the firm and they were two different entities and, as such, the assessee could not be said to be carrying on the business out of which the share income of the wife and minor children arose.
• Accordingly, it held that the assessee was not entitled to claim set off of his losses against the income of his wife and minor children.
• On appeal by assessee before HC, on a consideration of the scheme of the Act and the provisions there in referred to, the HC was of the opinion that the share income of the assessee’s wife and minor children included in the assessee’s total income should be regarded as business income derived from business carried on by the assessee and in that view of the matter the assessee was entitled to set off his loss carried forward from the previous year.
• Accordingly, the question referred to in respect of these years was answered in the affirmative and in favour of the assessee by the HC.
• Aggrieved with the order of the HC, revenue filed an appeal before the Supreme Court (SC)

Contention of the Assessee before SC

• SC noted that several propositions were canvassed before them on behalf of the assessee the main one being that the court should consider the purpose of the section for the proper construction of the relevant provisions of the Act.
• It was manifest, as contended for on behalf of the assessee, that the object of Section 16(3)(a) was to foil an individual’s attempt to reduce the incidence of tax by transferring his assets to his wife or minor child or by admitting his wife as a partner or his minor child to the benefits or partnership in a firm in which he was a partner by transferring the assets directly or indirectly to them otherwise than for adequate consideration
• In this connection, significant further dilation of the court narrated the business of the firm in which assessee’s wife was a partner and the benefits of which his minor children were admitted was a firm in which the assessee himself was not a partner and as such that business was not being carried on by the assessee.
• Assessee contended that the real object of Section 16(3) was to restore the position which obtained before the transfer, qua income.
• In other words, he urged that it was as if the transfer had not taken place.
• It was his submission that if the transfer had not taken place, the income of the wife and the minor children from the assets transferred viz., machinery in this case, would be the income of the assessee.
• In other words, it would be income from his business if the transfer was ignored.
• In that case loss from business could be carried forward for six to eight years as the case may be, to be set off against the business income of the assessee.
• Assessee urged that the object of the said section was not to punish for having transferred his assets to his wife or minor children by denying any allowance, concession, deduction, etc. to which he or others would otherwise be entitled to.
• SC found substance in this contention

Contention of Revenue before SC

• Further discussing the revenue’s case it was noted by SC that the question which arose here was whether against the inclusion of such income, loss suffered by the assessee in a previous year which was carried forward should be allowed to be set off or not.
• Revenue contended that it could not be.
• It laid emphasis on the fact that set off for the carried forward loss is permitted only by Section 24(1) and there should be strict literal construction of Section 24(2).
• In view of the provisions of Section 24(2)(ii) which stipulated that loss to be carried forward must be ‘loss sustained by him in any other business, profession or vocation, it should be set off against the profits and gains, if any, of any business, profession or vocation carried on by him in that year; provided that the business, profession or vocation in which the loss was originally sustained continued to be carried on by him in that year’.
• Therefore, it was required that the business, profession or vocation against profits of which the set off is claimed must be carried on by the assessee in that year.
• But the problem here was that the business out of whose share income of the wife or minor child was derived was no longer carried on by the assessee himself in the subsequent year in which set off was being claimed.
• Revenue emphasised that this requirement was to be strictly followed.
• It was further stressed by Revenue that equity had no place in interpreting fiscal legislation.

Observations of SC

• After considering rival contentions, SC held that the object of Section 16(3) had to be read in conjunction with Section 24(2) in this case for the present purpose.
• If the purpose of a particular provision was easily discernible from the whole scheme of the Act which in this case was, to counteract, the effect of the transfer of assets so far as computation of income of the assessee is concerned.
• Bearing that purpose in mind, one should find out the intention from the language used by the Legislature and if strict literal construction led to an absurd result i.e., result not intended to be subserved by the object of the legislation found out in the manner indicated before, and if another construction was possible apart from strict literal construction then that construction should be preferred to the strict literal construction.
• In the instant case SC was dealing with an artificial liability created for counteracting the effect only of attempts by the assessee to reduce tax liability by transfer.
• It was also noted how for various purposes the business from which profit was included or loss was set off was treated in various situations as assessee’s income.
• Therefore, where Section 16(3) operated, the profits or loss from a business of the wife or minor child included in the total income of the assessee should be treated as the profit or loss from a ‘business carried on by him’ for the purpose of carrying forward and set off such loss under Section 24(2).
• On a consideration of the scheme of the Act and the provisions therein, the share income of the wife and minor children included in the assessee’s total income under Section 16(3) should be regarded as business income derived from business carried on by the assessee.
• Therefore, the assessee was entitled to set off his loss carried forward from the previous years.

In the premises the question was answered in the affirmative and in favour of the assessee.

In conclusion:

• If strict literal construction leads to an absurd result i.e., result not intended to be subserved by the object of the legislation found out in the manner indicated before, and if another construction is possible apart from strict literal construction then that construction should be preferred to the strict literal construction
• The whole scheme of the Act has to be kept in mind and then the same needs to be balanced with the object/purpose of the stated provisions in consideration. It was very succinctly held that income would include loss

Notably in this case, the court took special cognizance of 1961 Act provisions and mentioned that, “When 1961 Act was enacted, this was also not clarified. The requirement of Section 72 which replaced Section 24(2) of the Act proceeded substantially on previous basis.”

Therefore, the income of the wife and/or minor children of the assessee from a partnership firm in which the wife is a partner and/or minor children have been admitted to the benefits of partnership carried on with the assets transferred by the assessee in any year subsequent to the year of transfer can be set off against any loss brought forward by the assessee in respect of a business carried on by the assessee.

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