Is amount received on surrender of tenancy rights is liable to capital gains tax?

Capital gain is the profit one earns on the sale of an asset like stocks, bonds or real estate. It results in capital gain when the selling price of an asset exceeds its purchase price. It is the difference between the selling price (higher) and cost price (lower) of the asset. Capital loss arises when the cost price is higher than the selling price. The sale of capital assets may lead to capital gains and these gains may attract tax under the Income Tax Act.

Section 45 of Income Tax Act, 1961 provides that any profits or gains arising from the transfer of a capital asset effected in the previous year will be chargeable to income-tax under the head ‘Capital Gains’. Such capital gains will be deemed to be the income of the previous year in which the transfer took place.

Let us refer to the case of CIT v. D. P. Sandhu Bros (P) Ltd, where the issue under consideration was whether the amount received by the respondent-assessee on surrender of tenancy rights is liable to capital gains tax under Section 45 of the Income tax Act, 1961 or not.

Facts of the Case:

A lease agreement was entered in 1959 for 50 years under which an annual rent was paid by the lessee/assessee to the lessor. The lease would have continued till 2009.
In March 1986, the assessee surrendered its tenancy right to its lessor prematurely.
In consideration for such premature termination, the lessor paid the assessee/lessee a sum of Rs.35 lakhs.
In the assessee’s return the sum of Rs.35 lakhs was credited to its reserve and surplus account.
This was disallowed by the Assessing Officer who held that the amount of Rs.35 lakhs was taxable as “income from other sources” under Section 10(3) read with Section 56 of the ‘Act’.

Order of Appellate Authorities and High Court (HC)

The assessee appealed to the Commissioner of Income Tax (Appeals) who came to the conclusion that the assessee was liable to pay capital gains on the amount of Rs.35 lakh after deducting an amount of Rs 7 lakhs as the cost of acquisition.
The Commissioner had determined the cost of acquisition at Rs.7 lakhs on the basis of the market value of the property as on 1.4.1974.
Both the Department and the assessee challenged the decision of the Commissioner before the Tribunal.
The Tribunal relied upon the decision of this Court in CIT v. Srinivasa Shetty (1981) as well as the amendment to Section 55(2) of the Act in 1995 and held that the assessee did not incur any cost to acquire the leasehold rights and that if at all any cost was incurred it was incapable of being ascertained.
It was therefore held that since the capital gains could not be computed as envisaged in Section 48, therefore capital gains earned by the assessee if any was not eligible to tax.
The Department preferred an appeal before the High Court.
The High Court dismissed the appeal.
Being aggrieved by the decision of the High Court, the Department further appealed before the Supreme Court (SC).

Reference by SC to an older case

SC in CIT v. B. C. Srinivasa Shetty (1981) held that the transactions encompassed by Section 45 must fall within the computation provisions of Section 48.
If the computation as provided under Section 48 could not be applied to a particular transaction, it must be regarded as “never intended by Section 45 to be the subject of the charge”.
In that case, SC was considering whether a firm was liable to pay capital gains on the sale of its goodwill to another firm.
SC found that the consideration received for the sale of goodwill could not be subjected to capital gains because the cost of its acquisition was inherently incapable of being determined.

Observations of SC

Dismissing the revenue’s appeal, SC held that, the tenancy rights was a capital asset, the surrender of the tenancy rights was a “transfer” and the consideration received therefore was a capital receipt within the meaning of Section 45.
The same was not questioned before SC and should in any event be taken to be concluded by the decision of this Court.
Normally the consideration would therefore be subjected to capital gains under Section 45.
Further SC held that, an asset which was capable of acquisition at a cost would be included within the provisions pertaining to the head ‘capital gains’ as opposed to assets in the acquisition of which no cost at all could be conceived.
Then SC considered the Circular issued by the Central Board of Direct Taxes Circular No.684 dated 10th June 1994 wherefrom it was observed by SC that, to meet the situation created by the decision in Srinivasa Shetty and the subsequent decisions of the High Court that the Finance Act 1994 amended Section 55(2) to provide that the cost of acquisition of inter alia a tenancy right would be taken as nil.
By this amendment, the judicial interpretation put on capital assets for the purposes of the provisions relating to capital gains was met.
In other words, the cost of acquisition would be taken as determinable but the rate would be nil.

Further the court considered the aspect of effective period of stated amendment by Finance Act, 1994 to which court noted that, amendment took effect from 1st April, 1995 and accordingly applied in relation to the assessment year 1995-96 and subsequent years.
But till that amendment in 1995 therefore covering the Assessment Year in question, the law as perceived by the Department was that if the cost of acquisition of a capital asset could not in fact be determined, the transfer of such capital asset would not attract capital gains.

SC considered the aspect of possibility of taxability under any other provision like section 56

According to Section 56, 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
SC held that, once applicable Section 45 cannot be applied, it was not open to the Department to impose tax on such capital receipt by the assessee under any other Section.
That is after considering various heads of taxation specified under section 14 of the ‘Act’, it held that, if the income is included under any one of the heads, it cannot be brought to tax under the residuary provisions of Section 56.
In other words, it held that, it would be illogical and against the language of Section 56 to hold that everything that is exempted from capital gains by statute could be taxed as a casual or non-recurring receipt under Section 10(3) read with Section 56 of the ‘Act’.

In simple words, amount received on surrender of tenancy rights is liable to capital gains tax under Section 45 of the Income tax Act, 1961 and not under Section 56 under the head ‘Income from Other Sources’.

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