The general rule of taxation in India is that revenue receipts are taxable under Income Tax law, unless otherwise explicitly exempted. Capital receipts, however, are not taxable under Income Tax law, unless otherwise explicitly made taxable. A capital receipt would not attract tax under Indian tax laws unless capital gain arises, or the receipt is taxable under any anti-abuse provision under section 56(2) of the Act.
A natural strategy to avoid taxation is to characterise revenue receipts as capital receipts. In fact, there is a general bias among tax consultants --when there is a grey area as to whether a receipt is capital or revenue in nature -- to characterise a receipt as capital.
Before moving towards the strategies used to colour a revenue receipt into a capital receipt, a look at some transactions declared as the latter by courts and tribunals.
In 2018, Bollywood actor Sushmita Sen received a compensation of Rs 1.5 crore from Coca Cola as final settlement for a contract that was prematurely terminated. Of this total amount, a settlement worth Rs 95 lakh was made regarding a sexual harassment complaint. Sen argued that the amount was not income in her hand, as it is a capital receipt. Tax assessors, on the other hand, argued that the payment is a revenue receipt and should be taxable. The tribunal ruled that the receipt was capital in nature and hence not taxable.
In 2014, the Supreme Court held that the termination amount under a work referral agreement with Deloitte Haskins & Sells is a capital receipt and hence not taxable. The Delhi High Court, in 2015, ruled that the sum received by a journalist on termination of their employment contract is a capital receipt and not chargeable to tax -- in order to compensate for their loss of income. Several other rulings have also clarified that when a receipt is in the nature of compensation for termination of contract or a breach of contract, it is to be considered as a capital receipt.
How India Today’s editor availed a tax-free reward
Aroon Purie is the founder-publisher of India Today and the chief executive of the India Today media conglomerate. His daughter Kallie Purie succeeded him as editor of India Today in October 2017.
Back in the financial year 1990-91, Purie had received the BD Goenka award from BD Goenka Foundation for excellence in journalism. The award included reward money of Rs 1 lakh. While filing his IT returns, Aroon Purie claimed a tax exemption on the reward money on grounds that the amount was not for any services rendered by him; rather it was a testimonial or a personal gift received as a token of appreciation.
However, the assessing officer disapproved this claim and characterised the amount as Purie’s own income. The appeals commissioner then reversed the assessing officer’s order and held the amount as a capital receipt. The IT department contested this stand in the Delhi Bench’s tax tribunal, which again reversed the appeals commissioner’s decision and held that the sum received by Purie is classified as income and should be taxed.
This time Purie filed a case against the tribunal’s order in the Delhi High Court. In 2015, the High Court ruled that the amount is a non-taxable capital receipt since the prize money was paid by a third party (not associated with Purie’s vocation). The court also stated that the prize money was not directly related to Purie’s job as a journalist, but rather linked to his personality. The Court ruled, “It, being payment of a personal nature, should be treated as capital payment, being akin to or like a gift, which does not have any element of quid pro quo.”
Scope for misuse
The principle that all capital receipts are exempt except otherwise stated is prone to misuse; it is easy to pass off one-time remuneration as capital receipt. Freelance artists usually work on a project on being commissioned. They can, with malafide intentions, draw an agreement in such a way that a small component of the amount they receive as compensation is characterised as fees and the rest as payment for not sharing the work with anyone else. A fee is classified as income -- but the rest could possibly be characterised as capital receipt.
During a business acquisition, sometimes the payment to previous owners are structured such that part payment is for share sale and part payment is for loss of business to the previous owners. Payment for loss of future business may be claimed as a capital receipt.
Extracted from the book Loophole Games: A Treatise on Tax Avoidance Strategies, with prior permission of the author. The author is an officer of the Indian Revenue Service.