Bombay High Court: Arbitration Award Amount Received By Retiring Partner For Relinquishing Claim In Firm Not Taxable
That’s because it does not fall within the scope of ‘capital gains’
The Bombay High Court has held that an amount of arbitration award received by a retiring partner for relinquishing its claim in the firm is not a taxable income.
The bench comprising Justice K.R. Shriram and Justice Dr. Neela Gokhale held that the amount received by a partner under a consent arbitration award for relinquishing its stake in the firm cannot be treated as an ‘income from other sources’ under Section 56(1) of the Income Tax Act, 1961.
The Court stated that to bring an amount within the fold of Section 56(1), it must first be shown as income. However, an amount received upon retirement is not an income. Therefore, it does not fall within the scope of ‘capital gains.’
The bench added that the receipt of an amount in lieu of inheritance or pursuant to family arrangement cannot be charged with tax under the Act. That’s because the arrangement is an agreement between members of the same family. It is for the benefit of the family either by compromising doubtful or disputed rights or by preserving the family’s peace, honor, security, and property, by avoiding litigation and amounts received or not exigible to tax.
P.N. Writer & Co., a Partnership Firm, was formed in 1954 by Charles D'Souza and P.N. Writer. The partnership underwent reconstitutions, with the last deed signed in 1979.
After the demise of D'Souza in 1997, his will bequeathed an additional 5 percent share to his daughter (the appellant), entitling her to a 25 percent share in the firm.
In 2005, the appellant learnt about a 1997 deed treating her as retired. Thus, disputes ensued and led to arbitration.
In 2007, the Supreme Court ordered the firm to pay the appellant Rs.50,000 per month as interim relief.
The arbitration award of 2009 stipulated that the appellant relinquished all claims in exchange for Rs.28 crores, payable in instalments. An initial sum of Rs.5 lakhs was received. The appellant asserted that the amount was related to her retirement, and therefore, not taxable.
While the Income Tax department initially accepted this stance, in 2014, it reopened the case. The department alleged escapement of income for the Assessment Year 2010-2011. It was based on information about the award and the order passed by the Apex Court.
The appellant objected that the amount was not income but related to her retirement from the firm. The IT department disposed of the objections, citing information from the Assessing Officer (AO) of the firm. It asserted that the amount was not proven conclusively.
The order was challenged by the appellant in a writ petition, which was allowed to be withdrawn in 2015 with the clarification that all contentions could be raised again before the IT authorities.
Thereafter, the IT department resumed reassessment proceedings. it issued a notice under Section 142(1), asking the appellant to justify the amount in terms of business income or capital gains.
In 2015, the department determined the appellant's total income at Rs.28,18,91,590. It added Rs.28 crores as business income under Section 28(iv) or as capital gains, claiming that the appellant had not retired from the firm.
On an appeal filed by the appellant, the Commissioner of Income Tax (Appeals) ruled out Section 28(iv) but considered the award as income from other sources.
The matter reached the tribunal, which upheld the reassessment, stating there was prima facie material showing an escapement of income. Aggrieved by the outcome, the appellant filed an appeal under Section 260A of the IT Act.
The appellant submitted:
• The reassessment proceedings were initiated without fulfilling the jurisdictional pre-conditions in Sections 147 and 148 of the IT Act. On receiving Rs.28 crores, all claims against the family and the partnership firm were satisfied, and the appellant had no further claims. The amount was received for retirement or relinquishment of rights under the will, making it non-taxable.
• No prima facie case was presented by the respondent to believe that income escaped assessment. The information from the firm’s AO was not fresh and didn’t establish a link between the information and the belief. Since the issue was considered in 2008-2009 and deemed non-taxable, initiating reassessment for 2010-2011 was a change of opinion, not permissible in law.
• The burden lies on the department to prove that the amount received is within the taxing provision. The revenue failed to discharge the burden. The primary purpose of the amount was the settlement of the relinquishment of rights in the partnership firm, with other issues being only incidental.
• Historically, amounts received by a partner upon retirement were not chargeable to tax before the insertion of Section 45(4) by the Finance Act 1987. The amount was received for retirement from the firm, as evidenced by various documents. Section 45(4) did not apply, as it deals with the distribution of capital assets, not a monetary amount.
• Even if any part of the arbitration award is related to inheritance, the absence of Estate Duty, or a similar tax, no tax is chargeable. The provisions of Section 56(2)(vii) specifically exclude amounts received pursuant to a bequest from taxation.
• The amount received was pursuant to a family arrangement, which is not chargeable to tax. Such arrangements aim to compromise disputed rights or preserve family peace and are not subject to taxation.
Submissions by Respondent:
• The amount received/receivable by the appellant should be charged under Section 28(iv). However, the submission was rejected as both the CIT(A) and the tribunal accepted that Section 28(iv) does not apply to benefits in cash or money.
• The motive behind the payment should determine the category of income. The consent terms did not clearly spell out that it was for relinquishing rights under the partnership firm, justifying the tribunal's conclusion.
• Since the appellant retired from the firm, it amounted to a dissolution of the firm, making the amount received upon dissolution chargeable to tax. The Apex Court's decision in the Erach F. D. Mehta vs. Minoo F. D. Mehta was cited in support.
• The amount received by the appellant would be chargeable to tax as ‘income from other sources’ under Section 56(1). The receipt was a special income and, therefore, taxable.
The Court analyzed the jurisdictional pre-conditions for initiating reassessment proceedings under Section 148. It emphasized that the AO must have a valid belief that the assessee's income escaped assessment, and it should not be based on a change of opinion.
The judges observed that the jurisdictional pre-conditions were not fulfilled. The reasons for reopening the assessment did not address whether the arbitration amount was an income. The AO lacked clarity and was contradicted by the available information.
The bench highlighted that the reassessment proceedings were initiated without investigating the facts. It examined the nature of the amount received through arbitration and concluded that it was related to the settlement of partnership interests and inheritance rights, making it capital in nature and not chargeable to tax.
Justice Shriram and Justice Gokhale criticized the tribunal's classification of the amount as ‘special income.’ They asserted that such a concept had no basis in the law.
Thus, while disposing of the appeal, the Court ruled in favor of the appellant. It stated that the AO assumed jurisdiction without fulfilling the necessary pre-conditions.