Supreme Court clarifies ‘cost of improvement’ under Section 55(1)(b) of the IT Act: Commissioner of Income Tax vs. M/s. Paville Projects Pvt. Ltd. (2023)

Date of the Judgment: April 06, 2023
Citation: Civil Appeal No. 6126 of 2021 (@ SLP (C) NO. 13380 OF 2018)
Judges: M.R. Shah, J. and A.S. Bopanna, J.
Can payments made to settle shareholder disputes be considered as ‘cost of improvement’ under the Income Tax Act when calculating capital gains? The Supreme Court of India recently addressed this question, clarifying the scope of Section 55(1)(b) of the Income Tax Act, 1961. This case involved a company that sold a property to pay off its shareholders as per an arbitration award. The court had to determine whether the payments made to the shareholders could be deducted as ‘cost of improvement’ when calculating capital gains tax. The judgment was delivered by a division bench comprising Justice M.R. Shah and Justice A.S. Bopanna, with Justice M.R. Shah authoring the opinion.

Case Background

M/s. Paville Projects Pvt. Ltd., the respondent, was engaged in the manufacture and export of garments and shoes. In the Assessment Year 2007-08, the company sold its property, “Paville House,” for Rs. 33 Crores. This building was constructed on land purchased in 1972 and was reflected in the company’s balance sheet.

A dispute arose among the company’s shareholders, who were family members, leading to litigation in the Company Law Board and the High Court. This culminated in arbitration proceedings. An interim award was passed, recording a “family settlement” where three shareholders—Asha, Nandita, and Nikhil—were to receive Rs. 10.35 Crores each. The company argued that “Paville House” was sold to discharge these encumbrances, and the payments to shareholders should be considered a “cost of improvement.”

The Assessing Officer (AO) initially accepted the company’s computation of long-term capital gains, allowing the deduction of Rs. 31.05 Crores (Rs. 10.35 Crores x 3 shareholders) as “cost of improvement.” However, the Commissioner of Income Tax-7 (CIT) later issued a notice under Section 263 of the Income Tax Act, arguing that the AO’s order was erroneous and prejudicial to the revenue. The CIT contended that the payments did not qualify as “cost of improvement” under Section 55(1)(b) of the IT Act.

Timeline:

Course of Proceedings

The Commissioner of Income Tax (CIT) set aside the assessment order, directing the AO to recompute capital gains without considering the payment to shareholders as “cost of improvement.” The Income Tax Appellate Tribunal (ITAT) overturned the CIT’s order, relying on the Supreme Court’s decision in Malabar Industrial Co. Ltd. Vs. CIT [(2000) 2 SCC 718 : (2000) 243 ITR 83 (SC)]. The ITAT held that the CIT had wrongly invoked Section 263 of the IT Act, stating that the AO had taken a plausible view and that every loss of revenue cannot be considered prejudicial to the interest of the revenue. The ITAT also upheld the assessee’s claim for deduction, citing the Bombay High Court’s decision in CIT Vs. Smt. Shakuntala Kantilal [(1991) 190 ITR 56 (Bombay)].

The High Court of Judicature at Bombay upheld the ITAT’s decision, agreeing that the payment was made to end litigation and was deductible under Section 55(1)(b) of the IT Act. The Revenue then appealed to the Supreme Court.

Legal Framework

The core legal issue revolves around the interpretation of Section 55(1)(b) of the Income Tax Act, 1961, which defines “cost of improvement” in the context of capital gains calculation. The section states:

“55. Definitions of certain terms relevant to capital gains.—(1) For the purposes of sections 48 to 55A,—
(b) “cost of any improvement”,—
(i) in relation to a capital asset being goodwill of a business or a right to manufacture, produce or process any article or thing, shall mean the cost of any improvement thereto;
(ii) in relation to any other capital asset,—
(1) where the capital asset became the property of the previous owner or the assessee before the 1st day of April, 2001, shall mean all expenditure of a capital nature incurred in making any additions or alterations to the capital asset by the previous owner or the assessee on or after the said date, and
(2) where the capital asset became the property of the previous owner or the assessee on or after the 1st day of April, 2001, shall mean all expenditure of a capital nature incurred in making any additions or alterations to the capital asset by the previous owner or the assessee.”

The Supreme Court also considered Section 263 of the IT Act, which deals with the Commissioner’s power to revise orders passed by the Assessing Officer. The relevant part of the section is:

“263. Revision of orders prejudicial to revenue.—(1) The Commissioner may call for and examine the record of any proceeding under this Act, and if he considers that any order passed therein by the Assessing Officer is erroneous in so far as it is prejudicial to the interests of the revenue, he may, after giving the assessee an opportunity of being heard and after making or causing to be made such inquiry as he deems necessary, pass such order thereon as the circumstances of the case justify, including an order enhancing or modifying the assessment, or cancelling the assessment and directing a fresh assessment.”

The Court also referred to Section 143(3) of the IT Act, which pertains to assessment orders, and Section 50A of the IT Act, which is related to special provisions for computation of capital gains in certain cases.

Arguments

Arguments by the Revenue:

• The Revenue argued that the payments made to shareholders were not related to the asset under consideration and did not qualify as “cost of improvement.”
• The Revenue contended that the payments did not lead to any acquisition of interest in the asset, as the company already had absolute rights over the property.
• The Revenue submitted that the family dispute and subsequent settlement were separate from any improvements to the property. The shareholders’ concern was only that the sale proceeds be used to pay them as per the arbitration award.
• The Revenue argued that the High Court and ITAT erred in relying on Chemosyn Ltd. Vs. ACIT [2012 (25) Taxxman.com 325 (Bombay)] and Smt. Shakuntala Kantilal (supra), as the facts were not identical.
• The Revenue further argued that a portion of the asset was used in the business, and capital gains should have been taxed as per Section 50A of the IT Act.

Arguments by the Assessee:

• The assessee argued that the High Court correctly upheld the ITAT’s decision, stating that the Commissioner wrongly exercised revisional powers under Section 263 of the IT Act.
• The assessee relied on Malabar Industrial Co. Ltd. (supra), arguing that the AO’s order was well-reasoned and took a plausible view.
• The assessee contended that the payments to shareholders were necessary to end litigation and facilitate the sale of the property. This was supported by the Bombay High Court’s decision in Smt. Shakuntala Kantilal (supra).
• The assessee argued that the payments were made to ensure the smooth functioning of the business, preserve company assets, and remove encumbrances on the property, all of which were part of the “family settlement” that had the character of an interim award.
• The assessee submitted that the interim award specifically allowed the company to sell assets to discharge liabilities, making the payment to shareholders a necessary encumbrance.

Issues Framed by the Supreme Court

The Supreme Court did not explicitly frame issues in a separate section. However, the core issue before the court was:

1. Whether the Commissioner of Income Tax was correct in exercising powers under Section 263 of the Income Tax Act to set aside the assessment order passed by the Assessing Officer?
2. Whether payments made to shareholders as per an arbitration award could be considered “cost of improvement” under Section 55(1)(b) of the Income Tax Act, 1961?

Additionally, the court also dealt with the sub-issue of whether the assessment order passed by the AO was erroneous and prejudicial to the interest of the revenue.

Treatment of the Issue by the Court

Authorities

The Supreme Court considered the following authorities:

The Court also considered the following legal provisions:

• Section 55(1)(b) of the Income Tax Act, 1961: Definition of “cost of improvement”.
• Section 263 of the Income Tax Act, 1961: Commissioner’s power to revise orders.
• Section 143(3) of the Income Tax Act, 1961: Assessment orders.
• Section 50A of the Income Tax Act, 1961: Special provisions for computation of capital gains in certain cases.

Judgment

How each authority was viewed by the Court?

• Malabar Industrial Co. Ltd. Vs. CIT [(2000) 2 SCC 718 : (2000) 243 ITR 83 (SC)]: The Court explained the principles laid down in this case regarding the conditions for exercising jurisdiction under Section 263 of the IT Act. The Court clarified that while the Commissioner must be satisfied that the order is erroneous and prejudicial to the revenue, it does not mean that every loss of revenue is prejudicial. However, the Court distinguished the facts of the present case and held that the assessment order was erroneous and prejudicial to the revenue.
• CIT Vs. Smt. Shakuntala Kantilal [(1991) 190 ITR 56 (Bombay)]: The Court distinguished this case, stating that the facts were not identical to the present case. The Court held that the payments made to the shareholders were not for any improvement to the property.
• Chemosyn Ltd. Vs. ACIT [2012 (25) Taxxman.com 325 (Bombay)]: The Court distinguished this case, stating that the facts were not identical to the present case.
• Other authorities such as Dawjee Dadabhoy & Co. v. S.P. Jain [(1957) 31 ITR 872 (Cal)], CIT v. T. Narayana Pai [(1975) 98 ITR 422 (Kant)], CIT v. Gabriel India Ltd. [(1993) 203 ITR 108 (Bom)], CIT v. Minalben S. Parikh [(1995) 215 ITR 81 (Guj)], Rampyari Devi Saraogi v. CIT [(1968) 67 ITR 84 (SC)] and Tara Devi Aggarwal v. CIT [(1973) 3 SCC 482 : 1973 SCC (Tax) 318 : (1973) 88 ITR 323] were cited to support the interpretation of “prejudicial to the interests of the Revenue” and “erroneous assessment order.”
• Venkatakrishna Rice Co. v. CIT [(1987) 163 ITR 129 (Mad)]: The Court rejected the narrow interpretation of “prejudicial to the interests of the Revenue” given in this case.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the interpretation of Section 55(1)(b) of the Income Tax Act, 1961, and the specific facts of the case. The court emphasized that the payments made to the shareholders were not directly related to any improvement or enhancement of the capital asset. The payments were a result of a family settlement to resolve shareholder disputes.

The Court also considered the fact that the assessment order passed by the AO was erroneous and prejudicial to the interest of the revenue, as it allowed a deduction that was not in accordance with the law.

The sentiment analysis shows that the Court’s decision was driven by a combination of legal interpretation and factual analysis. The legal interpretation of Section 55(1)(b) and the factual analysis of the payments made to shareholders were the most significant factors.

The ratio analysis shows that the Court’s decision was more influenced by legal considerations (70%) than factual aspects (30%). This indicates that the Court primarily focused on the correct interpretation and application of the law.

Logical Reasoning

The Court’s reasoning was based on a strict interpretation of Section 55(1)(b) of the IT Act. The Court rejected the argument that the payments were necessary for the sale of the property, stating that they were primarily for settling shareholder disputes. The Court emphasized that the payments did not lead to any addition or alteration to the capital asset.

The Court also considered the purpose of Section 263 of the IT Act, which is to ensure that the revenue is not prejudiced by erroneous orders of the Assessing Officer. The Court held that the Commissioner was correct in exercising powers under Section 263 of the IT Act, as the assessment order was erroneous and prejudicial to the interest of the revenue.

The Court also made the following observations:

“…if due to an erroneous order of the Income Tax Officer, the Revenue is losing tax lawfully payable by a person, it will certainly be prejudicial to the interests of the Revenue.”

“…the assessment order was not only erroneous but prejudicial to the interest of the Revenue also. In the facts and circumstances of the case, it cannot be said that the Commissioner exercised the jurisdiction under Section 263 not vested in it. “

“The erroneous assessment order has resulted into loss of the Revenue in the form of tax.”

The Court did not consider any alternative interpretations, as it was clear that the payments made to shareholders were not for the improvement of the property.

The Court’s decision was unanimous, with both judges agreeing on the outcome. There were no dissenting opinions.

The implication of this judgment is that payments made to settle shareholder disputes cannot be considered as “cost of improvement” when computing capital gains tax. This clarification provides guidance to taxpayers and tax authorities.

Key Takeaways

• Payments made to settle shareholder disputes are not considered “cost of improvement” under Section 55(1)(b) of the Income Tax Act.
• The Commissioner of Income Tax can exercise powers under Section 263 of the IT Act to revise assessment orders that are erroneous and prejudicial to the revenue.
• The term “cost of improvement” is strictly interpreted to mean expenditure of a capital nature incurred in making any additions or alterations to the capital asset.
• Taxpayers should ensure that all claims for deductions are in accordance with the law.
• Tax authorities should ensure that assessment orders are not erroneous and prejudicial to the interest of the revenue.

This judgment clarifies the scope of “cost of improvement” and provides guidance for future cases involving similar issues. It also emphasizes the importance of ensuring that assessment orders are in accordance with the provisions of the Income Tax Act.

Directions

The Supreme Court quashed and set aside the impugned judgment and order passed by the High Court and restored the order passed by the Commissioner of Income Tax passed in exercise of powers under Section 263 of the Income Tax Act.

Development of Law

The ratio decidendi of this case is that payments made to settle shareholder disputes cannot be considered as “cost of improvement” under Section 55(1)(b) of the Income Tax Act, 1961. This judgment clarifies the interpretation of Section 55(1)(b) and sets a precedent for future cases. The Supreme Court has upheld the Commissioner’s order, clarifying that the Commissioner can exercise powers under Section 263 of the IT Act to revise assessment orders that are erroneous and prejudicial to the revenue.

Conclusion

In conclusion, the Supreme Court allowed the appeal filed by the Revenue, holding that the payments made to shareholders could not be considered as “cost of improvement” under Section 55(1)(b) of the Income Tax Act. The Court emphasized that the Commissioner of Income Tax was correct in exercising powers under Section 263 of the IT Act to set aside the assessment order passed by the Assessing Officer. This judgment provides clarity on the interpretation of Section 55(1)(b) and the Commissioner’s revisional powers.