Bombay High Court rules that monies received pursuant to an arbitral award was towards retirement from partnership, settlement of family dispute; hence, same should not be chargeable to tax

This ruling also highlights another important principle in respect of properties that might be received pursuant to a family arrangement; as the same is received against settlement of disputed rights and to avoid litigation, it is considered to be a capital receipt not chargeable to tax under the IT Act.

In a recent ruling of the hon’ble Bombay High Court, in the case of Ramona Pinto v DCIT [ITA No 2610 of 2018], the Court quashed reassessment proceedings against the taxpayer for being bad in law while emphasising that reassessment proceedings under Section 148 of the Income-tax Act, 1961 (“IT Act”) can be initiated only where the tax authorities have requisite belief that income has escaped assessment and not when the proceedings have been initiated merely to investigate the notion of whether income has escaped assessment, as was the case here.

Additionally, while going into the merits of the case, the court also held that the monies received by the taxpayer under the arbitral award was in respect of (i) her retirement from the partnership firm (even though the same was not expressly stated), and (ii) settlement of family disputes. Placing reliance on the settled jurisprudence on these questions of law, the court held that the monies under consideration are capital receipts not chargeable to tax under the IT Act.

Background

The taxpayer’s father had established a partnership firm in 1954 (“Firm”). Pursuant to several reconstitutions over the years, the taxpayer came to hold a 20% profit-share in the Firm by 1979. Subsequent to her father’s demise in 1997, she inherited an additional 5% profit-share in the Firm, bringing her share in the Firm to 25%.

However, the taxpayer’s brothers, without her knowledge, retired her from the Firm. Upon realisation of the same, disputes arose, and the matter went up to the Supreme Court where the following directions were provided: (i) matter was referred to arbitration, and (ii) payment of INR 50,000 p.m. was awarded to the taxpayer (in the interim). The taxpayer received a sum of INR 5 lakhs under the interim award in FY 2007-08, which was not offered to tax. On being asked to justify this position during scrutiny proceedings, she submitted that the receipt was related to her retirement from the Firm and hence not taxable. This was accepted by the officer and no addition was made.

During the arbitration proceedings, the parties arrived at consent terms pursuant to which the taxpayer relinquished all her rights and claims against her brothers and the Firm against which she received a consideration of INR 28 crores (with INR 7 crores received in FY 2009-10 and balance in 7 annual, equal instalments).

While filing her tax returns, the above was not offered to tax. In the note annexed to the return, it was submitted that the amount of INR 7 crores was received in relation to her retirement from the Firm and hence shall not be chargeable to tax. Such return was filed, processed and accepted by the DCIT.

Subsequently, however, reassessment proceedings were initiated against the taxpayer under Section 148 of the IT Act on the basis that the arbitration award was not submitted to the department. The same was received subsequently from the tax officer of the Firm; accordingly, this information served as the “reason to believe” that income had escaped assessment.

The tax officer passed an order taxing the entire INR 28 crores in FY 2009-10 under Section 28(iv) of the IT Act. On subsequent appeal to the CIT(A), arguments of bringing such income to tax as business income or capital gains was rejected; however, the entire amount was taxed under Section 56 (for consideration received for settlement of a composite bundle of right) of the IT Act. The ITAT upheld the order of the CIT(A) claiming while holding that income received under an arbitral award is a sort of “special income” and hence taxable.

Ruling

The High Court has held the following:

On the jurisdiction of initiation of reassessment proceedings

• In the taxpayer’s own case, the tax officer had, in a previous year accepted the position (after scrutiny) that receipts pursuant to the interim order of the Supreme Court, are not chargeable to tax. Disputing this position in the year under consideration is a “change of opinion”, which does not fulfil the pre-requisites of Section 148 of the IT Act.

• Further, the assessing officer has not only failed to bring on record any “new tangible material” but the reasons for reassessment provided by the tax officer also do not expound on whether and how the receipt is the nature of an “income”. Therefore, while emphasizing that reassessment proceedings cannot be initiated merely to investigate whether income has escaped assessment, it was held that the burden of meeting the “reason to believe” condition has not been met and accordingly the reassessment is bad in law.

On the receipt of monies under the arbitral award

• Receipt pursuant to retirement from Firm: The monies have indisputably been received pursuant to the consent terms / arbitral award. The terms of this award clearly provide that the taxpayer relinquishes all her rights and claims as a partner in the Firm. Hene, the only inference possible would be that she would no longer continue as a partner of the Firm (even though the same is not expressly provided). Therefore, the monies have been received by her pursuant to her retirement from the Firm.

Placing reliance on the decisions¹ of the Supreme Court, it was held that amount receivable upon retirement from the Firm could not constitute “income” for the purposes of IT Act. This is based on the principle that what the partner gets on retirement is the realization of a pre-existing right / interest. Such amounts are received against working out the rights / entitlements of the partner in the firm (that she inherently holds on account of her partnership interest) and not for the transfer of outgoing partners’ interest to the continuing partners.

• Receipt pursuant to satisfaction of inheritance rights: The arbitration award also dealt with settlement of the taxpayer’s inheritance rights under her father’s will and any amount received in satisfaction of such rights have expressly been exempted from tax under Section 56(2)(vii) of the IT Act (now Section 56(2)(x)).

• Receipt pursuant to family arrangement: If the receipts are said to be relatable to a family arrangement, even then they would not be chargeable to tax. This is because an arrangement between family members is an agreement to either compromise on the disputed rights or “preserving peace, honour, security and property” of the family by avoiding litigation; such amounts should not be taxable².

• Receipt pursuant to damages: Even if the receipts are considered to be in the nature of damages, they are capital in nature and hence not taxable³.

• General principle: The settled position that unless expressly provided, a capital receipt does not constitute “income” has been reiterated while holding that the receipt under consideration here is a capital receipt. It was also held that it is the revenue’s obligation to justify as to why a particular receipt constitutes “income” under the IT Act; this onus has not been so discharged by the revenue.

Comments

The ruling reaffirms several accepted judicial principles with respect to initiation of reassessment proceedings under Section 148 of the IT Act and the taxability of receipts of capital nature under the IT Act. However, it is pertinent to note that the pre-requisites for reassessment under the newly introduced Section 148A of the IT Act differs materially and hence need to be analysed independently.

It also reaffirms the principles established by previous rulings in respect of non-taxability of consideration received pursuant to retirement from a partnership firm. However, it should be noted that provisions of Section 45(4) and 9B of the IT Act (as they stand today) were not applicable in the assessment year under consideration here.

This ruling also highlights another important principle in respect of properties that might be received pursuant to a family arrangement; as the same is received against settlement of disputed rights and to avoid litigation, it is considered to be a capital receipt not chargeable to tax under the IT Act.