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Deductibility of Interest on Loan Taken for Family Settlement against Capital Gains from Gifted Property

CA Divyajeet Singh Sabharwal , Last updated: 23 January 2024  
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The interplay between capital gains taxation and deductions allowed on borrowing for family settlements has been a subject of constant debate and judicial scrutiny. A recent income tax case involving an assessee claiming interest deduction on a loan taken to fulfill a family settlement against capital gains arising from the sale of a gifted property raises interesting questions about the nexus between these two aspects. This article delves into the intricacies of the case, analyzes the relevant legal provisions, and offers a critical perspective on the deductibility of such interest claims.

The Case in Point

The crux of the case involves an individual (assessee) who received a property as a gift from his parents. Subsequently, he sold the property and accrued capital gains from the sale. He claimed deduction for the interest paid on a loan taken from a third party, arguing that the loan proceeds were used to discharge his financial obligations arising from a family settlement agreement. The assessing officer, however, disallowed the deduction on the grounds that the interest payment on the loan bore no direct connection to the capital gains transaction. The assessee contested the decision, leading to a series of appeals through the various tax tribunals.

Deductibility of Interest on Loan Taken for Family Settlement against Capital Gains from Gifted Property

Relevant Legal Provisions

To understand the legal reasoning behind the disallowance, we must consider the pertinent provisions of the Income Tax Act, 1961.

  • Section 45: This section deals with the computation of income from capital gains and specifies the allowable and disallowable expenses in relation to such gains. While it allows deductions for certain incurred expenses related to asset acquisition and sale, there is no explicit provision permitting deduction of interest incurred on borrowing for purposes unrelated to the capital gains transaction.
  • Section 57: This section disallows the deduction of expenses incurred for any purpose which is illegal or the expenditure of which is not allowed by any other provision of the Act. While not directly applicable to family settlements, it underscores the principle that deductions are allowed only if they satisfy specific legal criteria.

Arguments for Allowing the Deduction

The assessee, and possibly those advocating for similar claims, might argue that:

  • Family settlements are recognized by law: Family arrangements and settlements hold social and legal importance in India. Their enforceability under the Contract Act and recognition under Hindu law could be invoked to argue that fulfilling obligations arising from such arrangements should be considered a legitimate personal expense.
  • Indirect nexus with capital gains: The argument could be made that the family settlement, by leading to the disposal of the gifted property, indirectly resulted in generating the capital gains. Therefore, the loan taken to fulfill the settlement could be construed as having a remote connection to the capital gains transaction.
  • Equity and hardship: Disallowing the deduction might cause undue hardship to the assessee, especially if the family settlement involved fulfilling genuine obligations towards dependents. This hardship argument could appeal to notions of fairness and equity in tax assessment.
 

Arguments against Allowing the Deduction

However, strong arguments also exist against allowing the deduction:

  • Strict interpretation of Section 45: Section 45 explicitly enumerates the allowable deductions for capital gains. Since interest on a loan for family settlement does not fall within these enumerated categories, its deductibility becomes dubious under a strict interpretation of the provision.
  • Potential for abuse: Allowing such deductions could open the door for misuse and tax evasion. Individuals could borrow funds for unrelated purposes and claim them as expenses incurred for family settlements, leading to artificial reduction in capital gains tax liability.
  • No direct nexus with property acquisition or sale: The family settlement, while leading to the eventual sale of the property, is not directly connected to the asset acquisition or its disposal. The loan taken for the settlement cannot be directly attributed to the capital gains transaction, weakening the claim for deductibility.
 

Judicial Precedents

Previous court decisions have also weighed in on the issue of deductibility of expenses incurred for family settlements. While there is no definitive and settled legal position, some noteworthy precedents include:

  • CIT v. R. Nagaraja Rao: The Karnataka High Court ruled that expenses incurred for family settlements cannot be automatically disallowed under Section 57 unless established to be illegal or contrary to public policy. However, the court did not specifically address the deductibility of interest on loans taken for such purposes.
  • SKM Shree Shivkumar: The Chennai ITAT held that where family settlement involves transfer of shares without any actual monetary transfer, Section 56(2)(vi) (now repealed) on deemed income from other sources may not be applicable. This case, while dealing with income sources, does not directly address the issue of loan interest deduction.
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Published by

CA Divyajeet Singh Sabharwal
(Accounts and Finance Analyst)
Category Income Tax   Report

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