CA Pavan Jain S, ACA., grad CS.
Taxability of a receipt is governed by section 2(24) of the Income Tax Act (hereinafter referred to as “Act”) which define the term “Income”. In ordinary parlance, the term income connotes a receipt arising regularly or with some sort of expected regularity. It is well accepted principle that a capital receipt shall not come under the net of Income tax unless otherwise specifically provided in the Act. Section 45 of the Income Tax Act is a enabling provision which enables taxation of capital gains. If a capital receipt fails to satisfy the conditions of section 45 r.w.48 [held in re B C Srinivas shetty] of the Act, the same cannot be subject to taxation.
I shall try to focus the provisions of section 45(1A) which was enacted to nullify the judgement of Supreme Court in Re Vania Silk Mills Private Limited . As per the provisions of section 45, a capital receipt shall be subject to taxation only if the same has arisen pursuant of “transfer” of a capital asset. The term ‘Transfer’ has been defined in a inclusive manner in section 2(47) which, inter alia, includes extinguishment of rights in an asset. In the case mentioned supra, the Supreme Court held that capital gains arising on destruction of asset shall not be subject to taxation since the destruction of asset does not amount to transfer.
To nullify the aforesaid judgement, sub section (1A) of section 45 was introduced which provided for the taxation of capital gains arising pursuant to receipt of insurance compensation subject to satisfaction of following two conditions:
- Compensation is received because of ‘damage’ to or ‘destruction’ of any capital asset.
- the damage or destruction is a result of four categories of circumstances:
- flood, typhoon, hurricane cyclone, earthquake or any other convulsion of nature; or
- riot or civil disturbance; or
- accidental fire explosion; or
- action by an enemy or action taken in combating an enemy.
The insurance compensation received shall be treated as a capital receipt and, consequently, shall not be subject to taxation if aforesaid conditions are not satisfied, e.g., theft of a machinery or destruction of machinery on account of road accident. In case of theft of machinery, there is no damage or destruction of property and, therefore, the first condition mentioned supra itself fails. In case of road accident, though the asset is destroyed, the reason for destruction being other than those mentioned in condition two supra. The compensation received will have to be dealt with as per the judgement in re vania silk mill case.
The objective of this article is to demonstrate the impact of following cases in determining WDV of block of assets.
Case 1: Damage to an Asset – Insurance compensation received:
In case of any expenditure incurred to restore the asset to its working condition, the normally accepted principle is that the expenditure is revenue in nature since it does not increase the performance of the asset beyond the previously assessed standard of performance. If any insurance money is received as a re imbursement for such expenditure incurred, the normal accounting practice followed by many is to reduce the expenditure incurred by the amount so received and to debit/credit the profit/loss account with the balance.
What should have been the treatment for the purposes of Income Tax Act?
Damage to an asset may tantamount to extinguishment of rights [in part] in the asset thereby resulting in transfer as contemplated in section 45(1A). But, how shall the cost of the asset transferred be arrived at u/s 48 especially when the asset is restored to working condition after carrying out necessary current repairs. It is judicially accepted [e.g., in re B C Srinivas Shetty case (SC)] that provisions of section 45 has to be read with section 48 and if the latter fails for any reason, the charging section itself fails. The Assessing officer is not allowed to make conjectures or surmises for the purposes of arriving at the cost of the asset transferred. The taxability of such receipt is a ‘?’ requiring solution.
As far as depreciable asset is concerned, the taxability of the same has to be arrived based on the provisions of section 50 r. w. section 43(6). If the insurance compensation so received exceeds the WDV of the block of the said asset, section 50 shall come into motion resulting in short term capital gain. If the compensation is less than the WDV of the block, it is undisputed that the compensation so received is a capital receipt not subject to taxation.
The next question that arises is whether the said insurance money so received can be reduced from the block of assets. The answer is ‘No’. Section 43(6) enables deletion of value from the block only if the asset, whether in whole or in part, is ‘sold or discarded or demolished or destroyed’. It is not applicable where the assets are merely damaged and by repairing the damage is restored to working condition. Thus, the insurance money is not taken in consideration while computing the WDV of block irrespective of fact whether any expenditure is incurred for restoration or the expenditure so incurred exceeds the insurance money.
Now what shall happen to the expenditure incurred? As discussed supra, the said expenditure is revenue in nature. In my opinion, the assessee can claim the same as deduction although the same would amount availment of double benefit by the assessee.
Case 2: Theft of Property – Compensation received:
In case of theft of property, there is no question of destruction of asset involved as it is known that asset is in existence though not in the possession of the assessee. Hence, section 45(1A) fails. If the judgement of vania silk mills is applied, the insurance compensation so received shall be treated as capital receipt not subject to taxation.
In case of depreciable assets, no deletion is required to be made from the block of assets since theft do not fit under any of the situation contemplated in section 43(6), i.e., neither the asset is sold nor discarded nor demolished nor destroyed. The assessee is allowed to claim depreciation on the block provided the block do not cease to exist on happening of theft – else the provision of section 50 shall come into operation.
A question may, however, loiter in mind that doesn’t theft results in extinguishment of rights of the assessee in the said asset? If yes, the provision of section 45 would apply. Next question that arises is that if the compensation is not received in the same previous year in which theft has taken place, how will the computation of capital gains for the purposes of section 45 be made in the assessment for said previous year?
Disregarding these anomalies, the assessee can move forward to claim the benefit of judgement made in vania silks mill case because the provisions of section 45(1A) failed to nullify the said judgement in its entirety.
Case 3: Destruction of a asset in road accident:
In case of destruction of asset in a road accident, the provisions of section 45(1A) shall not apply since the destruction took place in circumstances other than those mentioned in condition 2 mentioned supra. Applying the rationale of the judgement of vania silks mill case, the aforesaid receipt shall be treated as capital receipt not subject to taxation.
If the asset so destroyed is a depreciable asset, then the insurance money so received shall be reduced from the WDV of the block of the assets since the conditions mentioned in the provisions of section 43(6) are satisfied. However, if the insurance compensation exceeds the WDV of the block, then the excess shall not be subject to taxation. Similarly, if the block ceases to exist pursuant to such destruction, the excess compensation shall not be subject to taxation u/s 50 r.w. section 45(1A) for reasons mentioned supra. In this case also, the anomalies enumerated above shall arise.
The aforesaid interpretation/treatment/opinion is arrived at based on my knowledge and understanding of law and judicial pronouncements. I welcome the comments of readers on the aforesaid issue.