Disallowability of penalty

This query is : Resolved

Querist : Anonymous

Querist : Anonymous (Querist)

18 February 2015 FACTS:
The assessee purchased an open plot at GIDC VAPI (which is wholly owned by Government of Gujarat) costing Rs. 10,00,000 (ten lakh), with a condition that the assessee had to construct the factory building with with 3 years (from the date of purchase). If factory building is not constructed within stipulated period penalty will be levied depending upon the number of years delayed.

The assessee could not construct the factory premises within the stipulated period i.e. 3 years and had to pay Rs. 18,00,000 (eighteen lakh) as penalty to regularize.

Query:
Now the assess wants to sale the factory building along with the land. The question is whether the penalty of Rs 18,00,000 paid to G.I.D.C. (Gujarat Govt is 100% owner) will be allowed to add in cost of the land and indexation on it will be allowed or not? (or only the cost of Rs. 10 lakh will be allowed for indexation). Can assessee increase the cost of land with penalty amount of Rs. 18,00,000 for capital gains. Is it an offence under any law which is disallowable? As revenue / capital expenditure.

Querist : Anonymous

Querist : Anonymous (Querist)

19 February 2015 please answer if anybody knows

Aashok Kumar Sharma

Aashok Kumar Sharma (Expert)
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21 July 2024 In the scenario described, the key question revolves around whether the penalty of Rs. 18,00,000 paid to G.I.D.C. can be added to the cost of the land for the purpose of calculating capital gains tax when the factory building and land are sold.

Here's the analysis:

### Nature of Penalty Expense:

1. **Revenue vs. Capital Expenditure**: The treatment of the penalty amount depends on whether it is considered a revenue expense or a capital expenditure.
- **Revenue Expense**: If the penalty is considered a revenue expense, it would typically be deductible in the year it was paid for income tax purposes. It wouldn't form part of the cost of the asset (land) and hence wouldn't affect the capital gains calculation.
- **Capital Expenditure**: If the penalty is considered a capital expenditure, it could potentially be added to the cost of the land. This would increase the cost base of the land, which in turn affects the calculation of capital gains when the land is eventually sold.

2. **Purpose and Nature of the Penalty**:
- The penalty of Rs. 18,00,000 was paid to regularize the delay in constructing the factory building within the stipulated period.
- Penalties of this nature are often viewed as costs incurred to bring an asset into existence or to facilitate its use, which can be considered capital in nature.

### Tax Treatment and Indexation:

- **Indexation Benefit**: In India, for computing capital gains on the sale of a capital asset (such as land), the cost of acquisition can be adjusted using the cost inflation index (CII) to account for inflationary effects over the holding period.
- **Impact on Indexation**: If the penalty amount of Rs. 18,00,000 is treated as part of the cost of the land (assuming it's deemed a capital expenditure), then indexation benefits could potentially be available on this amount. This means the cost base for calculating capital gains would be higher, leading to potentially lower capital gains tax liability.

### Conclusion:

- **Allowability**: Generally, penalties paid for non-compliance or delays related to capital assets are treated as capital expenditures. Therefore, if the penalty of Rs. 18,00,000 is accepted as a capital expenditure by the tax authorities, it can be added to the cost of the land.
- **Indexation**: If added to the cost of the land, the penalty amount may qualify for indexation benefits, thereby increasing the cost base for calculating capital gains tax.
- **Compliance**: Ensure that the treatment of the penalty as a capital expenditure is supported by proper documentation and is in compliance with the Income Tax Act provisions and judicial precedents.

It's advisable for the assessee to consult with a qualified tax advisor or chartered accountant to assess the specific facts and circumstances comprehensively. They can provide tailored advice considering all relevant tax laws, rules, and precedents applicable to the particular case.

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