Treaty-based capital gains exemption permits carry-forward losses without forced set-off; draft assessment applies despite nil returned income.

Where the India-Mauritius DTAA gave Mauritius exclusive taxing rights over the relevant capital gains, India could not insist that brought-forward short-term and long-term capital losses be set off against gains exempt in India when the assessee validly chose the more beneficial treaty regime under section 90(2). Losses computed in earlier years retained their character for carry forward under section 74 and were allowable without forced set-off against those exempt gains. The draft assessment mechanism under section 144C was also held applicable because the adjustment altered the quantum of capital gains and losses, which constituted a prejudicial variation even though returned total income remained nil; the revenue's procedural objection failed.

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Issues: (i) Whether brought-forward short-term and long-term capital losses could be carried forward without setting off against capital gains exempt in India under Article 13(4) of the India-Mauritius DTAA. (ii) Whether the draft assessment procedure under section 144C was valid where the adjustment altered carried-forward losses though the returned total income remained nil.

Issue (i): Whether brought-forward short-term and long-term capital losses could be carried forward without setting off against capital gains exempt in India under Article 13(4) of the India-Mauritius DTAA.

Analysis: The treaty provision allocating exclusive taxing rights over such capital gains to Mauritius meant that the gains were not taxable in India for the relevant year. Once the assessee elected the more beneficial treaty regime under section 90(2), computation under the Act could not be forced merely to set off past losses against income that India had no right to tax. Losses incurred and computed in earlier years under the Act, when treaty benefits were not claimed, retained their character for carry forward under section 74 and could not be denied set-off against exempt gains in the later treaty year.

Conclusion: The carried-forward capital losses were allowable to be carried forward without set-off against the exempt capital gains, in favour of the assessee.

Issue (ii): Whether the draft assessment procedure under section 144C was valid where the adjustment altered carried-forward losses though the returned total income remained nil.

Analysis: The adjustment made by the Assessing Officer changed the quantum of capital gains and losses returned by the assessee and therefore constituted a variation prejudicial to the interest of the assessee within the scheme of section 144C. The absence of a change in returned total income did not by itself exclude the applicability of the draft assessment mechanism. The challenge to the draft assessment order therefore did not survive independently once the merits were decided, but the procedural objection of the revenue was not accepted.

Conclusion: The draft assessment procedure was held to be applicable; the revenue's objection to the CIT(A)'s view was rejected, though the issue became academic after the merits were decided.

Final Conclusion: The assessee succeeded on the substantive treaty and loss-carry forward issue, and the revenue's appeal did not alter the ultimate relief granted to the assessee.

Ratio Decidendi: Where a tax treaty grants exclusive taxing rights to the residence state over a class of capital gains, India cannot compel set-off of brought-forward domestic losses against those exempt gains in the source state when the assessee opts for the treaty regime under section 90(2) of the Income-tax Act, 1961.

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