Treaty-exempt capital gains cannot be reduced by carried forward losses; set-off under section 74 applies only to taxable gains.

Treaty-exempt long-term capital gains under Article 13(4) of the India-Mauritius tax treaty are outside the taxable income base, so they cannot be first reduced by brought forward capital losses under section 74 of the Income-tax Act. The adjustment mechanism applies only where there is taxable capital gain, making taxable gains a precondition for set-off of carried forward losses. On that reasoning, treaty-exempt grandfathered gains could not absorb prior losses, and the losses could be set off only against non-grandfathered taxable capital gains.

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Issues: Whether brought forward capital losses could be adjusted against capital gains exempt under Article 13(4) of the India-Mauritius tax treaty, and whether such exempt gains could be treated as income for the purposes of section 74 of the Income-tax Act, 1961.

Analysis: The exempt long-term capital gains were held to fall outside the taxable income base by virtue of the treaty. On that footing, there was no taxable capital gain against which brought forward capital losses could be set off under section 74, because the existence of taxable capital gains is a precondition for such adjustment. The reasoning followed the co-ordinate bench view that treaty-exempt gains cannot be first reduced by earlier losses, and only the non-grandfathered taxable gains could be adjusted against brought forward losses.

Conclusion: The brought forward capital losses could not be adjusted against the treaty-exempt grandfathered gains, and the adjustment was to operate only against the taxable capital gains. The issue was decided in favour of the assessee.

Final Conclusion: The assessment adjustment was unsustainable to the extent it applied brought forward losses against exempt treaty gains, and the assessee's appeal succeeded.

Ratio Decidendi: Treaty-exempt capital gains are not part of taxable income for the purpose of set-off provisions dealing with carried forward capital losses, and such losses can be adjusted only against taxable capital gains.

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