2025 (9) TMI 614 - AT - Income Tax

Compensation for cancellation of 14-acre agreement held agricultural, not capital asset under s.2(14); s.37(1) salary and s.57(iii) interest allowed

Sunil Khadawala Legal Heir of Manhar Khadawala Versus National Faceless Appeal Centre (NFAC) /ITO-12 (1) (2)

ITAT MUMBAI - AT held that compensation on cancellation of agreement for 14 acres (part of same 68 acres) is agricultural in character and not a 'capital ... Receipt as compensation on cancellation of an agreement/allotment pertaining to 14 acres of land - nature of land - Capital gain v/s income from other sources - As per AO land in question was not agricultural, but commercial in nature, as borne out by Collector’s permissions and Tehsildar’s report, thus to be taxed as “income from other sources.” - HELD THAT:- The doctrine of finality of facts and judicial discipline demands that what has been accepted as agricultural land in one year cannot be treated as non-agricultural in another, absent any material change in circumstances. The contention of the lower authorities that Collector’s permissions altered the character of the land stands diluted in light of the fact that the revenue records, statutory certificates, and prior adjudication all point to its agricultural character. Indeed, once the AO himself, in obedience to the Tribunal’s directions, has accepted the land as agricultural in earlier years, there remains little scope for disputation. We therefore hold that the compensation received on surrender of the 14 acres, forming part of the same 68 acres, partakes of the same character and must be regarded as arising from agricultural land. Consequently, such receipt lies outside the definition of “capital asset” under section 2(14) of the Act and is not taxable either as capital gains or as “income from other sources.” Disallowance of salary expenditure - The Assessing Officer, by mechanically linking this expenditure with the income from other sources, has conflated two distinct streams of income and their corresponding heads. The Income-tax Act is structured around the principle of compartmentalization of heads of income, and deductions permissible under one head cannot be disallowed by erroneously attributing them to another. Once it is accepted that the assessee carried on a business and salary expenditure was incurred wholly and exclusively for the purpose of that business, such expenditure becomes allowable under section 37(1) of the Act. No adverse material has been brought on record to suggest that the employees were non-existent or that the services were not rendered. In these circumstances, the disallowance made by the AO, and sustained by the CIT(A), rests on a flawed premise. Disallowance of interest expenses - AO allowed proportionate deduction only to the extent relatable to overdraft against FDs but disallowed the balance - By opting for overdraft at a marginal cost, the assessee effectively preserved the interest income stream while arranging liquidity. The interest paid, therefore, was inextricably linked to the earning of interest income; it was not an independent or extraneous outflow but a necessary incident of the chosen mode of financial management. The law under section 57(iii) requires that expenditure be “wholly and exclusively” incurred for the purpose of making or earning income from other sources. The present arrangement, being directly correlated with the assessee’s earning of interest income, satisfies that statutory test. We accordingly direct that the entire interest expenditure be allowed. ISSUES PRESENTED AND CONSIDERED 1. Whether compensation received on surrender/cancellation of allotment of land constitutes agricultural income, income from other sources, or capital receipt taxable as capital gains. 2. Whether a prior adjudication and revenue records holding the same contiguous land to be agricultural preclude treating the land as non-agricultural in a subsequent assessment (application of consistency, finality of facts, and estoppel against the Revenue). 3. Whether surrender/cancellation of an allotment letter without payment/consideration and where allottee did not acquire enforceable rights amounts to a 'transfer' under section 2(47) of the Income-tax Act, 1961. 4. Whether proportionate interest expenditure (claimed against income from other sources) satisfies the 'wholly and exclusively' test under section 57(iii) so as to be allowable, and if so, the quantum allowable. 5. Whether salary expenditure debited to the proprietorship business is allowable under section 37(1) where it relates to business and not to income from other sources. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Characterisation of compensation (agricultural income v. income from other sources v. capital gains) Legal framework: Definitions of 'agricultural income' (section 2(1A)), 'capital asset' (section 2(14)), and 'transfer' (section 2(47)) govern whether a receipt is exempted as agricultural income, taxable as capital gains, or falls under income from other sources. Precedent treatment: The Tribunal and Assessing Officer earlier examined identical/contiguous land in preceding assessment year; findings thereon are treated as material (see Issue 2 below). Lower authorities had classified the receipt as income from other sources; the AO alternatively invoked section 50C for valuation for capital gains computation. Interpretation and reasoning: The Tribunal examined the nature of the land through documentary and official evidence (Talathi, Gram Sewak, 7/12 extracts, DVO report) and prior adjudicatory findings. The Court held that where land is established to be agricultural in revenue records and accepted in an earlier adjudication, the compensation received on surrender of allotment forming part of the same contiguous holding partakes of agricultural character. Where land is agricultural, it falls outside the statutory definition of 'capital asset' and does not attract capital gains. Absent transfer within section 2(47), the receipt cannot be treated as capital gain; nor can it be taxed as income from other sources if it is agricultural and thus exempt. Ratio vs. Obiter: Ratio - compensation received on surrender of allotment relating to land already held and adjudicated as agricultural is not a capital receipt and does not become taxable as income from other sources when identical facts have been finally recorded; the character of the land determines tax treatment. Obiter - observations on motives of parties and self-serving arrangements are contextual but secondary to documentary findings. Conclusions: The compensation of Rs.75,95,230/- on surrender of 14 acres (part of same 68 acres) is agricultural in character and consequently lies outside the definition of 'capital asset' and is not taxable as capital gains or as income from other sources. Issue 2 - Preclusive effect of prior adjudication and revenue records; consistency and finality Legal framework: Principles of consistency, finality of factual findings, and estoppel against the Revenue when identical facts, same assessee, and same land have been adjudicated and supported by contemporaneous revenue records (7/12, Talathi/Gram Sewak certificates) and statutory DVO report. Precedent treatment: The Tribunal remitted earlier AY matter to AO for factual ascertainment; AO, pursuant to directions, accepted agricultural character. That acceptance was not challenged and hence attained finality. Interpretation and reasoning: The Tribunal reasoned that Revenue cannot take diametrically opposite stands on identical facts; once the AO, after detailed enquiry and official valuation, recorded agricultural character and such findings remained unchallenged, later forensic recharacterisation is impermissible absent material change. Collector's permissive acts cited by Revenue (permission for de-plotting) were held insufficient to negate the weight of revenue records and prior adjudication. The doctrine of judicial discipline and finality of facts mandates respect for such settled findings. Ratio vs. Obiter: Ratio - prior adjudication and unchallenged factual findings supported by revenue records bind subsequent assessments on same facts; Revenue cannot reopen characterisation absent new material. Conclusions: The prior findings that the land was agricultural are binding for the assessment year under consideration; revenue's contrary stance is unsustainable. Issue 3 - Whether surrender/cancellation without consideration amounts to 'transfer' under section 2(47) Legal framework: 'Transfer' includes relinquishment of rights; however, existence of enforceable rights and consideration are relevant to determine whether any transfer occurred that would give rise to capital gains. Precedent treatment: AO and CIT(A) treated compensation as revenue/income from other sources on ground that allotment conferred no real rights and was against related parties; Tribunal examined substance over form. Interpretation and reasoning: The Tribunal found that the allotment of 14 acres was without payment/consideration and, on facts, incapable of creating enforceable transferable rights; the surrounding transactions with related parties and cancellation seemed self-serving. In absence of pre-existing vested rights in the assessee qua the land, the surrender could not be treated as a 'transfer' under section 2(47) that would generate capital gain. Consequently, the receipt cannot be characterized as capital gain even if the land were a capital asset. Ratio vs. Obiter: Ratio - surrender of non-vested/allotted land where no consideration was paid and no enforceable rights existed does not constitute 'transfer' under section 2(47) for capital gains purposes. Conclusions: On the facts, the surrender did not amount to transfer under section 2(47); therefore capital gains treatment is inapplicable. Issue 4 - Allowability of interest expenditure under section 57(iii) Legal framework: Section 57(iii) permits deduction of expenditure 'wholly and exclusively' for making or earning income from other sources; causal and proximate connection between expenditure and income-earning is required. Precedent treatment: AO allowed proportionate deduction only for specific overdraft-linked interest; balance was disallowed. Assessee contended overdraft was availed to avoid premature encashment of FDs and thereby to preserve interest income. Interpretation and reasoning: The Tribunal accepted the assessee's commercial rationale: overdraft was a chosen mode to meet liquidity without disturbing income-bearing deposits; interest paid was integrally linked to earning interest income and thus incurred 'wholly and exclusively' for earning income from other sources. The statutory test under section 57(iii) was satisfied. The causal link and necessity of the outlay for preserving income stream justified full allowance. Ratio vs. Obiter: Ratio - interest incurred on overdraft availed to avoid encashment of income-bearing FDs is deductible under section 57(iii) if wholly and exclusively for earning income from other sources and factually established. Conclusions: Entire disallowed interest of Rs.1,63,373/- is allowable; disallowance deleted. Issue 5 - Allowability of salary expenditure under section 37(1) Legal framework: Section 37(1) allows business expenditure 'wholly and exclusively' for purpose of business/profession; head-wise compartmentalisation of income demands correct attribution of expenses. Precedent treatment: AO disallowed salary claimed in business accounts by treating it as not relatable to income from other sources; CIT(A) sustained. Interpretation and reasoning: The Tribunal held that salaries were debited to the proprietorship's business books and pertained to the restaurant business activity; there was no material to show non-existence of employees or non-rendering of services. The AO erred in conflating heads of income and attributing business expenses to income from other sources. The statutory compartmentalisation requires allowing bona fide business expenditure under section 37(1). Ratio vs. Obiter: Ratio - salary payments recorded and incurred for the proprietary business are allowable under section 37(1) when wholly and exclusively for business purpose; they cannot be disallowed by linkage to other heads absent contrary material. Conclusions: Salary expenditure of Rs.5,11,000/- is allowable in full and the addition is deleted.