Thursday, September 24, 2009

Capital Gains and the Cost of Acquisition

A recent post examined the decision of the Bombay High Court in Techno Shares which adopted a new stance on the law of depreciation. Soon after this decision, the Mumbai Bench of the Income Tax Appellate Tribunal seems to have marked another point of departure in relation to the taxation of capital assets, this time on the issue of capital gains tax.

The issue before the Tribunal in Bomi S. Billimoria v. ACIT was the taxation of cashless ESOPs offered by a non-resident company (Johnson & Johnson, USA) to employees resident in India. The option was to purchase the shares at their fair market value. However, the Reserve Bank of India approved the scheme on the condition that there should not be any payment, in India or abroad, for acquiring the shares. The assessee exercised the options, and sold the shares in the U.S. The Revenue sought to tax the gains made by virtue of this sale. The question before the Tribunal was two-fold:

Whether the said gain is a capital gain; and if so, whether it can be taxed as such.

The assessee contended that it was a capital gain, but could not be taxed. This argument was based on a 1981 decision of the Supreme Court in B.C. Srinivasa Setty, [128 ITR 294] which was cited as authority for the proposition that no capital gains tax can be charged if there is no cost of acquisition for the asset in question. The assessee argued that since there had been no cost of acquisition (due to the Reserve Bank of India directive), the gain could not be taxed. The Revenue contended that the said gain was not a capital gain, and was taxable even if it was considered to be a capital gain.

The ITAT decided the issue in favour of the assessee, relying on B.C. Srinivasa Setty. It held that when there was no cost of acquisition and the gain could not be taxed. It went on to say that even if the market price was to be considered the cost of acquisition, the options were sold on the very same day at the same price, and hence the gain would have to be considered nil. Thus, in either case, no tax was leviable on the assessee.

This decision throws up some interesting issues, and potentially problematic scenarios regarding capital gains tax. Conceptually, there is a distinction between there being no cost of acquisition for a particular type of asset, and the assessee not paying the cost of acquisition for a said asset. For instance, there cannot be a cost of acquisition for an asset like goodwill (though there is now a deemed cost of nil under the Act). However, this is different from an asset like the ESOPs in question here, for which there is a cost of acquisition (the market price), which does not have to be paid by the assessee, or is paid by a third party. While Srinivasa Setty is authority for cases similar to the sale of goodwill, it is the extension of the decision to the second type of capital gains that is suspect. A close reading of the decision indicates that the Supreme Court categorically restricted its decision to cases where the cost of acquisition for a type of asset was incapable of being computed. In the words of the Court, capital gains tax can only be charged when the asset is such that, in its acquisition, “it is possible to envisage a cost. The intent goes to the nature and character of the asset, that it is an asset which possesses the inherent quality of being available on the expenditure of money to a person seeking to acquire it. It is immaterial that although the asset belongs to such a class it may, on the facts of a certain case, be acquired without the payment of money”. The ratio of the case applied only to assets for which “no cost element can be identified or envisaged”.

This clearly shows that Srinivasa Setty did not hold that capital gains tax cannot be charged whenever there is no cost of acquisition; it only held that capital gains tax cannot be charged when the cost of acquisition is incapable of being computed. This is also implicitly affirmed by a recent decision of the Supreme Court in PNB Finance v. CIT [307 ITR 75], where the Court again held that no capital gains was chargeable on the facts of the case because “it was not possible to compute capital gains”. On the facts of Billimoria, there was no impossibility of computing the cost of acquisition. In fact, the cost of acquisition was clearly stated to be the market price, which was not paid by the assessee because of the RBI guideline. In such circumstances, the decision of the tribunal may be at odds with the decisions of the Supreme Court on this issue, and may require to be reconsidered.


National Law School of India Review said...

Is the cost of goodwill not capable of computation under principles of accountancy? Can't accountants calculate the value of goodwill? If so, how can Srinivasa Shetty say that cost of acquiring goodwill is not capable of calculation?

Shantanu Naravane said...

You are right in that the value of goodwill can be calculated, and once goodwill is created, the cost of acquiring it will be this value.

However, for the person who first generates the goodwill, there is no cost of 'acquisition', neither is there a specific date of acquisition. The decision in Srinivasa Setty holds that when the goodwill is sold by this first owner, he can't be charged capital gains tax, since the cost of acquisition cannot be computed.

Hemant Dujari said...

In case when the second owner, resell, how would the tax implications arise? Should he be taxed on the cost of acquisition of previous Goodwill ??

Anonymous said...

@ Hemant - yes I think that would be the correct implication.

Shantanu Naravane said...

An interesting sequel to the discussion is available at-