Friday, March 11, 2011

Waiver of a Loan - Capital or Revenue?

Recently, the Delhi High Court was called on to decide the interesting question of the tax treatment of loans and interest waived by financial institutions. In Logitronics v. CIT, the Court considered two cases which raised similar issues, and held that the treatment of the waived loan amount would depend on the purpose for which the loan was taken.

In the first case, the assessee had taken loans from the State Bank of India, which it had been unable to repay. As a result, proceedings before the Debt Recovery Tribunal had been commenced, which were settled. In return from the payment of a certain amount upfront, SBI waived the payment of the loan and the interest amount. The assessee offered the waived interest for tax, but did not offer the waived loan amount. The basis of this was because usually a loan is considered a capital asset, as a result of which the assessee argued that waiver of the asset would not be an income receipt in the hands of the assessee.

The Court drew a distinction between the nature of a loan and the nature of the benefit that accrues to the borrower on it being waived. Although the loan is a capital asset, its waiver need not necessarily result in a benefit of a capital nature. In a remarkably well-reasoned passage (¶ 13) , the Court lays down the position of law laid down by the Supreme Court in TV Sundaram Iyengar, in relation to whether nature of receipts in the hands of an assessee can change over the course of time. Departing from authority to the contrary in the United Kingdom (laid down in Tattersal), the Court there had held that although an amount may be capital at the time of receipt, if it was received in the course of the trade or business, it could change its nature over the course of time “when [it] becomes the assessee’s own money because of limitation or by any statutory or contractual right”. Subsequently, in Travencore Rubber and Tea Co v. CIT, the Supreme Court clarified that Tattersal could be departed only from only when there was a subsequent event which recharacterised the nature of the receipt.

The Court then cited past authority from the Delhi and the Madras High Courts for the proposition that the purpose for which a loan was taken would determine its tax treatment upon waiver. On facts here, the Assessing Officer had not made conclusive findings as to the purposes for which the loan had been borrowed. Hence, the Court held that the order by the ITAT to refer the matter back to the AO for determining the purpose for which the money was borrowed was valid in law.

In the second case, the assessee was an investment company engaged in shares and loan transactions. The Court there drew a distinction between the borrowings made for the purposes of the share business, and the financing business. On facts, the Tribunal had found that the loan was used for the former and not for the latter. As a result, though used to make its business run smoother, the loan amount itself was not a business receipt, and not taken ‘for the purpose’ of a business.

Much can be said for the Court’s decision that the tax treatment of a waived loan liability depends on the purpose for which it was taken. This is particularly true given that the nature of a receipt has been held to be amenable to change over the course of time. However, there are two aspects of the decision that are a cause for some concern and uncertainty-

First, not enough consideration has been given to distinguishing this case from Travencore Rubber and Tea Co v. CIT, which emphasised the importance of some event causing the nature of the receipts to change. On the facts of that case, a mere breakdown in a contractual relationship subsequent to which earnest moneys were forfeited, was not considered an event which would convert the capital receipts in the form of earnest moneys into revenue receipts. How the breakdown of a contractual receipt was different from the waiver of an unpaid loan on settlement is not sufficiently addressed.

Secondly, the test of what purpose the loan was taken for is one which may prove difficult to apply in practice. In the context of section 14A, several previous discussions have highlighted the problems that have arisen from the need to allocate specific borrowings to specific investments, which has led to highly arbitrary allocation provisions in the form of Rule 8D of the Income Tax Rules. Even if a purpose-oriented test is thought appropriate, the use of a presumption against a change in the nature of the receipt would have been a change for the better, and would not have been at odds with prior authority.

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