The Law On Taxability Of Loan Waivers Explained

Advocate Sashank Dundu has systematically analyzed all the recent judgements of the Supreme Court and High Courts on the controversial question as to whether benefits arising from waiver of loans constitute a capital or revenue receipt. He has also provided a clear-cut explanation of the interplay between sections 41(1), 28(iv) and 56(2)(x) on the taxability of such benefits

Waiver of Loan – Capital or Revenue – Benefit or Perquisite – Whether the law is settled?

1. Introduction:

1.1 Recently the Supreme Court in the case of Mahindra and Mahindra Ltd. [2018] 93 taxmann.com 32 (SC), laid down the law that waiver of loan shall not be taxable either u/s 28(iv) or s.41(1). The law has been laid down in respect of two sections under the Income-tax Act as follows :

• As per the requirement of s.28(iv), the value of any benefit or perquisite, whether convertible into money or not, arising from business or the exercise of a profession. It clearly mentions that such benefit can be in any form, which can also be convertible into money. However, it should not be money. The Apex court has now clarified that ‘waiver of loan’ should be treated as ‘receipt of money’ and hence such receipt of money would fall outside the purview of s.28(iv) and accordingly cannot be taxable.

• As per the requirement of s.41(1), where an allowance or deduction has been made in the assessment for any year in respect of loss, expenditure or trading liability incurred by the assesseeand subsequently during any previous year, any benefit, whether in terms of money or not, in lieu of such loss, expenditure or trading liability shall be chargeable to income-tax as the income of that previous year. The Apex Court has held that ‘waiver of loan’ does not amount to cessation of trading liability and also since deduction of interest u/s 36(1)(iii) had not been claimed earlier by the assessee, the same would not fall within the purview of s.41(1).

To understand the law laid down, one may have to know the facts of this case and then understand the reason behind laying down such a law and in what context has it been made.

1.2 Facts of Mahindra & Mahindra Case:

An agreement was entered into by the assessee with the seller company to purchase from such company dies, welding equipments and die models to the assessee.However, for the procurement of the said toolings and other equipments, a loan was taken from the seller at the rate of 6% interest repayable after 10 years in instalments. Later on, the seller company was taken over by another company, who had then waived the loan taken by the assessee. The Apex Court held that neither of the sections i.e. 41(1) nor 28(iv) would be applicable due to the following reasons:

• As per the requirement of s.28(iv), the benefit needs to be in any shape other than that of money. The Apex Court held the waiver of loan to be a benefit which is received in money and hence was held to be out of the purview of s.28(iv).

• As per the requirement of s.41(1), waiving of loan does not amount to cessation of trading liability and also since no deduction of interest u/s 36(1)(iii) had been claimed earlier by the assessee, it would not be covered by s.41(1).

2. To analyse the taxability of waiver of loan, discussing the same in two parts would make it comprehendible.

It can be divided into two parts :

(i) Taxability u/s 28(iv) ;

(ii) Taxability u/s 41(1).

2.1 Taxability u/s 28(iv) :

With respect to taxability u/s 28(iv), the courts have been clear about the fact that the benefit arising to the assessee should be anything but cash.

In the case of CIT v. Alchemic (P) Ltd [1981] 130 ITR 168 (Guj.) (HC), it held that taxability u/s 28(iv) would arise only if the benefit or perquisite is not in cash or money.

In the case of Ravinder Singh v. CIT [1994] 205 ITR 353 (Del.) (HC), it held that, “s.28(iv) can be invoked only where the benefit or perquisite is other than cash. If what was received either by way of benefit or perquisite was money, there would be no question of considering the value of such monetary benefit or perquisite under clause (iv) of s.28”.

The Apex court, in the present case, has held that “‘waiver of loan’ by the creditor results in the debtor having extra cash in his hand. It is receipt in the hands of the debtor/assessee.”

And once, ‘waiver of loan’ is treated as ‘cash receipt’ , it would automatically fall outside the purview of s.28(iv).

2.2 Taxability u/s 41(1) :

The Supreme Court in CCIT v. Kesaria Tea Co. [2002] 254 ITR 434 (SC) held that the following points are to be kept in view:

1) In the course of assessment for an earlier year, allowance or deduction has been made in respect of trading liability incurred by the assessee;

2) Subsequently, a benefit is obtained in respect of such trading liability by way of remission or cessation thereof during the year in which such event occurred;

3) In that situation the value of benefit accruing to the assessee is deemed to be the profit and gains of business which otherwise would not be his income; and

4) Such value of benefit is made chargeable to income-tax as the income of the previous year wherein such benefit was obtained.

The Karnataka High Court in the case of CIT v. Compaq Electric Ltd [2012] 249 CTR 214 (Karn.) (HC), held that for the application of s. 41(1), the condition precedent is that there should be an allowance or deduction in the assessment for any year in respect of loss, expenditure or trading liability incurred by the assessee. Then, subsequently, during any previous year, if the creditor remits or waives any such liability, then the assessee is liable to pay tax u/s 41.

The Apex court in the present case has held that since the loan had been obtained for the purpose of purchasing machinery i.e. capital assets, and such loan taken, was an independent transaction, such liability was not a trading liability and hence, would not come under the purview of s.41(1).

3. A question could arise as to what is a ‘trading liability’?

Trading Liability in general terms can be understood as an obligation of a person (Debtor) to pay another person (Creditor) for goods purchased or value received from that other person in the course of business. A genuine Trading Liability incurred in the course of business or Profession is a permissible expenditure under the Income-tax Act.

The expression "trading liability" has not been defined in the Income tax Act but a liability created for purchase of stock-in-trade on credit or a current trading transaction or a liability, which is awaiting adjustment by way of supply of goods or services, or a trade debt is certainly a trading liability which is quite different from a mere loan on capital account. This difference is generally overlooked by the A.Os. As per the accounting parlance and legal parlance a "trading liability" would mean the following –

a) Liability created for purchase of stock-in-trade on credit or a trade debt;

b) A liability, which is awaiting adjustment by way of supply of goods or services;

c) Borrowings for working capital

d) Sales tax collected in the course of business;

e) Receipt of compensation for loss of stock -in- trade;

f) Recoupment of debt / loss allowed as bad debts u/s 41(4) / business loss;

g) Remission / cessation of liability in respect of a trading transaction;

h) Remission in respect of unclaimed wages or bonus claimed in the return of income;

i) Unclaimed insurance premium;

j) Unclaimed excise duty liability, sales tax or purchase tax liability;

k) Refund of excise duty and sales tax;

l) Refund of electricity charges as grant / concession in power rates

m) Sums obtained as rebates;

n) Write back of excess provision;

o) Amounts earlier allowed as bad debts and later realised;

p) Unclaimed deposits received from customers in the course of trading operations credited to profit and loss account;

q) Monies kept for disbursement to meet business expenses;

r) Amounts received in the course of carrying on a trading;

4. Views of Courts treating waiver of loan as non-taxable:

The House of Lords and the High Court have taken views as seen below where they have treated the waiver of loan and trading liability as non-taxable:

4.1 In the case of British Mexican Petroleum Co. [1932] 16 Tax Case 570, the appellant company entered into a contract with an oil producing company for the purchase of petroleum for a minimum period of twenty years. The appellant company came into difficulties and the accounts of the company’s business were made up for the year ended the 30th of June, 1921, and for eighteen months ended the 31st of December, 1922. On the 30th of June, 1921, the amount which the appellant company owed to the oil producing company was £1,073,281 and on the 31st of December, 1922, £1,270,232. The appellant company paid to the oil producing company £ 325,000 and was released by the oil producing company from its liability to pay the balance, viz., £945,232. The amount so released was carried direct to the appellant company’s balance sheet and was shown as a separate item under the head "Reserve" on the 31st of December, 1922.

The contention of the Crown was that the amount released should be brought into account in computing the appellant company’s profits for the purposes of income-tax either in the account for eighteen months up to the 31st of December, 1922, or alternatively for the year ending 30th of June, 1921, that account being reopened for that purpose. Both those contentions were rejected by the Court.

The House of Lords took the view that the account having been once settled as on the 30th of June, 1921, and the liability of the appellant company fixed, that could not be re-opened merely because a creditor had remitted a part of the debt. With regard to the other contention that the remission should be looked upon as a trading receipt Lord Thankerton at p. 592 stated as follows:—

"The appellant’s alternative contention which was not seriously pressed by the Attorney-General, is equally unsound, in my opinion. I am unable to see how a release from a liability, which liability has been finally dealt with in the preceding account, can form a trading receipt in the account for the year in which it is granted."

Lord Macmillan at p. 593 is equally emphatic as to what he thought about it. This is what the learned Law Lord says :—

"I say so for the short and simple reason that the appellant company did not, in those eighteen months, either receive payment of that sum or acquire any right to receive payment of it. I cannot see how the extent to which a debt is forgiven can become a credit item in the trading account for the period within which the concession is made."

4.2 In the case of Mohsin Rehman Penkar v. CIT [1948] 16 ITR 183 (Bom.) (HC), it was held that “once the Income-tax department accepts the mercantile system of accounts keeping and taxes an assessee on the accrual and not on the payment basis the department is not concerned as to how the liability incurred by the assessee is in fact discharged. He may discharge that liability by actual payment or he may discharge it by getting a remission from his creditor. But that is a question entirely for the debtor to determine. It is impossible to see how a mere remission which leads to the discharge of the liability of the debtor can ever become income for the purposes of taxation.”

4.3 In the case of CIT v. Dholgiri Industries (P) Ltd. [2014] 266 CTR 111 (MP.) (HC), it was held that “where principal amount of loan being never been claimed by assessee as its expenditure, its waiver would not amount to income of assessee.”

5. Cases where cessation of trading liability was held to be taxable:

5.1 In the case of CIT v. T.V. Sundaiam Iyengar & Sons Ltd. [1996] 222 ITR 344 (SC), the court observed that the moneys had arisen out of ordinary trading transactions. The assessee had received certain deposits from customers in the course of carrying on his business, which were originally treated as capital receipts. Since these credit balances standing in favour of assessee’s customers, were not claimed by the customers, the assessee transferred such amounts to its profit and loss account. The assessee did not include such amounts in its total income.

The Court held that although the amounts received originally were not of income nature, the amounts remained with the assessee for a long period unclaimed by the trade parties. By lapse of time, the claim of the deposit became time barred and the amount attained a totally different quality. It became a definite trade surplus. Although it was treated as deposit and was of capital nature at the point of time it was received, by influx of time the money has become the assessee’s own money. What remains after adjustment of the deposits has not been claimed by the customers. The claims of the customers have become barred by limitation.

Here we see that the concept of ‘money changing character’ has been introduced wherein it is held such waiver to be taxable in the year when such waiver takes place and treats it to be the income of the assessee in such year.

5.2 In the case of Solid Containers Ltd. v. DCIT [2009] 308 ITR 417 (Bom.) (HC) in which, after considering the Bombay High Court decision of Mahindra and Mahindra Ltd. v. CIT[2003] 261 ITR 501 (Bom.)(HC), the Hon’ble High Court held that in the case of Mahindra & Mahindra, purchase consideration related to capital assets. The toolings were in the nature of dies and the assessee was a manufacturer of heavy vehicles. The import was that of plant and machinery and the waiver could not constitute business. The facts in the case of Solid Containers are entirely different inasmuch as it was a loan taken for trading activity and ultimately upon waiver, the amount was retained in business by the assessee, due to which the amount of deposit liability which was waived off, were treated as income in the hands of the Assessee.

5.3 The Bombay High Court in the case of Protex Engineer Co. (P.) Ltd. v. CIT [1995] 211 ITR 919 (Bom.) (HC) held that cessation of a trading liability is not receipt of money, but receipt in kind as required u/s 28(iv) and hence taxable under the same. In the facts of the case, there were trade advances i.e. amount received in advance for purchase of goods, however, such advances were never claimed by the customers. The Court held such receipt of money as trade receipts in the course of business. The second point to be decided was whether such receipts, which were not received during the year under consideration, but were received at an earlier date, could not be treated as receipt of cash in the year under consideration. The court held that such benefit was a receipt of benefit in kind and hence covered u/s 28(iv).

6. Law laid down by Mahindra & Mahindra Case:

6.1 Where the High Courts have clearly mentioned that waiver of loan cannot constitute income in the hands of the assessee, the Apex court in the case of Sunderam Iyengar (Supra) has clarified that in case of cessation of trading liability, it should be construed to be income in the hands of the assessee.

6.2 Where the Bombay high court in the case of Mahindra and Mahindra(supra) (HC) mentions that waiver of loan, where loan is taken for a capital asset, would not constitute to be a capital receipt at the time of waiver of such loan and hence not taxable in the hands of the assessee. The Bombay high court in the case of Solid Containers(Supra) states that the loan was taken for trading activity and ultimately, upon waiver the amount was retained in business by the assessee and hence the case of Mahindra & Mahindra (HC) (Supra) would not be applicable and the waiver of trading liability in question would be taxable in the hands of the assessee.

6.3 Now the recent Supreme Court Judgment of Mahindra and Mahindra Ltd [2018] 93 taxmann.com 32 (SC)., the hon’ble court has laid down the law that the waiver of loan is a case of cash receipt. It also explains that s.41(1) would not be applicable since firstly there should be an allowance or deduction claimed by the assessee in any assessment year in respect of loss, expenditure or trading liability incurred by the assessee. Then, subsequently, during any previous year, if the creditor remits or waives any such liability, then the assessee is liable to pay tax u/s 41 of the IT Act. The objective behind this Section is simple, i.e. it is made to ensure that the assessee does not get away with a double benefit once by way of deduction and another by not being taxed on the benefit received by him in the later year with reference to deduction allowed earlier in case of remission of such liability.

7. Solid Containers v/s Mahindra & Mahindra:

If we juxtapose the facts of Solid Containers and Mahindra and Mahindra, we may be able to distinguish each one of them and find out the law laid down by the court.

If we have a look at solid containers, the facts of the case are as under:

In the case of Solid containers the Court observed that although the amounts received originally were not of income nature, the amounts remained with the assessee for a long period unclaimed by the trade parties. By lapse of time, the claim of the deposit became time- barred and the amount attained a totally different quality. It became a definite trade surplus.

7.1 The High Court in the case of Solid Containers moves further to distinguish the High Court Decision of Mahindra and Mahindra where it states that the facts of both the cases are different because of the following factors :

• There was continuous payment of interest on the principal amount

• The purchase consideration related to capital assets.

• The toolings were in the nature of dies and the Assessee was a manufacturer of heavy vehicles.

• The import was that of plant and machinery and the waiver could not constitute business.

• In the present case, facts are entirely different in as much as it was a loan taken for trading activity and ultimately, upon waiver the amount was retained in business by the Assessee.

7.2 As it can be seen that the distinguishment on facts happens on the footing that borrowing of money was on the following basis:

a) Loan was obtained for the purpose of a non-trading activity i.e. purchase of a Capital asset and hence when the loan ceased, there was no cessation of trading liability in the case of Mahindra & Mahindra.

b) Since there was continuous interest payment, the character of loan did not change and was an independent transaction separate from its business activity in the case of Mahindra & Mahindra.

c) The interest amount in the case of Solid Containers, was credited to P&L a/c since the same was allowed as expense in the earlier years as mentioned in the CIT(A) order (CIT(A)’s order in appeal no. CIT(A)-I/SR-I/30891-92) whereas in the case of Mahindra & Mahindra, interest amount was not claimed as deduction by debiting the same to P&L a/c.

A reference may also be made to the case of CIT v. Sun Engineering Works (1992) 198 ITR 297 (SC) where the Supreme Court held:

“It is neither desirable nor permissible to pick out a word or a sentence from the judgment of this court, divorced from the context of the question under consideration and treat it to be the complete ‘law’ declared by this court. The Judgment must be read as a whole and the observations from the judgment have to be considered in the light of the questions before the court. A decision of this court takes colour from the questions involved in the case in which it is rendered and, while applying the decision to a later case, the Courts must carefully try to ascertain the true principle laid down by the decision of this court and not to pick out words or sentences from the judgment, divorced from the context of the questions under consideration by this court, to support their reasoning.”

Hence, the entire judgment and the facts of each case would have to be read and understood to come to a conclusion whether any of them would apply to the facts of the case of the Assessee.

Hence, we can safely come to the conclusion that the facts of both the cases are different and do not affect the legal position of the other.

8) Interplay between s.41(1), s.28(iv) and s.56(2)(x):

From the above observations, a few questions may arise which are as follows:

Q.1) Whether waiver of loan should be treated as receiving of cash in the hands of the assessee in the year when the loan gets waived?

Q.2) If the answer to Q1 is ‘yes’ i.e. if the waiver of loan is supposed to be treated a receipt of cash in the year when the loan gets waived, would the provisions of s.56(2)(x) be applicable?

Q.3) Whether in a case where a deduction would have been claimed of the interest amount u/s 36(1)(iii), would the entire amount of principal also get taxed?

Ans. 1) In para no. 13 of the Judgment of Mahindra and Mahindra, the words “having received as cash receipt due to the waiver of loan” have been used which suggest that the waiver of loan in the present case, means receiving cash.

Ans. 2) s.56(2)(x) of the Act states as under :

“where any person receives, in any previous year, from any person or persons on or after the 1st day of April, 2017,—

(a) any sum of money, without consideration, the aggregate value of which exceeds fifty thousand rupees, the whole of the aggregate value of such sum; ………."

Under s.56(2)(x), the provision mandates the receipt of money in the previous year. Now, because of the law laid down by the Apex court, the understanding of ‘receipt of money’ would incorporate in it, even waiver of loan. The event of loan being waived off, would now be treated as receiving money.

But, s.56(2)(x) clearly states that such receipt of money should be without any consideration. The next question which would arise due to this would be, whether the interest amount can be treated as consideration for the loan taken and subsequently waived off?

Since s.56(2)(x) does not mention ‘adequate consideration’ but clearly states ‘no consideration al all’, it could be safe to presume that the interest payment could serve as consideration in return of the waiver of loan.

Can delayed payment of the principal amount leading to breach of contract which inturn amounts to the fulfilment of the conditions of the contract wherein the waiver of loan being consequential would be mentioned, can be treated as consideration for the benefit being received by one? Such a question may be a cause of dispute in the future to be resolved by the Courts.

Ans. 3) Since, there is a clear mention that one of the main reasons behind the waiver of loan not coming under the purview of s.41(1) was since no deduction was claimed of the interest amount u/s 36(1)(iii), it can be said that, in case a deduction is claimed, then the principal amount would get taxed.

An immediate question which should now come to the minds of the professionals is what would be the quantum of such principal would get taxed? Would it be to the extent of the proportion of interest claimed to that of the principal amount or whether it would be the entire principal amount or whether only the amount claimed as deduction i.e. the interest amount would be taxable?

If we juxtapose the judgments of Solid Containers and Mahindra & Mahindra, we find that Solid Containers has tried to infuse the concept of ‘trading and non-trading purpose’. It mentions that, once it is established that the loan was taken in the course of business or for utilising it for trading activities, the nature of the loan changes from a capital receipt to a revenue receipt.

If we have a glance at s.36(1)(iii), it states that “the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession:”, such an amount would be allowed deduction under this section.

Hence, from the above, an inference can be drawn that, once deduction is claimed, it could be deemed to be used for the purposes of business, due to which the loan amount could be treated as borrowed for trading activity, which was upheld by the Court in the case of Solid Containers which states that in such an event(as mentioned above), such waiver of loan becomes taxable.

However, there is a specific exclusion of capital borrowed for acquisition of assets in s.36(1)(iii).

From the above discussion, we may be able to conclude that any loan, taken for the purpose of capital assets, on their waiver may be treated as a capital receipt which is in the form of ‘Money’. It shall not be taxable either u/s 28(iv) or s.41(1) of the Act.

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