Capital gain sec. 51

This query is : Open

Leela jain (Querist)
Follow

05 March 2014 sec. 51 dealt with earnest money which will forfeited by seller on default of buyer, and this forfeited amount is deducted from cost of acquisition. i want to know that the excess amount(earnest money. COA) will treated as a capital receipt not taxable? and if COA nil then no indexation and all sale consideration taxable?

SAMADHAN SHRIRAM

SAMADHAN SHRIRAM (Expert)
Follow

05 March 2014 Suppose you bought a property for Rs 10 lakh about 15 years ago, and two years ago, you decided to sell it for Rs 40 lakh. The deal was struck and the buyer gave you earnest money of Rs 2 lakh, but later backed out. The Rs 2 lakh will be treated as capital receipt and you will not be taxed in that year, but the amount will be deducted from the purchase price of your property when you sell it in the future. In this case, the purchase price will be taken as Rs 8 lakh (Rs 10 lakh—Rs 2 lakh).

In some cases, the deduction of earnest money from the cost price of the asset pushes up the capital gains tax of the owner substantially. In the example (How much tax...), the owner would not have had to pay any tax had he not forfeited the earnest money.

The indexed cost of acquisition without deducting Rs 50,000 from the cost price would have been Rs 8.3 lakh. One would be better off including the earnest money in one's income from other sources and paying tax on it. Is this possible? The law is silent on this because the earnest money is a capital receipt, not income.

Also, the seller must know that this is a one-way street. If you backed out of the deal and paid the buyer Rs 2 lakh compensation, it would be treated as a capital loss and not added to the purchase price of the property. You can claim tax benefit on this only if you were in the business of sale and purchase of the property. In such a case, the loss due to forfeiture would be treated as a revenue loss.
Earnest money is usually a very small percentage of the total value of the transaction, but sometimes it can be higher than the cost price of the asset. Under Section 48 (read with Section 51), if the amount forfeited is greater than or equal to the cost of acquisition, the cost of the asset will be taken as nil.

In one such case involving Sunita N Shah (2005) 94 ITD 492 (Mumbai), the forfeited amount was higher than the cost of acquisition. In such cases, the excess amount is considered capital receipt and is not chargeable to tax. The same ruling was given in the case of Travancore Rubber & Tea Co. Ltd (2000) 243 ITR 158, wherein the Supreme Court ruled in favour of the assessee.

Tax impact on buyer

In case the buyer defaults and the earnest money is forfeited, he will not be allowed to show it as a capital loss. This was the verdict in the case of CIT vs Sterling Investment Corporation Ltd (1980) 123 ITR 441.
However, if the seller fails to honour the deal and pays the buyer double the compensation, this will be treated as capital gain because it amounts to relinquishment of a right by the buyer. In the case of CIT vs Vijay Flexible Container (1990) 186 ITR 693, it was held that giving up the right to obtain conveyance of immovable property amounts to transfer of a capital asset.

What happens if the advance money was for the purchase of a commercial property? Can the loss be treated as business expenditure incurred by the purchaser? The amount cannot be claimed as revenue expenditure. In CIT vs Jaipur Mineral Develop Syndicate (1995) 216 ITR 469 (Raj), it was held that if the payment is made for the pupose of acquiring a capital asset, the amount lost upon forfeiture will not be considered as revenue loss though the amount may not have the same consequence or character in the hands of the recipient or beneficiary.