Tax deduction allowed on damages paid to previous buyer

A taxpayer had declared long-term capital gains from sale of Rs 5,42,000 from sale of an immovable property in Delhi. The sale of property was via a tripartite agreement dated November 4, 1993 between the buyer who paid Rs 45 lakh to the tenant to vacate the property and Rs 55 lakh to the taxpayer for transfer of title and ownership rights in the property. 

Prior to selling this property in 1993; the taxpayer had entered into an agreement to sell with another individual on April 10, 1989 and received Rs 7,50,000 as advance towards the said property. As per the terms of the said agreement, as the taxpayer backed out from the same, in addition to refund of the advance money, the tax payer paid Rs 25 lakh to the individual on December 16, 1993 for foregoing his right and claim to the same property. 

The Income-Tax Act (‘the Act’) prescribes that any expenditure incurred wholly and exclusively in connection with sale of a capital asset can be deducted from the consideration received on sale of the asset. Likewise, any amount spent on cost of improvement of a capital asset is also allowed as a deduction. The taxpayer claimed deduction of the amount of Rs 25 lakh, against the capital gains on sale of property, in her return of income under the above provisions.

The tax officer disallowed this claim and held that damages paid to the previous buyer cannot be treated as expenditure under the provisions. The I-T Act provides that any advance money received and retained by a taxpayer on account of previous negotiations for sale of a property; then the same shall be reduced from the cost of acquisition of the said property at the time of final sale. The tax officer, in accordance with this provision of the Act reduced the amount of Rs 7,50,000 received as advance under the first agreement, from the taxpayer’s cost of property. The tax officer also refused to accept the previous agreement to sell as a valid document. 

At the first appeal, the appellate authority allowed taxpayer’s claim for deduction of Rs 25 lakh as expenditure and at the same time also allowed the tax officer’s claim for reduction of the property cost by Rs 7,50,000 being advance money received and retained by the taxpayer. At the second level of appeal, the authority agreed with the taxpayer’s claims and allowed the deduction of Rs 25 lakh, as well as directed the tax officer to remove the reduction of Rs 7,50,000 from the cost of acquisition.

The I-T department filed an appeal with the Delhi High Court against this order, specifically against the claim for deduction of Rs 25 lakh. In its order, the court held that the words ‘wholly and exclusively’ require and mandate that the expenditure should be genuine and that the expenditure should be connected and for the purpose of transfer. Tax officers cannot question the commercial expediency or standard of reasonableness while deciding upon the allowability of the expenditure. As the taxpayer was able to produce agreement copies, the Court allowed the deduction to the taxpayer in this case.

The author is a SEBI registered investment adviser and a chartered accountant. He is the founder of Arvind Rao & Associates, Mumbai