A section largely relegated to the side, Sec 41(1) has seen a resurgence in recent months, with the income tax using it as a tool to bring to tax benefits gained by the Assessee from the waiver of trade liabilities. Sec 41(1) forms part of Profits Chargeable to Tax under Chapter IV of the Act.

In British Mexican Petroleum Company Ltd. v. Jackson [(1932) 16 Tax Cas 570] it was held that once a loss or an expenditure is allowed as a deduction or as a trading liability recoupment of the loss or expenditure or remission of the trading liability would be a capital advantage and not a business receipt. Hence, Sec. 10(2A) was enacted (in the Income Tax Act, 1922). The corresponding section in the Income Tax Act, 1961, is Sec. 41(1).

Given the economic climate in many sectors, there have been increasing instances of banks and other lenders restructuring their loans sanctioned, to accommodate the needs of businesses facing working capital issues. Many of the lenders, in this process, forgo a part of their loan and waive it for the purposes of recovering what is best possible from their client.

The borrower of the above mentioned working capital funds/trade liability gets relief due to the waiver of the loan. From a taxation point of view, the borrower (or assessee), receives a quantifiable relief by waiver, that had earlier been claimed as an expense. Therefore, Sec. 41(1) mandates that when there is any form of waiver of loan or cessation of trade liability, then such liabilities, which are no longer payable, should be added back to the Business Income of the Assessee and offered to tax in the year of waiver.

Example

‘A & Co.’ had, in AY 2008-09, purchased goods worth Rs.2 lakhs on credit from ‘XYZ Ltd’. ‘XYZ Ltd’ during AY 2012-13 shuts their business down and fails to collect its dues from its clients. Hence, A & Co.’s trade creditor liability is no longer payable to XYZ Ltd.

This is a benefit to ‘A & Co.’. Not just as the liability has not been waived, but for tax purposes, the company had already claimed the purchase as an expense in the Profit and Loss account, in AY 2008-09. Now that the liability has ceased to exist, it ought to be added back to the profit and loss account, in the year of such relief i.e. AY 2012-13.

What triggers Sec 41(1)

The following indicators can be considered as triggers for Sec. 41(1)

(i) Cessation of liability/waiver of liability or recovery of loss or expenditure

(ii) Liability must be trading/revenue in nature

(iii) A deduction/allowance has been claimed against the same in the earlier years

Capital and Revenue – Sec. 28(iv) vs Sec. 41(1)

Sec. 41(1) embodies the biggest conundrum in Income Tax i.e. Capital vs Revenue. Interestingly, the section, as detailed above, restricts itself only to trade liabilities. Therefore, it is presumed that liabilities which are capital in nature, when waived, need not be considered u/s. 28(iv); hence escapes the ambit of taxation.

But wait!

When the liability is written back in the books of accounts for some or the other reason for which a person might not have claimed any deduction from income in previous years (i.e. liabilities not in the nature of trading), the department takes recourse vide Sec. 28(iv).

Sec. 28(iv) brings to tax the value of any benefit or perquisite, whether convertible into money or not, arising from business or profession. The only condition to bring to tax an amount u/s. 28(iv) is that such sum must arise from business. If no nexus can be established between the benefit received and the business of the assessee, then the same cannot be taxed under this section (Protos Engineer Co. P. Ltd. v. CIT, [TS-5661-HC-1994(BOMBAY)-O]). The same was also held in the case of CIT v. Bhavnagar Bone & Fertiliser Co. Ltd., [TS-9-HC-1986(GUJ)-O].

In CIT v. R.L. Kasliwal, [TS-5616-HC-1993(RAJASTHAN)-O], the assessee was a partner of a firm and was occupying a part of the lease-hold premises of the firm. The premises were remodelled and renovated by the firm, free of rent; for the assessee. Such occupation constitutes benefit or perquisite within the meaning of section 28 (iv). Similarly, in the case where the premises of the firm is occupied by the managing partner for his personal residence, this will be a benefit taxable u/s. 28(iv) Prem Raj Loonawat v. CIT, [TS-5278-HC-1994(RAJASTHAN)-O].

Hence, as it can be seen. The income tax has 2 sections at it’s disposal to take recourse to, where liability ceases to exist.

We can understand this better with a scenario analysis.

Scenario 1: Liability towards fixed assets waived/no longer payable

A & Co. had purchased Fixed Assets on credit and due to certain reasons, the liability is no longer payable by A & Co.

A & Co., in the above scenario, has derived an advantage by not discharging the liability (as the liability has been waived). However, the second test of Sec. 41(1), i.e. it should have been claimed as a business allowance, deduction has not been satisfied. Hence, it cannot be brought to tax u/s. 41(1).

However, interestingly, it cannot be brought to tax u/s. 28(iv) either. In Mahindra & Mahindra Ltd. v. CIT [TS-25-HC-2003(BOMBAY)-O], it has been held that the amount of the loan, granted to the assessee by a foreign company for import of capital assets, subsequently waived by the lender, has been held NOT to attract the provisions of Sec. 28(iv). This is so because the income which can be taxed u/s. 28(iv) must not only be referable to a benefit or perquisite. Secondly, Sec. 28(iv) does not apply to benefits in cash or money. This was also held so in Solid Containers Ltd. [TS-84-HC-2008(BOM)-O].

Scenario 2: A & Co borrows working capital loan, that is subsequently waived

Here, Sec. 41(1) will bring to tax the benefit gained by the Assessee, as this will amount to a trade credit.

Scenario 3: Liabilities which have been on books for a very long time with little change

The Act is silent when it comes to treatment of liabilities lying dormant in books for a substantial period of time. The Assessing Officer often is empowered with taking his view in these circumstances. If a liability, which is outstanding for a very long period, ceases to be in existence either because the creditor is not demanding it or by operation of law it becomes barred by time; how will it be treated? There exist contradictory decision regarding the same across various courts in India.

In CIT vs Chipsoft Technology Pvt Ltd [TS-5490-HC-2012(DELHI)-O], it was held that where the assessee has just continued the entry in his books of accounts without any intention to pay back the same, it should be added to his income u/s 41(1).

In CIT vs Vardhaman Overseas Ltd. [TS-777-HC-2011(DELHI)-O], it was held that unconfirmed creditor balance as per balance sheet cannot be taxed u/s 41(1) - Creditors' balances remaining outstanding for over 4 years not taxable u/s 41(1), even if no balance confirmation available; Disclosure of creditors' balance in balance sheet amounts to acknowledgment of debt and fresh limitation period applicable under the Limitation Act ; Specific provision u/s 41(1) to prevail over general provision u/s 28(iv).

Scenario 4: A future liability is paid today, at a discounted rate

In Sulzar India vs JCIT [TS-138-ITAT-2010(Mumbai)-O], the assessee had taken advantage of a sales tax deferral scheme, launched by the Govt of Maharashtra. The assessee has accumulated 12 years’ worth sales tax deferral. While this was so, the Govt. offered the Assessee an opportunity to pay back, through an early repayment, a certain sum of money due as sales tax in the future, but today at a discounted rate. The Assessee took advantage of the same and made the early payment. The revenue, however, treated difference, due to early repayment, as remission of liability. It was held, by the Hon’ble Special Bench, that the Assessee had paid the entire value of loan at a discounted rate (discounted NPV), hence there was no remission of liability or waiver of liability.

Significant Points to Remember

For applicability of Sec. 41(1), the pre-requisite condition is that an allowance or deduction has been made in the assessment for any of the years in respect of an expenditure, loss or trading liability incurred by the assessee and subsequently during any previous year the assessee has received remission or obtained refund of the said amount [CIT v. Emkay Glass Works, [TS-5345-HC-2005(ALLAHABAD)-O]].

The AO failed to show that in any earlier year, allowance of deduction had been made in respect of any trading liability incurred by the assessee. It was also not proved that any benefit was obtained by the assessee concerning such trading liability by way of remission or cessation thereof during the concerned year and, thus, section 41(1) held not applicable [CIT v. Smt. Sita Devi Juneja,[TS-5983-HC-2009(PUNJAB)-O]].

However, in Rollatainers Ltd. v. CIT [TS-590-HC-2011(DEL)-O], it has been held that as far as the term loans were concerned, the waiver thereof by the financial institutions was not treated as income at the hands of the assessee and it was only the writing off loans on the cash credit account which was received for carrying out the day-to-day operations of the assessee which was treated as income in the hands of the assessee. In any case, even if Sec. 28 (iv) was not applicable, Sec. 41(1) would be applicable.

Assessee does not have to receive benefit by way of cash for application of the provisions of Sec. 41(1) . The benefit can be derived by way of book adjustment also. Thus, where the benefit is received by the assessee by way of settlement and consequently through book entry and book adjustment, such benefit is liable to be taxed under section 41(1) (Express Newspapers Pvt. Ltd. v. CIT, [TS-5858-HC-1996(MADRAS)-O]).

Sec. 41(1) does not cover a mistaken payment or mistake in calculation. The allowance, which was legally made, to the extent the assessee was able to reimburse himself, was added on to the assessee’s income in the year in which the assessee was able to reimburse himself (CIT v. Indian Cements Ltd.,[TS-5217-HC-1974(MADRAS)-O]).

Conclusion

Hence, companies and the Income Tax both need to give due consideration to the increasing waivers being extended by financial institutions. If the conditions of Sec. 41(1) are triggered, then the same ought to be added back to the profit of the company and brought to tax.