Surplus from transfer of restored development rights is taxable as capital gains, not business income.

ORDER

Amit Shukla, Judicial Member. – These cross appeals are directed against the order dated 27.03.2025 passed by the learned Commissioner of Income Tax (Appeals) for Assessment Year 2019-20. The Revenue, in its appeal, has challenged the action of the learned CIT(A) in holding that the gains arising from the transfer of the subject property are chargeable to tax under the head “Capital Gains” as against “Profits and Gains of Business or Profession” assessed by the Assessing Officer. The assessee, on the other hand, has challenged the confirmation of certain disallowances sustained by the learned CIT(A) and has also raised additional grounds contending that, on the peculiar facts of the case, the receipt itself constitutes a capital receipt not chargeable to tax. Since both the appeals arise out of the same appellate order, involve common facts and interconnected issues, they were heard together and are being disposed of by this consolidated order.

2. The effective grounds raised by the Revenue substantially assail the finding of the learned CIT(A) that the gains arising from the transfer of the subject property are liable to be assessed under the head “Capital Gains”. The original grounds raised by the assessee relate principally to the disallowance under section 40(a)(ia), the disallowance of provision towards compensation for removal of encroachments and settlement of boundary disputes, and the disallowance of health and education cess. By way of additional grounds, the assessee has further contended that the appreciation in the value of the asset during the period of its alleged sterilisation and the receipt arising upon termination of the Joint Development Agreement constitute capital receipts not chargeable to tax. As all these grounds emanate from a common set of facts, they are being considered together in the succeeding paragraphs. The respective grounds of appeal are reproduced hereunder:-

2.1. The effective grounds raised by the Revenue are reproduced hereunder:

2.2. The original grounds as well as the additional grounds raised by the assessee are reproduced hereunder:

3. The material facts giving rise to the present controversy are largely undisputed. The dispute centres around a parcel of land bearing Survey No. 38 (Part) and CTS No. 101 situated at Village Tirandaz, admeasuring approximately 32 Acres and 32 Gunthas. Originally, the said property belonged to the Sharma family, who, under an agreement dated 29.07.1971, granted leasehold rights in favour of Shri C.C. Sharma. Subsequently, the reversionary rights in the property came to be transferred to Manav Dharam Mission Trust, which, in turn, conveyed those rights on 20.01.1996 to M/s Bahupriya Properties Pvt. Ltd., subsequently known as M/s Skyline Mansions Pvt. Ltd. (“SMPL”). Consequently, while SMPL became the holder of the reversionary ownership rights in the property, Shri C.C. Sharma continued as the lessee under the original lease arrangement.

4. On 04.04.2006, the assessee acquired leasehold rights together with the corresponding development rights over an area admeasuring 32,262.79 square metres from Shri C.C. Sharma. With a view to commercially exploiting the property by undertaking a residential development, the assessee and SMPL entered into a Joint Development Agreement (“JDA”) dated 04.04.2008, whereby the responsibility for development of the project was undertaken by SMPL at its own cost, while the assessee became entitled to receive constructed area aggregating to 16,500 square metres as its consideration under the development arrangement. Simultaneously, under a Supplementary Joint Development Agreement dated 05.04.2008, the assessee also received a refundable security deposit of Rs.102 crores from SMPL. In the financial year relevant to Assessment Year 2012-13, the assessee treated the transfer of its development rights under the JDA as a transfer within the meaning of the Act and offered the resultant profits as business income by adopting the fair market value of the agreed constructed area as the full value of consideration. The year of taxability of the said transaction also came to be affirmed in the assessee’s own case by the Hon’ble Bombay High Court.

5. Although the project was contractually required to be completed within five years, it could not progress because of a series of supervening circumstances, including environmental clearance issues, encroachments, complaints before the municipal authorities, disputes with the lender, Urban Infrastructure Venture Capital Fund (UIVCF), and other regulatory impediments. Environmental clearance could ultimately be obtained only on 12.05.2017, and in the meanwhile disputes between SMPL and its lender also resulted in severe financial constraints affecting implementation of the project. Despite the passage of almost a decade from the execution of the JDA, the contemplated development never commenced. Significantly, under the terms of the Joint Development Agreement, the assessee did not possess any contractual right to terminate the arrangement; such right vested exclusively with SMPL. Consequently, throughout this period the assessee remained unable to retrieve or commercially exploit the development rights which had already become embedded in the Joint Development Agreement.

6. Ultimately, owing to the continued inability to implement the project, the Joint Development Agreement came to be terminated on 17.09.2018. Upon such termination, the development rights earlier vested in SMPL stood revested, and SMPL simultaneously transferred its reversionary rights in the property to the assessee for a consideration of Rs.109 crores. Thus, on 17.09.2018, the assessee became vested with complete rights in the property. On the very next day, namely 18.09.2018, the assessee transferred a portion of the property admeasuring 25,887 square metres to M/s Kanakia Spaces Realty Pvt. Ltd. for a total consideration of Rs.480 crores.

7. In its return of income for the year under consideration, the assessee declared the surplus arising from the aforesaid transaction under the head “Profits and Gains of Business or Profession” and claimed various deductions while computing the business income. During the course of the assessment proceedings, however, the assessee raised an alternative legal contention that, by reason of the prolonged and involuntary inability to commercially exploit the development rights embedded in the Joint Development Agreement for almost a decade, the commercial character of the asset had undergone a material transformation and, therefore, the gains arising upon its subsequent transfer were liable to be assessed under the head “Capital Gains”. Reliance in support of the said contention was placed upon various judicial precedents including Canara Bank Ltd., Universal Radiators and Aeren R Infrastructure. The Assessing Officer did not accept the said contention and proceeded to assess the entire surplus as business income while also making, inter alia, the disallowances under section 40(a)(ia), disallowance of provision towards compensation for removal of encroachments and settlement of boundary disputes, disallowance of education cess and certain other additions.

8. In appeal, the learned CIT(A) granted partial relief. While deleting the disallowances relating to construction of the compound wall and professional fees, he sustained the disallowances relating to health and education cess, section 40(a)(ia) and the provision created towards compensation payable for removal of encroachments and settlement of boundary disputes. On the principal issue, however, the learned CIT(A), after an elaborate examination of the factual matrix and the judicial precedents relied upon by the assessee, accepted the contention that the prolonged and involuntary sterilisation of the assessee’s business rights under the Joint Development Agreement constituted an exceptional factual situation warranting assessment of the gains arising from the subsequent transfer under the head “Capital Gains”. Aggrieved by the aforesaid findings, both the Revenue and the assessee are in appeal before us.

9. Before we advert to the principal controversy raised in the Revenue’s appeal, it would be appropriate to first deal with the additional grounds raised by the assessee, since the adjudication thereof has a direct bearing on the true nature and character of the receipt under consideration. By way of these additional grounds, the assessee has contended that the appreciation in the value of the subject asset during the period of its alleged sterilisation constitutes a capital receipt not chargeable to tax and, further, that the assets which ultimately came to be vested in the assessee upon termination of the Joint Development Agreement represented compensation for the loss of its profit-making apparatus. It was submitted that these grounds raise pure questions of law arising from the facts already available on record and, therefore, require no further investigation. Since the controversy sought to be raised is purely legal in nature and goes to the root of the taxability of the receipt itself, we admit the additional grounds by following the principle laid down by the Hon’ble Supreme Court in National Thermal Power Co. Ltd. v. CIT.

10. The learned counsel submitted that the assessee had already transferred its development rights under the Joint Development Agreement during the financial year relevant to Assessment Year 2012-13 and had offered the resultant profits to tax as business income. Thereafter, what remained with the assessee was its contractual entitlement to receive the agreed constructed area under the Joint Development Agreement. According to him, owing to prolonged legal and regulatory impediments, environmental issues, encroachments, third-party disputes and other supervening circumstances beyond the control of the assessee, the project remained incapable of implementation for almost a decade. During this entire period, the assessee had no contractual right to terminate the Joint Development Agreement or to commercially exploit the rights which had already become embedded therein. It was, therefore, argued that the assessee’s commercial rights remained completely blocked and involuntarily sterilised and that the appreciation accruing during such period could not be regarded as ordinary business profit. Reliance was placed upon the decisions in CIT v. Canara Bank Ltd [1967] 63 ITR 328 (SC), Universal Radiators v. CIT 201 ITR 800 (SC), CIT v. Bombay Burmah Trading Corpn. 161 ITR 386 (SC), CIT v. Saurashtra Cement Ltd. 325 ITR 422 (SC), CIT v. HCL Infosystems Ltd [2017]  [2016] 385 ITR 35 (Delhi) and Pr. CIT v. Aeren R Infrastructure Ltd [MANU/DE/1614/2018] to contend that the receipt should either be treated as a non-taxable capital receipt or, alternatively, as compensation for the destruction of the assessee’s profit-making apparatus.

11. The learned Departmental Representative, on the other hand, submitted that the entire transaction, commencing from the acquisition of the leasehold rights, execution of the Joint Development Agreement, transfer of development rights thereunder and the eventual termination of the arrangement, constituted an integral part of the assessee’s real estate business. It was contended that the assessee had originally returned the surplus as business income and only during the assessment proceedings sought to alter the head of income. Having succeeded before the learned CIT(A) to the extent of securing assessment under the head “Capital Gains”, the assessee has now advanced a further plea that the receipt itself falls outside the charging provisions of the Act. According to the learned Departmental Representative, none of the authorities relied upon by the assessee lays down that every receipt arising upon termination of a commercial arrangement necessarily constitutes a non-taxable capital receipt. It was, therefore, submitted that the additional grounds deserve to be rejected.

12. We have considered the rival submissions and also facts and material referred to before us. In our opinion, the additional grounds proceed on an assumption that the principles governing prolonged sterilisation of a commercial asset and those governing compensation for destruction of the profit-making apparatus are one and the same. They are not. While both sets of principles recognise that, in appropriate factual situations, the character of a receipt may differ from ordinary trading profits, the factual foundation necessary for invoking each principle is distinct. The authorities relied upon by the assessee undoubtedly explain the circumstances in which compensation for destruction or sterilisation of the profit-making apparatus may assume the character of a capital receipt. Equally, they recognise that prolonged blockage or sterilisation of a trading asset may have a bearing on the character of the gains arising therefrom. The applicability of those principles, however, depends entirely upon the factual context in which they were enunciated. It is, therefore, necessary to examine each of the judicial precedents relied upon by the parties in its proper factual setting before determining whether the assessee’s contention that the receipt itself is not chargeable to tax can be accepted. We shall accordingly first analyse the ratio laid down in the aforesaid authorities and thereafter examine their applicability to the peculiar facts of the present case.

13. We shall first advert to the decision of the Hon’ble Supreme Court in Canara Bank Ltd (Supra), upon which considerable reliance has been placed by the learned counsel. In that case, the funds of the assessee-bank, though originally forming part of its trading assets, remained blocked and incapable of being utilised in the ordinary course of its banking business because of circumstances beyond its control. The Hon’ble Supreme Court held that where a trading asset remains completely blocked and sterilised, and no commercial operations can be carried on with such asset during the period of blockage, the appreciation arising solely because of such involuntary sterilisation cannot be regarded as ordinary trading profit in the same manner as profits generated in the course of business operations.

13.1. The relevant observations of the Hon’ble Supreme Court are reproduced hereunder:

“The exchange rate was due to trading operations in the course of banking business. However, the appellate Tribunal found that the amount of Rs. 3,97,221/- was a “blocked” and “sterilised” balance, and the Bank was unable to deal with that amount or use it for any banking purpose between September 1949 and July 1953, when it was finally remitted to India. In their opinion, the money changed its character from ‘stock-in-trade’ to a capital asset when it was ‘blocked’ and ‘sterilised’, and any increment in its value owing to exchange fluctuation must therefore be treated as a capital receipt. The appellate Tribunal also found that the said amount was not utilised for internal banking operations within Pakistan, making it impossible to infer that the Bank realised any profit in the ordinary course of its business. Accordingly, the argument on this aspect could not be sustained, and the High Court was correct in concluding that the exchange difference of Rs. 1,70,746/- was not assessable to income-tax.”

13.2. The ratio of the aforesaid decision, in our considered opinion, is that the true character of a receipt cannot be determined merely by reference to the original character of the asset but must also take into account the commercial realities prevailing during the period in question. The decision, however, cannot be understood as laying down an absolute proposition that every blocked trading asset necessarily results in a receipt which is completely immune from taxation. The principle is one of characterisation of the receipt having regard to the peculiar facts of the case. Whether that principle ultimately supports the assessee’s contention that the receipt itself is not chargeable to tax is a distinct question, which must be examined in the light of the entire factual matrix obtaining before us.

14. We may next examine the decision of the Hon’ble Supreme Court in Universal Radiators (supra), which reiterates and explains the principle recognised in Canara Bank Ltd. In that case also, the goods originally intended to be utilised in the assessee’s manufacturing business became incapable of commercial utilisation because of extraordinary supervening events beyond the control of the assessee. The Hon’ble Supreme Court held that where the trading operations themselves become impossible on account of such intervening circumstances, the receipt arising merely because of the fortuitous appreciation attributable to those circumstances cannot automatically be equated with ordinary business profits.

14.1. The relevant observations of the Hon’ble Supreme Court are reproduced hereunder:

“Even assuming it was stock-in-trade, it was held by this Court in Canara Bank Ltd.’s case (supra)that stock-in-trade, if it gets blocked and sterilised and no trading activity could be carried with it, then it ceased to be stock-in-trade, and any devaluation surplus arising on such capital due to exchange rate would be capital and not revenue. Applying the ratio of this case, the copper ingots, which even if assumed to be stock-in-trade, were blocked and sterilised due to hostilities between India and Pakistan, and, therefore, it ceased to be stock-in-trade and any surplus arising due to exchange ratio in the circumstances was capital receipt only.

…

The assessee did not carry on business of buying and selling ingots. The compensation paid to the assessee was not for any trading or business activity, but just equivalent in money of the goods lost by the assessee which it was prevented from using. The excess arose on such payment in respect of goods in which the assessee did not carry on any business. Due to fortuitous circumstances of devaluation of currency, but not due to any business or trading activity, the amount could not be brought to tax.”

14.2. The aforesaid decision reinforces the proposition that prolonged involuntary blockage or sterilisation of a commercial asset is a relevant factor while determining the true nature of the receipt arising therefrom. At the same time, the Court was concerned with the peculiar factual situation obtaining before it, where the trading operations themselves had become impossible owing to extraordinary circumstances. The decision does not lay down that every receipt arising after such blockage necessarily constitutes a capital receipt outside the charging provisions of the Act. In our considered view, the principle emerging from Universal Radiators is required to be appreciated together with the facts of each case, and not in isolation.

15. The learned counsel has also placed considerable reliance upon the decision of the Hon’ble Supreme Court in Bombay Burmah Trading Corpn (Supra). In that case, the compensation came to be received because the very source from which the assessee carried on its commercial operations stood substantially impaired, thereby affecting the structure of its profit-making apparatus. The Hon’ble Supreme Court explained the distinction between a receipt arising in the ordinary course of carrying on business and compensation received for sterilisation or destruction of the very source of the business itself.

15.1. The relevant observations of the Hon’ble Supreme Court are reproduced hereunder:

“28.Secondly, if any payment was made for sterilization of the very source of profit-making apparatus of the assessee, or a capital asset, then that would also amount to a capital receipt in the hands of the recipient. .Compensation received for immobilisation, sterilization, destruction or loss, total or partial of a capital asset would be capital receipt. If a sum represented profit in a new form then that was income but where the agreement related to the structure of assessee’s profit-making apparatus and affect the conduct of the business, the sums received for cancellation or variation of such agreement would be a capital receipt.”

15.2. The principle emerging from the aforesaid decision is that where compensation is received for destruction, sterilisation or impairment of the very source or framework of the profit-making apparatus, such receipt may assume the character of a capital receipt. However, the applicability of that principle necessarily depends upon whether, on the facts of the particular case, the profit-making apparatus itself has been destroyed or whether what has merely occurred is a temporary or prolonged interruption in its commercial exploitation. It is this distinction which assumes significance while examining the assessee’s additional grounds and will be considered after discussing the remaining authorities relied upon by the parties.

16. The learned counsel has next relied upon the decision of the Hon’ble Supreme Court in Saurashtra Cement Ltd. (Supra) It was submitted that the said decision recognises the distinction between compensation received in the ordinary course of business and compensation received on account of impairment of the profit-making apparatus. We have carefully considered the ratio of the said judgment.

16.1. The relevant observations of the Hon’ble Supreme Court are reproduced hereunder:

“10. Thus, the short question for determination is whether the liquidated damages received by the assessee from the supplier of the plant and machinery on account of delay in the supply of plant is a capital or a revenue receipt?

11. The question whether a particular receipt is capital or revenue has frequently engaged the attention of the Courts but it has not been possible to lay down any single criterion as decisive in the determination of the question. Time and again, it has been reiterated that answer to the question must ultimately depend on the facts of a particular case, and the authorities bearing on the question are valuable only as indicating the matters that have to be taken into account in reaching a conclusion. In Rai Bahadur Jairam Valji’s case (supra), it was observed thus :

“The question whether a receipt is capital or income has frequently come up for determination before the courts. Various rules have been enunciated as furnishing a key to the solution of the question, but as often observed by the highest authorities, it is not possible to lay down any single test as infallible or any single criterion as decisive in the determination of the question, which must ultimately depend on the facts of the particular case, and the authorities bearing on the question are valuable only as indicating the matters that have to be taken into account in reaching a decision. Vide Van Den Berghs Ltd. v. Clark [1935] 3 ITR (Eng. Cas.) 17. That, however, is not to say that the question is one of fact, for, as observed in Davies (H.M. Inspector of Taxes) v. Shell Company of China Ltd. [1952] 22 ITR (Suppl.) 1, “these questions between capital and income, trading profit or no trading profit, are questions which, though they may depend no doubt to a very great extent on the particular facts of each case, do involve a conclusion of law to be drawn from those facts.”

12. In Kettlewell Bullen & Co. Ltd.’s case (supra), dealing with the question whether compensation received by an agent for premature determination of the contract of agency is a capital or a revenue receipt, echoing the views expressed in Rai Bahadur Jairam Valji’s case (supra) and analysing numerous judgments on the point, this Court laid down the following broad principle, which may be taken into account in reaching a decision on the issue :

Where on a consideration of the circumstances, payment is made to compensate a person for cancellation of a contract which does not affect the trading structure of his business, nor deprive him of what in substance is his source of income, termination of the contract being a normal incident of the business, and such cancellation leaves him free to carry on his trade (freed from the contract terminated) the receipt is revenue : Where by the cancellation of an agency the trading structure of the assessee is impaired, or such cancellation results in loss of what may be regarded as the source of the assessee’s income, the payment made to compensate for cancellation of the agency agreement is normally a capital receipt.”

13. We have considered the matter in the light of the afore-noted broad principle. It is clear from clause No. 6 of the agreement dated 1-9-1967, extracted above, that the liquidated damages were to be calculated at 0.5 per cent of the price of the respective machinery and equipment to which the items were delivered late, for each month of delay in delivery completion, without proof of the actual damages the assessee would have suffered on account of the delay. The delay in supply could be of the whole plant or a part thereof but the determination of damages was not based upon the calculation made in respect of loss of profit on account of supply of a particular part of the plant. It is evident that the damages to the assessee was directly and intimately linked with the procurement of a capital asset, i.e., the cement plant, which would obviously lead to delay in coming into existence of the profit-making apparatus, rather than a receipt in the course of profit-earning process. Compensation paid for the delay in procurement of capital asset amounted to sterilization of the capital asset of the assessee as supplier had failed to supply the plant within time as stipulated in the agreement and clause No. 6 thereof came into play. The afore-stated amount received by the assessee towards compensation for sterilization of the profit-earning source, not in the ordinary course of their business, in our opinion, was a capital receipt in the hands of the assessee. We are, therefore, in agreement with the opinion recorded by the High Court on question Nos. (i) and (ii) extracted in Para 1 (supra) and hold that the amount of Rs. 8,50,000 received by the assessee from the suppliers of the plant was in the nature of a capital receipt.

16.2. The principle emerging from the aforesaid decision is that the true nature of a receipt has to be determined by examining the purpose for which the compensation has been received and the real commercial effect thereof. Where the compensation is intended to make good the loss suffered in the ordinary course of carrying on business, the receipt ordinarily bears a revenue character. On the other hand, where the compensation is received because the very source or framework from which the business is carried on has been impaired or sterilised, different considerations may arise. However, the applicability of the said principle necessarily depends upon the factual foundation of each case and cannot be divorced from the surrounding commercial circumstances.

17. Reliance has also been placed upon the decision in HCL Infosystems Ltd (supra) to contend that where the commercial apparatus of the assessee is rendered incapable of effective exploitation by reason of supervening events beyond its control, the character of the resultant receipt has to be determined having regard to the real nature of the rights affected and not merely by the nomenclature employed by the parties. In that case the assessee, engaged in the manufacture, distribution and sale of computers and services in India, entered into a joint venture agreement with other companies manufacturing computers. Under the agreement the assessee was allowed to use name, license, patents, and trademarks of other company ‘HP’ During relevant assessment year, the agreement was terminated and assessee received certain amount as compensation for past and future loss of right to use brand name, trademark, etc., of HP and elimination of noncompetition obligations. The Assessing Officer held that the extinguishment of these bundle of rights by termination of the joint venture agreement resulted in transfer of an asset in terms of section 2(47)(if) and accordingly, the entire sum received by assessee was brought to tax under section 45 read with section 55 as ‘income from capital gain. The Hon’ble Court held that “What stood extinguished as a result of the termination of the joint venture agreement was a bundle of rights of the assessee. This included the right to manufacture computers using HP know-how and HP lables, trademarks and patents. At the same time it was not as if the assessee’s right to manufacture its own computers was also taken away by the termination. That stood revived. The transfer, if any, of the intangible assets of the kind described under the joint venture agreement could not, at the relevant time, be held to fall within the ambit of the kinds of capital assets that were contemplated in section 55(2)(a) as it then stood. Therefore, their cost of acquisition could not have been deemed to be ‘nil’ in terms of section 55(2)(a)(ii) as it stood at the relevant time.

17.1. The aforesaid decision reiterates the well-settled principle that the Court must ascertain the real nature of the commercial rights affected and the purpose for which the receipt has arisen. At the same time, it does not dispense with the requirement of establishing that the factual foundation necessary for treating the receipt as a capital receipt is actually present. Consequently, the decision must be appreciated in the backdrop of its own facts before applying its ratio to the controversy before us.

18. The learned counsel has lastly relied upon the decision in Aeren R Infrastructure Ltd (Supra). in support of the proposition that prolonged inability to commercially exploit a valuable business right may have a material bearing upon the character of the receipt ultimately arising therefrom. The aforesaid decision undoubtedly recognises that commercial realities cannot be ignored while determining the true character of a transaction. Equally, however, the principle emerging therefrom is that the legal character of a receipt must ultimately be determined on the cumulative appreciation of the contractual rights, surrounding circumstances and the true commercial substance of the transaction. It cannot be applied mechanically without examining whether the facts before the Court satisfy the legal tests laid down therein.

19. From a cumulative reading of the aforesaid decisions, one principle unmistakably emerges, namely, that the true character of a receipt is to be determined not merely by reference to its form but by examining the commercial realities and the legal effect of the transaction giving rise to it. The authorities relied upon by the assessee undoubtedly recognise the distinction between compensation received for destruction or sterilisation of the profit-making apparatus and receipts arising in the ordinary course of business. They also recognise that prolonged involuntary blockage of commercial rights may, in appropriate circumstances, influence the character of the gains ultimately realised. However, none of the aforesaid decisions lays down that every receipt arising after prolonged blockage or every appreciation occurring during such period automatically becomes a non-taxable capital receipt. The applicability of those principles necessarily depends upon the precise nature of the rights affected, the purpose for which the receipt has arisen and the surrounding commercial circumstances.

20. Applying the aforesaid principles to the facts before us, we are unable to accept the assessee’s contention that the receipt in question falls altogether outside the charging provisions of the Act. Admittedly, the assessee did not receive any compensation for destruction or extinction of its profitmaking apparatus. On the contrary, upon termination of the Joint Development Agreement, the contractual restrictions under which the assessee’s rights had remained embedded for several years came to an end; the pre-existing rights stood restored and, upon acquisition of the reversionary rights, became a complete and marketable bundle of rights capable of transfer. What ultimately generated the impugned surplus was the voluntary transfer of those consolidated rights in favour of the purchaser and not compensation received for destruction of the very source of the assessee’s business. The authorities relied upon by the assessee, though laying down important principles governing capital receipts and sterilisation of commercial assets, do not advance the assessee’s case to the extent canvassed before us. We accordingly reject the additional grounds seeking to treat the impugned receipt as a non-taxable capital receipt. Having so held, we shall now proceed to examine the principal controversy arising in the Revenue’s appeal, namely, whether the learned CIT(A) was justified, in the peculiar facts and circumstances of the present case, in directing that the gains arising from the transfer of the subject property be assessed under the head “Capital Gains” instead of “Profits and Gains of Business or Profession.”

21. We shall now examine the principal grievance raised by the Revenue. The issue is not whether the subject property was originally acquired by the assessee as part of its real estate business, for that position is not in dispute. Equally, there is no dispute that upon execution of the Joint Development Agreement, the assessee transferred its development rights and, in the financial year relevant to Assessment Year 2012-13, offered the resultant profits to tax as business income, which position has attained finality. The real controversy is whether, after the transfer of the development rights under the Joint Development Agreement and the extraordinary chain of supervening events which rendered the project incapable of implementation for almost a decade, the learned CIT(A.) was justified in holding that the gains arising upon the subsequent transfer of the consolidated rights were liable to be assessed under the head “Capital Gains” and not under the head “Profits and Gains of Business or Profession.” The determination of this issue necessarily depends upon the true legal character of the rights transferred on 18.09.2018 viewed in the backdrop of the entire commercial history of the transaction and not merely with reference to the original intention with which the property had been acquired.

22. The learned Departmental Representative assailed the impugned order by submitting that the learned CIT(A.) had erred in applying the doctrine of prolonged sterilisation to the facts of the present case. According to him, the assessee had at all material times acquired, held and dealt with the subject property as a trading asset in the ordinary course of its business as a real estate developer. The subsequent delay in execution of the project, however prolonged, did not alter the intrinsic character of the asset nor convert a trading asset into a capital asset. It was further submitted that the assessee itself had consistently treated the transaction as part of its business operations, had offered the transfer of development rights under the Joint Development Agreement to tax as business income in Assessment Year 2012-13 and had originally returned the surplus arising during the year under consideration also as business income. It was argued that the acquisition of the reversionary rights on 17.09.2018 resulted in the assessee obtaining complete ownership immediately prior to the transfer effected on 18.09.2018 and, therefore, the transaction represented nothing more than a commercial dealing in a business asset. It was thus contended that the learned CIT(A.) had misapplied the principles laid down in the judicial precedents relied upon by him and that the assessment made by the Assessing Officer under the head “Profits and Gains of Business or Profession” deserved to be restored.

23. Per contra, the learned counsel strongly supported the order of the learned CIT(A.) and submitted that the impugned order is founded upon an exhaustive appreciation of the entire factual chronology and the settled legal principles governing prolonged involuntary sterilisation of commercial rights. It was submitted that, after the execution of the Joint Development Agreement, the assessee had completely divested itself of the development rights and was left merely with a contractual entitlement to receive the agreed constructed area upon successful completion of the project. Thereafter, because of environmental issues, statutory impediments, encroachments, disputes involving the developer and its lender and other supervening circumstances, the project remained incapable of implementation for almost ten years. During the entire period, the assessee possessed no contractual right to terminate the Joint Development Agreement or to retrieve and commercially exploit the rights which had already become embedded therein. It was thus submitted that the prolonged and involuntary blockage of the assessee’s commercial rights constituted the distinguishing feature of the present case and that the learned CIT(A.), after correctly appreciating the commercial realities and the principles emerging from the decisions of the Hon’ble Supreme Court as well as the coordinate Bench in Neel Siddhi Developers, had rightly concluded that the gains arising from the subsequent transfer were liable to be assessed under the head “Capital Gains.”

24. We have carefully considered the rival submissions and have also examined the reasoning contained in the assessment order, the impugned appellate order and the judicial authorities relied upon by both sides. In our considered opinion, the controversy cannot be resolved by viewing the transaction through the narrow prism of the original character of the asset alone. Equally, it cannot be decided merely because the assessee had, at an earlier stage, offered the transfer of development rights under the Joint Development Agreement to tax as business income. The issue has to be examined by considering the entire chain of events commencing from the execution of the Joint Development Agreement, the transfer of the development rights thereunder, the prolonged inability to commercially exploit the contractual rights for reasons wholly beyond the control of the assessee, the eventual termination of the Joint Development Agreement, the acquisition of the reversionary rights and the subsequent transfer of the consolidated bundle of rights. It is only upon such cumulative appreciation of the factual matrix, read in the light of the governing legal principles, that the true character of the gains arising from the impugned transaction can be correctly determined. We shall, therefore, first examine the judicial authorities which have weighed with the learned CIT(A.) before dealing individually with the objections raised by the Revenue.

25. We shall first advert to the decision of the co-ordinate Bench of the Tribunal in Asstt. CIT v. Neel Siddhi Developers [IT Appeal No. 30 (Mum) of 2020, dated 28-10-2022]/[2022 (10) TMI 1159 (Mumbai–Trib.)], upon which considerable reliance has been placed by the learned CIT(A.). The controversy before the co-ordinate Bench also arose in the backdrop of a real estate transaction where, because of extraordinary supervening circumstances beyond the control of the assessee, the commercial exploitation of the property remained stalled for a prolonged period. The Tribunal examined the effect of such prolonged involuntary blockage upon the true character of the asset and, after analysing the decisions of the Hon’ble Supreme Court including Canara Bank Ltd (Supra)., Universal Radiators (Supra) and Bombay Burmah Trading Corpn. (Supra)., held that the issue cannot be decided merely by looking at the original intention with which the property was acquired. The Tribunal emphasised that where commercial rights remain completely incapable of exploitation for a substantial period because of circumstances beyond the assessee’s control, the commercial realities surrounding the transaction assume considerable significance while determining the correct head under which the resultant gains are liable to be assessed.

25.1. The relevant observations of the co-ordinate Bench are reproduced hereunder:

“Business Income v. Capital Gain:

7. The first ground of the Revenue is that the sale of land at Nagpur by the Assessee is a transaction in the nature of adventure in trade and hence, liable to be taxed under the head “Income from Business and Profession” and not under the head “Capital Gain” as offered by the Assessee. The reasons provided by the AO in his assessment order are summarised hereunder:

a. The said land was shown as “Stock in trade” in the balance sheet of the Assessee;

b. The Assessee is engaged in the business of development of real estate and without land no development can start. Hence, the argument of Assessee that it is not dealing in buying and selling of land is incorrect;

c. As per partnership deed, the Assessee is in the business of developing real estate (Copy of Partnership Deed is at Page 208 211 of PB).

d. Intention at the time of acquisition of land is more important than subsequent non utilization of said land,

e. The Assessee was aware of the various problems and difficulties which lay ahead and hence, it cannot be accepted that the said land was not developable

….

9. The CIT(A) has in Para 6.2 from page nos. 7- 22, summarised the arguments of the Assessee and thereafter, allowed the claim of the Assessee as per reasoning provided in para 6.5 of the appeal order being impugned before us which are stated hereunder:

…..

b. The AO has himself recorded a finding that the said land was classified as “stock in trade” in the books of the Assesseein the earlier years. The question is whether such classification in books is be all and end all of the matter. Supreme Court in the case of G. Venkataswami Naidu & Co. v. CIT (1959 35 ITR 594 (SC) held that all attendant facts and circumstances of the case is to be seen to determine whether the income is capital gain or business income No one test or formula can be applied as a thumb rule. The same sentiment has been echoed by the Mumbai High Court in the case of Fort Properties (P) Ltd v. CIT (1994) 208 ITR 232 (Bom.) wherein the Hon’ble Mumbai High Court treated the loss on sale of property classified as “stock in trade” as “capital loss” instead of “business loss”. In the present case, the Department had taken a stand that even if the asset was classified as “stock in trade” yet the loss on its sale is not “business loss” but is a “capital loss”. The Department had contended that the Assessee was though a real estate company, yet it did not carry out the business on the said land and hence, mere classification in books of accounts as “stock in trade” is not final. In the impugned case, the AO has contended exactly the opposite which is against the law laid down by the Bombay High Court in the case of Fort Properties (1994) 208 ITR 232 (Bom). Therefore, mere fact that the said land was classified as “stock in trade” in books in earlier years is not determinative of the fact that the gain on its sale is to be taxed as business income.

…..

e. ….On the other hand, the Assessee has produced the decision of hon’ble ITAT in the same case for A.Y. 2004-05 wherein the hon’ble ITAT has held that even in the case of real estate developer, the land acquired for the purpose of development shall be capital asset, if it is sold without development and the gain on such sale is taxable as “capital gain”. In fact, the said decision of the jurisdictional ITAT is on all fours with the facts of the Assessee’s case.

14. We have considered the submissions of the Ld. DR and the counter arguments of the Ld. AR of the Assessee and perused the assessment order and the CIT (A) order as well as material referred to before us. We find that the AO has in his order made contradictory observations. On one hand, he has stated that the business of the Assessee was that of “development” of the land and on the other hand, accepted the fact that the said land was sold as such without any development. In an earliest decision, while deciding the head of income, the Apex Court has in the case of G. Venkataswami Naidu & Co. us. CIT (1959) 35 ITR 594 (SC) held that all attendant facts and circumstances of the case is to be seen to determine whether the income is “capital gain” or “business income”.

…..

17. The judgments of courts relied upon by the ld. AR for the Assessee is squarely applicable to the facts of the case on hand. The Ld. DR of the Assessee has not brought on record any contra decision or shown that the decisions relied upon by the Assessee and as relied upon by the CIT (A) are over ruled. Further, the ld. DR has neither raised any additional argument other than what the AO has stated and already dealt with by the CIT (A) in an elaborate order nor stated as to why the findings and reasoning of CIT(A) is incorrect either on facts or in law. Hence, we uphold the order of CIT(A) on this ground and hold that the Assessee has rightly offered the gain on sale of Nagpur land under the head “Capital Gain”.

25.2 . In our considered opinion, the significance of the aforesaid decision lies not merely in the conclusion ultimately reached but in the principle adopted by the Tribunal, namely, that the issue has to be examined in the backdrop of the cumulative commercial realities and not by adopting an isolated or mechanical approach founded exclusively upon the original character of the asset. Although the decision is that of a co-ordinate Bench and, therefore, possesses persuasive rather than binding value, the factual similarity between the controversy before the Tribunal and the present case lends considerable assistance in appreciating the legal effect of prolonged involuntary sterilisation of commercial rights.

26. We may now examine the decision relied upon by the learned counsel in CIT v. Smt. Rama Rani Kalia [2013]  [2013] 358 ITR 499 (All), which has been pressed into service to answer the Revenue’s contention that the assessee acquired complete ownership only on 17.09.2018 and, therefore, a fresh capital asset came into existence immediately before its transfer. The submission of the learned counsel is that acquisition of an additional or complementary proprietary interest does not necessarily result in the creation of an altogether new asset if, in substance, it merely completes the existing bundle of rights already vested in the assessee. The relevant observations relied upon by the assessee are reproduced hereunder:

“The assessee purchased a property on leasehold basis in year 1984. She got said property converted into freehold property in year 2004 and thereupon sold it. The capital gain arising from sale of said property was declared as long term capital gain.

The Assessing Officer opined that since the property was acquired by converting the leasehold right into freehold right and was sold within three days, capital gain would amount to short-term capital gain. He thus added the amount of short-term capital gain to the taxable income of the assessee.

The Commissioner (Appeals) held that the conversion of leasehold property into freehold property was nothing but improvement of the title over the property, as the fact remained that the assessee was owner even prior to conversion. He, thus, concluded that capital gain arising from sale of property was to be taxed as long-term capital gain.

The Tribunal upheld the order of the Commissioner (Appeals).

On revenue’s appeal:

HELD

The difference between the ‘short-term capital asset’ and ‘long-term capital asset’ is the period over which the property has been held by the assessee and not the nature of title over the property.

The lessee of the property has rights as owner of the property subject to covenants of the lease, for all purposes. He may, subject to covenants of the lease deed, transfer the leasehold rights of the property with the consent of the lessor.

The conversion of the rights of the lessee in the property from having leasehold right into freehold is only by way of improvement of her rights over the property and it would not have any effect on the taxability of gain from such property, which is related to the period over which the property is held.

If the period of holding is less than 36 months, the gain arising from such transfer would be of short-term capital gain. [Para 11]

In the present case, the property was held by the assessee as a lessee since 1984, and the same was transferred on 31.3.2004, after the leasehold rights were converted into freehold rights on the same property which was in her possession. The conversion was by way of improvement of title, which would not have any effect on the taxability of profits. [Para 12]

In view of above, there is no error of law in the impugned order of the Tribunal. The revenue’s appeal is therefore dismissed.

26.1. The principle emerging from the aforesaid decision is that the legal character of a property interest has to be determined having regard to the totality of the rights held by the assessee and not by artificially segregating each constituent interest in isolation. Consequently, where an assessee already possesses substantial proprietary and commercial rights and subsequently acquires another complementary interest which merely perfects or consolidates those existing rights, it cannot invariably be said that a completely new and independent asset has come into existence on the date of such acquisition. Whether such consequence follows would necessarily depend upon the facts of the particular case.

27. Having examined the authorities relied upon by the parties, we shall now consider the principal objections raised by the Revenue. The foremost contention is that the subject property admittedly constituted a trading asset from the very inception and, therefore, its character could never undergo any legal transformation irrespective of the subsequent events. We are unable to subscribe to such an absolute proposition. There can be no quarrel with the proposition that the original intention with which an asset is acquired constitutes an important factor in determining its character. Equally, however, it is well settled that the issue cannot be concluded by reference to that factor alone if subsequent events of an extraordinary nature fundamentally affect the manner in which the commercial rights embedded in that asset can thereafter be exercised. The authorities discussed hereinabove consistently recognise that the Court must have due regard to the commercial realities prevailing during the relevant period. In the present case, after execution of the Joint Development Agreement, the assessee had already transferred its development rights and was left with a contractual entitlement which remained incapable of commercial enjoyment for almost a decade because of supervening circumstances wholly beyond its control. It is this exceptional factual feature which, in our considered opinion, distinguishes the present case from an ordinary transaction involving a trading asset held as part of the circulating capital of a real estate developer.

28. The second objection of the Revenue proceeds on the footing that the delay in implementation of the project, however prolonged, merely represented a commercial risk incidental to the assessee’s business and, therefore, could not alter the taxability of the gains. Here again, we are unable to accept the submission in the broad manner canvassed. The material on record demonstrates that the project remained stalled because of a combination of environmental issues, statutory impediments, encroachments, disputes involving the developer and its lender and other supervening circumstances over which the assessee admittedly had no effective control. More importantly, under the terms of the Joint Development Agreement, the assessee did not possess any contractual liberty to unilaterally terminate the arrangement or retrieve the commercial rights already transferred thereunder. Thus, the prolonged inability to commercially exploit the rights was neither voluntary nor the consequence of any conscious commercial strategy adopted by the assessee. It is this involuntary and prolonged sterilisation of the commercial rights, viewed cumulatively with the surrounding circumstances, which constitutes the distinguishing feature of the present case and which weighed with the learned CIT(A.) while directing assessment of the gains under the head “Capital Gains.”

29. The next objection of the Revenue is that the assessee acquired the reversionary rights from M/s Skyline Mansions Pvt. Ltd. only on 17.09.2018 and, therefore, an altogether fresh asset came into existence immediately before its transfer on 18.09.2018, thereby excluding the possibility of applying the doctrine of prolonged sterilisation. We are unable to persuade ourselves to accept the aforesaid contention. As noticed in the preceding paragraphs, the assessee had acquired the leasehold rights and the corresponding development rights much earlier and had, pursuant to the Joint Development Agreement, transferred the development rights while retaining the contractual entitlement flowing therefrom. Those rights continued to subsist in law, albeit remaining incapable of commercial exploitation because of the contractual framework of the Joint Development Agreement and the supervening circumstances which prevented the project from being implemented. Upon termination of the Joint Development Agreement, the contractual restraints came to an end and the pre-existing rights stood restored. The acquisition of the reversionary rights on 17.09.2018 merely completed and consolidated the existing bundle of rights so as to confer complete and marketable title upon the assessee. It did not bring into existence an altogether new commercial asset de hors the rights which had already vested in the assessee for several years. The subsequent transfer, therefore, was of the consolidated bundle of rights and not of a newly created asset coming into existence for the first time on 17.09.2018.

30. We also find no merit in the Revenue’s submission that the appreciation in the value of the property during the intervening period was merely the result of market forces and, therefore, necessarily retained the character of business profits. Such an argument overlooks the peculiar factual matrix obtaining before us. The learned CIT(A.) has not proceeded on the premise that mere appreciation in value converts a trading asset into a capital asset, nor has he laid down any proposition of general application. The foundation of the impugned order rests upon the cumulative effect of several exceptional circumstances, namely, the transfer of the development rights under the Joint Development Agreement, the prolonged inability to commercially exploit the contractual rights for almost a decade, the absence of any contractual right with the assessee to terminate the arrangement, the involuntary nature of the blockage, the eventual restoration of the rights upon termination of the Joint Development Agreement and the acquisition of the reversionary rights which completed the bundle of proprietary interests. It is this combination of exceptional facts, viewed in the light of the commercial principles recognised in the judicial precedents discussed hereinabove, that persuaded the learned CIT(A.) to direct assessment of the gains under the head “Capital Gains”. We find ourselves in agreement with the said approach. Our concurrence is founded not upon any abstract proposition that prolonged delay, by itself, changes the character of a trading asset, but upon the cumulative appreciation of the extraordinary facts peculiar to the present case.

31. In the light of the foregoing discussion, we are of the considered opinion that the learned CIT(A.) has correctly appreciated both the factual matrix and the governing legal principles. We have already rejected the assessee’s additional grounds seeking to treat the receipt as a non-taxable capital receipt. Equally, for the reasons discussed hereinabove, we find no infirmity in the conclusion of the learned CIT(A.) that, in the peculiar facts and circumstances of the present case, the gains arising from the transfer effected on 18.09.2018 are liable to be assessed under the head “Capital Gains” and not under the head “Profits and Gains of Business or Profession.” The Revenue has not been able to demonstrate any factual or legal error in the reasoning adopted by the learned CIT(A.) warranting our interference. We, therefore, uphold the impugned finding on the principal issue and dismiss the grounds raised by the Revenue.

32. Having upheld the order of the learned CIT(A.) on the principal controversy and dismissed the Revenue’s appeal on that issue, we shall now proceed to examine the remaining grounds urged by the assessee relating to the disallowance under section 40(a)(ia), the provision created towards removal of encroachments and settlement of boundary disputes, and the ground concerning health and education cess.

33. The next grievance raised by the assessee relates to the disallowance made under section 40(a)(ia) of the Act in respect of the value of the land proposed to be handed over to MCGM. The Assessing Officer invoked the provisions of section 40(a)(ia) while computing the income under the head “Profits and Gains of Business or Profession”, and the said disallowance came to be sustained by the learned CIT(A.). The learned counsel submitted that once the principal issue has been decided in favour of the assessee and the gains arising from the transfer of the subject property have been held to be assessable under the head “Capital Gains”, the provisions of section 40(a)(ia), which form part of the computation mechanism applicable to business income under Chapter IVD of the Act, would have no application. The learned Departmental Representative, though supporting the orders of the authorities below, fairly submitted that the issue would necessarily follow the ultimate determination of the head under which the income is assessable.

34. We have considered the rival submissions. The disallowance contemplated under section 40(a)(ia) is a computation provision applicable while determining income chargeable under the head “Profits and Gains of Business or Profession.” Once we have upheld the finding of the learned CIT(A.) that the gains arising from the impugned transfer are assessable under the head “Capital Gains”, the very foundation on which the impugned disallowance rests no longer survives. The computation of capital gains is governed by a separate and self-contained statutory scheme contained in sections 45 to 55A of the Act, and the provisions of section 40(a)(ia) cannot be imported into that computation. Consequently, irrespective of the merits of the disallowance under the business head, the same cannot survive after the income itself has been held to be assessable under a different head. We, therefore, direct the Assessing Officer to delete the disallowance made under section 40(a)(ia). The corresponding ground raised by the assessee is accordingly allowed.

35. The next issue relates to the disallowance of the provision created towards compensation payable for removal of encroachments and settlement of boundary disputes. The learned counsel submitted that the existence of encroachments and boundary related disputes is not in dispute and that, under the terms governing the transfer, the assessee was required to convey a clear and marketable title to the purchaser. It was submitted that the provision represented a commercial estimate of the liability which had accrued in connection with removal of encroachments and settlement of the boundary disputes and that the expenditure had a direct and proximate nexus with the transfer of the capital asset. The learned Departmental Representative, on the other hand, submitted that the liability had not crystallised during the relevant previous year and that, in any event, the quantum claimed by the assessee had not been substantiated by satisfactory evidence.

36. We have carefully considered the rival submissions. In principle, we find considerable merit in the contention of the assessee that expenditure genuinely incurred, or liability genuinely undertaken, for removal of encroachments or settlement of boundary disputes, where such expenditure is directly and intrinsically connected with conveying a clear, marketable and unencumbered title to the purchaser, cannot be excluded from consideration merely because it has been claimed by way of a provision. The allowability of such claim has to be examined on the basis of its real nature, the stage at which the liability crystallised and its direct nexus with the transfer. At the same time, the precise quantum allowable necessarily requires verification on the basis of the contemporaneous agreements, supporting documents and other material evidencing the crystallisation of the liability and its direct connection with the transfer. Since the authorities below examined the issue in the backdrop of computation under the head “Profits and Gains of Business or Profession”, and not from the perspective of computation under the head “Capital Gains”, we consider it appropriate to restore this limited issue to the file of the Assessing Officer. We accordingly uphold the assessee’s claim in principle, but remit the matter to the Assessing Officer solely for the limited purpose of verifying the quantum and the supporting evidences, after affording reasonable opportunity of being heard to the assessee. The assessee shall extend full cooperation and place all relevant material before the Assessing Officer. This ground is treated as allowed for statistical purposes.

37. The remaining ground relates to the disallowance of health and education cess. At the time of hearing, the learned counsel did not press the said ground. The same is, accordingly, dismissed as not pressed.

38. In the result, the additional grounds raised by the assessee seeking to treat the impugned receipt as a non-taxable capital receipt stand rejected. The Revenue’s challenge to the order of the learned CIT(A.) directing assessment of the gains under the head “Capital Gains” also fails and is accordingly dismissed. In the assessee’s appeal, the ground relating to the disallowance under section 40(a)(ia) is allowed, the issue relating to the provision created towards removal of encroachments and settlement of boundary disputes is restored to the file of the Assessing Officer for the limited purpose indicated hereinabove, and the ground relating to health and education cess is dismissed as not pressed.

nabove.