India: Cessation Of Trading Liability Under Income Tax Act, 1961

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. A genuine Trading Liability incurred in the course of Business or Profession is a permissible expenditure, in the relevant financial year, under the applicable provisions of the Income Tax Act, 1961, however when some benefit is derived by the Debtor in the form of remission or cessation of such trading liability, then such benefit received by the debtor is to be considered as a Taxable Income under Section 41(1) of the Income Tax Act, 1961. Section 41(1) deals with considering ceased trading liability as deemed profits of business or profession.

SECTION 41(1) OF THE INCOME TAX ACT, 1961

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 assessee (hereinafter referred to as the first-mentioned person) and subsequently during any previous year –

a. the first-mentioned person has obtained, whether in cash or in any other manner whatsoever, any amount in respect of such loss or expenditure or some benefit in respect of such trading liability by way of remission or cessation thereof, the amount obtained by such person or the value of benefit accruing to him shall be deemed to be profits and gains of business or profession and accordingly chargeable to income-tax as the income of that previous year, whether the business or profession in respect of which the allowance or deduction has been made is in existence in that year or not; or

b. the successor in business has obtained, whether in cash or in any other manner whatsoever, any amount in respect of which loss or expenditure was incurred by the first-mentioned person or some benefit in respect of the trading liability referred to in clause (a) by way of remission or cessation thereof, the amount obtained by the successor in business or the value of benefit accruing to the successor in business shall be deemed to be profits and gains of the business or profession, and accordingly chargeable to income-tax as the income of that previous year.

Explanation 1 - For the purposes of this subsection, the expression "loss or expenditure or some benefit in respect of any such trading liability by way of remission or cessation thereof" shall include the remission or cessation of any liability by a unilateral act by the first mentioned person under clause (a) or the successor in business under clause (b) of that sub-section by way of writing off such liability in his accounts.

Explanation 2 - For the purposes of this subsection, "successor in business" means –

i. where there has been an amalgamation of a company with another company, the amalgamated company;

ii. where the first-mentioned person is succeeded by any other person in that business or profession, the other person;

iii. where a firm carrying on a business or profession is succeeded by another firm, the other firm;

iv. where there has been a demerger, the resulting company.

SCOPE OF SECTION 41(1)

In the case of The Commissioner of Income Tax-III Shri Vardhman Overseas Ltd, ITA NO.774/2009, Date of Decision: 23.12.2011, Division Bench of Hon'ble High Court of Delhi, made the following Observation with regards to Section 41(1):

"The provisions of Section 41(1) have been specifically incorporated in the Act to cover a particular fact situation. The section applies where a trading liability was allowed as a deduction in an earlier year in computing the business income of the assessee and the assessee has obtained a benefit in respect of such trading liability in a later year by way of remission or cessation of the liability. In such a case the section says that whatever benefit has arisen to the assessee in the later year by way of remission or cessation of the liability will be brought to tax in that year. The principle behind the section is simple. It is a provision intended to ensure that the assessee does not get away with a double benefit once by way of deduction in an earlier assessment year and again by not being taxed on the benefit received by him in a later year with reference to the liability earlier allowed as a deduction."

Liability is barred by limitation but there are cases where a liability is being carried forward for years in the books of assessee. In such cases, the Income Tax Authorities have considered the liability as ceased/non existent, because of the fact that the liability is being shown outstanding for many years and the assessee has not provided confirmations from the creditors or has failed to provide necessary details like PAN/Address of the creditors or there is no possibility of the creditors claiming their debts in future and applied section 41(1) of the Income Tax Act, 1961 by adding the liability to the taxable income of the debtor. However, the Judicial fora has consistently held that a liability cannot be treated as ceased merely because of the fact that the liability is being carried forward for years and the assessee is not completely able to prove the genuineness of the trading liability, at the time of application of Section 41(1) by the Income Tax Authorities.

In a recent case1 decided by division bench of Hon'ble Delhi High Court, the following observation was made with regards to Cessation of liability under Section 41(1) of the Income Tax Act, 1961.

"It is well settled that reflecting an amount as outstanding in the balance sheet by a company amounts to the company acknowledging the debt for the purposes of Section 18 of the Limitation Act, 1963 and, thus, the claim by M/s Elephanta Oil & Vanaspati Ltd. can also not be considered as time barred as the period of limitation would stand extended. .................. It is well settled that in order to attract the provisions of Section 41(1) of the Act, there should have been an irrevocable cession of liability without any possibility of the same being revived. The assessee company having acknowledged its liability successively over the years would not be in a position to defend any claim that may be made on behalf of the liquidator for credit of the said amount reflected by the assessee as payable to M/s Elephanta Oil & Vanaspati Ltd.

We may also add that, admittedly, no credit entry has been made in the books of the assessee in the previous year relevant to the assessment year 2008- 2009. The outstanding balances reflected as payable to M/s Elephanta Oil & Vanaspati Ltd. are the opening balances which are being carried forward for several years. The issue as to the genuineness of a credit entry, thus does not arise in the current year and this issue could only be examined in the year when the liability was recorded as having arisen, that is, in the year 1984-1985. The department having accepted the balances outstanding over several years, it was not open for the CIT (Appeals) to confirm the addition of the amount of 1,53,48,850/- on the ground that the assessee could not produce sufficient evidence to prove the genuineness of the transactions which were undertaken in the year 1984- 85."

In another case2 decided by the Hon'ble Income Tax Appellate Tribunal, Ahmedabad Bench, the following observation was made with regards to Cessation of liability under Section 41(1) of the Income Tax Act, 1961.

"Considering the facts of the case as noted above it is clear that the assessee had continued to show the admitted amounts as liabilities in its balance sheet. The liabilities reflected in the balance sheet cannot be treated as cessation of liabilities. Merely because the liabilities are outstanding for last many years, it cannot be inferred that the said liabilities have ceased to exist. It is also a fact that the assessee has not written off the outstanding liabilities in the books of account and the outstanding liabilities are still in existence would prove that the assessee acknowledged his liabilities as per the books of account. Section 41(1) of the IT Act is attracted when there is cessation or remission of a trading liability. The AO shall have to prove that the assessee has obtained the benefits in respect of such trading liabilities by way of remission or cessation thereof. Merely because the assessee obtained benefit of deduction in the earlier years and balances are carried forward in the subsequent year, would not prove that the trading liabilities of the assessee have become non-existent. It may also be noted here that the assessee has not claimed any deduction of the expenditure in all the assessment years under appeal."

CONCLUSION

If a Trading Liability is being shown by an assessee in his books for years it cannot be considered as ceased merely because of the facts that it is being shown for years and the assessee is unable to provide confirmation from the editors or other details from the creditors or the possibility of creditors demanding their money back is minimal. The genuineness of the liability if not questioned by the Income Tax Authorities in the assessment year in which the liability incurred by the assessee came up for scrutiny, then it cannot be questioned at the time of applying Section 41(1) by the Income Tax Authorities. Hence, as long as the amount of the liability is not written off in the books by the assessee or there is some benefit derived to the assessee by way of remission or cessation it cannot be added in the income of the assessee under the provisions of Section 41(1) of the Income Tax Act, 1961.

Footnotes

1.The Commissioner of Income Tax Delhi-II vs Jain Exports Pvt. Ltd ,ITA No.235/2013, Judgment delivered on: 24.05.2013 2.Shri Nitin S. Garg vs The A. C. I. T., Circle-4, Surat, ITA No.169, 170, 171 and 172/Ahd/2009, Order Date 04-06-2010

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