Advance returns can't be contractee's income

T. N. Pandey | Updated on: Sep 18, 2011

The Supreme Court has said that income, which is earned, is to be taxed and not that, which could have been earned, but not earned.

A film actor, AR, is reported to have walked out, on mutual understanding basis, from a film contract because of personal reasons and returned the advance taken (signing amount) to the filmmaker. A view has been expressed that the actor may be liable to pay tax on the advance returned on various grounds such as diversion of income after it was earned or as an expenditure of a capital nature to save her goodwill or a payment guided by good conscience – not business prudence, etc. The amount returned is refund of advance taken, which is the most important ground for saving tax liability.

The situation needs examination from the angle of Indian Contract Act (ICA) and Income-Tax Act, 1961 (ITA).

In a contract, the agreement made is enforceable in law – each party to the contract, being legally bound to perform his/her obligations.

Obligations under law

However, the person, entitled to the performance of the contract, can dispense with the performance. In such a situation, the contract gets terminated. Obviously, by taking the advance back, the promisee has agreed not to insist on performance. Hence, the obligations as far as ICA is concerned, ceased.

As far as ITA is concerned, the amount refunded cannot be considered as expenditure u/s 37 of the Act - payment by way of diversion of income already earned. Expenditure implies expense and expense is money laid out by way of spending – paying out or away and is something gone out irretrievably. Diversion implies obligation to apply income in a particular way before it accrues or arises or is received. Obviously, this is not the situation in AR's case. The amount has been returned after it has been received. Tax liability cannot be tagged on these grounds.

Advance received and returned cannot constitute income

Over the years, the premise accepted for income taxation is the concept of ‘real income' i.e. the real commercial result of a particular action taken by an income-earning person.

Equally so, in trying to determine whether a certain transaction results in real profit or gain, the concepts of profit or gain are to be considered from commercial angles to the person, who enters into the transactions, and not from any narrow, technical or legalistic view.

True, when AR received the advance, it was in the nature of commercial receipt, but when she decided to abandon the contract/arrangement, because of some personal problem, and returned the advance received with mutual understanding, the contract or arrangement ended and no income or profit could be said to arise to AR.

Real income premise

Courts after courts have held that income-tax is a tax on the real income i.e. profits arrived at on commercial principles, barring some situations when it is legislatively deemed to arise [see (1965) 57 ITR 521 (SC)]. In this case, it has been categorically stated by the apex court that what is assessable is real income and the same cannot be arrived at without taking into account the amount genuinely foregone by the assessee. It cannot be proper to think that the principle of real income is so subordinated as to amount virtual negation of it, when surrender or concession or rebate is made on grounds of commercial expediency. It has been held that in examining any transaction and situation of the nature under discussion, regard is to be had to the reality, speciality and business aspects of the situation rather than purely theoretical or doctrinaire aspects. In CIT v. A. Raman & Co., 67 ITR 11 (SC), the Supreme Court has said that income, which is earned, is to be taxed and not that, which could have been earned, but not earned. Hence, the amount refunded by AR to the filmmaker, because of abandonment of contract, cannot constitute her income for taxation under ITA. No amendment of law is needed for such situations.

(The author is a former chairman of CBDT.)

Published on September 18, 2011
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