Capital restructuring and waiver of loan and interest- some aspects about account and taxation.

[C.A. DEV KUMAR KOTHARI]

Loan

Any amount of loan is received on capital account and not as revenue. Loan is received in consideration of promise or undertaking to repay the loan with or without interest. When a loan is received, the cash or bank balance increases and on the same time liabilities also stands increased with the same amount. Then the liability also goes on increasing on account of interest if it is not paid. Interest paid on loan taken may be allowed as an expenditure, however, repayment of loan is not an allowable expenditure. Therefore, receipt as well as repayment of loan both are transactions which are not on account of revenue but on capital account. Loan is considered as borrowed capital in the context of accounting, taxation and general commercial practices. Therefore, any amount of loan cannot be considered as income under any commercial and accounting principals and it cannot be deemed as income under tax laws except under some special circumstances like application of S. 68 when the source of loan is not satisfactorily explained and it is deemed as income of assessee.

Waiver of loans principal amount:

Some time due to difficulties in the business or financial affairs of the borrowers, the money lender may waive some amount of principal of loan. This may be an exercise to recover as much as possible or in an attempt to revive the business of the borrower so that in future further business can be carried out with them. In case of loan by promoter of borrower companies the promoters as well as banks and financial institutions some time waive loan to restructure the company for viability in future.

Interest waiver only allowed portion will be taxable:

In case interest is earlier charged and then waived, the waiver of interest may be considered as taxable income u/s 41 or as per general commercial accounting. However, if interest was earlier not claimed and allowed then the waiver of such un allowed interest will also not be taxable. The interest may remain un allowed due to several reasons like capitalization in account, or disallowance u/s 43B or a part of interest may be disallowed under any specific provision like section 40A (8), or it may have been disallowed for reason of not for business purpose (like for earning tax free income) or for higher rate paid to related persons etc.

Interest waiver will be taxable only if it was allowed against the taxable income under the Income-tax Act, 1961.

Therefore, in case of waiver of interest, a close examination is required to ascertain whether interest was disallowed in earlier years or it was not at all claimed in earlier years.

Waiver of principal amount:

As discussed earlier principal amount of loan can never be claimed as an allowable expenses. Therefore, if a waiver of principal amount is availed then the waiver of principal amount shall not be in nature of income from business or other operations of the businessman. As per general commercial understanding, the waiver of interest is on capital account and it should therefore be credited to capital reserves account and not the profit and loss account.

Section 41:

Section 41 applies when any expenditure or deduction has been allowed in earlier years and then the assessee get a waiver or remission or benefit in respect of the same. Fro scope of the chargeable items and specific circumstances the readers may refer to the section. In the conte3xt of this write-up it is just enough to say that the precondition to treat any such remission or waiver is that the trading liability should have been allowed in any earlier years.

Un-necessary litigation by revenue:

The rule is very clear that a waiver of principal amount of loan is not in nature of income. However, the revenue is sometimes indulging in un-necessary litigation and treating such waiver as income liable to tax in normal computation and / or in book profit.

Recent case:

In CIT V Tosha International Ltd 2008 TMI -30879 (Delhi) matter about waiver of principal amount of loan came for consideration.

In this case the assessee company had suffered huge losses in its new project to manufacture picture tubes for televisions and computer monitors. The company was declared sick unit by BIFR , in terms of rehabilitation scheme approved by consortium financial institutions and bankers the  assessee company  was granted waiver of the principal amount of loan. The assessee company has rightly credited such waiver to the Capital Reserve Account.  However, the AO disputed and considered that since the loans ceased to exist, this amounted to cessation of liability. Therefore the AO made addition to the income of assessee company.

On consideration of the accounting principals as well as provisions of section 41 the CIT(A)  deleted the addition by observing that the remission of the principal amount of loan did not amount to income under Section 41 (1) nor under Section 28 (iv) nor under Section 2(24) of the Income Tax Act, 1961 (hereinafter referred to as the "said Act").

It appears that the learned CIT(A) noted that there was no remission of a trading liability which was allowed as a deduction while computing income in any earlier year, therefore S. 41 is not applicable. A remission would become income u/s 41(1) only if assessee has claimed (and has been allowed) a deduction in respect of expenditure or trading liability in any earlier year. Therefore it was  held that remission of the principal amount of loan didn't amount to income  because the principal amount never entered in the profit and loss account as an item of expenditure and it never entered as an allowable deduction from taxable income. It was also held not taxable u/s 28 because the waiver was not as a result of carrying on business and it was in any case not on account of revenue but on capital account.

On revenue's appeal before the Tribunal, the appeal was decided against the revenue and in favor of the assessee. The High Court observed that the "Tribunal has examined the case in detail and particularly from the standpoint of the provisions of Section 41 (1) of the said Act. The Tribunal has observed as under:-

             "As per our considered view, for attracting the provisions of Section 41 (1), the first requisite condition to be satisfied is that the assessee should have got deduction or benefit of allowance in respect of loss, expenditure or trading liability incurred by it and subsequently during any previous year, the assessee should have received any amount in respect of such loss, expenditure or trading liability by way of remission or cessation thereof. The remission would become income only if the assessee has claimed deduction in respect of expenditure or trading liability. In Mahindra and Mahindra Ltd. Vs. CIT, Hon'ble High Court of Bombay 261 ITR 501, held that no allowance or deduction having been allowed in respect of loan taken by assessee for purchase of capital assets, Section 41 (1) was not attracted to remission of principal amount of loan. In the instant case, the assessee has not got any deduction on account of acquisition of capital assets as the same has been reflected in the balance sheet and not in the P and L account, and also the remission of the principal amount of loan so obtained from the bank and financial institution had not been claimed as expenditure or trading liability in any of the earlier previous year. So far as waiver of interest is concerned, the assessee company itself has treated the same either as income or has not claimed the same as expenditure in the computation of income filed before the lower authorities."

The court further held in paragraph 4 that "We see no reason to interfere with the conclusions of the Tribunal as the same have been rendered on a correct appreciation of law. The principles enunciated in Mahindra and Mahindra Limited v. CIT: 261 ITR 501(Bom) are fully applicable and we see no reason to take a different view.

Therefore the Court held that, no substantial question of law arises for our consideration hence the appeal was dismissed.

Conclusion:

Principal amount of loan waived by money lenders is not taxable as income as it was a capital receipt when received, and it was not allowed as an expenditure or trading liability in past.

Only interest which was actually allowed in computing taxable income will be taxable. If interest was not allowed for any reason, then un allowed interest will not be taxable as income u/s 41.  

Practice support:

Principal waiver is on capital account, therefore it should be credited to a separate account like "Capital Restructuring Reserve" under the head capital reserves.

Interest waived which is pertaining to earlier years cannot be considered as income or result of the working of the company for the accounting period. Therefore, such waiver should not be credited in the profit and loss account but should be credited to a separate reserve account like "Rehabilitation Reserve" under head  capital reserves.

Interest waived  pertaining to earlier years which was debited in profit and loss or otherwise claimed and allowed in earlier years is deemed as income u/s 41 only to the extent it was allowed. Any un allowed interest will not be taxable. Therefore, the aspect of allowed/ un allowed interest need to be carefully examined. The amount which was allowed only should be mentioned in clause 20 of Form 3CD in the Tax audit report.