EY Tax Alert. Executive summary. Supreme Court rules on characterization of property rental income as income from house property.

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1 16 May 2017 EY Tax Alert Supreme Court rules on characterization of property rental income as income from house property Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarizes a recent ruling of the Supreme Court (SC) in the case of Raj Dadarkar & Associates (Taxpayer) [1], wherein the issue before the SC was whether property rental income received by the Taxpayer was assessable under the head Income from House Property (House Property head) or the head Profits and Gains from Business or Profession (Business Income head). The characterization of the head of income is critical under the Indian Tax Laws (ITL), as it determines the methodology of computation of taxable income. Generally, assessment under the Business Income head leads to lower taxable income due to depreciation allowance and deduction for expenses. In the present case, the Taxpayer, a partnership firm, was set up with the object of taking premises on rent and sub-letting the same. It acquired certain premises on long-term lease and developed them into a marketplace by constructing shops and stalls. The units were sub-let with certain amenities such as electricity, sanitation, security, water etc. A part of the monthly amount was collected as service charges. The taxpayer claimed its income from rent and service charges as taxable under the Business Income head on the basis of earlier SC rulings in the cases of Chennai Properties & Investments (Chennai Properties ruling) [2] and Rayala Corporation Pvt. Ltd [3]. (Rayala Corporation ruling), wherein the SC had held that where the main object of the taxpayer as per its Memorandum of Association (MoA), as also the actual activities carried on by the taxpayer, comprised only acquisition and holding of properties and letting them out, the property rental income is assessable under the Business Income head. [1] Civil Appeal No of 2017 [2] [(2015) 373 ITR 673 (SC)] [3] [TS-437-SC-2016]

2 The SC, in the present case, held that the object clause of the business is not a determinative factor to arrive at the conclusion that the income is income from business and that classification depends on the facts of each case. The SC noted that, as per the undisputed finding of facts, the Taxpayer was not engaged in any systematic or organized activity of providing services to the occupiers so as to constitute its income as income from business. Also, the Taxpayer did not furnish sufficient material to show that its entire income or substantial income was from letting out of the property so as to constitute the principal activity of the Taxpayer. On the facts of the case, the SC concluded that the facts on hand were distinguishable compared to its earlier ruling in the case of Chennai Properties, while the facts were comparable to its earlier ruling in the case of East India Land Development Trust (East India ruling) [4], wherein property rental income was assessable under the House Property head, as the core or main object and activity of the company was not letting out of property but developing and setting up of markets. As compared to the House Property head, the Business Income head permits depreciation allowance and deduction for a large number of expenses. This usually results in taxable income being lower than the one computed under the House Property head. The question which has been a subject matter of debate for a while is whether rental income earned by a taxpayer from letting out the properties held by it as an owner would be taxable under the House Property head or the Business Income head. Tests which are to be applied for determining the real nature of income are laid down in judicial decisions on the interpretation of the provisions of these two heads. The judicial developments on this controversy may be traced as under: In the East India ruling, the taxpayer was incorporated with the object of buying and developing landed properties and promoting and developing markets. It earned rental income from some of the shops and stalls developed by it. The SC held that property rental income, in these facts, was assessable under the House Property head, as the core or main object and activity of the company was not letting out of property but developing and setting up of markets. Judicial developments The ITL classifies income under five heads and provides the methodology of computation of taxable income under each head. The House Property head is attracted for property rental income in a case where a taxpayer is the owner or deemed owner of [5] the property, other than properties which the taxpayer may occupy for the purposes of any business or profession carried on by it. Under this head, the ITL merely permits a standard deduction [6] and deduction for certain specified expenses (including interest). [4] [(1961) 42 ITR 49 (SC)] [3-judge Bench] In Sultan Brothers (P) Ltd [7]. (Sultan Brothers ruling), the taxpayer was incorporated with the object of acquiring land and buildings and turning them into account by construction and reconstruction, decoration, furnishing and maintenance, and by leasing and selling the same. The taxpayer owned a building which it furnished with furniture and fittings for being run as a hotel and let out the fully equipped building to another party for running the hotel. The SC considered the letting out activity as incidental to the development of the hotel building. The SC held that the activity of leasing did not, by itself, constitute a core business activity. The SC relied on its earlier ruling in the case of East India and held that the property rental income, though from a commercial asset, was assessable under the House Property head. [5] Including special circumstances under which a taxpayer is deemed to be owner of the house property for the purposes of the ITL (Illustratively, transfer of property by way of lease for a term of not less than twelve years) [6] Currently 30% of rental income (net of property taxes paid) [7] [(1964) 51 ITR 353 (SC)][ 5-judge Bench]

3 In the Chennai Properties ruling, there was letting out of bare premises. However, having regard to the fact that the main object of the taxpayer as per its MoA), as also the actual activities carried on by the taxpayer, comprised only acquisition and holding of properties and letting them out with no other activities being carried on by the Taxpayer, the SC held that owning and letting out of properties was part of the taxpayer s core trading operations and, hence, the property rental income was assessable under the Business Income head [8]. The SC distinguished its earlier rulings in the cases of East India and Sultan Brothers on the ground that, in those cases, the main objective of the company was never letting out of properties, but developing and setting up the properties. Facts of the case The Taxpayer is a partnership firm registered with the main object, as borne out by its partnership deed, of: (a.) Acquiring premises on rent and subletting the same; or (b.) Undertaking any other business activity. The Taxpayer, in a bid, acquired the ground floor of buildings constructed by the Maharashtra Housing and Area Development Authority (MHADA) on a monthly license in the form of a right to run and maintain the municipal market in the said area. The premises allotted to the Taxpayer was a bare structure with pillars and columns and the Taxpayer converted the area into 95 shops and 30 stalls of different carpet areas by constructing walls, common amenities like toilet blocks, etc., at a substantial cost. The Taxpayer also obtained the necessary licenses under the Shops and Establishment Act and other permissions from the Government to carry on trading activities on the said premises. [8] To the similar effect, the SC ruling, in the case of Rayala Corporation (P) Ltd. [TS-437-SC-2016], which applied the ratio of the SC in the Chennai Properties ruling Additionally, the Taxpayer was responsible for the day-to-day maintenance, cleanliness and upkeep of the market premises and incurred expenses on water charges, electricity charges, taxes and repair charges. The Taxpayer sub-licensed the premises to small vendors and businessmen and collected the following receipts as consideration for the sub-licensing activity: Compensation for sub-license representing monthly charges payable by the Taxpayer to MHADA. Leave and license fees. Service charges for providing various services, including security, utilities etc. The Taxpayer had been offering the income from the sub-licensing activity under the Business Income head and the income had been assessed accordingly. However, for the tax year , the Tax Authority assessed the sub-licensing income of the Taxpayer under the House Property head on the ground that the Taxpayer was deemed owner of the property and the income received from the market stalls was income from house property. The First Appellate Authority ruled in the Taxpayer s favor and upheld assessment under the Business Income head. On further appeal by the Tax Authority, the Mumbai Income Tax Appellate Tribunal (Tribunal) ruled in favor of the Tax Authority. On further appeal by the Taxpayer, the Bombay High Court (HC) upheld that the Taxpayer acquired the properties to be developed and used as a marketplace on a license basis for a period of more than twelve months, thereby making the Taxpayer deemed owner of the property for income tax purposes to trigger taxation under the House Property head. Being aggrieved, the Taxpayer further appealed to the SC.

4 Issue before the SC The following are the main questions considered by the SC: 1. Whether the order of the Tribunal was perverse, being based on surmises, conjectures and suspicions by taking into account incorrect, irrelevant and extraneous considerations. 2. Whether the license income earned by the Taxpayer was required to be taxed under the House Property head or the Business Income head. Taxpayer s contentions Consistent with the chartered document of the Taxpayer, the main object of the Taxpayer was to take the premises on rent and sub-let the same. The subletting of the premises was a part of the predominant object and, thus, constituted the business of the Taxpayer. Income earned from sublicencing is business income. The sole intention of the Taxpayer was to establish a retail hub wherein various small retailers could come together and carry on their businesses in an organized and systematic manner. Sub-licensing was the sole activity of the Taxpayer and the Taxpayer maintained full and complete records of these business activities. Right from the year 1999 to 2004, the Taxpayer has been offering the sublicensing income under the Business Income head. The HC s ruling restricted itself to determination of the issue of whether the Taxpayer qualified to be deemed owner of the premises and omitted to consider the contention that the main business of the Taxpayer was to take premises on rent and sub-let the same to earn income therefrom. Even if the Taxpayer is deemed owner of the premises, as the letting out activity is the main business activity of the Taxpayer, applying the dominant test, the income generated from sub-licensing should be treated under the Business Income head, and not under the House Property head. The Taxpayer s case is covered by the ratio of the SC s rulings in the Chennai Properties and Rayala Corporation cases. SC s ruling The SC ruled against the Taxpayer and held that, considering the facts of the Taxpayer s case, property rental income received by the Taxpayer was assessable under the House Property head for the following reasons: Characterization of income from house property or as business income depends upon the facts of a particular case. The test to be applied is: (a.) If there is income from leasing out of premises and collecting rent, normally, such income would be treated under the House Property head if the taxpayer is the owner of such building or land appurtenant thereto. (b.) Under certain circumstances, however, the income derived from letting out of premises can be treated as business income if the letting out activity itself is the business of the taxpayer. The object clause of the business is not a determinative factor to arrive at the conclusion that the income is income from business. Classification would still be dependent on the facts of each case. For this proposition, the SC relied on its earlier rulings in the East India and Sultan Brothers cases. The Tribunal, the ultimate fact-finding authority, had found that the service charges received were inseparable from the basic charges of rent. The SC s decision in the case of Shambu Investments Pvt. Ltd., was held applicable by the Tribunal. Also, it was undisputed that the Taxpayer did not undertake any systematic or organized activity of providing services to the occupiers, which can constitute receipt

5 as business income for the Taxpayer. These finding of fact attained finality. Apart from relying upon the object clause in the partnership deed, the Taxpayer did not furnish any material to substantiate that its entire income or substantial income was from letting out of the property as the principal business activity. The decision applicable to the facts of the case is that of the SC in the East India case. In the East India ruling, rent income was earned by the taxpayer which was formed with the object of developing landed properties. The income was taxed under the House Property head, as it was received by the company whose object was and which had undertaken the activity of developing and setting up of the properties. The Taxpayer s reliance on the SC decisions in the Chennai Properties and Rayala Corporation cases was of no help. In those cases, the taxpayer s income was entirely from letting out of properties, which was the business of the taxpayer. In the present case, the Taxpayer could not establish that its substantial income was from letting out of the property, which was its principal business activity. Comments On the facts of the case, the SC held that income earned by the Taxpayer, including incidental service charges, was chargeable as house property income. While observing that the object clause of the entity was not conclusive, the SC, in the present case, held that the object of the Taxpayer was to take premises on rent and sub-let the same. The SC also noted that there was no dispute on the proposition that the Taxpayer had not undertaken any systematic or organized activity of providing services and the services so provided were inseparable from the basic letting out of the property. The SC, on facts, concluded that its earlier rulings in the Chennai Properties and Rayala Corporation cases were distinguishable. The SC s decision, along with its earlier rulings referred above, will need critical attention by taxpayers earning property income. The tax implications of property income may get significantly influenced by its characterization as business or property income.

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