Commissioner of Income Tax vs C.D. Karaka

Desai, J.—The Tribunal has referred the following questions of law for our opinion:

Whether, the Tribunal was right in law in holding that the decision to form an association by the said C.D. Karaka, Mrs. J.D. Karaka, M.D. Karaka and Rashne D. Karaka was made for the first time when two buildings were decided to be constructed with the object of earning income by way of rent and not from the time the land was purchased?

Whether, the purchase and sale of land in question was an adventure in the nature of trade and whether, the surplus realised by the sale of the land is taxable as business income in the hands of the association of persons.

Whether, the Tribunal was right in holding that the surplus realised out of the purchase and sale of land in question was taxable as capital gains in the hands of each of the said Shri C.D. Karaka, Mrs. J.D. Karaka, M.D. Karaka, and R.D. Karaka and not in the hands of the association?

The record of the case is comparatively bulky and the three questions project different facts of law. However, after the matter was extensively argued and the questions were examined in depth, the parties agreed that on the facts and in the circumstances of the case and having regard to the legal principles governing the same, the several questions could be answered only in one way, namely, that the association of persons (AOP) consisting of the four Karakas, came into existence some time in 1961 and that the object of the AOP was not only to earn income by way of rent by letting out premises in the two buildings situate on sub-plot nos. 2 and 3 and by giving on lease open plot of land between the said two buildings, but also to hold sub-plot no. 1, which continued to remain an open plot till the date of its ultimate sale, and to realise income there from in suitable mode, including by sale thereof, and that the surplus realised on the sale was taxable as capital gains. We are of the view that the parties have fairly and rightly reached a consensus on these points, as would be evident from the brief reasons which we propose to give hereafter. Before we do so, however, the facts may be briefly set out.

C.D. Karaka, M.D. Karaka and R.D. Karaka (minor acting through her guardian, J.D. Karaka) jointly purchased land bearing final plot nos. 181/2, 189/2 and 189/4 comprised in the Ellisbridge Town Planning Scheme No. 3, totally admeasuring 7,405 sq. yards, for a consideration of Rs. 88,860 on 25-4-1956. The consideration was paid in three parts: Rs. 5,000 were paid on 28-2-1956 when the agreement to sell was executed, Rs. 39,430 were paid on 25-4-1956 at the time of the execution of the sale deed and Rs. 44,430 were paid subsequently on 30-4-1957. In addition, an amount of Rs. 2,258 was paid as and by way of interest on the sum of Rs. 44,430, which was paid subsequently. The expenses which the vendees had to bear in connection with the said transaction amounted to Rs. 5,456. The total cost for the purchase of land accordingly came to Rs. 96,574. The three co-purchasers share the total cost of purchase as follows:

Rs.

(1) C.D. Karaka

49,230

(2) M.D. Karaka

23,672

(3) R.D. Karaka

23,672

96,574

On 10-7-1958, C.D. Karaka entered into an agreement with J.D. Karaka for the sale of his half undivided share in the land, at the rate of Rs. 16 per sq. yard. The conveyance in respect thereof was executed on 29-11-1961 for a total consideration of Rs. 29,620. Meanwhile, R.D. Karaka, who was a minor, attained majority on 30-1-1961.

After the land was purchased, the co-owners divided the same into three sub-plots after setting apart 195 sq. yards for roads, etc. Sub-plot no. 1 with which we are concerned herein, admeasured 2,400 sq. yards, sub-plot no. 2 admeasured 2,402 sq. yards and sub-plot no. 3 admeasured 2,400 sq. yards. The Ahmedabad Municipal Corporation accorded sanction to the sub-plotting as aforesaid on or about 2-5-1960.

On 6-4-1960, the three original co-owners obtained permission from the Ahmedabad Municipal Corporation for construction of a residential building on one of the sub-plots. Soon thereafter, permission for non-agricultural use of the land was obtained from the competent authority on 2-5-1960. The permission so obtained covered not only the sub-plot on which the residential building was intended to be put up but also the remaining two sub-plots.

On or about 20-7-1960, the area in which the land was situate was declared as commercial zone by the Ahmedabad Municipal Corporation.

At this stage, an event which chronologically took place earlier requires to be mention ed. Towards the end of 1958, the Life Insurance Corporation of India (LIC), Bombay Zonal Office, had approached C.K. Karaka with a proposal to purchase the land. At that time, Karaka had expressed his unwillingness to sell the land on the ground that a residential building was proposed to be put up on the land for the use of the co-owners. The LIC again approached C.D. Karaka on 3-3-1960 and renewed the proposal for the purchase of land. It is not clear from the record as to what precise response the letter evoked. However, it would not be unreasonable to assume having regard to the events to be presently mentioned, which took place within a short time thereafter, that Karaka must have again turned down the proposal.

The co-owners appear to have decided to construct buildings on plot nos. 2 and 3 soon after the area in which the land was situate was declared as commercial zone. With the end in view of constructing the buildings, the co-owners jointly borrowed a sum of Rs. 7,10,000 as under :

Rs 70 000

from F.D. Gheyara of Surat on 23-9-1961.

Rs 5,00,000

from the, LIC between January 10 and 2-11-1962 against the security of the entire plot of land comprised of three sub-plots and the proposed buildings under the mortgage deed jointly executed by all the co-owners on 10-1-1962.

Rs. 1,40,000

from the Union of India

Rs. 7,10,000

Ultimately, two buildings were constructed in 1961 or 1962 and they came to be named as Karaka Building No. 1 and Karaka Building No. 2.

On 1-12-1962, the co-owners gave on lease a piece or parcel of land admeasuring 983 sq. yards comprised between the two buildings to the Burmah Shell Oil Storage and Distributing Company of India Limited at the monthly rent of Rs. 983. Be it clarified at this stage that sub-plot nos. 2 and 3 came to be occupied by the two buildings together with the piece or parcel of land let out to the Burmah Shell. Sub-plot no. 1, although permission for non-agricultural use thereof was obtained, was not constructed upon or put to any other use, either prior to, at the time or subsequent to the aforesaid user of sub-plot nos. 2 and 3 (sic).

The co-owners started realising income by way of rent from the assessment year 1962-63 onwards. They file returns of income in the status of AOP from the assessment year 1962-63 onwards. The returns disclosed income from ground rent and income from property and interest income. In paragraph 3 of the statement of facts, the Tribunal has given the relevant particulars in this behalf so far as the returns for the assessment year 1962-63 to the assessment year 1967-68 are concerned. So far as the assessment year 1968-69 (previous year, being calendar year 1967), which is the assessment year under consideration, is concerned, we shall give particulars a little later.

On 1-12-1966, by a deed executed by and between the LIC and the four co-owners, sub-plot no. 1, which was mortgaged to the LIC was released from the encumbrance.

On 7-4-1967, the four co-owners entered into an agreement to sell sub-plot no. 1 admeasuring 2,400 sq. yards at the rate of Rs. 180 per sq. yard. The agreement was executed in favour of Vijay Corporation and it stipulated that the conveyance would be completed on or before 5-8-1967. At the time of the execution of the said agreement, C.D. Karaka and others received a sum of Rs. 75,000 as earnest money. The amount received accordingly was credited in the name of Vijay Corporation in the books of the AOP and it was deposited in the bank account operated by the AOP. The time- limit for execution of conveyance was extended from 5-8-1967 to 31-12-1967 by a supplementary agreement executed between Vijay Corporation and the four co-owners on 30-7-1967. On the date of the execution of the supplementary agreement, the four co-owners received a sum of Rs. 75,000 towards sale consideration. The amount received accordingly received the same treatment as was accorded to the sum of Rs. 75,000 received earlier as earnest money. Subsequently, before the conveyance was executed, two sums of moneys were received on two occasions towards sale consideration; Rs. 50,000 were received on 5-11-1967 by the four co-owners and Rs. 32,000 were received by the four co-owners on 20-12-1967. Both the aforesaid amounts also received the same treatment as was accorded to the earnest money. In all, therefore, a sum of Rs. 2,32,000 was received by the four co-owners before the actual conveyance was executed on 28-12-1967. Be it stated at this stage that the rights acquired by Vijay Corporation under the agreement to sell were transferred in favour of Sarita Darshan Co-operative Housing Society Ltd. and under the agreement arrived at between those two parties, the sale price was fixed at Rs. 2.15 per sq. yard. The conveyance was, therefore, made in favour of Sarita Darshan Co-operative Housing Society Ltd. at the rate of Rs. 215 per sq. yard by four separate sale deeds executed by each of the co-owners in his individual capacity. At the time of the conveyance as aforesaid, each co-owner received Rs. 37,500 in cash and post-dated cheques of Rs. 12,500 bearing the date 31-1-1968. The aggregate of the sums of Rs. 37,500 received in cash by each co-owner, that is to say, Rs. 1,50,000, was credited in the name of Vijay Corporation in the books of the AOP and it was credited in the bank account operated by the AOP. After the post-dated cheques, each for the sum of Rs. 12,500 were encashed, the aggregate sum of Rs. 50,000 was again credited in the same way in the books of the AOP and it was paid into the bank account of the AOP. On 31-12-1967, that is to say, the last day of the accounting year, which is the subject-matter of the present reference, certain entries were made in the books of the AOP which are material and which may be referred to at this stage. A sum of Rs. 4,32,000 (total amount of consideration) was debited to the account of Vijay Corporation and corresponding credit entries in the sum of Rs. 1,08,000 each were made in the four individual accounts of the co-owners.

In the return of income for the assessment year 1968-69, the AOP disclosed income from house property, income from ground rent and interest income, totalling up to Rs. 1,51,192. In part IV of the return, the following endorsement was made.

Open land of sq. yards 2,400 have been allotted to members Mr. C.D. Karaka, Mrs. Jeanie D. Karaka, Meher D. Karaka and Rashqe D. Karaka equally and surplus realised on the sale there from have been shown in their respective tax returns.

The return filed accordingly would indicate that the surplus realised on the sale of subplot no. 1 was not returned as the income of the AOP and that it was stated to have been returned as individual income of each co-owner in proportionate share. This is the starting point of the controversy between the assessee-AOP and the revenue.

The ITO called upon the assessee to show cause why the surplus should not be included in its total income for the assessment year 1968-69 and why it should not be taxed as business income arising from an adventure in the nature of trade. The assessee resented the proposed action. The ITO, for the reasons recorded in his order, treated the surplus in the sum of Rs. 3,87,416 as the income of the assessee and brought the same to tax as income arising from an adventure in the nature of trade. As a protective measure, however, he included a sum of Rs. 50,519 as capital gains arising out of the said transaction in the total income of each of the co-owners in his or her individual assessment.

The assessee carried the matter in appeal. The AAC, for the reasons recorded in his order held, that the sale of the land in question was by the assessee and that the assessee had realised the surplus on such sale. The AAC, however, held that the income realised accordingly was not business income arising out of an adventure in the nature of trade and that it was taxable only as capital gains. The sum of Rs. 3,87,460 was accordingly held liable to be taxed in the hands of the assessee as capital gains and consequently, the inclusion of the sum of Rs. 50,519 by way of capital gains made in the individual assessment of each co-owner was deleted.

The decision of the AAC aggrieved both the assessee and the revenue and both preferred appeals before the Tribunal. The Tribunal posed for its consideration three questions, namely, (1) whether there was an association of the four co-owners, the object of which was to produce income, profits or gains; (2) whether the purchase and sale of land in question was an adventure in the nature of the trade, (3) whether the surplus realised by the sale of sub-plot no. 1 was taxable as business income in the hands of the assessee; and (4) whether, if the surplus was not taxable as business income, it was liable to be taxed as capital gains in the hands of the assessee. The Tribunal recorded the following finding in the course of its order, as regards the formation of the AOP: (1) the initial purchase of land by C.D. Karaka, M.D. Karaka and R.D. Karaka in the year 1956 was not with the object or intention of re-selling the same or any portion thereof in view of the fact that the proposal of the LIC with regard to the purchase of the land was turned down and a residential building was proposed to be constructed on a portion of the land; (2) the size and nature and character of the land was not indicative of the intention on the part of the assessee at the time of its purchase to ultimately re-sell the same; (3) whereas the land was purchased in 1956, only a portion (approximately one-third) was sold in 1967; (4) the AOP, therefore, was not formed at the time when the land was purchased; and (5) the AOP came into existence between the four co-owners only when they decided to construct the two buildings with the end in view of letting them out in view of the fact that (a) the decision to put up the construction was taken after the land was included in the commercial zone on 20-7-1960; (b) loans amounting to Rs. 7,10,000 were borrowed thereafter from different parties between 23-9-1961 and 2-11-1962; (c) a small portion of the land was let out to the Burmah Shell on 1-12-1962; (d) the buildings were actually constructed in 1961 or 1962; and (e) the first return of income was filed in the capacity of AOP for the assessment year 1962-63. The Tribunal, in terms found as follows:

There is, therefore, no doubt that so far as the income from the aforesaid two buildings, the ground rent and the interest are concerned, they were earned by the association of persons. We, however, do not agree with Mr. Kothari''s submission that the association was formed right from the time the land was purchased and that it was from the date of purchase of land that the assessees had combined together to earn income by developing the land or by reselling it. In our opinion, the decision to form an association was made for the first time when the assessee decided to construct the aforesaid two buildings and for that purpose raised loans. The association was formed with the object of earning income by letting out premises in the buildings and by giving on lease the plot of land between the two buildings. The idea of selling the land does not appear to be present in the minds of the assessee even at the time when the decision was taken to combine together to earn income as aforesaid.

On the question whether the purchase and sale of land could be held to be an adventure in the nature of trade, the Tribunal found, inter alia, that since normally purchase of land represented investment of money in land and since there was no evidence to indicate that the land was purchased with the intention to resell, the transaction was not an adventure in the nature of trade. The Tribunal also emphasised in this connection, the circumstances that the transaction of initial purchase of the land was an isolated transaction and so also was the transaction of sale.

On the question whether the surplus realised on the sale was taxable in the hands of the AOP as capital gains, the Tribunal held that the AOP which came into existence only when it was decided to construct buildings and to give an open plot on lease, was formed with the limited object of earning income from property, ground rent and interest. There was no evidence to indicate that sub-plot no. 1 on which no construction was made or which was not let out was an asset of the assessee. The mere fact that the said sub-plot of the land was jointly purchased was not sufficient to establish that it was one of the assets of the assessee. The Tribunal in terms recorded the finding that ''the said land never became the asset of the AOP''. Alternatively, the Tribunal held that ''even if the land was at one time asset of the AOP, it ceased to be so when each of the co-owners. separately sold his or her own share''. In the view of the Tribunal since there was no AOP so far as sub-plot no. 1 was concerned, the surplus realised on the sale of the said sub-plot was required to be taxed as capital gains in the hands of each co-owner in the proportionate share.

From the history of the litigation before the hierarchy of departmental authorities set out above, it would appear that the outcome of litigation at each stage was different and that the revenue progressively lost. At the first stage, the holding was that the entire land, comprised all the three sub-plots, was the asset of the assessee which had come into existence in 1956 and that the surplus realised on the sale of sub-plot no. 1 was taxable as business income arising out of an adventure in the nature of trade. At the second stage, the holding was that though the entire land was the asset of the assessee, the surplus realised on sale of sub-plot no. 1 was taxable not as business income but as capital gains in the hands of the assessee.

At the last stage, the holding was that the AOP came into existence for the first time in 1961 and that sub-plot no. 1 was not the asset of the said AOP and that if ever it formed part of the assets of the AOP, it ceased to be so when it was sold under separate conveyances by each co- owner and that the surplus realised by each of them in proportionate share was liable to be taxed in the hands of each of them as capital gains. The questions posed for our opinion admittedly embrace the entire controversy of departmental authorities wherein, as indicated above, different conclusions were reached at different stages.

The first question which we may briefly consider is as to when the AOP was formed. We agree with the reasoning and conclusion of the Tribunal that the AOP was formed at or about the time when the co-owners decided to put up construction on a portion of the land and jointly took effective steps in that direction, that is to say, in or about 1961. The factors, which are relevant in this connection, are (1) when the land was purchased in 1956, there were only three co- owners and not four, whereas the AOP consists of four persons, (2) the land was purchased as an agricultural land and permission to convert it to non-agricultural use was not taken till 1960, (3) even when the permission was taken, the apparent intention was to put up a residential building on a portion of the land for the use of the co-owners, (4) offers made by the LIC for the purchase of land in 1958 and 1961 were rejected by the co- owners, (5) the object of utilising the land or any portion thereof for the purpose of producing income could have been ordinarily formed only after the area in which the land was included in the commercial zone in 1960, (6) effective steps was covered by the direction of utilisation of the land for the purpose of production and income were taken only in 1961 when the decision to construct buildings was taken in or about 1961 and for that purpose loans were borrowed in the same year (sic), (7) the further manifestation of the object is in the conduct of letting out a portion of the land to the Burmah Shell in 1962, and (8) the fourth co-owner acquired interest in the property only towards the end of 196h All these factors put together leave no doubt in our minds that the AOP with the object of producing income from the land came into existence only in 1961.

The next question which must be briefly considered is whether the whole of the land was the asset of the AOP or whether sub plot nos. 2 and 3 alone constituted the asset of the AOP. On this aspect, it appears to us, with respect, that the reasoning and conclusion of the Tribunal is not consistent with and/or possible on the evidence on record. The Tribunal, while emphasising certain aspects which have a hearing on the question, has omitted to take into consideration altogether certain other relevant aspects, which, if taken into account, are capable of turning the scales. The factors which in our opinion are material on this aspect of the case are as follows:

The land was purchased under a single transaction and it was treated as a single asset by the co-owners from the date of purchase.

When J.D. Karaka acquired specified interest in the land, she acquired the same in the whole of the land and not in any defined portion.

The sub-plotting was made in respect of the whole of the land and the permission for non-agricultural use was also obtained for the whole land. At the time when the proposal for purchase of the land was made by the LIC no indication was given that any portion of the land was to be accorded a separate treatment.

Even at the time when the AOP was formed in 1961, there is no indication that it was confined only to the two sub-plots on which the buildings ultimately were constructed and the evidence in fact points in the other direction.

The entire property was mortgaged to the LIC for the purpose of raising loan for putting up the construction on two sub-plots.

In the books of the AOP, there is no entry confining the asset of the AOP to the two sub-plots and excluding the third sub-plot in question.

The AOP incurred expenses in respect of the whole of the land till the date of the sale of sub-plot no. 1 and those expenses were debited in the books of the AOP.

The earnest money and part consideration received from time to time in respect of sub plot no. 1 were credited in the books of AOP and they were paid into the bank account of the AOP and the funds were treated as the asset of the AOP.

Vijay Corporation was shown as the debtor of AOP in respect of the balance due towards the sale price of sub-plot no. 1.

The final consideration separately received by each co-owner in cash as well as by cheque was reflected in the books of the AOP and the amounts were paid into the bank account of the AOP.

On the last day of the accounting year in question, debit and credit entries were made as stated above in respect of the entire consideration by debiting the account of Vijay Corporation by the sum of Rs. 4,32,000 and by giving credit in the sum of Rs. 1,08,000 in the individual account of each co-owner in the books of the AOP.

On a comprehensive view of the several circumstances set out above, the only reasonable conclusion which can be arrived at is that the entire land, comprised all the three sub-plots, was treated as a single entity right from the date of its purchase till the date of the sale of sub-plot no. 1 initially by the three co-owners, then for a short period, by the four co-owners and ultimately by the AOP. The Tribunal, with respect, has failed to consider the entire material on record, and more particularly the circumstances that the four co-owners had jointly mortgaged the entire plot of land to the LIC for the purpose of raising funds for construction of buildings on sub-plot nos. 2 and 3 and the treatment accorded by the four co-owners to the receipt of earnest money, part payment of consideration, and the final payment of consideration to which we have referred earlier. These two circumstances leave no doubt minds that when the AOP was formed in 1961, the whole of the land became its asset and that it was treated as such till the date of sale.

The further question which required to be briefly examined is whether sub-plot no. 1 ceased to be the asset of the AOP when each co-owner separately conveyed his or her own individual share. Against the aforesaid back ground and in face of the finding that sub plot no. 1 was a part of the assets of the AOP and that it was treated as such till the date of sale, something more than that circumstance was required to establish the withdrawal of the asset from the AOP just prior to or at the time of sale. We are conscious of the fact that there cannot be any set formula or modality in this behalf and that the determination of the question would depend upon the facts and circumstances of each case. However, in the present case, the circumstance of execution of separate conveyances loses much of its force on account of the treatment which co-owner gave to the earnest money and consideration amounts received from time to time. On one hand, there are separate conveyances, and on the Other, the amounts of earnest money and considerations received from time to time are credited in the books of the AOP and they are paid into the bank account of the AOP and they are retained and treated by the AOP as its asset and it is only on the last day of the accounting year in question that by havala entries the amount is distributed and credited into the individual account of each co-owner or member of the AOP. The overall impression which is left on the mind is that there several circumstances neutralise each other (sic) and the result, therefore, is that sub-plot no. 1 cannot be treated as having been separated from the assets of the AOP and regarded as the individual property of each co-owner at the stage of sale.

As a result of the foregoing discussion, we reach the conclusion that the AOP was formed in 1961, that the object of the association was not only to earn rental income by way of rent from the buildings constructed on the two sub-plots and from the portion of the land let out to the Burmah Shell, but also to hold the vacant land and to realise income there from in a suitable mode, including the sale thereof, at an appropriate time, and that, therefore, the surplus realised on the sale of the said sub-plot is taxable in the hands of the AOP.

We are prima facie inclined to agree with the Tribunal, however, that the surplus is not taxable in the hands of the AOP as business income, because on the evidence on record it seemingly appears difficult to reach the conclusion that the transaction of sale was an adventure in the nature of trade. The surplus which the AOP realised on sale was, prima facie, not business income but capital gains arising out of liquidation of a capital asset. On this aspect, however, we are not required to go into greater depth and to express any final opinion, because, on behalf of the revenue, it has been stated that the second question posed for our opinion is not pressed and that it is not required to be answered. In the light of the stand adopted by the parties and discussion and conclusions afore said, the questions referred for our opinion are answered as follows:

Question No. 1 : In the affirmative, to the extent that the AOP was formed at the time when the two buildings were decided to be constructed some time in 1961; in the negative, to the extent that the assets of the AOP consisted merely of sub-plot nos. 2 and 3 and the buildings standing thereon and that the object of the AOP was confined merely to the earning of income by way of rent from the two buildings constructed on sub-plot nos. 2 and 3 and the portion of land let out to the Burmah Shell, the object of the said association was not only to earn income by way of rent from the buildings constructed on the two sub-plots and from the portion of the land let out to the Burmah Shell but also to hold the vacant land of sub-plot no. 1 and to realise income there from in a suitable mode, including the sale thereof, at an appropriate-time.

Question No. 1 is thus answered partly in favour of the revenue and partly in favour of the assessee.

Question No. 2: Not pressed and therefore not answered.

Question No. 3: In the negative, that is, in favour of the revenue and against the assessee, that is to say, the surplus is taxable as capital gains in the hands of the AOP.

There shall be no order as to costs of the reference having regard to the ultimate outcome.

Before parting with the case, it requires to be on record that in the light of the broad consensus between the parties as regards the answers to be furnished to the questions posed for our opinion, the revenue has agreed not to prosecute proceedings u/s 271(1)(c) of the Act, against the assessee. The revenue has further agreed not to initiate any proceedings u/s 140A(1) of the Act, against the assessee for failure to pay the tax, if any, in accordance with the provisions of section 140A(1) on the basis that the surplus realised on the sale of sub-plot no. 1 was the income of the assessee. The revenue has further agreed that on and with effect from 1-1-1968, the proportionate share of the sale-price of sub-plot no. 1 of each member of the association will be treated as the individual property of each member and that for the utilisation of the amount received as and by way of proportionate share, each member of the AOP would be individually answerable in his own assessment as from 1-1-1968.