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The following article offers an understanding of the funds received and disbursed by involved parties in a settlement outside the courtroom. It also outlines how such funds are handled according to the Income Tax Act and GST Act.
1.Treatment as per Income tax in the hands of a recipient
2.Treatment as per Income tax in the hands of the settling party
3.Understanding GST applicability on the same
4.Case laws
5.Conclusion
Treatment as per Income tax in the hands of a recipient
In the realm of taxation concerning out-of-court settlements, a pivotal aspect to consider is the categorization of receipts into revenue and capital under the Income Tax Act, 1961 (“IT Act”). This distinction helps identify whether the settlement amount is taxable or not.
Revenue receipts
- Arise from the regular and routine business operations of an entity and are generally recurring in nature.
- In out of court settlement, compensation for loss of trading stock or loss of profits can be considered as Revenue receipts.
- Generally, revenue receipts are taxable unless specifically exempted.
- Examples – amounts received for sale of goods, interest on loans, rental income.
Capital Receipts
- Do not arise from the normal business operations and usually one-time receipts and are not recurrent.
- In out of court settlement, compensation for damages leading to the diminution of the asset’s value or for the termination of a business can be considered as Capital Receipts.
- Generally not taxable, unless it’s mentioned otherwise under the IT Act
- Examples – Receipts include sale proceeds from selling an asset, money received from a share issue.
Distinguishing between compensatory and punitive nature is crucial for determining if compensation payments can be treated as allowable expenses. The following points outline this differentiation clearly.
Compensatory Expense
- Paid damages or losses in business operations are compensatory expenses.
- Paid to end a lawsuit for alleged damages or harm caused or payments to businesses for losses incurred due to contract breaches are compensatory expenses.
- Examples include Payment for breach of contract or business losses.
Penal Expense
- Paof toward fines or penalties levied for legal or regulatory violations are penal expenses.
- In out of court settlement context, amounts paid to end a lawsuit for regulatory violations or payments for statutory non-compliances are penal in nature.
- Common examples include fines for legal infringements or regulatory non-compliances
Untangling GST Applicability in Out-of-Court Settlements
The taxable event in GST is supply of goods or services or both. Hence its important to understand the meaning and scope of “Supply” under GST which clearly defined in the following 6 parameter
1. Supply of goods or services. Supply of anything other than goods or services does not attract GST
2. Supply should be made for a consideration
3. Supply should be made in the course or furtherance of business
4. Supply should be made by a taxable person
5. Supply should be a taxable supply
6. Supply should be made within the taxable territory
Compensation paid in out of court settlements does not qualify as a ‘supply’ under the GST regime. Therefore, it is not liable to GST. However, it’s vital to analyze the nature and purpose of the compensation to ascertain the exact GST implications.
Taxability of compensation paid under GST depends on whether the compensation is for
- breach of contract – be considered as consideration for supply of a service and would be taxable under GST
- for any other reason – it would not be taxable under GST as they cannot be treated as any sort of service and they lack the element of mutual consideration
- For damages / liquidated damages – may be considered as supply of goods or services considering such receipt fall within the ambit of ‘agreeing to obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’.
Case Laws
Under Income Tax:
Commissioner of Income Tax v. D.P. Sandu Bros., Supreme Court
Compensation received due to the termination of a dealership agreement is a capital receipt and hence not taxable.
Kettlewell Bullen & Co. Ltd. v. Commissioner of Income Tax, Supreme Court
Compensation received in lieu of a trading asset is a revenue receipt. But if for the loss of a profit-making structure, it’s a capital receipt.
Commissioner of Income Tax v. Panbari Tea Co. Ltd., Supreme Court
Compensation received for the loss of a source of income is considered a capital receipt and is not taxable.
Under GST:
Bai Mamubai Trust, VithaldasLaxmidas Bhatia, Smt. InduVithaldas Bhatia vs. Suchitra, Bombay High Court
GST is not payable on damages/compensation paid for a legal injury as payment lacking the element of mutuality of consideration.
Conclusion
•Classification of receipts, whether revenue or capital, especially in the context of out-of-court settlements, might require a detailed analysis of the nature and purpose of the receipt.
•Decisions from judiciary and expert advice can aid in providing clarity.
•In practice, nature of receipt shall be determined by extensive scrutiny of pleadings in suit and / or recitals contained in the settlement agreement and careful drafting will be quintessential.
