ITAT Pune Upholds Deductibility of Compensation Paid on Cancellation of Share Transfer Agreements

Background of the Dispute

The Pune Bench of the Income Tax Appellate Tribunal (ITAT) in the case of DCIT Vs Somnath Vaijnath Sakre dealt with an important question: whether a large compensation paid by an assessee while cancelling earlier share sale agreements could be treated as a genuine “selling expense” deductible while computing long-term capital gains (LTCG), or whether it was merely a colourable device to reduce tax.

The appeal before the Tribunal arose from the order dated 24.07.2024 passed by the CIT(A) / NFAC, Delhi for Assessment Year (AY) 2013-14. This was the second time the matter reached the Tribunal, after an earlier round under revisionary proceedings.

The assessee, an individual engaged in manufacturing plastic water tanks and plastic milk cans under the name M/s. Shree Maruti Udyog, had originally filed a return on 31.10.2013 declaring total income of Rs.5,55,53,700/-. Assessment under Section 143(3) was completed on 01.03.2016, determining income at Rs.5,55,85,528/-.

Subsequently, the PCIT invoked revisionary jurisdiction under Section 263 on the ground that the assessment order was erroneous and prejudicial to the interests of the Revenue, primarily focusing on a claim of Rs.7,84,00,000/- as selling expenses while computing LTCG on sale of shares of Lord Ganesh Minerals Pvt. Ltd., Pune (LGMPL).

Transaction Structure and Core Issue

Sale of Shares and Claim of Selling Expenses

The facts that triggered the dispute were as follows:

  • The assessee sold 3,50,000 equity shares of Lord Ganesh Minerals Pvt. Ltd., Pune to KSL Holding Pvt. Ltd.
  • Sale consideration was Rs.21,87,50,000/-, supported by share transfer form No.075773 dated 03.07.2012.
  • While computing LTCG, the assessee claimed a deduction of Rs.7,84,00,000/- as selling expenses.

This sum of Rs.7,84,00,000/- represented compensation allegedly paid by the assessee to two companies:

  1. Nilesh Steel & Alloys Pvt. Ltd. (NPL) – Rs.4,80,20,000/-
  2. Dhanlaxmi TMT Bars Pvt. Ltd. (DPL) – Rs.3,03,80,000/-

The payments arose from cancellation of earlier agreements dated 09.04.2012 and 07.05.2012, under which these companies were to acquire the same shares of LGMPL.

PCIT’s Findings in Section 263 Proceedings

The PCIT examined the assessment records and concluded that:

  • The assessee had first entered into share sale agreements with NPL and DPL for the same 3,50,000 shares of LGMPL.
  • When these earlier agreements were subsequently cancelled, the assessee agreed to pay substantial “compensation” of Rs.4,80,20,000/- and Rs.3,03,80,000/- to NPL and DPL respectively for alleged breach of contract.
  • These cancellation agreements were executed:
    • Without registration, and
    • Without appropriate stamp duty, according to the PCIT.
  • Instead of litigating the alleged breach, the parties swiftly settled by executing cancellation deeds and accepting compensation.

According to the PCIT, the arrangement constituted a colourable device intended to reduce LTCG by artificially inflating “selling expenses”. Accordingly, the PCIT held that the allowance of Rs.7,84,00,000/- as selling expenses in the original assessment was erroneous and prejudicial to the Revenue.

The matter was remanded back to the Assessing Officer (AO) with directions to reframe the assessment.

Fresh Assessment After Section 263 Revision

Following the PCIT’s order, the AO initiated fresh proceedings, issued notice under Section 143(2), and examined the assessee’s submissions.

The AO ultimately disallowed the entire claim of Rs.7,84,00,000/- as selling expenses, and added it back to LTCG, with key reasoning summarised as:

  • The assessee had originally entered into agreements with NPL and DPL for sale of shares at a lower price.
  • Later, the assessee sold the same shares to KSL Holding Pvt. Ltd. for a higher consideration.
  • The “cancellation agreements” with NPL and DPL were, according to the AO:
    • Executed without proper stamp duty,
    • Not registered,
    • Used as a tool to route compensation and thereby reduce the assessee’s taxable capital gains.
  • The AO characterised the entire arrangement as a colourable device and held that such compensation could not qualify as “expenditure incurred wholly and exclusively in connection with the transfer” under Section 48.

Therefore, the AO treated the amount of Rs.7,84,00,000/- as part of LTCG income, disallowing the claimed deduction.

Relief Before CIT(A) / NFAC

The assessee challenged the reassessment before the CIT(A) / NFAC, who deleted the addition. The CIT(A)’s detailed reasoning (reproduced in the Tribunal’s order) accepted the assessee’s explanation that:

  • The compensation was paid in line with binding contractual obligations under prior share sale agreements with NPL and DPL.
  • The transaction allowed the assessee to sell shares at a significantly higher rate (Rs.625 per share to KSL Holding Pvt. Ltd. instead of Rs.305 per share to DPL/NPL), even after factoring in compensation.
  • The recipients of compensation were genuine companies with substantial turnover and were assessed to tax, and the compensation amounts were duly taxed in their hands.

Aggrieved, the Revenue carried the matter in appeal before the ITAT, Pune.

Grounds Raised by the Revenue Before ITAT

The Revenue’s main grounds in appeal were:

  1. Colourable Device Allegation
    The CIT(A) erred in treating the compensation as genuine selling expenses despite the alleged artificial nature of cancellation deeds and avoidance of court proceedings, asserting it was a tax minimisation device.