The Income Tax Act, 1961, encapsulates a myriad of provisions governing the taxation of various incomes, and among them, Section 45(5) assumes significance in delineating the taxation contours pertaining to capital gains arising from the transfer of a capital asset under the circumstances of compulsory acquisition or consideration determined by designated authorities.
In essence, Section 45(5) outlines the treatment of capital gains when the transfer of a capital asset occurs through compulsory acquisition under any law or when the consideration is determined or approved by the Central Government or the Reserve Bank of India. If, subsequently, the compensation or consideration is modified by a court, Tribunal, or another authority, the computation and taxation of capital gains undergo specific modifications.
Usually, capital gain is taxed in the year of transfer, but in case of compulsory acquisition of capital asset, there can be two types of treatments, one for Initial Compensation and another for enhanced compensation:
The capital gain, initially computed with reference to the compensation awarded or consideration determined by the Central Government or the Reserve Bank of India, is chargeable as income under the head "Capital gains" in the year when the first installment of compensation or consideration is received.
Calculation of Capital Gain will be done in the following manner:
Full value of consideration (Initial Compensation)
(-) Cost of Acquisition/Indexed Cost of Acquisition
(-) Cost of Improvement /Indexed Cost of Improvement
The amount by which the compensation or consideration is enhanced by a court, Tribunal, or other authority is deemed income chargeable under "Capital gains" in the year of receipt by the assessee. Although, if any enhanced compensation is received due to interim order of any court or tribunal, then such compensation shall be taxable in the year in which final order is passed.
Calculation of Capital Gain will be done in the following manner:
Full value of consideration (Enhanced Compensation)
(-) Litigation Expenses
In case of Enhanced Compensation, the cost of acquisition and the cost of improvement are considered nil.
However, If, in a subsequent assessment, the compensation or consideration is reduced by a court, Tribunal, or authority, the assessed capital gain shall be recomputed based on the reduced compensation or consideration.
Succession and Enhanced Compensation: In cases where the enhanced compensation or consideration is received by another person due to the transferor`s death or any other reason, the amount of enhanced compensation is deemed the income chargeable to tax under "Capital gains" for that person.
Section 10(37): Section 10(37) provides that any capital gain arising to an Individual or HUF on compulsory acquisition of urban agricultural land shall be exempt from tax provided such land has been used for agricultural purposes during preceding two years by the individual or his parents or such HUF.
Deduction for Interest Income: In cases where the taxpayer receives interest on the compensation or enhanced compensation, a deduction equal to fifty percent of such income is allowed under section 57.
Consistency in Nature of Capital Gain: The nature of the capital gain arising from enhanced compensation always aligns with that of the initial compensation i.e., Nature of Capital Gain of Enhanced Compensation shall always be same as that of Initial Compensation.
Balakrishnan vs Union Of India on 11 January, 2017  160 TAXLOK.COM (IT) 069 (SC)
In the case of Balakrishnan vs. Union of India (2017)  160 TAXLOK.COM (IT) 069 (SC), the appellant`s land was subject to compulsory acquisition by the State Government under the Land Acquisition Act (LA Act). The acquisition process involved the issuance of a notification under Section 4, followed by a declaration under Section 6 and an award under Section 9 of the LA Act. The acquisition was deemed complete with the award, and the only remaining steps were the payment of compensation and taking possession of the land.
The appellant, while not contesting the acquisition itself, disagreed with the compensation amount fixed by the Land Acquisition Collector. According to the LA Act, the appellant could have sought a reference under Section 18 for the District Judge to determine the proper compensation. Instead, the appellant chose to negotiate directly with Techno Park and reached a settlement, agreeing to receive Rs. 38,42,489 as compensation. This settlement required the appellant to execute a sale deed, a step taken to fulfill the agreement.
The court held that, despite the negotiated compensation, the nature of the acquisition remained compulsory. The appellant`s actions were seen as a response to the government`s steps under Sections 4, 6, and 9 of the LA Act. The court rejected the argument that the negotiated settlement altered the compulsory nature of the acquisition, emphasizing that the appellant entered negotiations to salvage the situation and receive fair compensation, not to voluntarily sell the land.
Furthermore, the court expressed doubts about the correctness of a previous judgment in Info Park Kerala vs. Assistant Commissioner of Income Tax  115 TAXLOK.COM (IT) 013 (KERALA), (2008) 4 KLT 782. In that case, the court had taken the view that if landowners passed title through sale deeds, it was not a compulsory acquisition. The Balakrishnan case disagreed with this view, stating that the crucial elements were the notification and award under the LA Act, without which the negotiations for compensation would not have occurred. The court explicitly overruled the judgment in Info Park Kerala.
CBDT Circular No.06/2016
Historically, agricultural land not situated in specified urban areas was not regarded as a capital asset under the Income-tax Act, 1961. Consequently, capital gains arising from the transfer, including compulsory acquisition, of such agricultural land were not taxable. The Finance (No. 2) Act, 2004 introduced Section 10(37) to provide a specific exemption for capital gains arising from the compulsory acquisition of agricultural land situated in specified urban limits, subject to certain conditions.
The RFCTLAAR Act, effective from January 1, 2014, introduced section 96, stipulating that income-tax shall not be levied on any award or agreement made under the RFCTLAAR Act, except those made under section 46. This provision essentially exempts compensation received for the compulsory acquisition of land under the RFCTLAAR Act (excluding those made under section 46) from the levy of income-tax.
While the existing provisions of the Income-tax Act, 1961, distinguish between agricultural and non-agricultural land for tax exemption, the RFCTLAAR Act does not make such a distinction. Section 96 of the RFCTLAAR Act provides a broader exemption scope than the existing provisions, leading to uncertainty regarding the taxability of compensation, particularly in non-agricultural land acquisitions.
Addressing this ambiguity, the Board has issued a clarification. It asserts that compensation received for an award or agreement exempted from income tax under section 96 of the RFCTLAAR Act shall not be taxable under the provisions of the Income-tax Act, 1961. This holds true even when there is no specific provision for the exemption of such compensation in the Income-tax Act, 1961.
So, in conclusion it can be said that Section 45(5) of the Income Tax Act, 1961, serves as a critical instrument in delineating the tax implications surrounding capital gains arising from compulsory acquisitions or consideration determined by designated authorities. Its meticulous provisions aim to ensure a fair and equitable taxation framework, accounting for enhancements or reductions in compensation or consideration, thus fostering clarity in the taxation of capital gains under diverse circumstances. Taxpayers and professionals alike must navigate these provisions judiciously to ensure compliance and a nuanced understanding of their tax obligations in such scenarios.
CA Pranay Jain is a young and aspiring Chartered accountant. He qualified Chartered Accountancy Course in 2021 and has a well-established practice in various fields of taxation and auditing, with his core area of practice being in the field of litigation i.e., handling assessment and appeal-related matters and representing assesses before various tax departments.
He is also socially active on LinkedIn at linkedin.com/in/capranayjain
FOR FREE CONDUCTED TOUR OF OUR ON-LINE LIBRARIES WITH OUR REPRESENTATIVE-- CLICK HERE