Navigating Notional Losses: Punjab & Haryana High Court Clarifies Rules on Carry Forward of Business Losses

Introduction

In a significant ruling, the Punjab & Haryana High Court delivered a judgment in Principal Commissioner of Income Tax v. Adinath Investment & Trading Co.[i], addressing the treatment of notional loss and the carry forward of business losses. This case examined whether the assessee could carry forward a capital loss, primarily caused by the fall in equity share prices following a rights issue, despite no actual transfer of shares. The High Court’s decision to allow the carry forward of the notional loss reflects critical principles regarding loss calculation in both business and capital gains contexts under the Income-tax Act, 1961 (‘Act’).

This article analyses the High Court’s approach to the treatment of notional losses and the implications of this judgment on businesses, particularly those dealing in stock market investments.

Brief Facts

• Adinath Investment & Trading Co. (‘Assessee’), an investment company, had claimed a significant capital loss due to the fall in the value of its equity shares in Vardhman Spinning and General Mills Ltd. Following a rights issue, the value of the shares dropped from Rs. 610 to Rs. 400 per share, leading to a claimed loss of Rs. 1.94 crore. In addition, the assessee claimed a short-term capital loss of Rs. 9.87 lakh from the sale of non-convertible debentures.

• The company sought to carry forward the total capital loss of Rs. 2.04 crore to subsequent assessment years. The assessing officer (‘AO’), however, rejected this claim on the grounds that the loss was notional, given that no actual transfer of shares had occurred. The AO held that the loss was theoretical and not permissible for carry forward.

• The Commissioner of Income Tax (Appeals) [CIT(A)] allowed part of the claim, but the Revenue further appealed to the Income Tax Appellate Tribunal (‘ITAT’). The ITAT ultimately ruled in favour of the Assessee, allowing the carry forward of the loss, which led the Revenue to challenge the decision before the High Court.

Issue

The primary issue before the High Court was whether the fall in share prices, which caused a significant loss for the assessee without any actual transfer of shares, could be considered a legitimate business loss and carried forward under the provisions of the Act. The Revenue argued that the loss was purely notional, as there had been no actual transaction. In contrast, the assessee contended that the loss was real and arose due to a fall in market value, which directly impacted its business operations, warranting the carry forward.

This case required the Court to interpret the provisions relating to the carry forward and set-off of losses, particularly sections 72 and 28(i) of the Act, and to determine whether a notional loss could be treated similarly to a business loss for taxation purposes.

Held

• The High Court upheld the decision of the ITAT, ruling in favour of the assessee. The High Court acknowledged that although an actual transfer of shares did not accompany the loss in question, it was nevertheless a genuine loss arising from market conditions. The fall in the price of the shares, as documented by stock market quotations, constituted a legitimate business loss. The High Court further noted that the distinction between capital gains and business profits does not affect the method of calculating losses, as both are derived by subtracting the cost price from the market value or sale proceeds.

• Relying on precedents from the Supreme Court, particularly in the case of Dhun Dadabhoy Kapadia v. Commissioner of Income Tax[ii], the High Court emphasized that even in cases where losses arise from fluctuations in share value following a rights issue, the loss must be considered a business loss if it impacts the company’s financial position.

• The High Court held that the fall in the share value was real, irrespective of whether an actual transfer occurred, and directed that the loss be allowed to be carried forward as a business loss. The Revenue’s appeal was dismissed, and the decision of the ITAT was affirmed, allowing the assessee to carry forward the claimed loss.

Our Analysis

In its deliberation, the High Court notably clarified that the distinction between business profits and capital gains primarily impacts the rate and incidence of taxation but not the method of calculating the loss itself. This interpretation is significant for businesses, as it ensures that losses incurred due to market fluctuations can be carried forward, regardless of whether they are categorized as capital losses or business losses. The ruling helps in providing clarity to taxpayers who might face disputes over how their losses are treated under the Act.

This ruling is particularly important for investment companies and others that engage in share trading. The judgment establishes that market-driven losses, even if actual share transfers do not accompany them, are real and can be carried forward. Investment companies, whose portfolios are often affected by the volatility of stock prices, will benefit from this ruling as it clarifies the tax treatment of unrealized losses.

End Notes

[i] [2024] 165 taxmann.com 639 (Punjab & Haryana) [23-07-2024].

[ii] [1967] 63 ITR 651 (SC) [31-10-1966].

Authored by Muskaan Jain, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinions.