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Tax Provisions Relating To Receipt and Forfeiture Of Earnest Money

The provisions of the Income-Tax Act- section 51 deal with advance money received for transfer of a capital asset. As per the old provisions where any capital asset was on any previous occasion the subject of negotiations for its transfer, any advance or other money received and retained by the assessee in respect of this kind of negotiations shall be deducted from the cost of acquisition of the asset/WDV or Fair Market Value as the case may be.

The provisions of sec 51 have changed with effect from 01st April 2014 and the amount forfeited cannot be taxed under any other head as the nature of receipt is capital received. In order to ensure that amount does not skip taxation, section 51 of the Income tax Act 1961 provides for reducing the same amount from the cost of acquisition of the asset. However, a new section 56(2) (ix) was introduced, which provides for taxing the amount so forfeited under Income from other sources.

So the said amendments seek to prepone the taxability of the advance money forfeited to the year of receipt of the money as against the current provision effectively. Since in the year of receipt of advance money, the necessary element of transfer is missing, it cannot be taxed as Capital Gains and hence the government can make it taxable as Income from other sources in the year of receipt of the money.

What are the Tax Benefits to Seller due to Amendment in Section 51?

Earlier in section 51, forfeiture of advance received for transfer of capital asset was reduced from the cost of acquisition which results into loss to tax payer at the time of sale of capital asset. Since on the sale of capital asset he/she loose the indexed benefit if the advance was not forfeited. Thus, to avoid this drawback, the new section 56(2) (ix) of Finance (No.2) Act, 2014 was introduced and as per new section cost will remain same & advance will be taxed under “Income from other source”.

What are the Reasons to Introduce Section 56(2)(ix):-

The meaning to introduce Section 56(2) (ix) is to Change in Tax Treatment of Amount Forfeited.

There were various problems and complexities in the previous law and many time it was also used to regulate the unaccounted money and so the new law has been introduced with Section 56(2) (ix) coming into force from Assessment Year 2015-16 onwards. A provison for the same has also been entered in Section 51 for the same so as to assure that there will be no any double taxation.

What are the Other Causes for Introduction of Section 56(2)(ix) are as Follows:-

  1. Under the old Law if advance has been forfeited it was not taxable in the year of receipt but taxable in the year of Actual Sale of the Property.
  2. If the amount was received in the year in which the Period of Holding was Short Term and the actual sale happened in the year in which the Period of Holding was Long Term – the total transaction was lead as Long Term not for the short term. So, the seller was needed to pay only 20% of the amount as Long Term Capital Gains Tax & could also claim Exemption under Section 54 and Section 54 F.
  3. There was trouble in ascertaining the Indexed Cost of Acquisition as the Indexation was allowed only after reducing the amount forfeited.
  4. Tax Treatment in the hands of the Buyer
  5. The amount paid by the Buyer which has been forfeited does not amount to relinquishment of a right and therefore would not be allowed to be claimed as a Capital Loss.
  6. If the Seller fails to honor the deal and pays back the Buyer the advance as well as some amount because of failure to dishonor the deal, this amount would be treated as Capital Gain since it amounts to relinquishment of a right by a buyer.
  7. The amount forfeited which was paid for purchase of a Commercial Building will not be regarded as Revenue Loss.