ANALYSIS OF SECTION 41(1) OF INCOME TAX ACT, 1961

The caption
heading of section 41(1) is ‘Profits Chargeable to tax’. The section falls
under Chapter IV – Computation of Income from Business or Profession.
In business
there are circumstances where a person might have incurred a liability but
later on he need not have to pay it for one or other reason. The Income Tax Act
brings to tax such liabilities which are no more payable.
The section
brings in to its ambit benefit in cash or in kind obtained by a person by
remission or cessation of liability. The only condition is that the person must
have obtained a deduction or allowance in his computation of income for the
said liability in any previous years.

To tabulate
the same one needs to consider the following mandatory points, 
1. There has to be a remission or cessation of
a liability or 
2. There has
to be recovery of any loss or 
3. There has
to be recovery of any expenditure 
4. The
liability must be a trading liability and not on capital Account 
5. The
person is allowed deduction or allowance for the same in any previous
year. 
Many a times
a liability is written back in books of accounts for some or other reasons for
which a person might not have claimed any deduction from income in previous
years in such cases income tax department take recourse to section 28(iv) which
brings to tax the value of any benefit or perquisite, whether convertible into
money or not, arising from business or profession.
So the
income tax department takes recourse to two sections to bring to tax any loss,
expenditure or liability which might have been waived or not payable or
obtained.
Please note
that a person may write back liability in his books of accounts unilaterally,
i.e. without consent of the payee or many a times a liability remains in
existence continuously over reasonably long time and the payee does not write
it back in his books of accounts then also section 41(1) comes in to operation
and benefit is brought back to taxation by income tax department.
Given below
are some case studies which will clarify how the modalities of these two
sections operate in real life situations:
  
CASE STUDY –
1: 
A person has
some liability towards acquisition of fixed assets and due to some reason the
same is not payable in full or in part at a later date.
In such
cases though the person has gained an advantage by not paying the liability,
the second test which is regarding claim or any allowance or deduction is not
satisfied. The acquisition of fixed asset is never allowed as a deduction.
Hence the amount written back cannot be brought to tax. Secondly it also cannot
be brought to tax u/s 28(iv) because 28(iv) refers to benefit in kind and not
in cash. [Solid Containers Ltd. 308 ITR 407 (BOM)] 
Someone may
ask a question as to the depreciation claimed on such fixed assets in the past
years. As per my point of view, the allowance of deprecation in previous years
cannot be brought to tax because cessation of liability only pertains to the
principal amount of fixed assets and not the depreciation on it. These two are
different and have independent accounting and tax treatment. But the Hyderabad
ITAT in the matter of Binjrajka Steel Tubes Ltd. v. ACIT 130 ITD 46 has taken a
different view and observed that
the assessee
has obtained benefit of tax to the extent of depreciation allowance and brought
such depreciation to tax.
CASE STUDY –
2:
An assessee
has borrowed a loan for purchasing a fixed asset and later on loan is waived or
not paid. Such cases
are also not covered u/s 41(1) because though there is remission or cessation
of a liability, a person has not claimed any deduction for the same in income
tax in past. Hence section 41(1) is not applicable. 
CASE STUDY –
3: 
An assessee
gets waiver of Working Capital loan. Waiver of
working capital loan falls in the trap of section 41(1) and the waived amount
is brought to tax. During the year 2004-05 till 2006-07 there were many such
instances of loan waiver. The lender financial institutions and banks were
asking their defaulting borrowers to accept OTS (one time settlement scheme) to
recover its dues. The borrowers were offered reduction in principal payment,
reduction in interest and complete waiver of penalty and interest.
In case the
reduction is of term loan then section 41(1) does not apply as said earlier.
However if the interest on term loan is reduced or waived then to that extend
it is taxable. [Refer Mahindra and Mahindra Ltd 261 ITR 501 (BOM)]
In case
reduction or waiver is of working capital loan then the whole amount waived is
brought to tax. Reason being, in Cash Credit and debtors credit limits the
interest is accumulated with the loan amount every quarter and is not separable
from original credit limits.
CASE STUDY –
4: 
Liability
outstanding for a very long period of time and not written back in account. Many a
times, there are instances where the person has standing liability in his books
of accounts year after year. The person neither receives any payment against it
nor writes it back in books of accounts. In such a situation, the Assessing
officer takes the stand that the liability which is outstanding for a very long
period ceases to be in existence either because the creditor is not demanding
it or by operation of law it becomes barred by time. There are contradictory
judgements of different courts, some in favour of the assessee and few against.
In recent
times, an interesting case came up before the Mumbai Tribunal- ITO v/s Shailesh
D. Shah ITA 7012/M/10 wherein it was held that the assessee has just continued
the entry in his books of accounts without any intention to pay back the same
and relied on Chipsoft Technology 210 Taxman 173 (Del) and confirmed addition
of liability u/s 41(1).
It referred
to Vardhaman Overseas Ltd. 343 ITR 408 (Del) wherein it was held that section
41(1) does not apply if the amount is not written back in the books of
accounts.
Contrary to
this, in CIT v/s Bhogilal Ramjibhai Atara (Guj) held that even if there is
unclaimed liability of earlier years where even creditors are untraceable and
liabilities are non-genuine, then also the addition cannot be made u/s 41(1)
since assessee has not written it back in books of account.
 
CASE STUDY –
5:
Net Present
Value (NPV) of future liability is paid at a discounted rate. This interesting
case has come up before Mumbai special bench in the case of Sulzar India Ltd.
v. JCIT ITA No. 2944/Mum-2007 wherein the assessee was enjoying sales tax
deferral scheme from Maharashtra Government and it accumulated sales tax for 12
years for about 7.52 Crs. In the meanwhile sales tax dept had come out with an
early repayment scheme wherein Suzlar was asked to pay Rs. 3.37 Crs. as onetime
payment at NPV calculated at fixed interest rate. The IT Department treated
this difference due to early repayment at NPV of Rs. 4.15 Crs. as remission of liability.
The matter went upto the Special Bench and the Hon’ble Special Bench observed
that in paying NPV the assessee has paid the equivalent value of the sum and
hence there is no remission of liability.
Usually in
every case, where there is a possible disallowance u/s 41(1), the Department
surely takes support from the Hon’ble Supreme Court decision in the case of CIT
vs. T.V. Sundaram Iyengar & Sons Ltd. reported in 222 ITR 344 SC
(11/09/1996)
In this case
trade security deposit received by the assessee and not payable later on was
routed through Profit & Loss a/c. This case has gone against the assessee
due to 3 reasons:
1. It was a
trade security deposit from debtors.
2. It was
reversed by crediting Profit & Loss a/c.
3. It was a
trade liability.
If any of
these 3 components are present then it is not covered u/s 41(1).
In the case
of Bombay Gas Co. Ltd. v/s ACIT (MUM) ITA no. 646 and 1188 of 2009, the Hon’ble
High Court has observed that it is settled law that if the loan was taken for
acquiring the capital asset, waiver thereof would not amount to any income
eligible to tax. On the other hand, if this loan was for trading purpose and
was treated as such from the very beginning in the books of account, as per
T.V. Sundaram Iyengar & Sons Ltd.’s case, the waiver thereof may result in
the income more so when it was transferred to Profit and Loss account.
The High
Court also distinguished T.V. Sundaram Iyengar & Sons Ltd. (SC) and Solid
Containers Ltd. (BOM).

In the light
of above discussions and various judicial pronouncements, one should be very
careful in giving treatment of unclaimed trade or otherwise long term liability
in the books of accounts.
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