Whether provisions of Sec 179 will apply in case where project runs into losses due to earthquake and FIs restructure debt and permit sale of property and creditors being proportionately paid out of such sale proceeds and when payments were made, assessment order was still pending - NO: HC

THE issue before the Bench is - Whether provisions of Sec 179 will apply in a case where project runs into losses due to earthquake and FIs restructure debt and permit sale of property and creditors being proportionately paid out of such sale proceeds and when payments were made, assessment order was still pending. And the HC's answer is NO.

Facts of the case

The assessee is a director of a private limited company. For the assessment year 2010-2011, the said company filed its return which was taken in scrutiny. The Assessing Officer framed assessment and computed the long term capital gain after set off of business loss at Rs.4.14 crores (rounded off). The company filed appeal against the order of the assessment. Such appeal was pending before the CIT(Appeals). The said company also prayed for stay against the recovery of tax demand flowing from the order of assessment. CIT(Appeals) refused to grant stay. No further proceedings were carried by the company against such order of CIT(Appeals). As of now thus there was no stay against recovery of the tax.

The company was unable to pay the taxes. The Tax Recovery Officer issued a show cause notice calling upon the assessee, as the director of the said company, why the tax demand of Rs.1.95 crores (rounded off) for the assessment year 2010-2011 due from the said company be not recovered from him in terms of section 179 of the Act by holding him jointly and severally liable for payment of tax, interest and penalty due from the company.

The assessee replied to the show cause notice in which he pointed out that provisions of section 179 of the Act cannot be invoked, unless the non recovery could not be attributed to any gross neglect, misfeasance or breach of duty on his part in relation to the affairs of the company. The company was incorporated to run a five star hotel. A hotel building for such purpose was constructed on leasehold land acquired by the company. The inauguration of the hotel was planned in the first week of February 2001. During the devastating earthquake of 26.01.2001, the hotel building was severely damaged. On account of this, the total investment was destroyed with no act of negligence or breach of duty on part of any of the directors. Despite best efforts, the director could not even secure the insurance claim for the building for one reason or the other. The company had already filed suit against the insurance company which was still pending before the Civil Court. The financial institutions however, gave one time settlement relief to enable the company to sell the property which was disposed of in the year 2009-2010. There was no tax demand outstanding against the company as per the return filed. However, demand arose on account of the assessment order. The income-tax department had raised an issue with respect to sale transaction of the property sold by the company. The company had already carried the matter in appeal. It was further pointed out that the company was not having any property to pay the dues of the department, due to which the taxes could not be recovered from the company. However, such non recovery from the company could not be attributed to any gross negligence. misfeasance or breach of duty on part of the directors.

Ignoring assessee’s pleas, impugned notice was issued declaring the assessee jointly and severally liable for payment of the tax, interest and penalties. AO directed the assessee be treated as an assessee in default in respect of such dues of the company. He observed that dues had become irrecoverable from the company as the company had no assets from which the recovery could be made. No efforts were made by the director of the company to pay the demands. While selling the properties, no provisions were made to pay the dues of the income tax out of the sale of the land. The directors were engaged in the daily affairs of the company. Adjustments as made by the company were not allowable under the law. The company was not entitled to carry forward any losses not allowed under the law and to adjust the same against any subsequent gain. He further observed that the destruction of the building may be attributed to natural calamity, the director still had the responsibility to take proper measures to protect the interest of the company like insuring the property against the earthquake. As far as matter of taxation is concerned, the director showed gross negligence in following the applicable laws and thus tried to evade the due amount of taxes arising from the subsequent gains.

Assessees submitted that the tax demand had not become final. The order of the Assessing Officer was carried in appeal. Such appeal was still pending. At that stage, no recovery could be effected from the directors resorting to section 179 of the Act. It was further submitted that even otherwise the requirements of section 179 of the Act were not fulfilled. The assessees had demonstrated that there was no negligence, misfeasance or breach of duty on their part in relation to the affairs of the company. The constructed property of the company was destroyed in an earthquake. The company therefore, could not set up and start its five star hotel as per its project and ran into heavy losses. The properties were sold and dues of the creditors were paid off as per the restructured debts.

Revenue contended that the company had set up a false claim of set off of losses which were not allowable against the gains arising out of the sale of land. Sale proceeds were utilised for paying debts of other creditors without making provision for possible income tax liabilities. The directors had thus committed breach of duty in relation to the affairs of the company.

Having heard the parties, the Court held that,

++ in terms of sub-section (1) of section 179, thus when any tax dues from a private company cannot be recovered, then every person who was a director of the private company during the previous year when the tax dues arose, would be jointly and severally liable for payment of tax, unless he proves that non recovery cannot be attributed to any gross neglect, misfeasance or breach of duty on his part in relation to the affairs of the company;

++ under sub-section(1) of section 179, thus what can be recovered from a director of a private company is the tax dues of the company which cannot be recovered from the company in which he is the director. In that view of the matter, we see no mandate under sub-section(1) of section 179 that the income tax department must await the outcome of appeal or further appeals by the assessee against any order of assessment which gives rise to such tax dues of the company. If the stay pending such appeal is refused, the tax becomes recoverable from the company, ofcourse, subject to outcome of the pending appeal. If such tax is not paid by the company, it becomes its tax due. Under section 156 of the Act, when any tax, interest, penalty, fine or other sum is payable in consequence of any order passed under this Act, Assessing Officer would serve a notice of demand on the assessee. As per section 220(1), the assessee would have to pay the amount specified in the demand notice issued under section 156 within 30 days unless this period is curtailed under the proviso. Under section 220(3), the Assessing Officer has the power to extend the period. As per section 220(4), if the amount is not deposited within time allowed under sub-section(1) or extended under sub-section(3), the assessee shall be deemed to be in default. The decision of Kerala High Court in case of Khaders International Construction Ltd. was rendered in peculiar facts of the case where the original tax demand by the Assessing Officer was Rs.21.61 lakhs(rounded off). The directors of the company challenged the order of assessment before various authorities and the tax demand was reduced to Rs. 2 lakhs. It was in this background the Judge observed that it cannot be stated that non recovery of tax was due to negligence of the directors. The first contention of the counsel for the assessees therefore, cannot be accepted;

++ once it is established that the taxes of a private company cannot be recovered from the said company, the directors of the company at the relevant time would be jointly and severally liable for payment of such taxes, unless, it is proved that non recovery cannot be attributed to any gross negligence, misfeasance or breach of duty on their part in relation to the affairs of the company. The burden cast by statute is thus in the negative and is on the director concerned as is observed in case of Maganbhai Hansrajbhai Patel. However, once in defence, the director places necessary facts before the Tax Recovery Officer to establish that non recovery cannot be attributed to gross negligence, misfeasance or breach of duty on his part, the Tax Recovery Officer is required to apply his mind and come to definite findings. In the present case, the directors pointed out to the Tax Recovery Officer that the entire project ran into heavy losses due to devastating earthquake. Before the hotel could be inaugurated, the building was destroyed. The project therefore, never took off. This resulted into heavy losses to the company. The financial institutions restructured the debts and permitted sale of its property. Out of the sale proceeds, the creditors were paid off proportionately. When such payments were made, assessment order was still not passed. The insurance claim is not passed by the insurance company and civil disputes are still pending. In such facts and circumstances, the Tax Recovery Officer committed a serious error in applying section 179 of the Act against the directors;

++ the dues were paid to the creditors at the time when assessment order was yet to be passed. The assessee made a bona fide claim of set off. It may be that according to the Assessing Officer such claim was not maintainable. The issue however, has not yet achieved finality and is pending before the appellate authority. There is nothing on record to suggest that the company raised such a claim wholly mala fide. Under the circumstances, the ground that while paying all other creditors, the company made no provision for income tax liability, was not a valid ground. On the date when the creditors were paid off, there was no outstanding liability towards the income tax department;

++ second ground that the directors should have taken appropriate measures to protect the property of the company is neither maintainable in law nor in fact. The company had insured its property. However, the insurance claim ran into disputes. It was therefore, not a case where the directors failed to take measures for protecting the property or interest of the company as suggested by the Tax Recovery Officer. Even otherwise, whether to insure a property against any loss and if done against which risks, would be a purely commercial decision of a company. Depending on the threat perception in the area and insurance premium, the company would be taking appropriate decision. Such decision may turn out to be wise or in some case unwise. That by itself would not mean that the directors were negligent in performing their duties or they committed breach of duty in affairs of the company;

++ in a given case, if the company raises a completely bogus and mala fide claim of tax deduction, with the sole purpose of defrauding the Revenue, it may still be open for the Revenue to argue that provisions of section 179 of the Act would be applicable. Before the same however, can be done, there has to be material on record and which material must be disclosed to the director who is likely to face the adversity of the order. In the present case, in the show cause notice, no such averments or suggestions were made. Nor in the impugned order any material from the record is referred to which would enable the Tax Recovery Officer to draw such conclusions.