Compensation Paid for Cancellation of Share Sale Agreements Allowable as Deduction Against Capital Gains

 Recently, the Pune ITAT held that compensation paid for cancelling an earlier share sale arrangement can be allowed as a deduction while computing capital gains, provided the payment arises from genuine contractual obligations and is directly linked to the eventual transfer of shares.

The case involved an assessee who initially agreed to sell shares of a company to two prospective buyers at ₹305 per share. As the assessee was unable to obtain the requisite consent from the other shareholders and subsequently received an offer from a third buyer at a substantially higher price of ₹625 per share, the earlier agreements were cancelled and compensation of ₹7.84 crore was paid to the original buyers in accordance with the contractual terms. The assessee claimed this amount as a deductible expense while computing long term capital gains. The matter was picked up in revisionary proceedings under Section 263, pursuant to which the tax authorities alleged that the arrangement was merely a colourable device to reduce tax liability and disallowed the deduction. The assessee challenged the disallowance before the CIT(A), which deleted the addition made. Thereafter, Revenue preferred an appeal before the ITAT.

The Tribunal noted that the compensation payments were supported by valid contractual agreements and were made pursuant to pre-agreed terms rather than as an afterthought. Importantly, the payments enabled the assessee to complete the share sale at a significantly higher price, resulting in greater overall gains and higher tax outgo. The Tribunal also rejected the Revenue's contention that the agreements were not genuine because they were not registered. It observed that there is no legal requirement for registration of agreements relating to the sale of shares and that the Revenue had not produced any evidence to establish that the transactions were sham.

This ruling reinforces the principle that genuine commercial arrangements cannot be disregarded merely because they result in a tax benefit. It also reiterates that deductions from Capital Gains are permissible only in respect of expenditure incurred wholly and exclusively in connection with the transfer, and therefore, where payments are made pursuant to bona fide contractual obligations and bear a direct nexus to the transfer of a capital asset, the tax authorities cannot disallow such expenditure merely on suspicion or by questioning the commercial prudence of the taxpayer.