Real Estate Transactions- Accounting and Taxation aspect

Tax Planning- how far legitimate:

Case of IRC V Duke of Westminister (1936) AC 1 (House of Lords)

CIT V A Raman & Co (1968) 67 ITR 11 (SC)

Mc Dowell & Col (1985) 154 ITR 148 SC Held colourable device cannot be part of tax planning

Azadi Bachao Andolan (2003)  263 ITR 706 SC

Position of a land owner:

Options before him:

1.    To sell the land without any development

2.    To develop the land himself and sell constructed area:

3.    Join hands with another party called builder who would do the work of development on behalf of the land owner- execute the developer agreement- necessity :

Real estate transactions – Agreement between Land owner and developer

This agreement is popularly known as the Developer Agreement. This is considered as a starting point of the tax implication on the parties based on the nature of their status, rights and other obligations. 

Various Aspects

1.    Accounting Aspect

2.    Taxation Aspect: Whether  capital gain or business income

Accounting for Construction Contracts AS-7: (as revised in 2002) Generally the construction contract spreads over different accounting years.  Therefore, it becomes necessary to know how to book the revenue and expenses in different accounting years.

The salient features of AS – 7 are:

·       It is applicable only on developer or builder and not on the land owners who themselves develop their land.

·       It recognizes only the Percentage Completion Method of Accounting and not the Completed Contracts Method.

Percentage Completion Method: Recognition of revenue and expenses with reference to the stage of completion - Revenue received or not is not material-Reasonable certainty of recovery should be there.

Completed Contract Method: Result in determination of revenue when the contract is completed or substantially completed.

Guidance Note of ICAI : ‘ Guidance Note on Recognition of revenue by Real Estate Developer -  ICAI journal June 2006 issue page 1764

Recommends: to record revenue when all significant risk and rewards of ownership can be said to have been transferred – by transfer of legal title to buyer OR by giving possession of real estate.

Once the seller has transferred all the risks and rewards of ownership to the buyer, any further acts on the real estate performed by the seller are , in substance, performed on behalf of the buyer in the manner similar to a contractor. Accordingly, thereafter, the revenue is recognized by applying percentage completion method explained in AS-7 (Revised) Thus it can be said that through this guidance note, the AS-7 has become applicable even on enterprises undertaking construction activities on their own.

Whether percentage completion method must be followed in view of AS -7: Different view of Banglore ITAT

Prestige Estate Projects P Ltd V DCIT 33 DTR 514 (AT-Bang)

Sec. 145(3): Assessee developer having regularly employed project completion method which is an accepted method of accounting and the Central Govt having not notified AS- 7 u/s 145(2), AO could not reject the accounts u/s 145(3) on the ground that the assessee had not followed the percentage completion method.

Challenges of Accounting and Taxation:

A. For the builder or developer:

Accounting:

AS – 7 is applicable  on the builder.

Taxation:

Since the developer is doing the activity as business, the entire profits will be taxable under the head Income from Business or Profession.

The business profits will be computed as under :

Amount received on sale of his share in the constructed property less

a.   amount of consideration given to the land owner in cash

b.   cost of construction of  entire superstructure

B. For the land owner

a)Accounting: AS-7 is not applicable in any case

b) Year of taxability:

When the land is developed by the land owner himself:

The tax liability will arise only  in the year when the constructed property is ultimately sold – either fully or partly.

Some issues:

Whether on receipt of consolidated sale price for sale of land and building,  capital gain from land can be taxed as LTCG and on sale of super structure as STCG

In the case of CIT V Vimal Chand Golecha 201 ITR 442(Raj) it was held by the Hon’ble Rajasthan High Court that if consolidated price is received for two capital assets eg land and buildings, the price can be bifurcated. One capital asset may be long term and the other may be short term capital asset.  This view was also supported by Bomay High Court in the case of CIT V Citibank NA 134 Taxman 467 ( Bombay).

Whether where land is sold after plotting  and gains arises there from, whether the gains are  taxable as LTCG or as business income:

In the case of CIT V Sohan Khan 304 ITR 194 (Raj), it was held by the Hon’ble Rajasthan High Court that if land is sold after plotting and gains arises there from, such  gains are in the nature of LTCG  and not adventure in the nature of trade. Also distinguished the decision of SC in the case of G. Venkataswami Naidu & Co V CIT 35 ITR 594 (SC). 

When the land is given to developer for development:

Whether the capital gains are taxable in the year when the agreement with the developer was executed or in the year when consideration is received by the land owner - depends on the language of the developers agreement. It is taxable in the year in which risk and rewards in the property are transferred. In practice the handing over of the possession of the property by the land owner to the developer is deferred till the handing over of the built up area constructed by the developer to the land owner. Till that time, a  license is given to the developer to enter the property for the limited purpose of development and construction. In such case, the view is that the transfer does not take place immediately and the liability to capital gains does not arise until the built up space earmarked for land owner is constructed and handed over by the builder to the land owner.

However, a different view has been taken  by Bombay High Court in the case of :

Chaturbhuj Dwarkadas Kapadia V CIT 260 ITR 491 (Bombay)

Held:  In the light of Sec. 2(47)(v), the Capital gain was taxable in the year in which said transaction were entered into even if transfer of immovable property is not effective or complete under the general law.

POSER:  What is the option before land owner to beat the above case law Whether it is better to convert the land into stock in trade and fall under Sec. 2(47)(iv) and allow Sec. 45(2) to determine the year of chargeability.

c) Computation of income :

In case the land is developed by the land owner himself

Long term capital gains( Sale of land) Sale price of                   less     -Cost of construction Constructed                              -Indexed cost of land    Property                                  -STCG Short term capital gain ( Sale of superstructure) Estimated Profit of construction

In case the land is given for development to a developer

Consideration: It can be in Cash or Exchange of Constructed Area or partly in cash and partly in exchange of constructed area. If it is Exchange of constructed area, then the value thereof will be determined as per the books and records maintained by the developer in regular course of his business. Long term capital gains: Amount of consideration received(in cash or in kind ) less Indexed cost of land Short term capital gain Sale Price less consideration received ( in kind)

Difference Planning V Advocacy

Controversies of deductions u/s 54, 54F , 54 EC available to land owner

·       Whether to claim u/s 54 or u/s 54F:

It will depend on the fact whether old house was given for development or vacant land was given after demolition of old house. Condition attached to Sec 54F are more stringent therefore it is better to go for Sec. 54

·       Whether simultaneous deduction under two  sections is possible:

Claiming of deductions simultaneously us 54/ 54F is possible along with Sec. 54EC – Yes

·       Whether farm house is also a house for the purpose of Sec. 54 or Sec. 54F: Farm house is a house 38 ITD 125

·       Whether extension in the existing house will also quality for deduction u/s 54/54F: Extension of house is also eligible for exemption 65 ITD 352 ( Delhi)

·       Whether construction of new house must be completed within the time stipulated in the Act: Sec 54 F held that construction need not be completed within stipulated time- the investment of entire consideration is the condition to be satisfied. CIT V Sardarmal Kothari & others 302 ITR 286 ( Madras)

·       Whether each individual co owner of new house can claim deduction u/s 54/54F in respect of the new house: Each co owner be called the owner of new residential house 245 ITR 182 ( Guj)

·       Whether assessee can construct new house on the land belonging to his wife: CIT V P R Seshadari 228 ITR 334 (Ker) Sec. 54F: Assessee is entitled to exemption u/s 54F in respect of investment in the construction of house property on the land owned by his wife.

·       Whether the new house must be registered in the name of the assessee within the stipulated time: For claiming exemption u/s 54, purchase of residential house with possession is necessary, registration of document is not required. 254 ITR 22 Del

·       Purchase of new house under hire purchase agreement- when the assessee becomes the owner of the house: u/s 54  Date of acquisition is date of allotment. Payment of installment is only a follow up action. 33 Tax World 193 ITAT Jaipur

·       Whether cost of land will also qualify for exemption u/s 54/54F: Land cost also qualified for exemption u/s 54 and 54F Circular no. 667 dt. 18.10.93

·       Whether purchase of more than one flat will qualify for deduction: Purchase of more than one flat u/s 54. Deduction allowable if they are adjacent and are commonly occupied. 16 ITD 195 ( ITAT Bombay)

·       Whether purchase of more than one residential house will also qualify for deduction u/s 54: Held Yes. In the case of  CIT V. D Ananda Basappa (2009) 180 Taxman 4 (Kerala) the Hon’ble Kerala HC has opined that the expression ‘a residential house’ should be understood in a sense that building should be residential in nature and ‘a’ should not be understood to indicate a singular number.

·       Whether deduction u/s 54EC can also be claimed in respect of LTCG on sale of a depreciable asset,  where the capital gains are taxable as STCG as per scheme of Sec. 50: Deduction u/s 54 EC is available even for depreciable asset as mentioned in Sec. 50. ACE builders P Ltd 281 ITR 210 (Bombay)

·       Period of holding of inherited property- from the date of inheritance or earlier:  (Explanation (iii) to Sec. 48 on ‘indexed cost of acquisition’ refers to the first year in which asset was held by the assessee. ) When some property is inherited by the assessee after 1.4.81 and the original owner acquired the property before 1.4.81,  and such property is sold by the assessee- in such case, the indexation benefit will be given to the assessee considering as if the property was held by him since 1.4.81. ITO V Mahendra K Agarwal 42 Tax World 61 (ITAT Jaipur) and DCIT V Manjula Shah (2009) 126 TTJ 145 (Mumbai) and M Siva Parvathi & Others V ITO(2010) 129 TTJ (Vaisakha) 463

·       Whether deduction for payments to tenants for vacation of premises is allowed  for computing LTCG: Held that deduction is allowed if any amount is paid to tenants for vacation of premises, while computing LTCG. M Siva Parvathi & Others V ITO(2010) 129 TTJ (Vaisakha) 463

Other important provisions of the Income tax Act useful in tax planning:

1.    Deferment of chargeability of Capital Gain Tax: Sec. 45(2) read with Sec. 2(47)(iv)

This section provides an opportunity to convert the capital assts into stock in trade. The capital gains tax liability arises only when you sell the stock in trade ( property) No tax liability will arise on mere conversion. The year of capital gain and investment u/s 54EC/ 54/54F will be calculated from the date of actual transfer. For the purpose of Sec. 48, the FMV of the asset on the date of such conversion shall be deemed to be the full value of consideration received.

2.    Introduction of capital asset as capital contribution by the partner: Sec. 45(3)

If any capital asset is brought into the firm [ Firm includes LLP also by virtue of provisions of Sec. 2 (23) ] by a landowner while becoming a partner as capital contribution, it shall be chargeable to tax in the year in which he became a partner, and the amount recorded in the books of accounts of the firm shall be deemed to be full value of consideration. The landowner can claim exemption u/s 54 or 54F depending on the purchase of flat in the project. Also as per Sec. 14 of the Indian Partnership Act no registration is required in such cases.

3.    Transfer of capital asset on dissolution of a firm: Sec. 45(4):

Profit or gain from transfer of capital asset by way of distribution of capital asset on the dissolution of a firm shall be chargeable to tax at the FMV of the asset on the date of such transfer. If there is dissolution of firm but no distribution of asset, capital gains tax not leviable 281 ITR 52 (MP)

4.    Presumptive scheme of taxation for small contractors: Sec. 44AD

If the turnover of an assessee from any business other than the  business of playing goods carriages does not exceed Rs. 60 lacs,  and he shows NP of 8% or more, before deduction of salary and interest to partners - in such cases there is no need to maintain account books. If lesser NP is shown than proper books of accounts should be maintained and audited u/s 44AB.  These provisions are also applicable in the case of a contractor, builder or developer.  Material directly supplied by the principal will be deducted from turnover for the purpose of determining the total turnover.

5.    Conversion of Partnership firm into companies: Part IX companies

If at the time of conversion, the firm is holding certain capital assets, it will not be deemed to be a transfer of asset to the company and the liability for capital gains shall not arise. 286 ITR (AT) 121, 103 ITD 53.

Also it has been held that asset and liabilities of erstwhile firm becomes assets and liabilities of the company on such conversion. 281 ITR (AT) 162 ITAT Jodhpur

6.    Consideration of value taken for the purpose of payment of stamp duty for computing LTCG: Sec. 50C (inserted w.e.f 1.4.2003)

This section makes a departure from well established principle by linking consideration with the guidable value adopted or assessed or assessable for stamp duty purposes.  Earlier there was very old case of K P Vergese 131 ITR 597 (SC) in which SC held that FMV cannot be taken as sale consideration and the AO has to prove that the assessee has under stated the consideration. The remedies available to the assessee are either appeal before stamp duty authorities or request for referring the matter to DVO for fresh valuation.

Whether Sec. 50C is also applicable on stock in trade: In the case of KR PalanisamyV UOI 180 Taxman 253 (Mad) it has been held that Sec. 50C is not applicable on trading assets or stock in trade. Also followed in the case of CIT V Thiruvengadam Investments P Ltd (2010) 229 CTR 284 (Mad)

Whether Sec. 50C is applicable in case sale of of depreciable asset  as per scheme of Sec. 50: In the case of Panchiram Nahta v ACIT 127 TTJ 128 (Kol) it has been held that Sec. 50C is not applicable on sale of depreciable assets where profit is to be taxed as STCG as per Sec. 50 of Income tax Act.

Whether Sec. 50C is applicable if asset introduced by partner in firm as his capital u/s 45(3): Held that Sec. 50C is not applicable if a partner introduce his asset as his capital in the firm u/s 45(3). Carlton Hotel P Ltd V ACIT 122 TTJ 515 (Chennai)

POSER:

Where any property is transferred for a value which is less than the assessable value. To claim the deduction u/s 54F whether the assessee has to invest the net realized sale consideration or the assessable value of the property.

7.    Gift of immovable properties: Sec. 56(2)(vii)

Although the Gift Tax Act has been repealed on 1.10.98, tax on gifts has been introduced in the income tax law. Earlier the tax on gift was donor based but now it has become donee based.

Finance (No. 2) Act, 2004 introduced a new clause (v) to Sec. 56(2) which provided that  a sum of money received by an individual or HUF from any person after 1^st Sept 2004 without consideration will be deemed to be income under the head ‘Income from other sources.’. After that many amendments were made from time to time. Sec. 56(2)(vii) introduced by Finance (No. 2) Act 2009 made gift of immovable property without consideration or for inadequate consideration also taxable in the hands of donee.

This clause has again been amended by Finance Act 2010 which has restricted this addition only in respect of Immovable Properties received without consideration in which case the  whole of the stamp duty value shall be treated as taxable in the hands of the donee. This is not applicable in the following cases:

a.    If the stamp duty value of property is less than Rs. 50,000.

b.    If the impugned property is not a capital asset in the hands of assessee.

c.    If the property is received from a ‘relative’, or on the occasion of marriage of the individual, or under a will.

8.              Deduction for low cost housing projects : Sec. 80-IB(10)

i)                  Deduction if housing project approved by local authority before 31.3.2008.

ii)                The undertaking should have commenced development and construction of the housing project on or after 1.10.08

iii)              Deduction: 100% of Profit for 5 years from the end of the financial year in which the housing project is approved by local authority.

iv)              The plot size should not exceed 1 acre

v)                Maximum built up area not to exceed 1000 Sq Ft for Delhi and Mumbai and 1500 Sq Ft for any other place

vi)              Commercial built up area should not exceed 3% of total built up area or 5000 Sq Ft whichever is higher.

vii)            Not more than one residential unit is  allotted to any person who is not an individual.

viii)          Restriction on allotment of further residential units of in the name of family members of an individual who has been allotted one residential unit.

POSER 1:

Since this deduction is available only out of business profits therefore it will not be available to a land owner who is not promoting the project himself but rather getting it done through a developer. In such cases, land owner can convert  the capital asset into stock in trade and enter into a joint venture with the developer in partnership or AOP.  Case of Sec. 45(2)

POSER 2:

Whether a partner can introduce his land as his capital at book value of Rs. 1lacs ( market value of Rs 50 lacs) in a firm developing eligible housing project  and claim whole of the profits exempt under the above section. Case of Sec. 45(3)

9.              Family Arrangement: A good tool for tax planning and for giving good title to all                               the concerned parties. It has to be accepted as valid enforceable if its bonafide is not doubted by AO. 26 Tax World 381 ITAT Jaipur

Delhi ITAT  has held in ACIT V Baldev Raj Charla 121 TTJ 366 (ITAT Del) that if family partition takes place for very old properties,  indexation benefit is to be given from 1.4.81 on sale of such properties.