Kolkata Tribunal Rules Compensation for Settling Litigation Is Non-Taxable When Only 'Right to Sue' Is Surrendered

 In a recent ruling, the Kolkata Income Tax Appellate Tribunal (ITAT) held that compensation received by a taxpayer to settle ongoing disputes and withdraw pending litigation constitutes a non-taxable capital receipt, provided the taxpayer merely gave up its ‘right to sue’ and no enforceable contractual right existed.

Background of the Case

• The taxpayer, a real estate developer, entered into an agreement to acquire land for a proposed project.

• A dispute later arose regarding the enforceability of the agreement, prompting the taxpayer to initiate arbitration proceedings against the other party to enforce the land transfer.

• The arbitrator ruled that the other party did not possess valid or marketable title to the land on the date of the agreement, and therefore could not legally transfer it.

• Aggrieved by this decision, the taxpayer filed suits before the District Court. While these suits were pending, the other party approached the taxpayer to settle the entire dispute.

• A settlement agreement was executed, under which the taxpayer received compensation in exchange for unconditionally withdrawing all pending cases and claims.

• The taxpayer treated the compensation as a non-taxable capital receipt. The tax authorities, however, argued that by settling, the taxpayer had given up its valuable right to ‘specific performance’ under the contract (i.e., the right to compel the other party to complete the land sale). According to the Revenue, this extinguishment of a right amounted to a ‘transfer’ and was liable to capital gains tax.

Key Findings of the ITAT

• Purpose of payment: On reviewing the settlement agreement, the Tribunal found that the payment was made for withdrawing pending litigation and claims, not for relinquishing any rights in the property or contract.

• No enforceable right existed: Since the arbitrator had already held that the seller had no valid title, the taxpayer never actually acquired a legally enforceable right in the property under the original contract. The sale agreement was void ab initio (from the beginning). Therefore, the taxpayer could not be considered as having relinquished a right it did not possess at the time of settlement.

• ‘Right to sue’ is not a capital asset: At the time of settlement, the taxpayer only possessed a ‘right to sue’. This right does not qualify as a ‘capital asset’ under the Income-tax Act, and consequently, compensation received for surrendering it cannot be taxed as capital gains.

• Distinction from revenue’s precedents: The Tribunal distinguished the rulings relied upon by the Revenue, noting that those cases involved the surrender of legally enforceable contractual rights—unlike the present case where no such contractual right was surrendered.

• Capital nature of receipt: The Tribunal further observed that the failed acquisition resulted in the loss of a potential source of income for the taxpayer’s real estate business. Compensation received for such a loss was therefore capital in nature and not taxable as revenue income.

Key Takeaway

This ruling reinforces that where a taxpayer merely settles litigation and gives up only a ‘right to sue’—without holding any enforceable right in the underlying asset—the compensation received may continue to be treated as a non-taxable capital receipt.

Parties entering into dispute settlement arrangements should carefully evaluate the nature of the rights being surrendered and ensure that the settlement terms are appropriately documented.

Important Note: It remains to be seen how the principles laid down in this ruling will apply in light of the amendment made to the Income-tax Act, 1961, effective from Assessment Year 2019-20 onwards, under which compensation received in connection with the termination or modification of business contracts has been expressly brought to tax as business income.