Profits or gains arising from transfer of a capital asset are charged to tax under Section 45 of the Income Tax Act, 1961 (‘Act’) as capital gains. Capital gains are computed under Section 48 of the Act by deducting the cost of acquisition of the asset, its cost of improvement or the expenditure incurred in connection with transfer from the ‘full value of the consideration’ received or accruing as a result of such transfer.
Barring the legal fictions created to deal with certain specific transfers, the phrase ‘full value of the consideration’ has not been defined under the Act. In the context of a sale, the Hon’ble Supreme Court[1] has defined the said phrase to mean the price bargained for by the parties to the sale. Therefore, ordinarily in the case of a sale, the price mutually agreed upon by the parties which is received by or accrues to a seller should be taken as the ‘full value of the consideration’ for calculating capital gains.
Having stated the above, a legal quandary arises in the case of those sales where a portion of the consideration has been retained in an escrow account under an agreement between the parties. In this context two issues arise:
(i) Would such retained amount fall within the purview of ‘full value of the consideration’?
(ii) If such retained amount is to be taxed, what would be the year of taxation, namely, the year in which the transfer takes place or the year in which the retained amount is released to the seller?
One can imagine that where the consideration otherwise accrued in the escrow is sought to be applied towards agreed purposes, the gross consideration accrues to the transferor and should be taxed in the year of transfer. However, practically, such retentions may be far more complex. There are cases where the consideration is parked in escrow and the accrual of consideration is dependent on contingencies to be satisfied in future. These contingencies could be in the form of disposal of litigations, meeting agreed performance parameters or expiry of certain statutory periods. In all such cases, one could argue that the sums in escrow would accrue upon completion of the contingency recognized by the contracting parties. Thus, the inclusion and timing of sums in escrow to sale consideration becomes litigious. In this context, depending on the facts of each case, judicial forums have elucidated on taxation of sums in escrow which have been discussed in the subsequent paragraphs.
(a) Caborandum Universal ACIT[2], Madras High Court
In the case of Caborandum Universal Ltd.[3] the seller sold its plant by way of a business sale agreement (‘BSA’), whereunder an amount of INR 31.14 crore was the ‘Full and Final Consideration’ for the transfer. The BSA also provided that, out of the aforesaid sum, a sum of INR 3.25 crore was to be set aside and kept in an escrow account which was operable with the consent of both the parties. The BSA further stated that the sum kept in the escrow account was to be used to indemnify the purchaser for any post-sale contingent liabilities and the interest accruing on the said sum belonged to the seller.
The seller excluded the sums in the escrow account to compute capital gains and paid tax on such gains in the year of transfer. Further, since no contingent liabilities materialized during the agreed period, no withdrawals were made by the purchaser from the escrow account and the entire sum therein was received by the seller. The seller offered the sum lying in the escrow account to tax as capital gains in the year of the receipt. The Income-tax Department (‘Department’), however, contended that the entire sum lying in the escrow account should have also been offered to tax in the year in which the transfer took place.
Disagreeing with the position by taken by the seller in this case, the High Court of Madras held that the entire sale consideration would be taxable in the year of transfer since:
(i) Setting aside of a portion of the sale consideration in an escrow account, after mutually agreeing upon a ‘Full and Final Consideration’, would represent application of income as the consideration received from the transfer would thereafter be utilized for the purpose of meeting contingent liabilities. Such conduct of the parties to the transaction would not exclude the said amount from the purview of consideration being received by/accruing to the seller for computing capital gains under section 48 of the Act.
(ii) As the interest on the sum retained in the escrow account accrued in favour of the seller, and the escrow account was operable only with the consent of both the parties, the seller had a clear right over the retained sum. Thus, even if a portion of the retained consideration were to be utilised to indemnify the purchaser, it would not alter the full consideration received by/accruing to the seller pursuant to the BSA.
It is pertinent to note that the aforementioned judgement has been challenged by the seller before the Supreme Court and the said appeal has been admitted.[4]
(b) Dinesh Vazirani PCIT[5], Bombay High Court
In its subsequent decision in Dinesh Vazirani[6], the High Court of Bombay has upheld re-computation of capital gains to give effect to the downward adjustment of escrow sums. In this case, a total sale consideration of INR 155 crore agreed upon under the share purchase agreement (‘SPA’) for the transfer of the shares of a company. Out of the said total sale consideration, an amount of INR 30 crore was retained in an escrow account for 2 years to indemnify the purchaser for any liability that might arise post the transfer of shares. The seller computed the capital gains from such transfer by considering the total sale consideration of INR 155 crore as the ‘full value of the consideration’ and offered the same to tax in the year of transfer.
Subsequently, certain liabilities arose in the company for the period prior to the share sale, on account of which an amount of approximately INR 9 crore was withdrawn from the escrow account. Thus, at the end of the 2-year period stipulated in the SPA, the remaining sum of approximately INR 21 crore was released to the seller. Considering the same, the seller filed an application before PCIT for recomputing the capital gains, that had already been offered to tax, after reducing the amount that had been withdrawn from the escrow account from the ‘full value of the consideration’ as the said amount never accrued to the seller.
However, the said revision application was rejected by the PCIT inter-alia on the ground that while computing capital gains under Section 48 of the Act only the cost of acquisition, cost of improvement or expenditure incurred exclusively in connection with the transfer could be reduced from the total sale consideration under the SPA. The indemnification clause in the SPA, for meeting contingent liabilities which may arise subsequent to the transfer, cannot be reduced from consideration received for computing capital gains.
The Bombay High Court, however, quashed the PCIT’s order and observed as follows:
(i) As per the SPA between the parties, the purchase price defined therein was not an absolute amount and was subject to certain liabilities contemplated therein that might arise due to certain subsequent events.
(ii) The portion of the retained consideration that had been withdrawn by the purchaser had neither been received by the seller nor did it accrue to the seller, as the said amount was transferred directly to and thereafter withdrawn from the escrow account.
(iii) Tax can be levied only on the real income of the seller, which in this case would be the total sale consideration as reduced by the amount withdrawn from the escrow account. This was because the liability for which the amount was withdrawn was contemplated in the SPA and had to be taken into account while determining the ‘full value of the consideration’. Irrespective of the fact that the actualisation of the contingent liabilities is a subsequent event, the same ought to be taken into consideration for determining capital gains.
(c) Modi Rubber Ltd. v. DCIT[7], ITAT Delhi
Analysing the aforesaid decisions, the ITAT Delhi in Modi Rubber Ltd.[8] emphasised that the question of taxability of the consideration retained in an escrow account has to be decided as per the facts of the case and a principle for universal application cannot be laid down.
In this case, the seller sold the shares of a company for a total consideration of approximately INR 117 crore out of which an amount of approximately INR 25 crore was kept aside in an escrow account for indemnifying the purchaser against some liabilities. The operation of the escrow account was under joint instructions of the seller and the purchaser, and the amount kept in escrow was to be released at pre-determined points of time along with the accrued interest after adjustment of claims of indemnification. The seller excluded the sum retained in the escrow account from the ‘full value of the consideration’ for computing capital gains. Subsequently, in another year, some portion of the retained money was received by the seller and offered to tax as capital gains in that year. Furthermore, during the period of retention, substantial claims of more than approximately INR 78 crore had been identified and raised against the retention amount remaining in the escrow account.
The ITAT Delhi, while ascertaining the tax treatment of the part of consideration retained in an escrow account, differentiated the judgement in Caborandum Universal[9] by holding that, unlike the facts of the present case, therein the entire amount placed in the escrow account was returned to the seller without any deductions and accordingly, the question of amendment of the ‘full value of the consideration’ for computing capital gains did not arise. Accordingly, in that case the entire sale consideration, including the amount lying in the escrow account, was held to be taxable under the head capital gains.
The ITAT instead placed reliance on the decision in Dinesh Vazirani[10] by holding that it was factually identical to the case before it. Basis the same, the ITAT held that even though the sum retained in the escrow account forms a part of the mutually agreed consideration, such an amount would not necessarily form part of the ‘full value of the consideration received or accruing’ as result of transfer of a capital asset in a case where there is a likelihood that the retained sum may never come into the hands of the seller. It also held that the retained sum shall not be taxed in the year in which the transfer of the asset took place.
Analysis
As may be seen from the above, different views have been taken by various judicial forums regarding the inclusion of the amounts set aside in an escrow account in the ‘full value of the consideration’ and also the year in which the said amounts are to be taxed:
(i) Caborandum Universal[11] - The amounts set aside in an escrow account must be taken into consideration for determining the ‘full value of the consideration’ for computing capital gains. Thus, the amounts retained in the escrow account are to be taxed in the year in which the transfer has taken place.
(ii) Dinesh Vazirani[12] - The subsequent adjustment to amounts set aside in an escrow account must be reduced from the total sale consideration agreed by the parties for determining the ‘full value of the consideration’ for computing capital gains. However, the question regarding the year in which the retained amounts are to be taxed never arose before the High Court.
(iii) Modi Rubber Ltd.[13] - The ITAT Delhi has followed the position laid down in Dinesh Vazirani[14] regarding the reduction of the amounts set aside in an escrow account while determining the ‘full value of the consideration’ for computing capital gains. Further, it has held that the said amounts must be taxed in the year in which they are received by the seller.
In light of the above discussion, it may appear that the position taken by the ITAT Delhi represents a successful middle path for taxpayers as: (a) it gives the benefit of reduction of the retention amount lying in the escrow account for computing capital gains and; (b) also the benefit of the retention money only being chargeable to tax in the year in which it is received.
However, the latter position regarding the timing of taxation of the sums retained in the escrow account may face challenge from the Department as it may be argued that Section 45(1) of the Act provides that the capital gains arising from a transfer shall be the income of the year in which the transfer takes place. The Department may also argue that upon a perusal of Section 45 of the Act, it becomes apparent that the situations wherein the Legislature’s intent was to take a particular transfer out of the purview of Section 45(1) and defer the taxation of capital gains, specific provisions have been enacted with a non-obstante clause to Section 45(1). To illustrate the same, reference is being made to some of the said provisions:
(a) Section 45(1A) provides that where any person receives an insurance payout on account of damage to, or destruction of, any capital asset then the capital gains arising from the receipt of such money shall be chargeable to tax in the year in which such money was received and not in the year in which the asset is damaged/destroyed.
(b) Section 45(5) inter-alia provides that where the capital gain arises from the transfer of a capital asset as a result of its compulsory acquisition under any law and the compensation for such transfer is enhanced or further enhanced by any authority, the capital gain shall be chargeable to tax in the following manner:
(i) The capital gains computed with reference to the initial compensation awarded shall be chargeable to tax in the year in which such compensation is received; and
(ii) The amount by which the compensation is enhanced shall be chargeable to tax in the year in which such an amount is received.
Furthermore, considering the fact that the ‘full value of the consideration’ may vary depending on the contingent liabilities that may be met out of the sums retained in the escrow account, it may be that the Department may take a position that since the consideration accruing to the seller as a result of the sale is unascertainable, the provisions of Section 50D of the Act may be invoked and the fair market value of the said asset on the date of transfer shall be deemed to be the ‘full value of the consideration’.
Accordingly, as is apparent from the above discussion, the position in the case of a taxpayer would completely depend on the facts and circumstances in their case. Thus, the language utilized in the sale agreement becomes critical for determining the taxability of the sums retained in an escrow account and therefore the parties to such sale should keep in mind factors such as:
(i) What does the sale agreement provide regarding the right of the seller to receive the sums retained in the escrow account?
(ii) Whether the retention has been made by way of the same sale agreement which facilitates the transfer of the capital asset?
(iii) What are the rights or control, if any, that the seller has over the sums retained in the escrow account?
(iv) What will be the right of the seller over the interest, if any, that may accumulate in the escrow account?
(v) What is the nature of the liabilities for which the purchaser is being provided an indemnity through the sums lying retained in the escrow account?
(vi) What is the likelihood of materialisation of the liabilities for which the purchaser is being provided an indemnity through the sums lying retained in the escrow account?
(vii) Whether the sums retained in the escrow account have actually been utilized to meet some claims/indemnify the purchaser?
Therefore, till the time the position regarding the sums retained in an escrow account is not settled by way of the decision of the Supreme Court, any position taken by a taxpayer in relation thereto is likely to be litigative. The specifics of each agreement will play a critical role in determining the liability of the taxpayer. Thus, till the time some final word is spoken on the subject by the Supreme Court, the taxpayers should carefully determine their rights and liabilities towards the escrow sums to trace their tax liabilities in relation to these sums.
[The authors are Principal Associate, Senior Associate and Associate, respectively, in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys]
[1] CIT v. Gillanders Arbuthnot & Co., [1973] 87 ITR 407 (SC)
[2] [2021] 130 taxmann.com 133 (Madras)
[3] Ibid.
[4] C.A. No. 8054/2024 arising out of SLP(c) No. 17978/2022
[5] [2022] 140 taxmann.com 581 (Bombay).
[6] Ibid.
[7] I.T.A. No. 6866/DEL/2018.
[8] Ibid.
[9] Supra at 2.
[10] Supra at 4.
[11] Supra at 2.
[12] Supra at 4.
[13] Supra at 9.
[14] Supra at 4.
