2.2 As the builder and developer deals with immovable property, laws relating to the same are analysed and discussed first hereinafter.

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1 INCOME TAX ISSUES IN REAL ESTATE TRANSACTIONS Chetan A. Karia Chartered Accountant 1. Introduction The issue of taxation of income from business of real estate development is refusing to settle. With the issue of latest guidance note for recognition of revenue from real estate development, the issue for the purposes of income tax would have to be considered in the context of the guidance note. 2. Sale by a real estate developer 2.1 A builder or a developer is as much in business of purchase and sale as any other trader or manufacturer. It is only the nature of product which is different but the nature of transaction is of sale. A builder purchases land and he constructs buildings or bungalows on such land and sell such houses. The nature of transaction is sale. However, as development and construction may span over more than one financial year, issue of year in which profit arises assumes importance. 2.2 As the builder and developer deals with immovable property, laws relating to the same are analysed and discussed first hereinafter. 3. Provisions of Transfer of Property Act 3.1 For a developer, the transaction is of sale of immovable property and provisions of Transfer of Property (TOP) Act are applicable to the transaction. 3.2 Section 54 of TOP Act provides that sale of an immovable property of value of one hundred rupees and above can be made only by a registered document. It further provides that a contract for sale, does not create any interest in or charge on immovable property. The position of law that a contract for sale does not create any interest in or charge on 1

2 immovable property has been upheld by hon ble Supreme Court in a series of judgments and reiterated again in recent judgment in case of Suraj Lamp Industries P Ltd v. State of Haryana. An agreement for sale entered into by a developer during the period of development is not a sale but a contract for sale and it does not create any interest in immovable property in favour of purchaser. 3.3 Section 53A of TOP Act reads as follows: Where any person contracts to transfer for consideration any immovable property by writing signed by him or on his behalf from which the terms necessary to constitute the transfer can be ascertained with reasonable certainty, and the transferee has, in part performance of the contract, taken possession of the property or any part thereof, or the transferee, being already in possession, continues in possession in part performance of the contract and has done some act in furtherance of the contract, and the transferee has performed or is willing to perform his part of the contract, then, notwithstanding that the contract, though required to be registered, has not been registered, or, where there is an instrument of transfer, that the transfer has not been completed in the manner prescribed therefor by the law for the time being in force, the transferor or any person claiming under him shall be debarred from enforcing against the transferee and persons claiming under him any right in respect of the property of which the transferee has taken or continued in possession, other than a right expressly provided by the terms of the contract: Provided that nothing in this section shall affect the rights of a transferee for consideration who has no notice of the contract or of the part performance thereof. 3.4 If the purchaser has received possession of property in part performance of the contract and the purchaser has performed or is ready 2

3 to perform his obligations under the contract, than as between the purchaser and seller, the transaction is complete though legal ownership is transferred only on conveyance being registered in favour of the purchaser. S. 53A acts as a shield for the purchaser to protect his possession against the seller or any person claiming through him except for a transferee who has no notice of the contract or possession in hands of the purchaser. However, between the purchaser and the developer, the transaction is legally complete when possession is handed over in part performance of the contract. 4. Provisions of Maharastra Ownership Flats Act In the State of Maharastra, the business of developer and builder of immovable property is regulated by Maharastra Ownership Flats (Regulation of the promotion of construction, sale, management and transfer) Act, 1963, hereinafter referred to as MOFA. 4.2 Section 3 of MOFA provides for general liabilities of a promoter and it provides that every agreement for sale of unit developed will be registered. Clause (f) thereof provides that date of possession shall be specified in the agreement for sale and clause (i) thereof provides that possession shall not be handed over till completion certificate is granted by the local authority. 4.3 In the City of Mumbai, Regulation 6(6) and 6(7) of the Development Control Regulations for Greater Mumbai, 1991 provides for obtaining completion certificate and occupation certificates. 4.4 Section 8 of MOFA provides that if possession is not given within specified time, the amount collected have to be refunded. 4.5 To summarise, MOFA, to the extent relevant to the issue provides that, if a developer enters into contract for sale while the units are under development: i) the contract has to be registered, 3

4 ii) the contract for sale shall specify the date by which possession shall be given, iii) possession cannot be handed over till completion certificate is granted by local authority, and iv) if possession is not granted by date specified, the purchaser can cancel the contract for sale and the amounts collected will have to be refunded by the developer. 5. Views of ICAI 5.1 The Institute of Chartered Accountants of India had issued AS 7 in 1983 relating to accounting for Construction Contract. Old AS7 prescribed two methods, i.e., percentage of completion method or completed contract method and an enterprise had an option to follow either of the two methods. As statement related to accounting for construction contracts, it would not have normally applied to builders or developers as nature of their business is not of executing construction contracts but of sale of constructed units. However, in initial paras the said standard stated: The statement also applies to enterprises undertaking construction activities of the type dealt with in this Statement not as contractors but on their own account as a venture of a commercial nature where the enterprise has entered into agreements for sale. The standard has been revised and revised Accounting Standard 7 (AS 7) dealing with Accounting for Construction Contracts has been issued in 2002, which is effective from Revised AS7 makes it mandatory to follow percentage of completion method if the prescribed conditions are satisfied. The revised AS 7 does not make the statement as in original AS 7 that it shall also apply to builders and developers. In opinion of Expert Advisory Committee of the ICAI reported in The Chartered Accountant (Vol. 52, No. 3) at page 232, 4

5 revised AS 7 would not apply to builders carrying on construction on their own account for sale of constructed units; rather AS 9 would apply. 5.2 A Guidance note was subsequently issued by ICAI in the year 2006 providing that in case of builders, if agreement for sale is entered into than one can say that conditions of AS 9 for recognizing revenue are satisfied and income can be recognized in the year in which agreement for sale is entered into. 5.3 The ICAI has in February, 2012 issued revised GN on the subject. The revised Guidance Note can be briefly summarized as follows: i) The enterprise shall have to determine on the basis of document for sale and other circumstance as to whether the transaction is of sale or rendering construction services on behalf of buyer as a contractor. ii) Profit shall be recognized in respect of real estate sales as per AS 9 if the transaction is of sale para 3.3 iii) Four conditions have been prescribed in para 4.2 on completion of which profit from a sale transaction shall be recognized and handing over possession is one of the four conditions prescribed, iv) Profit shall be recognized on percentage completion method if transaction is similar to a contractor para 3.3 v) Circumstances have been narrated when it can be said that transaction is similar a contractor para 5.1 vi) Four conditions have been prescribed in para 5.2 on completion of which profit can be recognized under percentage method vii) Further additional conditions have been prescribed in para 5.3 for recognition of profit as per percentage method viii) Method to be applied for determination of profit as per percentage method has also been prescribed. 5.4 To summarise, the revised GN permits a developer to follow either percentage completion method or sale method depending on the nature of the transaction. 5

6 6. When profit accrues for the purposes of Income Tax 6.1 Under the Income Tax Act, the issue has been subject matter of litigation in many a judgments and both department and assessee s have at times, adopted extreme stands. 6.2 Section 5 of the Income Tax Act, 1961, provides for scope of income chargeable to tax and to the extent relevant, it reads: accrues or arises or is deemed to accrue or arise to him. What is chargeable to tax is income, which has accrued or arisen to a person. The concept of accrual was considered in E. D. Sassoon & Co. v. CIT (1954) 26 ITR 27 (SC) and it was held: What is sought to be taxed must be income and it cannot be taxed unless it has arrived at a stage when it can be called income. 6.3 Merely because advance payment is received the same does not become taxable. For any receipt to be taxable, the receipt has to be as income and not otherwise. The said principle has been laid down in judgment of hon ble Supreme Court in Keshav Mills, 23 ITR 230. The said principle has been followed by hon ble Bombay High Court in case reported in 237 ITR 814 and by hon ble Income Tax Appellate Tribunal in case reported in 57 ITD 81 (Hyd). Therefore mere receipt of advance cannot be criteria to determine the taxability of the amount. 6.4 Section 145 of the Act provides that profits and gains of business shall be computed as per method of accounting regularly followed by the assessee. The choice of method of accounting is with the assessee. Before amendment in the year 1997, under proviso to S. 145(1) the Assessing Officer could determine income by a different manner if he was of the opinion that method of accounting followed does not determine correct income. The power under the proviso is no more available to the Assessing Officer. Now book results can be rejected only if books of accounts are not correct or complete or method prescribed has not been followed. No method of accounting has been prescribed for builders and developers u/s. 145(2). 6

7 6.5 Profits for the purpose of taxation have to be determined as per commercial principles, subject to specific provisions of the Act. Accounting practices and standards, which are widely accepted and adopted, would be a good guide to determination of commercial profits. However, though accounting standards and practices are relevant, they cannot override specific provisions of the Act. The Hon ble Supreme Court in Challapali Sugars Ltd. vs. CIT, 98 ITR 167 (SC) has laid down that pronouncements of accounting bodies are relevant in determining commercial profits. In Tuticorin Alkali Chemicals & Fertilizers Ltd v. CIT (1997) 227 ITR 172 (SC), it was held that: The argument based on accountancy practice has little merit if such practice cannot be justified by any provision of the statute or is contrary to it. Accounting practices though relevant are to be ignored if they are contrary to specific provisions of the Act. Further accounting practices are relevant for computation of income but cannot determine chargeability of income to tax. 6.6 The issue when profit is taxable in case of builders and developers has been subject matter of many decisions and some of them are as follows: i) Sukhdeodas Jalan, 26 ITR 617 determination of profit in case of a contractor need not wait for completion of contract. ii) Tirath Ram Ahuja, 103 ITR 15 profit determination in case of contractor need not wait for completion of contract iii) Champion Construction, 5 ITD 495 (Bom) assessee, a developer, had claimed that profit from development project cannot be determined till the time sale of whole of the project is completed which was negatived. Appeals for many years were heard together and the hon ble ITAT upheld estimate of 8% after work was complete. iv) CIT v. Motilal C. Patel & Co (1988) 173 ITR 666 (Guj) - Under an agreement to sale of flat under construction, income accrues only when transaction of sale is complete and any advances received under the agreement for sale are mere earnest money and cannot be taxed as income before the transaction of sale is complete. 7

8 6.7 In quite a few judgments the only issue was whether percentage completion method or completed contract method is appropriate for a builder and it has been held that completion method is appropriate if regularly followed by assessee. 7. Conclusion Like a typical developer, I have delayed delivery of paper to the organizers, I only hope that they do not drag me to consumer forum for deficiency in service. I thank the organizers for giving me an opportunity to make the presentation. 8