21 January 2008

My experiences with the Income Tax Department -- 8
[A single-page version of this blog can be seen here]

On 28 November 2003 Mr Sebastian completed his assessment order. When I received it I couldn’t help laughing out aloud. Of course, having about 15% of your wealth chopped off is no joking matter. But you must remember that at the start Mr Sebastian had threatened to disallow the entire payment made to the software developer, Rs 50. Now, after meditating on the case for a year and trying his worst, the best he had come up with was to disallow Rs 10. And the logic was so warped that it seemed obvious to me that the assessment would be thrown out at any subsequent hearings before a neutral authority.

The assessment order was all of 20 pages long, 20 pages of sheer torture, and since the Geneva convention bans torture I shall not inflict it on the readers.

Those who are familiar with the world of newspapers and magazines will know that there is a category of employee called the rewriter. The rewriter’s job is to take copy written by the reporter in the heat of battle, remove the dross, and polish the metal that is left until it sparkles. I have tried to do a bit of rewriting with Mr Sebastian’s assessement order (it would be incomprehensible otherwise). But in this case after removing a considerable amount of dross, what I am left with is merely a smaller mass of dross. That cannot be helped. I am not an alchemist.

Pages 1 to 15 are devoted to proving that the sale of the website etc amounted to a transfer of a capital asset and was not business income. Readers will have heard stories of people who bought shares of Wipro in paper form, forgot about them for 25 years, and woke up one day to find the shares were worth crores of rupees. If they sell the shares, the profit they make would be treated as a capital gain, that is, a gain from the sale of a capital asset. The primary feature of such capital gain is that the buyer of the asset has not carried out any substantial changes on the asset, and that the gain is a consequence of an inherent rise in value of a basically unchanged asset.

If I had bought a url like www.business.com or www.sex.com for $70 and sold it for a few million dollars a couple of years later, the profit could have been termed as a capital gain, because it came from the inherent rise in worth of the url and not from any modifications I had carried out on it.

Alternatively, I may have developed an ingenious toy solely for the amusement of my own child and the neighbourhood tykes, but then Mattel spotted it and paid me a million dollars for it. The sale would amount to a transfer of a capital asset because it was developed with no business intention in mind.

My own website was a search engine that I had worked on for more than two years at the time of the sale. I had catalogued sites for more than two years and had drawn up the features that the software should have, etc. In January 2000, in a comparison between various Indian search engines by an Indian PC magazine, mine had been rated the "most accurate Indian search engine". In other words, it was hardly something that I had bought and left to age in the cupboard. Also, I had promoted it through advertisements (at considerable cost) and in my columns, hardly something I would have done if I had developed it for my own amusement.

Mr Sebastian’s logic was obviously silly, and both the Commissioner of Income Tax Appeals in its order of 28 October 2004 and the Income Tax Appellate Tribunal in its order of 30 August 2007 rejected Mr Sebastian’s contention that the transfer amounted to the sale of a capital asset.

Having argued that the transfer of the website amounted to a capital asset sale, Mr Sebastian had a slight problem. How ought he to explain the fact that the domain name bought for $70 had increased in value several hundred times. His explanation was that it came about because of the software. To understand his logic (or the absence of it) you have to descend to his level.

Think of the transfer of the web site as the sale of a big lump of concrete, a capital asset. Now this big lump of concrete contains a smaller lump of concrete, the software that runs the site. But in thinking of it thus Mr Sebastian ties himself up in more knots. On page 7 and at several other places he concedes that I was the owner of the software at all times. But then on page 16 he talks of the “cost of acquisition” of the software.

I do not know if the reader is in the habit of acquiring things that belong to himself. But apparently Mr Sebastian thinks it commonplace. I suppose that to do it properly you have to stand in front of the mirror and say to yourself, "Would you mind passing me the software? Here is the money I am willing to pay to acquire it." In this case of course Mr Sebastian goes a step further. He has me paying the software developer to acquire software that, Mr Sebastian agrees, belongs to me in the first place.

The warped logic goes further. The reader will recall that I had paid Rs 50 to X. According to the agreement with the buyer of the site X and I had to work with the buyer for six months, modifying the software, improving it, installing it on the buyer’s servers, recruiting and training the buyer’s employees to catalogue sites etc.

Now Mr Sebastian neatly divides the Rs 50 I had paid to the software developer into two parts. One is the cost of acquisition of software (though why I should pay for software that was mine in the first place was something that does not seem to have occurred to him) and the other was payment for working with the buyer for six months.

Without thinking it necessary to offer any reasons as to how he had arrived at the division, he decides that the cost of acquisition of the software (a capital asset, in his opinion) is Rs 40, which he will allow as part of the cost of the capital asset that I had sold, but will disallow Rs 10.

In a letter to the vigilance officer I couldn’t resist taking a dig at Mr Sebastian:

"Reducing this to a mathematical equation I would write:
x < 50
Therefore x = 40

"This is the kind of logic that would merit a fourth standard fail. You will observe that any number between 0 and 50 would satisfy the above equation. Mr Sebastian’s threat to me was that he would make x = 0. Now he has been kind enough to make x = 40. I suppose a Rs 10 lakh bribe would have made x = 50. Who knows, I might even have got a substantial refund.”

The problem of course is that when Mr Sebastian divided the sum paid to Mr X into two parts, he should have done the same with the Rs 100 paid to me by the buyer. After all, the agreement clearly said: "'Consideration' means the amount to be paid by the company in consideration for the transfer of the Internet Portal, Search Engine, Software, Database and for the Development Work and recruitment for the Company to be carried out by the vendors as mentioned herein."

But then Mr Sebastian’s objective was not to accurately reflect the merits of the case. It was to get his own back on an assessee who not only did not fork out the necessary but actually had the temerity to file a complaint against him.

This is what the appellate tribunal had to say about Mr Sebastian’s decision to disallow Rs 10 of the Rs 50: "After considering the rival submissions and perusing the relevant material on record, it is observed that the total quantum of payment of Rs [50] made by the assessee to [X] has not been disputed by the Assessing Officer. This amount is specified in the Memorandum of Understanding and has been paid in full by the assessee and also accounted for by [X]. We are unable to appreciate the stand point of the learned Assessing Officer in allowing the deduction of Rs [40], thereby disallowing the remaining amount of Rs [10]. We therefore approve the finding of the learned CIT(A) in this case."

More in the next.

Category: Income-Tax

Philip George
Debunker of Keynesian, monetarist and Austrian economics

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