Bangalore Tribunal allows compensation paid to former purchaser as deduction in computing capital gains

In the case of Shankare Gowda ^[1]  (Taxpayer), the issue before Bangalore Tribunal was whether the amount paid as compensation/penalty/liquidated damages for cancelling a prior sale agreement qualifies as "cost of improvement" or "expenditure incurred wholly and exclusively in connection with the transfer" under Section 48(i) of the Income Tax Act, 1961 (ITA) deductible while computing capital gains from the subsequent property sale.

In the facts of the case, the Taxpayer entered into a sale agreement in 2012 for sale of his property to a former purchaser and received an advance towards the purchase consideration. The sale agreement included a clause which obliged the seller to pay liquidated damages of double the advance, if the seller defaulted. The purchaser intended to use the property for developing Special Economic Zone (SEZ). However, it was found to be unviable to use the land for SEZ purposes. The Taxpayer cancelled the first sale agreement in 2017 through a cancellation deed by repaying the advance along with an additional amount towards compensation/penalty to clear any encumbrance towards the first purchaser. The additional amount was as mutually negotiated with first purchaser for cancellation of the agreement. The Taxpayer subsequently sold the property to another purchaser and claimed deduction of compensation paid to first purchaser as cost of improvement while computing capital gains. 

The tax authority denied the deduction of the compensation on the ground that such a payment was in the nature of penalty and it did not enhance the value of the property. The first appellate authority upheld the tax authority's decision.

However, the Bangalore Tribunal ruled in favor of the Taxpayer. It verified the “agreement to sell’ entered with the first purchaser and noted the existence of clause mandating payment of liquidated damages on default. The Tribunal also verified the cancellation deed and found that the Taxpayer paid the compensation to clear any title, liens and encumbrances favoring the first purchaser, enabling the subsequent sale with clear title. The Tribunal relied on the Madras High Court ruling in the case of Ramaswamy Mudaliar^[2]  and held that the term “Improvement” includes actions and activities that enhance the asset value or price. The Tribunal further relied on the Delhi High Court ruling in the case of Kaushalya Devi ^[3]  and held that "expenditure wholly and exclusively in connection with transfer" requires genuine, proximate nexus; includes capital expenditure to settle claims for clear title; and that the tax authority cannot question commercial expediency or quantum if genuineness stands proved.

The Tribunal, thus, held that the nature of the payment (penalty, interest or compensation) was irrelevant and that the payment was directly linked to the property transfer, enhancing the value by resolving disputes and securing clear title, which would otherwise result in a litigated property fetching lower value. The Tribunal, therefore, held that the payment was not remote but essential for the transfer generating capital gains, making it allowable under Section 48(i).

^[1] ITA No.323/Bang/2025
^[2] CIT v. V. Ramaswamy Mudaliar [1992] 196 ITR 939 (Madras HC)
^[3] Kaushalya Devi v. CIT (2018) 404 ITR 136 (Delhi HC)