Treatment of income from renting immovable properties for the purpose of calculating taxes has been a common point of dispute between the Income Tax department and the taxpayers. Rental income
of property has different connotations depending on whether it is treated as house property or business income. Accordingly, such income may broadly fall under the following two heads of income in the Income Tax Act –
Income from House Property, or
Income from Business and Profession
In case the property income is declared as income from house property, then according to section 24 of the Income Tax Act, 1961, a maximum tax deduction of 30% of Net Annual Value may be claimed. This deduction is towards the repair and maintenance of the property. Besides standard deduction, only municipal taxes and interest paid on capital borrowed for the purposes of acquisition, construction, reconstruction, repair, etc. (subject to limitations provided under the Act) are allowed as a deduction against the rental income. This deduction is irrespective of the actual expenses incurred by the owner. It limits the overall tax benefits available to the assessee.
On the other hand, if taxed as income from business, any expense incurred wholly and exclusively for the business of renting shall be permitted as a deduction for tax determination.
As there are no constraints on deductions under the head PGBP, assessees prefer classifying rental income received from the lease of immovable property as income from business, which will, in turn, mean revenue loss for the government. Therefore, the Income Tax department scrutinizes every such case to dissuade taxpayers from claiming it as business income.
The stand taken by the department in such cases is based on the judgement in the case of East India Housing and Land Development Trust Ltd vs CIT wherein the Hon’ble Supreme Court held that specific provisions prevail over general provisions and hence the income derived by the company from shops and stalls is income received from property and falls under the specific head ‘Income from House Property’ only as it is received by the company formed with the object of developing and setting up markets.
Hence, the department believes that when there is a particular head for property income, i.e., ‘Income from House Property’ under the Act, then the income earned from renting of immovable property should be charged under such head only.
This is the point of dispute between taxpayers and the department on the taxability of rental income earned from leasing the immovable property. However, over time and after many judicial pronouncements, certain fundamental principles have emerged as cornerstones for characterizing rental income under the head PGBP.
Prominent principles to classify Rental Income as Business Income –
The intent of the assessee is to do business – this intention may be inferred from the agreement for lease, objectives listed in the Memorandum of Association and consequent conduct of the parties.
Active ownership of property – if property yields rental income because of its own legal existence, it would be categorized as passive ownership and may be classified as House Property.
Constitution documents of the assessee provide that the principal objective is to hold the properties (presumably not for gains) and lease them out to earn rental income – the activities conducted by the assessee should be in line with the constitution documents.
To have a better understanding of the principles as mentioned above, let’s have a look at some of the related case judgements –
Chennai Properties and Investment Ltd. vs Commissioner of Income Tax, (2015)
In this case, the assessee company was incorporated with the primary objective, as mentioned in the Memorandum of Association, to procure the properties in the city and let out those properties.
The Hon’ble Supreme Court held that since holding the properties and earning income by letting them out is the main objective of the company, as stated in the Memorandum of Association, the income so derived is in the nature of business income and shall be disclosed under the head ‘Income from Business or Profession’ and not under ‘Income from House Property’.
Rayala Corporation (P.) Limited vs ACIT, (2016)
In this case, the assessee company was in the business of renting its properties and was receiving rent as its business income. The assessee company claimed that the said income should be taxed under the head ‘Profits and Gains from Business or Profession’ and not under ‘Income from House Property’. In the appeal filed before the High Court, the revenue department argued that leasing and letting out of shops and properties was not the main business of the assessee-company as per the Memorandum of Association and, therefore, the income earned by the assessee-company should be treated as income earned from house property.
However, the Apex court held that the assessee company has only one business: leasing its property and earning rental income. Therefore, the income so derived should be treated as its business income.
Raj Dadarkar & Associates vs ACIT, (2017)
In the above-mentioned case, the Hon’ble Supreme Court held that apart from relying on the object clause, the assessee would be required to provide or refer any other material to prove the conduct of activities according to its constitution documents.
Based on the material provided by the taxpayer, it was held that the assessee was not able to establish that he was engaged in any systematic or organized activity of rendering services to the occupiers of the shops to consider receipts from them as income from the business.
Sultan Brothers (P) Ltd. vs Commissioner of Income Tax, (1964)
In this case, the Appellant had let out the building fully equipped and furnished for a period of six years for running a hotel and for other ancillary purposes.
The Apex court observed that whether a particular letting is business has to be determined as per the circumstances of every case. Further, it was observed that “every case has to be looked at from the point of view of a businessman to find out whether the renting out was the doing of a business or the utilization of his property by an owner”.
Accordingly, in the facts of the above case, the Supreme Court held the income to be in the nature of business income.
Karanpura Development Co. Ltd. vs Commissioner of Income Tax, (1961)
The facts before the Supreme Court, in this case, were that the income had been received pursuant to the leasing of coal mining rights. The assessee company was incorporated with the object of acquiring and disposing of the underground coal mining rights in specific coal fields. It had limited its activities to procuring coal mining leases over large areas, developing them as coalfields and then sub-leasing them to collieries and other companies.
The taxpayer had shown the income as business income. The Supreme Court observed that the objective and the manner of its activities and the nature of its dealings with its properties need to be taken into account. Accordingly, it had held the income to be in the nature of business income for the above case and not as house property income.
Hence, the trend of judicial pronouncements and directions issued by the Central Board of Direct Taxes (CBDT) show that the authorities are now accepting that owning a property and renting it out may also be done as part of a business, besides as a mere owner of the property.
The Hon’ble Supreme Court, in several cases, held that the deciding element is not the ownership of the property but the nature of the activity of the assessee and the nature of the operations concerning the same. Further, it has emphasized that for income to be characterized as business income, the activities actually carried out by the assessee need to be in line with its primary object, according to its constitution documents.
As seen above, in the case of Raj Dadarkar & Associates vs ACIT, Supreme Court held that apart from depending on the object clause, the assessee would be required to provide or refer any other material to show that the conduct of activities is as per its constitution documents. Therefore, reduced litigation is expected on this issue if taxpayers are able to provide factual material to prove that their activities are in the nature of their business and according to their constitution documents.
Moreover, the CBDT released circular no. 16/2017 on 25th April 2017, wherein it has been clarified that the income from renting out of premises/developed space with other facilities in an industrial park/ Special Economic Zone is to be leviable to tax under the head PGBP and has instructed the revenue department to not file any appeals on this matter and to withdraw/not press upon appeals already filed.
Another point worth noting here is that residential and commercial properties are treated in the same way from a tax perspective. The deciding factor is the main line of business of the owner, irrespective of the fact that whether the property is residential or commercial. If the individual is in the business of letting out property, then the rental income, even from the residential property, will be accounted for as a business income.
The Rental Income may only be considered under the head ‘Profits or Gains from Business or Profession’ if the person can substantiate that the same is in accordance with the firm’s primary objective from its constitution documents and conduct of activities.
Since it is mandatory to substantiate that the rental income is in accordance with the ancillary or the main objective of business, it is prudent for the individuals to consider the rental income under the head 'Income from House Property' if they are not having a business of a similar objective.
And if they wish to consider it as business income, they must have solid grounds and documentary evidence to substantiate that the rental income is in line with the ancillary/main objective of its business activity.
The above-discussed treatment is applicable to rental income from both residential and commercial properties in the same manner for the purpose of their classification.
The information given above is to provide a general guidance to the readers. This information should not be sought as a substitute for legal opinion.