An interesting issue arose where a certain amount was embezzled by the person who assisted in the sale of the property. The question was whether such a loss could be deducted while computing the taxable capital gains under Section 45 of the Income-tax Act.

In GY Chenoy vs CIT (234 ITR 89), the assessee appointed her mother as her attorney and agent to sell a property and to do all acts and things incidental thereto. Her mother took the help of one Sri R in settling the property. Sri R found a buyer and on behalf of the assessee's mother received the sale consideration from Nataraj Constructions.

The sale deed was executed on April 10, 1980, and registered on May 6, 1980. The cheques were deposited by him in the bank account of the assessee's mother.Cash amounting to Rs 1,12,500 was stated to have not been deposited in her account. subsequently, Sri R withdrew money which was not turned over to the assessee. Thus, he misappropriated huge sums. Sri R had a general power of attorney executed by the assessee's mother to look after her properties of which she was the trustee.

Since the assessee received consideration for the sale of the property less the amount embezzled by Sri R, she claimed that for the purpose of computation of capital gains, the consideration which was received by her was relevant and not the full amount of consideration under the sale deed. She offered for assessment the capital gains which she actually received excluding the amount embezzled by Sri R. The income-tax officer rejected the claim of the assessee and held that for the purpose of computing capital gains tax, the entire amount of Rs 5 lakh under the sale deed had to be taken into account and not the consideration which she had actually received after excluding the amountembezzled by Sri R.

On appeal, the commissioner of income-tax (appeals) dismissed the same. On further appeal to the tribunal, the tribunal held that the amount of Rs 3,37,500 misappropriated by Sri R did not constitute an expenditure incurred in connection with the transfer of the asset. It was also held by the tribunal that it could not be considered a loss of a capital asset to be set off against the capital gains.

According to the tribunal, capital loss in order to be set off must arise on the transfer of a capital asset. In order to bring in any embezzlement within the meaning of capital loss, there should be a nexus between the extinguishment of any right in a capital asset and the loss arising therefrom.

On a reference, the Andhra Pradesh high court held that it was not the case of the assessee that it was an expenditure incurred wholly and exclusively in connection with such transfer. Therefore, Section 48(i) had no application. The main argument of counsel for the assessee was that the capitalgains should be computed on the value of the consideration received since the assessee had received less than the amount misappropriated and it was only that amount which was to be assessed under Section 48 of the Act.The court did not accept the argument of the counsel for the assessee in view of the law laid down by the Supreme Court in various decisions. It referred in this context to the judgment in CIT vs Nainital Bank Ltd (55 ITR 707 (SC)).

It was a case where there was a dacoity in the bank and the dacoits carried away cash amounting to Rs 1,06,000 and some ornaments. The bank claimed the said amount as a deduction in computing its income from the banking business on the ground that it was a trading loss. The matter went up to the Supreme Court. The Supreme Court held that the branch of the bank had kept large amounts in the bank premises in the usual course of its business in order to meet the demands of its constituents and that the cash was the stock-in-trade of the banking company.

It was alsoheld that the loss of cash, which was its stock-in-trade, in the course of its business under varying circumstances was deductible as a trading loss in computing the total income of the business.

While holding so, the judges pointed out that every loss of stock-in-trade in whatsoever way it is caused is not a trading loss, but the said loss should have been caused not only in the course of the business but also should have been incidental to it. It was also pointed out that whether it is an admissible deduction or not will depend on the accepted commercial practice and trading principles of it can be said to arise out of the carrying on of the business and to be incidental to it.

The judges also referred to the observations made by the Supreme Court in Badridas Daga vs CIT (34 ITR 10,15) and pointed out that if, for example, a thief were to break overnight into the premises of a money-lender and run away with funds secured therein, that would result in the depletion of the resources available to him forlending and the loss would, in that sense, be a business loss, but it was not one incurred in the running of the business, but was one to which all owners of properties were exposed whether they did business or not.

According to the judges, loss in such a case could be said to fall on the assessee not as a person carrying on business but as owner of the funds. This distinction, though fine, was a very material one as on it depended whether deduction could be made under Section 10(1) or not. The legal position was summarised stating that under Section 10(1) of the Act the trading loss of a business was deductible for computing the profit earned by the business. However, every loss was not so deductible unless it was incurred in carrying out the operation of the business and was incidental to the operation.

Whether loss is incidental to the operation of a business is a question of fact to be decided on the facts of each case, having regard to the nature of the operations carried out and the nature of therisk involved in carrying them out. The degree of the risk or its frequency is not of much relevance but its nexus to the nature of the business is material.

It was further held by the Supreme Court that it is an integral part of the process of banking that sufficient moneys should be kept in the bank duly guarded to meet the demands of the constituents. The retention of money in the bank is part of the operation of banking. The retention of money in the bank premises carried with it the ordinary risk of its being subject to embezzlement, theft, dacoity or destruction by fire and such other things. Such risk of loss is incidental to the carrying on of the operations of the business of banking.

Therefore, if the principles of accepted commercial practice and trading principles of business are applicable, yet in order to claim a deduction, the assessee should establish and the loss is incurred in carrying on the operations of the transaction and is incidental to the operations of the transaction is aquestion of fact to be decided on the facts of each case.In the light of the above principles laid down by the Supreme Court, the Andhra Pradesh high court had to examine whether in the case of GY Chenoy, the loss had occurred in the course of the transactions and was incidental to the carrying on of the transactions.

The high court held that this was a case where the loss occurred after the transaction was completed and the loss was not incidental to the carrying on of the business. It was a loss incurred as an owner of the property. Therefore, the tribunal was right in its view that the assessee was not entitled to deduction of the amounts misappropriated by the power of attorney holder or agent of the assessee.

In a related judgment in N Chenoy vs CIT (234 ITR 95)), the Andhra Pradesh high court held that the expenditure incurred in getting the tenants to vacate the premises had nexus with the transaction, as, without the tenants vacating the premises, the building could not be sold. Hence, theexpenditure was fully deductible under Section 48 of the Act while computing the capital gains.

The aforesaid decisions throw considerable light on what constitutes expenditure relating to the transfer of an asset. Loss on account of embezzlement of funds results in no tax-break and the full capital gains become liable to tax.