Introduction
CIT v. B.C. Srinivasa Setty (1981) is one of the most influential Supreme Court judgments in Indian income-tax jurisprudence. It fundamentally shaped the law relating to capital gains, especially in situations where the cost of acquisition of an asset cannot be determined. This case is often taught as a turning point in understanding how capital gains operate under Section 45 and Section 48 of the Income Tax Act, 1961. The ruling remains essential for interpreting the taxable nature of transactions involving self-generated assets such as goodwill, trademarks, and other intangible assets created without a determinable cost.
“Tip: Always test capital gains questions by asking — does the asset have an ascertainable cost of acquisition?”
The Court’s interpretation continues to influence numerous subsequent judgments and amendments, making it a mandatory topic for all taxation-law exams and professional practice.
Background of the Case
The assessee, B.C. Srinivasa Setty, entered into a partnership in which he contributed the business’s goodwill as his capital contribution. The Income Tax Department sought to levy capital gains tax on the transfer of goodwill, claiming it was a capital asset within the meaning of Section 2(14). The Department argued that since goodwill had a value, its transfer should attract Section 45.
The core problem, however, was that goodwill was self-generated, meaning it had not been purchased and therefore had no determinable cost of acquisition. Under Section 48, computation of capital gains requires:
- Full value of consideration, minus
- Cost of acquisition and cost of improvement.
Thus, the case focused on whether capital gains could arise when the statutory computation machinery itself could not operate.
Issues Before the Supreme Court
1. Can self-generated goodwill be considered a “capital asset”?
Goodwill undoubtedly qualifies as a capital asset under Section 2(14). It represents the reputation, customer loyalty, and business connections built over years of operation.
2. Can capital gains be charged under Section 45 when the cost of acquisition is indeterminate?
Section 45 imposes a charge, but Section 48 provides the computational mechanism. If Section 48 cannot be applied, does the charge under Section 45 fail?
3. Was goodwill “acquired” at all?
Since no identifiable cost was incurred in creating goodwill, could it be said to have been “acquired” within the meaning of the Act?
Arguments of the Revenue
The Revenue argued that:
- Goodwill has monetary value and is a capital asset.
- Transfer of goodwill for partnership rights is a taxable transfer.
- Even if cost of acquisition is difficult to determine, capital gains should still be levied to prevent revenue leakage.
They relied on a broad interpretation of the charging section and argued for a purposive approach.
Arguments of the Assessee
The assessee contended that:
- Goodwill is self-generated and has no determinable historical cost.
- The computation provision under Section 48 becomes unworkable.
- If computation fails, the charge cannot stand.
- Capital gains arise only from assets that have a definite cost of acquisition.
Judgment of the Supreme Court
The Supreme Court delivered a landmark ruling, holding in favor of the assessee.
Key Principles Laid Down by the Court
1. Goodwill is a Capital Asset
The Court acknowledged that goodwill is a capital asset, but its peculiar nature must be understood. Goodwill develops gradually, influenced by reputation, location, business strategies, and customer connections. It cannot be quantified as a single, identifiable financial expenditure.
2. Cost of Acquisition Must Be Capable of Determination
The Court held that capital gains tax requires a determinable cost of acquisition. Since goodwill is self-generated, it does not have such a cost.
“Tip: Capital gains cannot arise unless both the charging section and computation machinery work together.”
3. Failure of Computation Machinery Means No Taxable Capital Gain
The Court famously applied the “machinery provisions doctrine,” stating:
- If the computation mechanism in Section 48 cannot be applied,
- Then the charge under Section 45 fails.
- Therefore, transfer of self-generated goodwill cannot attract capital gains tax.
This principle was reaffirmed in later cases involving other self-generated assets.
4. Section 45 and Section 48 Form an Integrated Code
The Court held that both provisions must work harmoniously. A charge cannot stand independent of the machinery intended to compute that charge.
Impact of the Judgment
1. Clarity on Treatment of Self-Generated Assets
The ruling clarified that certain assets—such as goodwill, tenancy rights, loom hours, and route permits—may not be taxable if their cost cannot be calculated.
2. Led to Amendments in the Income Tax Act
The decision prompted the legislature to amend Section 55 in later years by deeming the cost of acquisition for certain self-generated assets as ‘Nil’. This amendment effectively neutralized the impact of the judgment for future cases.
3. Strengthened Principles of Interpretation
The judgment reinforced that tax statutes must be interpreted strictly and computational provisions must be functional.
4. Became Foundational for Capital Gains Jurisprudence
The decision still forms a key principle taught in all taxation courses—especially when analyzing computation anomalies.
“Tip: When reading capital-gains cases, always check whether the legislature later amended Section 55 to reverse the ruling.”
Conclusion
CIT v. B.C. Srinivasa Setty (1981) is a milestone in Indian tax jurisprudence. It established that capital gains cannot be taxed if the cost of acquisition of the asset is indeterminable, making the statutory computation mechanism unworkable. The judgment continues to guide interpretation despite later amendments. For law students, this case is an essential illustration of how the judiciary balances statutory interpretation, tax machinery provisions, and the fundamental principles of equity in taxation.
Also Read: A.P. High Court v. State of A.P. (1965)
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