No Capital Gain Tax if Sale Agreement Was Cancelled and Land Reverted Back to Assessee: Supreme Court
In a significant relief to taxpayers, the Hon’ble Supreme Court in the case of Commissioner of Income-tax vs. Lok Housing and Construction Ltd. [2025] 175 taxmann.com 848 (SC) has reaffirmed a crucial principle of income tax law – “no tax can be levied on hypothetical income.”
The apex court held that where an agreement for the sale of land was subsequently cancelled and the land was reverted back to the assessee, no capital gains could be taxed, as no real income had accrued to the assessee.
Background of the Case
The assessee, Lok Housing and Construction Ltd., had initially filed its return of income for the Assessment Year 2007–08 declaring taxable income that included capital gains arising from the sale of land and Floor Space Index (FSI) to its associate and sister concerns.
However, the sale agreements were later cancelled, and the ownership of the land/FSI was reverted back to the assessee-company. The cancellation was duly reflected in the revised balance sheet and supported by revised accounts that were subsequently audited and found to be in order.
To reflect the true financial position, the assessee filed a revised return declaring nil income, withdrawing the earlier offered capital gain.
Assessment and Department’s Stand
The Assessing Officer (AO), however, refused to accept the revised return. He alleged that the assessee’s act of filing a revised return was not bona fide, and that the income originally declared – being on account of the sale of land – had already accrued and was taxable.
Accordingly, the AO taxed the income from the purported sale, treating the cancellation as a subsequent event that did not undo the original accrual.
Findings of the High Court
The Bombay High Court, in its judgment, sided with the assessee. It observed that once the sale agreements were duly cancelled and the assets had reverted to the assessee, there was no “real income” that had accrued or arisen.
The Court made an important observation:
“The original return represented a wrong statement of fact which was corrected through a valid revised return. No hypothetical or fictional income can be brought to tax.”
Supreme Court’s Verdict
The Supreme Court dismissed the Revenue’s appeal and upheld the High Court’s order, thereby confirming that:
• When a sale transaction is cancelled, and
• The property is restored to the assessee, and
• Such restoration is genuinely reflected in books and accounts,
then no capital gain can be said to have accrued, and therefore, no tax liability arises under section 45 of the Income-tax Act.
The apex court further noted that the accrual of income must be real and not notional. Even if a transaction appears complete on paper, if the underlying sale is later rescinded and the consideration is not realized, the income ceases to exist in real terms.
Legal Principle Reinforced
This case reiterates the age-old and judicially settled doctrine that “income tax is levied only on real income, not hypothetical or imaginary income.”
The following principles emerge clearly from the judgment:
1. Cancellation of Sale Nullifies Accrual of Income:
Once a sale agreement is cancelled, the transaction ceases to exist for taxation purposes. Any earlier recognition of gain can be reversed through a revised return.
2. Revised Return is Valid Correction Mechanism:
If the original return contained incorrect or premature income recognition, filing a revised return under section 139(5) is a valid corrective step, provided it reflects the true and fair position.
3. Accrual Requires Realization or Enforceable Right:
Mere execution of a sale agreement does not guarantee accrual of income. There must be an enforceable right to receive the consideration.
4. Books of Account Must Reflect Reality:
The genuineness of the claim depends on whether the assessee’s books and balance sheet truly reflect the reversal of the transaction — as was done in this case.
Practical Implications for Taxpayers
This ruling is a welcome clarification for developers, real estate businesses, and individuals who face similar situations where sale transactions fall through after being executed.
It ensures that:
• Tax cannot be levied on income that never materialized, and
• Assessees can revise returns to reflect the cancellation, without being accused of bad faith.
However, the cancellation must be genuine, documented, and supported by accounting entries and, where applicable, board resolutions or mutual agreements.
Conclusion
The Supreme Court’s ruling in Lok Housing and Construction Ltd. stands as another pillar supporting the “real income theory” – that tax can only be charged on income that has actually accrued, arisen, or received, not on mere book entries or hypothetical accruals.
This judgment protects taxpayers from being taxed on unreal transactions and emphasizes the importance of substance over form in taxation.
Key Takeaway
“When there is no real income, there can be no real tax.”
The Income Tax Act taxes actual profits, not illusory gains. The Supreme Court has once again reminded both taxpayers and the department that the essence of taxation lies in reality, not fiction.
The copy of the order is as under:
