ITAT Cuttack Scraps Audit Penalty on Investor After Failed Tax-Loss Harvesting Attempt

Taxpayers rely on tax-loss harvesting to decrease their tax burden. The practice involves selling securities at a loss to offset the taxes they owe on capital gains. However, not knowing the exact statutory provisions governing the set-off of losses can result in legal trouble. Claiming deductions under incorrect sections triggers scrutiny from the income tax department. In one such case, something similar happened to an individual investor who found himself embroiled in a legal dispute over an incorrect claim and a subsequent audit penalty.

What Happened In The Case

Ratan Kumar Kejriwal, a resident of Cuttack, Odisha, filed his tax return for the assessment year (AY) 2013-14 declaring zero total income. He earned interest income and generated short-term capital gains. Alongside these gains, he also incurred a financial loss of Rs. 21,60,066 while doing speculative trading in the share market.

In order to reduce his tax burden, he attempted to set off his share trading loss against his interest income and short-term capital gains. He claimed this loss deduction under Section 57 of the Income Tax Act, 1961. Section 57 of the Income Tax Act, 1961 allows deductions to be subtracted from income earned from other sources like interest.

However, the Income Tax Department flagged his return for scrutiny. Assessing officers alleged that setting off speculative share trading losses against short-term capital gains and interest income was prohibited. The department cited Section 70 and Section 71 of the Income Tax Act, 1961. Section 70 and Section 71 of the Income Tax Act, 1961 outline the rules for setting off losses from one source against another source.

The assessing officer classified his share trading as a speculative business. The department argued he must audit his accounts under Section 44AD of the Income Tax Act, 1961. Notably, Section 44AD of the Income Tax Act, 1961 provides a presumptive taxation scheme for small businesses and mandates an audit if losses are claimed.

However, the officer levied a penalty under Section 271B of the Income Tax Act, 1961, which imposes a penalty on taxpayers who fail to get their business accounts audited.

Kejriwal argued that he was merely an individual earning income from other sources and capital gains. He insisted his investments were not a formal business activity, meaning no audit was necessary. Just before the case was taken up before the Income Tax Appellate Tribunal (ITAT), Cuttack, the Commissioner of Income Tax (Appeals) confirmed the penalty.

What ITAT Cuttack Said In The Matter

ITAT’s Cuttack bench heard the appeal and ruled in favour of the investor. The tribunal members reviewed the original reasons the tax department recorded when selecting the return for scrutiny and discovered a major contradiction.

"The reason for CASS selection was a large deduction claimed u/s 57 and a non-corporate assessee having no business," the AO said.

The tribunal noted that the revenue department explicitly acknowledged the individual did not possess a business. The department could not alter its position during assessment just to penalise the taxpayer for missing an aud"It no longer lies in the hands of the revenue to turn around and then treat the activity of the assessee in the share transaction as the business activity of the assessee," the tribunal said.

Taxpayers must carefully classify their investments and apply correct sections when claiming losses. On the other hand, the ruling shows authorities cannot reclassify investments as businesses to impose penalties. Thus, taxpayers should maintain a distinction between casual investments and business activities and consider consulting a professional before attempting tax-loss harvesting. Additionally, taxpayers should ensure they use the correct sections of the Income Tax Act and not attempt to set off speculative losses against unrelated income without verifying limits.it.