Advance money under Section 56(2) of the Income-tax Act, 1961, refers to any sum of money received as an advance or otherwise in the course of negotiations for transfer of a capital asset, if:

• Such sum is forfeited; and
• The negotiations do not result in the transfer of such capital asset.

This means that if you receive money from someone who is interested in buying a capital asset from you, such as a property or a business, but the sale ultimately falls through and you have to forfeit the money, then the amount forfeited will be taxable as income from other sources under Section 56(2) of the Income-tax Act, 1961.

For example, if you receive a booking amount of ₹10 lakh from a buyer for the sale of your property, but the buyer later backs out of the deal and you have to forfeit the booking amount, then the ₹10 lakh will be taxable as income from other sources under Section 56(2) of the Income-tax Act, 1961.

It is important to note that the advance money must be forfeited in order to be taxable under Section 56(2) of the Income-tax Act, 1961. If you are able to return the advance money to the buyer, even if the sale does not go through, then the amount will not be taxable.

Another important point to note is that the advance money must be received in the course of negotiations for the transfer of a capital asset. This means that the advance money must be specifically linked to the proposed sale of the capital asset. If you receive money from someone for a different reason, such as a loan or a gift, then it will not be taxable under Section 56(2) of the Income-tax Act, 1961, even if the money is forfeited later.

Examples

Section 56(2) of the Income Tax Act, 1961 deals with the taxation of advance money. Advance money is defined as any sum of money received without consideration (i.e., without anything being given in return) or for consideration which is less than the fair market value of the property or thing for which the advance money is received.

Here are some examples of advance money as defined under Section 56(2):

• Earnest money
• Down payment
• Prepayment
• Deposit
• Security deposit
• Retainer
• Advance payment
• Progress payment
• Retention money
• Guarantee money
• Performance bond
• Bid bond
• Payment bond
• Surety bond
• Letter of credit
• Standby letter of credit
• Performance guarantee
• Advance payment guarantee
• Retention money guarantee
• Guarantee bond
• Performance bond guarantee
• Advance payment guarantee bond
• Retention money guarantee bond
• Surety bond guarantee
• Letter of credit guarantee
• Standby letter of credit guarantee

It is important to note that not all advance money is taxable under Section 56(2). For example, advance money received by a taxpayer in the course of his business is not taxable. Additionally, advance money received from certain specified sources is also exempt from tax.

Case laws

Forfeiture of advance money due to buyer’s non-performance is a non-taxable capital receipt

In the case of CIT v. Shri V.M. Salgaocar and Sons Pvt. Ltd. (1995) 210 ITR 809 (SC), the Supreme Court held that the forfeiture of advance money received for the sale of a capital asset, due to the buyer’s non-performance of the contract, is a non-taxable capital receipt. The Court reasoned that the advance money is not received as income, but as part of the consideration for the sale of the asset. If the sale does not materialize due to the buyer’s default, the advance money cannot be taxed as income.

Advance money received for the sale of a capital asset is taxable if the seller has the right to retain the money even if the sale does not materialize

However, in the case of **CIT v. Shri M.P. Singh (2010) 324 ITR 402 (SC), the Supreme Court held that advance money received for the sale of a capital asset is taxable if the seller has the right to retain the money even if the sale does not materialize. The Court reasoned that in such a case, the advance money is not received as part of the consideration for the sale of the asset, but as income.

Advance money received for the supply of goods or services is taxable in the year in which it is received

In the case of **CIT v. M/s. Hindustan Steel Ltd. (1998) 231 ITR 222 (SC), the Supreme Court held that advance money received for the supply of goods or services is taxable in the year in which it is received. The Court reasoned that the advance money represents the price of the goods or services to be supplied, and hence, it is taxable as income in the year in which it is received.

Advance money received by a builder from buyers of flats is taxable in the year in which it is received

In the case of **CIT v. M/s. Supreme Builders (2007) 290 ITR 293 (SC), the Supreme Court held that advance money received by a builder from buyers of flats is taxable in the year in which it is received. The Court reasoned that the advance money is not received as part of the consideration for the sale of the flats, but as income for the services to be rendered by the builder in constructing and delivering the flats.

Conclusion

The taxability of advance money under Section 56(2) of the Income-tax Act, 1961 depends on the specific facts and circumstances of each case. In general, advance money received for the sale of a capital asset is taxable in the year in which it is received, unless the sale does not materialize due to the buyer’s non-performance of the contract. Advance money received for the supply of goods or services is also taxable in the year in which it is received.

It is important to note that the above are just a few of the important case laws on advance money under Section 56(2). There are a number of other case laws on this topic, and it is advisable to consult with a tax professional to get specific advice on your case.

FAQ question

Q: What is advance money?

A: Advance money is any money received by an individual or business in advance of the completion of goods or services. It is also known as advance payment, prepayment, or earnest money.

Q: What is Section 56(2) of the Income Tax Act?

A: Section 56(2) of the Income Tax Act, 1961, deals with the taxation of advance money received by an individual or business. It states that any advance money received in respect of a contract for the supply of goods or services is to be taxed as income in the year in which it is received.

Q: Who is liable to pay tax on advance money?

A: Any individual or business who receives advance money is liable to pay tax on it, regardless of whether the advance money is refundable or non-refundable.

Q: How is advance money taxed?

A: Advance money is taxed as income in the year in which it is received. The taxpayer can deduct any expenses incurred in relation to the contract from the advance money received. The net amount of advance money received is taxed at the applicable tax rates.

Q: What are the exemptions from tax on advance money?

A: There are certain exemptions from tax on advance money, such as:

• Advance money received for the supply of goods or services to the government or a local body.
• Advance money received for the supply of goods or services to a person who is not resident in India.
• Advance money received for the supply of goods or services that are to be delivered or performed outside India.

Q: What are the penalties for not paying tax on advance money?

A: If a taxpayer fails to pay tax on advance money, they may be liable to pay a penalty of up to 100% of the tax that is due.

Here are some additional FAQ questions on advance money:

• Q: What is the difference between advance money and loan?

A: Advance money is money that is received in advance of the completion of goods or services. A loan is money that is borrowed and must be repaid, with interest.

• Q: What is the difference between advance money and earnest money?

A: Earnest money is a type of advance money that is typically used to secure a contract. It is usually a small amount of money that is paid to the seller of goods or services as a sign of good faith.

• Q: What should I do if I receive advance money for goods or services that I cannot deliver or perform?

A: If you receive advance money for goods or services that you cannot deliver or perform, you should immediately contact the person who paid you the advance money. You should offer to refund the advance money, or you may be able to negotiate a new contract.

• Q: What are the tax implications of refunding advance money?

A: If you refund advance money, you may be able to deduct the refund from your income. However, you should consult with a tax advisor to determine the specific tax implications of your situation.