Section 50AA and principal non-protected unlisted debentures.

Would the Capital Gain on sale of an unlisted debenture, which has an underlying principal non-protected debt component, be taxable as short-term Capital Gain under the provisions of Section 50AA of the Act?
At the outset, it would be necessary to understand the provisions of section 50AA of the Act which has been inserted w.e.f. assessment year 2024-25, i.e., all such capital gain in the financial year 2023-24 would be taxable. Section 50AA of the Act reads as under: –

‘50AA. Notwithstanding anything contained in clause (42A) of section 2 or section 48, where the capital asset is a unit of a Specified Mutual Fund acquired on or after the 1^st day of April, 2023 or a Market Linked Debenture, the full value of consideration received or accruing as a result of the transfer or redemption or maturity of such debenture or unit as reduced by-

(i) the cost of acquisition of the debenture or unit; and

(ii) the expenditure incurred wholly and exclusively in connection with such transfer or redemption or maturity,

shall be deemed to be the capital gains arising from the transfer of a short-term capital asset:

Provided that no deduction shall be allowed in computing the income chargeable under the head “Capital gains” in respect of any sum paid on account of securities transaction tax under the provisions of Chapter VII of the Finance (No.2) Act, 2004 (23 of 2004).

Explanation. – For the purposes of this section –

(i) “Market Linked Debenture” means a security by whatever named called, which has an underlying principal component in the form of a debt security and where the returns are linked to market returns on other underlying securities or indices and include any security classified or regulated as a market linked debenture by the Securities and Exchange Board of India;

(ii) “Specified Mutual Fund” means ….’ (emphasis supplied)

3. The reason for the insertion of this new section 50AA is set out in the Memorandum Explaining the Provisions in the Finance Bill, 2023. That reads as under:

“Special provision for taxation of capital gains in case of Market Linked Debentures

It has been noticed that a variety of hybrid securities that combine features of plain vanilla debt securities and exchange traded derivatives are being issued through private placements and listed on stock exchanges. It is seen that such securities differ from plain vanilla debt securities.

2. ‘Market Linked Debentures’ are listed securities. They are currently being taxed as long-term capital gain at the rate of 10% without indexation. However, these securities are in the nature of derivatives which are normally taxed at applicable rates. Further, they give variable interests as they are linked with the performance of the market.

3. In order to tax the capital gains arising from the transfer or redemption or maturity of these securities as short-term capital gains at the applicable rates, it is proposed to insert a new section 50AA in the Act to treat the full value of the consideration received or accruing as a result of the transfer or redemption or maturity of the “Market Linked Debentures” as reduced by the cost of acquisition of the debenture and the expenditure incurred wholly or exclusively in connection with transfer or redemption of such debenture, as capital gains arising from the transfer of a short term capital asset.

4. Further, it is also proposed to define the ‘Market linked Debenture’ as a security by whatever name called, which has an underlying principal component in the form of a debt security and where the returns are linked to market returns on other underlying securities or indices and include any securities classified or regulated as a Market Linked Debenture by Securities and Exchange Board of India.

5. This amendment will take effect from the 1^st day of April, 2024 and shall accordingly, apply in relation to the assessment year 2024-25 and subsequent assessment years.” (emphasis supplied)

4. It will be seen from the explanation to section 50AA that the requirements for being considered as a Market Link Debenture (“MLD”) is that (i) there should be an underlying principal component in the form of a debt security and (ii) the returns are linked to market returns on other underlying securities or indices and (iii) would include any security classified or regulated as an MLD by the Securities and Exchange Board of India (“SEBI”).

5. The question which arises is that if there is an underlying principal component in the form of a debt security, even though the holder could lose some of the principal component due to variations in the market, could such a debenture be considered as an MLD?

6. It is unclear from the explanation of the term MLD whether if the principal itself could be lost to the investor it could still be called an MLD. After all, if the underlying principal component is in the form of a debt security, could there be a further requirement that the underlying debt security should itself not be subject to loss?! In other words, should the principal be payable under any circumstances in order to be considered a debt security.

7. Unfortunately, the term “debt security’ has itself not been defined under the Act. As this issue is not clear in the explanation to section 50AA, it may perhaps be useful to understand MLDs from their meaning under the SEBI Act. For this, one could refer to the Operational Circular No. SEBI/HO/DDHS/P/CIR/2021/613 dated 10^th August, 2021 (updated on 13^th April, 2022). Chapter X deals with “Issue and Listing of Structured Debt Securities / Market Linked Debt Securities”. Para 2.1 thereof reads as under:

“2.1 Debt securities which do not promise to return the principal amount in full at the end of the tenor of the instrument, i.e., ‘principal non-protected’ shall not be considered as debt securities under regulation 2(k) of SEBI NCS Regulations, 2021 and therefore will not be eligible for issue and listing under the said regulations.”

8. From the above meaning under the SEBI Operational Circular it would be apparent that if the principal component is not secured, that is, it is possible that the principal will be eaten into in case of a loss, such a security cannot be considered as a “debt security”. Once this is the case, and the meaning of the “debt security” under the aforementioned Circular issued by SEBI can be imported into understanding the meaning of the term “debt security” for the purposes of the explanation to section 50AA of the Act, which explains the meaning of an MLD, it would be clear that if the principal is non-protected, it would not be a debt security and hence not an MLD for the purposes of section 50AA – even though the second facet of the explanation namely, the returns being “linked to market return on other underlying securities or indices” are met.

9. But for the purposes of the Income Tax Act, 1961, would it be possible to import such a meaning as has been set out under the SEBI Act to be read with the Operation Circular?

10. The general principal is that words and expressions defined in one statute as judicially interpreted do not afford a guide to the construction of the same words or expressions in another statute, CIT vs. Venkateswara Hatcheries, 237 ITR 174 (SC). However, where both the statutes are pari materia legislation or it is specifically provided in one statute to give the same meaning to the words as defined in another statute then it would be permissible to adopt the construction given in the other statute. See decision in the case of Jagatram Ahuja vs. CGT, 246 ITR 609 (SC), and other High Court decisions on the same subject.

11. In the following cases, Courts have held that it would be possible to refer to other legislation where a particular item has not been defined under the Act:

(i) In Re Moolamattom Electricity Board Employees’ Co-operative Bank Ltd, [1997] 238 ITR 630 (Ker.), the High Court has held that resort to a different provision of another Act may be permissible in the absence of a definition or where the term is of a technical nature;

(ii) In CWT vs. Bhaskar Mitter, (1993) 202 ITR 612 (Cal.), the Court has held that in a fiscal statute, unless the context otherwise warrants, the same expression occurring in a different enactment should be assigned the same meaning where the colour content and context of such statute are the same or similar. See also Commissioner of Customs vs. Indian Oil Corporation, 267 ITR 272 (SC), where the power of CBDT and the CBEC to issue board circulars under the customs and central excise and income tax enactments were held to be in pari materia.

12. In the issue on hand there is no definition of the term “debt security” under the Act and the term “debt security” is a technical term. The SEBI Act is also, in a sense, a fiscal statute as it regulates securities transactions in India. Therefore resorting to the meaning given by SEBI in its aforementioned circular would be a plausible legal course of interpretation of the term “debt security”.

13. In my view, therefore, it would be possible and reasonable to import the definition of debt security from the SEBI Act into the Income Tax Act, 1961. In that view of the matter, I am of the view that the unlisted debentures whose principal is non-protected are not “debt securities”. In that view of the matter, the capital gain on the sale of such securities would not be covered by the provisions of section 50AA of the Act and hence would not be a short term capital gain but would, rather, be a long term capital gain covered by section 112 of the Act, taxable at the rate of 20% plus applicable surcharge and cess, if any.

14. There is one other issue that needs to be mentioned. If one sees the Explanatory Memorandum set out at para 7 hereinbefore, it will be seen that the Explanatory Memorandum mentions that Market Linked Debentures (MLDs) are listed securities (at para 2 thereof). The Explanatory Memorandum further goes on to state (at para 3 thereof) that the insertion of section 50AA is “In order to tax the capital gains from the transfer or redemption of these securities as short-term capital gain….”. Thus, the Explanatory Memorandum in effect speaks of only listed securities being taxed as short-term capital gain. But if one sees the definition of MLD in section 50AA of the Act, as set out in para 6 hereinabove, there is no mention of an MLD being a “listed” security. However, if the Explanatory Memorandum mentions that MLDs are listed securities, it has a persuasive effect in understanding as to what are MLDs. Though it is now well settled by legal decisions that an Explanatory Memorandum by itself cannot detract from the actual provisions of the Act, where such provisions are clear and unambiguous, it is also well settled that the Explanatory Memorandum would have a persuasive effect in understanding the concerned section where there is ambiguity about the same. These debentures which are not listed securities and whose debt portion is unsecure (non-protected), need not be considered as falling under the provisions of section 50AA of the Act.

15. To sum up:

(i) In order for the capital gain to be taxed as short-term capital gain u/s.50AA of the Act, it should be a “debt security”;

(ii) The term “debt security” is not defined in the Act;

(iii) Therefore, it may be permissible to understand the term “debt security” as per the definition under SEBI which is also a kind of fiscal statute;

(iv) Courts have allowed resort to different provisions of another act in the absence of a definition or where the term is of a technical nature. Hence, the definition under the SEBI Circular of “debt security” would be possible to be imported into the understanding of “debt security” under the Act.

(v) The Explanatory Memorandum too refers to Market Linked Debentures being listed securities, which the securities in question are not.

16. For all the above reasons, Capital Gain on the sale of the debentures (which are not listed on the Stock Exchange) and whose principal is non-protected would not be chargeable u/s.50AA of the Act as short-term capital gain. To the contrary, it would be taxable u/s.112 of the Act as long-term capital gain @ 20% plus surcharge and cess, as applicable.

DISCLAIMER

The views expressed in this article:

(i) are the views of the author of the article;

(ii) are based on the facts, as set out in this article and the orders, judgments, circulars and other material of courts, tribunals, the CBDT, CBIC, SEBI, et.al., as on date;

(iii) are as per the existing law and would be subject to changes in the law and to orders, judgments, circulars, et.al., post this article;

(iv) may not be in tandem with the views of the concerned executive authorities, appellate authorities, tribunals or courts.

Ashok Rao

Place: Mumbai

Date : 15^th December, 2023

Availability of ITC in respect of major repairs by Societies.

1. Would the set-off of Input Tax Credit (“ITC”) be available to housing and office premises societies, in respect of major repair works undertaken by them, against the GST liability which they have to incur, under the Central Goods and Services Tax Act, 2017 (“GST Act”)?

2. At the outset, it is absolutely undisputed that housing / office premises society would come within the ambit of GST in view of the fact that section 2(17) of the GST Act, includes, under sub-clause (e) thereof, “provision by a club, association, society, or any such body (for a subscription or any other consideration) of the facilities or benefits to its members”. Of course, this is subject to other parameters for taxability (after taking into account exemptions provided) being met. It is not the intent of this article to set out the conditions under which such societies would fall within the ambit of GST and the limited purpose is to set out whether ITC on major repairs in the case of such societies which fall within the ambit of GST would be available as set off against GST payable by the society.

3. The reason why this issue has become important is because of decision of Maharashtra Appellate Authority for Advance Ruling (“MAAAR”) in the case of Mahavir Nagar Shrushti CHS Ltd. (Order No.MAH/AAAR/AM-RM/10/2022-23, dated 30.09.2022). In this case, the MAAAR took the view that “… the appellant society was not eligible to avail ITC of the tax paid on the works contract services received from their appointed contractor in terms of limitations provided under section 17 (5) (c ) of the GST Act, 2017, as it cannot be said to be providing works contract services to their members.”

4. Though this Order is an Advance Ruling and is binding only on the parties to the Ruling, it has a persuasive effect in respect of other parties as well and the revenue authorities will be emboldened to take the view expressed by the MAAAR.

5. At the outset, it must be mentioned here that under section 16 (1) of the GST Act –

“Every registered person shall subject to such conditions and restrictions as may be prescribed and in the manner specified in section 49, be entitled to take credit of input tax charged on any supply of goods or services or both to him which are used or intended to be used in the course of furtherance of his business and the said amount shall be credited to the electronic credit ledger of such person.”

It will, therefore, be seen from the above that generally there is no restriction in claiming any input tax credit as along as concerned input services are utilized in the course of furtherance of the business of the service recipient. The restrictions, if any, in claiming such ITC as set-off are set out, inter alia, in section 17 of the GST Act.

6. One of those restrictions is under section 17 (5) (c ) of the GST Act. This clause, as extracted by the MAAAR, reads as under:

“(5) Notwithstanding anything contained in sub-section (1) of section 16 and sub-section (1) of section 18, input tax credit shall not be available in respect of the following, namely:

(a) ……

(b) ……

( c) Works contract services when supplied for construction of an immovable property (other than plant and machinery) except where it is an input service for further supply of works contract service”

(d) goods or services or both received by a taxable person for construction of an immovable property (other than plant or machinery) on his own account including when such goods or services or both are used in the course or furtherance of business.

‘Explanation – For the purposes of clauses( c) and (d), the expression “construction includes reconstruction, renovation, additions or alterations or repairs, to the extent of capitalization, to the said immoveable property’.

7. It is clear that the MAAAR has ignored the explanation. Clearly the works contract must be for construction of an immoveable property in order for the ITC not to be available. The explanation purports to enlarge the ambit of the expression ‘construction’ to include, inter alia, alterations and repairs. However, this inclusion of such alterations and repairs, etc., is only if the concerned expenditure is capitalized in the books of the service recipient. If such expenditure is not so capitalized, there should be no reason for the ITC on the repairs being not allowed as a set-off in the hands of the society for the purposes of the GST Act, since such repairs would not be in the nature of construction of an immovable property.

8. Then, why has the MAAAR taken the view that the ITC would not be available in respect of the repairs undertaken by the appellant society in that case? This is because of two factors –

(i) Firstly, the case of the appellant society was that the works contract was a sort of pass-through from the service provider through the society to its members – which argument did not meet with the approval of the MAAAR.

(ii) Secondly, and more importantly the issue that the ITC was not proscribed from being set-off because the works contract was not for construction of an immoveable properties was never argued.

9. The above view also takes grist from the following –

(a) the decision of the Maharashtra Authority for Advance Ruling (“MAAR”) in re Vishal Co-op. Housing Society Ltd., being No.GST-ARA-75/2019-20/B-83 dated 02.11.2021. In this case, MAAR has held in response to Q.No.2 posed by the Applicant Housing Society as under:-

“In view of the discussions made above, ITC on GST paid on above said works contract service received by the applicant will not be available to the extent of capitalisation as mentioned in Explanation of Section 17(5) of the CGST Act, 2017” (emphasis supplied); and

(b) The decision of the Maharashtra Authority for Advance Ruling (“MAAR”) in re M/s. Mahindra Splendour CHS Ltd., bearing No.GST-ARA-38/2020-21/B-103, dated 01.12.2021. In this case, MAAR has held in response to Q.No.6 posed by the Applicant Housing Society as under:

“In view of the discussions made above, ITC on the expenses incurred for heavy repairs and maintenance of the society building will not be available to the extent of capitalisation as mentioned in Explanation of Section 17(5) of the CGST Act, 2017.” (emphasis supplied)

10. The problem arises because the MAAR in the case of Mahindra Splendour CHS Ltd. (supra), set out at para 5.8.6. as under:

“The applicant is engaged in club or association supply of service as a business and the construction service is used for furtherance of the said business. Thus the supply rendered by the applicant is also covered under Section 17(5)(d) read with explanation mentioned therein. ITC on GST paid on such supply of service as mentioned above will not be available to the extent of capitalisation of the said service. Any expenditure benefit which is likely flow over a few years needs to be capitalized, so no ITC is available for such expenditure. Major repairs involve large expenditures that extend the useful life of an asset. For example, the replacement of a building roof is considered a major repair if it allows the building to be used beyond its normal operating life or, if the engine / main motor in a lift is replaced, thereby results in extending the lifespan of the said lift equipment. In accounting, major repairs are capitalized as assets and depreciated over time. Minor repairs do not extend the useful life of an asset, and so are charged to expense as incurred. Proper facts regarding nature of work and whether benefits of such major repair shall flow over the years or not; are not produced, so no further comments in this respect can be made.”

What the MAAR in effect saying is that, per se, if the expenditure is capital expenditure, in any event, the benefit of ITC would not be available (whether or not it is capitalised). In my opinion, this is not a correct view for, in a taxation statute, there is no scope for departing from the clear wordings of the statute. If an exemption is granted, it should be liberally interpreted in favour of the tax payer. Therefore, if the major repairs are written off, there is no scope for treating that amount as capital expenditure.

11. Besides factually most major repairs are in the nature of guniting and painting of the building and prevention of leakages in the building. The whole purpose of the major repairs is only to retain the life of the building and not to extend the life of the building. In general, major repairs are considered as capital expenditure, if they –

(i) extend the useful life of the asset;

(ii) increase the capacity or efficiency of the asset and/or;

(iii) improve the quality and performance of the asset

Most major repairs generally neither increase the useful life of the asset; nor does it increase its capacity; nor does it increase the quality of the performance. The building continues to be a building as earlier and at best the repairs would bring it back to its earlier state. Such major repairs, therefore, cannot be categorised as capital expenditure.

12. Therefore, such major repairs which are revenue in nature and which are not being capitalised in the books of the service recipient would be available for the benefits of set-off on ITC.

13. Therefore, in my view, ITC on the said repairs would be allowable as a set-off against the GST payable by the society, if the said major repairs and renovations are not capitalized in the books of the society.

DISCLAIMER

The views expressed in this article:

are the views of the author of the article;
are based on the facts as set out in this article and the orders, judgements, circulars and other material of courts, tribunals, the CBDT, CBIC, et.al., as on date;
are as per the existing law and would be subject to changes in the law and to orders, judgements, circulars, et.al., post this article;
may not be in tandem with the views of the concerned executive authorities, appellate authorities, tribunals or courts.

Ashok Rao

Place: Mumbai

Date: 6th November, 2023.

GST on export outbound freight

Is GST payable on outbound freight, i.e., freight on exports?

2. This is the limited question on which there seems to be a lot of confusion.

3. For the purpose of understanding this issue, one has first to look at the legal provisions including any notifications that may have been issued in this regard. This article primarily concentrates on outbound freight, i.e., freight on exports outside India.

4. Before proceeding to understand the position regarding taxation of ocean freight on outbound services of exports out of India, it would be fruitful to see the types of contracts for supply of goods that can be entered into for such exports.

5. There can be 3 types of contracts for supply of goods. These are (i) Free on Board (“FOB”); Cost and Freight (“C&F”); and Cost, Insurance and Freight (“CIF”).

6. In FOB contracts, the delivery of the goods is made at the port of export – all charges till the port being met by the exporter. In C & F contracts, the exporter pays the outbound freight upto the importer’s port. In CIF contracts, the insurance too is borne by the exporter. Thus, in an FOB contract, the shipping line charging the freight is dealing with the importer of the goods in the foreign country. Whereas in the other two types of contracts (i.e. C & F and CIF), the shipping line charging the freight is dealing with the exporter of the goods, i.e., the person located in India.

7. At the outset, the reason for this article is the non-extension of a notification which exempted “services by way of transportation of goods by a vessel from customs station of clearance in India to a place outside India”. This was by notification under the IGST Act, the initial notification bearing No.2/2018 – Interpreted Tax (Rate). This exemption notification was extended from time to time till 30.09.2022 and ceased to be extended beyond this date.

8. Since this issue is concerned with outbound freights on exports, the provisions are covered by the Integrated Goods and Services Tax Act, 2017 (“IGST Act”).

9. Under the IGST Act, in order to understand this position regarding GST on export freight, there two sections of the IGST Act which have relevance. Firstly, section 12 and, secondly, section 13. Section 12 covers the place of supply of services where location of supplier and the recipient is in India; whereas the section 13 covers the place of supply of services where either the location of the supplier or the location of the recipient is outside India. It is the latter provision (section 13) which is addressed here, as this would cover ocean freight on exports.

10. In addition, it is necessary to understand what is “export of services” and the term “location of recipient of services”. These are defined by section 2(6) and section 2(14) respectively of the IGST Act which reads as under:

“Section 2(6) “export of services” means the supply of any service when –

the supplier of service is located in India;

the recipient of service is located outside India;

the place of supply of service is outside India;

the payment for such service has been received by the supplier of service in convertible foreign exchange [or in Indian rupees wherever permitted by the Reserve Bank of India]; and

the supplier of service and the recipient of service are not merely establishments of a distinct person in accordance with Explanation 1 in section 8;”

“Section 2(14) “location of the recipient of services” means –

where a supply is received at a place of business for which the registration has been obtained, the location of such place of business;

where a supply is received at a place other than the place of business for which registration has been obtained (a fixed establishment elsewhere), the location of such fixed establishment;

where a supply is received at more than one establishment, whether the place of business or fixed establishment, the location of the establishment most directly concerned with the receipt of the supply; and

in absence of such places, the location of the usual place of residence of the recipient;”

11. Sub-sections (1) and (2) of section 13 of the IGST Act read as under:

“Place of supply of services where the location of supplier or location of recipient is outside India –

13(1) The provisions of this section shall apply to determine the place of supply of services where the location of the supplier of services or the location of the recipient of services is outside India.

(2) The place of supply of services except the services specified in sub-sections (3) to (13) shall be the location of the recipient of services.

Provided that where the location of the recipient of services is not available in the ordinary course of business, the place of supply shall be the location of the supplier of services.

12. It may be useful to point out that the “supplier” who is charging the ocean freight would be the shipping line and the recipient of the services is normally the shipping exporter.

13. Instantly, it will be seen from sub-section 2 that the place of supply of services would be the location of the recipient of the services – unless any of the provisions of sub-sections (3) to (13) are attracted in which case that sub-section will determine the taxability of the outbound freight.

14. Sub-section (9) of section 13 specifically deals with transportation of goods and it reads as under:

“(a) The place of supply of services of transportation of goods, other than by way of mail or courier, shall be the place of destination of such goods.”

This sub-section (9) made the destination of the goods as the criterion and not the recipient/supplier of the service of transportation. Therefore, it created an unintended confusion. At this stage, it may be pointed out that sub-section (9) has been omitted by the Finance Act, 2023, but with effect from a date yet to be notified.

15. There were two main reasons for omitting this section. First, it was felt that it was unnecessary. The place of supply of services of transportation of goods is already determined by other provisions of the IGST Act, such as section 13(2) which states that the place of supply of services is the location of the recipient of the service. Second, it was felt that Section 13(9) could lead to unintended consequences. For example, it could have been interpreted to mean that transportation services provided by foreign shipping lines to Indian exporters – who were also responsible for bearing the ocean freight – were not taxable in India. This could have given foreign shipping lines an unfair advantage over Indian shipping lines.

16. The deletion of section 13(9) ensures that all transportation services, regardless of whether they are provided by Indian or foreign shipping lines, are taxed in India in the same way. This helps to create a level playing field for all businesses and ensures that the Indian government collects the correct amount of tax revenue.

17. However, this omission of sub-section (9) in no way prejudices the manner in which one should view the taxability of outbound freight on exports. This is because under sub-section (2) the place of supply and services shall be the location of the recipient of the services.

18. Now, there are two ways in which one can look at outbound freight on exports. If the export is on C & F or CIF basis, the freight is to be borne by the Indian exporter. In such an event, the recipient of the services would be the Indian party and, therefore, the ocean freight would be subjected to GST. If however, the export from India is FOB (i.e. Free on Board), the insurance and the freight would be met by the importer in the foreign country. It is evident from this that once the export is made on FOB basis, so far as the Indian exporter is concerned the title in the goods and the liability for the payment, inter alia, of the ocean freight would be the responsibility of the foreign importer. The shipping line is, therefore, dealing only with the foreign importer who is located outside India and, therefore, the freight would not fall within the taxable ambit of section 13 of the IGST Act.

19. Indian exporters are not the “recipient of the services” of outbound freight on exports on FOB basis. That person would be the foreign importer and, therefore, outbound freight in an FOB contract will also be the responsibility of the importing foreign party which is located outside India and, therefore, the place of supply would be that place where the importer recipient is located. In such an event, therefore, freight on exports where the foreign importer is responsible for the insurance and freight would not be subjected to the IGST.

20. To sum up,

(i) the non-extension of the exemption notification – for payment of ocean freight in regard to export out of India – beyond 30^th September, 2022, does not, by itself, change the position with regard to payment of freight on exports on an FOB basis.

(ii) Under section 13 of IGST Act, the place of supply of services would be the location of the recipient of the services.

(iii) In the case of an FOB contract, for export out of India, the recipient would be the foreign importer and, therefore, no GST would be leviable in such cases.

(iv) However, where the export from India is either CIF or C&F, the recipient of services of freight from the shipping line would be the Indian exporter and, hence, in such cases, GST is leviable.

Ashok Rao

Place: Mumbai

Date: 2^nd September, 2023.

LEASEHOLD LAND PREMIUM – CAPITAL OR REVENUE

Should the premium paid on signing an agreement for a long-term lease of land be considered as capital or revenue in nature?

2. In Raja Bahadur Kamakshya Narain Singh of Ramgarh vs. CIT (1943) 11 ITR 513 (PC), the Judicial Committee distinguished between premium (salami) and rent by stating :

“It (salami) is a single payment made for the acquisition of the right of the lessees to enjoy the benefits granted to them by the lease. That general right may properly be regarded as a capital asset, and the money paid to purchase it may properly be held to be a payment on capital account. But the royalties are on a different footing”.

3. In Member for the Board of Agrl. IT vs. Sindhurani Chaudhurani, (1957) 31 ITR 169

(SC), the Supreme Court defined “salami” as follows :

“The indicia of salami are (1) its single non-recurring character and (2) payment prior to the creation of the tenancy. It is the consideration paid by the tenant for being let into possession and can be neither rent nor revenue but is a capital receipt in the hands of the landlord” (emphasis supplied).

4. In Maharaja Chintamani Saran Nath Sah Deo vs. CIT (1961) 41 ITR 506 (SC), the Supreme Court observed that “the definition of salami was a general one in that and it was a consideration paid by a tenant for being let into possession for the purpose of creating a new tenancy” (emphasis supplied).

5. In Assam Bengal Cement Co.Ltd. vs. Commissioner of Income Tax, 27 ITR 34 (SC) –

the facts were that on the 14^th Nov.1938, the appellant company acquired from the Government of Assam a lease of certain limestone quarries, known as the Komorrah quarries situated in the Khasi and Jaintia Hills District for the purpose of carrying on the manufacture of cement. The lease was for 20 years commencing on the 1^st Nov., 1938, and ending on the 31^st Oct., 1958 with a clause for renewal for a further tem of 20 years. The rent reserved was a half-yearly rent certain of Rs.3,000 for the first two years and thereafter a half-yearly rent certain of Rs.6,000 with the provision for payment of further royalties in certain events. In addition to these rents and royalties two further sums were payable under the special covenants contained in cls. 4 and 5 of the lease as “protection fees”. Under cl. 4 the protection was in respect of another group of quarries called the Durgasil area, the lessor undertaking not to grant any lease, permit or prospecting licence regarding the limestone to any other party therein without a condition that no limestone should be used for the manufacture of cement in consideration of a sum of Rs.5,000 payable annually during the whole period of the lease. Under cl.5, a further protection was given in respect of the whole of the Khasi and Jaintia Hills District, a similar undertaking being given by the lessor in consideration of a sum of Rs.35,000 payable annually but only for 5 years from the 15^th Nov., 1940.

In the accounting years 1944-45 and 1945-46 the company paid its lessor sums of Rs.40,000 in accordance with these two covenants and claimed these amounts on revenue expenditure.

The Court held that:

Under cl.4 of the deed the lessors undertook not to grant any lease, permit or prospecting licence regarding limestone to any other party in respect of the group of quarries called the Durgasil area without a condition therein that no limestone shall be used for the manufacture of cement. The consideration of Rs.5,000 per annum was to be paid by the company to the lessor during the whole period of the lease and this advantage or benefit was to ensure for the whole period of the lease. It was an enduring benefit for the benefit of the whole of the business of the company and came well within the test laid down by Viscount Cave. It was not a lump sum payment but was spread over the whole period of the lease and it could be urged that it was a recurring payment. The fact however that it was a recurring payment was immaterial, because one had got to look to the nature of the payment which in its turn was determined by the nature of the asset which the company had acquired. The asset which the company had acquired in consideration of this recurring payment was in the nature of a capital asset, the right to carry on its business unfettered by any competition from outsiders within the area. It was a protection acquired by the company for its business as a whole. It was not a part of the working of the business but went to appreciate the whole of the capital asset and make it more profit yielding. The expenditure made by the company in acquiring this advantage which was certainly an enduring advantage was thus of the nature of capital expenditure and was not an allowable deduction under s.10(2)(xv) of the IT Act.

The further protection fee which was paid by the company to the lessor under cl.5 of the deed was also of a similar nature. It was no doubt spread over a period of 5 years, but the advantage which the company got as a result of the payment was to enure for its benefit for the whole of the period of the lease unless determined in the manner provided in the last part of the clause. It provided protection to the company against all competitors in the whole of the Khasi and Jaintia Hills District and the capital asset which the company acquired under the lease was thereby appreciated to a considerable extent. The sum of Rs.35,000 agreed to be paid by the company to the lessor for the period of 5 years was not a revenue expenditure which was made by the company for working the capital asset which it had acquired. It was no part of the working or operational expenses of the company. It was an expenditure made for the purpose of acquiring an appreciated capital asset which would no doubt by reason of the undertaking given by the lessor make the capital asset more profit yielding. The period of 5 years over which the payments were spread did not make any difference to the nature of the acquisition. It was none the less an acquisition of an advantage of an enduring nature which enured for the benefit of the whole of the business for the full period of the lease unless terminated by the lessor by notice as prescribed in the last part of the clause. This again was the acquisition of an asset or advantage of an enduring nature for the whole of the business and was of the nature of capital expenditure and thus was not an allowable deduction under s.10(2)(xv) of the Act.

6. In CIT vs. Panbari Tea Co. Ltd., 57 ITR 422 (SC) –

the facts were that by a registered lease deed dt. 31^st March, 1950, the assessee-company, leased out two tea estates named “Panbari Tea Estate” and “Barchola Tea Estate”, along with machinery and buildings owned and held by it, in Darrang, in the State of Assam, to a firm named M/s.Hiralal Ramdas for a period of 10 years commencing from 1^st Jan., 1950. The lease was executed in consideration of a sum of Rs.2,25,000 as and by way of premium and an annual rent of Rs.54,000 to be paid by lessee to the lessor. The premium was made payable as follows : Rs.45,000 to be paid in one lump sum at the time of the execution of the lease deed and the balance of Rs.1,80,000 in 16 half yearly instalments of Rs.11,250 on or before 31^st January and 31^st July of each year. The annual rent of Rs.54,000 was payable as follows: Rs.1,000 per month to be paid on or before the last day of each month, making in all Rs.12,000 per year, and the balance of Rs.42,000 on or before 31^st December of each year. On 25^th Feb., 1957, for the asst. yr. 1952-53, the ITO made the assessment treating the instalment of Rs.11,250 paid towards the premium in the relevant accounting year as a revenue receipt of the assessee. On appeal, the AAC confirmed the order of the ITO. On further appeal, the Tribunal also held that the premium was really the rent payable under the lease deed and, therefore, it was chargeable to income-tax. The High Court, however, held that the said sum of Rs.11,250/- received by the assessee was a capital receipt.

(ii) The Court, at the outset, set out the three decisions in Raja Bahadur Kamakshya Narain Singh of Ramgarh, Sindhurani Chaudhurani and Maharaja Chintamani Saran Nath Sah Deo, supra. Thereafter, at para 9 the Court stated as under:-

“Under s. 105, of the Transfer of Property Act, a lease of immovable property is a transfer of a right to enjoy the property made for a certain time, express or implied, or in perpetuity, in consideration of a price paid or promised, or of money, a share of crops, service or any other thing of value, to be rendered periodically or on specified occasions to the transferor by the transferee, who accepts the transfer on such terms. The transferor is called the lessor, the transferee is called the lessee, the price is called the premium, and the money, share, service or other thing to be so rendered is called the rent. The section, therefore, brings out the distinction between a price paid for a transfer of a right to enjoy the property and the rent to be paid periodically to the lessor. When the interest of the lessor is parted with for a price, the price paid is premium or salami. But the periodical payments made for the continuous enjoyment of the benefits under lease are in the nature of rent. The former is a capital income and the latter a revenue receipt. There may be circumstances where the parties may camouflage the real nature of the transaction by using clever phraseology. In some cases, the so-called premium is in fact advance rent and in others rent is deferred price. It is not the form but the substance of the transaction that matters. The nomenclature used may not be decisive or conclusive but it helps the Court, having regard to the other circumstances, to ascertain the intention of the parties” (emphasis supplied).

(iii) The Court went on to hold that two expressions were used in the document namely “premium” and “rent”. It held that the mere fact that the premium was paid in instalments cannot be decisive of the issue, for that might have been to accommodate the lessee. The Court, therefore, held that the premium amount was a capital receipt.

7. In CIT vs. Associated Cement Companies Ltd., (1988) 172 ITR 257 (SC), the question was whether the expenditure incurred by the assessee towards installing water pipelines and accessories outside the factory premises which were to belong to and maintained by the municipality in return for the assessee being exempted from paying municipal rates and taxes for a period of 15 years, was revenue expenditure. It was held that, since the installations and accessories were the assets of the municipality and not of the assessee, the expenditure did not result in bringing into existence any capital asset for the company. Further, that the advantage secured by the assessee by incurring the expenditure was absolution or immunity from liability to pay municipal rates or taxes for a period of 15 years; if these liabilities had to be paid, the payments would have been on revenue account, and, therefore, the advantage secured was in the field of revenue and not capital.

8. In CIT vs. Madras Auto service (P) Ltd., (1985) 156 ITR 740 (Mad), the assessee-company therein had taken on lease land and building in Bangalore for housing its branch in that city. The building was in a good business locality, but rather old. Under an agreement between the assessee and the landlord, the building was demolished and a new building constructed in its place and, as a consideration for this, the landlord agreed to take a very low rent of Rs.1,000 per mensem initially and Rs.2,000 for the last four years of the lease which was extended to 39 years. The prevailing rent in the area would have worked out to Rs.12,000 per month. The amount spent by the assessee for the construction of the new building was claimed as deductible business expenditure. It was held that (i) no tangible or intangible asset came into existence as a result of the expenditure incurred by the assessee in demolishing the old building and constructing a new one and it would be more appropriate to regard the amounts spent as losses and (ii) the terms of the agreement and the circumstances of the case clearly showed that the assessee had entered into the agreement only because of the obvious savings in rent charges, and, therefore, the amount of expenditure was deductible as losses incidental to business. In the instant case, the rent of Re.1 payable for the premises is only nominal which would lead to the irresistible inference that the lump sum amount paid at the inception of the lessee under the agreement is nothing but rent paid in advance and to obviate the need for making periodical payments.

9. CIT vs. Project Automobiles, (1984) 150 ITR 266 (Bom), the assessee had entered into an agreement of lease with the owners for thirty years. Premium was to be paid at the rate of Re.1 per square foot. In addition, the assessee was also to pay economic rent calculated at the rate of five per cent of the total ground rent per annum which was to be revised at the end of fifteen years. The premium which amounted to Rs.62,500 was payable in instalments. In the facts and circumstances of that case and construing the terms and conditions of the lease in its entirety and in the absence of material to prove that the premium was payment of advance rent (since separate economic rent was also payable), the amount of Rs.62,500 was capital expenditure and hence not deductible.

10. In CIT vs. H.M.T. Ltd., 203 (ITR) 820 (Kar), the facts were that – the assessee had entered into a lease agreement with the Maharashtra Industrial Development Corporation (M.I.D.C) on 24^th Nov.1980, granting lease of a plot of land at Aurangabad. Under the terms of the agreement, the assessee was required to construct a building thereon within a period of two years. Thereafter, the assessee was entitled to use and occupy the property with the building thereon for a period of 95 years upon payment of rent of Re.1 per annum. After the expiry of the lease period, the plot together with the building thereon had to be surrendered to the M.I.D.C. Under the said agreement, the assessee had paid a sum of Rs.12,09,200 as premium for acquiring the leasehold. The assessee claimed that the said amount, although stated as premium, is nothing but rent paid in advance instead of paying the rent periodically, and that the said payment should be considered as a revenue or business expenditure. Both the AO and the Commissioner (Appeals) held that this was a capital expenditure. In second appeal, the Tribunal held that the expenditure was for the sole purpose of the assessee’s business and, as such, eligible for deduction. However, according to the Revenue, the said payment was a capital expenditure.

The High Court held that (i) the Tribunal had found as a fact that what was paid by the assessee in a lump sum to M.I.D.C was the future rent payable by it and which the assessee had to pay periodically. This was evident from the fact that the assessee was paying Re.1 per annum which was obviously for the purpose of retaining the character of the transfer of property as a lessee and not for any other purpose; and (ii) in the circumstances, the use of the term “premium” in the agreement in respect of the advance rent paid did not render the payment anything more than rent paid in advance instead of paying the same in future periodically. There was absolutely no indication in the agreement that the amount paid by the assessee could be considered as a consideration paid by it for being let into possession of the premises while reserving a separate or economic rate of rent to be paid periodically thereafter. The court differentiated the decision in the case of CIT vs. Project Automobiles (supra).

11. In the case of CIT vs. Gemini Arts (P) Ltd 254 ITR 201 (Mad), the facts were that the Assessee which had leasehold for 48 years chose to pay with the consent of the lessor the rent for 47 years in the asst.yr. 1981-82. The lease was for a period of 48 years from 18^th Feb., 1980, and the lump sum payment was made on 22^nd March, 1980. The terms of the lease did not contemplate any increase in the rate or rental during the period of lease. The lessee got no other advantage by reason of this lump sum payment except the relief of not having to make the annual payment during the period of lease.

12. In the case of GAIL India Ltd vs. Joint CIT 211 Taxman 587 (Del), the facts were that the assessee, which was engaged in the manufacture of Hydrocarbon and distribution of natural gas, entered into lease arrangements with local municipalities, in respect of land. The lease agreements contained certain standard terms. The lease arrangements were for a long period ranging between 60-95 years. The various clauses in the lease agreements in question permitted the appellant to construct buildings upon the lease lands which were to ultimately vest with the landlord upon expiry of term of the lease. These leases were granted on payment of heavy premia upfront and down payment basis. Lease agreements also contained stipulation reserving nominal rent ranging between Rs.1 to Rs.100 p.a. and in some cases worked out to 2.5 per cent of the premium paid. The appellant had claimed deduction of Rs.30,94,464 towards amortizing of such premia paid for use of land on long-term lease. The assessee had contended that the premium paid on lump sum basis indicated the capitalised value or a consolidated lump sum payment of rent, which would otherwise have been payable annually. The AO in respect of both the assessment years in question disallowed the claim for amortised value of lease rentals which was sought to be on the ground that the lump sum premium was capital expenditure. The CIT(A) for both the assessment orders rejected the assessee’s claim.

The High Court held that it was no doubt true that the decisions in HMT (supra), Sun Pharmaceuticals (supra) and Gemini Arts (supra) dealt with fact situations where the assessee had obtained long lease, and where the Court found the down payment as lump sum premium to be a real advance rental payment which therefore qualified as revenue expenditure. At the same time, the Court noticed that in Madras Auto Services (supra), the leased land contained a dilapidated structure, and since it could not be used by the assessee, the parties therefore had agreed that the assessee could construct upon the land at its own cost but at the same time it would have no right or title in the new construction. All this was taken into consideration by the Court to hold that the amount paid at the commencement of the lease was the advance rent that could be amortised. At the same time, there were other rulings by the Supreme Court {in Assam Bengal Cement Co. Ltd. vs. CIT (1955) 27 ITR 34 (SC), CIT vs. Panbari Tea Co. Ltd. (1965)57 ITR 422 (SC) and Durga Madira Sangh vs. CIT (1985) 44 CTR (Raj) 266 : (1985) 153 ITR 226 (Raj)}. In all these cases, the Court upheld the Revenue’s contention and stated that the expenditure towards acquisition of lease amounted to “bringing into existence an asset or advantage for enduring benefit of the business” and was properly attributable by way of capital expenditure – cf (Assam Bengal Cement Co. Ltd.). In Panbari Tea Co. Ltd. (supra), the Court had underlined the fact that where the party consciously chose to assign two different meanings to the expressions “premium” and “rent”. The Court would not be justified in concluding that the premium paid constituted advance rent. Significantly, the High Court noticed that in Panbari Tea Co. Ltd. (supra) the lease arrangement itself was for a period of 10 years, despite which the Supreme Court held it to constitute a capital asset. In the present case, unlike in Madras Auto Services or other decisions of the Supreme Court cited by the assessee, the lease arrangements were for a substantially long period i.e. 60-95 years. That the arrangements did not confer outright ownership rights to the lessee was in the Court’s view, besides the point as the enjoyment of the land as a lessee in such cases was substantially that of the owner itself. In other words, barring the right to alienate or outright sale of the property in unqualified manner, all rights of enjoyment in respect of leased properties were with the assessee. Furthermore, even though the stipulation in the deed enjoined the lessee not to transfer either directly or indirectly, sell or encumber the lease benefits to any other party, the same stipulation also enabled transfer with “previous consent in writing of the Chief Executive Officer”. This Court stated that it was conscious of the fact that the conditions embodied in such lease deed are part of the general policies consciously adopted by the municipal and statutory authorities who manage and lease out such assets. It held that the amount paid as capital expenditure.

13. In the case of CIT vs. Gemini Arts (P) Ltd. 254 ITR 201 (Mad), the facts were that the Assessee which had leasehold for 48 years chose to pay with the consent of the lessor the rent for 47 years in the asst.yr. 1981-82. The lease was for a period of 48 years from 18^th Feb., 1980, and the lump sum payment was made on 22^nd March, 1980. The terms of the lease did not contemplate any increase in the rate or rental during the period of lease. The lessee got no other advantage by reason of this lump sum payment except the relief of not having to make the annual payment during the period of lease.

The Court held that the payment to be revenue expenditure for which it relied on the decision of the Supreme Court in the case of CIT vs. Madras Auto Services (P) Ltd., which had held that had the assessee chosen to pay the rent annually for each and every year of the lease, such expenditure certainly would have to be regarded as revenue expenditure. The fact that the payment had been made in lump sum for the entire duration of the lease did not alter the character of it being a revenue expenditure.

14. To sum up:

(i) premium for being let into possession of land or for parting of the interest of the lessor, would be a capital expenditure, but rent paid annually would be revenue expenditure;

(ii) where two different expressions “premium” and “rent” are concurrently used in the agreements, prima facie the payments for the same are accordingly capital or revenue expenditure.

(iii) Premium, even though paid by instalments, would continue to be capital expenditure. Similarly, rent paid in a lump sum in advance would still retain its revenue character;

(iv) where the rent is a nominal amount, say Re.1 per annum, the lump sum amount paid could be considered as revenue expenditure;

(v) where separate economic rent is also being paid, then the premium amount, though small, would be capital expenditure;

(vi) every case has to be decided on its own merits, the guiding factor being that no asset of enduring benefit should be created by the expenditure, each case being decided upon its own facts.

(Ashok Rao)

Date: 25^th July, 2022.

SECTION 94B – APPLICABILITY TO RESIDENT COMPANIES

Are the provisions of section 94B of the Income Tax Act, 1961 (“the Act”) applicable to the interest paid on loans taken by resident entities?

2. Section 94B of the Act, limits the deduction of interest to 30 percent of the earnings before interest, taxes, depreciation and amortization (“EBIDTA”) of the borrowers in the previous year in respect of interest paid on loans given by an Associated Enterprise (AE) or guaranteed by such AE.

3. Provisions of section 94B read as under:-

‘94B. (1) Notwithstanding anything contained in this Act, where an Indian company, or a permanent establishment of a foreign company in India, being the borrower, incurs any expenditure by way of interest or of similar nature exceeding one crore rupees, which is deductible in computing income chargeable under the head “Profits and gains of business or profession” in respect of any debt issued by a non-resident, being an associated enterprise of such borrower, the interest shall not be deductible in computation of income under the said head to the extent that it arises from excess interest, as specified in sub-section (2) :

Provided that where the debt is issued by a lender which is not associated but an associated enterprise either provides an implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender, such debt shall be deemed to have been issued by an associated enterprise.

(1A) Nothing contained in sub-station (1) shall apply to interest paid in respect of a debt issued by a lender which is a permanent establishment in India of a non-resident, being a person engaged in the business of banking.

(2) For the purposes of sub-section (1), the excess interest shall mean an amount of total interest paid or payable in excess of thirty per cent of earnings before interest, taxes, depreciation and amortisation of the borrower in the previous year or interest paid or payable to associated enterprises for that previous year, whichever is less.

(3) Nothing contained in sub-section (1) shall apply to an Indian company or a permanent establishment of a foreign company which is engaged in the business of banking or insurance.

(4) Where for any assessment year, the interest expenditure is not wholly deducted against income under the head “Profits and gains of business or profession”, so much of the interest expenditure as has not been so deducted, shall be carried forward to the following assessment year or assessment years, and it shall be allowed as a deduction against the profits and gains, if any, of any business or profession carried on by it and assessable for that assessment year to the extent of maximum allowable interest expenditure in accordance with sub-section (2):

Provided that no interest expenditure shall be carried forward under this sub-section for more than eight assessment years immediately succeeding the assessment year for which the excess interest expenditure was first computed.

(5) For the purposes of this section, the expressions –

“associated enterprise” shall have the meaning assigned to it in sub-section (1) and sub-section (2) of section 92A;

“debt” means any loan, financial instrument, finance lease, financial derivative, or any arrangement that gives rise to interest, discounts or other finance charges that are deductible in the computation of income chargeable under the head “Profits and gains of business or profession”;

“permanent establishment” includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.’

(Emphasis supplied)

It may be pointed out that section 94B was brought on the statute by the Finance Act, 2017 with effect from Assessment Year 2018-19. However, sub-section (1A) was brought on under the statute by the Finance Act, 2020 with effect from Assessment Year 2021-22.

At the outset, it will be noted that, by sub-section (3) of section 94B, the section has been made inapplicable to an Indian company or a Permanent Establishment (“PE”) of a foreign company which is engaged in the business of banking. Thus, limitation of interest deduction in the case of Indian banks does not arise. It may also be noticed that a PE of a foreign bank is not subject to the rigours of section 94B. This sub-section, however, deals with the treatment of interest paid by such banks. Thus, interest paid to banks by entities not carrying on banking business may be covered by the provisions of section 94B of the Act. The inclusion of a PE of a foreign entity carrying on the business of banking would also need to be noted, as this has a bearing on the subsequent introduction of sub-section 1(A) of section 94B – which will be discussed infra.

At the second outset, may be pointed out the constitutionality of the section was challenged before the Madras High Court in Siemens Gamesa Renewable Power Pvt.Ltd., vs UOI, being WP No.19436/2018. The High Court ruled in favour of the constitutionality of the enactment of section 94B.

Before interpreting the provisions of section 94B of the Act, it would be necessary to understand the reasons for the provisions of section 94B being incorporated in the Act. It may be noted that there is no reference by the Finance Minister in her Budget Speech either to the reason for the introduction of Section 94B in the Act or to the addition of sub-section (1A) in Section 94B of the Act when she introduced the provisions in the Finance Bills 2017 and 2020, respectively, in the Parliament. Therefore, one would have to look at the Explanatory Memorandums to the respective Finance Bills to understand the reasons for the introduction of section 94B and the addition of sub-section (1A) thereto. These Memorandums read as under :-

A. To the Finance Bill 2017 – “Limitation of interest deduction in certain cases.

A company is typically financed or capitalized through a mixture of debt and equity. The way a company is capitalized often has a significant impact on the amount of profit it reports for tax purposes as the tax legislations of countries typically allow a deduction for interest paid or payable in arriving at the profit for tax purposes while the dividend paid on equity contribution is not deductible. Therefore, the higher the level of debt in a company, and thus the amount of interest it pays, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of finance than equity. Multinational groups are often able to structure their financing arrangements to maximize these benefits. For this reason, country’s tax administrations often introduce rules that place a limit on the amount of interest that can be deducted in computing a company’s profit for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive interest payments, and thus aim to protect a country’s tax base.

Under the initiative of the G-20 countries, the Organization for Economic Co-operation and Development (OECD) in its Base Erosion and Profit Shifting (BEPS) project had taken up the issue of base erosion and profit shifting by way of excess interest deductions by the MNEs in Action plan 4. The OECD has recommended several measures in its final report to address this issue.

In view of the above, it is proposed to insert a new section 94B, in line with the recommendations of OECD BEPS Action Plan 4, to provide that interest expenses claimed by an entity to its associated enterprises shall be restricted to 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise, whichever is less.

The provision shall be applicable to an Indian company, or a permanent establishment of a foreign company being the borrower who pays interest in respect of any form of debt issued to a non-resident or to a permanent establishment of a non-resident and who is an ‘associated enterprise’ of the borrower. Further, the debt shall be deemed to be treated as issued by an associated enterprise where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.

The provisions shall allow for carry forward of disallowed interest expense to eight assessment years immediately succeeding the assessment year for which the disallowance was first made and deduction against the income computed under the head “Profits and gains of business or profession to the extent of maximum allowable interest expenditure.

In order to target only large interest payments, it is proposed to provide for a threshold of interest expenditure of one crore rupees exceeding which the provision would be applicable.

It is further proposed to exclude Banks and Insurance business from the ambit of the said provisions keeping in view of special nature of these businesses.

This amendment will take effect from 1^st April 2018 and will, accordingly, apply in relation to the assessment year 2018-19 and subsequent years.

(Clause 43)”

(Emphasis supplied)

B. To the Finance Bill 2020 – “Excluding interest paid or payable to Permanent Establishment of a non-resident Bank for the purpose of disallowance of interest under section 94B.

Section 94B of the Act, inter alia, provides that deductible interest or similar expenses exceeding one crore rupees of an Indian company, or a permanent establishment (PE) of a foreign company, paid to the associated enterprises (AE) shall be restricted to 30 per cent of its earnings before interest, taxes, depreciation and amortisation (EBITDA)

or interest paid or payable to AE, whichever is less. Further, a loan is deemed to be from an AE, if an AE provides implicit or explicit guarantee in respect of that loan. AE

for the purposes of this section has the meaning assigned to it in section 92A of the Act. This section was inserted in the Act through the Finance Act, 2017 in order to implement the measures recommended in final report on Action Plan 4 of the Base Erosion and Profit Shifting (BEPS) project under the aegis of G-2—Organisation of Economic Co-operation and Development (OECD) countries to address the issue of base erosion and profit shifting by way of excess interest deductions.

Representations have been received to carve out interest paid or payable in respect of debt issued by a PE of a non-resident in India, being a person engaged in the business of banking for the reason that as per the existing provisions a branch of the foreign company in India is a non-resident in India. Further, the definition of the AE in section 92A, inter alia, deems two enterprises to be AE, if during the previous year a loan advanced by one enterprise to the other enterprise is at 50 per cent or more of the book value of the total assets of the other enterprise. Thus, the interest paid or payable in respect of loan from the branch of a foreign bank may attract provisions of interest limitation provided for under this section.

It is, therefore, proposed to amend section 94B of the Act so as to provide that provisions of interest limitation would not apply to interest paid in respect of a debt issued by a lender which is a PE of a non-resident, being a person engaged in the business of banking, in India.

This amendment will take effect from 1^st April, 2021 and will, accordingly, apply in relation to the assessment year 2021-22 and subsequent assessment years.

Clause 46”

In this regard, by the Circular No. 2/2018, dated 15.02.2018, issued by CBDT, vide paras 46.1, 46.2 and 46.3, the following has been set out:

“46. Limitation of Interest deduction in certain cases.

46.1. A company is typically financed or capitalized through a mixture of debt and equity. The way a company is capitalized often has a significant impact on the amount of profit it reports for tax purposes as the tax legislations of countries typically allow a deduction for interest paid or payable in arriving at the profit for tax purposes while the dividend paid on equity contribution is not deductible. Therefore, the higher the level of debit in a company, and thus higher the amount of interest it pays, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of finance than equity. Multinational Enterprises (MNEs) are often able to structure their financing

arrangements to maximize these benefits. For this reason, tax administrations of several countries have introduced rules that place a limit on the amount of interest that can be deducted in computing a company’s profit for tax purposes.

Such rules are designed to counter cross-border shifting of profit through excessive interest payments, and thus aim to protect a country’s tax base.

46.2. Under the initiative of the G-20 countries, OECD in its Base Erosion and Profit Shifting (BEPS) project had taken up the issue of base erosion and profit shifting by way of excess interest deductions by the MNEs in Action plan 4 and has recommended several measures in its final report to address this issue.

46.3. In view of the above, a new section 94B has been inserted in the Income-tax Act so as to provide that interest expenses claimed by an entity to tis associated enterprises shall be restricted to 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise, whichever is less”

Virtually, this circular has reiterated what has been mentioned in the Explanatory Memorandum to the Finance Bill, 2017.

Sub-section (1) of Section 94B is very clear in that it is speaking of any debt issued by a non-resident, being an associated enterprises of said borrower. As per main provisions of the sub-section (1) of section 94B, therefore, it is only such direct debt from the AE which would be subject to the restriction of the interest allowability to 30 per cent of EBITDA.

One can understand the purport of the main sub-section (1) of Section 94B. In this regard, it will be interesting to note the following words in the Explanatory Memorandum to the Finance Bill 2017.

“Therefore, the higher the level of debt in a company, and thus the amount of interest it pays, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of finance than equity. Multinational groups are often able to structure their financing arrangements to maximize these benefits. For this reason, country’s tax administrations often introduce rules

that place a limit on the amount of interest that can be deducted in computing a company’s profit for tax purposes.”

The purport seems to be that the funding by the AE to companies by way of loan (as compared to equity) should be reasonable and not excessive. It is not the rate at which the interest is charged but the amount of outgoing which is considered – by the Legislature and the BEPS Action Plan 4 – as reasonable. That reasonability has been fixed at 30 per cent of EBIDTA – above which the limitation and disallowance of interest would come to play. Nor is it the currency in which the payment is made; or whether in India or outside India. So far, so good!

However, the proviso to sub-section (1) puts the cat amongst the pigeons. This is because in the proviso even though the debt is issued by a lender, who is not an AE, when the AE guarantees the debt, the interest thereon becomes subject to the restrictions provided in section 94B of the Act. There is a presumption that, because of the guarantee, there is a higher interest charge in the accounts of the company, by the AE providing more loans and less equity.

What should be the interpretation of the proviso? Though it has not been mentioned in the proviso, under the main sub-section (1) of section 94B, the debt should be issued by a lender, which is a non-resident. After all the proviso is a proviso and should, as far as possible, be read in conjunction with the main provision. The main sub-section (1) of section 94B is applicable to any debt by a non-resident, being an associated enterprise. This should be interpreted as “debt by a non-resident and being an associated enterprise.” If either the lender or the AE is not a non-resident the provisions of section 94B(1) would not be applicable. Therefore, it is only if the debt is issued by a non-resident that Section 94B(1) would come into play – with the added condition of it being by the AE, being a non-resident. By the proviso, even a guarantee given by the AE to the lender (who is not an AE), would make the interest restriction applicable to the company. But is it any lender or should the proviso be applicable in respect of only a non-resident lender in view of the provisions of section 94B(1)? In my opinion, the lender should be a non-resident, i.e., the debt should be issued by a

non-resident lender and guaranteed by the non-resident AE. So, if the debt is issued by an Indian entity, which is a resident, though guaranteed by an AE which is non-

resident, such lending would not be covered by the restrictive provisions of 94B(1) and the proviso for limitation on the allowability of interest.

This interpretation is now strengthened by the provisions of sub-section (1A) of section 94B of the Act. The reason that sub-section (1A) was brought on the statute was, as mentioned in the Explanatory Memorandum, that a PE of a non-resident would take the status of “non-resident” and any lending by the PE to a company in India would get covered by the interest deduction limitation under section 94B of the Act, if the said loan given by the PE in India is also guaranteed by a non-resident AE of the company in India, primarily because the PE of a non-resident would continue to have the status of non-resident. In order to not bring such PEs which are non-residents, within the purview of limitation of interest deduction, sub-section (1A) of section 94B has been enacted, virtually categorising the PE a resident so that the disallowability would not need to take place. This sub-section, therefore, indirectly makes it clear that, otherwise, only if the lender is a non-resident would the interest limitation provisions of section 94B apply. Of course, the non-resident PE should be in the business of banking.

Therefore, this sub-section (1A) makes it clear that the legislature did not want loans by residents to be covered by the restrictive provisions of section 94B. This is the only way in which these provisions can be read harmoniously. This would imply that the proviso to sub-section (1) of section 94B should have some words inserted in it and the proviso would then look as under :-

“Provided that where the debt is issued by a lender, being a non-resident, which is not associated, but an associated enterprise either provides an implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender, such debt shall be deemed to have been issued by an associated enterprise”.

(Inserted words in Italics)

There are ample case law to support the theory that a Court can interpret the Section by adding in certain requisite words. This is what the Learned Author and Jurist, Shri N.A. Palkhivala says in his book “The Law and Practice of Income Tax, 10^th Edition (2014), at page 12, which is reproduced as under :-

“Though ordinarily no words can be added or read into an Act unless it is absolutely necessary to do so, departure from this rule is legitimate in such cases where literal construction may result in depriving certain existing words of all the meaning or to avoid any part of the statue becoming meaningless or otiose. Thus, where a literal construction would defeat the obvious intention of the legislation and produce a wholly unreasonable or manifestly unjust result, the court must follow the rule of reasonable construction or modify the language of the statute or even ‘do some violence to the words’ to achieve that obvious intention and produce a rational construction. The intention of the legislature has to be gathered from the language used in the statute, which means that attention should be paid to what has been said as also to what has not been said.”

Inter-alia, the following case laws have been relied upon for the aforementioned propositions.

Luke v IRC, 54 ITR 692 709 (HL)
CIT v National Taj Traders, 121 ITR 535, 542 (SC)
K.P. Varghese v ITO, 131 ITR 597, 606 (SC)
CIT v J.H. Gotla, 156 ITR 323, 339 (SC)
Keshavji Ravji & Co. v CIT, 183 ITR 1 (SC)
Goodyear India Ltd v State of Haryana, 188 ITR 402, 440 (SC)
Bajaj Tempo Ltd. v CIT, 196 ITR 188, 194, 197(SC)
CWS (India) Ltd v CIT, 208 ITR 649(SC)
Padmasundara Rao v State of TN, 255 ITR 147 (SC)
CIT v Hindustan Bulk Carriers, 259 ITR 449, 464-65(SC)
Jamshedpur Motor Accessories v UOI, 189 ITR 70

(SLP rejected 191 ITR 8)

CIT v B.M. Bhatacharjee, 118 ITR 461, 479-80(SC)

Therefore, in my view, this proviso to sub-section (1) of section 94B should be interpreted as applicable in respect of a non-resident lender only, and not in respect of a resident lender, even though guaranteed by the non-resident AE.

To sum up :

Sub-section (1) of section 94B should be interpreted as if both the lender and the AE are non-residents;

The proviso to section 94B(1) should be interpreted as if the lender is a non-resident lender in order to bring it in tandem with the main provisions of sub-section (1) of section 94B;

Sub-section (1A) of section 94B takes even a PE of a non-resident engaged in the business of banking outside the purview of the interest limitation provisions thereby virtually making it clear that other non-residents fall within the purview of section 94B and in effect makes it clear that loans by resident lenders are outside the purview of section 94B of the Act. This also gives grist to the view that it is only lendings by non-residents which would be covered by the main provisions of section 94B (1) read with its proviso;

The court is competent to provide requisite words to give a harmonious view to the provisions of section 94B of the Act. And hence the words “being a non-resident” can be added into the proviso to sub-section (1) of section 94B of the Act at the appropriate place, as set out, supra.

Ashok Rao

Date : 7^th July, 2022.

Section 49(4) – Period of Indexation and Cost of Acquisition for Capital Gains

What would be the period for indexation where an asset has been received in any of the modes mentioned in the provisions of section 49(1) of the Act?

2. This question has already been answered by Courts, particularly the Mumbai High Court. However, there is a new twist to this issue in a case where an asset has been received from a non-relative and has been taxed as such under the provisions of section 56(2)(vii)(b) of the Act. The question which arises is whether that amount which has been taxed, when received as a gift from the previous owner, should be taken only to be the value deemed u/s.49(4) of the Act.

3. At the outset it should be understood that, under the provisions of 56(2)(vii)(b) of the Act, where any immovable property is received from a non-relative (the stamp duty of which exceeds Rs.50,000/-) the shortfall between the amount paid for the property and the stamp duty value will be deemed to be income taxable under the head “Income from other sources” in the hands of recipient (non-relative).

4. The term “relative” has been defined in Section 56(2) (vii) explanation (e) as meaning-

(i) In case of an individual
(A) spouse of the individual

(B) brother or sister of the individual;

(C) brother or sister of the spouse of the individual;

(D) brother or sister of either of the parents of the individual;

(E) any lineal ascendant or descendant of the individual;

(F) any lineal ascendant or descendant of the spouse of the individual;

(G) spouse of the person referred to items (B) to (F); and

(ii) in case of a Hindu undivided family, any member thereof.

5. Under Section 49(4) of the Act where the capital gain arises from the transfer of a property, the value of which has been subject to tax, inter alia, under clause (vii) of Section 56(2) of the Act, the cost of acquisition of such property shall be deemed to be the value which has been taken into account for the purposes of the said clause (vii) viz. inter alia, the stamp duty value of the property. For instance if immovable property, has been received under a gift (i.e. for zero consideration paid by donee) and stamp duty valuation is, say, Rs.5 Crore, this Rs.5 Crore is the value which will be taxed in the hands of the recipient if he is not a relative. Now, if the person sells the said property, for say, Rs.9 Crore the ostensible taxable gain would only be Rs.4 Crore. But is this really the case? Would the entire Rs.4 Crore be taxable in hands of the assessee?

6. In my opinion this would not be the case. The relevant provisions which have to be read together are Explanation 1(i)(b) to section 2(42A), section 2(29B), Explanation (iii) to section 48 and section 49(1) of the Act. These sections are reproduced hereunder–

Section 2(42A) Explanation 1 –

“(i) In determining the period for which any capital asset is held by the assessee-

(a) ….

(b) in the case of a capital asset which becomes the property of the assessee in the circumstances mentioned in sub-section (1) of section 49, there shall be included the period for which the asset was held by the previous owner referred to in the said section;”

S.2(29B) – “long-term capital gain” means capital gain arising from the transfer of a long-term capital asset.

Explanation (iii) of s.48 –

“(iii) “indexed cost of acquisition” means an amount which bears to the cost of acquisition the same proportion as Cost Inflation Index for the year in which the asset is transferred bears to the Cost Inflation Index for the first year in which the asset was held by the assessee or for the year beginning on the 1^st day of April, 2001, whichever is later”

S.49(1)

“Where the capital asset became the property of the assessee-

(i) on any distribution of assets on the total or partial partition of a Hindu undivided family;

(ii) under a gift or will;

(iii) (a) by succession, inheritance or devolution, or

(b) on any distribution of assets on the dissolution of a firm, body or individuals, or other association of persons, where such dissolution had taken place at anytime before the 1^st day of April, 1987, or

(c) on any distribution of assets on the liquidation of a company, or

d) under a transfer to a recoverable or an irrevocable trust, or (e) under any such transfer as is referred to in clause (iv) or clause (v) or clause (vi) or clause (via) or clause (viaa) or clause (viab) or clause (vib) or clause (vic) or clause (vica) or clause (vicb) or clause (vicc) or clause (viiiac) or clause (viiad) or clause (viiae) or clause (viiaf) or clause (xiii) or clause (xiiib) or clause (xiv) of section 47.

(iv) such assessee being a Hindu undivided family, by the mode referred to in sub-section (2) of section 64 at any time after the 31^st day of December, 1969 the cost of acquisition of the asset shall be deemed to be the cost for which the previous owner of the property acquired it, as increased by the cost of any improvement of the assets incurred or borne by the previous owner or the assessee, as the case may be.

Explanation – In this sub-section the expression “previous owner of the property” in relation to any capital asset owned by an assessee means the last previous owner of the capital asset who acquired it by a mode of acquisition other than that referred to in clause (i) or clause (ii) or clause (iii) or clause (iv) of this sub section.” (emphasis supplied)

7. From the above it will be seen that in order to determine whether the asset is a long term asset the period of holding in case the assessee has received the property, inter alia, under a gift or will or by way of succession, etc., as mentioned in clause 49(1) of the Act, the period of holding would include the period for which asset was held by the “previous owner” as has been set out in section 2(42A). Under the Explanation to section 49 the “previous owner” means a person who has acquired by a means other than by gift, will, succession etc. as listed in Section 49(1) of the Act. In other words the person who has actually paid for property would be considered as the “previous owner”. For instance, if A has purchased a property for Rs.1 Crore and he gifts it to his son, B. There is no tax on this occasion as it has been gifted to a relative. B then gifts the property to C who is not a relative. C would then be taxable on the stamp duty value of the assets which may be, say, Rs.5 Crore. If now C (the non-relative) sells it to any other person, D, for say Rs.9 Crore, the question arises as to what is the date of the holding of the property and what is the value of the property for the purpose of taxation.

8. It will be apparent from the facts that the previous owner in this case was A who purchased it on, say, 01.01.2004. Since both B and C have received property by way of gift [the second gift being taxable in the hands of C u/s. 56(2)(vii)(b) of the Act], the period of holding must include the period from the time the property was purchased by A. Thus, if the property is now sold on, say, 01.07.2021 to D, the property would have been held from 01.01.2004 to 30.06.2021 and indexation would have to be provided accordingly. This is because under Explanation (iii) of section 48, “the indexed cost of acquisition means an amount which bears to the cost of acquisition the same proportion as Cost Inflation Index for the year in which the asset is transferred bears to the Cost Inflation Index for the first year in which the asset was held by the assessee or for the year beginning on the 1^st day of April, 2001 whichever is later”. (emphasis supplied)

9. As has already been noticed, in the aforementioned illustration, the period of holding would be from 01.01.2004 and, therefore, indexation would also have to be from that day and, under Section 49(4), the cost of acquisition has to be the stamp duty value, namely, Rs.5 Crore. The indexation, therefore will be available on Rs.5 Crore for period from 01.01.2004 to 30.06.2021. The issue regarding holding period and cost of acquisition – but in the circumstances other than Section 49(4) – has already been decided in the cases of CIT v Manjula J. Shah, (2012) 68 DTR (Bom.) 269, and CIT v Ms. Janhavi S. Desai, (2012) 75 DTC (Bom.)

10. In Manjula Shah’s case, supra, it was held by the Court at paras 17 to 24 as under –

“17) We see on merit in the above contention. As rightly contended by Mr. Rail, learned counsel for the assessee, the indexed cost of acquisition has to be determined with reference to the cost inflation index for the first year in which the capital asset was ‘held by the assessee’. Since the expression ‘held by the assessee’ is not defined under Section 48 of the Act, that expression has to be understood as defined under Section 2 of the Act. Explanation 1(i)(b) to Section 2(42A) of the Act provides that in determining the period for which an asset is held by an assessee under a gift, the period for which the said asset was held by the previous owner shall be included. As the previous owner held the capital asset from 29/1/1993, as per Explanation 1(i)(b) to Section 2(42A) of the Act, the assessee is deemed to have held the capital asset from 29/1/1993. By reason of the deemed holding of the asset from 29/1/1993, the assessee is deemed to have held the asset as a long term capital asset. If the long term capital gains liability has to be computed under Section 48 of the Act by treating that the assessee held the capital asset from 29/1/1993, then, naturally in determining the indexed cost of acquisition under Section 48 of the Act, the assessee must be treated to have held the asset from 29/1/1993 and accordingly the cost inflation index for 1992-93 would be applicable in determining the indexed cost of acquisition.

18) If the argument of the revenue that the deeming fiction contained in Explanation 1(i)(b) to Section 2(42A) of the Act cannot be applied in computing the capital gains under Section 48 of the act is accepted, then, the assessee would not be liable for long term capital gains tax, because, it is only by applying the deemed fiction contained in Explanation 1(i)(b) to Section 2(42A) and Section 49(1)(ii) of the Act, the assessee is deemed to have held the asset from 29/1/1993 and deemed to have incurred the cost of acquisition and accordingly made liable for the long term capital gains tax. Therefore, when the legislature by introducing the deeming fiction seeks to tax the gains arising on transfer of a capital asset acquired under a gift or will and the capital gains under Section 48 of the Act has to be computed by applying the deemed fiction, it is not possible to accept the contention of revenue that the fiction contained in Explanation 1(i)(b) to Section 2(42A) of the Act cannot be applied in determining the indexed cost of acquisition under Section 48 of the Act.

19) It is true that the words of a statute are to be understood in their natural and ordinary sense unless the object of the statute suggests to the contrary. Thus, in construing the words ‘asset was held by the assessee’ in clause (iii) of Explanation to Section 48 of the Act, one has to see the object with which the said words are used in the statute. If one reads Explanation 1(i)(b) to Section 2(42A) together with Section 48 and 49 of the Act, it becomes absolutely clear that the object of the statute is not merely to tax the capital gains arising on transfer of a capital asset acquired by an assessee by incurring the cost of acquisition, but also to tax the gains arising on transfer of a capital asset inter alia acquired by an assessee under a gift or will as provided under Section 49 of the Act where the assessee is deemed to have incurred the cost of acquisition. Therefore, if the object of the legislature is to tax the gains arising on transfer of a capital acquired under a gift or will by including the period for which the said asset was held by the previous owner in determining the period for which the said asset was held by the assessee, then that object cannot be defeated by excluding the period for which the said asset was held by the previous owner while determining the indexed cost of acquisition of that asset to the assessee. In other words, in the absence of any indication in clause (iii) of the Explanation to Section 48 of the Act that the words ‘asset was held by the assessee’ has to be construed differently, the said words should be construed in accordance with the object of the statute, that is, in the manner set out in Explanation 1(i)(b) to section 2(42A) of the Act.

20) To accept the contention of the revenue that the words used in clause (iii) of the Explanation to Section 48 of the Act has to be read by ignoring the provisions contained in Section 2 of the Act runs counter to the entire scheme of the Act. Section 2 of the Act expressly provides that unless the context otherwise requires, the provisions of the Act have to be construed as provided under Section 2 of the Act. In section 48 of the Act, the expression ‘asset held by the assessee’ is not defined and, therefore, in the absence of any intention to the contrary the expression ‘asset held by the assessee’ in clause (iii) of the Explanation to Section 48 of the Act has to be construed in consonance with the meaning given in section 2(42A) of the Act. If the meaning given in Section 2(42A) is not adopted in construing the words used in Section 48 of the Act, then the gains arising on transfer of a capital asset acquired under a gift or will be outside the purview of the capital gains tax which is not intended by the legislature. Therefore, the argument of the revenue which runs counter to the legislative intent cannot be accepted.

21) Apart from the above, Section 55(1)(b)(2)(ii) of the Act provides that where the capital asset became the property of the assessee by any of the modes specified under Section 49(1) of the Act, not only the cost of improvement incurred by the assessee but also the cost of improvement incurred by the previous owner shall be deducted from the total consideration received by the assessee while computing the capital gains under Section 48 of the Act. The question of deducting the cost of improvement incurred by the previous owner in the case of an assessee covered under Section 49(1) of the Act would arise only if the period for which the asset was held by the previous owner is included in determining the period for which the asset was held by the assessee. Therefore, it is reasonable to hold that in case of an assessee covered under Section 49(1) of the Act, the capital gains liability has to be computed by considering that the assessee held the said asset from the date it was held by the previous owner and the same analogy has also to be applied in determining the indexed cost of acquisition.

22) The object of giving relief to an assessee by allowing indexation is with a view to offset the effect of inflation. As per the CBDT Circular No.636 dated 31/8/1992 [see 198 ITR 1 (St)] a fair method of allowing relief by way of indexation is to link it to the period of holding the asset. The said circular further provides that the cost of acquisition and the cost of improvement have to be inflated to arrive at the indexed cost of acquisition and the indexed cost of improvement and then deduct the same from the sale consideration to arrive at the long term capital gains. If indexation is linked to the period of holding the asset and in the case of an assessee covered under Section 49(1) of the Act, the period of holding the asset has to be determined by including the period for which the said asset was held by the previous owner, then obviously in arriving at the indexation, the first year in which the said asset was held by the previous owner would be the first year for which the said asset was held by the assessee.

23) Since the assessee in the present case is held liable for long term capital gains tax by treating the period for which the capital asset in question was held by the previous owner as the period for which the said asset was held by the assessee, the indexed cost of acquisition has also to be determined on the very same basis.

24) In the result, we hold that the ITAT was justified in holding that while computing the capital gains arising on transfer of a capital asset acquired by the assessee under a gift, the indexed cost of acquisition has to be computed with reference to the year in which the previous owner first held the asset and not the year in which the assessee became the owner of the asset.”

11. In Janhavi’s case, supra, it was held by the Court at paras 13 to 18 as under –

“13) The Tribunal however held that in respect of 50% of the property inherited by the respondent from his mother, the period of holding would start from 21.8.1988, as she became the owner of her 50% share in the property only from that date under the will made by her husband who died on 21.8.1988.

14) This requires a consideration of the second issue viz. a computation of the period for which the respondent held that 50% portion of the property he acquires from his mother.

15) The respondent’s mother also acquired the property under her husband’s will. She therefore, acquired the property by a mode of acquisition referred to in section 49(1)(ii). In other words, the respondent’s mother did not become the owner of the asset by a mode of acquisition other than than that referred to in section 49(1).

Thus the date of the acquisition of her share in the property is not relevant. The last previous owner of her share was therefore her husband’s father and at the highest her husband.

16) Section 2(42A) defines “short term capital asset” to mean a capital asset held by an assessee for the stipulated period immediately preceding the date of its transfer. Explanation (1)(b) sets out factors to be taken into consideration while determining the period for which the capital asset is held. In respect of a capital asset, which became the property of the assessee in the circumstances mentioned in section 49(1), it is provided that there shall be included the period for which the asset was held by the “previous owner referred to in the said section”. The said section is section 49(1). Thus the definition of “previous owner” in the Explanation to section 49(1) is incorporated in Explanation 1(i)(b) to section 2(42A). If therefore a capital asset becomes the property of the assessee in the circumstances mentioned in section 49(1) and the period for which it is held as determined by section 49(1) read with section 2(42A) is more than the period stipulated in section 2(42A), the case would not fall within the ambit of a short term capital asset.

17. The last previous owner of the respondent’s mother’s 50% share in the property was therefore her husband’s father and at the highest her husband. Thus the respondent must be deemed to have held this 50% share in the property also from 1.4.1981.

18. In the circumstances, the questions are answered in favour of the respondent. The period of holding shall be from 1.4.1981 in respect of the entire property.”

12. The aforementioned cases make it clear that for the purpose of computing indexation the date of acquisition would be the date of acquisition by the “previous owner” as defined in the Act, i.e., the person who has purchased it for value and who has not received it by way of gift, inheritance, succession, etc. And the cost of acquisition will be linked to the date of purchase by previous owner.

13. All that section 49(4) does is that it substitutes the cost of acquisition of the property with the stamp duty valuation thereof at the time of gift to the non-relative. However, this sub-section does not disturb the other provisions of the Act regarding the period of holding which would continue to be as in the aforecited cases. Actually, it must be seen that section 49(4) is a benefit giving provision to the assessee because he has already been taxed once at the time of receipt of the property by way of gift from a non-relative on the stamp duty value thereof. Such a benefit giving provision has to be interpreted liberally and in favour of the assessee. However, on this issue there is no doubt whatsoever about the period of holding as that has been clearly laid down under the Act. In the aforementioned illustration period of holding will be 01.01.2004 and cost of acquisition will be deemed to be Rs.5 Crore. It is this Rs.5 Crore which has to be indexed and accordingly capital gain on sale of the property by the non-relative, C to D would have to be computed.

(Ashok Rao)

Place: Mumbai

Date: 30/09/2021

Fines or penalties – Whether deductible business expenditure

Is a fine or penalty deductible under the provisions of the Income Tax Act, 1961 (“the Act”)?

2. This is a vexed issue but over the years some sort of clarity has come in the interpretation of allowability of deduction of such fines / penalties.

3. At the outset it may be noted that legality of a transaction is not a relevant factor as it has been held that the Act does not differentiate between the profits of a legal or illegal business. And rightly so! The reason is that otherwise illegality of a business or a transaction would allow a person who is not acting within the bounds of law to escape taxation of the profits of such illegal businesses or transactions.

4. With this background, the corollary would also be true, namely, that violation or infraction of a law which is mostly administrative in nature should not be considered as defeating the rights of the assessee to claim deduction of the fine or penalty, provided it is in rem.

5. The first Supreme Court decision, namely, that of Haji Aziz and Abdul Shakoor Bros. vs. CIT, 41 ITR 350 (SC), took a very harsh view on this issue and matter went against the assessee. In this case the assessee was carrying on the business of importing dates from abroad and selling them in India. It imported from Iraq partly by steamer and partly by country craft, at a time when import of dates by steamer was prohibited. The goods which were imported by steamer were confiscated by the Customs authorities under Section 167 of Sea Customs Act (item 8) and the assessee was given an option under section 183 of that Act to pay a fine instead – which it did and had the goods released. The Court held, with respect, incorrectly, at page 359, has taken a very narrow view and held as under:

“A review of these cases shows that expenses which are permitted as deductions are such as are made for the purpose of carrying on the business, i.e., to enable a person to carry on and earn profit in that business. It is not enough that the disbursements are made in the course of or arise out of or are concerned with or made out of the profits of the business but they must also be for the purpose of earning the profits of the business. As was pointed out in von Glehn’s case an expenditure is not deductible unless it is a commercial loss in trade and a penalty imposed for breach of the law during the course of trade cannot be described as such. If a sum is paid by an assessee conducting his business, because in conducting it he has acted in a manner which was rendered him liable to penalty, it cannot be claimed as a deductible expense. It must be a commercial loss and in its nature must be contemplable as such. Such penalties which are incurred by an assessee in proceedings launched against him for an infraction of the law cannot be called commercial losses incurred by an assessee in carrying on his business. Infraction of the law is not a normal incident of business and, therefore, only such disbursements can be deducted as are really incidental to the business itself. They cannot be deducted if they fall on the assessee in some character other than that of a trader. Therefore, where a penalty is incurred for the contravention of any specific statutory provision, it cannot be said to be a commercial loss falling on the assessee as a trader the test being that the expenses which are for the purpose of enabling a person to carry on trade for making profits in the business are permitted but not if they are merely connected with the business.”

6. Fortunately, the Supreme Court in its decision in Prakash Cotton Mills P. Ltd. vs. CIT 201 ITR 684 (SC) has taken a partially favourable view to the assessee. In this case the Appellant was a company carrying on business in the manufacture of textile goods. In the income-tax return of the assessee for the assessment year 1966-67 (the previous accounting year being from July 1, 1964, to June 30, 1965), the interest and the damage of Rs.19,635 paid by it for delayed payment of sales tax under the Bombay Sales Tax Act and for delayed payment of contribution under the Employees’ State Insurance Act, was claimed as revenue expenditure allowable under section 37(1) of the Act. The AO disallowed the amount of Rs.19,635 treating the said item as penal interest. The Supreme Court held at 690 as under: –

“The decision of this court in Mahalakshmi Sugar Mills Co. (1980) 123 ITR 429 and the decision of the Division Bench of the Andhra Pradesh High Court in Hyderabad Allwyn Metal Works (1988) 172 ITR 113 with the views of which we are in complete agreement, are, in our opinion, decisions which settle the law on the question as to when an amount paid by an assessee as interest or damages or penalty could be regarded as compensatory (reparatory) in character as would entitle such assessee to claim it as an allowable expenditure under section 37(1) of the Income-tax Act. Therefore, whenever any statutory impost paid by an assessee by way of damages or penalty or interest is claimed as an allowable expenditure under section 37(1) of the Income-tax Act, the assessing authority is required to examine the scheme of the provisions of the relevant statute providing for payment of such impost notwithstanding the nomenclature of the impost as given by the statute, to find whether it is compensatory or penal in nature. The authority has to allow deduction under section 37(1) of the Income-tax Act, wherever such examination reveals the concerned impost to be purely compensatory in nature. Wherever such impost is found to be of a composite nature, that is, partly of compensatory nature and partly of penal nature, the authorities are obligated to bifurcate the two components of the impost and give deduction to that component which is compensatory in nature and refuse to give deduction to that component which is penal in nature.” (emphasis supplied)

7. However, as the AO had not examined the scheme of the provisions of Bombay Sales Tax Act to find out whether the impost of the interest paid by the assessee for delayed payment of Sales Tax was compensatory in nature as would entitle it for deduction u/s.37(1) of the Bombay Sales Tax Act, 1959, as too was the case of impost of damages paid by the assessee under the Employees’ State Insurance Act, 1948 for delayed payment of deduction thereunder, the Supreme Court remitted the issue back to the Tribunal for deciding the assessee’s claim for deduction of interest and damages u/s. 37(1) of the Act.

8. From this decision it would seen that if the fine or penalty is in the nature of an impost for delay in payment, it would be deductible even though called a fine penalty.

9. In CIT vs. Ahmedabad Cotton Mfg. Co. Ltd., 205 ITR 163 (SC), the facts were that a textile mill was being run by Mihir Textiles Ltd., Ahmedabad, the assessee, during the accounting year 1971-72 previous to the assessment year 1972-73. The assessee, being a manufacturer of cotton textiles, had to comply with the directions issued from time to time by the Textile Commissioner under the provisions of the Cotton Textiles (Control) Order, 1948 (hereinafter referred to as “the Control Order”), as amended and then in force, in the matter of producing and packing a minimum quantity of specified type of cloth by it during the accounting year. The assessee, instead of producing and packing the minimum quantity of specified type of cloth as required by the aforesaid directions of the Textile Commissioner, paid to the Textile Commissioner Rs. 1,70,766 in exercise of the option available to it under clause 21C(1)(b) of the Control Order. Thereafter, when the assessee filed its income-tax return relating to the accounting year 1971-72 with the jurisdictional Income-tax Officer, it claimed deduction of the said amount out of its profits, as business expenditure. So also, the assessee, which had not fulfilled its export obligation under a bond entered into as regards exporting a certain quantity of sanforized cloth, had paid to the Textile Commissioner Rs. 5,17,781 for non-fulfilment of that obligation, in exercise of its option available under the terms of the bond. It claimed deduction of that amount as well in its income-tax return of the accounting year 1971-72 as its business expenditure. The AO disallowed the amounts.

10. The High Court held that both items were allowable deductions. Following its earlier decision in CIT (Addl.) vs. Rustam Jehangir Vakil Mills Ltd., 103 ITR 298 (Guj.) and its decision in CIT vs. Tarun Commercial Mills Co. Ltd., 107 ITR 172 (Guj.)

11. In Rustam Mills case, the High had held that amount paid was neither penalty nor something akin to penalty paid for infraction of any law or public policy in as much as that amount was paid by Rustam Mills by exercise its option under clause 21C(1)(b) of the Cotton Textiles (Control) Order, 1948, which formed part and parcel of the statutory scheme. In Tarun Mills case the assessee was obliged to export annually a quantity of not less than ten percent of the “Sanforized” cloth during the concerned year. The scheme also contained a provision requiring the concerned mills to execute bonds in that regard in favour of President of India. One of the conditions in that bond enabled the concerned mills to pay to the Central Government ten paise per linear yard on the shortfall in its export of “Sanforized” cloth during the relevant year and that amount referred to as “penalty” was required to be deposited with the Government of India. The amount of Rs.18,247 was deposited by the Mills with the Central Government in exercise of its option under the bond to pay an amount in lieu of the shortfall in the quantity of “Sanforized” cloth to be exported, and was claimed as deduction u/s.37(1) of the Act which was disallowed by AO. The High Court had answered this question in favour of Mills and took the view that even if the bond referred to the amount payable by the Mills for non-fulfilment of its export obligation as “penalty” such amount being payable at the option of Tarun Mills for non-fulfilment of its export obligation under the Scheme, it could not be regarded as penalty or something akin to penalty payable for any breach of law or public policy, for the very scheme under which that amount was payable by Tarun Mills to the Government provided for such payment at the option of the concerned Mills.

12. Referring to aforementioned two decisions of the Bombay High Court as well as to the decision in Haji Aziz’s case (supra), [which the Supreme Court differentiated] the Supreme Court took the view that High Court decision in allowing the amount of Rs.91,387/- paid under the Textile Commissioner’s direction issued to the textile mills was an option provided to the mills and could not be viewed as infraction of law and agreed with the High Court on this issue. Similarly, the Court endorsed the view taken in Tarun Mills that the export target was optional and the exercise of option provided to the mills was the result of commercial expediency and in view of the scheme it cannot be said that that there is a breach of public policy which may render the payment, agreed to be made for the default arising as a result of the breach, as one akin to penalty. The Supreme Court, at pages 174 and 175, held as under: –

“It is true that an assessee doing business in the accounting year is not entitled to claim deduction under section 37 of the Income-tax Act, 1961, of an amount paid by such assessee during the year as an amount of penalty or an amount akin to penalty for any breach or infraction of law or any public policy which is sought to be achieved by such law, as is also held by this court in Haji Aziz and Abdul Shakoor Bros.’ case [1961] 41 ITR 350. But if such payment is made by the assessee during the relevant accounting year without any breach or infraction of any law or any public policy sought to be achieved by it and in fact in obedience to provisions of such law as a measure of business expediency, there could be no valid reason not to allow such payment as deductible expenditure of the assessee under section 37 of the Income-tax Act.

Therefore, what needs to be done by an assessing authority under the Income-tax Act, 1961, in examining the claim of an assessee that the payment made by such assessee was a deductible expenditure under section 37 of the Income-tax Act although called a penalty is to see whether the law or scheme under which the amount was paid required such payment to be made, as penalty or as something akin to penalty, that is imposed by way of punishment for breach or infraction of the law or the statutory scheme. If the amount so paid is found to be not a penalty or something akin to penalty due to the fact that the amount paid by the assessee was in exercise of the option conferred upon him under the very law or scheme concerned, then one has to regard such payment as business expenditure of the assessee, allowable under section 37 of the Income-tax Act, as an incident of business laid out and expended wholly and exclusively for the purposes of the business. However, such payment of the assessee is one which is made in exercise of the option given to such assessee by the law or the statutory scheme and there arises no need for the assessing authority to go into the question whether the payment could be regarded as one made as a measure of business expediency, for it cannot ignore the fact that the law or the statutory scheme enables incurring of such expenditure in the course of the assessee’s business.” (emphasis supplied)

13. In CIT vs. N.M. Parthasarathy, 212 ITR 105 (Mad.), the Madras High Court held:

“On the face of the decision in the cases of Prakash Cotton Mills P. Ltd. vs. CIT [1993] 201 ITR 684 (SC) and CIT vs. Ahmedabad Cotton Mfg. Co. Ltd. [1994] 205 ITR 163 (SC), the rule laid down in the case of Haji Aziz and Abdul Shakoor Bros. v. CIT [1961] 41 ITR 350 (SC) cannot at all be stated to have laid down an inflexible rule of law to be followed in all eventualities and situations.”

The Court therefore held, that, in the instant case, the goods belonging to the assessee had been confiscated under section 111(d) of the Customs Act, 1962, read with section 3 of the Imports and Exports (Control) Act, 1947. However, under section 125 of the Customs Act, 1962, an option had been given to the owner-assessee to pay, in lieu of such confiscation, a fine of Rs.1,84,000 which had been reduced on appeal to Rs. 84,000 and the goods had been cleared exercising the option. The fine could not, in such a situation, be stated to be penal in nature notwithstanding its nomenclature. It was compensatory and as such deductible under section 37 of the Act.

14. A similar view was taken in CIT vs. Hoshiari Lal Kewal Krishan, [2009] 311 ITR 336 (P & H), where the High Court endorsed the view of the Tribunal that the amount of Rs.31,433/- paid as fine for belated payment of the excise duty instalment was an allowable deduction as making a belated payment would indirectly benefit the assessee inasmuch as money would remain available to the assessee, and, therefore, any penalty levied on this count could be claimed as legitimate business expenditure. The Tribunal had further placed reliance on the decision in the case of Dwarka Dass and Co. v. Excise and Taxation Commissioner, [1969] Current Law Journal 290 (Punj), which had held that a penalty u/s.18(2) of the Punjab Excise Act was not in the nature of punishment and the option to pay the penalty was in the nature of an enabling provision which could have some relation with the approximate quantum of loss which the licensee might suffer in case of an order cancelling the licence for the remaining period. The Tribunal also relied upon decision in Shadi Singh Kashmira Singh v. ITO, [1983] 15 TLR 485 (Chg.), where it was held that the payments made in respect of default u/s.36B of the Punjab Excise Act, 2014, was incidental to trade and was allowable as such.

15. Some other items which have been held as deductible are as under: –

(i) Interest on delayed payment of sales tax.

CIT v. H.P. State Forest Corporation, High Court of HP; 320 ITR 170 (HP);

CIT v. H.P. State Forest Corporation (2010) 229 CTR (HP) 287.

(ii) Penalty for under invoicing imports and importing more than what was permitted by the import licence.

CIT v P.C. Tangal, 184 ITR 88 (Bom.)

(iii) Compounding fees paid for understating the insurable value of goods under the Emergency Risks Insurance Act.

CIT v Sutlej Cotton Mills Ltd., 196 ITR 421 (Cal.)

(iv) Amount paid to the government by a liquor trader for the difference between the actual purchase of liquor and the minimum guaranteed purchase.

CIT v Ramesh Chand Gopi Chand, 205 ITR 332 (Raj.)

(v) Penalty for cutting blazes in trees larger than permitted.

(vi) Penalty paid for saving of confiscation of goods purchased from a third party without knowing that they are being illegally imported.

CIT v Pannalal Narottamdas & Co., 67 ITR 667 (Bom.)

(vii) Penalty in the nature of extra sales tax.

Simplex Structural Works v CIT, 140 ITR 782 (MP)

(viii) Penalty in the nature of damages for breach of contract.

Govind Choudhury & Sons v CIT, 79 ITR 493 (Ori.); CIT v A.R. Damodara Mudaliar

& Co., 119 ITR 583 (Mad.)

(ix) Interest on damages.

CIT v Sri Rajagopal Transports (Pvt) Ltd., 144 ITR 573 (Mad.)

(x) Penalty for delayed performance of contract.

CIT v R.D. Sharma & Co., 137 ITR 333

(xi) Demurrage paid for delay in clearing goods.

Nanhoomal Jyoti Prasad v CIT, 123 ITR 269 (All.); Mahalaxmi Sugar Mills Co. Ltd.

v CIT, 157 ITR 683 (Del.)

(xii) Amount paid or forfeited in lieu of producing or exporting a stipulated quantity of goods.

CIT v Ahmedabad Cotton Mfg. Co. Ltd., 205 ITR 163 (SC); CIT v Mihir Textiles Ltd., 206

ITR 112 (Guj.); CIT v Hukumchand Mills Ltd., 202 ITR 474 (Bom.); CIT v Rustam Jehangir

Vakil Mills Ltd., 103 ITR 298 (Guj.) and numerous other decisions.

(xiii) Compensation paid by a building constructor to the municipality for condoning deviations from the original sanction and accepting the revised plan of construction.

CIT v Loke Nath & Co. (Construction), 147 ITR 624 (Del.)

However, a contrary view was taken where regularising fee and compounding fee were disallowed by the Karnataka High Court.

Millennia Developers P. Ltd. v CIT, 322 ITR 401 (Kar.) and CIT v Mamta Enterprises,

266 ITR 356 (Kar.)

(xiv) Amount paid to RIICO (a State Industrial Development Corporation) for legalising unauthorised construction made for business.

Jaswant Trading Co. v CIT, 212 ITR 293 (Raj.)

16. Items which have been held as not deductible are as under: –

(i) Loss of smuggled stock-in-trade resulting from confiscation while carrying on a lawful businesses.

Ishwar Das v CIT, 244 ITR 146 (All.); Bimal Kumar Damani v CIT, 261 ITR 635 (Cal.)

(ii) Redemption fine paid to release unaccounted excisable goods that were confiscated.

CIT v Jayaram Metal Industries, 286 ITR 403; 204 CTR (Kar) 447.

(iii) Compounding fee paid to condone violation of building laws.

CIT v Mamta Enterprises, 266 ITR 356 (Kar.)

To sum up:

Where an option has been given in a Scheme/Act, the payment on exercising such option is an allowable deduction;
Where the ‘penalty’ is for a mere delay in payment, it would be an allowable deduction.
The nomenclature of the amount to be paid – whether called a fine or penalty – is not relevant in determining the deductibility of amount.
Criminally illegal acts attracting penalty would not be deductible.
Where a payment is in rem (i.e. in respect of goods) and not in persona (i.e. on the person) then the amount paid by way of penalty / fine would be an allowable deduction.

Generally, each case has to be decided on its peculiar facts, but the aforementioned cases and guidelines should give a good idea about whether the penalty is deductible or not.

(Ashok Rao)

Place: Mumbai

Date: 22.09.2021

Tested Party

Can a tested party ever be the Associated Enterprise with respect to the Transfer Pricing Provisions enacted under Income Tax Act, 1961 (“the Act”)?

2. By Chapter X of the Act, containing Sections 92 to 92F, certain provisions have been introduced in the Act to deal with international transactions and with regard to certain specified domestic transactions with an Associated Enterprise (“AE”). The Rules containing the same are prescribed by Rules 10A to 10E of the Income Tax Rules, 1961 (“the Rules”). As will be seen from Section 92C of the Act, it provides for the following methods for determining the arm’s length price (“ALP”) in relation to an international transaction or a specified domestic transaction. These are (a) comparable uncontrolled price method (“CUP”); (b) resale price method; (c) cost plus method; (d) profit split method; (e) transactional net margin method (“TNMM”); and (f) such other method as may be prescribed by the Board. The prescribed method for the purpose is provided by Rule 10AB.

3. The question which is sought to be addressed here is who can be a “tested party” for the purpose of determining the ALP in such an international transaction. The tested party means a party whose transactions would form the basis for determination of the ALP, whichever method may be used.

4. Inter alia, the issue of selection of tested party has been decided by the Hon’ble ITAT, Mumbai, in the case of M/s. Onward Technologies Limited vs. DCIT in ITA No.7985/Mum/2010 – A.Y. 2006-07. The relevant portion of the order of the Hon’ble ITAT in the said case is reproduced as under:

“4. We have considered the rival submissions and carefully perused the relevant record as well as the impugned order. The grievance raised by the assessee in the Miscellaneous Application against the finding of the Tribunal on the issue whether a foreign party/AE of the assessee can be a tested party for determination of ALP. As regards the first contention of the Ld.A.R. that the TPO has not considered the contention of the assessee that foreign party can be a tested party, we note that when the ALP determined by the assessee was rejected by the TPO on the ground that it is not as per the provisions of Section 92, this itself shows that the computation of the ALP by considering the foreign party as tested party was found not as per the provisions of Section 92. Therefore, we do not find any merit in the said contention of the assessee. The Tribunal in the impugned order has elaborately discussion and analysed the Transfer Pricing provision as contained u/s 92 of the Income Tax Act as well Rule 10B of the Income Tax Rules 1963 in para 11.2.1 to 11.3 as under:

“11.2. 1 We take up the first contention by which the assessee has compared the profit earned by its foreign AE with outside comparables to prove that the price charged by it from the transactions with the AEs is at ALP. As can be noticed from internal page no. 34 of the TP Study that the assessee is harping on the selection of its AE as tested party on the basis of the US and UK Regulations. We have to decide as to whether the selection of the foreign AE as tested party is correct in the Indian context. For that purpose, we need to visit the provisions of the Chapter X of the Act with the caption “Special Provisions Relating to Avoidance of Tax” dealing with the computation of income from international transactions having regard to ALP. Section 92(1)of the Act provides that : ‘Any income arising from an international transaction shall be computed having regard to the arm’s length price.’ The term “international transaction” has been defined in section 92B to mean ‘a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or ………….’ The methodology for the computation of arm’s length price has been set out in section 92C(1) to be as per any of the prescribed methods, including ‘Transactional net margin method’ (TNMM). This method has been admittedly employed by the assessee in the present case as the most appropriate method for determining the ALP in respect of the international transactions under consideration. Sub-section (3) of section 92C provides that: ‘Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that-(a) the price charged or paid in an international transaction has not been determined in accordance with sub-sections (1) and (2); or……………. the Assessing Officer may proceed to determine the arm’s length price in relation to the said international transaction in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him.’ Rule 10B dealing with the determination of arm’s length price under section 92C provides through sub-rule (1) that for the purposes of sub-section (2) of section 92C, the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method. The mechanism for determining ALP under TNMM has been enshrined under clause (e), which states that:

‘(i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to another relevant base;

(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to he the same as the net profit margin referred to in sub-clause (iii).

(v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.’

11.2.2 A conjoint reading of the above provisions indicates that firstly, a transaction between two or more associated enterprises is called an international transaction; secondly, any income from such international transaction is required to be determined at ALP; thirdly, the ALP in respect of such international transaction should be determined by one of the prescribed methods, which also include the TNMM. Under this method, the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base, which is then compared with the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction. The modus operandi of determining ALP of an international transaction under this method is that firstly, the profit rate earned by the assessee from a transaction with its AE is determined (say, profit A), which is then compared with the rate of profit of comparable cases (say, profit B) for ascertaining as to whether profit A is at arm’s length vis-a-vis the profit B. If it is not, then the transfer pricing adjustment is made having regard to the difference between the rates of profit and profit B. The rate of profit of comparable cases (profit B) may be computed from internally or externally comparable cases, depending upon the FAR analysis and the facts and circumstances of each case. Thus the calculation of profit B may undergo change with the varying set of comparable cases. However, in so far as calculation of profit A is concerned, there cannot be any dispute as the same has to necessarily result only from the transaction between two or more associated enterprises, as is the mandate of sections 92 read with 92B in juxtaposition to rule 10B. The natural corollary which, thus, follows is that under no situation can the calculation of ‘profit A’ be substituted with anything other than from the international transaction, that is,a transaction between the associated enterprises. So, it is the profit actually realized by the Indian assessee from the transaction with its foreign AE which is compared with that of the comparables. There can be no question of substituting the profit realized by the Indian enterprise from its foreign AE with the profit realized by the foreign AE from the ultimate customers for the purposes of determining the ALP of the international transaction of the Indian enterprise with its foreign AE. The scope TP adjustment under the Indian taxation law is limited to transaction between the assessee and its foreign AE. It can neither call for also roping in and taxing in India the margin from the activities undertaken by the foreign AE nor can it curtail the profit arising out of transaction between the Indian and foreign AE at arm’s length. The contention of the ld. AR in considering the profit of the foreign AE as ‘profit A’ for the purposes of comparison with profit of comparables, being ‘profit B’, to determine the ALP of transaction between the assessee and its foreign AE, misses the wood from the tree making the substantive section 92 otiose and the definition of ‘international transaction’ u/s 92B and rule 10B redundant. This is patently an unacceptable position having no sanction of the Indian transfer pricing law. Borrowing a contrary mandate of the TP provisions of other countries and reading it into our provisions is not permissible. The requirement under our law is to compute the income from an international transaction between two AEs having regard to its ALP and the same is required to be strictly adhered to as prescribed. This contention, is therefore, repelled.

11.3….”

Other decisions in this regard are that of Aurionpro Solutions Ltd. vs Addl. CIT (ITA) No.7872/Mum/2011); Eaton Industrial Systems Pvt. Ltd. vs DCIT (ITA No.505/PUN/2015); and Bekaert Industries Private Limited vs DCIT (ITA No.146/PUN/2014).

5. At once, it will be seen that the concerned decision is with regard to TNMM and cannot be considered as a carte blanche for always having the tested party as the Indian entity. No doubt, the Indian entity’s data would be easier to deal with. But there may be cases when the tested party must be taken to be the AE. One such illustration of the AE being selected as a tested party would be where, for instance, the Indian entity is only dealing in purchases made from the foreign entity which are then manufactured / assembled and sold in India. It could be entirely envisioned that the concerned goods which have been received from the AE by the Indian entity could be items which have no comparables in India, as such items may not be imported into the country by other parties. At once it will be seen that it is a purchase by the Indian entity which is being spoken about. Now, the Indian entity may not have purchased similar goods from any other foreign entity. It could also be a possibility that such products are not being purchased by other entities in India. Thus the cost to the Indian entity in India may not be comparable with the cost of similar purchases by the Indian entity or with similar purchases by another entity in India.

6. In such a case how would one work out whether the ALP is a fair one. In such circumstances I can only think of comparing such sales made by the AE to the Indian entity with similar sales made by the AE to other unrelated entities. No doubt certain adjustments have to be made in comparing the prices such as the geographical regions to which the AE is selling to other unrelated parties and also with respect to the cost of freight and insurance which may be involved in selling the goods to the Indian entity as compared to selling by the AE to unrelated entities. The tested party in the aforementioned circumstances can only be the AE and not the Indian entity.

7. I also do not see any provisions in the Act or in OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations which would restrict the tested party only to the Indian entity (in the context of taxation in India).

8. To this extent it is important to recognize that the decision in the case of M/s. Onward Technologies Ltd. and other cases listed above were only with respect to the TNM Method. The reasoning of the Tribunal is clear that Rule 10B(1)(e) specifies the Indian enterprise to be the tested party. But in the case of Comparable Uncontrolled Price (“CUP”), for instance, the concerned sub rule reads totally differently.

9. For the sake of facility 10B(1)(a), and 10B(1)(e) are set out hereunder for easy comparison.

10B(1)“(a) comparable uncontrolled price method, by which,-

(i) the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified;
(ii) such price is adjusted to account for differences, if any, between the international transaction or the specified domestic transaction and the comparable uncontrolled transactions, which could materially affect the price in the open market;
(iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm’s length price in respect of the property transferred or services provided in the international transaction or the specified domestic transaction.”
10B(1)(c) and (d) ….
10B(1)(e) “transactional net margin method, by which, –
(i) the net profit margin realised by the enterprise from an international transaction or a specified domestic transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;
(ii) the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;
(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction or the specified domestic transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;
(iv) the net profit margin realized by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);
(v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction or the specified domestic transaction.”

10. Therefore, it will be seen that clause (e) which deals with the TNMM specifically states that net profit margin – realized by the enterprise from an international transaction entered into with an associated enterprise – is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base.

11. On the other hand, the CUP method is not speaking about the enterprise itself, but generally dealing with comparable uncontrolled transaction or a number of such transactions. Those transactions may even be that of an unrelated enterprise or of the Associated Enterprise with unrelated parties. It is, therefore, submitted that, in so far as the CUP method, the aforementioned decisions of the ITAT cannot be applied to the CUP method and must be restricted to the interpretation of the TMM Method.

12. With regard to the selection of a tested party, the OECD guidelines have this to say at paras 3.18 and 3.19:-

“3.18 When applying a cost plus, resale price or transactional net margin method as described in Chapter II, it is necessary to choose the party to the transaction for which a financial indicator (mark-up on costs, gross margin, or net profit indicator) is tested. The choice of the tested party should be consistent with the functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e. it will most often be the one that has the less complex functional analysis.

3.19 This can be illustrated as follows. Assume that company A manufactures two types of products, P1 and P2, that it sells to company B, an associated enterprise in another country. Assume that A is found to manufacture P1 products using valuable, unique intangibles that belong to B and following technical specifications set by B. Assume that in this P1 transaction, A only performs simple functions and does not make any valuable, unique contribution in relation to the transaction. The tested party for this P1 transaction would most often be A. Assume now that A is also manufacturing P2 products for which its owns and uses valuable unique intangibles such as valuable patents and trademarks, and for which B acts as a distributor. Assume that in this P2 transaction, B only performs simple functions and does not make any valuable, unique contribution in relation to the transaction. The tested party for the P2 transaction would most often be B.”

13. My view that a tested party could be the foreign AE has been given credence by the Delhi Tribunal in the case of GKN Driveshaft (India) Ltd., TS-297-ITAT-2018 (Del)-TP. After referring to paras 3.18 and 3.19 of the OECD Guidelines, the Tribunal held that, in selecting the tested party (who could be the AE) (1) the choice of selecting a tested party for comparability is only available in the comparable uncontrolled price method and transactional net margin method. (2) the tested party should be the least complex party to the controlled transactions and should be supported by sufficient data to substantiate that.

14. To sum up, if the TNMM is applicable then usually the tested party should be the Indian party, as has been held by the Tribunal in the decision in Onward Technologies and other decisions, supra. However, where the TNMM is not applicable and there are no comparables then, in such exceptional circumstances, where the CUP or Cost Plus Method could be used, it would be necessary to use the AE as the tested party. However, I am not in agreement with the Hon. Tribunal in the case of GKN Driveshaft, supra, that selecting a tested party for comparability is available only with the TNMM or the CUP Method.

Ashok Rao

Place : Mumbai

Date : 17/11/2021

AIR information – whether sufficient for reopening assessment

1. Would information on the basis of the Annual Information Report (“AIR”) be sufficient in itself for reopening of the assessment of an assessee under the provisions of section 148 of the Income Tax Act, 1961 (“the Act”).

2. I would answer this question straightaway in the negative for the very obvious reason that, apart from an explanation being available, the veracity of AIR information could itself be in doubt because of various factors, including human factors, resulting in clerical errors in inputs of information. But it would be useful to see how the case law has emerged on this issue.

3. Two Supreme Court decisions are those of CIT vs. Daulat Ram Rawatmull, 87 ITR 349 (SC) and ITO vs. Lakhmani Mewal Das, 103 ITR 437 (SC)

4. In the latter case, one M.K., who was shown to be one of the creditors of the assessee, had since confessed that he was doing only name-lending. The Court held that since there was nothing to show that the confession of M.K. related to a loan to the assessee (which had been disclosed in the books of the assessee), there was no live link or close nexus between the material before the AO and the belief which he was to form.

5. In Pr. CIT vs. G & G Pharma India Ltd., (2016) 384 ITR 147 (Del.), the Tribunal had concluded from the reasons recorded, that the AO issued notice only on the basis of information received from the Investigation Wing but without coming to an independent conclusion for his reason to believe that income had escaped assessment. It allowed the appeal of the assessee. On travel to the High Court, it was held, dismissing the appeal of the Department, that once the date on which the so-called accommodation entries were provided was known, it would not have been difficult for the AO, if he had in fact undertaken the exercise, to make a reference to the manner in which those very entries were provided in the accounts of the assessee which must have been tendered alongwith the return which had been processed under section 143(3) of the Act. Without forming a prima facie opinion, on the basis of such material, it was not possible for the AO to have simply concluded that it was evident that the assessee had introduced its own unaccounted money in his bank by way of accommodation entries. The basic jurisdictional requirement was application of mind by the AO to the material produced before issuing the notice for reassessment. Without analyzing and forming a prima facie opinion on the basis of material produced, it was not possible for the AO to conclude that income had escaped assessment. The High Court upheld the order of the Tribunal.

6. In Pr. CIT vs. Meenakshi Overseas Pvt. Ltd., (2017) 395 ITR 677 (Del.), the issue of a notice u/s.148 solely on the basis of information received from the Director (Investigation) – without further enquiry to form a “reason to believe” – was held to be not sufficient for reopening the assessment. A mere reproduction of the conclusion in the Investigation Report received from the DI would only be a “borrowed satisfaction” which was insufficient for forming a belief.

7. In Pr. CIT vs. RMG Polyvinyl (I) Ltd., (2017) 396 ITR 5 (Del.), the Investigation Wing of the Department had given information that the assessee was the beneficiary of certain accommodation entries, which were given in the garb of share application money or expenses or gifts or purchase of shares during the relevant assessment year. It was held that the information received from Investigation Wing was not tangible material, per se, without a further enquiry having been undertaken by the AO. No link between the tangible material and the formation of the reasons to believe that income had escaped assessment could be discerned.

8. In Swati Verma vs. ITO, ITA No.42/Del/2018(SMC Del), AIR information had been received for purchase of immovable property for Rs.1,00,96,750/- by the AO’s office. A letter was issued to the assessee for verification. On non-receipt of any reply the AO reopened the assessment. The Tribunal held that without analyzing and forming a prima facie opinion on the basis of material produced, it was not possible for the AO to conclude that he had reason to believe that income chargeable to tax had escaped assessment. Merely because the assessee did not respond to the AO’s query was no reason to reopen the assessment if there was nothing otherwise to show that income had escaped assessment. An enquiry after receipt of information but before reopening was essential to form a belief that income had escaped assessment. The reopening was quashed by the Tribunal.

9. In Bir Bahadur Singh Sijwali vs ITO, ITA No.3814/Del/11, certain deposits in cash had been made in the assessee’s account. Notice was issued for reopening and, thereafter, the reasons were recorded in writing. It was held that without verifying that the deposits were income in nature, the AO could not have reopened the assessment. The Tribunal differentiated the decision in Mithila Credit Services Ltd. vs. ITO, ITA No.1078/Del/2013 by stating that that was a reopening done on the basis of information from the Directorate of Investigation to the effect that “the name of the assessee figures as one of the beneficiaries of these alleged bogus transactions”. If the assessee was a beneficiary of such a scam, in Mithila’s case, supra, the income was indeed to have been taxed in its hands – but there was no such recorded reason in Bir Bahadur’s case, supra.

10. In Ashwani Kumar vs. ITO, ITA No.129(Asr)/2015, the only material before the AO was the AIR information of the assessee having deposited an amount of 11.60 Lakhs in his savings bank account. Following Bir Bahadur’s case, supra, the Tribunal held that the reasons recorded did not contain any recital that the assessee was engaged in some business and the income from such a business had not been returned by the assessee. A vanilla reliance upon AIR information without further enquiry that there was a possibility of the deposit being income would not suffice for a reopening of an assessment.

11. In Amrik Singh vs ITO, ITA No.630(Asr)/2015, deposit made in the bank account prompted the AO to initiate reassessment proceeding u/s.147 of the Act. The AO had proceeded on the fallacious assumption that the bank deposits constituted undisclosed income, overlooking the fact that the source of deposit need not necessarily be income of the assessee. Following Bir Bahadur’s case, supra, the Tribunal cancelled the re-assessment proceedings.

12. Another decision in this regard is that of Ravindra Deo Tyagi vs. ITO, ITA No.123 to 125/LKW/2017, where, too, re-assessment proceedings on the basis of cash deposits in the bank account without any hint that they could be income of the assessee were held to be invalid.

13. To sum up, a pure reliance on AIR information or on the report of the Investigation Wing of the Department, without further enquiry that there is possibility of the information representing the undisclosed income of the assessee, cannot be a just reason for reopening of an assessment.

Ashok Rao

Place : Mumbai

Date : 16.10.2020

Charitable Institutions – Multiplicity of objects specified in Form 10

Can a multiplicity of objects, specified in Form 10 for accumulation, be acceptable for charitable institutions to get the benefit of the provisions of section u/s. 11(2) of the Income Tax Act, 1961 (“the Act”) where 85% of the income of the charitable institution cannot be spent in the same year.

2. A charitable institution is allowed to accumulate or set apart, either in whole or a part, for application to charitable purposes in India. One of the conditions for getting the benefit of accumulation is that the institution should furnish a statement in the prescribed form to the Assessing Officer. The said purposes for which the income is being accumulated or set apart and period for which the income is to be accumulated can in no case shall exceed five years. As per Rule 17, the prescribed form is Form 10 for purpose of accumulation.

3. There are two High Courts which have taken the view that the purpose of accumulation mentioned in Form 10 should be specific and an option to spend on a multiplicity of objects would not suffice in giving the benefit of accumulation.

4. The first is that of the Calcutta High Court in Director of Income Tax (Exemption) vs. Trustees of Singhania Charitable Trust, (1992) 199 ITR 819 (Cal). In this case the trust had passed a resolution to the following effect:-

“That consent be and is hereby accorded that, out of the balance of unapplied income of Rs.94,125 for the year, the sum of Rs.68,814 be accumulated and/or set apart for purposes of application to any one or more of the objects of the trust as set out in items Nos. (i) to (xvi) under paragraph 1 of the deed of trust till the previous year ending on March 31, 1994.”

The Court held at page 823 and 824 as under:-

“…Doubtless, it is not necessary that the assesse has to mention only one specific object. There can be setting apart and accumulation of income for more objects than one but whatever the objects or purposes might be, the assessee must specify in the notice the concrete nature of the purpose for which the accumulation is being made. Plurality of the purposes for accumulation may not be precluded but it must depend on the exact and precise purposes for which the accumulation is intended for the statutory period of ten years. The generality of the objects of the trust cannot take the place of the specificity of the need for accumulation.”

“The Tribunal’s decision in fact overlooks the scheme relating to the accumulation of income for a particular future use. Section 11(1) itself provides for marginal setting apart and accumulation not in excess of 25 per cent of the income of the trust. It is only such accumulation which can be taken for the broad purposes of the trust as a whole that the statute does not require specification of the purpose. Such setting apart for any of the purposes of the trust is, however, a short-term accumulation, accumulation not beyond the year succeeding. It is sub-section (2) which provides for the long–term accumulation of the income. Obviously, such long-term accumulation should be for a definite and concrete purpose or purposes. What the assessee has sought to be permitted to do here is to accumulate not for any determinate purpose or purposes but for the objects as enshrined in the trust deed in a blanket manner. Accumulation in such a global manner is definitely not in the contemplation of section 11(2) when it is construed in its setting. The assessee’s contention that saving and accumulation of income for future application of the same is for the purposes of the trust in the widest terms so as to embrace the entirety of the objects clause of the trust deed would render the requirement of specification of the purpose for accumulation in that sub-section redundant. The purposes to be specified cannot, under any circumstances, tread beyond the objects clause of the trust. The legislature could not have thought of the need of specification of the purposes if it did not have in a mind the particularity of the purpose or purposes falling within the ambit of the objects clause of the trust deed. When sub-section (2) of section 11 requires specification of the purpose, it does so having in mind a statement of some specific purpose or purposes out of the multiple purposes for which the trust stands. Were it not so, there would have been no mandate for such specification. For, a charitable trust, in no circumstances, can apply its income, whether current or accumulated, for any purposes other than the objects for which it stands. The very fact that the statute requires the purpose for accumulation to be specified implies such a purpose to be a concrete one, an itemised purpose or a purpose instrumental or ancillary to the implementation of its object or objects. The very requirement of specification of purpose predicates that the purpose must have an individuality. In our view, the provision of sub-section (2) is a concession provision to enable a charitable trust to meet the contingency where the fulfilment of any project within its object or objects needs heavy outlay to call for accumulation to amass sufficient money to implement it. Therefore, specification of purpose as required by section 11(2) admits of no amount of vagueness about such purpose.”

5. The second such decision is that of the Madras High Court in CIT vs. M.CT. Muthiah Chettiar Family Trust & Ors., (2000) 162 CTR 63 (Mad). The Court stated, at para 10:-

“…We are in agreement with the view of the Calcutta High Court in Director of IT vs. Singhania Charitable Trust (1993) 199 ITR 819 (Cal) : TC 23R.1317 wherein the Calcutta High Court held that the long-term accumulation should be for a definite and concrete purpose or purposes and the charitable trust cannot use its objects as the purposes for the accumulation of the income under s. 11(2) of the Act. It is only by mentioning the purposes specifically, it will be possible for the ITO to monitor the situation whether the trust has applied its accumulated income for the purposes mentioned in Form No. 10. Therefore, it is essential that the trust should specify its purposes and the requirement is that the purposes must have some individuality and mere repetition of the objects of the trust would not meet the requirements of s. 11(2) of the Act …”

6. However, the Delhi, Gujarat and Karnataka High Courts have taken a broader and contrary view to that of the Calcutta and Madras High Courts.

7. In CIT vs. Hotel & Restaurant Association, (2003) 261 ITR 190 (Del), the Delhi High Court held in para 7 as under:-

“7. We do not agree. It is true that specification of certain purpose or purposes is needed for accumulations of trust’s income under s. 11(2) of the Act. At the same time the purpose or purposes to be specified cannot be beyond the objects of the trust. Plurality of the purposes for accumulation is not precluded but it depends on the precise purpose for which the accumulation is intended. In the present case, both the appellate authorities below have recorded a concurrent finding that the income was sought to be accumulated by the assessee to achieve the object for which the assessee was incorporated. It is not the case of the Revenue that any of the objects of the assessee-company were not for charitable purpose. The aforenoted finding by the Tribunal is essentially a finding of fact giving rise to no question of law”. (emphasis supplied)

8. In Bharat Kalyan Pratisthan vs. Director of Income Tax (Exemption), (2008) 299 ITR 406 (Delhi) the Court after referring to the contrary decisions of the Calcutta High Court in Director of IT (Exemption) vs. Trustees of Singhania Charitable Trust, (1992) 199 ITR 819 (Cal), and that of the Madras High Court in CIT vs. M.Ct. Muthaiah Chettiar Family Trust & Ors. (2000) 162 CTR (Mad) 63, held, at para 6, as under:-

“6. …It is true that specification of certain purpose or purposes is needed for accumulations of the trust’s income under s. 11(2) of the Act. At the same time, the purpose or purposes to be specified cannot be beyond the objects of the trust. Plurality of the purposes for accumulation is not precluded but it depends on the precise purpose for which the accumulation is intended. In the present case, both the appellate authorities below have recorded a concurrent finding that the income was sought to be accumulated by the assessee to achieve the object for which the assessee was incorporated. It is not the case of the Revenue that any of the objects of the assessee-company was not for charitable purpose. The aforenoted finding by the Tribunal is essentially a finding of fact giving rise to no question of law.” (emphasis supplied)

Further, the High Court followed its own decision in Hotel and Restaurants Association (supra) and held as under at paras 8, 9 and 10:

“8. Learned counsel for the Revenue has contended that if the observations of this Court in Hotel & Restaurants Association (supra) are carefully read, then the purpose should be specified. We are of the view that given the question of law in Hotel & Restaurants Association (supra), the conclusion of this Court was that the details of the purposes for which the income was accumulated need not be specified. For example, if the purpose of accumulation is educational, the assessee is not required to indicate or specify whether it is elementary education, primary education or secondary education, etc. If the assessee’s case is that the income was accumulated for utilization for educational purposes, it would not require specification as long as the educational purpose is one of the objects of the assessee.

9. In the present case, the assessee has only three objects as far as its trust deed, a copy of which has been placed on record, is concerned. The trust deed requires the trust to utilize its funds for charitable purposes which are medical relief, education and relief to the poor. In the application seeking exemption, the assessee has specified these three objects. We are of the opinion that it was not required for the assessee to be more specific with regard to the utilization of the funds.

10. It is true that the assessee has mentioned that it is accumulating funds for all the objects for which it was created, but as held by this Court in Hotel & Restaurants Association (supra), plurality of purposes is permitted and if it so happens that an assessee has only three objects or purposes, it may well utilize the funds for all the three objects and purposes.” (emphasis supplied)

9. In DIT vs. Mitsui & Co. Environmental Trust, (2008) 303 ITR 111 (Del), the Court held at paras 5 and 6, as under:-

“5. As regards the first issue considered by the AO, namely, that the assessee had not specified in Form No. 10 the purpose for which the accumulation was sought to be made, our attention has been drawn to a decision of this Court in CIT vs. Hotel & Restaurant Association (2003) 182 CTR (Del) 374 : (2003) 261 ITR 190 (Del). In that case, a similar argument was raised by the learned senior standing counsel for the Revenue to the effect that the assessee had failed to indicate in the prescribed form the specific purpose for which the income was sought to be accumulated and, therefore, the statutory requirement had not been strictly complied with, disentitling the assessee from relief under s. 11(2) of the Act.

This Court rejected the contention and held that the purpose or purposes to be specified cannot be beyond the objects of the trust. Plurality of purposes for accumulation is not precluded. In other words, it need not necessarily be specifically stated for which purpose the accumulation is sought.

6. While we reiterate the view already taken by this Court, we may mention that the Calcutta High Court had taken different view in Director of IT (Exemption) vs. Trustees of Singhania Charitable Trust (1993) 199 ITR 819 (Cal).”

It is important to note that Delhi High Court noticed the Calcutta High Court decision which took different view but still did not choose to follow it.

10. In DIT (Exemption) vs. Guru Nanak Vidya Bhandar Trust, (2004) 187 CTR (Del) 558, at para 8 (i) and 8(ii), it was held that where the assessee was allowed to accumulate income in the preceding as well as subsequent years and there was no change in objects of the assessee during the relevant assessment years, the accumulation of income could not be denied.

11. In CIT (Exemptions) vs. Bochasanwasi Shri Akshar Purshottam Public Cable Trust, (2018) 409 ITR 591 (Guj), at para 8, the Court held that:-

“8. Section 11(2) of the Act provides that eighty five percent of the income which is not utilized by the Trust for charitable or religious purposes would not be included in the total income of the previous year of receipt of the income provided the conditions laid down in clause (a) to (c) contained therein are satisfied. Clause (a) in particular, which is applicable, provides that such person furnishes the statement in the prescribed form and in prescribed manner to the Assessing Officer stating the purpose for which the income is being accumulated or set apart and the period for which the income is to be accumulated or set apart which shall in no case exceed five years. Undoubtedly therefore, the statement of purpose for which the income is being accumulated or set apart is one of the requirements which must be satisfied before the assessee can avail the benefit under sub-section (2) of section 11 of the Act. However, that by itself would not mean that any inaccuracy or lack of full declaration in the prescribed format by itself would be fatal to the claimant. The prime requirement of this clause is of stating of the purpose for which the income is being accumulated or set apart. In the present case, we are prepared to accept the Revenue’s stand that the declaration made in Form 10 by the assessee was not sufficient to fulfill this requirement. However, as noted, during the course of assessment proceedings, the Assessing Officer called upon the assessee to explain the position in response to which, the assessee in detail pointed out background under which the board of trustees had met, considered the material and eventually passed a formal resolution setting apart the funds for the ongoing hospital projects of the Trust and for modernization of the existing hospitals. There was thus a clear statement made by the assessee setting out the purpose for which the income was being set apart. We therefore do not find any error in view of the Tribunal.”

12. In DIT (Exemption) vs. Envisions, (2015) 378 ITR 483 (Kar), the Karnataka High Court observed, at page 486, as under:-

“In the present case, we find that the revenue does not dispute the fact that all the three purposes specified by the assessee in Form 10 are for achieving the objects of the trust, and that the purposes as well as objects, are both charitable. Merely because more than one purpose has been specified and details about the plan of such expenditure has not been given, the same would not, in our view, be sufficient to deny the benefit under section 11(2) of the Act to the assessee. As long as the objects of the trust are charitable in character and as long as the purpose or purposes mentioned in Form 10 are for achieving the objects of the trust, merely because of non-functioning of the details, as how the said amount is proposed to be spent in future, the assessee cannot be denied the exemption as is admissible under sub-section (2) of section 11 of the Income-tax Act, 1961”. (emphasis supplied)

13. Following this view, in CIT (Exemption) vs. Gokula Education Foundation, (2017) 394 ITR 236 (Kar), the Court held, at page 246, as under:-

“The aforesaid shows that as per the view taken by this court as long as the objects of the trust are charitable in character and as long as the purpose or purposes mentioned in Form 10 are for achieving the objects of the trust, merely because the details are not furnished, the assessee cannot be denied benefit of the exemption under section 11(2) of the Act.” (emphasis supplied)

14. In Sir Sobha Singh Public Charitable Trust vs. Asstt. Director of IT (2001) 72 TTJ (Del)(TM) 1007 : (2001) 79 ITD 1 (Del)(TM) it was held by Delhi Tribunal as under:-

“Perhaps to meet the contingency where the fulfilment of the project requires heavy outlay and calls for accumulation of funds, which wants to accumulate its income for a long period of 10 years to carry out the charitable objects as set out in the trust deed, does require time to think, time to plan and time to garner its resources, etc. to fulfil those objects for which it has sought accumulation of funds and the legislature in its wisdom has allowed a long period of 10 years. Therefore, the argument of the Revenue that even when the application for accumulation was filed, assessee trust must mention the type of institution, medical or educational which it should set up as also the type of the educational or medical treatment which it would impart could not be appreciated. This was never the intention of the law makers and the provision in the form of concession was introduced thereby a charitable institution need not pay any tax on its earning for a good period of 10 years, provided it carried out charitable activities with a view to fulfilling the specific objects mentioned in the application seeking accumulation.” (emphasis supplied)

15. In M.P. Gandhi Trust vs. ADIT, (2006) 8 SOT 0808 (Mumbai Trib), the Mumbai Tribunal held as under at paras 7 and 8 of the Order:-

“7. Coming to the purpose for which the income is sought to be accumulated or set apart by the assessee as mentioned in the notice under s. 11(2)(d) of the Act, the assessee has mentioned that it was for the purpose of making substantial donations to selected institutions after a careful appraisal for meeting the objects of the trust. According to us, the section only provides for specifying the purpose for accumulating the funds. The assessee had mentioned the purposes i.e., for making donations and has not mentioned the specific institutions to which the donations are to be made.

8. The object of permitting the accumulation or setting apart of the income of the trust is to facilitate the trust to meet the contingency where for fulfilment of its objects, heavy outlay is needed and accumulation of sufficient funds is called for. Therefore, the accumulation must necessarily be for charitable purposes alone and as held by the Hon’ble Delhi High Court in the case of Hotel & Restaurant Associated accumulation depends on the precise purpose or object of the trust and as long as it was for the fulfilment of the object of the trust, the exemption cannot be denied.”

16. The summation of the aforementioned judgments is as under:-

i. The decisions of the Madras and Calcutta High Courts taking the view that a specific purpose should be specified in the form for accumulation has been dissented from the Delhi and Gujarat High Courts.

ii. The subsequent decisions should hold the field.

iii. Even multiple objects specified in the form of accumulation would be in order so long as they are charitable purposes.

iv. An inaccuracy or lack of full declaration in the format would not be fatal to the assessee’s claim so long as there is a clear statement (in the form of a resolution or otherwise) setting out the purpose for which the income is being set apart (see Bochasanwasi’s case supra)

(Ashok Rao)

Place : Mumbai

Date : 11.12.2019