Rav Singh

Short Note from Tax History: Cost of Acquisition and Capital Gains Tax

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This article aims to examine in detail a judgment on capital gains tax that continues to have enduring relevance. B.C. Srinivasa Shetty case was decided in 1981 by a 3-Judge Bench of the Supreme Court and its observations on chargeability of capital gains tax continue to be cited in various contemporary cases. In the impugned case, Supreme Court clarified the chargeability of capital gains tax on transfer of goodwill of a business. This article tries to underline the observations of Supreme Court and argues that an overlooked contribution of the decision is its adherence to strict interpretation of charging provision of a tax statute.   

Facts 

The assessee was a registered firm and Clause 13 of the Instrument of Partnership – executed on July 1954 – stated that the goodwill of the firm had not been valued and would be valued on its dissolution. In December 1965 when the firm was dissolved, its goodwill was valued at Rs 1,50,000. A new firm by the same name was constituted, registered and it took over all the assets, liabilities, and goodwill of the previous firm. There were differing views as to whether transfer of goodwill from the dissolved firm to the new firm attracted capital gains tax. The ITAT and the Karnataka High Court both held that the consideration received by the assessee on transfer of goodwill was not liable to tax under Section 45 of the IT Act, 1961. At that time, Section 45 of the IT Act, 1961 read as follows: 

(1) Any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in sections 53 and 54, be chargeable to income-tax under the head “Capital gains”, and shall be deemed to be the income of the previous year in which the transfer took place.”   

Further, Section 2(14) of the IT Act, 1961 defined ‘capital asset’ to include property of any kind held by an assessee. And the term property included various kinds of property unless specifically excluded under Section 2(14)(i) to Section 2(14)(iv) and goodwill was not in the list of excluded properties. At the same time, Section 2, was subject to an overall restrictive clause ‘unless the context otherwise requires’. The Supreme Court had to examine all the above provisions in conjunction to determine if goodwill was contemplated as a capital asset under Section 45. Since goodwill was not specifically excluded from the definition of property under Section 2(14), the Supreme Court’s analysis centred on whether the context of Section 45 suggested that goodwill can/cannot be considered as a capital asset.   

 Ratio 

The Supreme Court cited relevant precedents to elaborate on the nature of goodwill and acknowledged that it was easier to describe it than define it. For example, the value of goodwill of a successful business would increase with time while that of a business on wane would decrease. At the same time, it was impossible to state the exact time of birth of goodwill. The Court then noted that Section 45 was a charging provision for capital gains and the Parliament has also enacted detailed computation provisions for capital gains tax. And the charge of capital gains tax cannot be said to apply to a transaction if the computation provisions cannot be applied to the transaction. Defending its views on the close inter-linkage between charging and computation provisions, the Supreme Court observed that: 

This inference flows from the general arrangement of the provisions in the Income-tax Act, where under each head of income the charging provision is accompanied by a set of provisions for computing the income subject to that charge. The character of the computation provisions in each case bears a relationship to the nature of the charge. Thus the charging section and the computation provisions together constitute an integrated code. When there is a case to which the computation provisions cannot apply at all, it is evident that such a case was not intended to fall within the charging section. (emphasis added)     

The above reasoning is reasonable and helpful to understand the scope of a charging provision especially if the words used in a charging provision are not clearly defined or if their import is not clear. So, did the computation provisions provide for calculating cost of goodwill of a new business? And whether transfer of the said goodwill was liable to capital gains tax? The Supreme Court answered in the negative. 

The Supreme Court made three observations to support its conclusion: 

First, the Supreme Court clarified that as per the computation provisions of IT Act, 1961, calculating the cost of any capital asset was necessary to determine the capital gains. Legislative intent therefore was to apply capital gains tax provision to assets which could be acquired after spending some money. None of the computation provisions – as they existed then – could be applied to assets whose cost cannot be identified or envisaged. And, the Supreme Court noted, goodwill of a new business was the kind of asset whose cost of acquisition was not possible to identify. 

Second, the Supreme Court noted that it was impossible to determine the date on which an asset such as goodwill came into existence for a new business. And determining the date of acquisition of a capital asset was crucial to apply the computation provisions relating to capital gains. 

Third, the Supreme Court invoked the doctrine of impossibility, without naming it as such. The Court acknowledged that there was a qualitative difference between a charging provision and a computation provision, and usually the former cannot be controlled by the latter. But, in the impugned case, the Supreme Court noted that the question was whether it was ‘possible to apply the computation provision at all’ if a certain interpretation was pressed on the charging provision. Since the cost and date of acquisition of a goodwill as an asset were impossible to determine – and both were a necessity to apply computation provisions of capital gains – the Supreme Court concluded that goodwill was not a capital asset as contemplated under Section 45, IT Act, 1961.  

Simply put, while goodwill as an asset was not excluded from the definition of property, its transfer could not give rise to capital gains tax since it was impossible to compute the cost and date of acquisition of goodwill as per the computation provisions of the IT Act, 1961. Despite the Supreme Court stating otherwise, it was clearly a case of computation provision determining the scope and applicability of a charging provision, on grounds of impossibility. 

Enduring Relevance 

The first aspect of the relevance arises from the statutory amendment the case triggered and provided that the cost of acquisition of a goodwill in case of purchase from a previous owner would be the purchase price and in other cases the cost of acquisition would be treated as nil. Section 55, IT Act, 1961 currently contains the above deeming fiction and ensures that by treating cost of acquisition of goodwill of a new business as nil, the entire consideration received on its transfer would be exigible to capital gains tax. While the provision has undergone several amendments since pronouncement of the Supreme Court’s decision in B.C. Srinivas Shetty case, the core policy of treating cost of acquisition of goodwill of a new business as nil has remained constant.     

Second, the ratio of B.C. Srinivas Shetty case has differing views. Either the ratio is interpreted to mean that an asset whose cost of acquisition cannot be computed is not liable to capital gains tax or it is interpreted to mean that an asset whose cost was not paid by an assessee on acquisition is not liable to tax. The latter is certainly not the import of the B.C. Srinivas Shetty case as the Supreme Court itself in the impugned case clarified that capital gains tax was applicable to assets that could be purchased on expenditure, and it was immaterial if on the facts of the case the asset in question was ‘acquired without the payment of money’. The above has been endorsed in a later case too.     

Third, and this is curiously an under-appreciated aspect of the case – strict interpretation of the IT Act, 1961. As most of us familiar with tax law would know, strict interpretation of tax statutes is a thumb rule that is adhered to by most courts. And this is especially in interpreting charging provisions. The impugned case is a prime example of the Court not supplementing the bare text of the statute with any word or otherwise trying to plug a gap only to ensure that a particular gain is taxable. For example, prior to the Supreme Court’s decision in the impugned case, various High Courts did hold that the cost of acquisition for an asset like goodwill should be treated as nil. For example, in one case, the Gujarat High Court reasoned that the inquiry must not be whether goodwill is intended to subject of charge of capital gains tax, but whether it is intended to be excluded from charge despite falling within the plain terms of Section 45, IT Act, 1961. And concluded that transfer of goodwill even in absence of cost of acquisition was liable to capital gains tax. However, the Gujarat High Court’s view was not a strict interpretation of relevant the statutory provisions and neither did goodwill fall within the purview of Section 45 in ‘plain terms’. The Supreme Court in interpreting the provision the way it did, avoided the temptation to levy a capital gain tax on transfer of goodwill by ‘plugging’ a gap in the legislation and did a better job of respecting the legislative intent.    

   

Single Administrative Interface under GST: Identifying Two Rough Patches  

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GST is a dual nationwide tax implying that both the Union and States concurrently levy it on supply of goods or services. While a single indirect tax jointly administered by the Union and States is supposed to augur well for ease of doing business and improve other economic efficiencies, it also requires demarcating administrative responsibilities to prevent the taxpayer from being subjected to proceedings by two different authorities. One such issue is demarcating and assigning tax base to tax authorities of the Union on one hand and the States/Union Territories on the other. GST laws anticipated overlap of tax administration in a dual tax such as GST and incorporated a specific provision – Section 6, CGST Act and Section 6 in SGST Act/UTGST Acts to prevent taxpayer harassment.  

Section 6, CGST Act, 2017 is pari materia with SGST and UTGST and provides for the following: 

First, officers appointed under SGST and UTGST Acts are authorized to be proper officers for purposes of CGST Act as well; 

Second, where a proper officer issues an order under CGST Act he shall also issue an order under the SGST or UTGST Act under intimation to the jurisdictional officer of State tax or UT tax. 

Third, where a proper officer under the SGST Act or UTGST Act has initiated any proceedings on a subject matter, no proceedings shall be initiated by the proper officer under CGST Act on the same subject matter. 

Finally, any proceedings for rectification, appeal, and revision, wherever applicable, of any order passed by an officer under CGST Act shall not lie before an officer appointed under the SGST Act or UTGST Act.        

While the cross empowerment of officials is a sound policy encoded in Section 6, there are two dominant uncertainties that prevail in the interpretation and implementation of the impugned provision: first, is the meaning and scope of the term ‘intelligence-based’ enforcement action’; second, is the implication of the term ‘proceedings on the subject matter’. The former term is not used in Section 6 but is proving to be crucial in allocation of tax administrative responsibilities. I will discuss the uncertainties that revolve around both phrases.   

Intelligence-Based Enforcement Action 

The 9th GST Council meeting discussed the issue of cross empowerment of tax officials under GST. There was detailed discussion on the issue of allocation of tax base as per turnover of the taxpayer, powers relating to audits, and issues relating to administration of IGST. In so far as is relevant to the current discussion, the GST Council agreed that:

Of the total number of taxpayers below Rs. 1.5 crore turnover, all administrative control over 90% of the taxpayers shall vest with the State tax administration and 10% with the Central tax administration; 

In respect of the total number of taxpayers above Rs. 1.5 crore turnover, all administrative control shall be divided equally in the ratio of 5O% each for the Central and the State tax administration; (para 28)

In view of the same, the CBIC issue a Circular reiterating the same as well as prescribing broad guidelines for computing turnover of the taxpayers.  

Apart from the above division of tax base to smoothen administration of GST, there was another agreement reached in the GST Council, i.e., both the Union and State administrations shall have the power to take ‘intelligence-based enforcement action’ across the entire value chain. The import of the GST Council’s above decision was clarified via a letter issued on 05. 10. 2018. Two important things that were clarified through the letter were:

First, that irrespective of assignment of taxpayer base as per turnover, both the Union and State are empowered to initiate intelligence-based enforcement action on the entire tax base which includes entire process of investigation, issuance of SCN, recovery, appeal, etc. 

Second, it added that:

If an officer of the Central tax authority initiates intelligence based enforcement action against a taxpayer administratively assigned to State tax authority, the officers of Central tax authority would not transfer the said case to its Sate tax counterpart and would themselves take the case to its logical conclusions. (para 4)  

The initial allocation of taxpayer base is thus subject to intelligence-based enforcement action, and once the latter is initiated by any authority it will retain the jurisdiction over that particular taxpayer and take the case to its logical conclusion.   

Reading both the above legal instruments alongside minutes of the 9th GST Council meeting clarify the division of taxpayer base amongst the State and Union tax officers, but the term ‘intelligence-based enforcement action’ adds a layer of uncertainty. To what extent and what action exactly amounts to such an ‘intelligence-based action’ remains unclear. The phrase indicates that the action is based on some information obtained by tax officers and not a random scrutiny of taxpayer. But, the scope and limit of the phrase needs a more precise understanding which is currently lacking. And the same will, hopefully, be available as the jurisprudence on the issue develops.  

‘Proceedings’ on Same ‘Subject-Matter’  

The other prong of uncertainty is if a taxpayer can be subjected to proceedings on the same subject matter by two different authorities – at the Union and State level. Section 6(2)(b) states:  

            … where a proper officer under the State Goods and Services Tax Act or the Union Territory Goods and Services Tax Act has initiated any proceedings on a subject matter, no proceedings shall be initiated by the proper officer under this Act on the same subject matter.  (emphasis added) 

While Section 6(2)(b) uses the phrases ‘proceedings’ and ‘subject matter’, they are not defined under GST laws. Courts in certain cases have attempted to unravel the meaning of the two terms ‘proceedings’ and ‘subject-matter’. The most prominent attempt was by the Allahabad High Court in GK Trading case where the petitioner’s contention was that once the Deputy Commissioner, Ghaziabad has conducted survey of its business premises and is investigating the matter pursuant to the survey, the issuance of summons by another authority – DGGSTI, Meerut – under Section 70 of CGST Act, 2017 is barred by Section 6(2)(b).

The Allahabad High Court relied on previous judicial decisions – largely unrelated to GST – to conclude that the term ‘inquiry’ used in Section 70, under which summons were issued and the term ‘proceedings’ used in Section 6(2)(b) had different meanings. The High Court noted that the term ‘inquiry’ under Section 70 was limited to requiring the presence of a person to produce evidence or documents and cannot be intermixed with steps that may ensue on conclusion of the inquiry. Noting that words ‘proceeding’ and ‘inquiry’ are not synonymous, the High Court held that: 

The word “proceedings” used in Section 6(2)(b) is qualified by the words “subject-matter” which indicates an adjudication process/ proceedings on the same cause of action and for the same dispute which may be proceedings relating to assessment, audit, demands and recovery, and offences and penalties etc. These proceedings are subsequent to inquiry under Section 70 of the Act. (para 17) 

The above observation implies that the power of inquiry under Section 70 – and issuance of summons – can be invoked against a taxpayer even if proceedings have been initiated by another tax authority, but the steps subsequent to inquiry cannot be taken if proceedings are underway. What is the point of inquiry if Section 6(2)(b) bars the inquiry authority to take steps subsequent to an inquiry? The answer is unclear, and the High Court does not delve into the issue, and rightly so. Nonetheless, the High Court’s strict interpretation of the relevant statutory provisions ensure that the bar under Section 6(2)(b) has been interpreted in a strict fashion, but the implications of the High Court’s interpretation will only become clear in due time.   

Conclusion 

On both the above discussed issues, single-interface GST administration is likely to remain in a state of flux. Given that ‘intelligence-based enforcement action’ is a phrase of uncertain scope and the words ‘proceedings’ and ‘subject-matter’ are not defined under the GST Acts, the tax officers are likely to interpret in differing manner and as per the facts of each case. While the Allahabad High Court has tried to demarcate the scope of latter, and to some extent succeeded, the meaning of the phrase ‘intelligence-based enforcement action’ remains even more elusive. And we are likely to witness some disputes over the same.     

SAAR v/s GAAR: Inauguration of an Interpretive Dilemma 

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In a recent decision, the Telangana High Court dismissed petitioner’s contention that General Anti-Avoidance Rule (‘GAAR’) cannot be applied by the Income Tax Department since the impugned fact situation is apparently covered by Specific Anti-Avoidance Rule (‘SAAR’). And that the relevant SAAR provision – Section 94(8) – specifically excludes the impugned situation from its purview thereby obviating the need to apply SAAR as well. In my view, the petitioner adopted a far-fetched argument to circumvent the application of GAAR and the High Court correctly acknowledged the feeble nature of petitioner’s arguments and rejected the same. At the same time, in deciding the writ petition, the High Court seems to have arrived at a pre-mature conclusion about the nature of transaction.  

This article is an attempt to provide a detailed comment on the case which involves the crucial issue of application of GAAR. At the same time, I try to understand and analyze the relation between GAAR and SAAR provisions, how they interact – or should interact – under the IT Act, 1961.

Petitioner’s Arguments 

The petitioner in the impugned case approached the Telangana High Court arguing that provisions relating to GAAR were inapplicable in the impugned case since the facts were within the scope of a Specific Anti-Avoidance Rule (‘SAAR’) provision. 

The facts as narrated in the judgment were: In the Annual General Meeting held on 27.02.2019, the share capital of a company, REFL, was increased to its authorized share capital of Rs 1130,00,00,000/- and through private placement, shares were allotted to the petitioner and another company, M/s OACSP. Thereafter, the petitioner purchased the shares from M/s OACSP at a value of Rs 115 per share. On 04.03.2019, the REFL issued bonus shares in the ratio of 1:5 resulting in reduction of share price by 1/5, i.e., Rs 19.20 per share. The petitioner thereafter sold the newly issued shares to one entity via two separate transactions. In the latter transaction, the purchaser did not have funds and was funded by M/s OACSP and an inter-corporate deposit – which was written off – resulting in rotation of funds. The Revenue’s contention was that the entire exercise was carried by the petitioner to evade tax and with no commercial purpose. The short-term capital loss on sale of shares was created to offset the long term capital gains the petitioner had made on sale of shares.         

The petitioner’s claim was that its transactions were covered by Section 94(8), IT Act, 1961. Section 94(8) states that: 

Where – 

  • Any person buys or acquires any units within a period of three months prior to the record date;
  • Such person is allotted additional units without any payment on the basis of holding of such units on such date; 
  • Such person sells or transfers all or any of the units referred to in clause (a) within a period of nine months after such date, while continuing to hold all or any of the additional units referred to in clause (b),

Then, the loss, arising to him on account of such purchase and sale of all or any of such units shall be ignored for the purposes of computing his income chargeable to tax and notwithstanding anything contained in any other provision of this Act, the amount of loss so ignored shall be deemed to be the cost of purchase of acquisition of such additional units referred to in clause (b) as are held by him on the date of such sale or transfer. 

The term unit has been defined to mean any unit of a mutual fund. 

The petitioner’s main argument against applicability of GAAR can be understood as follows: first, the general rule of interpretation is that specific provision overrides a general provision and thus SAAR should override GAAR; second, the relevant provision applying SAAR is Section 94(8) which inter alia tries to address the issue of a person selling additional units received without payment and claiming capital loss on the sale of all or some of those units. But, the petitioner argued that the legislature has deliberately kept securities outside the ambit of Section 94(8) and thus the transaction in question was outside the scope of Section 94(8). Alternatively, the petitioner’s argument can also be phrased as: if SAAR specifically tries to address a fact situation/transaction but fails to do so, then it cannot be curbed by applying GAAR. Or if SAAR specifically excludes a particular transaction from its purview, then the transaction cannot be scrutinized under GAAR. As per the High Court, the petitioner’s argument was: 

… what has been specifically excluded from the provisions curbing bonus stripping by way of SAAR cannot be indirectly curbed by applying GAAR. This in the opinion of the learned Senior Counsel was nothing but expansion of the scope of a specific provision in the Income Tax Act which is otherwise impermissible under the law. (para 13)

The questions that arise are: What is the legislative intent driving Section 94(8)? Was Section 94(8) intended to be a catch-all provision to address bonus-stripping? If the answer to the latter is in the affirmative, it would imply that if a particular transaction involving bonus stripping is not addressed by Section 94(8) or is intended to be addressed by Section 94(8) but it fails to address it, then it excludes the applicability of GAAR to that transaction. But, if Section 94(8) is specifically restricted to only units of mutual funds and not securities, then it is tough to argue that it also aimed to apply to securities but fell short in its attempt regulate transactions involving the latter. Or in the alternative, it is also plausible, as argued here, that the entire transaction is much more than bonus stripping and cannot be reasonably said to be within the scope of Section 94(8).  

The petitioner also tried to rely on observations of the Expert Committee on GAAR and argued that if SAAR is applicable to a particular transaction, it would exclude the applicability of GAAR. The Expert Committee on GAAR was of the view that where SAAR is applicable to the particular aspect/element, then GAAR shall not be invoked to look into that aspect/element. The Expert Committee observed that: 

It is a settled principle that, where a specific rule is available, a general rule will not apply. SAAR normally covers a specific aspect or situation of tax avoidance and provides a specific rule to deal with specific tax avoidance schemes. For instance, transfer pricing regulation in respect of transactions between associated enterprises ensures determination of taxable income based on arm‘s length price of such transactions. Here GAAR cannot be applied if such transactions between associated enterprises are not at arm‘s length even though one of the tainted elements of GAAR refers to dealings not at arm‘s length. (page 49) 

While the committee’s opinion cannot be countenanced, the impugned case was different. SAAR was clearly not applicable to the fact situation as Section 94(8) did not include the impugned transaction in its scope. The question before the High Court, which it chose not to answer clearly, was if SAAR was intended to be applicable to the transaction. It is a trickier and more difficult question to answer unless one scrutinises legislative intent and history of the provision.   

Revenue’s Arguments 

The Revenue Department questioned maintainability of the writ petition on the ground that the petitioner was only issued a showcause notice and the petitioner can appear before the relevant authorities and explain the case. In the absence of any patent illegality in issuance of showcause notice, filing writ petition before the High Court and interference with proceedings was not necessary at this stage. 

The Revenue Department also claimed that the series of transactions undertaken by the petitioner amounted to round tripping of funds with no commercial purpose and for a mala fide purpose to avoid payment of tax. Thus, the transaction was an impermissible avoidance arrangement warranting the invocation of GAAR.  

High Court’s Observations 

The first observation of the Telangana High Court was with regard to applicability of SAAR vis-à-vis GAAR. Noting the legislative history of GAAR, the High Court concluded that: 

In the present case, the petitioner puts forth an argument rooted in the belief that the Specific Anti Avoidance Rules (SAAR), particularly Section 94(8), should take precedence over the General Anti Avoidance Rule (GAAR). This contention, however, is fundamentally flawed and lacks consistency .The reason being the Petitioner’s own previous assertion that Section 94(8) is not applicable to shares during the relevant time frame. This inherent contradiction in the Petitioner’s stance significantly weakens the overall credibility of their argument. (para 31) 

As is clear, the Telangana High Court only observed that since Section 94(8) was inapplicable to the facts, GAAR would apply. But, it did not engage with the more difficult question: Was Section 94(8) intended to cover the impugned fact situation? In the absence of engaging with this question, the High Court’s observation looks reasonable and defensible. This is not to suggest that deciphering the legislative intent behind Section 94(8) may have provided a different answer, but would have provided a more comprehensive understanding of the interaction of SAAR and GAAR. 

The High Court made additional observations that, in my view, were pre-mature given that the petitioner had only been issued a showcause notice and further proceedings under IT Act, 1961 were yet to commence. The High Court noted that the petitioner’s transactions were not in good faith and in violation of general principles of fair dealing. And further commented that: 

In this particular case, there is clear and convincing evidence to suggest that the entire arrangement was intricately designed with the sole intent of evading tax. The Petitioner, on their part, hasn’t been able to provide substantial and persuasive proof to counter this claim. (para 37) 

Finally, the Telangana High Court invoked the Vodafone and McDowell judgments to hold that tax planning is permissible only if it is within the framework of law and taxpayer cannot resort to colorable devices and subterfuges. The High Court held that the Revenue Department has been able to persuasively and convincingly show that the petitioner’s transactions were not permissible tax arrangements and the GAAR provisions are applicable. Here the High Court tied another knot that may take time to unravel: the relevance and applicability of judicial anti-avoidance rules in tandem with the statutory provisions of SAAR and GAAR. The latter were incorporated in the IT Act, 1961 after the Vodafone and McDowell judgments, and while the non-obstante in Section 95 of IT Act, 1961 ensures that GAAR will override all other provisions in the statute, there is little clarity on the relevance of judicial pronouncements on tax evasion and tax avoidance. Can both be invoked simultaneously against an assessee?   

Conclusion

The Telangana High Court’s judgment is of two parts. The first part where the High Court resolved the tension between SAAR provisions and GAAR provisions convincingly and the petitioner’s weak and contradictory arguments were rejected. The second part if where the High Court, in my opinion, pre-maturely concluded that the transactions in question were impermissible avoidance arrangements before the adjudication proceedings under the IT Act, 1961 were concluded. The petitioner had approached the High Court by filing a writ petition on the basis of a showcause notice. Instead of joining the proceedings under the IT Act, 1961 the petitioner chose writ remedy to resist application of GAAR provisions. The High Court’s observations in the second part were on merits of the transaction and perhaps not needed and may have prejudiced the petitioner’s case. As a final note, the High Court left open the question of the relevance of judicial pronouncements on tax evasion despite the incorporation of statutory provisions on the same. The impugned judgments offers some answers, but provides a glimpse of the recurring interpretive issues that may arise from applicability of GAAR, SAAR, and judicial pronouncements on the same.  

Yin-Yang Nature of ITC and Supplier-Purchaser Obligations

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In a recent decision, the Kerala High Court upheld constitutionality of Section 16, CGST, 2017, specifically Section 16(2)(c) which restricts the ITC of a purchasing dealer (‘purchaser’) if the supplier has not remitted tax collected from the purchaser to the Government. The decision examines validity of the conditions to claim ITC under Section 16(2)(c) and Section 16(4). In this article, I examine the only the former by headlining two under-examined aspects of ITC: first, nature of ITC as a right/concession; second, the reliance of purchaser on supplier to claim ITC. Both aspects influence each other and in turn the success or otherwise of claims related to ITC. The issue relating to time limit for claiming ITC under Section 16(4) – though an influential part of the judgment – will be subject of a separate post.   

ITC: Right or a Concession? 

One of petitioner’s contention before the Kerala High Court was that ITC is a right of the purchaser and not a concession given by the Government. And since ITC is a property of the purchaser, denying the same for supplier’s default to remit tax is violative of purchaser’s right to property under Article 300A of the Constitution. The State countered the purchaser’s argument and argued that ITC is a concession granted by the State to avoid cascading effect of taxes, and the State can impose such restrictions as it deems fit to restrict taxpayer’s claim for ITC.

In deciding the true nature of ITC, and whether it is a right or a concession, the Kerala High Court gave an unambiguous conclusion that: 

The Input Tax Credit is in the nature of a benefit or concession extended to the dealer under the statutory scheme. Even if it is held to be an entitlement, this entitlement is subject to the restrictions as provided under the Scheme or the Statute. The claim to Input Tax Credit is not an absolute right, but it can be said that it is an entitlement subject to the conditions and restrictions as envisaged in Sections 16(2) to 16(4), Section 43, and Rules made thereunder. (para 71) (emphasis added)

The Kerala High Court cited a slew of precedents that aligned with its conclusion. The language here is noteworthy: the High Court is clearly leaning in favor of ITC being a concession and not a right, though it says it is not an ‘absolute right’. What does it mean? It can imply that either ITC is a limited right and can be subject to certain conditions by the State. Or that ITC is not a right but a concession. The latter seems more likely, but it is not clear. But does the distinction matter? If ITC is a taxpayer’s right, then it imposes a greater burden on the State before curtailing it. While conceptualizing ITC as a concession provides the State a comparatively wide leeway to impose conditions before allowing a taxpayer to claim ITC. If the policy decision of providing taxpayers of claiming ITC is a concession from inception, then even onerous restrictions on such claims are within the State’s remit. And a taxpayer needs to fulfil the conditions – onerous or otherwise – to successfully claim ITC since there is no vested right to claim ITC. The State has extended a concession on certain conditions and to avail the concession, the taxpayer needs to fulfil the prescribed conditions.  

In abstract, there are no easy answers if ITC is a concession or a right, though I’ve suggested elsewhere that if we bifurcate the stages of ITC: first stage involving claim of ITC and then the latter stage of utilizing ITC, there is room to suggest that ITC should be understood as one or the other depending on which stage is relevant to the case at hand. But a broad approach that ITC is a concession, irrespective of whether it is the stage of claiming of ITC or its utilization may not be the best way to answer this dilemma. The Kerala High Court does mention that GST laws contemplate four stages vis-à-vis ITC but didn’t co-relate it to the issue of nature of ITC. (para 11)  

Finally, it never was the purchaser’s claim that ITC is an absolute right. The purchaser’s claim was that if the conditions prescribed under the statutory provisions and rules have been fulfilled by the purchaser, then ITC transforms into its right, and denial of the same amounts to violation of right to property. By dismissing the argument by characterizing it as a claim for an absolute right, the Kerala High Court did not to do justice to the petitioner’s claim. Also, the core question before the High Court was whether the onerous conditions such as those prescribed under Section 16(2)(c) and Section 16(4), place all purchasers – bona fide and those colluding with suppliers – in a similar category and thereby violate Article 14 of the Constitution. The High Court’s analysis of the arguments relating to Article 14 was bereft of a comprehensive analysis as I elaborate in the section below.      

Purchaser’s Reliance on Supplier 

Section 16(2)(c) states that no person shall be entitled to claim ITC unless the tax charged in respect of such supply has been actually paid to the Government either in cash or utilization of ITC admissible in respect of such supply. This condition translates into the supplier filing their monthly return – GSTR-1 – indicating its outward supplies for the month. The information in the said return will auto-populate a return of the purchaser – GSTR-2A – which will indicate the inward supplies of the purchaser. The latter informs the purchaser’s claim for ITC. As is understandable, the purchaser is dependent on the supplier filing GSTR-1 accurately and in a timely fashion to enable it to claim ITC.

The purchaser’s argument was that GSTR-2A is a dynamic, read-only document, and is merely a facilitation document. And if certain purchases are not reflected in GSTR-2A, then it cannot be the basis of denial of ITC. The purchaser argued that if it possesses all the documents listed in Rule 36, CGST Rules, 2017, i.e., tax invoice, proof payment, actual receipt of goods then it should be presumed to have discharged the burden of genuineness of its ITC claim. Also, the purchaser cannot be burdened to ensure that the supplier has remitted the tax as it an impossible condition to fulfil for the purchaser. In the absence of purchaser lacking the resources to force a supplier to remit the tax, the doctrine of impossibility should be applicable. And since Section 16(2)(c) prescribes an impossible condition, it should be held as unconstitutional.  

The purchaser’s final argument vis-à-vis Section 16(2)(c) was that the provision treats bona fide purchasers similarly as purchasers that collude with suppliers to fraudulently claim ITC thereby being violative of Art 14. The purchaser’s claim was that denial of ITC to bona fide purchaser for supplier’s default in tax payment was arbitrary and irrational exercise of power. The purchaser also made an alternative argument that Section 16(2)(c) should restrict its ITC only if mala fide on its part was established. And that purchaser’s ITC should not be blocked if it has all the documentary evidence and by extension a prima facie proof of its bona fide intent and transaction.   

State’s defence of making the purchaser’s claim of ITC dependent on supplier’s payment of tax was as follows: the State argued that ITC ‘crosses State borders’. The supplier in originating State USES SGST/CGST credits of IGST collected from the purchaser and the latter will discharge output liability by claiming SGST/CGST credits of the IGST paid to the supplier. The originating State and the Union are under an obligation under Section 53, CGST Act, 2017 to transfer the CGST/SGST component utilized by the supplier and make it available to the destination State, since GST is a destination-based tax. The State’s claim was that if the supplier defaults in remitting the tax, but purchaser it allowed to claim ITC based on invoice, the originating State would have transferred tax to destination State without the former having received the tax. 

The purchaser raised some important and vital Constitutional arguments, but the Kerala High Court’s summary analysis was a complete endorsement and replication of the State’s argument and it concluded that: 

Considering the aforesaid scenario, without Section 16(2)(c) where the inter-state supplier’s supplier in the originating State defaults payment of tax (SGST+CGST collected) and the inter-state supplier is allowed to take credit based on their invoice, the originating State Government will have to transfer the amounts it never received in the tax period in a financial year to the destination States, causing loss to the tune of several crores in each tax period. (para 83)

The Kerala High Court added that: 

… this renders the whole GST laws and schemes unworkable. Therefore, as contended, the conditions cannot be said to be onerous or in violation of the Constitution, and Section 16(2)(c) is neither unconstitutional nor onerous on the taxpayer. (para 84)

The Kerala High Court dismissed the Constitution and fundamental rights-based arguments by agreeing to the State’s argument about administrative workability of the GST. But the High Court never seriously engaged with the argument if Section 16(2)(c) places a bona fide purchaser in the same category as a purchaser who colludes with a supplier to claim ITC fraudulently. The two categories of purchasers, prima facie, constitute two different categories. Neither was the ‘doctrine of impossibility’ squarely addressed by the High Court. How can a purchaser ensure that the supplier remits GST to the State? The purchaser can, ordinarily speaking, pay the tax to the supplier and ensure it has adequate proof of the payment. Persuading or forcing the supplier to remit the tax to the State in a timely and proper fashion isn’t or shouldn’t be the purchaser’ task. 

There is precedent – in pre-GST laws – that mandates payment of tax by the supplier before the purchaser can claim ITC. Legality apart, what is the policy driving enactment of such provisions? State wants to be secure about its revenue. State’s objective is to obtain tax from the supplier before it provides purchaser ITC on tax paid to the supplier. Documentary evidence of the supply of goods/services and payment of tax is insufficient to provide ITC. The reason is that, at times, the purchaser and supplier collude to make bogus transactions and claim ITC fraudulently. The fear or perhaps experience of allowing bogus ITC claims has resulted in making a statutory provision that places an onerous burden on the bona fide purchasers too. But the Courts have – until now – not engaged in a serious analysis if this similar treatment of all kinds of taxpayers violates Article 14 and whether it amounts to reasonable restriction under Article 19(6).    

Conclusion The Kerala High Court’s decision follows a burgeoning body of judicial precedents that have termed ITC as a concession and subject to statutory conditions. And yet Courts have not been able to cogently analyze as to why ITC cannot, under certain conditions, be termed as a right and not a concession. Neither have the Constitutional arguments based on Fundamental Rights been examined in any methodological fashion. While one may – and it seems to be increasingly the case – may become familiar with provisions imposing onerous demands on taxpayers to successfully claim ITC, it not a certificate of their constitutionality. Neither do the legality of such provisions provide them a stamp of good tax policy. Securing revenues for itself is certainly one of the goals of the State, but tax laws cannot and should not be so designed that they impose increasingly burdensome conditions on the taxpayers before they can claim ITC or similar such benefits under a tax statute.    

Section 71(3A), IT Act, 1961 is Constitutional: Delhi HC

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In a recent judgment, the Delhi High Court held that Section 71(3A), IT Act, 1961 was constitutional and did not violate Art 14 and/or Art 19(1)(g) of the Constitution. The High Court’s primary reasoning was that the introduction of sub-section (3A) to Section 71 did not take away a vested right of the assessee but only introduced a new condition for an assessee to set off the loss. 

Section 71, IT Act, 1961

Section 71(1), IT Act, 1961 allows an assessee to set off loss under one head of income against income under another head of income, subject to certain conditions. To the said conditions, Finance Act, 2017 added another condition by introducing a new sub-section (3A) which states that: 

Notwithstanding anything contained in sub-section (1) or sub-section (2), where in respect of any assessment year, the net result of the computation under the head “Income from house property” is a loss and the assessee has income assessable under any other head of income, the assessee shall not be entitled set off such loss, to the extent the amount of the loss exceeds two lakh rupees, against income under the other head. (emphasis added)

The condition of claiming a set off of loss, not beyond two lakh rupees was challenged by the assessee before the Delhi High Court. 

Assessee’s Challenge 

The asssesee made the following main arguments in its attempt to assail the constitutional validity of Section 71(3A), IT Act, 1961: first, that that prior to the amendment assessee had an unhindered right to claim set of loss and promissory estoppel should be applied against the State since introduction of Section 71(3A) amounted to breach of a promise; second, the assessee claimed that the impugned sub-section created unreasonable restrictions on taxpayer rights and was violative of Art 14 and Art 19(1)(g) of the Constitution. 

The State’s arguments, in short, were that the Section 71(3A) was not a revenue harvesting measure but an anti-abuse provision. In the absence of an upper limit, high income taxpayers were paying huge amount as interest payments and setting off the same against incomes from other heads. 

High Court’s Analysis 

The Delhi High Court noted that as per the facts: when the assessee constructed his house in 2014, he was entitled to claim deductions – without an upper limit – on interest payments made for housing loan; but, from Assessment Year 2018-19, the deductions were limited to a maximum of Rs 2 lakhs. The introduction of the upper limit was challenged by the assessee as an unreasonable restriction on taxpayer rights. 

The Delhi High Court noted that assessee’s challenge to Section 71(3A) was founded on the impugned sub-section having a retroactive effect, i.e., applicability of a law/provision to a fact situation where assessee has vested rights. And a successful challenge to retrospectivity was only possible if a vested right of the assessee was disturbed by introduction of the impugned sub-section. The High Court noted that neither the previous nor the amended provision created an indefeasible right in the petitioner’s favor to set off the losses. (para 24) 

In the absence of a crystallised right, the Delhi High Court added, the assessee’s argument that impugned sub-section violates Article 14 does not hold water. The High Court’s reasoning was that the impugned sub-section does not take away the right of assessee to set off losses in toto, but only circumscribes it and imposes conditions. And further, a new class of taxpayers has not been created by the impugned provisions but only new conditions have been imposed on an existing class of taxpayers. Further, the State has provided a clear rationale for imposing the conditions, i.e., to prevent misuse of the provision by high-income taxpayers. Thus, the High Court concluded that the criteria of reasonable classification and intelligible differentia were met by the impugned sub-section and it was not violative of Article 14. The High Court added that the provision was not manifestly arbitrary either. Finally, the High Court also rejected the assessee’s challenge vis-à-vis Article 19(1)(g) and noted that the restriction was proportional and reasonable and not in violation of the assessee’s right to do business. 

Conclusion 

The assessee’s case that a vested right has been taken away by a retroactive amendment to Section 71 did not have much traction to begin with. The legislature has the discretion to limit the tax benefits, in this case, the deductions were restricted to a certain amount to prevent certain high-income taxpayers from misusing the provision. While the introduction of said limit also affected taxpayers such as the assessee in this case, it was still not a right of the assessee to claim such a deduction. The mere fact that the assessee could claim the deduction without any limit from 2014 until 2018, was not enough for it to claim a vested right for such deductions. And the Delhi High Court correctly dismissed the claim of violation of Article 14 and Art 19(1)(g) of the Constitution.     

Section 54, IT Act, 1961: A Short Note on its Evolution

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Section 54, IT Act, 1961 provides exemption from capital gains tax if an assessee sells residential house and reinvests the capital gains in another residential house. While core of the Section 54 has remained unaltered, various amendments to the provision have altered the scope of exemption. For example, the benefit of Section 54 was earlier was only available only to an individual, but the provision was amended via Finance Act, 1987 to extend the benefit of tax exemption to both – an individual and a Hindu Undivided Family (‘HUF’). While Section 54 has been similarly amended multiple times, this article is an attempt to catalogue three important amendments to the provisions that have materially altered its scope and examines the rationale for each of the amendments.

A Residential House -> One Residential House in India 

Section 54 – before 2014 – provided that when an individual or HUF has within one year before or two years after transfer of the original asset purchased or constructed ‘a residential house’, then the assessee shall be eligible for capital gains tax exemption as per the conditions specified in the provision. There were two interpretive questions that arose from the phrase ‘a residential house’. First, whether different residential units constitute a residential house; Second, whether it was essential to purchase OR construct a residential house in India or whether it could be anywhere outside India too. 

As regards the first, courts took the view that if an assessee purchases different residential flats, they all qualify for exemption under Section 54. In one case, the Karnataka High Court reasoned as follows:

The context in which the expression ‘a residential house’ is used in Section 54 makes it clear that, it was not the intention of the legislation to convey the meaning that: it refers to a single residential house, if, that was the intention, they would have used the word “one.”

In the impugned case, the assessee had purchased four residential flats in a single residential building. The High Court held that the four flats constituted ‘a residential house’ and not ‘four residential houseS’ and tax exemption for the assessee needs to be determined accordingly.

Similarly, the Delhi High Court in another case, endorsed the Karnataka High Court’s stance and observed that as long as the assessee acquires a building which may be constructed to consist of several units which if need arises can be independently and separately used as residences, the requirement of Section 54 is fulfilled. There is no requirement that the residential house should be constructed in a particular manner or that it cannot have independent units.  

As regards the second issue, ITAT in one of its decision was categorical in its conclusion that purchase of residential house outside India does not preclude an assessee from claiming the benefit of Section 54. The ITAT noted that: 

It does not exclude the right of the assessee to claim the property purchased in a foreign country, if all other conditions laid down in the section are satisfied, merely because the property acquired is in a foreign country.

It was partially in response to the above judicial interpretations, that Section 54 was amended via Finance Act, 2014 and the phrase ‘a residential house’ was replaced with ‘one residential house in India’. In the accompanying document to the Finance Act, 2014 it was clarified, that the benefit under Section 54 was aimed for investment of capital gains made in one residential house in India, and the provision has been amended to reflect the said legislative intent. This was the first major amendment to Section 54 that altered its scope and clarified its intent. Though the courts were not incorrect in interpreting the pre-2014 provision in the manner that they did, particularly the lack of clarity that reinvestment should be made in a residential house in India.   

Purchase of Two Houses 

While the Finance Act, 2014 restricted the benefit of tax exemption under Section 54 to only one residential house, the Finance Act, 2019 did the opposite and expanded the scope of exemption. Section 54 was amended in 2019 to enable an assessee to claim exemption even if the capital gains from the first residential house were invested in two houses. Two Provisos were added to Section 54 via Finance Act, 2019 which allowed an assessee to claim benefit of Section 54 if: first, the assessee had not made capital gains of more than 2 crores on selling the first residential house; second, it was provided that if the assessee exercised the option of claiming the tax benefit on two houses, he shall not be subsequently entitled to exercise the option for the same or any other assessement year. 

The legislature, thus, in 2019, expanded the scope of Section 54 but with two important caveats of an upper limit of capital gains and it being once in a lifetime option. Generally, there is no limit on the no. of times an assessee can claim the benefit of Section 54, but if the exemption is claimed in respect of two residential houses, then further benefit of Section 54 is not permissible. There is no clarity as to why both the restriction(s) have been imposed vis-à-vis exemption on the two residential houses. Otherwise, the legislature certainly thought fit to expand the scope of exemption in 2019 after limiting the scope to one house in 2014.     

Cap of Ten Crores 

The third important amendment to Section 54 was made via Finance Act, 2023. The amendment to Section 54 – and simultaneously Section 54F – was to the effect that the maximum benefit that can be claimed by an assessee under the provision was Rs 10 crores. Thus, if an assessee purchased a new asset worth more than Rs 10 crores, then it would presumed that the cost of new asset was Rs 10 crores. Why impose an upper limit of Rs 10 crores? The accompanying explanation for the amendment clarified that: 

The primary objective of the sections 54 and section 54F of the Act was to mitigate the acute shortage of housing, and to give impetus to house building activity. However, it has been observed that claims of huge deductions by high-net-worth assessees are being made under these provisions, by purchasing very expensive residential houses. It is defeating the very purpose of these sections. 

The above rationale while partially understandable does not fully explain how the upper limit of Rs 10 crores was arrived at. Neither are the unintended consequences of prescribing the upper limit are, for now, fully decipherable. We do not know if in the bid to restrict tax exemption claims of high net worth individuals, we are also preventing tax exemptions claim of taxpayers who may wish to liquidate their high value residence in favor of their offsprings or otherwise distribute wealth to the next generation. In such cases, the intent may not be to purchase more expensive residential houses, but the taxpayer may suffer due to imposition of the upper limit. 

Conclusion 

Section 54 is a beneficial provision for assessees and helps mitigate the tax liabilities of a significant no. of taxpayers who sell one residential house to purchase another. The provision has undergone some changes to clarify legislative intent and prevent a certain category of taxpayers from taking undue advantange of the tax exemption. At the same time, some of the conditions and restrictions to avail the exemption are not fully explained. While a tax exemption is always provided subject to certain conditions and restrictions, if they are fully explained and rational, it is easier to understand their scope. Finally, while currently the Section 54 seems to have a relatively settled interpretive scope, one cannot with authority and full confidence state if further uncertainty may not arise and may catalyze further amendments to the provision.    

Powers of Arrest under GST: Unravelling the Phrase ‘Committed an Offence’

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CGST Act, 2017 provides the Commissioner power to arrest under specific circumstances. Section 69, CGST Act, 2017 states that: 

Where the Commissioner has reasons to believe that a person committed any offence specified in clause (a) or clause (b) or clause (c) or clause (d) of sub-section (1) of section 132 which is punishable under clause (i) or (ii) of sub-section (1), or sub-section (2) of the said section, he may, by order, authorise any officer or central tax to arrest such person. (emphasis added)   

There are several aspects of the power to arrest under GST that were and are under scrutiny of courts. For example, scope and meaning of the phrase ‘reason to believe’ remains open-ended even though the same phrase has a long standing presence under the IT Act, 1961. In this post, I will focus on judicial understanding of the phrase ‘committed an offence’ and its implication. Similar phrase and powers of arrest were provided in pre-GST laws as well, e.g., under Finance Act, 1994 which implemented service tax in India. Section 91, Finance Act, 1994 provided that: 

If the Commissioner of Central Excise has reason to believe that any person has committed any offencespecified in clause (i) or clause (ii) of section 89, he may, by general or special order, authorise any officer of Central Excise, not below the rank of Superintendent of Central Excise, to arrest such person. (emphasis added)     

The tenor and intent of both the above cited provisions is similar. The power to arrest has been entrusted to a relatively senior officer, who must have a ‘reason to believe’ that the person in question has ‘committed an offence’. Courts have made divergent observations on the meaning of the phrase ‘committed an offence’. Typically, a person is said to have committed an offence under a tax statute once the adjudication proceedings are completed and the quantum of tax evaded/not deposited is determined by the relevant tax authority after receiving a statement from the accused. In some cases, the tax officers have been found wanting in patience and have initiated arrests without completing the adjudication proceedings of establishing commission of an offence. Courts have made certain observations on the validity and permissibility of such a course of action.  

Pre-GST Interpretation 

There are two broad ways to interpret the above arrest-related provisions vis-à-vis commission of offence. First, the officer in question is in possession of credible material which provides it a ‘reason to believe’ that a taxpayer or other person has committed the offence(s) in question. In such a situation, the officer can authorise arrest of such person without completing the adjudication proceedings. Second, the officer’s reason to believe cannot – by itself – trigger powers of arrest, but the adjudication proceedings need to be completed to ascertain the amount of tax payable. The adjudication proceedings typically require issuance of a showcause notice to the taxpayer, and on receiving representation from the taxpayer the proceedings are completed by issuance of an order/assessment determining the tax payable by such person. Arrests can only happen once the adjudication proceedings have been completed and quantum of tax payable has been determined. The Delhi High Court – interpreting the relevant provisions of Finance Act, 1994 – in MakemyTrip case affirmed that the latter constituted the position of law and stated that authorities cannot without issuance of a showcause notice or enquiry or investigation arrest a person merely on the suspicion of evasion of service tax or failure to deposit the service tax collected. The High Court added: 

Therefore, while the prosecution for the purposes of determining the commission of an offence under Section 89 (1) (d)of the FA and adjudication proceedings for penalty under Section 83 A of the FA can go on simultaneously, both will have to be preceded by the adjudication for the purposes of determining the evasion of service tax. The Petitioners are, therefore, right that without any such determination, to straightaway conclude that the Petitioners had collected and not deposited service tax in excess of Rs. 50 lakhs and thereby had committed a cognizable offence would be putting the cart before the horse. This is all the more so because one consequence of such determination is the triggering of the power to arrest under Section 90 (1) of the FA. (para 78)

The only exceptions to the above rule as per the High Court was that if the taxpayer is a habitual offender, doesn’t file the tax returns on time and has a repeated history of defaults. The Supreme Court, in a short order, upheld and endorsed the Delhi High Court’s interpretation of the law. Various other courts, such as the Bombay High Court in ICICI Bank Ltd case, also took the view that adjudication proceedings should precede any coercive actions by tax officers.       

Courts in the above cases seem to be guided by at least two things: first, that the powers of arrest and recovery of tax are coercive actions and shouldn’t be resorted to in a whimsical fashion; second, establishing the ‘commission of an offence’ can only happen through adjudication proceedings and not based on opinion of the relevant officer, even if the opinion satisfies the threshold of ‘reason to believe’. Insisting on completion of adjudication proceedings also ensures that the ingredient of ‘commission of an offence’ prescribed in the provision is satisfied. Again, this is for the simple reason that an officer’s reason to believe that an offence has been committed is not the same as establishing that an offence has been committed in adjudication proceedings. The latter also provides the accused an opportunity to respond and make their representation instead of directly facing coercive action. 

Rapidly Swinging Pendulum under GST

Similar question has repeatedly arisen under GST, with no satisfactory answer one way or the other. While some High Courts have relied on the MakemyTrip case, others have suggested otherwise. The contradictory opinions can be highlighted by two cases. In Raj Punj case, the Rajasthan High Court deciding a case involving false invoices and fake ITC held that the petitioner’s contention that tax should be first determined under Sections 73 and 74 of CGST Act, 2017 does not have any force and the Department can proceed straightaway by issuing summons or if reasonable grounds are available by arresting the offender. (para 21) The High Court curiously added that determination of tax is not required if an offence is committed under Section 132, CGST Act, 2017. The observation is curious because Section 132(l), CGST Act, 2017 clearly links the penalty and imprisonment to the amount of tax evaded or amount of ITC wrongfully availed.  

The Madras High Court in M/s Jayachandran Alloys (P) Ltd case though had a different opinion. The High Court held that use of the word ‘commits’ in Section 132, CGST Act, 2017 made it clear that an act of committal of an offence had to be fixed before punishment was imposed. And that recovery of excess ITC claimed can only be initiated once it has been quantified by way of procedure set out in Sections 73 and 74 of the CGST Act, 2017. The High Court endorsed the approach and interpretation adopted in the MakemyTrip case and added that its view was similar in that an exception to the procedure of assessement is available in case of habitual offenders. 

What is the reason for invoking arrest powers before completing adjudication proceedings? Various. First, the Supreme Court’s observations in Radheshyam Kejriwal case that criminal prosecution and adjudication proceedings can be launched simultaneously, and both are independent of each other. While the Supreme Court was right in noting that both proceedings are independent of each other, it did not specifically opine on the inter-relation of adjudication proceedings and arrest. Second, if there is reason to believe that a large amount of tax has been evaded, arrests are justified by tax officers by arguing that they are necessary for protection of revenue’s interest. Third, evidentiary or other reasons can be invoked as failure to arrest the suspects may lead to destruction of evidence of tax evasion. And various other reasons that can be clubbed under the broader umbrella of expediency and revenue’s interest. The exceptions will always be recognized – as in the MakemyTrip case – the question is the boundary and scope of such exceptions tends to be malleable and there is little that can be done to address the issue.     

Way Forward 

The Supreme Court is currently seized of the matter involving scope of the powers of arrest under GST. While I’m unaware of the precise grounds of appeal before the Supreme Court, the issues broadly involve the scope of powers of arrest, pre-conditions for invoking the powers of arrest, the exceptions, and possibility of the misuse of powers of arrest. The latter have been indirectly acknowledged and ‘Guidelines’ have been issued, exhorting officers not invoke powers of arrest in a routine and mechanical manner. And only make arrest where ‘palpable’ guilty mind is involved. There is empirical data – yet – that can establish the efficacy or otherwise of the guidelines. And Supreme Court may enunciate its own set of guidelines in its judgment. But, as the cliché goes, the proof pudding is in its eating. Powers of arrest are necessary to create the necessary deterrent effect: minimize and detect tax evasion. At the same time, frequent resort to coercive powers under a tax statute adversely affects business freedoms. The balancing act is tough to achieve. I’ve written elsewhereabout the uncertainty that bedevils this area of law, and I suspect little is going to change in the instantly. Supreme Court’s judgment may provide a guiding light, but one should temper one’s expectations and not hope for a magic wand that may, at once, resolve a tricky issue.    

Tax Treatment of Mandatory CSR: Alignment of CGST Act, 2017 and IT Act, 1961

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In this article, I elaborate on one of the several changes introduced by Finance Act, 2023 to CGST Act, 2017. Section 17, CGST Act, 2017 was amended via Finance Act, 2023 to clarify that the goods or services or both used to comply with mandatory CSR obligations, i.e., CSR obligations under Section 135, Companies Act, 2013, would not be eligible for Input Tax Credit (‘ITC’). The amendment sought to achieve two objectives: first, it clarified law on a point which attracted contradictory opinions by authorities for advance rulings (‘AARs’); second, it tried to ensure that the tax treatment of mandatory CSR activities under CGST Act, 2017 aligns with that of IT Act, 1961. I suggest that while the former objective may have been fulfilled, the latter remains questionable since the tax policy vis-à-vis mandatory CSR is itself confusing under IT Act, 1961.  

Confusion to Clarity: ITC on Mandatory CSR Activities

Section 16, CGST Act, 2017 states that a registered person shall be entitled to ITC charged on any supply of goods or services or both ‘which are used or intended to be used in the course or furtherance of his business’ and the said amount shall be credited to the electronic ledger of the person. As regards CSR, AARs were confronted with the question if CSR activities undertaken by a registered person should be understood ‘in the course of business’.   

In Re: M/s Dwarikesh Sugar Industries Limited the applicant wished to know if it can claim ITC on expenses incurred to fulfil its mandatory CSR obligations. AAR endorsed the interpretation adopted in a pre-GST case, i.e., Essel Propack case and noted that since the applicant was ‘compulsorily required to undertake CSR activities in order to run its business’, CSR activities should be treated as incurred ‘in the course of business.’ (para 12) AAR emphasised the compulsory nature of CSR and reasoned that it should not be equated with gift, since the latter had a voluntary element.

In Re: M/s Adama India Pvt Limited the applicant relied on Re: M/s Dwarikesh Sugar Industries Limited and Essel Propack case to support the contention that ITC on its mandatory CSR activities should not be blocked. Curiously, AAR did not examine scope of the term ‘business’ or ‘in the course of business’ used in CGST Act, 2017, but instead relied on the Companies (CSR Policy) Rules, 2014 which defined CSR activities undertaken by a company to not include activities undertaken in pursuance of the normal course of business. But the definition of CSR under these Rules has a different purpose and context. And reliance on Companies (CSR Policy) Rules, 2014 would be understandable if the term ‘business’ was not defined or was unclear under CGST Act, 2017. Section 2(17), CGST Act, 2017 contains an elaborate definition of business to which AAR paid no attention.  

In Re: M/s Adama India Pvt Limited, AAR also refused to refer to Essel Propack case reasoning that it was decided under pre-GST laws, but strangely it considered Companies (CSR Policy) Rules, 2014 as relevant to GST. While it may be reasonable to suggest that cases decided under pre-GST regime (in this case excise law regime) need not always be applicable in the GST regime; but, such a line of argument would only be persuasive if there was a marked difference in the applicable provisions in pre-GST and GST laws, which wasn’t the case as far the impugned issue was concerned. Even so, AAR should have examined the scope of ‘business’ under CGST Act, 2017 and the nature of mandatory CSR activities instead of referring to other legislative sources.   

In Re: M/s Polycab Wires Private Limited, Kerala AAR held that goods distributed by the applicant for free – and shown as CSR expenses – were not eligible for ITC under Section 17(5)(h), CGST Act, 2017. While AAR did not state it expressly, it seemed to equate the applicant’s free distribution of goods – as part of its CSR Activities – to gift or free samples. While for the latter, ITC is expressly blocked under Section 17(5)(h), CGST Act, 2017, it was an error to equate gifts and free samples with goods distributed under the CSR initiative. The applicant distributed goods at the request of Kerala State Electricity Board and thus, it was not entirely out of the applicant’s volition nor was it a compulsory CSR activity under Companies Act, 2013. AAR avoided the tough question on how to best classify the impugned CSR activity.

Thus, as is evident, AARs were struggling to adopt convincing reasoning and were arriving at different conclusions regarding eligibility of taxable persons to claim ITC on their CSR activities. Nor were they meaningfully distinguishing between mandatory and voluntary CSR activities.  

Ostensibly, to clear the confusion caused by contradictory advance rulings, Section 139, Finance Act, 2023 introduced the following clause to Section 17(5), CGST Act, 2017:

(fa) goods or services or both received by a taxable person, which are used or intended to be used for activities relating to his obligations under corporate social responsibility referred to in section 135 of the Companies Act,2013; 

Section 17(5), CGST Act, 2017 enumerates the situations in which ITC is blocked, and the insertion of above clause in Section 17(5), CGST Act, 2017 means that goods or services or both used to fulfil mandatory CSR obligations will not be eligible for ITC.. And to this extent, the law on ITC vis-à-vis mandatory CSR activities is sufficiently clear post the enactment of Finance Act, 2023. 

Clarity to Confusion: Mandatory CSR under IT Act, 1961

Blocking ITC for mandatory CSR via Section 17(5)(fa), CGST Act, 2017 superficially aligns with the tax treatment of mandatory CSR under IT Act, 1961. Section 37, IT Act, 1961 states that any expenditure – not being an expenditure of the nature described in Sections 30 to 36 – laid out or expended wholly and exclusively for the purpose of business or professions shall be allowed in computing the income chargeable under the head ‘Profits and gains of business or profession’. Section 37, IT Act, 1961 is a residual provision and allows an assessee to claim expenditure if some of the expenditure does not meet the requirements under specific heads, from Sections 30 to 36 of IT Act, 1961. The primary requirement under Section 37, IT Act, 1961 being that the expenditure should be for the purpose of business or profession. However, Explanation 2 to Section 37 clarifies that:

For the removal of doubts, it is hereby declared that for the purposes of sub-section (1), any expenditure incurred by an assessee on the activities relating to corporate social responsibility referred to in section 135 of the Companies Act, 2013 (18 of 2013) shall not be deemed to be an expenditure incurred by the assessee for the purposes of the business or profession. 

The above Explanation to Section 37 expressly disallows an assessee from claiming deductions on expenses incurred in fulfiling mandatory CSR obligations. 

However, the confusion on mandatory CSR expenses and IT Act, 1961 is two-fold: first, if mandatory CSR expenses satisfy the requirements of Sections 30 to 36, an assessee can claim deductions. This implies that there is no across the board bar on claiming mandatory CSR expenses under the IT Act, 1961 but the prohibition is only under Section 37 resulting in an uneven tax treatment of mandatory CSR IT Act, 1961; second, Section 80G states that an assessee cannot claim deductions if the mandatory CSR money is contributed to the Clean Ganga Fund or the Swach Bharat Kosh Fund. There is no express prohibition against mandatory CSR money contributions to any other fund listed under Section 80G creating a confusion about the objective of partial disallowance for only two funds.   

Conclusion

It is evident that the State does not view mandatory CSR activities as integral to or in the course or furtherance of business for tax purposes. The introduction of Section 17(5)(fa), CGST Act, 2017 reinforces the deeming fiction previously incorporated under Explanation 2, Section 37, IT Act, 1961. As far as these two provisions are concerned, mandatory CSR is not treated as an activity in the course or furtherance of business. The issue is partial bar against mandatory CSR expenses under IT Act, 1961. The limited scope of bar under both provisions – Section 80G and Section 37 only – raises the question as to why mandatory CSR is treated as business expense under other provisions. Reflection of a confused tax policy as far as IT Act, 1961 is concerned. 

Finally, the reasons for denying tax benefits for mandatory CSR activities seem to be rooted in the State’s conception of CSR activities as a backstop to its own welfare measures. And since the denial of tax benefits is limited only to mandatory CSR activities, there is room to suggest that the State does not wish to ‘subsidise’ only some CSR activities, as tax benefits are not denied to voluntary CSR activities. ITC is not blocked for voluntary CSR activity neither is deduction of expenses barred – even partially – for voluntary CSR. Creating a ‘two-track’ tax policy vis-à-vis CSR expenses.      

Dividend Distribution or Reduction of Share Capital: DDT’s Long Shadow on Cognizant

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Dividend Distribution Tax (‘DDT’) – abolished in April 2020 – was one of the most contested taxes in India as it taxed dividends in hands of companies which distributed dividends. Making companies liable to pay dividend tax was opposite to widely followed classical system of dividend taxation wherein dividends are taxed in the hands of shareholders. The various questionable policy reasons for introduction of DDT aside, DDT also created incentives for companies to find innovative ways to put money in the hands of its shareholders without declaring dividends. One such alternative way was buyback of shares. The alternate means of transferring money in hands of shareholders has been questioned in various cases, most recently and prominently in the Cognizant ruling by ITAT Chennai – currently under appeal before the Madras High Court – where Cognizant was held liable to pay DDT of Rs 19,000 crores (appx.). I look at ITAT’s decision and analyze whether ITAT has imposed tax liability on Cognizant based on persuasive reasons or otherwise.  

Scheme of Amalgamation and Tax Payments  

M/s Cognizant Technology Solutions India Pvt Ltd. (‘assessee’) purchased its own shares from non-resident shareholders under a ‘Scheme of Amalgamation & Compromise’ sanctioned by the Madras High Court under sections 391-393 of the Companies Act, 1956. The scheme was sanctioned in April 2016, when DDT was still in force. The result of the scheme and buyback of shares by the assessee was that the shareholding of its Mauritius based shareholders increased while that of the US-based shareholders decreased. Thus, a significant capital base of the assessee moved to Mauritius because of the scheme. Though the assessee maintained that its reasons for restructuring were corporate structure streamlining, improving earnings per share, reduce fluctuations in terms of foreign currency fluctuations, and improving overall capital structure of the company.  

After approval of the scheme, in Financial Year 2016-17, assessee bought back 94,00534 equity shares of face value of Rs 10 each from its shareholders at a price of Rs 20,297/ per share. Assessee deducted TDS before making payments to the US -resident shareholders since their capital gains arose in India but did not withhold tax for its shareholder resident in Mauritius because the transaction was not liable to tax in India as per the India-Mauritius DTAA.

Revenue’s Arguments for Levy of DDT 

The Revenue’s contention was that the consideration paid by assessee to its own non-resident shareholders comes within the ambit of Section 2(22)(a)/2(22)(d) of the IT Act, 1961 and the assessee is liable to pay DDT under Section 115-O of the IT Act, 1961.  

Section 2(22)(a) of the IT Act, 1961 defines dividend to include any distribution by a company to its shareholders to the extent of accumulated profits of the company, whether capitalized or not, whether such distribution entails release by the company all or any part of the assets of a company. Section 2(22)(d) further includes within the definition of dividend any distribution made to the shareholders by a company on reduction of its share capital to the extent company possesses accumulated profits. 

Revenue Department’s argument was that the sum paid by the assessee after approval of its scheme by the High Court was akin to distribution of accumulated profits by a company to its shareholders, whether capitalized or not, and was taxable under Section 2(22(a), IT Act, 1961. Alternatively, the Revenue Department argued that the consideration paid by the assessee on purchase of its own shares was akin to distribution of accumulated profits on reduction of its share capital and was taxable under Section 2(22)(d), IT Act, 1961. Either way, the Revenue Department’s argument was that the consideration paid was on reduction of share capital amounted to dividend as defined under IT Act, 1961 and was thus taxable under Section 115-0 of the IT Act, 1961. 

Assessee Resists Levy of DDT 

One of the assessee’s arguments was that Section 2(22)(a)/2(22)(d) are not attracted in the impugned case since distribution of profits would imply absence of quid pro quo. While in the current case there was an offer by the company and acceptance by the shareholders and therefore there is no ‘distribution’ of profits in the true sense. Further, the provisions require that the reduction of capital should be co-terminus with distribution of profits, while in the impugned case the reduction was a result of scheme approved by the High Court. ITAT rejected both prongs of the argument: first, it noted that distribution does not require quid pro quo or lack thereof, only requirement is that the payment and disbursal of profits should be made to more than one person; second, the ITAT held that the assessee is trying to assign a hyper-technical meaning to ‘reduction of share capital’ and to attract Section 2(22)(a)/2(22)(d), it is immaterial if the reduction is a result of the scheme or otherwise. 

Assessee’s second argument was that once the scheme was approved by the High Court, the approval operated in rem and was binding on the Revenue Department. The scheme could not be re-characterised by the Revenue Department to levy taxes on the assessee. The ITAT clarified that the approval of the scheme is subject to the condition that it does not grant immunity to the assessee from payment of taxes. Also, the High Court in approving the scheme only acts an umpire to note if the conditions prescribed under the statutory provisions have been met. Finally, the ITAT clarified that the Revenue Department is not seeking to recharacterize the scheme but merely analyse its tax implications. And assessee cannot legitimately argue that the scheme once approved by the High Court excludes the applicability of IT Act, 1961.   

Assessee further contended that the reduction of its share capital was sui generis under Sections 391-393 of Companies Act, 1956 and not under Section 77. Thereby, it was taxable only via buyback tax provided under Section 115QA, IT Act, 1961. Section 115QA included only buyback of shares under Section 77A in its scope and included all other forms of buyback in its scope only from 2016 onwards. The assessee’s contention was that its buyback was not under Section 77A but under Sections 391-393 and thus the transaction was not taxable under Section 115QA. ITAT dismissed assessee’s categorization of its transaction and held that no buyback of shares can take place solely under Sections 391-393 and the buyback is necessarily read with section 100-104. Thus, no buyback of shares can take place under Sections 391-393 alone. Finally, ITAT concluded that all forms of buyback – except under Section 77A – are included in the definition of dividend since they entail release of assets of a company. And since assessee’s buyback – by its own admission is not under Section 77A – the distribution of consideration is covered by the definition of dividend.     

Use of ‘Colorable Device’ by Cognizant 

ITAT was clear and unambiguous in its conclusion that the assessee adopted a colorable device to evade taxes. ITAT noted that the ‘real intent’ of the scheme was to artificially shift the capital base of the company to Mauritius. The other reasons cited by the assessee to streamline corporate structure, increase earnings per share were discounted by ITAT. Further, ITAT noted, assessee was wished to evade taxes by resorting to buyback under general provisions instead of specific provisions, since latter would have triggered their liability to tax. Thus, ITAT concluded:

Therefore, from the facts of the present case, it is undoubtedly clear that the scheme as such is only a colourable device intended to evade legitimate tax dues. Such colourable devices which do not have any commercial purpose can be excluded for physical nullity and the AO empowered to ‘look through’ rather ‘look at’ the transactions. This is further established by the fact that there is no commercial nexus between the company activities and Mauritius and this fact has been specifically dealt by the lower authorities. (para 43)

The cumulative factors led ITAT to conclude that the scheme amounted to distribution of accumulated profits, the consideration paid amounts to dividend under Section 2(22)(a)/2(22)(d) read with Section 115-O and thus is taxable under the IT Act, 1961. 

‘Tax Exemption’ Enjoyed by Cognizant

Another fact, though should have been irrelevant, was found germane to the issue by ITAT. The ITAT noted that the assesee had enjoyed ‘tax exemption’ of Rs 30,000 crores (appx) as the assessee has accumulated profits of Rs 33,000 crores (appx) and has not declared interim dividend since 2006-07. (para 31) The assumption in this statement is that the assessee by not declaring dividends was enjoying tax exemption, since under DDT regime, tax was payable by a company only on declaration of dividend. The fact that wasn’t articulated by ITAT was that DDT was introduced to disincentivize companies from declaring dividends and encourage them to invest their profits in growth of the companies. So, fulfilling the objective of DDT amounted to enjoying a tax exemption? Also if the taxable event under DDT is distribution of dividends, and a company chooses not to distribute dividends, how does it amount to a company enjoying ‘tax exemption’? It is at best a case of tax planning. A company can choose not to declare dividend if it feels it will add to its tax liability. The decision not to declare dividend hardly amounts to ‘enjoying’ a tax exemption. Whether the impugned buyback of shares amounts to distribution of dividends should have been interpreted on its own terms, rather than making prior dividend policy of the assessee relevant to determine its tax liability.  

Conclusion 

ITAT relied heavily on the facts to characterize assessee’s transaction as a colorable device intended to evade tax under the IT Act, 1961. The use of general provisions of Sections 391-393 instead of specific provision of Section 77A to buyback its shares, hyper technical interpretation of reduction of capital and distribution of profits, all were interpreted against the assessee to term the scheme as a colorable device intended to evade DDT. The factual matrix – as captured in ITAT’s decision – certainly doesn’t seem to favor the assessee and even the definition of dividend is wide enough to include the distribution of profits – even if as part of buyback – under the scope of DDT. Whether the arguments and facts are argued and interpreted in a different manner in the High Court and whether any other factors are considered in determining the tax liability of assessee will be known soon. 

But, ITAT seems to have stacked the odds against assessee especially by making it prior dividend policy relevant to the impugned case. However, ITAT’s decision is heavily reliant on the interpretation of the definition of dividend which inter alia includes distribution of profits, a stipulation which is certainly fulfilled in the current case. The assessee’s arguments that there was quid pro quo and thus there was no distribution of profits, and that reduction of share capital was a result of the scheme and not co-terminus with distribution do not hold much water. The assessee’s arguments come across as ‘hyper-technical’ as ITAT rightly pointed out. It is to be seen whether assessee adopts alternate or additional arguments in the High Court.              

Taxation of Perquisites: SC Rules on Constitutionality

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Challenge 

In a recent judgment, the Supreme Court ruled on constitutionality of Section 17(2)(viii), IT Act, 1961 and Rule 3(7)(i), IT Rules, 1962 which include concession loans under perquisites and provided for their valuation respectively.  

Section 17(2) defines perquisites to include various perks under different clauses. Section 17(2)(viii) is a residuary clause which empowers the executive to include other perks and uses the phrase: ‘as may be prescribed’. Rule 3, IT Rules, 1962 prescribes the additional amenities and benefits that are taxable as perquisites. Rule 3(7)(i) provides that interest-free/concessional loans provided by a bank to its employees are taxable as fringe benefits or amenities if the interest charged on such loans is less than the Prime Lending Rate charged by the State Bank of India. 

Both the provisions – Section 17(2)(viii), IT Act, 1961 and Rule 3(7)(i), IT Rules, 1962 – were challenged on the ground of excessive and unguided delegation of essential legislative function to the Central Board of Direct Taxes (‘CBDT’). Rule 3(7)(i) was also challenged for being arbitrary as it made the Prime lending Rate charged by the SBI as the benchmark lending rate. 

SC Decides: Not Unconstitutional

Supreme Court examined the scope of Section 17 and noted that while the various clauses had included different kinds of perquisites in its scope, clause (viii) as a residuary clause had deliberately left it to the rule making authority to tax ‘any other fringe benefit or amenity’ by promulgating a rule. And it was in exercise of this power that Rule 3(7)(i) of IT Rules, 1962 was enacted. The effect of the Rule was two-fold: first, interest-free/concession loans were included in the definition of perquisite; second, the valuation rule suggested that the value of loan was to be calculated as per the Prime Lending Rate charged by the State Bank of India. 

The Supreme Court elaborated on the meaning of the term perquisite and noted that it should be assigned the meaning as in common parlance. It also cited a few judicial decisions and held that perquisite can be understood to mean a privilege or gain related to employment. And based on this understanding a concessional/interest-free loan will certainly qualify as a perquisite. (para 19) 

The other questions were whether Section 17(2)(viii) read with Rule 3(7)(i) led to delegation of essential legislative function. Relying on Birla, Cotton, Spinning and Weaving Mills case, the Supreme Court noted that essential delegated legislative function means the determination of legislative policy. And that as per relevant judicial precedents, allowing executive freedom to determine whom to tax and finalizing tax rates was not delegation of essential legislative function. In the impugned case, the Supreme Court observed that the legislative policy was encoded in Section 17, and the rule making power was not boundless. The rule making body under Section 17(2)(viii) was bound to include only a perquisite within the ambit of taxation. And it was in pursuance of the policy provided in the main legislation, that Rule 3(7)(i) makes an interest-free/concession loan taxable. 

Supreme Court cited a bunch of judicial precedents where Courts have held that a delegated legislation is not unconstitutional if the essential legislative function is not delegated. And it concluded:

We are of the opinion that the enactment of subordinate legislation for levying tax on interest free/concessional loans as a fringe benefit is within the rule- making power under Section 17(2)(viii) of the Act. Section 17(2)(viii) itself, and the enactment of Rule 3(7)(i) is not a case of excessive delegation and falls within the parameters of permissible delegation. Section 17(2) clearly delineates the legislative policy and lays down standards for the rule-making authority. (para 31) 

The Supreme Court was right in stating that the essential legislative function was not delegated by Section 17(2)(viii) as perquisite was defined, and the phrase ‘as may be prescribed’ was to be interpreted in the context of the preceding clauses and was not unregulated for the executive to include any benefits within the meaning of perquisite. And an interest-free loan/concession loan was certainly a perquisite as per common understanding of the term.  

Rule 3(7)(i), IT Rules, 1962: Not Arbitrary 

The final question that the Supreme Court had to decide was whether Rule 3(7)(i), IT Rules, 1962 was arbitrary because it used the Prime Lending Rate by State Bank of India as the benchmark in comparison to the rate of interest charged by other banks. (paras 32-34) While the Supreme Court did not articulate the argument of petitioner’s in full, it seems the petitioner wanted the interest rates of their banks to be the benchmark instead of the interest rate of one bank of which many may not be employees. The Supreme Court decided this question in favor of the State and held that using the SBI interest rate as benchmark was neither arbitrary nor unequal exercise of power. The Supreme Court’s conclusion rested on two reasons: first, that benchmarking all concession/interest-free loans ensured consistency in application and provided certainty on the amount to be taxed. And tax efficiency was promoted through certainty and simplicity; second, that in matters of taxation law the legislature deserves a wider latitude since taxation law deal with complex and contingent issues. 

Both the above reasons are not beyond reproach, but the latter certainly has acquired a cult-like status in cases involving challenges to constitutionality of provisions of a tax statute. The assumption that tax laws are complex is a half-truth as taxation laws do try to address multi-faceted problems, but not every tax provision is ‘complex’ for it to warrant a hands-off approach by the judiciary. Also, I would suggest that ‘complexity’ is a feature of most laws in today’s complex regulatory and economic law environment. Thus, there is a danger of courts not scrutinizing taxation laws/provisions adequately before dismissing challenges to their constitutionality. Perhaps the doctrine of wide leeway to legislature in matters of tax law needs a small course correction and a rescrutiny of its rationale. 

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