Rav Singh

Tax Exemption v/s Tax Exemption for ‘Beneficial Purpose’: Interpretive Dilemmas 

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The thumb rule in interpreting a tax statute is that it must be strictly construed and any ambiguities in statutory provisions are resolved in favor of the taxpayer. However, the rule relating to interpretation of ambiguities is only applicable for charging provisions or provisions that provide authority to levy tax. In case of provisions or notifications that provide a tax exemption, the opinion of Courts have swung both ways. In 2018, a 5-Judge Bench of the Supreme Court in Dilip Kumar case authoritatively ruled that any ambiguity in a tax exemption provision is resolved in favor of the State. However, in 2021, a Division Bench of the Supreme Court clarified that not all ambiguities in tax exemptions can be interpreted similarly. In 2021, the Supreme Court clarified that tax exemptions that have a ‘beneficial purpose’ constitute a separate category and any ambiguity in such situations needs to be resolved in favor of the taxpayer, to serve the ‘beneficial’ purpose of tax exemption. This article scrutinizes the reasoning of both the judgments and their implications on interpretation of tax exemption provisions. 

Tax Exemption to be Interpreted Strictly: Dilip Kumar Case 

Dilip Kumar case overruled a 3-Judge Bench case on the appropriate manner to interpret tax exemptions. A 3-Judge Bench of the Supreme Court in M/S Sun Export Corporation case while deciding if the appellant was entitled to a tax exemption observed that when two views are possible, it is well settled in matters of taxation, that the one that is favorable to the assessee must be preferred. However, the Supreme Court in Dilip Kumar case overruled the 3-Judge Bench and held that when there is ambiguity on interpretation of a tax exemption, it must be resolved in favor of the State. The Supreme Court’s reasoning for its conclusion rested on two reasons: 

first, that a tax exemption creates additional tax burden on unexempted taxpayers and therefore a person claiming exemption must prove that their case for exemption falls squarely within the scope of exemption; 

second, the Supreme Court contrasted how ambiguities are resolved for charging provisions with how they should be resolved in case of tax exemption provisions. It held that in the former ambiguity is resolved in favor of the taxpayer and in the latter, it should be resolved in favor of the State. There was no further explanation of why the latter needs to be interpreted in favor of the State especially since it is the State that drafts the provision and would thereby benefit from its own drafting oversight/error.  

Both the above reasons mentioned by the Supreme Court are not entirely convincing. As per the Supreme Court, tax exemptions ‘have a tendency’ to increase the tax burden of unexempted taxpayers. This is a policy assumption disguised as a conclusion. And even if one assumes that it is a factual statement, there is no attempt to examine the rationale and objective of the tax exemption in question. Further, contrasting strict interpretation of a charging provision with a tax exemption provision while relevant, need not necessarily lead one to the conclusion that an ambiguity in a tax exemption provision must be resolved in favor of the State. It cannot be a game of one for the State, one for the taxpayer. 

Finally, Dilip Kumar case endorsed another layer of interpretation and approved a slew of precedents wherein it was held that an exemption provision must be construed strictly at the time of determining the eligibility of taxpayer and once the ambiguity is resolved then the notification must be construed in a liberal and wide manner to give full play to the exemption provision. While this ‘two-level’ interpretation has been approved in various precedents, it is not entirely clear how it is applied in the true sense.   

Interpretation of Tax Exemption for Beneficial Purpose: Mother Superior Case 

Mother Superior case, decided by the Supreme Court in 2022 clarified the ratio of Dilip Kumar case and restricted its applicability and scope to only a select kind of tax exemptions. One of the arguments that the State’s counsel – relying on Dilip Kumar case – made was that an exemption in a tax statute must be construed strictly and any ambiguity must be resolved in favor of the State. Engaging with the argument about interpretation of tax exemption, a Division Bench of the Supreme Court held that the 5-Judge Bench in Dilip Kumar case did not make the distinction between tax exemptions generally and tax exemptions for a beneficial purpose. The Supreme Court noted that the tax exemption for a beneficial purpose were required to be interpreted in a different manner and there was a line of judicial precedents to that effect which were not considered in the Dilip Kumar case. 

In Mother Superior case, the Supreme Court noted that an exemption provision must be construed liberally in accordance with the objective sought to be achieved if the provision is to promote economic growth or some other ‘beneficial reason’ behind it. The Supreme Court cited a bunch of precedents with approval whose effect was to hold that exemptions such non-payment of sales tax is for encouraging capital investment and promoting industrial growth should be liberally interpreted. The rationale is that tax exemptions that are designed or aimed to promote or encourage certain activities need to be interpreted liberally to achieve the objective of promoting the intended activity. The Supreme Court clarified that the line of judicial decisions which hold that tax exemption for beneficial purpose should be liberally interpreted were not noticed in Dilip Kumar case and thus cannot be said to be overruled by the said case. The Supreme Court was clear that in tax exemptions with beneficial purpose, the literal and formalistic interpretation of tax statutes had to be eschewed in favor of a purposive interpretation and courts must ask the question ‘what is the object sought to be achieved by the provision’ and construe the provision in accordance with such object.      

Conclusion 

The above two judgments can certainly stand together as the Mother Superior case endorses a sub-category of tax exemptions, i.e., tax exemptions for a beneficial purpose. The crucial questions then – because of these two judgments – are: What is the meaning of beneficial purpose? What is the scope of this phrase? Is beneficial purpose determined by the executive or to be deciphered by courts? The answers are uncertain. Tax exemptions are created for various and multiple reasons. The reasons can range from alleviating burden of a category of taxpayers for socio-economic reasons, encouraging industrial activity in an economic sector or a geographical location, facilitating newly established businesses, or encouraging not-for-profit organisations. Many of the reasons are tough to be categorized as ‘non-beneficial’ from the State’s viewpoint simply because the State would not create the tax exemptions in the first place if it did not think that the exemptions were not overall beneficial. Some benefits may be visible in short-term others may require a longer gestation period to manifest. In view of the law laid in two judgments, the interpretive questions are likely to be decided on case-to-case basis revealing little promise of certainty and predictability. 

Rainbow Papers Case and the Art of Misinterpretation

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On September 6, 2022, the Supreme Court pronounced its judgment in Rainbow Papers case that unsettled prevailing understanding of the waterfall mechanism under Section 53, Insolvency and Bankruptcy Code, 2016 (‘IBC’). And equally unconvincingly defended the merits of the decision in the review petition further entrenching a position of law that is not aligned with the text of Section 53 of IBC and other provisions of IBC. In this post, I look at the case, its dissatisfactory interpretive approach, and the implications. 

Interpretive Question 

In the impugned case, the corporate debtor owed VAT and Central Sales Tax to the State tax authorities. When the insolvency proceedings were initiated, the tax claims were filed before the Resolution Professional, but the Resolution Professional informed the tax authorities that their claims had been waived off under the final Resolution Plan. The tax authorities challenged the Resolution Plan on the ground that tax claims cannot be waived as the State was a secured creditor. The claim of tax authorities was not accepted inter alia on the ground that tax authorities were not secured creditors as per Section 53, IBC. The appeal against the decision reached the Supreme Court.   

One of the issues before the Supreme Court was about the interplay between Section 48, Gujarat VAT Act, 2003 and Section 53, IBC. The former provided that:

Notwithstanding anything to the contrary contained in any law for the time being in force, any amount payable by a dealer or any other person on account of tax, interest or penalty for which he is liable to pay to the Government shall be a first charge on the property of such dealer, or as the case maybe, such person.

Two things worth pointing out: first, the non-obstante clause in the provision which ensures the provision overrides every other law; second, that tax shall be the first charge on the property of the taxpayer who owes money to the State. Section 48, Gujarat VAT Act, 2003 ran into conflict with Section 53, IBC which provides for the waterfall mechanism or the priority in which proceeds from sale of liquidation assets shall be distributed. Section 53 accords priority to secured creditors while any amount due to the Union or State is lower in priority. Which means in case there is not sufficient money after payment to secured creditors, the State may not get paid its taxes owed by the corporate debtor. To prevent such a situation, tax authorities – at the Union and State level – have repeatedly argued that they are akin to secured creditors, without much success except in the impugned case. 

Section 30(2), IBC

Before the Supreme Court, the State clarified that that its case is not that Section 48, Gujarat VAT Act, 2003 prevails over Section 53, IBC. Instead, its argument was that the view of lower judicial authorities that State was not a secured creditor was an erroneous view and contrary to definition of a secured creditor. Section 3(30), IBC, 2016 defines secured creditor to mean a person in whose favor a security interest is created. And, Section 3(31) further defines security interest in wide terms to include within its scope right, title, interest, or claim to a property created in favor of or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, etc. Relying on the aforesaid provisions, the State claimed that the statutory charge created by Section 48, Gujarat VAT Act, 2003 was a security interest under Section 3(31) and State was a secured creditor under Section 3(30) of IBC. 

The State further argued that the approved resolution plan waived the tax claims and was not in accordance with Section 30(2), IBC which inter alia enjoins a resolution professional to examine each resolution plan received by him and ensure that liquidation costs are met and payments to operational creditors are not less than they would be received in event of liquidation. The Supreme Court accepted this argument and observed that a resolution plan that does not meet the requirements of Section 30(2) would be invalid and would not be binding on the State or Union to whom a debt in respect of dues arising under any law for the time being in force is due. (para 48)

The Supreme Court’s understanding of the scope and mandate of Section 30(2) is fair and reasonable until it applied its understanding to the facts of impugned case. As per Supreme Court, a resolution plan must be rejected by an adjudicating authority if the plan ignores statutory demands payable to State government or a legal authority altogether. (para 52) And that a Committee of Creditors cannot secure its dues at the cost of statutory dues owed to the Government. (para 54) Thus, if a company cannot repay its debts – including statutory dues – and there is no contemplation of dissipation of its debts in a phased manner, then the company should be liquidated, its assets sold, and proceeds distributed as per Section 53, IBC, 2016.   

The above observations mean that a resolution plan of corporate debtor is contrary to Section 30(2), IBC, 2016 if it waives statutory dues. This observation casts too wide a tax net, and would possibly mean that tax waivers for corporate debtors would inevitably make the resolution plan violative of IBC, 2016 defeating the purpose of reviving distressed companies. If the tax burden of a corporate debtor – significant or otherwise – cannot be waived to ensure its revival, and every tax outstanding tax demand must be necessarily or in some proportion to be satisfied, that places an onerous burden on a distressed company. Some elbow room needs to be available to final a resolution plan that may waive some outstanding tax dues to revive the company in question.  

State as a Secured Creditor 

The other issue that the Supreme Court had to navigate was whether the non-obstante clause of Section 48, Gujarat VAT Act, 2003 would prevail over the non-obstante clause contained in Section 53, IBC. The Supreme Court held that the two provisions are not in conflict with each other as the latter cannot override the former since the State is a secured creditor. It noted: 

Section 3(30) of the IBC defines secured creditor to mean a creditor in favour of whom security interest is credited. Such security interest could be created by operation of law. The definition of secured creditor in the IBC does not exclude any Government or Governmental Authority. (para 57)

The above cited conclusion of the Supreme Court is clearly contradictory to the understanding that prevailed before this decision and the text of Section 53, IBC. Secured creditors are a separate category under Section 53, IBC while dues owed to the Union or State – that are to be credited either to the Consolidated Fund of India or the State – are a separate category. Since, the latter have been clearly demarcated as a separate category it is evidence that the legislators did not intend to club them with secured creditors. The only reasonable explanation for including State as a secured creditor was if the taxes due to the State were not mentioned as a separate category in Section 53, IBC. However, when dues payable to State have clearly been mentioned as a separate category, there is little justification to include State in secured creditor category. Merely by observing that the definition of secured creditor does not expressly exclude State from its definition, does not necessarily lead to the conclusion that State is included. Provisions of IBC need to be interpreted harmoniously, and Court should have taken cognizance of the definition of secured creditor alongside the waterfall mechanism under Section 53, IBC to arrive at a more reasonable conclusion. 

Review of Rainbow Case 

An application to review the decision in Rainbow case was filed, inter alia, on the ground that the Supreme Court in a subsequent decision had cast suspicion on the Rainbow case. The Supreme Court in PVVN Ltdcase noted that the judgment in Rainbow case ‘has to be confined to the facts of that case alone.’ (para 53) It clearly doubted the correctness of the judgment and observed that Parliament’s intent to accord to lower priority to State’s dues was clear from Section 53, IBC. Relying on the observations of the PVVN Ltd, a review was filed against the Rainbow decision. The Supreme Court dismissed the review and held that in Rainbow case all the relevant provisions were correctly and categorically reproduced, and the ‘well- considered judgment’ should not be reviewed. (para 27)    

Conclusion 

The decision in Rainbow case is an apt example of the misinterpretation and the error is blatant because there is no ambiguity in Section 53, IBC and the ‘silence’ in the definition of secured creditor was unjustifiably interpreted in favor of the State. By interpreting the definition of secured creditor and security interest in an unjustifiably wide manner, the Supreme Court completely upturned the priority of payments prescribed under Section 53, IBC. And while some of us make take solace in the fact that the decision in Rainbow case will be confined only to the facts of that case, it is just polite speak for a decision that goes against the plain text and intent of IBC. And what does ‘confined to facts of the case’ really mean? If any statute creates a charge in favor of State, Rainbow case is applicable? Or anytime taxes due are waived from a resolution plan, Rainbow case is applicable? The answers aren’t clear.  

In my view, Rainbow case is an example of misinterpretation of IBC, and no less. The suggestion that its applicability is confined only to the facts of the case cannot hide the misinterpretation of relevant provisions of IBC, specifically the scope and meaning of secured creditor.    

Intersection of Trusts, DTAAs, and IT Act, 1961: Profile of ADIA Case

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Abu Dhabi Investment Authority (‘ADIA’) is currently embroiled in a tax dispute in India that involves questions about its eligibility to claim tax benefit under India-UAE DTAA, recognition of foreign trusts in India, and interpretation of provisions of IT Act, 1961 on taxability of revocable trusts and their representative assessees. The Bombay High Court, in October 2021, held that ADIA was entitled to avail the tax exemption under India-UAE DTAA despite ADIA making the investments and earning income through a trust registered in Jersey. The High Court held that AAR’s ruling – against which an appeal was filed before the High Court – that ADIA was not entitled to tax exemption was erroneous. An appeal against the High Court’s decision is currently pending before the Supreme Court. I rely on the High Court’s judgment to highlight some of the novel questions that arise in the case.   

Facts 

The case involves Green Maiden A 2013 Trust (‘trust’) settled in Jersey. ADIA was both the settlor and sole beneficiary of the trust while Equity Trust (Jersey) Ltd. was the trustee. Under its Deed of Settlement, the trust was a revocable trust and ADIA in its capacity as a settlor contributed two hundred million dollars in the trust. ADIA’s reasons for settling the trust and using it for investment in India were that UAE did not offer a legal framework for settling trusts or incorporating a sole shareholder subsidiary company. Also, ADIA preferred making illiquid investments through separate legal entities which ensured it does not have to directly deal with portfolio companies. The trust through which ADIA made investments was registered with SEBI under the relevant Foreign Institutional Investor and Foreign Portfolio Investor regulations.     

ADIA’s case was that since the capital contribution made to the trust were revocable, any income earned by trust on investments made in India should be treated as income of ADIA itself. Under Article 24, India-UAE DTAA, any income earned by Government of one of the Contracting States is exempt from tax, and in case of UAE, Government includes ADIA. If the income of trust was treated as income ADIA, the income would be eligible for exemption under the said provision. The Revenue resisted such interpretation by arguing that the income was of the trust registered in Jersey and India-UAE DTAA could not be invoked, but the Bombay High Court rejected the Revenue’s assertion.     

Relevant Statutory Provisions 

Before I dig deeper into the issues and arguments, it is important to highlight the relevant provisions of IT Act, 1961:

Section 61, IT Act, 1961 states that all income arising to any person by virtue of a revocable transfer of assets shall be chargeable to income tax as the income tax of a transferor and shall be included in his total income. Section 63, IT Act, 1961 states that a transfer shall inter alia be revocable if it in any way gives transferor a right to reassume power directly or indirectly over whole or any part of the income directly or indirectly. And Section 63(b) specifically states that transfer shall include a trust. Finally, Section 161(1)(iv), IT Act, 1961 states that a “representative assessee” means in respect of income which a trustee appointed under a trust declared by a duly executed instrument in writing whether testamentary or otherwise, receives or is entitled to receive on behalf, or for the benefit, of any person, such trustee, or trustees. 

Arguments on Income and DTAA 

ADIA’s argument was that as per the Deed of Settlement, ADIA has the right to terminate the trust before end of its term, ADIA can re-assume power over entire income arising from investments in portfolio companies as well as principal amount in portfolio companies meaning that all capital contributions made or to be made by ADIA were revocable transfers under Section 63, IT Act, 1961. Thus, in view of Section 61, all income from investments made by trusts shall be chargeable as part of total income of the transferor/settlor, i.e., ADIA.

ADIA made an alternative argument and argued that even presuming Section 61 was inapplicable, under Section 161(1)(iv) the trustee, i.e., Equity Trust (Jersey) Ltd. can only be taxed ‘in the like manner to the same extent’ as the beneficiary. Thus, the income assessed in the hands of the trustee ‘will take colour’ of that of ADIA’s income and will be eligible for exemption under Art 24, India-UAE DTAA. (para 14) The argument that the tax liability of the representative assessee is co-extensive with that of the assessee is on firm footing especially if one reads Section 166 whereunder the Income Tax Department is not barred from directly proceeding against the assessee. For example, it can proceed either against the trustee or beneficiary of a trust for recovery of tax. Either way, ADIA added, it is the beneficial interest in trust that that is taxable in the hands of the trustee and not the corpus of the trust. And more importantly, as per ADIA, any income for which the representative assessee/trustee is liable is income of the beneficiary.  

The Revenue’s arguments were that: first, there is no DTAA between India and Jersey, thus the trust which was settled in Jersey was taxable as a non-resident under IT Act, 1961; second, Indian Trusts Act, 1882 will not be applicable to foreign trusts though it conceded that there is nothing in the IT Act, 1961 which suggests that Sections 60-63, 161, 166 will not be applicable to foreign trusts; lastly, that ADIA would have been eligible for tax exemption under Art 24, India-UAE DTAA if it had invested in India directly.     

The High Court decided in favor of ADIA by interpreting the relevant provisions of IT Act, 1961 strictly. I elaborate on the High Court’s observations below.        

Recognition and Validity of Trusts 

There were two major aspects regarding trusts that were discussed in the case: first, as per ADIA, Sections 61-63, 160, 161, and 166 do not expressly state that they are not applicable to foreign trusts; second, was whether the settlor of a trust can also be its beneficiary.

The Bombay High Court approached the first issue in a straightforward fashion and noted that there is nothing in Sections 61 and 63 that restricts their applicability to foreign trusts and the argument that India has not ratified the Hague Convention on the Law Applicable to Trust and their Recognition does not resolve the issue one way or the other. (para 26) The High Court relied on H.M.M. Virkamjit Singh Gondal case to note that even foreign trusts are recognized under the IT Act, 1961. As regards the second issue, the High Court relied on Bhavna Nalinkant Nanavati case to note that the only restriction on trusts is that the settlor cannot be the trustee and sole beneficiary of a trust, while in the impugned case the settlor – ADIA – was only a beneficiary and not trustee which is permissible. 

Once the applicability of IT Act, 1961 to foreign trusts was established, and correctly so, the High Court’s other conclusions relying on other relevant judicial precedents were inevitable and resolved the issues satisfactorily.      

Merit(s) of High Court’s Decision  

The Bombay High Court’s decision is laudable for evaluating the factual matrix appropriately and applying the relevant law. Since the decision is currently under appeal and pending before the Supreme Court, any comment on the outcome of the case is mere speculation for a distant observer. Nonetheless, a perusal of the Bombay High Court’s decision reveals certain merits in its reasoning and conclusion. 

Most notable aspect of the Bombay High Court’s decision is its engagement with the intent of Sections 60-64, IT Act, 1961, colloquially referred to as ‘clubbing provisions’. AAR, as per the High Court, had noted that the intent of clubbing provisions is to ensure that a taxpayer does not circumvent tax payments by ensuring that it does not receive income from a property but still retains control over that property. The High Court observed that AAR’s observation that if ADIA had invested directly in India, it would have been exempt from tax does not appreciate why ADIA had not directly invested in India. The reason, the High Court noted, as been explained in detail by ADIA, was commercial expediency. Again, this is a correct understanding and optimum application of the relevant provisions to the commercial transactions. Clubbing provisions have an anti-tax evasion intent and are intended to prevent use of devices such as trust for tax evasion. But, if an entity is entering into commercial transactions which makes it difficult to obtain a tax benefit, then the commercial reasons for such transactions should be understood. However, acknowledging commercial reasons and commercial expediency is a tricky territory and needs to be navigated appropriately. The combination of facts in the impugned case justified High Court’s conclusion, but commercial expediency cannot always be treated as sacrosanct to determine eligibility for tax benefits and may not be a prudent approach in all factual scenarios.  

Further, it is indeed novel that the Income Tax Department was emphasizing on the formal nature of transaction while the taxpayer was trying to underline the substance of it. The former was arguing that since the investment was made by a trust from Jersey, ADIA cannot claim tax exemption under India-UAE DTAA while ADIA was trying to emphasise that since it was the settlor of a revocable trust and its beneficiary, the income of Jersey trust was effectively ADIA’s income. Typically, one witnesses the Income Tax Department trying to invoke substance of a transaction to justify taxation or recharacterize the transaction. The roles seemed to have reversed in the impugned case.  

Finally, the case also reflects the intricate nature of trusts and how determining their taxability is sometimes more peculiar than that of other forms such as corporates. The revocable/irrevocable nature of trusts, their discretionary nature, foreign trusts, representative assessees all add layers that make their taxability an intricate affair, as in the impugned case. 

Water Cess: States Run into a Constitutional Hurdle

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Two States – Himachal Pradesh and Uttarakhand – in their attempts to generate additional sources of revenue have run into constitutional hurdles. Both States attempted to levy a ‘water cess’, a tax on use of water by power generation companies but the Courts declared the same as unconstitutional. Both the Himachal Pradesh High Court and the Uttarakhand High Court have declared the respective levies of both States as unconstitutional. The High Courts of both States held that while the States are terming the levy as a water cess/tax, it was in effect a tax on electricity and States do not have the power to levy tax on electricity. In this article, I focus on the nature of tax, State’s competence, and the possible ramifications of the judgments on State’s efforts to generate additional sources of revenue. 

Cess on ‘Drawl of Water’ or ‘Generation of Electricity’

Both the legislations – of Himachal Pradesh and Uttarakhand – levied tax on drawl of water of generation of electricity. The Himachal Pradesh Water Cess on Hydropower Generation Act, 2023 (‘Act of 2023’)in the Statement of Objects and Reasons stated that the water cess on hydropower generation will be imposed on consumption of water and head available in the project, which is the difference in levy at entry and exit of water conductor system. The Himachal Pradesh High Court referred to the relevant provisions of the Act of 2023 and observed that it was clear that water cess was not on ‘water’ but on ‘water drawn for hydropower generation’. And since there is no generation of electricity without drawl of water, in the absence of generation of electricity no water cess is imposed. 

The Himachal Pradesh High Court also referred to the Notification issued under the Act of 2023 wherein the tax rates were determined by considering the head-height and not the quantum of water. The greater the height from which water falls on the turbine, greater the momentum resulting in electromagnetic field causing generation of electricity meant, as per the High Court, that the tax was on user of water, but user of water for generation of electricity. The High Court added that it was clear that if tax was on quantum of water, then height from which the water fell would be irrelevant and that:

            The “use of water” in fact does not go by the text of the impugned Act. It is “generation of electricity” that is the “bone” and “water drawn” is only the “flesh”. The taxable event is “hydropower generation” and not the “usage of water” because if there is no generation, there is no “tax”. Moreover, if the cess was on “usage of water”, then how could the height, at which the water falls on the turbine, be made the taxable event? (para 41)     

The Himachal Pradesh High Court was clear that the nature and character of water cess was such that it was inextricable with electricity generation, and it was a misnomer that the tax was levied on water and not on generation of electricity. (para 42)

The Uttarakhand High Court made similar observations vis-à-vis the Uttarakhand Water Tax on Electricity Generation Act, 2012 and observed that the user for the purpose of water tax was not a person who draws water, but a person who draws water for the purpose of generation of electricity. And further the measure of tax was not the volume of water used, but the units of electricity generated which was evident from the fact that for different heights different tax rates were prescribed. The High Court observed:

The measure of tax definitely is as per cubic meter water used but it depends on the height available for power generation. Higher the height, more is the tax per cubic meter water. Had it been tax on mere drawal of water, there would have been no necessity to correspond the use of water with the height available for power generation. (para 178) 

The measure of the tax, the Uttarakhand High Court concluded was on generation of electricity, thus the tax was in pith and substance a tax on generation of electricity and not on use of water. (para 179)

 The Himachal Pradesh High Court and the Uttarakhand High Court, correctly understood the nature of tax. Both the High Courts correctly adopted the approach of looking at the substance of the levy, and were not guided by its nomenclature alone. In doing so, they were able to correctly identify the nature of levy and concluded that it was not on use of water, as claimed by States, but on its use for generation of electricity. 

State’s Competence 

States tried to justify their competence to levy the impugned water cess/water tax by relying on and referring to various legislative entries of the Seventh Schedule. Some of the legislative entries of List II, that were referred to were: Entry 49 which provides for ‘Taxes on lands and buildings’, Entry 50 which provides for ‘Taxes on mineral rights subject to any limitations imposed by Parliament by law relating to mineral development’, Entry 45 which provides ‘Land revenue, including the assessment and collection of revenue, the maintenance of land records, survey for revenue purposes and records of rights and alienation of revenues’, Entry 17 which states ‘Water, that is to say, water supplies, irrigation and canals, drainage and embankments, water storage and water power subject to the provisions of entry 56 of List I as well as Entry 18 which provides for ‘Land, that is to say, right in or over land, ..’

While the High Court spend considerable space in interpreting each of the legislative entries, there are three broad points worth mentioning: first, water cess/ tax could not be justified by States by relying on Entry 17 or entry 18 since these are general legislative entries and taxes can be levied by States or the Union only by referring to tax legislative entries; second, water cess/tax could not justified as a tax on minerals, because while States argued that water is a mineral as held in Ichapur case, the Court’s observation in Ichapur was in the specific context of Petroleum & Mineral Pipelines (Acquisition of Right of User in Land) Act, 1962 and could not be applied in the impugned case; and third, the High Courts refused to interpret the water cess/tax as a tax on land despite State’s assertion that water flows on land, and land includes water and air because the High Courts refused to give an unusually wide interpretation to the term land and also High Courts were not convinced that there is a proximate relation between the water cess/tax and the land. The Uttarakhand High Court summarized its observations on the issues as: 

Now, this Court has held that in the instant case, the water drawn from the source though falls on generator attached to land, but it is not use of water on land and it is also not land revenue for the simple reason because it is not only fall of water on land, but it is use of water for electricity generation that makes a taxable event. The pith and substance of the Act is water tax for generation of electricity. Therefore, the State Legislature is not competent to levy the tax under E 45 and 49 L II of S VII. (para 181) 

The States were on the backfoot in their attempt to justify that the water cess/tax was within their legislative competence. And the drafting of statutory provisions and Notifications for tax rates, left little doubt that the tax was on generation of electricity, but the nomenclature used was that of a water tax. Equally weak was the State’s attempt to justify water as part of land. Finally, it is worth pointing out that the High Courts did not give enough credence to financial necessity of States to adjudicate a constitutional issue and correctly so as the need for additional sources of revenue cannot triumph Constitutional limits.   

Revenue Ramifications for States 

The revenue ramifications of States not being able to levy water cess are likely to be multiple. The obvious one is that States with rich water resources will not be able to use these water resources for generating additional revenue, at least for now. The Statement of Objects and Reasons of The Himachal Pradesh Water Cess on Hydropower Generation Act, 2023 clearly stated that the State of Himachal Pradesh has limited revenue generation resources, it faces financial constraints and the immense water resources can be used as a useful source for revenue generation. Similar reasons can be assigned to the State of Uttarakhand, in fact, the levy of water by the latter was one of the reasons cited by the State of Himachal Pradesh to levy its water cess. But, as I mentioned above, these reasons cannot inform interpretation of the Constitution, even if Constitutional constraints lead to revenue squeeze for States.  

Successive Finance Commissions in their awards have enjoined States to explore additional revenue sources. While the recommendations of the Finance Commissions are well meaning, there are major hurdles for States to explore additional sources of revenue. To begin with, the distribution of tax bases under the Constitution is such that the taxes with greater buoyancy and wider bases have been allocated to the Union. And since 2017, relatively lucrative indirect taxes in State’s domain have been subsumed under GST. To the extent, States are being innovative such as by levying water cess, they are testing and also understanding the limits of their competence. While in the impugned cases, Courts have rightly not upheld the water cess, it will take equally innovative and proactive measures from various States to further test their taxation powers in their attempts to be able to finance themselves and not become increasingly dependent on the Union for their finances. 

Conclusion    

Both the judgments discussed above rely on a wide set of judicial precedents to determine the scope of each of the legislative entries that States used to justify their legislative competence. The High Courts correctly identified the nature of levy and its substance and relied on the relevant statutory provisions and Notifications to hold the levy as unconstitutional. Of course, the States can redraft the legislations in constitutionally compatible manner since resource crunch is a recurring issue. The thing worth seeing would be if States modify the way they wish to levy water cess/tax or will they now focus their efforts at trying to find other sources of revenue.  

Kerala versus Union: Dispute Lingers 

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The dispute between the State of Kerala and Union of India involving disagreement on the latter’s scope of power to restrict debt levels of the former, was referred to a Constitution Bench by the Supreme Court. Previously, I’ve written about the dispute, likely issues, and interpretive questions that Kerala’s petition is likely to raise. In this article, I comment on the Supreme Court’s latest order where it has summarized the arguments raised by both Kerala and the Union of India and enlisted the issues involved.

Summary of Arguments 

The overarching issue, to recall briefly, is that under Section 4, Fiscal Responsibility and Budget Management Act, 2003 the Union is obligated to ensure that total debt of the Union and State Governments does not exceed 60% of Gross Domestic Product (‘GDP’) by end of the Financial Year 2024-25. In a letter dated March 27, 2003 the Union imposed a ‘Net Borrowing Limit’ on Kerala and the flashpoint is that the Union included the borrowings of State-owned enterprises in the limit, a move Kerala views as unconstitutional and unprecedented intrusion on its borrowing powers.   

Kerala’s arguments inter alia included that under Article 293 of the Constitution, the Union cannot impose conditions on all loans of a State government, but only on loans sought by the Union; second, liabilities of State-owned enterprises cannot be included in the borrowing limit. Kerala made two additional arguments, which prima facie seem contradictory. As per Kerala if it has underutilized the borrowing limit in the previous years, it should be allowed to use it in the current year while if it has over-borrowed in the previous years before Financial Year 2023-24, it cannot be adjusted against the net borrowing limit of the current Financial Year. A joint reading of the latter two arguments makes it seem that Kerala wants the benefits of under borrowing, but no hazards of over borrowing. Though the true import of the arguments may play out in full detail in the Court at a later stage and I discuss one further aspect of these arguments below. 

The Union’s response was to categorise the dispute under the broad umbrella head of public finance and argue that the fiscal health of India will be in jeopardy if Kerala is allowed to borrow beyond its ceiling limit. And that the Union’s determination of the ceiling limit by including loans of State-owned enterprises in the limit is precisely to prevent State’s from bypassing the ceiling limit imposed under FRBM Act, 2003. 

A preliminary survey of the arguments as summarized by the Supreme Court suggests that Kerala is trying to keep the dispute closer to the scope of Article 293, persuade the Court to adopt a narrow reading of the provision, and thereby preserve its right to borrow more money. The Union, on the other hand, has suggested that the issue is more proximate to the national debt management, public finance, and perhaps overall management of the economy. By suggesting that the larger issue of national finance and economy is involved, the Union gets to suggest that it has a pre-eminent power to regulate the economy and State’s rights should cede in favor of nationwide economic management. The legal issue that should cut across is that the Union’s power to regulate economy cannot traverse beyond the Constitutionally allocated powers. The Union’s power to regulate economy is not an all-pervasive power. Every power must be traced to a Constitutional provision and the Supreme Court will have to determine the outer limit of such power, which in the absence of any precedents is a tough ask.  

Littany of Issues 

The Supreme Court in its impugned order enlists certain ‘corollary’ questions that arise from Kerala’s petition and impact the fiscal federal structure envisaged under the Constitution. Some of these questions include: Whether fiscal decentralization is an aspect of Indian federalism? What are the past practices relating to regulating borrowing of the States? And whether they can form basis of legitimate expectations of the States? Whether the restrictions imposed by the Union in conflict with the role assigned to the Reserve Bank of India as manager of public debt of the State? 

The foundation question, from a constitutional law standpoint is: whether fiscal decentralization is an aspect of Indian federalism? Indian federalism, relating to economic relations of the Union and States has, for decades, largely revolved around allocation of taxation powers and rarely on public debt management. This is perhaps because the latter has never been the site of contestation or because it has not been vital to the federal relations. Supreme Court’s framing of the question is interesting as the query is does not relate to allocation of powers on public debt but whether public debt can be viewed as part of fiscal federalism. And if the answer is yes, what are the implications? Again, questions that may not have easy answers. Public debt is managed by various 

The Supreme Court also framed other questions such as: Does Article 293 of the Constitution vest a State with an enforceable right to borrow money from the Union and/or other sources? Whether borrowing by State owned enterprises can be included in scope of Article 293(3) of the Constitution? Answering all these questions will require an inquiry into intent of the Constituent Assembly, past practice, and their relevance to the current dispute.  

While the Supreme Court may have termed the above questions as corollary, I doubt they are likely or should be viewed as corollary. Perhaps the questions are incidental to the immediate dispute at hand, but certainly not from the standpoint of constitutional law. Corollary or principal questions, the Supreme Court has acknowledged that since Article 293 has not been the subject of an authoritative interpretation by the Supreme Court, all the questions fell within the scope of Article 145(3) of the Constitution and should be decided by a five-judge bench of the Supreme Court. 

Injunction is Ousted 

Kerala pleaded for a mandatory injunction and requested that the Union should undo the imposition of net borrowing ceiling limit and restore the position that existed before imposition of the limit. The Supreme Court denied Kerala the injunction by agreeing with the Union’s argument on overutilization. As per the Supreme Court, Kerala’s argument that over borrowing in certain financial years is irrelevant once the net five-year period of a successive Finance Commission commences is not prima facie convincing. The Union’s argument was that if Kerala or any other State over borrows during certain financial years, then the borrowing ceiling can be adjusted in subsequent financial years even if the subsequent financial years are within the 5-year period of a new Finance Commission. In the impugned case, Kerala’s argument that both underutilization and overutilization of borrowing limit has to be made within the 5-year period of a Finance Commission was based on its reading of select paragraphs of the Finance Commission reports. For example, the 15th Finance Commission specifically stated that the adjustments can be made ‘within our award period’. (para 12.64) But, whether the 15th Finance Commission meant that adjustments can be made ‘only’ within its award period is not clear. To be sure, the Supreme Court has only made prima facie determination in favor of the Union and refused to grant Kerala an injunction. But, whether the refusal of injunction would cause irreparable harm to Kerala will be known in the future.     

Conclusion 

While hitherto our understanding and framing of Union-State economic relations has only centred around the issues of taxation, the issue of public debt has remained dormant and outside the lens of law. This case presents an opportunity to understand the statutory framework on public debt in tandem with the constitutional framework, and by extension the nature of State’s right to raise money from the market including whether Courts understand the power of a State to raise money as a right itself. Equally, this case may determine if the term fiscal federalism can encompass public debt in its scope. Finally, it is worh seeing if the Courts adopt an approach of deference, a well-entrenched judicial approach on all matters of taxation law. Or will it treat economic management, nationwide economic interests as justification in themselves and excuse itself from examining the underlying constitutional issues in a significant and meaningful manner.     

‘Simple and Non-Controversial’: Section 13A, IT Act, 1961

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Section 13A was introduced in the IT Act, 1961 via the Taxation Laws (Amendment) Act, 1978 (‘1978 Act’) to grant income tax exemption to political parties. The then Minister of Finance, Shri H.M. Patel, introduced Taxation Laws (Amendment) Bill, 1978 in the Lok Sabha and remarked that it was ‘a simple and non-controversial bill’ and he trusted that it would receive unanimous support of all the parties. The 1978 Act was solely dedicated to clarifying income tax obligations of political parties and did not contain provisions on any other subject. The Lok Sabha debate that followed reflected anything but a unanimous view, and the provision, as some recent developments suggest, are no longer non-controversial. This article – relying on Lok Sabha debate on Taxation Laws (Amendment) Bill, 1978 – aims to examine the rationale for Section 13A, IT Act, 1961 with an aim to provide an informed context to income tax obligations of political parties. To begin with, it is pertinent to provide a brief summary of the scope of Section 13A.    

Reasons for Income Tax Exemption to Political Parties 

When Shri H.M. Patel introduced the Taxation Laws (Amendment) Bill, 1978 in the Lok Sabha, he provided several reasons for introduction the exemption. He reasoned that political parties are central in a democratic setup and that they spend a considerable amount of money in carrying out their political activities. Thereby if income of political parties is subjected to income tax it would reduce their disposable funds hampering their capacity to carry out their legitimate activities from their legitimate sources of income. Thereby, Shri H.M. Patel reasoned it was necessary to exempt income of political parties derived from any of their investments in movable and immovable assets.

There are two noticeable aspects in the reasons articulated by Shri H.M. Patel: first, the attempt to place political parties at the epicentre of democracy; second, the emphasis on legitimate activities and legitimate sources of income. The former is debatable to some extent, but I will focus on the latter. The latter was clearly suggestive of the fact that not just excess, even some taxation on income of political parties results in them using illegitimate funding. This argument, of course, is as old as tax law and can be used by anyone. But, typically the argument is framed on the foundation of excess taxation, i.e., excessive tax/high tax rates incentivizes taxpayers to indulge in tax evasion and accumulation of unaccounted money. While in the context of Taxation Laws (Amendment) Bill, 1978, the suggestion seemed to be that taxation per se reduces space for political parties to indulge in legitimate activities from legitimate sources. The Minister never argued that taxation rates were an issue, he simply stated that levying tax on political parties hampered their activities. And there was no vociferous or principled opposition to the tax exemption, except by a handful of members who alleged that the party in power was trying to benefit from the tax exemption. 

Income from Souvenirs 

A substantial part of the Lok Sabha debate touched on Section 37(2B), IT Act, 1961 which was added to disallow expenditure of companies on advertisements purchased in souvenirs published by political parties. To understand the importance of souvenirs as a source of income in 1978, it is important to remember that donations by companies to political parties was banned at that time. (Imagine that happening today!) Instead, companies used to purchase advertisement space in souvenirs published by political parties to contribute to income of political parties. Shri H.M. Patel argued that the companies were not purchasing these advertisements on commercial considerations but to circumvent the ban on company donations. Also, to claim deductions on their profits. He reasoned that to plug this loophole, Taxation Laws (Amendment) Bill, 1978 proposes that expenses of companies towards advertisements in souvenirs shall not be eligible for deduction. Various members considered this provision as a half-baked attempt to plug the loophole, and instead advocated for a complete ban on advertisements by companies in souvenirs of political parties. A complete ban on advertisements would have halted a lucractive source of money for political parties and unsurprisingly the provision was not amended and only restricted companies from claiming deductions on advertisement expenses.  

I’m unsure how much souvenirs contribute towards income of political parties presently, though the provision relating to disallowance of souvenirs remains on the book. However, as has been pointed elsewhere the innovative use of coupons helps political parties earn income without necessarily showing it on their books of account. Coupons are issued by political parties in return for donations and can also be issued for small amounts of five or ten rupees. In the absence of any upper cap on coupons or regulatory guidelines on issuance of coupons, they are a known, but not well-documented avenue for political parties to channelize unaccounted money. 

Scope of Section 13A

So, what is the scope of Section 13A and does it offer complete tax exemption to political parties. Let me summarise its scope. 

Section 13A, in its current form exempts any income of a political party which is chargeable under the head ‘Income from house property’ or ‘Income from other sources’ or ‘Capital gains’ or any income by way of voluntary contributions received by a political party from any person. Originally, the provision exempted ‘income from securities’ as well, but it was deleted in 1988, and ‘capital gains’ was added in 2003, perhaps in accordance with the changing sources of income of a political party.

Section 13A prescribes certain conditions for a political party to successfully claim the income tax exemption under IT Act, 1961. Some of the conditions are: first, the political party keeps and maintains such books of account and other documents as would enable an assessing officer to properly deduce its income; second, in respect of such voluntary contribution in excess of twenty thousand rupees, such political party keeps and maintains record of such contribution and the name and address of person who has made such contribution; third, accounts of such political party are audited by an account. 

Section 13A was amended in 2017 to provide that political parties were not required to maintain records of contributions received through electoral bonds and that, no donation exceeding two thousand rupees is received by such political party otherwise than by an account payee cheque, electronic clearing system or through a bank account or electoral bond. The Supreme Court declared these amendments to Section 13A as unconstitutional.

Compared to the compliance obligations that IT Act, 1961 imposes on various taxpayers, the compliance requirements for political parties can be fairly characterized as ‘light touch.’ The electoral bond scheme – while it existed – made the income tax obligations of political parties even more relaxed and effectively placed political parties outside the ambit of IT Act, 1961. However, political parties were not obeying even the minimum mandate that IT Act, 1961 had imposed on them even prior to 2017. 

Willful Ignorance of Section 13A

Common Cause Society case perhaps best documents the abuse of Section 13A, and laxity of the Income Tax Department towards political parties. The petitioners, Common Cause Society, brought to the Supreme Court’s notice that various political parties were guilty of not fulfilling the statutory conditions prescribed under Section 13A, IT Act, 1961 and yet seemed to enjoy tax exempt status on their income. And that the Income Tax Department was dragging its feet and not ensuring that the political parties comply with their obligations under IT Act, 1961. Some of the political parties that were accused of not filing their income tax returns as per the law were: Bharatiya Janta Party, Indian National Congress, All India Forward Bloc, Janta Party, Revolution Socialist Party among others. 

The Supreme Court held that various political parties have for several years violated the statutory provisions, and the Income Tax authorities ‘have been wholly remiss in the performance of their statutory duties under law.’ The Income Tax Department was directed to take necessary action against the defaulting political parties as per the provisions of IT Act, 1961 and the Ministry of Finance was instructed to conduct an inquiry against the erring officials who did not perform their statutory duties. I’m not privy to the result of these actions as to whether any penalties were imposed on the erring political parties under the IT Act, 1961 or if the erring officers were held responsible for ignoring their statutory duties.       

Conclusion 

Section 13A, IT Act, 1961 was introduced with a particular and narrow objective. While Members of Parliament during the debate correctly highlighted that such the provision favors the political party in power, it does not detract from the fact that all political parties enjoy the income tax exemption and need to satisfy identical conditions to lawfully obtain the exemption. As Common Cause Society case showed us, even the minimal statutory requirements are rarely fulfilled by all political parties. It is this culture of impunity that has afforded an opportunity to the current BJP government to target the Indian National Congress. The timing and aggressive behavior of tax authorities hardly signals a bona fide attempt at enforcing the IT Act, 1961 because history clearly suggests that income tax authorities have ignored contravention of IT Act, 1961 by political parties. At the same time, the Income Tax Department has ample legal cover to argue that Section 13A has not been complied with. Whether similar enthusiasm will be shown in ensuring compliance by political parties in power is yet to be seen.   

Including Capital Gains within Scope of Income: A Short Note from Tax History

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Provisions to tax capital gains in India’s income tax law were first included in 1947. The Act XII(22) of 1947, amended Income Tax Act, 1922 (‘IT Act, 1922’) – predecessor to India’s current income tax statute, IT Act, 1961 – and expanded the definition of income to include capital gains. The expansion of definition of income was subject of a judicial challenge where the Bombay High Court and thereafter the Supreme Court concluded that the term income can encompass capital gains, though Justice Chagla – then at the Bombay High Court – had a different opinion. The different reasonings offer us a small glimpse of the understanding of the term income seven decades ago, and wider interpretive challenges at the interface of constitutional law and tax law that continue until today. 

Amendment of 1947 

The Act XII (22) of 1947 introduced certain amendments to the IT Act, 1922 to bring capital gains within the net of income tax. A new definition of capital asset was inserted under Section 2(42A) where it was defined as property of any kind held by an assessee whether connected with his business, profession, or vocation. Section 6 was amended to include an additional head of capital gain, and definition of income was expanded include any capital gain chargeable under Section 12B. In turn, Section 12B stated that capital gains shall be payable by an assessee under the head capital gains in respect of any profits or gains arising from sale, transfer or exchange of a capital asset effectuated after 31.03.1946. The Bombay High Court correctly noted that the amendments aimed to levy tax on capital gains earned through sale, transfer or exchange and not on the entire value of the underlying capital asset. Levying tax on the realised gains continues to be the commonly accepted and widely adopted definition of capital gains tax.   

Challenge on Grounds of Legislative Competence

The legislative competence to enact the amendment was the subject of a judicial challenge before the Bombay High Court and thereafter the Supreme Court. The Bombay High Court noted that the central question before it was whether the Union was competent to enact the amendment in view of the provisions of Government of India Act, 1935. The High Court noted the relevant legislative entries in List I of the Seventh Schedule that required interpretation were:

Entry 54, List I stated: ‘Taxes on income other than agricultural income.’ 

Entry 55, List II stated: ‘Taxes on the capital value of the assets, exclusive of agricultural land, of individuals and companies; taxes on the capital of companies.’ 

The Bombay High Court, through Justice Chagla and Justice Tendulkar pronounced an interesting judgment wherein both the judges upheld the vires of the amendment but reasoned differently. Justice Chagla, in his opinion, emphasised on the distinction between income and capital and opined that he need not be guided by the reasonable or common interpretation of the term ‘income’, but instead it is important that he relies on legislative practice. He referred to the relevant cases British cases and concluded that ‘capital accretion could never have been looked upon as income by an English lawyer’ and it was not correct to give a connotation to the word income that was foreign to legislative practice. Justice Chagla concluded that taxes on income could not include taxes on capital accretion. 

Justice Tendulkar though opined that relying on legislative practice was only appropriate when the term in question was ambiguous. Also, that income has been held to not include capital accretion only in the context of taxation laws and the cases do not restrict the scope of the term income outside taxation laws. This distinction may seem specious, because in the impugned case, the scope of the term income was also in reference to a tax statute, i.e., IT Act, 1922, even if indirectly. At the same time, it is true that the immediate query was whether income can include capital gains under the legislative entry – Entry 54, List I. Justice Tendulkar accordingly observed that merely because the term income is interpreted narrowly for purposes of income tax law, does not mean it acquires a similar meaning outside taxation law. The term income as used in Entry 54, List I could be interpreted differently as compared to the term income as used in a tax statute. Justice Tendulkar further reasoned that words should be given their natural meaning and concluded that the term income under Entry 54, List I was wide enough to include capital gains AS contemplated under Section 12B, IT Act, 1922. 

While both judges of the Bombay High Court adopted different reasoning in their opinions, both concluded that the provisions inserted in IT Act, 1922 were intra vires the Government of India Act, 1935. The difference was that Justice Chagla’s view was that the amendment was covered by Entry 55, List I while Justice Tendulkar was of the view that Entry 54, List I was wide enough to include the amendment relating to capital gains within its ambit. Justice Tendulkar’s reasoning though left one question unanswered: if capital gains could be included in Entry 54, List I, was Entry 55, List I redundant? The latter specifically included taxation on capital value of assets in its ambit. One could argue though that Entry 55, List I only included taxation on capital value of assets and did not contemplate taxation on capital gains. This interplay of both the legislative entries was not addressed adequately by Justice Tendulkar.     

Supreme Court Interprets Income Liberally  

In appeal against the Bombay High Court’s judgment, the Supreme Court expressed its agreement with the view adopted by Justice Tendulkar. The Supreme Court made two crucial observations: first, in citing legislative practice, the Bombay High Court observed that legislative practice deducted by citing the judicial decisions only revealed interpretation of the term income in the context of tax statutes and it does not necessarily narrow the natural and grammatical meaning of the term income; second, the Supreme Court observed that the words used in a legislative entry should be construed liberally and in their widest amplitude. Thus, the Supreme Court concluded that the impugned amendment was intra vires Entry 54, List I and it was unnecessary to state if the amendment was within the scope of Entry 55. Supreme Court’s judgment which aligned with Justice Tendulkar also suffered from similar limitation of not adequately addressing the interplay of both the entries: Entry 54, List I and Entry 55, List I.    

Capital Gains = Income 

One takeaway from the High Court and Supreme Court decisions is that income wasn’t intuitively understood to comprise capital gains, until as recent as 1947. Taxation on capital gains is such an integral part of our contemporary income tax laws that the notion of capital gains not being included in the scope of income may seem otherworldly to contemporary tax lawyers. Yet the process of expansion of income to include within its scope capital gains wasn’t a straightforward process as evident in the case discussed above. In fact, the only debates since 1947 have been about rationalizing capital gains provisions and not their place in income tax laws per se. While jurisprudence has grown on the distinction between revenue and capital receipts, and arguments that the latter are not taxable unless there is an express charging provision to that effect; the wider place of capital gains under income tax law is never under challenge per se. At least not directly.     

Another aspect that is worth pointing in some detail is the interpretive tools that judges used to determine the meaning of the term income and capital gains. Legislative practice, reasonable interpretation of the term, as well as the notion of liberal interpretation of legislative entries all interlocked to determine the fate of India’s first attempt to include capital gains in the universe of income tax laws. The judges also observed that to hold that the term income has been crystallised would act against any attempt to further enlarge the definition of income, and would imply that no further amendments to the definition of income are possible. Though I doubt that the intent of arguing that income excludes capital gains was to imply that the definition of income is permanent. The argument that capital gains cannot form part of income was based on the understanding of income as a regular or recurring source of monetary benefit while capital gains was understood as a rare or at least a non-regular means of benefitting monetarily and thereby outside the ambit of income.  

No Service Tax on Carried Interest: GST Applicability Remains an Open Question

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In a recent decision the Karnataka High Court has held that a Venture Capital Fund (‘VCF’) is not liable for service tax on carried interest. The decision reversed Customs, Excise & Service Tax Appellate Tribunal’s (‘CESAT’) ruling which was under appeal. CESAT had held that service tax was payable by the VCF primarily on the grounds that a VCF constituted as trust can be considered a person and that the doctrine of mutuality was not applicable to it since it further invests the money of its contributors with third parties, breaching the mutuality. The High Court viewed the VCF as a pass-through entity and viewed the asset management company appointed by trustee as the service provider. The decisions take contrary stands on whether VCF constituted as a trust is a person, its role, and the applicability of doctrine of mutuality. And while we do seem to have some answers about the taxability of carried interest under service tax regime, the same issue under GST regime remains an open question. I focus on the role of trusts and doctrine of mutuality in this article.  

Role of VCFs and Investment Managers

The appellants before the Karnataka High Court were established as a trust under the Indian Trusts Act, 1882 and registered as a VCF with Securities and Exchange Board of India (‘SEBI’). The appellants were managed and represented by a trustee. The terms and conditions in the formation of the appellant’s trust were contained in the Indenture of Trust, an offer document inviting subscribers and contributors to be part of the trust. The trust in turn appointed an investment manager to handle the funds of contributors. The Revenue Department demanded service tax on the expenses incurred by the trust – which they argued should have been characterized as service income as well as service tax on disbursement of carried interest to Class C unit holders in the VCF, i.e., typically the investment manager itself, among other trust expenses which were sought to be characterized as income of the VCF. Service was demanded under the head of ‘banking and financial services’ under Sec 65, Finance Act ,1994.   

Returns on investments are termed as carried interest, and as per the Indenture of Trust, the contributors receive the same as per the terms stated in the trust. Since the investment manager can and does invest alongiwth the contributors, it becomes entitled to carried interest on its investment in addition to the performance fee charged by it for its services. The former money is paid to it in its capacity as an investor and the Revenue’s case was that it should be subjected to service tax, though the applicability of service tax on the latter was not in dispute. CESAT’s understanding of the arrangement was that the trust was engaged in asset management and was responsible for managing the funds of contributors until delegated to the investment manager. (para 40.2) The Karnataka High Court, on the other hand, observed that VCF does not make any profit or provide any service and merely acts as a ‘pass through’ wherein funds from contributors are consolidated and invested by investment managers. VCF acts a trustee holding the money on behalf of the contributors and invests the money as per advice of the investment manager. (para 21) The latter understanding is proximate to the real nature of transaction and it was influential in the High Court’s conclusion that no service tax was payable by VCF. However, CESAT in overemphasizing the role of trust in the entire transaction arrived at the questionable conclusion that trust was providing banking and financial services by indulging in asset management of its contributors. CESAT was persuaded by the Revenue’s argument that carried interest paid to investment manager was a disguised performance fee and should be subject to service tax, an argument that – if one reads the two decisions – is not entirely proven by facts.       

Trust as a Person and Doctrine of Mutuality 

The appellant’s argued that trust was not recognized as a person and thus cannot be held liable to tax. The appellant’s further argument was that VCF, constituted as trust, was not providing any service to the contributors, and expenses incurred by the trust cannot be considered as consideration for ‘services’. Also, the appellant added, assuming but conceding, that the trust was providing a service – no service tax was payable due to the doctrine of mutuality. There was complete identity between the trusts and its contributors. The appellants relied on the jurisprudence of doctrine of mutuality, with the Calcutta Club case being the focal point of reference. The doctrine of mutuality postulates that when persons contributed to a common fund in pursuance of a scheme for their mutual benefit, having no dealings or relations with any outside body, they cannot be said to have traded or made profit from such mutual undertaking since there the identity of the persons and the mutual undertaking is the same. 

CESAT rejected all the above appellant’s arguments. CESAT noted that VCF is registered as a fund under the SEBI VCF Regulations and under the Regulations it is treated as a body corporate and it should be treated as such for tax purposes too. CESAT held that: 

As the Trusts are treated as juridical persons for the purposes of SEBI Regulations, we do not find any reason as to why they should not be treated so for the purpose of taxation. (para 37.4)

On the same issue, the Karnataka High Court took an opposite view and held that while SEBI and other legislations may treat a trust as a juridical person, the relevant statute for the purpose of service tax liability is Finance Act, 1994 and the latter does not treat trust as a juridical person. The High Court held that definitions of each statute must be read with the object and purpose of that statute as intended by the legislature and accordingly refused to treat trust as juridical person for the purpose of Finance Act, 1994. (para 15)

The Karnataka High Court’s emphasis on the intent and context of each legislation is vital. It is important to note that courts should be circumspect before importing definitions of one statute into another, unless there is complete silence on the issue in the latter. In the context of tax, the issue is even more vital as the general rule of construction of tax statutes is that a burden cannot be imposed on an assessee, unless expressly stated in the statute. It thus follows that if an entity is not expressly regarded as an assessee, it cannot be subjected to tax.  

As regards the applicability of doctrine of mutuality, the Karnataka High Court gave a succinct  and correctfinding. The High Court observed that the trust and its contributors cannot be dissected into two distinct entities because the contributors investment is held in trust by the fund and investments the money on the advice of investment manager. Thus, the trust cannot be held liable for providing service to itself. CESAT had a different opinion and noted the doctrine of mutuality as applied in various cases in India was in the context of member clubs where the contributions were made by members and the clubs were not pursuing profits. While in the impugned case the main purpose of VCF was to earn profits. The CESAT observed that VCF had violated the principle of mutuality by engaging itself in commercial activity and using its discretionary powers over funds to benefit a certain class of investors. Relying on the Calcutta Club case, the CESAT rejected the applicability of the doctrine of mutuality. 

While attributing profit to VCF was not incorrect, CESAT’s understanding of the scope of discretion VCF possessed over the funds of its contributors and the importance placed to profit motive is perhaps misplaced. Profit motive of an entity that collects funds does not per se rule out the applicability of the doctrine of mutuality. And if the trust in this case was retaining some money as expenses for holding the money, it was per the terms of trust and that factor also is relevant but not determinative in ruling out the doctrine of mutuality. While it is important to understand the context of previous decisions, the scope and applicability of the doctrine needed a better articulation in the CESAT’s decision.  

Finally, CESAT relied on ‘common parlance’ to state that no common man would consider VCF trusts like clubs. Here again, the reliance on a common man’s view of the role, object, and relevance of VCF is inaccurate as the tribunals are bound to consider the statutory definitions and not rely on an elastic and ambiguous understanding of entities as adopted in common usage.      

GST and Doctrine of Mutuality 

The doctrine of mutuality already has a small history under the GST regime. In reaction to the Supreme Court’s decision in Calcutta Club case, the definition of supply was amended – with retrospective effect – and the following clause was added via Finance Act, 2021:

(aa) the activities or transactions, by a person, other than an individual, to its members or constituents or vice-versa, for cash, deferred payment or other valuable consideration. 

The Explanation stated that notwithstanding anything contrary contained in any judgment or decree, the person and its members or constituents shall be deemed to be two separate persons and the supply of activities or transactions inter se shall be deemed to take place from one person to another. While the above clause, does signal to a significant extent that doctrine of mutuality is truly buried, and has not survived the 46th Constitutional Amendment, despite the Supreme Court holding otherwise, its applicability to the specific context of VCFs and carried interest remains uncertain and untested. This also because trust is included in the definition of a person under Section 2(84)(m), CGST Act, 2017 meaning that arguments relevant in the impugned case may not be entirely transferable to similar demands of tax under GST.    

Conclusion

CESAT’s decision created turmoil as VCFs have never been understood to be service providers, but only conduits for channeling the investments and holding the money in trust. The actual investment advice is provided to the contributors by the investment management company. CESAT overemphasized the role of trust, to some extent misunderstood the nature of payments, and decided that trust was acting as a service provider. The Karnataka High Court has corrected this position, but its applicability and relevance is for service tax levied under the Finance Act, 1994. We yet do not know if similar demands will made under GST and their likely fate. 

Portuguese Civil Code, Income Tax, and Companies Act: Understanding Beneficial Ownership 

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The Bombay High Court, in a recent judgment, had to unravel the interplay of Portuguese Civil Code, IT Act, 1961, and the Companies Act, 1956 – among other issues – to ascertain the tax liability of assessees. While the case involved other issues, I will focus on the beneficial ownership aspect and how the assessees understood it and the High Courts’ response to the same.   

Introduction  

The appellant in the case, along with his two brothers each held around 30-33% of shares in private limited companies which were engaged in the business of construction and hospitality. All the three brothers were married to their spouses in terms of the Portuguese Civil Code (‘Code’) as applicable to the State of Goa. Under the Code, in the absence of any ante nuptial agreement between the spouses, each of them had 50% right to their common estate. The IT Act, 1961 acknowledges the applicability of the Code and to that extent, under Section 5A provides that: 

            Where the husband and wife are governed by the system of community of property (known under the Portuguese Civil Code of 1860 as “Communiao Dos Bens”) in force in the State of Goa and in the Union Territories of Dadra and Nagar Haveli and Daman and Diu, the income of the husband and of the wife under any head of income shall not be assessed as that of such community of property (whether treated as an association of persons or a body of individuals), but such income of the husband and of the wife under each head of income (other than the head “Salaries”) shall be apportioned equally between the husband and the wife and the income so apportioned shall be included separately in the total income of the husband and of the wife respectively, and the remaining provisions of this Act shall apply accordingly.    

For the Assessment Year 2011-12, the appellant filed the return on income on 29.09.2011 under Section 139(1) of the IT Act, 1961, comprising of income under various heads. The return was processed on 27.09.2012. A search was conducted on 30.01.2012 in the premises of one of the companies in which the appellant was a registered shareholder and subsequently was issued a notice requiring filing of their revised returns for the Assessment Years from 2006-07 including those of 2011-12. The appellant replied that the returns filed on 29.09.2011 be treated as the returns in response to the notice. The appellant also submitted detailed explanations and documents. The Assessing Officer rejected explanations of the appellant and added income under Section 2(22)(e) of the IT Act, 1961 and held that the payments made to the appellant in various transactions through the companies was deemed dividend. Similar additions were also made to the incomes of wives of all the three brothers. 

After a series of contrary decisions at the Assessing Officer and Commissioner level, the ITAT held that the amounts were correctly added to the income of appellant against which the latter approached the Bombay High Court. On the issue of beneficial ownership, the question before the High Court was: the appellant who holds 33% of the shares in company can by virtue of being governed by the Code said to be holding only 16.5% shares with his wife being the beneficial owner of the other half? Why was the extent of shareholding – 33% or 16.5% – important? This is because under Section 2(22)(e) of the IT Act, 1961, for a loan or advance made by a private company, to be considered as a deemed dividend, it is important that such payment is made to a person holding a substantial interest, subject to fulfilment of other conditions. And under Section 2(32) of the IT Act, 1961 a ‘person who has a substantial interest in the company’ in relation to a company, means a person who is the beneficial owner of the shares, not being shares entitled to a fixed rate of dividend whether or without a right to participate in profits, carrying not less than 20% of the voting power.  Section 2(22)(e) read with Section 2(32) of the IT Act, 1961 meant that for the purposes of appellant, if his shareholding in the company was adjudged to be 16.5% and not 33%, the deemed dividend provision would not apply to it.       

The appellant’s argument thus was: Under the Code, in a contract of marriage, the ownership and possession of common assets vests in both the spouses during the subsistence of marriage. Where the husband is 33% registered holder of the shares in a company, his wife is the beneficial owner of half (16.5%) of the shares in company. The argument ran into the hurdle of Section 187C, Companies Act, 1956.  

Section 187C, Companies Act, 1956

Section 187C (1), Companies Act, 1956 provides that any person whose name is entered in the register of members of a company but does not hold beneficial interest in the shares shall make a declaration to the company specifying name and particulars of the person who holds the beneficial interest. Sub-section (2) further provides that a person who holds beneficial interest in a share or shares of a company shall make a declaration the company specifying the nature of interest.   

Relying on the mandate of Section 187C(1) and (2), the Revenue argued that under Section 187C of the Companies Act, 1956 the appellant was under an obligation make declaration to the company about who holds beneficial ownership of shares but having failed to do so, now cannot take advantage of the Code to claim beneficial ownership. Further, the Revenue argued that the Code which provides for communion of assets between spouses is not applicable to shares of companies since only the person whose name is in the Register of Shareholders of the company has the voting rights based on shares held by him and that voting right cannot be divided between the two spouses.  

The appellant though contested the Revenue’s argument and stated that Section 187C of Companies Act, 1956 only applied where beneficial shareholding was created through contract and not by virtue of the operation of law, in this case, the Code. The appellant’s view, as per the High Court, would imply that two class of shareholders could be created – those bound by Section 187C, while those exempt from Section 187C since they were governed by the Code. But was this distinct and separate class of shareholders recognized under the Companies Act, 1956? The High Court answered in the negative. 

Examining the relevant provisions of Companies Act, 1956 the High Court correctly concluded that only a person who agrees to Memorandum of Articles of a company, or a person who holds equity capital in the company, and whose name is entered as beneficial owner of shares can claim to be a member of the company. And only a member of the company shall hold voting rights in the company in proportion to the capital owned. No third person can claim to be a member or hold voting rights. The High Court’s conclusion was that Companies Act, 1956 was a complete code in itself and it ‘does not does not envisage a situation where by virtue of a personal law applicable to a shareholder of a company, the spouse of such shareholder could claim voting rights in a poll to pass resolutions or, for that matter, claim a privity of contract to bind herself to the Memorandum of a Company and the Articles of Association of such company.’ (para 57) 

The High Court’s conclusion did not disrupt the position under the Code in that each spouse is entitled to 50% of the assets. However, the High Court was clear in its opinion that the Code not per se or automatically disrupt internal scheme of the Companies Act, 1956.  

Narrow Understanding of Beneficial Ownership? 

The concept of beneficial ownership is acknowledged under all the above-mentioned relevant provisions of the IT Act, 1961 and the Companies Act, 1956. The question is if the concept needs to be understood and interpreted as per the objectives of the provision and statute in question, and whether there is parity in the concepts of both the statutes? The Bombay High Court’s opinion was that the terms ‘beneficial owner of shares’, ‘shareholder’, ‘member’ used in Section 2(22)(e) of IT Act, 1961 only meant registered shareholder or registered beneficial owner whose name is in the register of shareholders. To this extent, it was correct in stating that there was an equivalence in the concepts under both the statutes – IT Act, 1961 and Companies Act, 1956.

However, was the High Court’s opinion, that the wife is not a beneficial owner of shares unless her name is registered a narrow understanding of the concept of beneficial ownership and does it dilute one of the core ideas contained in the Code. Prima facie, yes. But, as the High Court justified, personal law cannot create a relationship between the wife and other members of the company. Such a relation must be and can only be created under the Companies Act or there needs to be an express provision acknowledging the overriding effect of the personal law. The accommodation to the Code is provided in Section 5A of the IT Act, 1961, but a similar and comparable provision is absent in the Companies Act, 1956. In such a scenario, while the concept of beneficial ownership seems to be narrowly interpreted by the Bombay High Court, it shows fidelity to the provisions that governed the concept and issue at hand.

Further, it is worth thinking if the wife was registered as a beneficial owner of 16.5% of shares, if and how the outcome would have differed? The outcome, in my view, would have been in favour of the appellant, but not because of operation of the Code but because of proof of compliance with the Companies Act which would have created evidence of beneficial ownership. Again, the concept of beneficial ownership is acknowledged, but only if the prescribed formalities under the Companies Act are followed. This to be seems a reasonable and defensible approach towards the interplay of the Code and Companies Act.     

Unfamiliar Terrain of Loyalty Points and GST

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Levying GST on atypical forms of consideration is a familiar problem under GST regime. One such problem relates to the levy of GST on vouchers issued by a supplier. While we have a modicum of certainty on the interface of vouchers and GST, on another form of consideration, i.e., loyalty points, applicability of GST remain a source of intrigue. In this article, I elaborate on some of the challenges posed by issuance of loyalty points and the unanswered questions about the levy of GST on their issuance, cancellation, among other aspects. 

Identity of Loyalty Points

The first challenge is accurately identifying loyalty points. It is unclear if loyalty points can be classified as actionable claims, vouchers, or a form of money. One advance ruling relating loyalty points has stated that loyalty points, until they are valid, constitute as actionable claims. However, after their expiry period, they cease to be actionable claims. AAR’s reasoning was that after the expiry date of the loyalty points, the customer can no longer redeem them and loses any right over them. Since the customer loses the right to initiate legal action in relation to their loyalty points after their expiry, they cease to be actionable claims. AAR however, stopped short of identifying the nature of loyalty points after their expiry period. AAAR, in an appealagainst the ruling, took the same view.  

During the hearing before AAR, the Revenue Department commented that loyalty points do not amount to actionable claims but chose in possession. The Department emphasized that actionable claims comprise of two kinds of claims: (a) claim to unsecured debt; and (b) claim to beneficial interest in a movable property. And argued that since the beneficial interest in movable property was in the possession of customers the loyalty points cannot be termed as actionable claims but instead should be characterized as chose in possession. 

It is difficult to buy the distinction between actionable claims and chose in possession articulated by the Revenue Department. Actionable claims rarely cease to be such merely because the beneficial interest in the movable property is in the possession of the customer. Chose in possession tends to be broader concept encompassing a bundle of rights over an object, and the possession of the object is not determinative of its character. Further, the identity of loyalty points also overlaps with the definition of vouchers. Section 2(118), CGST Act, 2017 defines voucher as an instrument where there is an obligation to accept it as consideration or part consideration for a supply of goods or services or both and where the goods or services to be supplied or identities of potential suppliers are indicated on the instrument itself. It is difficult to argue that loyalty points constitute as an ‘instrument’ and can strictly speaking, be considered as vouchers as defined under CGST Act, 2017 even though loyalty points would typically fulfil remaining ingredients enlisted in definition of the voucher. 

While High Courts have termed gift vouchers as actionable claims, money, and vouchers as defined under CGST Act, 2017, it is difficult to state if loyalty points can be satisfactorily included in any one of the three categories even if they are analogous with gift vouchers often issued by suppliers to retain and cultivate loyal customers. The context and facts would require examination to accurately determine the identity of loyalty points as it is possible that they are identified in different categories depending on their nature and purpose of use.

Prima facie, it does seem that loyalty points satisfy the definition of an actionable claim. Though, if loyalty points are used in consideration or part consideration of a supply of goods or services, they can be considered as vouchers provided one adopts a broad view of what constitutes as an ‘instrument’ in the definition of vouchers. Irrespective, the identity of loyalty points under the GST regime remains an open question.    

Taxation of Loyalty Points 

The GST consequences of issuance, use, redemption, and expiration of loyalty points remains an equally open-ended question partially, if not substantially, because the identity of loyalty points is not established. The levy of GST in respect of loyalty points has multiple dimensions: their effect on the value of supply, time of supply, and whether the expiry of loyalty points constitutes an independent supply. The last question was the subject of attention in an advance ruling. 

In the advance ruling, the applicant was responsible for managing loyalty points issued by one of its clients to its customers. The applicant charged GST on the service fee it charged its clients for managing their loyalty point program. The client used to pay the applicant Rs 0.25 per loyalty point as issuance charge. If the customer redeemed the loyalty points, the applicant would Rs 0.25 per loyalty point redeemed by the customer to the client. If the customer did not redeem the loyalty points and/or if the loyalty points expired, the applicant would forfeit and retain the amount equivalent to Rs 0.25 per loyalty point. AAR had to answer the question whether the forfeiture of amounts equivalent to expired loyalty points was consideration for actionable claims and whether it would be subject to GST? As mentioned above, AAR held that loyalty points were actionable claims until they expired but ceased to actionable claims after their expiry. AAAR held the same. The other related question was the issue of consideration. AAR held that the forfeiture of amount equivalent to expired loyalty points constituted as revenue for the applicant was issuance fee for the services it provided to its clients for managing their loyalty point programs. The forfeiture amount was consideration for supply of services to its clients in the normal course of business and was part of their remuneration. The forfeiture of expired loyalty points was termed as a supply, and their value was held part of the value of supply. AAAR similarly took the view that consideration for expired loyalty points had flown to the applicant and was its revenue for managing its loyalty point program.  

The advance ruling mentioned above, dealt with specific facts where the loyalty point program of a supplier was managed by a third party. And the taxability of forfeited amount was the specific issue before the advance ruling authority. However, in case, the loyalty point program is managed in-house by a supplier would some of the answers be different? Perhaps. The answers would depend on the terms and conditions underlying the loyalty point program relating to their issuance, redemption, and expiry. Forfeiture of the loyalty points in case of in-house management would not ordinarily amount to a supply, since a third party would not be involved. Neither would any question of consideration arise in such a scenario. 

In another scenario, what if the value of loyalty points reduces at stipulated dates. For example, after 24 months, each loyalty point, instead of being worth Rs 0.25 would be worth Rs 0.10. Would the difference, i.e., Rs 0.15 be treated as consideration? In case of third party managing the loyalty point program, the reduced value is likely to be forfeited by the third party, making it a supply to the extent of the reduced value. In case of in-house management of loyalty point program, the reduced value is unlikely to invite any GST consequences. But, again these are tentative answers and would require scrutiny depending on the terms and conditions of the loyalty program offered by a supplier.     

Conclusion 

This article is a preliminary attempt to highlight some of the GST implications and issues that may arise from the issuance, redemption, and expiry of loyalty points. The aim is to highlight a couple of issues and how the answers are not – currently – straightforward under the GST laws. A parallel aim of the article was also to highlight that loyalty points while comparable are not completely analogous to gift vouchers issued by suppliers and may require customized answers. Though gift vouchers and loyalty points may also intersect in certain circumstances. And further loyalty point programs also differ – third party managed and in-house – and may invite different interpretations and inevitably varied answers.    

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