Two Certainties

There are two certainties in India: Income Tax and GST.

Safari Retreats: Supreme Court Adopts a ‘Strict’ Stance

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The Supreme Court pronounced its judgment in the Safari Retreats case a few days ago. The judgment involved interpretation of Section 17(5), CGST Act, 2017, specifically clauses (c) and (d) read with two Explanations contained in the Section. The judgment has been greeted with a mixed response by tax community with some commending the Supreme Court for adhering to strict interpretation of tax statutes while others criticizing it for misreading the provision and by extension legislative intent. While a lot of ink has already been spilled in writing comments on the judgment, I think there is room for one more view. 

In this article, I describe the judgment, issues involved and argue that the Supreme Court in the impugned judgment identified the issue clearly, applied the doctrine of strict interpretation of tax statutes correctly, and any criticism that the Court misread legislative intent doesn’t have strong legs. At the same time, the judgment is not without flaws. Finally, it is vital to acknowledge that the judgment is an interpretive exercise in abstract as it didn’t decide the case on facts and remanded the matter to the High Court with instructions to decide the matter on merit ‘by applying the functionality test in terms of this judgment.’ (para 67) It is in application of the functionality test where implications of the impugned judgment will be most visible.   

Introduction 

The writ petition before the Supreme Court was a result of Orissa High Court’s decision wherein it read down Section 17(5)(d). I’ve discussed the High Court’s judgment here, but I will recall brief facts of the case for purpose of this article: the petitioner was in the business of construction of shopping malls. During construction, the petitioner bought raw materials as inputs and utilized various input services such as engineering and architect services. The petitioner paid GST on the inputs and input services. In the process, the petitioner accumulated Input Tax Credit (‘ITC’) of Rs 34 crores. After completion of construction of the shopping mall, the petitioner rented premises of the shopping mall and collected GST from the tenants. The petitioner was not allowed to claim ITC against the GST collected from the tenants. The Revenue Department invoked Section 17(5)(d), CGST Act, 2017 to block the petitioner’s ITC claim. It is worth reproducing the relevant Section 17(5)(d) and (e), as they form nucleus of the impugned judgment. 

17. Apportionment of credit and blocked credits.— 

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

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

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

Explanation.––For the purposes of clauses (c) and (d), the expression ―construction includes re-construction, renovation, additions or alterations or repairs, to the extent of capitalisation, to the said immovable property; 

Another Explanation is appended to Section 17, after Section 17(6), which states as follows: 

Explanation.––For the purposes of this Chapter and Chapter VI, the expression ― “plant and machinery”means apparatus, equipment, and machinery fixed to earth by foundation or structural support that are used for making outward supply of goods or services or both and includes such foundation and structural supports but excludes— 

  1. (i)  land, building or any other civil structures; 
  2. (ii)  telecommunication towers; and 
  3. (iii)  pipelines laid outside the factory premises. 

The Revenue’s argument was that the petitioner constructed an immovable property, i.e., a shopping mall on his own account and ITC in such a situation is blocked under Section 17(5)(d). The Orissa High Court read down Section 17(5)(d) and allowed the petitioner to claim ITC by reasoning that denial of ITC would lead to cascading effect of taxes. The High Court crucially did not examine if the shopping mall could be categorized in the exemption of ‘plant or machinery’. While the High Court’s judgment is not an exemplar of legal reasoning, it triggered a debate on the permissibility of petitioner’s ITC claim and the Supreme Court has clarified some issues through its judgment.  

Arguments 

Petitioners 

The Supreme Court, in the initial pages of the judgment, laments that the arguments in the case were repetitive and cajoles lawyers to make brevity their friend. (para 6) I will try and summarise the arguments from both sides by paying heed to the above suggestion.  

Petitioners argued that denial of ITC under Section 17(5)(d) amounted to treating unequals equally. Petitioners argued that renting/leasing of immovable property cannot be treated the same as sale of immovable property. There is no intelligible differentia since the transactions are different. Latter does not attract GST while the former is subject to GST. There is no break in chain in case of petitioners since both input and output are taxable under GST and blocking of ITC will lead to cascading effect of taxes and defeat a core objective of GST. It was further argued that the provision suffered from vagueness since the phrase ‘on its own account’ was not defined, and use of two different phrases – ‘plant or machinery’/ ‘plant and machinery’ – and their meanings were not sufficiently clarified by the legislature. 

A ‘three-pronged’ argument of the petitioner stated that claim of ITC could be allowed without reading down Section 17(5)(d). The three prongs were:  

First, clause (d) exempts ‘plant or machinery’ from blocked credit while the Explanation after Section 17(6) is applicable to ‘plant and machinery’. Thus, the Explanation is inapplicable to the clause (d). This point is further underlined by use of the phrase ‘plant or machinery’ in clause (c) indicating that the two phrases – ‘plant and machinery’/‘plant or machinery’ are different. Explanation to Section 17(6) effectively states that land, building and other civil structure cannot form ‘plant and machinery’; if the Explanation cannot be applied to clause (d) a building such as a shopping mall can be categorized as a ‘plant’ on which ITC is not blocked.  

Second, it was argued that malls, hotels, warehouses, etc. are plants under Section 17(d). Stressing on strict interpretation of statutes and need to avoid cascading effect of taxes, the petitioners specifically added that the term ‘plant’ should include buildings that are an ‘essential tool of the trade’ with which the business is carried on. But, if it is merely a ‘setting within which the business’ is carried on, then the building would not qualify as a plant.

Third, it was argued that supply of service under Section 7 of CGST Act, 2017 read with Clause 2 of Schedule II includes leasing and renting of any building including a commercial or residential complex. And ITC accumulated on construction of such property should be available against such service. This argument seems to address the issue of blocking of ITC under Section 17(5) indirectly and advocated for a seamless availability of ITC. But this argument side steps the fact that a transaction can amount to supply under Section 7, and yet ITC on it can be blocked under Section 17. 

The first argument though was the most crucial argument, as the latter part of this article will examine.  

The State

The State’s arguments oscillated from sublime to the ridiculous. The State argued that  classification of the petitioners with assessees who constructed immovable property and sold it was based on intelligible differentia. And the intelligible differentia was that both kinds of asssessees ‘created immovable property’. The State also mentioned that there was a break in the chain of tax, but this is not true for petitioner since renting of premises in the shopping mall was taxable. The petitioners were paying GST on their inputs and collecting GST on the output, i.e., renting of premises of shopping mall. The break in tax chain, as the petitioners rightly argued was only when an immovable property is sold after receiving a completion certificate as in such transactions output is not subject to GST. Further, State stressed that ITC is not a fundamental or a constitutional right and thus State has the discretion to limit the availability/block ITC. While ITC not being a right is now a well-established legal position, the State’s justification for blocking ITC in this case lacked an express and cogent reason.  

The State further argued, unsuprisingly, that the phrase ‘plant or machinery’ should be interpreted to mean ‘plant and machinery’. As per the State, it was not uncommon to interpret ‘or’ to mean ‘and’. I’m terming this argument as unsurprising because this is not a novel argument in taxation matters and the State even had a few authorities to back this view. The State though did admit that the phrase ‘plant or machinery’ occurs only once in Chapters V and VI of the CGST Act, 2017 while the phrase ‘plant and machinery’ occurred ten times. The existence of both phrases in the CGST Act, 2017 proved crucial in the final view taken by the Supreme Court that both phrases have a different meaning. Finally, the State also cited ‘revenue loss’ as a reason for disallowing ITC. It was argued that the petitioner could claim ITC while renting/leasing the mall, but the mall would be sold after 5 or 6 years and on such sale no GST would be paid since GST is not payable on sale of immovable property sold after receiving a completion certificate. This would cause a loss to the exchequer. This again is a curious argument: if sale of immovable property does not attract GST as per the legal provisions, how can non-payment of GST in such cases cause a ‘loss’ to exchequer? Further, if blocking of ITC is done to prevent such a ‘loss’ then it defeats a central purpose of GST as a value-added tax.   

Despite the voluminous arguments, if one were to identify the core issue in the judgment, it would be whether ‘or’ can mean ‘and’ and further whether a shopping mall could be termed as a ‘plant’. Supreme Court said answered the former in negative and the latter is to be decided by the High Court based on facts of the case and by applying the ‘functionality test’ endorsed by the Supreme Court. 

Supreme Court’s conclusion is based on two pillars: first, reiteration and clear articulation of the elements of strict interpretation of statutes; second, reliance on a variety of judicial precedents to endorse the functionality test. 

First Pillar of the Judgment: Strict Interpretation of Tax Statutes  

To begin with, strict interpretation of tax statutes is a principle that is followed universally and adhered to in most jurisdictions including India. The principle can be summarized can be expressed in a thesis length and has various nuances. In the context of impugned judgment, the Supreme Court highlighted summarized the core principles as: a taxation statute must be interpreted with no additions or subtractions; a taxation statute cannot be interpreted on any assumption or presumption; in the fiscal arena it is not the function of the Court to compel the Parliament to go further and do more and there is nothing unjust if a taxpayer escapes the letter of law due to failure of the legislature to express itself clearly. (para 25) 

Second, while Courts in various judgments have stated that taxation statutes should be interpreted strictly, they have failed to apply the said principle in its true sense. But in the impugned judgment we see a correct application of the strict interpretation principle as evidenced in the following observations of the Supreme Court: 

The explanation to Section 17 defines “plant and machinery”. The explanation seeks to define the expression “plant and machinery” used in Chapter V and Chapter VI. In Chapter VI, the expression “plant and machinery” appears in several places, but the expression “plant or machinery” is found only in Section 17(5)(d). If the legislature intended to give the expression “plant or machinery” the same meaning as “plant and machinery” as defined in the explanation, the legislature would not have specifically used the expression “plant or machinery” in Section 17(5)(d). The legislature has made this distinction consciously. Therefore, the expression “plant and machinery” and “plant or machinery” cannot be given the same meaning. (para 44) 

The Supreme Court in making the above observations clarified that interpreting ‘plant or machinery’ to mean same as ‘plant and machinery’ would amount to doing violence to words in the statute and in interpreting tax statutes, the Courts cannot supply deficiencies in the statute. Dominant part of the reasoning for above conclusion was derived from adherence to strict interpretation, but also that the phrase ‘plant and machinery’ occurred ten times in Chapter V and VI of the CGST Act, 2017 while the phrase ‘plant or machinery’ occurred only once indicating that the legislature intended to use different phrases at different places. Also, the Supreme Court noted that even if use of ‘or’ was a mistake the legislature had ample time since the High Court’s judgment to intervene and correct the error, but it had not done so. Hence, the assumption should be that use of the phrase ‘plant or machinery’ was not a mistake. The bulk of the reasoning though did come from principles of strict interpretation. Both, Supreme Court’s summary of principles of strict interpretation of tax statutes and its application to Section 17(5)(d) read with Explanation to Section 17(6) are a perfect example of crisp articulation of a principle and its application.     

Second Pillar of the Judgment: Functionality Test 

Once the Supreme Court concluded that the phrase ‘plant or machinery’ is distinct from ‘plant and machinery’, it had to interpret meaning and scope of the former phrase since only the latter was defined under Explanation to Section 17(6). The Supreme Court clarified that the expression ‘immovable property other than plant or machinery’ used in Section 17 shows that a plant could be an immovable property. And in the absence of a definition of ‘plant’ in CGST Act, 2017 meaning of the word in commercial sense will have to be relied on. The Court cited a series of precedents where the word ‘plant’ had been interpreted and the ‘functionality test’ had been laid down. Clarifying the import of various precedents, the Supreme Court borrowed the language from previous judicial decisions and expressed the functionality test in following terms: 

 … if it is found on facts that a building has been so planned and constructed as to serve an assessee’s special technical requirements, it will qualify to be treated as a plant for the purposes of investment allowance. The word ‘plant’ used in a bracketed portion of Section 17(5)(d) cannot be given the restricted meaning provided in the definition of “plant and machinery”, which excludes land, buildings or any other civil structures … To give a plain interpretation to clause (d) of Section 17(5), the word “plant” will have to be interpreted by taking recourse to the functionality test. (para 52)

 While the functionality test expressed above provides broad guidelines, there is enough in the test to cause tremendous confusion and uncertainty once it is applied to varied fact situations. For example, the Supreme Court itself clarified that the Orissa High Court did not decide if the shopping mall of the petitioner was a ‘plant’ and the High Court needs to answer the question determine if ITC will be blocked. But even if the petitioner’s shopping mall is held to constitute a plant, it would not mean that all shopping malls will receive similar treatment. Because the Supreme Court clearly says: 

‘Each mall is different. Therefore, in each case, fact-finding enquiry is contemplated.’ (para 56)

The answer on applying the functionality test would depend on facts of each case and similar buildings can be labelled as a plant or not depending on factual variations. While the Supreme Court has clarified that the functionality test is the appropriate framework to determine the eligibility for ITC in the impugned case and other similar cases, the application of it has been left to the High Court for now. Only once several such cases are decided, will be know if coherence is emerging in the interpretation and application of the functionality test. But since the functionality test is highly fact sensitive, we should expect varied answers depending on the underlying fact situation.  

Finally, the Supreme Court helpfully did clarify the import and ratio of the precedents on this issue mostly notably Anand Theatres judgment. In Anand Theatres case, the issue was whether a building which is used for running a hotel or a cinema theatre can be considered as a tool for business and thus a plant for purpose of allowing depreciation under the IT Act, 1961. The Court answered in the negative, but a later decision in Karnataka Power Corporations judgment limited the decision in Anand Theatres case to only cinemas and hotels. The Supreme Court in the impugned judgment also made it amply clear that Anand Theatres case was only applicable for hotels and cinema theatres and could not be used to determine if shopping malls, warehouses, or any other building amounts to a plant.  In clarifying so, the legal position that emerges is that hotels and cinema theatres are not plants while other buildings are a plant or not needs to be determined by applying the functionality test. This was a welcome clarification since there was confusion as to which decision is relevant and applicable in the context of deciding if a building is a plant or not while applying the functionality test.         

Meaning of ‘On Own Account’ Lacks Proper Reasoning 

A notable flaw of the judgment, which in my opinion, should be scrutinized in future decisions is the Supreme Court’s explanation of the meaning of ‘own account’. It interpreted the phrase in following terms: 

Construction is said to be on a taxable person’s “own account” when (i) it is made for his personal use and not for service or (ii) it is to be used by the person constructing as a setting in which business is carried out. However, construction cannot said to be on a taxable person’s “own account” if it is intended to be sold or given on lease or license. (para 32)

The flaw in the above opinion is that it comes from ‘nowhere’. The latter element of ‘own account’ was the petitioner’s understanding of the phrase. But, in the Supreme Court in reaching this conclusion does not cite any authority or how or why does it agree with this interpretation of the phrase. The paragraphs that precede and succeed the above conclusion are focused on Supreme Court’s analysis that clause (c) and (d) of Section 17(5) are distinct and occupy different territories and its view about meaning of ‘own account’ seems to hang in air with no discernible reason to support it. One could argue that the Supreme Court’s interpretation is a commercial understanding of the phrase, but I doubt if adopting commercial meaning of the phrase can be done without stating reasons for subscribing to it. 

Also, the petitioner’s had argued that ‘on own account’ should be restricted to scenarios when a building is used as a setting for carrying out the business, not when it a tool for the business. Supreme Court seems to have endorsed the distinction based on the above cited paragraph. Again, this distinction works well in abstract but applying it to the facts of each case and distinguishing between what is ‘setting for a business’ and what is merely a ‘tool for business’ may not be obvious in each case. 

Implications and Way Forward 

The implications of the impugned judgment are various. To begin with, the phrase ‘plant or machinery’ does not mean the same as ‘plant and machinery’. A clear and unambiguous application of the doctrine of strict interpretation of tax statutes signals and reiterates the need to adopt this doctrine while interpreting provisions of tax law. At the same time, while the Supreme Court has not inaugurated a new test, it has unambiguously thrown its weight behind a well-established test, i.e., functionality test to determine if a plant or fixture in question is a plant. And judicial decisions that have applied the functionality test in the pre-GST and IT Act, 1961 indicate that uniform answers are unlikely as the query is fact specific and so are the answers. Thus, in the foreseeable future as courts adjudicate on this issue, we should expect varied answers and not a classical coherent and uniform jurisprudence on this issue.  

Much Ado About Demo Vehicles: Ambiguity on ITC Clarified

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The CBIC recently issued a Circular clarifying availability of ITC in respect of demo vehicles. The Circular, as I briefly mentioned elsewhere, seems like an exercise in law making rather than a mere interpretation of law. But I will keep that view aside for the purpose of this article. In this article, I focus on the ambiguity that emerged on ITC availability for demo vehicles, due to divergent views of AARs/AAARs, the relevant statutory provisions, and then describe how the recent CBIC Circular clarifies the law. I conclude that the confusion regarding availability of ITC on demo vehicles was avoidable if AARs/AAARs had adopted a more rigorous interpretive approach. However, going forward it may be prudent to align with the CBIC’s view expressed in its latest circular in the interest of taxpayers. 

ITC is Blocked, but there are Exceptions 

Section 17(5)(a), CGST Act, 2017 states that: ITC shall not be available in respect of motor vehicles for transportation of persons having approved seating capacity of not more than thirteen persons (including the driver), except when they are used for making the following taxable supplies, namely –  

(A)  further supply of such motor vehicles; or 

(B)  transportation of passengers; or 

(C)  imparting training on driving such motor vehicles; 

The policy rationale behind blocking ITC for motor vehicles of the above description is unclear and so is the reason for exceptions incorporated in the provision. And while the CBIC in its Circular and AAR/AAARs in some of their rulings have said that they are trying to decipher the ‘intent of law’, the phrase has been used erroneously. Neither the CBIC nor AAR/AAARs have referred to any legislative debates or other legislative instruments to decipher legislative intent behind the above provision. The phrase ‘intent of law’ has been used to merely describe the process of statutory interpretation. In fact, I would argue that the attempt to decipher legislative intent in the above instances is nothing except but second guessing legislative policy. It is best to understand the attempts by AAR/AAARs and CBIC as an attempt to clarify the meaning of the above provision through a process of interpretation. And nothing more.  

Advance Rulings are Decidedly Ambiguous   

The advance rulings – of AAR and AAAR – on the issue can be broadly grouped into two categories: one category has allowed ITC on demo vehicles, while the other category has disallowed it. An overview of both categories of advance rulings is below. 

In one ruling the Madhya Pradesh AAAR expressed its agreement with the AAR and held that the sale of demo vehicle in the subsequent year when depreciation has been charged shall be treated as sale of a second hand vehicle. It negatived the appellant’s contention that there was no time limit for ‘further supply’ of the demo vehicles under sub-clause (A) and that ITC should be available on sale of demo vehicle. AAAR’s emphasis was on the fact that demo vehicles are capitalised by the car dealer and serve a particular purpose for a limited period. Thereafter, the dealer sells the demo car as a second hand car. AAAR refused to engage with the appellant’s argument that the demo vehicles were used for further supply of such motor vehicles, and its focus on depreciation and capitalisation almost nudged the appellant to claim depreciation on the tax component under IT Act, 1961 instead of claiming ITC under GST laws. 

In another ruling, the Haryana AAAR expressed a similar opinion as the Madhya Pradesh AAAR and noted that sale of a demo vehicle is akin to sale of a ‘second hand good’ which is different from a new vehicle and it cannot be said that ‘demo vehicle is for further supply of such vehicles’. Haryana AAAR expressed the apprehension that: 

If the contentions of the applicant is allowed then in that case all the motor vehicles, irrespective of the nature of Supply will be eligible for ITC across the industries. It will no longer be a restricted clause for Car Dealers , but will be an open-clause for all the trade and industry to avail the ITC on all the Vehicles purchased by them. 

As per the Haryana AAAR, the legislative intent was to allow ITC on motor vehicles only in limited conditions such as when there is further supply of such vehicles. However, a demo vehicle is put to different uses and then sold as a second hand good making it ineligible to claim ITC. 

At the same time, other AARs have held that ITC is available on demo cars. Goa AAR, simply held that demo cars are an indispensable tool for providing a trial run to the customers and are used in the course or furtherance of business. Thus, ITC is available on demo cars whenever they are sold. The Bengal AAR, delved a bit deeper into the provision and clarified that claim for ITC under Section 17(5)(a)(A) is not time barred nor is it barred on the ground that the outer supply was made at a lower price than the purchase price. Interpreting the provision in a pointed fashion, the AAR opined that: 

In our considered opinion, the word ‘such’ as used in the expression ‘further supply of such vehicles’ relates to the vehicle only that was purchased. It is a fact that the condition of a demo vehicle at the time of its further supply might have undergone some deterioration from the spick and span condition in which it was at the time of its purchase. But that does not detract from the reality that the vehicle when supplied by a car dealer has ceased to be such vehicle that was purchased. (para 4.11)

The Bengal AAR clarified an important interpretive point which seems to have bypassed other AARs: whether the outward supply should be of the demo vehicle or other similar vehicles? Bengal AAR’s view was that used of the word ‘such’ qualifies and clarifies that outward supply has to be of the vehicle purchased, i.e., the demo vehicle. And the demo vehicle may have deteriorated due to its use by the car dealer, but it does not detract from the intent and scope of the provision. Kerala AAR also took a similar view and held that the demo vehicles are purchased for further supply and sale after their use for a certain period of time. Thus, the sale of such demo vehicles satisfies the requirement of ‘further supply of such vehicles’ as prescribed under Section 17(5)(A) and ITC is available on demo vehicles.  

The denial of ITC on sale of demo vehicles was premised their sale being comparable to second hand goods, the fact that they were capitalised in books of the car dealer while allowance of ITC was based on the fact that demo vehicles were used for furtherance of business and there was no express restriction on ITC even if the demo vehicles were used by the dealer before being sold. Except for the Bengal AAR, no advance ruling provided clarity or attempted to provide it by interpreting if the phrase ‘supply of such motor vehicles’ included only the demo vehicle or other motor vehicles that were sold by using the demo vehicle. To its credit, only CBIC engaged with this crucial interpretive issue in its Circular. 

CBIC Clarifies and Decodes ‘Intent of the Law’ 

CBIC has intervened to clarify the law on the point, since the rulings of various AARs and AAARs failed to provide any certainty and clarity. The Circular notes a few elemental points and clarifies a few crucial ones: 

First, the Circular notes a fairly obvious point: the intent of the law seems clear that based on the nature of outward supplies, ITC in respect of motor vehicles is blocked in several instances. 

Second, that sub-clauses (B) and (C) are inapplicable in situations involving sale of demo vehicles. And only clause (A) of the exception is relevant to determine if ITC can be claimed on sale of demo vehicles. Interpreting the expression ‘such motor vehicles’, the Circular states: 

… the usage of the words “such motor vehicles” instead of “said motor vehicle”, in sub-clause (A) of the clause (a) of section 17(5) of CGST Act, implies that the intention of the lawmakers was not only to exclude from the blockage of input tax credit, the motor vehicle which is itself further supplied, but also to exclude from the blockage of input tax credit, the motor vehicle which is being used for the purpose of further supply of similar type of motor vehicles. (Para 4.4) 

The Circular added that since demo vehicles are used by authorised dealers to provide trial runs to the customers, display features of the vehicle and help consumer purchase similar features, they can be considered by the dealer as being used for making ‘further supply of such vehicles’. Thus, ITC is available in respect of sale of demo vehicles. 

However, the Circular clarifies that when demo vehicles are used to transport employees/management, etc. ITC will be blocked. Equally, ITC will be blocked when the dealer merely uses the demo vehicle for advertising on behalf of the manufacturer and is not directly involved in the sale and purchase of the vehicles. Since in such cases, the invoice is issued by the manufacturer and sale of the vehicle is not made by the dealer on his own account. 

Finally, the Circular also clarified – what should have been obvious and a straightforward conclusion for AAR/AAARs – that capitalisation of demo vehicle in the books of the dealer does not affect the availability of ITC. Under Section 16 read with Section 17 of the CGST Act, 2017, ITC is available on both capital and non-capital goods as long as the goods are used in the course or furtherance of business. In clarifying the capitalisation aspect, CBIC through its Circular has effectively negated a line of inquiry adopted by certain AAR/AAARs that treated capitalisation of the demo vehicles as vital in determining if ITC is available on their sale. 

Conclusion 

The entire saga on availability of ITC on demo vehicles seems like much ado about nothing. The entire issue revolved around whether the demo vehicle can be included in the expression ‘further supply of such motor vehicles’, with the word ‘such’ being crucial. The Bengal AAR interpreted ‘such’ to only include the vehicle in question, while CBIC has adopted a comparatively wider approach and included vehicles purchased to make further supply of similar motor vehicles. Demo vehicles are now undoubtedly included in the expression. But, does this mean – an anxiety expressed by Haryana AAAR – that now ‘all vehicles’ purchased by a dealer could be included in the exception of sub-clause (A) and on all such vehicles ITC can be claimed? Unlikely. The proximate relationship of the purchased vehicle and further supply will need to be established to claim ITC, which can be easily done in case of demo vehicles. Establishing the same would be much tougher for ‘all other vehicles’ that a dealer may purchase. Thus, the anxiety of Haryana AAAR may turn out to be hollow. Or at least it should be unless AAR/AAARs decide to another unwanted twist to the issue.  

Finally, if the AAR/AAARs had kept the interpretive question narrow and focused on the words and expressions of Section 17(5)(a) that demanded an interpretation, we would have had better and perhaps coherent answers to the taxpayer’s queries. The tangents of sale of demo vehicles being akin to sale of second hand vehicles, and undue emphasis on capitalisation of the demo vehicles by AAR/AAARs prevented a more prudent answer from emerging through various advance rulings. Hopefully, we will witness better advance rulings going forward, at least on this issue which seems to have gained great clarity with the issuance of CBIC’s circular.  

Fee for Technical Services: Future Demands Answers

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Introduction 

Tax practitioners tend to refer to Fee for technical services (‘FTS’) and Royalty income in tandem with an intent to highlight the shape shifting nature of both concepts under domestic and international tax law. And in Indian context, the discussion is also about the high volume of litigation that both concepts invite. This article is an attempt to briefly highlight how the term FTS has been interpreted by Indian courts and whether in view of the technological advancements, specifically the ability to offer technical expertise without human intervention – such as with the help of AI bots – presents an opportunity and a challenge to re-orient the jurisprudence. And in which direction and based on which parameters should the reorientation happen? 

Fee for technical services is defined under Explanation 2 to Section 9(1)(vii), IT Act, 1961 as follows: 

Any consideration (including any lump sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel) but does not include consideration for any construction, assembly, mining or like project undertaken by the recipient or consideration which would be income of the recipient chargeable under the head “Salaries”.  

The key phrase – also relevant for this article – that has invited judicial interpretation is: ‘rendering of any managerial, technical or consultancy services’. Courts have, at various times, emphasised the meaning of the above phrase by reading into it certain elements that are not found in the bare text of the provision. The two elements – relevant to this article – are: first, the requirement of providing a service as opposed to merely offering a facility; second, the presence of a human element as courts have taken the view that managerial, technical or consultancy services can be provided only by intervention of humans. The latter element is likely to come under scrutiny in the future as increasingly managerial, technical and, consultancy services are being and will be provided without direct involvement of human beings. The insistence of human element thus cannot and in my view, should not be insisted in each case to determine if a certain payment amounts to FTS. At the same time, will it be prudent to remove the human element altogether? What should be the legislative and judicial response to technological advancements such as AI bots be in this specific case? 

FTS under Section 9, IT Act, 1961: Rendering of Service and Requirement of Human Element 

In interpreting the requirements of Section 9, courts have taken the view that Explanation 2 contemplates rendering of service to the payer of fee and merely collecting a fee for use of a standard facility from those willing to pay for the fee would not amount to receiving a fee for technical services. This view has been reiterated in various decisions. For example, in one case, the Supreme Court was required to decide that if a company in the shipping business provides its agents access to an integrated communication system in order to enable them track the cargo efficiently, communicate better, and otherwise perform their work in an improved manner and thereafter charges the agents on a pro rata basis for providing the communication system, would the payments by agents amount to FTS? The Supreme Court relying on precedents concluded that: 

Once that is accepted and it is also found that the Maersk Net System is an integral part of the shipping business and the business cannot be conducted without the same, which was allowed to be used by the agents of the assessee as well in order to enable them to discharge their role more effectively as agents, it is only a facility that was allowed to be shared by the agents. By no stretch of imagination it can be treated as any technical services provided to the agents.

The service needs to be provided specifically to the customer/service recipient and merely providing access to a standardized facility and charging fee for using that facility would not amount to FTS. The service needs to specialized, exclusive, and meet individual requirements of the customer or user who may approach the service provider and only those kind of services can fall within the ambit of Explanation 2 of Section 9(1)(vii). This requirement may require tailoring in context of AI as a typical AI-assisted solution currently involves a programmed bot that can address a variety of situations. And such a situation raises lots of unanswered questions. Merely because one bot is providing different and differing solutions based on requirements of clients, would it be appropriate to say it is not rendering services? And subscription to the AI bot is merely a fee being paid by various customers? And that only if AI bot is specifically designed and customized to the clients current and anticipated needs would be the payment for such bot be termed as FTS? What if there are only minor variations in the standard bot that is providing services to various clients? The incremental changes would be enough to term the payment for such ‘customised’ AI bot as FTS? 

The second requirement that the Courts have insisted on for a payment to constitute as FTS is presence of human element. This element has been best explained by the Supreme Court in one of its judgments where it noted that the term manager and consultant and the respective management and consultancy services provided by them have a definite human element involved. The Supreme Court noted: 

… it is apparent that both the words ―”managerial” and ― “consultancy” involve a human element. And, both, managerial service and consultancy service, are provided by humans. Consequently, applying the rule of noscitur a sociis, the word ― “technical” as appearing in Explanation 2 to Section 9 (1) (vii) would also have to be construed as involving a human element. (para 15) 

In the impugned case, the Supreme Court concluded that since the services being provided by sophisticated machines without human interface, it could not be said that the companies which were providing such services through machines were rendering FTS. Recently, the ITAT has also observed that the burden is on the Revenue to prove that in the course of rendition of services, the assessee transferred technical knowledge, know how, skill, etc. to the service recipient which enables the recipient to utilize it independently without the aid and assistance of the service provider. This was in the context of an online service provider, Coursera, which the Revenue argued was providing technical services to an educational institute in India. Coursera though successfully argued that it merely an aggregator and all contents of courses had been created by its customers. And it merely provided a customized landing page to the institutions and thus its role cannot be understood as that of provider of a technical service.   

Thus, the jurisprudence is relatively clear on the requirements of rendering a service, customized to the needs of the client and presence of a human element since the former cannot be provided without the latter. But, with the advent of AI and AI-assisted services, this may and should require us to rethink.    

Interpretation of IT Act, 1961 Needs to be Dynamic 

In a abovementioned case, the Madras High Court in interpreting scope of FTS under Section 9, IT Act, 1961 observed that when the provision was enacted human life was not surrounded by technological devices of various kinds and further noted that: 

Any construction of the provisions of the Act must be in the background of the realities of day-to-day life in which the products of technology play an important role in making life smoother and more convenient. Section 194J, as also Explanation 2 in Section 9(1)(vii) of the Act were not intended to cover the charges paid by the average house-holder or consumer for utilising the products of modern technology, such as, use of the telephone fixed or mobile, the cable T. V., the internet, the automobile, the railway, the aeroplane, consumption of electrical energy, etc. (para 17)

If one adopts the above view as one of the guiding principles for interpretation of IT Act, 1961, especially when it comes to the interface with technology, then there is a case to be made that the jurisprudence on FTS under Section 9 – as developed by courts over several years and through various decisions – needs to be keep abreast of the technological advances such as AI. Presence of human element is fundamental to classify a fee or an income as FTS and there is a defensible premise in courts insisting on it. However, as the Madras High noted in its above cited observation, IT Act, 1961 and the Explanation 2 were not drafted by contemplating all kinds of technological developments such AI-assisted services. One could argue, – and again it is a valid point – tax statutes need to be interpreted strictly and that the Courts should not read into the provision that human element is not required for ‘AI dependent services’ or ‘AI assisted services’ unless the statute is amended. But that is only a partial view of the challenge posed by AI. One could also argue that the human element was actually read into the definition of FTS by courts and it is not in the bare provision. Thereby making a case for some de minimis judicial intervention even in interpretation of tax statutes. And courts would be justified in developing a sui generis jurisprudence on FTS-AI interface even without the statutory amendment to that effect.  

I’m not sure of the exact and most appropriate response to the ‘AI-challenge’ and the tax lawyer in me does lean towards a statutory amendment to dispense with the human presence requirement. And this is not solely on the grounds that judiciary needs to adhere to strict interpretation of tax laws but also because a statutory amendment may be able to tailor the definition of FTS vis-à-vis AI in a more suitable fashion as opposed to judiciary-led interpretation which can be ad hoc and not sometimes only suited for limited fact situations. While any response – legislative or judicial – does not seem to be in the near horizon in India, I do believe and it is evident that AI is going to pose significant challenges to collection of taxes, the FTS example which is the focus of this article is only one such challenge. We need to be mindful of such emerging challenges and reflect on them suitably for considered responses catalyze a more appropriate tax policy solution.  

ESOPs-Related Compensation Present an Interesting Dilemma

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Introduction 

Employee Stock Options (ESOPs) are typically taxable under the IT Act, 1961 in the following two instances: 

first, at the time of exercise of option by the employee as a perquisite. The rationale is that the employee has received a benefit by obtaining the share at a price below the market price and thereby the difference in the option price and the market price constitutes as a perquisite is taxable under the head ‘salaries.’ 

second, when the said stocks are sold by the employees, the gains realized are taxed as capital gains. 

In above respects, the law regarding taxability of ESOPs is well-settled. Of late, two cases – one decided by the Delhi High Court and another by the Madras High Court – have opined on another issue: taxability of compensation received in relation to ESOPs. Both the High Courts arrived at different conclusions on the nature of compensation received and its taxability. In this article I examine both the decisions in detail to highlight that determining the taxability of compensation received in relation to ESOPs – before exercising the options – is not a straightforward task and presents a challenge in interpreting the relevant provision and yet one may not have a completely acceptable answer to the issue. 

Facts 

The facts of both the cases are largely similar and in interest of brevity I will mention the facts as recorded in the Madras High Court’s judgment. The petitioner was an employee of Flipkart Interest Private Limited (FIPL) incorporated in India and a wholly owned subsidiary of Flipkart Marketplace Private Limited (FMPL) incorporated in Singapore. The latter was in turn a subsidiary of Flipkart Private Limited Singapore (FPS).

FPS implemented the Flipkart Employee Stock Option Scheme, 2012 under which stock options were granted to various employees and other persons approved by the Board. In April 2023, FPS announced compensation of US $43.67 per ESOP is view of the divestment of its stake in the PhonePe business. As per FPS, the divestment of PhonePe reduced the potential of stocks in respect for which ESOPs were offered to the employees. The compensation was payable to stakeholders in respect of vested options, but only to current employees in case of unvested options. FPS clarified that the compensation was being paid to the employees despite there being no legal or contractual obligation on its part to pay the said compensation. 

The petitioner received US$258,701.08 as compensation from FPS after deduction of tax at source under Section 192, IT Act, 1961 since the said compensation was treated by FPS as part of ‘salary’. The petitioner claimed that the compensation was a capital receipt and applied for a ‘nil’ TDS certificate arguing that the compensation was not taxable under the IT Act, 1961. But the petitioner’s application was denied against which the petitioner filed a writ petition and approached the Madras High Court. 

Characterizing the Compensation – Summary of Arguments  

The petitioner’s arguments for treating the compensation as a capital receipt were manifold: 

First, that the petitioner continued to hold all the ESOPs after receipt of compensation and since there was no transfer of capital assets, no taxable capital gains can arise from the impugned transaction. 

Second, the compensation received by the petitioner was not a consideration for relinquishment of the right to sue since the compensation was discretionary in nature. The petitioner did not have a right to sue FPS if the said compensation was not awarded. 

Third, in the context of taxable capital gains: IT Act, 1961 contains machinery and computation provisions for taxation of all capital gains which are absent in the impugned case. In the absence of computation provisions relating to compensation received in relation to ESOPs and lack of identification of specific provisions under which such compensation is taxable, the petitioner argued that attempt to tax the compensation should fail.    

Fourth, the petitioner before the Delhi High Court was an ex-employee of FIPL and the petitioner relied on the same to argue that the compensation received in relation to ESOP cannot be treated as a salary or a perquisite since it was a one-time voluntary payment by FPS in relation to ESOPs. 

The State resisted petitioner’s attempt to carve the compensation out of the scope of salaries and perquisites. The primary argument seemed to be that the petitioner’s ESOPs had a higher value when FPS held stake in the PhonePe businesss, and on divestment of its stake, the value of ESOPs declined and thus petitioner had a right to sue for the decline in value of ESOPs. The compensation paid to the petitioner, the State argued was a consideration for relinquishment of the right to sue and the said relinquishment amounted to transfer of a capital asset. 

ESOPs are not a Capital Asset – Madras High Court

The Madras High Court was categorical in its conclusion that ESOPs are not a capital asset, and neither was there any transfer of capital asset in the impugned case. Section 2(14), IT Act, 1961 defines a capital asset as – 

  • property of any kind held by an assessee, whether or not connected with his business or profession;

Explanation 1 of the provision clarifies that property includes rights in or in relation to a company.  Since the petitioner did not hold any rights in relation to an Indian company, Explanation 1 was inapplicable to the impugned case. 

The Madras High Court examined the petitioner’s rights and observed that under the ESOP scheme, petitioner had a right to receive the shares subject to exercise of options as per terms of the scheme. And only in case of breach of obligation by the employer would the petitioner have a right to sue for compensation. Apart from the above, the petitioner had no right to a compensation nor was there a guarantee that value of its ESOPs would not be impaired. Accordingly, the Madras High Court correctly held that:  

In the absence of a contractual right to compensation for diminution in value, it cannot be said that a non-existent right was relinquished. As discussed earlier, the ESOP holder has the right to receive shares upon exercise of the Option in terms of the FSOP 2012 and the right to claim compensation if such right were to be breached. But, here, the compensation was not paid for relinquishment of ESOPs or of the right to receive shares as per the FSOP 2012. In fact, the admitted position is that the petitioner retains all the ESOPs and the right to receive the same number of shares of FPS subject to Vesting and Exercise. Upon considering all the above aspects holistically, I conclude that ESOPs do not fall within the ambit of the expression “property of any kind held by an assessee” in Section 2(14) and are, consequently, not capital assets. As a corollary, the receipt was not a capital receipt. (para 29)

The Madras High Court concluded since the petitioner did not exercise any option in respect of vested ESOPs, no shares of FPS were issued or allotted to it meaning there was no transfer of capital asset either. Thus, in the absence of a right to receive compensation for diminution in value of ESOPs or  transfer of capital assets it cannot be said that the petitioner was paid compensation for relinquishment of the right to sue or had received taxable capital gains. 

ESOPs are not Perquisites – Delhi High Court 

The second primary question which engaged both the Delhi and the Madras High Court was whether the compensation received by the petitioner constituted as perquisite under Section 17, IT Act, 1961. Section 17(2)(vi), IT Act, 1961 states that a perquisite includes: 

the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee. 

To begin with, let me elaborate on the Delhi High Court’s reasoning and conclusion. 

In trying to interpret if the compensation received by the petitioner would fall within the remit of Section 17(2)(vi), IT Act, 1961 the Delhi High Court observed that a literal interpretation of the provision reveals that the value of specified securities or sweat equity shares is dependent on the exercise of options by the petitioner. An income can only be included in the definition of perquisite if it is generated by exercise of options by an employee. The High Court added: 

Under the facts of the present case, the stock options were merely held by the petitioner and the same have not been exercised till date and thus, they do not constitute income chargeable to tax in the hands of the petitioner as none of the contingencies specified in Section 17(2)(vi) of the Act have occurred. (para 25)

The Delhi High Court further added that the compensation could not be considered as perquisite since: 

… it is elementary to highlight that the payment in question was not linked to the employment or business of the petitioner, rather it was a one-time voluntary payment to all the option holders of FSOP, pursuant to the disinvestment of PhonePe business from FPS. In the present case, even though the right to exercise an option was available to the petitioner, the amount received by him did not arise out of any transfer of stock options by the employer. Rather, it was a one- time voluntary payment not arising out of any statutory or contractual obligation. (para 27)

The Delhi High Court’s above reasoning and conclusion are defensible on the touchstone of strict interpretation of tax statutes. Unless the stocks were allotted or transferred, the conditions specified in Section 17(2)(vi) were not satisfied ensuring the compensation is outside the scope of the impugned provision. Further, the fact of petitioner being an ex-employee influenced the High Court in de-linking the compensation from employment of the petitioner.   

ESOPs are Perquisites – Madras High Court 

The Madras High Court went a step further than the Delhi High Court and also examined Explanation (a) to Section 17(2)(vi) which states that:

“specified security” means the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees’ stock option has been granted under any plan or scheme therefor, includes the securities offered under such plan or scheme; (emphasis added)

The Madras High Court emphasised three aspects of the Explanation: first, that the petitioner admittedly received the ESOPs under a ‘plan or scheme’, i.e., Flipkart Employee Stock Option Scheme, 2012; second, that the use of word ‘includes’ in the latter part indicates that the phrase ‘securities offered under such plan or scheme’ is not meant to be exhaustive; third, that follows from the second is that ‘specified security’ in the context of ESOPs does not include shares ‘allotted’ but also includes securities ‘offered’ to the holder of ESOPs. 

The Madras High Court further added that in order to tax the compensation received by the petitioner as a perquisite, the benefit flowing to the petitioner must be ascertained. That though was not a difficult task as the High Court noted, in its own words: 

ESOPs were clearly granted to the petitioner as an Employee under the FSOP 2012. If payments had been made by the petitioner in relation to the ESOPs, it would have been necessary to deduct the value thereof to arrive at the value of the perquisite. Since the petitioner did not make any payment towards the ESOPs and continues to retain all the ESOPs even after the receipt of compensation, the entire receipt qualifies as the perquisite and becomes liable to be taxed under the head “salaries”. (para 40)

The Madras High Court’s interpretation of the impugned provision also adheres to a strict interpretation of the statute. And one crucial reason its conclusion differs from that of the Delhi High Court is because the Madras High Court also took note of the Explanation to Section 17(2)(vi) and interpreted it strictly to include within the remit of perquisite not only share allotted or transferred but also shares securities offered under a plan or scheme. And before exercise of options by an employee, the ESOPs can be accurately understood as an offer for securities. 

One could, however, argue as to whether the legislative intent was to tax and include within the remit of perquisite a one-off compensation by the company to a person who had yet to exercise their options or was the intent to cover all kinds of securities offered and allotted to the option grantee. But, the counterargument is that legislative intent is difficult to ascertain in this particular case and the manner in which the Madras High Court interpreted Explanation(a) alongside Section 17(2)(vi) reveals adherence to strict interpretation, which in itself is reflective of manifesting legislative intent. Additionally, one could argue that the compensation is included in ‘value of securities offered’ since it was meant to compensate the option grantee for diminution in value of securities in relation to which ESOPs were offered. One could also argue that the Delhi High Court treated the ‘exercise of options’ as a taxable event under Section 17(2)(vi), which is a correct reading of the provision. And that the High Court not acknowledging Explanation(a) since the latter cannot expand the former’s scope. I do feel that there are several persuasive arguments but not one overarching clenching argument in this particular issue.   

Conclusion 

I’ve attempted a detailed analysis of both the judgments with a view to provide clarity on the interpretive approach and reasoning of both the High Courts on the issue. While both the High Courts adopted a strict interpretive approach, the Madras High Court by taking cognizance of the Explanation alongside the provision arrived at a conclusion that was at variance with the Delhi High Court.

Prima facie though, the provisions as they exist today do not seem to contemplate compensation received by an option grantee before the exercise of options. Regarding ESOPs, there are two taxable scenarios contemplated – on exercise of options and on sale of securities – and taxability of compensation, it seems can only be read into the relevant provisions – specifically Section 17(2)(vi) – by a process of interpretation. As the Madras High Court itself noted the compensation paid in the impugned case was atypical creating the conundrum of whether it was taxable under the relevant provisions. Ambiguity in a charging provision should ideally be resolved in favor of the assessee, but the Madras High Court clearly did not think there was an ambiguity and neither did the Delhi High Court for that matter. Thus, creating a scenario of multiple possibilities with more than one valid interpretive approach.

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

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

Facts 

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

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

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

 Ratio 

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

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

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

The Supreme Court made three observations to support its conclusion: 

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

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

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

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

Enduring Relevance 

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

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

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

   

Single Administrative Interface under GST: Identifying Two Rough Patches  

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

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

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

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

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

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

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

Intelligence-Based Enforcement Action 

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

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

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

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

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

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

Second, it added that:

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

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

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

‘Proceedings’ on Same ‘Subject-Matter’  

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

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

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

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

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

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

Conclusion 

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

SAAR v/s GAAR: Inauguration of an Interpretive Dilemma 

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

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

Petitioner’s Arguments 

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

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

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

Where – 

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

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

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

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

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

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

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

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

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

Revenue’s Arguments 

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

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

High Court’s Observations 

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

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

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

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

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

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

Conclusion

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

Yin-Yang Nature of ITC and Supplier-Purchaser Obligations

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

ITC: Right or a Concession? 

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

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

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

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

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

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

Purchaser’s Reliance on Supplier 

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

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

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

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

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

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

The Kerala High Court added that: 

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

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

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

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

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

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

A Residential House -> One Residential House in India 

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

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

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

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

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

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

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

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

Purchase of Two Houses 

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

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

Cap of Ten Crores 

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

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

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

Conclusion 

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

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

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

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

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

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

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

Pre-GST Interpretation 

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

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

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

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

Rapidly Swinging Pendulum under GST

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

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

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

Way Forward 

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

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