Two Certainties

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

Powers of Arrest under CGST Act, 2017 and Customs Act, 1962: Constitutionality and their Scope

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The Supreme Court in a recent judgment upheld the constitutionality of arrest-related provisions contained in Customs Act, 1962 and CGST Act, 2017. The Court also elaborated on the scope of arrest powers under CGST Act, 2017 and safeguards applicable to an arrestee. The judgment reiterates some well-established principles and clarifies the law on a few uncertain issues. In this article, I examine the judgment in 3 parts: first, the import of Om Prakash judgment and Court’s opinion on arrest powers under Customs Act ,1962; second, the issue of constitutionality of arrest-related provisions contained in CGST Act, 2017, and third, the scope and contours of arrest-related powers under GST laws along with a comment on Justice Bela Trivedi’s concurring opinion and its possible implication. 

Part I: Om Prakash Judgment and Customs Act, 1962 

Om Prakash Judgment 

In Om Prakash judgment, the Supreme Court heard two matters relating to Customs Act, 1962 and Central Excise Act, 1944. The issue in both matters was that all offences under both the statutes are non-cognizable, but are they bailable? The Court held that while the offences were non-cognizable, they were bailable. The Court referred to relevant provisions of the CrPC, 1973 and statutes in question to support its conclusion. For example, the Court referred to Section 9A, Central Excise Act, 1944 and held that the legislative intent is recovery of dues and not punish individuals who contravene the statutory provisions. And the scheme of CrPC also suggests that even non-cognizable offences are bailable, unless specifically provided. 

The Supreme Court in Om Prakash judgment also clarified that even though customs and excise officers had been conferred with powers of arrest, their powers were not beyond that of a police officer. And for non-cognizable offences, the officers under both statutes had to seek warrant from the Magistrate under Sec 41, CrPC, 1973.  

Amendments to Customs Act, 1962 

Section 104, Customs Act, 1962 was amended in 2012, 2013, and 2019 to modify and to some extent circumvent the application of Om Prakash judgment. Supreme Court’s insistence on tax officers seeking Magistrate’s permission before making an arrest was sought both – acknowledged and modified via amendments to the Customs Act, 1962. To begin with, Customs Act, 1962 bifurcated offences into two clear categories: cognizable and non-cognizable and the amended provisions clearly specified which offences were bailable or non-bailable. These amendments which were the subject of challenge in the impugned case. 

The Supreme Court rejected the challenge and held that petitioner’s reliance on Om Prakash judgment was incorrect. But were the pre-conditions for arrest in Customs Act, 1962 sufficient to safeguard liberty? Were there sufficient safeguards against arbitrary arrest to protect the constitutional guaranteed liberties? 

The Supreme Court clarified that the safeguards contained in Sections 41-A, 41-D, 50A, and 55A of CrPC shall be applicable to arrests made by customs officers under the Customs Act, 1962. The arrestee would have to informed about grounds of arrest, the arresting officer should be clearly identifiable through a badge being some of the protections available to an arrestee. Court added that mandating that said safeguards of CrPC shall apply to arrests by customs officers ‘do not in any way fall foul of or repudiate the provisions of the Customs Act. They complement the provisions of the Customs Act and in a way ensure better regulation, ensuring due compliance with the statutory conditions of making an arrest.’ (para 29) 

The Supreme Court further added that safeguards provided in Customs Act, 1962 were in itself also adequate to protect life and liberty of the persons who could be arrested under the statute. The Supreme Court noted that the threshold of ‘reason to believe’ was higher than the ‘mere suspicion’ threshold provided under Section 41, CrPC. And that the categorisation of offences under the Customs Act, 1962 wherein clear monetary thresholds were prescribed for non-cognizable and non-bailable offences enjoined the arresting officers to specifically state that the statutory thresholds for arrest have been satisfied. 

Finally, the Supreme Court read into Section 104, Customs Act, 1962 the requirement of informing the accused of grounds of arrest as it was in consonance with the mandate of Article 22 of the Constitution. The Supreme Court exhorted the officers to follow the mandate and guidelines laid down in Arvind Kejriwal casewhere it had specified parameters of a legal arrest in the context of Sec 19, PMLA, 2002. 

While dismissing the challenge to constitutionality of arrest-related provisions of Customs Act, 1962 the Supreme Court cautioned and underlined the need to prevent frustration of statutory and constitutional rights of the arrestee. 

Overall, the Supreme Court was of the view that pre-conditions for arrest specified in Customs Act, 1962 were not constitutional and safeguarded the liberties of an arrestee while obligating the custom officers to clearly specify that the conditions for arrest were satisfied. The Court also clarified that various safeguards prescribed in CrPC, 1973 were available to an arrestee during arrests made under Customs Act, 1962.  

Part II: Constitutionality of Arrest-Related Provisions in CGST Act, 2017

Article 246A Has a Broad Scope 

The constitutionality of arrest-related provisions contained in CGST Act, 2017 was previously upheld by the Delhi High Court in Dhruv Krishan Maggu case, as I mentioned elsewhere. The Supreme Court in impugned case also upheld the constitutionality of provisions.  The arguments against constitutionality of arrest-related provisions in CGST Act, 2017 were similar in the impugned case as they were before the Delhi High Court. The petitioner’s challenge was two-fold: first, Parliament can enact arrest related provisions only for subject matters contained in List I; second, powers relating to arrest, summon, etc. are not incidental to power to levy GST and thus arrest-related provisions cannot be enacted under Article 246A of the Constitution.

The Supreme Court’s rejection of petitioner’s argument on constitutionality was in the following words: 

The Parliament, under Article 246-A of the Constitution, has the power to make laws regarding GST and, as a necessary corollary, enact provisions against tax evasion. Article 246-A of the Constitution is a comprehensive provision and the doctrine of pith and substance applies. The impugned provisions lay down the power to summon and arrest, powers necessary for the effective levy and collection of GST. (para 75) 

Supreme Court relied on the doctrine of liberal interpretation of legislative entries, wherein courts have noted that the entries need to be interpreted liberally to include legislative powers on matters that are incidental and ancillary to the subject contained in legislative entry. Relying on above, the Supreme Court concluded that: 

Thus, a penalty or prosecution mechanism for the levy and collection of GST, and for checking its evasion, is a permissible exercise of legislative power. The GST Acts, in pith and substance, pertain to Article 246-A of the Constitution and the powers to summon, arrest and prosecute are ancillary and incidental to the power to levy and collect goods and services tax. In view of the aforesaid, the vires challenge to Sections 69 and 70 of the GST Acts must fail and is accordingly rejected. (para 75) 

The Supreme Court has correctly interpreted Article 246A in the impugned case. The Court liberally interpreted the scope of Article 246A in a previous case as well. The Court’s observations in the impugned case align with its previous interpretation wherein the Court has been clear that Article 246A needs to be interpreted liberally – akin to legislative entries – and include in its sweep legislative powers not merely to levy GST but ancillary powers relating to administration and ensuring compliance with GST laws. 

The nature of Article 246A is such that it needs to be interpreted akin to a legislative entry since there is no specific GST-related legislative entry in the Constitution. The power to enact GST laws and bifurcation of powers in relation to GST are both contained in Article 246A itself investing the provision with the unique character of a legislative entry as well as source of legislative power in relation to GST. 

Part III: Scope and Contours of Arrest Powers under CGST Act, 2017

Reason to Believe and Judicial Review  

The Supreme Court referred to the relevant provisions of GST laws to note that there is clear distinction between cognizable and non-cognizable offences under the GST laws. And bailable and non-bailable offences have also been bifurcated indicating the legislature’s cognizance of Om Prakash’s judgment. Further, the nature of offence is linked to the quantum of tax evaded. While the threshold to trigger arrest under CGST Act, 2017 is the Commissioner’s ‘reason to believe’ that an offence has been committed. In this respect, the Court emphasized that the Commissioner should refer to the material forming the basis of his finding regarding commission of the offence. And that an arrest cannot be made to investigate if an offence has been committed. The Supreme Court also pronounced a general caution about the need to exercise arrest powers judiciously. 

Another riddle of arrest that the Supreme Court tried to resolve was: whether a taxpayer can be arrested prior to completion of assessment? An assessment order quantifies the tax evasion or input tax credit wrongly availed. And since under CGST Act, 2017 the classification of whether an offence is cognizable or otherwise is typically dependent on the quantum of tax evaded, this is a crucial question. And there is merit in stating that the assessment order should precede an arrest since only then can the nature of offence by truly established. In MakeMyTrip case – decided under Finance Act, 1994, the Delhi High Court had mentioned that an arrest without an assessment order is akin to putting the horse before a cart. And in my view, in the absence of an assessment order, the Revenue’s allegation about the quantum of tax evaded is merely that: an allegation. And there is a tendency to inflate the amount of tax evaded in the absence of an assessment order. And an inflated amount tends to discourage courts from granting bail immediately and can even change the nature of an offence.  

However, the Supreme Court in the impugned case noted that it cannot lay down a ‘general and broad proposition’ that arrest powers cannot be exercised before issuance of assessment orders. (para 59) There may be cases, the Supreme Court noted where the Commissioner can state with a certain degree of certainty that an offence has been committed and in such cases arrest can be effectuated without completion of an assessment order. 

Here again, the Supreme Court stated that the CBIC’s guidelines on arrest will act as a safeguard alongwith its previous observations on arrest by custom officers, which will also apply to arrest under GST laws.      

The issue is that CBIC issued the guidelines on arrest in 2022, and yet the Supreme Court noted that there have been instances of officers forcing tax payments and arresting taxpayers. And though the arrests led to recovery of revenue, the element of coercion in tax payments cannot be overlooked. If the coercive element during arrest was present even despite the guidelines, then perhaps an even stronger pushback is needed against arbitrary and excessive use of arrest powers. While the Supreme Court has done well in stating that various safeguards will apply to arrests such as those enlisted in various provisions of CrPC and requirements of warrants from Magistrates in non-cognizable offences, even the numerous safeguards, at times, don’t seem enough to protect taxpayers.   

Justice Bela M. Trivedi’s Concurring Opinion  

Justice Bela M. Trivedi’s concurring opinion prima facie dilutes safeguards provided to taxpayers. The Revenue is likely to use her words to argue against any judicial interference and deny bail to accused. Justice Trivedi clearly noted that when legality of arrests under legislations such as GST are challenged, the courts must be extremely loath in exercising their power of judicial review. The courts must confine themselves to examine if the constitutional and statutory safeguards were met and not examine the adequacy of material on which the Commissioner formed a ‘reason to believe’ nor examine accuracy of facts. 

Justice Trivedi was emphatic that adequacy of material will not be subject to judicial review since an arrest may ordinarily happen at initial stages of an investigation. The phrase ‘reason to believe’, she observed, implies that the Commissioner has formed a prima facie opinion that the offence has been committed. Sufficiency or adequacy of material leading to formation of such belief will not be subject to judicial review at nascent stage of inquiry. The reason, as per Justice Trivedi was that ‘casual and frequent’ interference by courts could embolden the accused and frustrate the objects of special legislations such as GST laws. Limited judicial review powers for powers exercised on ‘reason to believe’ is a recurring theme in the jurisprudence on this standard. Reason to believe is a standard prescribed under IT Act, 1961 as well and courts have clear about not scrutinizing the material which forms the basis of the officer’s belief. 

However, some of Justice Trivedi’s observations seem at odds with the lead opinion which requires written statements about Commissioner’s belief, reference to material on basis of which the Commissioner forms the ‘reason to believe’ that lead to arrest. The majority opinion is also clear about power of judicial review in case of payment of tax under threat of arrest, power of courts to provide bail even if no FIR is filed, among other safeguards. Though in the leading opinion there is no clear opinion about scope of judicial review at preliminary or later stages of investigation.  

One possible manner to reconcile Justice Trivedi’s concurring opinion with the lead opinion is that her observations about narrow judicial review are only for preliminary stages of investigation. And that courts can exercise wider powers of judicial review at later stages of investigation. And that her view is only limited to ensuring that once the statutory safeguards have been met, courts should not stand in the way of officers to complete their inquiries and investigations else aims of the special laws such as GST may not be met. But her views are likely to be interpreted in multiple manners and the Revenue will certainly prefer her stance in matters relating to bail, not just at the initial stage of investigation but during the entire investigative process.   

Conclusion 

In the impugned case, the Supreme Court has advanced the jurisprudence on arrests under tax laws to some extent. But the observations are not in the context of any facts but in a case involving constitutional challenge. Thus, numerous safeguards that the Court has noted will apply to arrests made by customs officers or under GST Acts will be tested in future. Courts will have to ascertain if the arrests were made after fulfilment of the various safeguards, whether taxes were paid under threats of arrests, and other likely abuse of powers. The crucial test will be how and if to grant bail including anticipatory bail in matters where FIR is not registered. 

Finally, ‘reason to believe’ is admittedly a subjective standard. It is the opinion of an officer based on the material that comes to their notice. And courts while may examine the material, cannot replace their own subjective view with that of the officer. The test in such cases is if a reasonable person will arrive at the same conclusion based on the material as arrived at by the Commissioner. Thus, ‘reason to believe’ as a standard per se, limits scope of judicial review and confers immense discretion to the Commissioner to exercise powers of arrest. The jurisprudence on this issue – both under the IT Act, 1961 and GST laws – is evidently uneven due to the subjective nature of standard. And courts have not been able to form a clear and unambiguous stance on the scope of judicial review with respect to the ‘reason to believe’ standard. And this unevenness and relatively weak protection afforded to taxpayers is likely to continue in the future as well despite the Supreme Court’s lofty observations in the impugned case.             

            

Long Wait for GSTATs: July 2017 … and Counting. 

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GSTATs have been envisaged as the first appellate forum under GST laws. And yet, 7.5 years since implementation of GST, not a single GSTAT is functioning. Reason? Many. Some are easy to identify, others are tough to understand. Nonetheless, here is a small story of the ill-fated GSTATs since the implementation of GST laws in July 2017. 

Provision is Declared Unconstitutional 

CGST Act, 2017, as originally enacted, provided that the no. of technical members in GSTATs would exceed the no. of judicial members. Both the Union and States wanted to ensure their representation on GSTATs via technical members which led to each GSTAT accommodating at least 2 technical members, i.e., technical member (Centre) and technical member (State). But CGST Act, 2017 provided for only one judicial member on the Bench of GSTAT. The Madras High Court ruled that the strength of technical members in tribunals cannot exceed that of judicial members, as per the law laid down by the Supreme Court. The relevant provision – Section 109(9) as originally enacted – was struck down as unconstitutional. There was a simultaneous challenge on the ground of Article 14 wherein the petitioners argued that under CGST Act, 2017 advocates were not eligible to become members of GSTATs and it violated their fundamental right to equality. The High Court refused to accept this plea and requested the Union to reconsider the ineligibility of advocates. Making advocates ineligible to become members of GSTAT is rather strange since a similar disqualification does not exist for ITATs under the IT Act, 1961.     

No Appeal Against the Decision  

The Union didn’t appeal against the Madras High Court’s decision. Surprising, since the Union likes to defend all its decisions including its interpretation of tax statutes until the last possible forum. Or perhaps in this instance the Union decided it was prudent to agree with the High Court’s decision. Or it wanted to use the High Court’s decision as a shield to defend the delay in operationalizing GSTATs. Irrespective, the Union’s decision to not file an appeal against the High Court’s decision meant it had to explore options to operationalize the GSTATs. During 2019-2021, the GST Council did discuss the options and feasibility of GSTATs in various States and the required no. of Benches, but the discussions didn’t prove to be immediately fruitful. One possible option of breaking the logjam was by amending the respective provision of CGST Act, 2017. 

Provisions are Amended 

The Finance Act, 2023 amended the provisions relating to composition of GSTATs. Below are the relevant provisions before amendment and post-amendment respectively: 

Pre-Amendment

Section 109(3):

The National Bench of the Appellate Tribunal shall be situated at New Delhi which shall be presided over by the President and shall consist of one Technical Member (Centre) and one Technical Member (State). 

Section 109(9): 

Each State Bench and Area Benches of the Appellate Tribunal shall consist of a Judicial Member, one Technical Member (Centre) and one Technical Member (State) and the State Government may designate the seniormost Judicial Member in a State as the State President. 

Post-Amendment 

Section 109(3): 

The Government shall, by notification, constitute a Principal Bench of the Appellate Tribunal at New Delhi which shall consist of the President, a Judicial Member, a Technical Member (Centre) and a Technical Member (State). 

Section 109(4): 

On request of the State, the Government may, by notification, constitute such number of State Benches at such places and with such jurisdiction, as may be recommended by the Council, which shall consist of two Judicial Members, a Technical Member (Centre) and a Technical Member (State). 

In summary, the amendments via the Finance Act, 2023 have ensured that the no. of judicial members are equal to technical members, if not more. This is because the President of GSTAT is usually the senior most judicial member. The balance of judicial and technical members needed to be met on two fronts: ensuring balance of representation between the Union and States inter-se needs and the balance between judicial and technical side to avoid executive domination. Now that the initial hurdle to constitute GSTATs was officially removed via Finance Act, 2023, one would have expected speedy and decisive steps towards constitution of GSTATs. But that wasn’t the case.  

Benches, Chairperson, Website … and Other Puny Steps 

Since the provisions relating to GSTATs have been amended, the Union has taken multiple – but tiny – steps towards operationalizing the GSTATs. With each step, the tax community has raised its hopes for quick operationalization of GSTATs. But each step seems a step too far. 

In May 2024, the Minister of Finance administered oath to the first President of GSTAT, New Delhi. Since GSTATs are not yet operational and do not hear cases, I’m not sure what the President of GSTAT does to earn his salary.  

In July 2024, in another step forward, the Ministry of Finance notified various Benches of GSTATs, with the Principal Bench in New Delhi. 

Recently, the tax community was rejoicing at GSTATs having a dedicated website. It is hard for me to understand the joy of having a functional website for an institution that itself isn’t functional. And the purpose of having a website is difficult to comprehend due to a recent report in January 2025, mentioning that GSTATs will take another 6 months to begin their functioning. When the formalities for appointing personnel have not completed, IT infrastructure is yet uncertain, and real estate for GSTATs has not been finalized, even 6 months seem like an ambitious target. Especially due to the track record of the Union and States on this aspect of GST.  

Constitutional Courts are Impatient  

Since GSTATs, ideally the first appellate forum for GST-related disputes, are not functioning, the burden has shifted to constitutional courts. High Courts and the Supreme Court end up hearing matters that typically should not have received attention beyond GSTATs. Supreme Court has recognized the effect of not having GSTATs and has recently raised the following query in one of its orders:

We would like to first know at the earliest why the Goods and Services Tax Appellate Tribunal has not been made functional till this date.  

The Union is supposed to reply to the above query in three weeks, but do not expect any fireworks and new revelations. 

Supreme Court’s question was prompted after it noted that the petitioner had the remedy to file an appeal under CGST Act, 2017 but had to approach the High Court via writ petition due to GSTATs not functioning. Many such cases that did not deserve or should not have been heard by High Courts and Supreme Court are currently in limbo because these constitutional courts do not have the advantage of GSTATs judgments and fact finding.   

Previously, the Allahabad High Court also tried to make the Union act quickly. But, despite the High Court’s eagerness to constitute GSTATs in the State of UP, there wasn’t much headway. 

Additionally, GSTATs are necessary to ensure harmony in interpretation and coherence in jurisprudence which has, for a long time, been at the mercy of AARs and AAARs. Both are intended to be interpretive bodies, not dispute resolution bodies but their several sub-par interpretations have caused tremendous confusion on various matters.

To conclude, I cannot say for sure when GSTATs will start functioning, but it is imperative that they do. And they function efficiently. A reform such as GST cannot be truly called a bold or a transformative reform until the accompanying rule of law infrastructure is operational. And GSTATs are a vital cog of that infrastructure. Until then, GST has certainly transformed the landscape of indirect tax in India. But, the promise of fair and speedy resolution of disputes remains a distant and unfulfilled promise.  

Income Tax Bill, 2025: In Search of a Big Idea

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The Department of Revenue claims that Income Tax Bill, 2025 – tabled in the Parliament on 13 February 2025 – marks a significant step towards simplifying the language and structure of the Income Tax Act, 1961. Does it? Yes. Was it needed? Yes. Is it a major reform? No, and herein lies the rub.  

The Press Release accompanying the IT Bill, 2025 makes it clear that the ‘simplification exercise’ did not implement any major tax policy changes to ensure continuity and certainty for taxpayers. This statement presumes two things: first, that there isn’t much uncertainty in the current IT Act, 1961 or certainly not worth immediate attention; second, that simplification and policy changes are easily separable. Both contain an element of truth without being completely true. 

In more than six decades of its existence, the IT Act, 1961 has ensured some stability and continuity in the direct tax domain, despite repeated amendments. But that does not mean that any major policy change in direct taxes should be frowned upon and sacrificed at the altar of certainty. There is enough ambiguity on various issues in income tax that could do with more clarity and better policy direction. Capital gains tax is one example. 

Equally, if the underlying policy is muddled, then the legislative language can only be that ‘simple’. Merely because the Provisos have been rearranged into sub-sections, Schedules have been appended, or ‘notwithstanding’ has been replaced with ‘irrespective’ will not be enough to reduce income tax litigation and disputes. Straightforward policy decisions usually lead to simpler statutes. Ad hoc policy changes cause frequent amendments and an eventual bloating of the statute. As it happened with IT Act, 1961. To aim for simplification of language without ensuring adequate clarity in policy is a limited exercise.   

In this post, I intend to highlight three major things: one achievement of IT Bill, 2025; one major flaw, and the way forward. 

IT Bill, 2025: Improves Readability, Not Comprehension  

IT Bill, 2025 has achieved one thing: it has improved reading flow of the proposed statute, the provisions are easier to locate without unnecessary alphanumeric numbers and caveats obstructing one’s view. The multiple Explanations, Provisos, non-obstante clauses, some with prospective, others with retrospective effect have been realigned into sub-sections to make the provisions easier to follow. Schedules are more informative, some redundancies have been eliminated, and overall, it is much easier to navigate the law as compared to the IT Act, 1961. But the ease of readability, and improved navigation is only for tax professionals. 

I don’t intend to speak for an ‘average’ taxpayer, but I’m going out on a limb to say that any claim that IT Bill, 2025 will be easier to comprehend for an average taxpayer is a bit of a stretch. The proposed law does not in any way remove the legalese to such an extent that the average taxpayer can fully understand the tax implications of their transactions. It is self-serving for tax administration to sell hope on the back of this simplification exercise, but let us draw a line and stop them from selling a fantasy. Let me illustrate: 

Section 9(1), IT Bill, 2025 states that income deemed to accrue or arise in India shall be the incomes mentioned in sub-sections (2) to (10). Section 9(2) then states that any income accruing or arising, directly or indirectly, through or from the transfer of capital asset situated in India shall be deemed to accrue or arise in India. Section 9(9) refers back to Section 9(2) and elaborates the latter via seven clauses with almost each clause containing various sub-clauses. We expect an average taxpayer to not only read this legal language, but also understand it, make a reasonable prediction as to how the tax officers and courts will interpret it? It should not even be an expectation. It is pure fantasy.

And if anyone still doubts my assertion, let us show an average taxpayer the Revenue Department’s explanation of what is a ‘tax year’ and the need for its introduction. The clueless expression that a taxpayer may respond with will give us some answers about the simplicity of language and lucidity of the IT Bill, 2025. Don’t get me wrong, tax year as a concept is welcome and can be easily understood by tax professionals. Not by a layman. And the claim that somehow by rearranging the provisions and improving flow of the statute may make it easier for an average taxpayer to comprehend it is something that I’m unable to accept.

In fact, improved readability is all the simplification exercise offers to tax professionals. For all intents and purposes, the changes in the IT Bill, 2025 will not make it easier to understand and interpret. IT Bill, 2025 remains as complicated and dense a statute as its predecessor and is likely to attract similar volume of litigation and same nature of interpretive disputes.      

Simplistic Understanding of Simplification  

Is simplifying the language of statute a ‘significant step’? Rarely. 

Simplification of legal language is a desirable step. It is not necessarily a significant one. 

Tax law, like every other law, is a constant site of interpretation. Judiciary performs the prime role in statutory interpretation. One can then argue that simplifying the language of statutory provisions may make it easy for the judiciary to understand ‘legislative intent’. It is a phrase that is often-invoked by the Revenue Department. However, the expectations should be muted on this front. A simple language in a statute does not guarantee that the judiciary will always agree with the Revenue’s interpretation. An outcome that the latter terribly desires, but rarely achieves. 

IT Bill, 2025 contains provisions of charge, exemptions, deductions, corporate taxation, tax evasion, assessments, clubbing of income, powers of tax officers, to name just a few. Each of these provisions require constant interpretation and re-interpretation depending on the transactions and facts that emerge. It is the dynamic nature of personal and commercial transactions, their shape shifting nature that provides scope and opportunity for tax officers to interpret the law and determining tax liabilities of taxpayers. And depending on the fate of disputes, the law changes frequently to address the emerging circumstances. If the Revenue Department disagrees with a particular interpretation, changes to income tax law happen soon thereafter. Why? Because protecting revenue’s interest is primary, policy direction is easily divorced. Simplification, is thus, rarely about drafting provisions in easy-to-understand language. Simplification emerges from clear policy.    

Simplification of provisions of IT Act, 1961 currently seems like a desire that legislative language will be easier to decipher during adjudication of tax disputes. The desire will only become a fact once the judiciary starts interpreting the ‘simple’ statutory provisions. And if one goes by the track record of Department of Revenue, each time the judiciary disagrees with it, the statute is amended to reflect its position and interpretation via an Explanation, a Proviso, an insertion or deletion of a clause. Will that not happen in the future? We don’t know because there have been no such commitments. Also, because we don’t know what tax policies are driving the simplification of provisions, apart from generic statements such as ‘improving ease of business’, ‘rationalisation of tax law’, ‘improving compliance’, etc.  

In Search of a Big Idea 

There is no big idea that underscores the IT Bill, 2025. Admittedly, if the official Press Release itself admits no major policy change has been introduced, then highlighting lack of substantive changes is an obvious comment. But it doesn’t and shouldn’t distract us from the fact that India’s direct tax policy is not ideal. The claim that direct tax policy shouldn’t be disrupted to prevent ‘instability’ is shallow and insincere. To be sure, India’s income tax has witnessed some changes in recent times, the primary one being the introduction of new tax regime. And, of course, the recent introduction of income tax exemption on income upto 12 lakhs per annum. What else? Nothing. Political parties continue to enjoy a durable income tax exemption, there is no movement to tax agricultural income, charitable organisations keep facing undue scrutiny and onerous compliance requirements, tax officers continue to enjoy unbridled powers of search, seizure, and survey without any meaningful scrutiny. Faceless assessments and attempts to limit powers of reassessments were well intentioned reforms, but both are embroiled in tangles that seem to have limited their administrative reform potential. 

We had the opportunity to create a trailblazing direct tax policy for cryptocurrencies, instead we opted for and continue with a punitive regime that all but discourages all kinds of cryptocurrency transactions in India. Digital taxation continues to hang in balance, with India participating in the OECD’s attempts to overhaul the corporate and international tax landscape without being able to fully retain its autonomy and wriggle space for autonomous domestic policies. How about capital gains tax? No major idea on the anvil. Tax evasion? GAAR, introduced as a reaction to Vodafone case, alongside the Principal Purpose Test in tax treaties require constant reassurance to calm investors. But no major clarity has emerged on applicability and scope of either. Certainly not until the Revenue’s clarifications are tested in actual cases. Presence of wide-ranging anti-tax evasion provisions while conferring extensive and intrusive powers to tax officers are not typical hallmarks of a tax law attempting to inspire confidence in taxpayers. And, certainly do not boost taxpayer morale. 

Finally, burgeoning bots, robots, and deployment of artificial intelligence seem to have not made a dent in India’s substantive direct tax policy. We are still waiting for someone else to show us the path and then incorporate derived version of AI-related tax policy in India. AI is the biggest idea in today’s tech obsessed world and needs a tax response. How about promoting environment friendly activities? Better and more encompassing tax policies for electric vehicles? Environment taxes on polluting corporates? We refuse to engage with such ideas and instead and are focusing on renumbering our statute instead of unveiling new tax ideas.        

Conclusion 

India’s direct tax policy needs big ideas. Simplification of statute is not one. It is a reform, but we do ourselves a disservice by calling it a major milestone or a significant step. We need better ideas as to how to rethink source rules in a digital world, and how to guard our revenue interests while engaging with OECD, evolving a suitable anti-tax avoidance approach – domestically and in our tax treaties – as well as ensuring that our residence principles do not remain stuck in the past while the contemporary world increasingly inhabits digital nomads. And, not the least, ensure tax administration reforms are not just about ‘using’ AI, data processing, big data but also sowing seeds of substantive tax policies towards these technologies. We also need a first principles approach towards powers of tax officers to ensure that they have sufficient powers, but are not unaccountable for their actions. The only solace is that the simplification of language of IT Act, 1961 may prove to be the launchpad of such major reforms of income tax law. Time will tell if there is appetite for such reforms.  

Skeletal Timeline of Income Tax Reform in India

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1860-1886: 

Income tax was introduced in India for the first time in 1860 to overcome the financial difficulties due to First War of Independence of 1857. The period of 1860-1886 saw the Govt alternating between income tax and license tax as a source of revenue. Income tax became the preferred option when the first systematic form of income tax law was passed in 1886. 

1860: Income Tax Act, 1860 enacted in India

  • First income tax law of India 
  • Income was divided into four schedules to be taxed separately 
  • Four schedules were: income from landed property, income from professions and trades, income from securities, and income from salaries and pensions

1863: Income Tax Act, 1860 ‘expired’ 

1869: Income tax was reintroduced due to financial difficulties faced by the British Govt 

1873: Income Tax Act, 1869 ‘expired’  

1878: Income tax was replaced by license tax to raise money for famine insurance

1886: Income Tax Act, 1886 enacted with important changes 

  • Income was divided into four classes
  • Four classes were: salaries, pensions or gratuities, net profits of companies, interest on securities of Govt of India, and income from other sources 
  • Agricultural income was exempt from income tax and so were properties devoted to charitable and religious purposes  

1918-1961: 

The foundation for modern Indian income tax law – as we know it today – was laid with enactment of 1918. Income tax reforms were initiated after the First World War and eventually led to a broad review of income tax collections leading to enactment of Income Tax Act, 1922, foundational legislation for the current Income Tax Act, 1961. The foundation for tax administration was also laid during this period.   

1918: Income Tax Act, 1918 replaced the Income Tax Act, 1886 

  • Broad shape of contemporary income tax law started emerging  
  • Act of 1918 replaced ‘schedular income tax’ with ‘total income tax’ 

1922: Predecessor to the Income Tax Act, 1961 enacted 

  • Income Tax Act, 1922 was enacted based on recommendations of All India Committee
  • Income tax rates were determined annually via ‘Finance Acts’ (Annual Budget) and were not encoded in the Income Tax Act itself 

1939: Special Enquiry Committee comprised of experts from India and England 

1941: Income Tax Appellate Tribunals were established 

  • First specialist tribunals constituted in India 

1956: Union of India stresses on reform of IT Act, 1922

  • It was acknowledged that IT Act, 1922 had grown in an unplanned manner 
  • It was decided to re-examine the IT Act, 1922 to simplify it and make it more intelligible and referred the task to Law Commission of India  

1958: Law Commission of India submits it report 

  • 12th Report of the LCI made extensive suggestions for rearrangement of provisions
  • LCI stated that income tax law was in a state of ‘hopeless confusion’ due to constant tinkering with the IT Act, 1922 via short sighted amendments 

1959: Tyagi Committee submitted its report 

  • The Committee was formally called ‘Direct Taxes Administration Enquiry Committee’ 
  • The Committee acknowledged that simplification of tax laws was not an easy task. It recommended that provisions of IT Act, 1961 should be rearranged more logically and expressed in clearer language to remove ambiguities in the law

1961: Income Tax Act, 1961 was enacted 

Promise of IT Act, 1961

Promise of Income Tax Act, 1961: 

Morarji Desai promised the following when introducing the income tax law in 1961: 

Simplification has been sought to be obtained by replacing obscure and ambiguous expressions with clear ones and by re-arranging the provisions of the Act so as to make them more easy of comprehension than they are at present. 

1961-Present: 

Over years, Income Tax Act, 1961 grew complex, longer, and difficult to decipher due to various reasons. The Union of India’s propensity to amend the law every year, frequently with retrospective effect, emergence of novel forms of business transactions, incomes, tax evasion techniques, and divergence between the Revenue Department’s understanding of income tax law provisions and judicial interpretation of such provisions contributed to the complexity. Not least was the use of extensive ‘Provisos’, ‘Explanations’ in the statute which made the law difficult to understand and administer.   

1963: Central Boards of Revenue Act, 1963 passed 

  • Repealed the Central Board of Revenue Act, 1924 
  • Central Board of Revenue was replaced by two entities: Central Board of Direct Taxes and Central Board of Indirect Taxes and Customs. Former is the ape administrative body for income taxes in India  

1991-92: Raja Chelliah Committee examined India’s entire tax landscape 

  • Formally called the ‘Tax Reforms Committee’, it recommended a series of tax reforms for direct and indirect taxation 
  • The Committee though did not suggest enacting a new income tax law, only suggested various changes including but not limited to corporate taxes, interest taxation, agricultural income, and gift tax  

2009: First notable attempt to replace the IT Act, 1961 

2010: Revised version, Direct Taxes Code Bill, 2010 presented in the Parliament 

  • Revised version incorporated some comments received on the 2009 version
  • Direct Taxes Code Bill, 2010 referred to the Standing Committee on Finance

2012: Standing Committee on Finance submitted its Report on Direct Taxes Code Bill, 2010 

2014: Revised version of Direct Taxes Code Bill, 2010 was again put up for comments 

  • Direct Taxes Code Bill, 2010 lapsed with dissolution of the 15th Lok Sabha 
  • No clear commitment by the new BJP Govt to take the process forward 

2017: Task Force on Direct Tax Code setup 

  • Initially the Task Force was led by Mr. Arbind Modi and later by Mr. Akhilesh Ranjan 

2019: Task Force submitted its Report 

  • Report was never released to the public 

2024: Ms Nirmala Sitharaman announces a review of IT Act, 1961

  • CBDT forms an ‘Internal Committee’ to substantively review IT Act, 1961 
  • It was announced that the review will be completed within 6 months 

2025: Ms Nirmala Sitharaman announces that new income tax bill will be introduced 

  • Promises that new income tax law will be based on ‘trust first, scrutinize later’ principle 
  • New law will be substantively shorter and simpler as compared to IT Act, 1961
  • Also indicates that the income tax bill will be referred to the Standing Committee 

Promise of Income Tax Bill, 2025: 

Nirmala Sitharaman promised the following in her Budget Speech of 2025 

New IT bill will carry forward the spirit of  ‘nyaya based on the concept of trust first, scrutinise later’ and ‘the new bill will be clear and direct in text with close to half of the present law, in terms of both chapters and words. Also ‘It will be simple to understand for taxpayers and tax administration, leading to tax certainty and reduced litigation.’ [Not verbatim]

Why Should Tax Lawyers Care About the Annual Budget?

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Tax law, especially Indian tax law discussions are far too often contained by self-sustaining logic of statutory provisions and case laws. Tax lawyers, including me, feel validated and satisfied having decoded a particular judgment or the meaning of a provision. The satisfaction is often short lived because another judgment or amendment is on the horizon. Else, another Press Release, Circular, Notification, Clarification of the Circular, Amendment to the Notification, Guideline, Order that needs to be read. If we don’t keep abreast, we risk losing clients for missing a deadline of tax return, or failure to obtain tax refunds, or for our failure to render a timely advice. Where does the Budget fit in such daily scheme of things for a tax lawyer? 

In not many places. But, it should.  

In the Budget of 2020-21, for example, it was announced that the Union of India has decided to abolish Dividend Distribution Tax (‘DDT’). It was crucial information. As a tax lawyer I certainly need to know that w.e.f. 1.04.2020, shareholders and not companies are obliged to pay income tax on dividends. Unfortunately, the curiosity of most tax lawyers stops here. 

Ideally, and this is where I aspire to make my case: a tax lawyer should also know why the change was introduced? Union of India introduced DDT in 1997 reasoning that it was easier to collect tax on dividends in the hands of companies itself? It was easier to administer tax law over companies than large swathe of shareholders. Subsequently, ‘Buyback Tax’ was also introduced to plug the loophole of companies avoiding payment of DDT. What changed in 2020 to prompt the Union to upend its policy of taxing dividends in hands of companies? Especially when the no. of shareholders had increased multifold since 1997. Is it because the earlier was policy ill-conceived to begin with? Or is it that despite the large no. of shareholders it was easier track online payment of dividends? Dividends ‘should’ always be taxed in hands of shareholders is not a convincing explanation. For such an explanation impliedly castigates the introduction of DDT and its continuation for close to two decades. 

Now, of course, most practicing tax lawyers are likely to consider the above as superfluous inquiries. Or inquiries that are best addressed by academic lawyers. But that hardly changes the reality that most tax lawyers aren’t curious beyond the immediate needs of their clients. And many don’t have the luxury to meet such curiosity. But I would like to state that understanding reasons for major tax policy changes helps us better anticipate future changes, if not predict them. And ability to anticipate policy changes is an underrated but core quality for many lawyers, not just tax lawyers. 

To take another example, the Budget of 2022-23 revealed that cryptocurrency transactions are no longer in a tax vacuum and will be subject to a flat tax rate of 30%. Not much explanation was forthcoming for the punitive tax for cryptocurrency. But most tax lawyers worth their salt knew that the tax rate was a clear signal to discourage cryptocurrency transactions in India. The prelude to ‘crypto tax’ where RBI attempted to shackle cryptocurrency exchanges should have offered enough clue about the direction of regulatory environment for cryptocurrency in India. But, is it enough for a tax lawyer to know that the Budget has introduced new provisions relating to cryptocurrency transactions in the Income Tax Act, 1961? I guess you know my answer by this point. In my view, timely advice for clients for cryptocurrency transactions was ‘before’ the provision was introduced, not ‘after’. Thus, merely knowing the provisions once they are on the book is not enough. We need deeper and better understanding of the winds of change and their direction.       

But does the Budget tell us more? 

Yes, it does. (Especially if you can sit through the entire Budget Speech!)

Sometimes it tells us that when it comes to taxation, the Union of India operates in mysterious ways. And making anticipating changes may not always be a straightforward task. Because, I think, sometimes it is a mystery to the Union itself as to what tax policies it is enacting and why is it making certain tax policies. The Union of India, can, for example, attempt to ‘rationalise’ capital gains tax by completely doing away with indexation benefits in one sweeping announcement as in the Budget of 2024-25. Done and dusted. Or so it thought.   

And once the Union of India failed to fully explain its decision and received a wave of backlash, it amended its rationalization by introducing a grandfathering provision to ensure that the investments made before 23.07.2024 continued to receive the indexation benefits. 

One explanation for removing indexation benefits was to remove difficult and complicated calculations from the IT Act, 1961. Instead, the Union of India argued, it was better to prescribe a single capital gains tax of 12.5%. But what we now have instead is that for properties bought before 23.07.2024, taxpayers have the option of choosing between an indexation benefit or a capital gains tax of 12.5% from 2024 onwards. Simplification, they said. Dual options for taxpayers were created instead. And no, more is not merrier in every context.   

On second thoughts, maybe Union of India’s approach to tax policy is not a mystery. Maybe the goal is to try and see if through ‘shock and awe’ a policy change can be pushed through. If not, it is prepared make some prudent concessions that should have been incorporated in the first instance itself.    

Apart from the ‘whys’, Budget thus also reveals the ‘hows’ of tax policy changes. Is it a sledgehammer approach, a genteel incremental path, or a passionate persuasion for a change that the Government in power is advocating. Example: rumors that the Budget of 2025 will introduce a new Income Tax Bill. And there isn’t much disbelief about the rumor. An entirely new legislation on income tax is rumored to be introduced in a couple of days and the public is yet to see a draft version. When the Government in power is not averse to such a ‘hide and seek’ way of operating, it becomes a necessity for tax lawyers to be in tune with the Annual Budget. 

Further, the Budget reveals a lot about the nature of time. 

It is trite that laws can be amended or repealed. Statutory provisions can be replaced. And effect of unfavorable judgments can be nullified. But each year the Budget tells us that time does not move only in one direction. Linearity of time is a myth. Tax laws can be amended in 2025 ‘with effect from’ 2017, 2000 or even 1961. For example, there is a distinct possibility that through the Budget of 2025, CGST Act, 2017 will be amended to replace the words ‘plant or machinery’ with ‘plant and machinery’ to negate Supreme Court’s judgment in Safari Retreats case. The GST Council has recommended the amendment be effectuated retrospective effect, i.e., from 2017. Tax lawyers are so used to retrospective amendments that they no longer battle an eyelid when another such amendment is announced. But maybe we should battle an eyelid and more. And ask the tough question: why? Why is it not enough to amend the law w.e.f. 2025? Why do we have to travel back in time and amend it w.e.f. 2017? Can the Union of India, for once, accept it made a legislative oversight/error, change the law and move forward.    

English grammar tells us that conjunctions are important. The expected turn that the Safari Retreats case will take can tell us that conjunctions can be fulcrum of a long litigation battle that may award half a win to the taxpayer, but the Budget will convert it into a full loss. And tax lawyers are none the wiser. Not a great commentary on tax law and its practitioners.  

In formal legal language, Annual Union Budget is many things at the same time. It is the Annual Financial Statement as per Article 112 of the Constitution, Finance Bill when introduced, Finance Act once Parliament approves it, a tool to amend past financial mistakes, and a platform to unveil not a financial but also socio-economic vision of the future. 

In common parlance, Annual Union Budget presents an opportunity to demand ‘relief for middle class’, ‘create investment opportunities’, ‘attract FDI’, and of late hurtle us towards the promised land of ‘Viksit Bharat’. 

But for us tax lawyers, the Budget is also an opportunity to examine if the tax policies are adhering to the enduring canons of taxation propounded by Adam Smith. About time that the examination is public, expressive, and articulate instead of just being reactionary.  

Finally, Budget reveals numbers. It a statement of expenditures and revenues of the past financial year. And proposed expenses for the upcoming financial year. But that’s only one part of a larger story. 

Of late, tax collections are soaring. Undoubtedly. GST collections have only shown an upward trend post-COVID. And the trajectory will likely continue in that direction if there an income tax relief in the Budget of 2025. Income tax relief generally increases cash in hand for taxpayers which in turn will likely spur consumption and generate revenue via GST. So, a further bump in GST collections means a chance to spin the success story of Indian tax policy, including but specifically of GST. But numbers should never be enough. 

To use an analogy: as a tax lawyer, receiving client fee is crucial. Even necessary. But fee cannot be the only barometer of success, no matter how tempting it is to equate money with success.    

If numbers were the ‘be all and end all’, equalization levy was a roaring success and angel tax mopped up some revenue as well. Former is being phased out and latter was abolished via the Budget of 2024-25. Ending the life of both taxes should not be a cause for celebration if numbers are the only touchstone on which success of taxes is to be judged.  

Numbers reveal a story and hide another one. It is upto us what we make of them. If the no. of people filing income tax returns has increased, it is worth applauding. Not so, if they are only filing returns and not paying any effective income tax. Reducing corporate tax rates was supposed to be an incentive for spurring investments, but reduced corporate tax collections since the rate reductions may tell a different story. Ever increasing GST collections may reveal success, but if the burden of GST is primarily being borne by low earning groups, it calls into question the fairness of such a tax. And as much as tax lawyers believe that questions of fairness, justice, and equity are outside their realm, they stare us back in the face every now and then. We may choose to ‘hide’ behind the ‘logic’ and ‘coldness’ of statutory provisions, it won’t change the reality. And neither can we deny how Indian tax policy is increasingly being shaped without a meaningful contribution from tax lawyers.  

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.    

   

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