Supreme Court

Fee for Technical Services: Future Demands Answers

by

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.  

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

by

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.    

   

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

by

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

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

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

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

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

Pre-GST Interpretation 

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

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

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

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

Rapidly Swinging Pendulum under GST

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

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

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

Way Forward 

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

Taxation of Perquisites: SC Rules on Constitutionality

by

Challenge 

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

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

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

SC Decides: Not Unconstitutional

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

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

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

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

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

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

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

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

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

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

by

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

Tax Exemption to be Interpreted Strictly: Dilip Kumar Case 

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

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

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

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

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

Interpretation of Tax Exemption for Beneficial Purpose: Mother Superior Case 

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

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

Conclusion 

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

Rainbow Papers Case and the Art of Misinterpretation

by

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

Interpretive Question 

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

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

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

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

Section 30(2), IBC

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

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

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

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

State as a Secured Creditor 

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

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

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

Review of Rainbow Case 

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

Conclusion 

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

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

Kerala versus Union: Dispute Lingers 

by

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

Summary of Arguments 

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

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

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

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

Littany of Issues 

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

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

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

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

Injunction is Ousted 

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

Conclusion 

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

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

by

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

Reasons for Income Tax Exemption to Political Parties 

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

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

Income from Souvenirs 

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

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

Scope of Section 13A

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

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

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

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

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

Willful Ignorance of Section 13A

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

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

Conclusion 

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

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

by

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

Amendment of 1947 

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

Challenge on Grounds of Legislative Competence

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

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

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

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

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

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

Supreme Court Interprets Income Liberally  

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

Capital Gains = Income 

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

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

State’s Powers to Secure Loans: Kerala-Union Tussle 

by

The State of Kerala (‘Kerala’) recently filed an original suit against the Union of India (‘Union’) alleging that the latter has interfered with its fiscal autonomy by imposing a ceiling limit on its borrowing powers. The issue has been brewing for a while and Kerala has only recently approached the Supreme Court, which is yet to adjudicate on this issue. Kerala’s suit though brings into focus an important but largely ignored provision of the Constitution, i.e., Article 293. This article is an attempt to understand the provision and the related legal issues in the dispute between Kerala and the Union. 

Kerala Alleges Violation of Fiscal Autonomy 

Relevant media reports reveal that Kerala has challenged the Union’s amendment to Section 4, Fiscal Responsibility and Budget Management Act, 2003 (‘FRBM’) introduced via Finance Act, 2018. The two relevant amendments made to FRBM in 2018 are: first, amendment of definition of the term ‘general Government debt’ which has been defined to include sum total of debt of Central and State Governments, excluding inter-Governmental liabilities; second, Section 4(1)(b) which inter alia states that the Central Government shall ‘endeavour’ to ensure that the general Government debt does not exceed 60% of GDP by end of the financial year 2024-25. Section 4(1)(b) also states that the Central Government shall endeavour to ensure that the Central Government debt does not exceed 40% of GDP by end of the financial year 2024-25. 

The implication of the above amendments is that State debt is included in the definition of ‘general Government debt’ in FRBM even though it is a central legislation. Also, the desirable upper limit of fiscal deficit of all States is 20% of the GDP. As a result of this amendment, State debt levels are not exclusively within their control under State-level FRBMs, but also under the Union-FRBM.  

Kerala has challenged the above amendment specifically the amended definition of ‘general Government debt’ whereby State debts have been included in the term. Kerala’s argument is that ‘public debt of the State’ is a matter exclusively within the State’s competence under Entry 43, List II of the Seventh Schedule. By introducing a ceiling limit on the State’s borrowing, the Union is infringing the State’s fiscal autonomy. Kerala is arguing that States have fiscal autonomy to borrow money on the security and guarantee of the Consolidated Fund of the State and have exclusive power to regulate their finances through preparation and management of its budget. Union’s interference in the borrowing powers of States is violation of the fiscal federal structure envisaged under the Constitution.   

Mandate of Article 293 

Kerala’s challenge also touches Article 293 of the Constitution. Kerala’s arguments, as reported, are that relying on the 2018 amendments to FRBM, the Union imposed an upper ceiling on its borrowing limits. And that in the guise of exercise of its powers under Article 293(3) and 293(4), the Union is curtailing its fiscal autonomy. Two letters seem to have been issued by the Union informing Kerala that in view of the amendments to FRBM in 2018, it cannot borrow additional sums, while Kerala is arguing that it needs the additional money to finance its welfare schemes and pay its pensioners among apart from meeting other essential expenditure needs.

This brings us to the question of what is the scope and nature of the Union’s power under Article 293? Article 293, with the marginal heading ‘Borrowing by States’ provides that: 

  • Subject to the provisions of this article, the executive power of a State extends to borrowing within the territory of India upon the security of the Consolidated Fund of the State within such limits, if any, as may from time to time be fixed by the Legislature of such State by law and to the giving of guarantees within such limits, if any, as may be so fixed.
  • The Government of India may, subject to such conditions as may be laid down by or under any law made by Parliament, make loans to any State or, so long as any limits fixed under article 292 are not exceeded, give guarantees in respect of loans raised by any State, and any sums required for the purpose of making such loans shall be charged on the Consolidated Fund of India.
  • A State may not without the consent of the Government of India raise any loan if there is still outstanding any part of a loan which has been made to the State by the Government of India or by its predecessor Government, or in respect of which a guarantee has been given by the Government of India or by its predecessor Government.
  • A consent under clause (3) may be granted subject to such conditions, if any, as the Government of India may think fit to impose.

Article 293 is not a novel provision and had a comparable predecessor in the Government of India Act, 1935. However, the scope and implications of Article 293 have not been truly tested in a dispute before Courts. Nonetheless, it is important to examine if some of the arguments put forth by Kerala are a reasonable interpretation of the text of Article 293. 

To begin with, Article 293(1) provides complete freedom to the State to borrow money ‘within the territory of India’ and any limits on such powers are imposed by the State legislature by a law. To this end, States, including Kerala, have enacted their own fiscal responsibility statutes – State-level FRBMs – which set targets of the fiscal deficit vis-à-vis the GDP of the State. And in enactment of these laws, Article 293 envisages no role of the Union. 

Article 293(2) empowers the Union to extend loans to any State. Also, the Union can extend guarantees in respect of loans raised by any State, subject to satisfaction of the conditions of Article 292 or any law made by the Parliament. In this respect, Article 292 provides that the executive power of the Union extends to borrowing upon the security of Consolidated Fund of India within such limits as may be prescribed by law. And Section 4(1)(c) of FRBM states that the Central Government shall not give guarantees on any loan on the security of the Consolidated Fund of India in excess of one-half per cent of GDP in that financial year. And there is a Guarantee Policy that elaborates the administrative and other aspects of the Union providing guarantees.  

Articles 293(3) and 293(4) – central to the dispute – provide the Union powers to interfere with the State’s autonomy to raise money. Article 293(3) states that the Union’s consent is a pre-condition for a State to raise any loan if the loan granted to it by the Union is still outstanding or if the loan in respect of which the Union was a guarantor is outstanding. The Union can intervene in a State’s attempt to raise more money via loans, but only in the two circumstances mentioned above. 

Article 293(4), at first glance, seem to offer a wide discretion to the Union as its provides that the Union may grant consent under clause (3) subject by imposing  conditions as it ‘may think fit to impose.’ The conditions, if the Union’s response Kerala petition is any indicator, may include macroeconomic stability/financial stability, credit ratings among other related economic considerations. The Union, of course, is responsible for maintaining a stable economic environment at the national level and the Union imposing conditions on State’s borrowing by invoking macroeconomic stability which in turn is influenced by fiscal deficit limits seems to be reasonable. In the absence of any express caveats in Article 293(4), the outer limits of the Union’s discretion will have to be read into the provision. For example, if the conditions imposed by the Union are not unreasonable or arbitrary, they are likely to be within the scope of Article 293(4). At the same time, it is possible to argue that the conditions while reasonable should have a sufficient nexus with the objective of either maintaining or achieving the fiscal deficit targets provided in FRBM- State and Union level. While the outer limits are relatively easier to articulate in abstract and general terms, the true test is applying them to the facts at hand which is easier said than done.   

Kerala’s other argument that amendment of Section 4 of FRBM whereby State debts have been included in the definition of ‘general Government debt’ is beyond the Union’s legislative competence is persuasive. The persuasiveness is because public debt of a State is clearly listed in Entry 43, List II and in pursuance of that power the States have enacted their own FRBMs. The Union can of course, claim that the encroachment on State’s public debt is incidental and the pith and substance of the Union-level FRBM is to set limits for the Union’s fiscal deficit. Or in the alternative, Union-level FRBM is aimed to preserve macroeconomic stability and any encroachment on State public debt is incidental. The counter argument is that what the Union cannot do directly it cannot do indirectly. In the guise of legislating for macroeconomic stability and providing fiscal deficit targets for the Union’s debts, it cannot set ceiling limits on State’s borrowing powers and encroach State’s legislative power under Entry 43, List II.   

Kerala Finance Minister Interprets Article 293 

In a letter dated 22.07.2022, the then Finance Minister of Kerala wrote a letter to the Union Finance Minister expressing displeasure at the Union’s attempt to regulate financial management of the State. The Finance Minister of Kerala stated that Article 293(3) and (4) were only meant to provide the Union power to protect its interest as a creditor and not grant a general power to the Union to oversee the overall borrowing program of the States. While the letter also highlighted the Union’s questionable methods of calculating its debts such as inclusion of debts of instrumentalities of State Government, i.e., statutory bodies and corporations but excluding the public account of the State, I will keep the focus on the Finance Minister of Kerala’s understanding of Article 293.

In the letter, Finance Minister of Kerala argued that the term ‘any loan’ used in Article 293(3) must be interpreted by applying the principle of ‘ejusdem generis’ and can only mean a loan advanced by the Union to States. And that the requirement of obtaining the Union’s consent under Article 293(3) is only for the purpose of protecting the rights of the Union as a creditor. Thereby, the conditions that the Union can impose under Article 293(4) can only be related to the loan for which it issues consent under Article 293(3). 

Finance Minister of Kerala places a restrictive interpretation on the Union’s powers under Article 293(3) and (4). While the argument that ‘any loan’ under Article 293(3) should be interpreted to mean loans by the Union to States is interesting, in the absence of any definitive external aid to interpret this provision it cannot be termed as a decisive understanding of the phrase. The restrictive and purposive interpretation of Article 293(3) and (4) by the Finance Minister of Kerala also seeks to ensure that the Union can exercise its power to provide consent and impose conditions only to protect its interests as a creditor for the outstanding loans and not to regulate the financial borrowings of the State in general. For the latter is within the legislative competence and by extension executive power of the State in question. The restrictive interpretation will thus maintain the delicate balance of distribution of legislative powers.     

Finance Minister of Kerala also brings into question the legislative competence of the Union to regulate the State’s borrowings. The letter states that the executive power of the Union is co-extensive with its legislative power and since Parliament has no legislative power vis-à-vis Article 293 no executive power can be exercised by the Union under the provision. I think there is another way to look at the legislative and executive powers of the Union vis-à-vis public debt of States: since the Union has no legislative power on public debt of a State, it cannot exercise executive power on the same issue except beyond the confines of Article 293(3) and 293(4). Of course, even in this scenario what is exact scope of Articles 293(3) and 293(4) and the nature and extent of the Union’s powers under these provisions will need to be necessarily determined.  

The Argument of Union’s ‘Superior Financial Powers’

Article 293 and the issue of public debt is fairly novel in Indian Constitutional jurisprudence. In such situations, the broader Constitutional design vis-a-vis taxation and financial matters can help understand the extent of Union’s powers under Article 293. As regards taxation, the more lucrative and buoyant tax sources are with the Union though the States bear relatively more administrative responsibilities. Drawing an analogy from division of taxation powers, one of the Union’s initial arguments before the Supreme Court was that the Union is also vested with greater powers in managing finances given its responsibility of promoting macroeconomic stability. The dangers of adopting this interpretive approach are manifold. First, the term ‘macroeconomic stability’ is malleable and all-encompassing and provides wide leeway to the Union. Second, while the greater taxation powers of the Union are evident from the tax-related legislative entries in the Seventh Schedule and GST-related provisions, the case for the Union possessing greater financial powers rests on a contextual reading of the relevant Constitutional provisions. Greater emphasis needs to given to legislative competence of States over their public debts vis-à-vis the Union’s powers under Article 293(3) and 293(4). As far as possible, the division of financial powers need to be understood and interpreted on their own terms. If the Constitutional design on taxation powers becomes the springboard for interpreting the financial powers in a similar manner, States will have to contend with the Union imposing strict conditions before raising loans and more intrusive scrutiny of their borrowing powers.  

Conclusion 

Kerala has raised important Constitutional and legal questions through its petition and its satisfactory resolution will require, among other things, an adept understanding of the Constitutional design and importance of finances in the Union-State relations. Majority of fiscal federalism discussions in India have centred around the devolution of taxation powers with little to no attention to the borrowing powers. Even though successive Finance Commissions have dealt with the subject they have not opined specifically on the scope and meaning of Article 293. The distribution of financial powers especially relating to borrowings has never been truly discussed in a meaningful manner nor has it been tested before Courts. It is possible that the Union and Kerala may resolve this disagreement outside the Court, but irrespective the latter’s petition presents interesting questions that may throw equally interesting or surprising answers.      

LinkedIn