IT Act 1961

When A Princess Worried About Tax on Alimony

by

All things in life have a tax angle, including alimony payments. In this article I elaborate on tax treatment of alimony payments under the Income Tax Act, 1961 (‘IT Act, 1961’). Upfront, these are the three takeaways from this article: 

first, a lump sum payment of alimony amount is not taxable in the hands of recipient, since it is a capital receipt.

second, the monthly payment of alimony amount is taxable in the hands of recipient, since it is an income from a particular source. 

third, the payer receives no tax deductions for alimony payments, even if the payments are made under a decree of court. 

The law on all three above aspects was laid down by the Bombay High Court in Princess Maheshwari of Pratapgarh v Commissioner of Income Tax. This case is the focus of my article below. 

Decree of Nullity Sprouts Tax Questions  

(i) Decree of Nullity of Marriage 

In September 1963, Princess Maheshwari Devi of Pratapgarh obtained a decree of nullity of her marriage with Maharaja of Kotah. The Bombay City Civil Court (‘civil court’) pronounced the decree of nullity under Section 25, Hindu Marriage Act, 1955. As part of the proceedings, the Princess had claimed monthly alimony and a gross sum as permanent alimony from the Maharaja. The Civil Court ordered the Maharaja to pay the Princess an amount of Rs 25,000 as permanent lump sum alimony and a sum of Rs 750 per month as monthly alimony. The Maharaja was obligated to pay the latter until her remarriage, if and when, it took place.    

(ii) Two Tax Questions 

I will spare you details of assessment years and focus on the broader issue: the Princess claimed tax exemption on the lump sum alimony amount as well as the monthly alimony amounts. Her claims were rejected by the Income Tax Office and Appellate Tribunal, and against the said decisions she appealed to the Bombay High Court.

The High Court had to answer two questions: 

First, whether the monthly alimony of Rs 750 was income in hands of the Princess and liable to tax? 

Second, whether the lump sum alimony of Rs 25,000 was income in hands of the Princess and liable to tax? 

The framing of questions is crucial, from an income tax viewpoint. A receipt of money is only taxable if it constitutes ‘income’ as defined under the Income Tax Act, 1961 (‘IT Act, 1961’). Else the receipt falls outside the ambit of IT Act, 1961 though given the current and expansive definition of income, rarely if ever is a receipt of money not subjected to income tax. 

Monthly Alimony is Taxable in Hands of Princess  

The Bombay High Court answered the first question in favor of the Income Tax Department and held that the monthly alimony payment to the Princess constituted her income and was taxable in her hands. The arguments from both sides were as follows.  

(i) Arguments 

The advocate for the Princess rested her case for tax exemption of the monthly alimony on various grounds. Some of them were: 

First, alimony is merely an extension of husband’s obligation to maintain his wife and Section 25, Hindu Marriage Act merely enlarges that obligation. The advocate was implying that the husband is obligated to maintain his wife, whether they continue to remain married or not.  

Second, the alimony payment to the Princess did not emerge from a definite or particular source and in fact, the payment would cease on her remarriage. 

Third, monthly alimony is a personal payment from her ex-husband and not a consideration for any services performed – past or future. 

The counsel for the State though argued that the decree of Civil Court had created a legal right in favor of the Princess. The right to receive a monthly alimony amount had a definite source, i.e., the decree of court, and should be taxed as income in hands of the Princess.   

(ii) High Court Applies the Law

The Bombay High Court scanned through the previous cases to state judicial understanding o the term ‘income’. For example, one notable case, the Privy Council had observed that income is something that is ‘coming in’ with some sort of regularity from a definite source. The High Court after scanning various other precedents, succinctly stated the judicial definition of income as: 

a periodical return for labour/skill that a person receives with some regularity, and from a definite source. But an income excludes a ‘windfall’ gain. 

The above definition would squarely cover a monthly alimony payment. The only point then in the Princess’s favor was her claim that the monthly alimony was not a result of application of any labour or skill on her part. But the High Court rejected this point and held that even voluntary payments can constitute income in hands of recipient if they come with regularity from a definite source. The High Court though further pointed out that the monthly alimony was paid to the Princess because of the civil court decree which was obtained by her by expending effort and labour. And the civil court decree is the source of her right to claim monthly alimony as minus the decree she would have no right to alimony. The High Court concluded: 

Although it is true that it could never be said that the assessee entered into the marriage with any view to get alimony, on the other hand, it cannot be deneid that the assessee consciously obtained the decree and obtaining the decree did involve some effort on the part of the assessee. The monthly alimony being a regular and periodical return from a definite source, being the decree, must be held to be “income” within the meaning of the said term in the said Act.

The monthly alimony amount was something the Princess would receive regularly because of the decree, because of her efforts to obtain to same from the civil court and thus it would constitute her income under IT Act, 1961 and be subjected to income tax. 

Lump Sum Amount Received as Alimony: Exempt from Tax  

As regards the taxability of lump sum amount of Rs 25,000 received as alimony, the Bombay High Court decided that it amounted to a capital receipt and was not taxable as income in the hands of the Princess. The High Court observed: 

It is not as if the payment of Rs. 25,000 can be looked upon as a commutation of any future monthly or annual payments because there was no pre-existing right in the assessee to obtain any monthly payment at all. Nor is there anything in the decree to indicate that Rs. 25,000 were paid in commutation of any right to any periodic payment. In these circumstances, in our view, the receipt of that amount must be looked upon as a capital receipt.

Capital receipt, in income tax law, is only taxable if there is an express charging provision in income tax law to that effect. Else, not. Only revenue receipt is charged to income tax by default. Thus, the above distinction of revenue and capital receipts was in favor of the Princess. Also, because the High Court took the view that the lump sum payment did not ‘commute’ any monthly or periodical payments that the Princess would have received since she had no pre-existing right to receive the monthly alimony payment. To be clear, the lump sum alimony amount could be taxable if it ‘commutes a part of the future alimony’. However, the High Court said there was nothing in the civil court decree that indicated that the lump sum amount commuted her monthly payments. At the same time, the High Court did acknowledge that ‘beyond doubt that had the amount of Rs. 25,000 not been awarded in a lump sum under the decree to the assessee, a larger monthly sum would have been awarded to her on account of alimony.’ Thus, leaving a window ajar to tax lumpsum alimony amounts in future cases.     

No Tax Deductions for Alimony Payments

The unfairness of IT Act, 1961 is that it does not allow deduction for alimony payments. Typically, husbands pay alimonies to their ex-wives. Presuming that the alimony payment is from a portion of husband’s already taxed income, such payment should ideally qualify for a deduction. It can be viewed as an expense. If not the entire amount, a deduction with an upper cap can be provided. And for monthly alimony payments anyways the wife is liable to pay income tax, so providing the husband income tax deduction on such payments may not be too harmful from a revenue perspective. Currently, the husband pays income tax on his income, pays a portion of such income as monthly alimony to his ex-wife, and the ex-wife is liable to income tax for the monthly alimony as it constitutes her income. A bountiful for the revenue, unless the spouses are smart and rich enough to agree only to a one-time alimony amount, circumventing the uneven tax consequences of IT Act, 1961.   

In fact, the Bombay High Court described the above position of law as ‘unfortunate’. It heeded the legislature to pay attention to this aspect and noted: 

It is clearly desirable that a suitable amendment should be considered to see that in cases where the payments of alimony are made by a husband from his income and are such that they cannot be claimed as deductions from the income of the husband, in the assessment of his income, they should not be taxed in the hands of the wife. That, however, is not for the courts but for the Legislature to consider.

The Bombay High Court made the above observations in 1982. Since the IT Act, 1961 has been amended several times to include various capital receipts within the realm of taxability. But not lump sum alimony payments categorized as capital receipts have not been made taxable. Neither have deductions on alimony payments been included. Our lawmakers seem busy ‘simplifying’ the income tax law, rather than introducing substantive and meaningful policy changes that acknowledge new social realities. 

Conclusion 

Neither the Income Tax Act, 1961 and unfortunately nor does the Income Tax Bill, 2025 provide a clear answer about taxability of alimony payments. Tax lawyers typically advice their clients based on above discussed judgment of the Bombay High Court. Any legislative clarity on this front seems a bit distant for now.    

Regardless, I would like to conclude with a normative question: 

Who SHOULD pay the tax on alimony payments? 

Depending on your gender biases, views on divorce, necessity of alimony payments, your perception of divorce settlements as fair or otherwise, your answers would vary. Typically, women receive alimony payments from their ex-husbands. And people who have strong and inflexible opinions that women use family laws as ‘get rich quick’ route are likely to argue that women should foot the tax bill on both kinds of alimony payments: made via lump sum amounts and/or on monthly basis. 

A tax law view would be to ask who benefits from the alimony payment? And who bears the burden? The latter should receive a deduction on the payment and the former should shoulder the tax liability. Irrespective of gender. I’m willing to go a step further and suggest that even if the alimony payment is not made because of a court order, but voluntarily as part of a valid contract, the above principles should apply. Taxability of alimony payments should not depend on whether court ordered it, or parties themselves agreed to it. IT Act, 1961 provides deductions to all kinds of voluntary contributions including to political parties, it is imperative that same principles apply to personal relationships if it ends with mutual consent – actual or perceived. We should stop hiding behind the argument that alimony payment is a personal obligation and thus does not qualify for deduction. Unless one entertains the far-fetched belief that providing such a deduction may further catalyze divorces.         

Finally, and just as a matter of abundant caution I would like to add that transfer of various assets – jewelry, house, etc. – between two spouses can and do happen when they are still legally married and sometimes after the marriage has legally ended. The transfers of such assets attract different tax liabilities and warrant a separate discussion.  

Tax Privacy: To Begin a Conversation … 

by

Income tax law is based on disclosing information to the State. Personal financial information. Bank account statements, investments, salary receipts, rent paid or received, medical expenses, money transferred to spouse, expenses of children, insurance premiums, political donations, charitable contributions to name a few. Each piece of information is necessary to ascertain the exact tax liability of a taxpayer. And it is statutory duty of a taxpayer to make accurate and timely disclosures.  

If income tax administration is based on State compulsorily seeking detailed financial information from taxpayers, is it even possible to expect tax privacy? Yes. In fact, one could argue it is necessary to demand tax privacy. But what would tax privacy look like? What safeguards can be reasonably demanded and expected? There are no concrete answers and if I may dare suggest, no tentative answers either. Because the conversation around tax privacy in India has not even begun. 

To Begin a Conversation … 

Conduct an unscientific and random survey: ask your colleagues and friends if they are comfortable sharing their income tax returns with everyone? The dominant response will be no. Tax privacy in India starts and ends with a strong disagreement to make income tax returns public. Tax privacy in India hasn’t progressed beyond the notion of income tax returns. And even in this example, privacy exists in a rudimentary shape. The disinclination to share one’s income tax return with public at large isn’t entirely rooted in privacy, but a desire to avoid unnecessary scrutiny by social media and other ‘experts’, who may find numerous inconsistencies or point at insufficient income disclosures. And there lies the risk of reassessment notices, a trigger with which the Income Tax Department isn’t unfamiliar. And if you are even mildly popular, your income tax returns will be the fodder of endless gossip. Though you may not be object if your advance tax payments are conveniently disclosed to underline your success. 

The broad expectation of an Indian taxpayer seems to be that the State can access all relevant financial information, but the details contained in income tax returns should not be disclosed to the public at large without previous consent of the taxpayer, if at all. But we seem to have accepted or at least resigned to the fact that there is no concrete limit on the State’s power to secure personal financial information. How else will the State assess your income tax liability is the retort? 

An accurate response is that the State does not need unfettered access to your personal financial information to ascertain your income tax liability. State needs access to your ‘relevant’ personal financial information. Ordinarily, a taxpayer makes self-assessment – with help of a tax lawyer or an accountant – and discloses the relevant financial information. The State may, at times, demand additional information on the ground of ‘insufficient disclosure’ or to verify certain expenses. And it is at the juncture of disclosure and additional disclosure where privacy needs to be a shield for taxpayer, but it is conspicuous by its absence. The concept of tax privacy as a legal concept isn’t sufficiently articulated in India, especially to mediate the exchange of information and additional information between the State and taxpayers.          

Disclosing Financial Information 

Privacy is in the context of tax law, especially income tax law requires specific articulation. If I disclose to the State that I received a gift of immovable property from my parents, it is to ensure that an appropriate amount of tax is paid on the gift received. Hiding the transaction may allow me to escape the tax liability, in the short term or even forever, but it would be contravention of income tax law. But what if the State secures access to the transaction between me and my parents? If I did not disclose it voluntarily, maybe I boasted about acquiring a new immovable property on social media, and the State monitoring my virtual activity suddenly swung into action.

One pertinent question here is: can the State monitor my virtual activities in the hope of finding my ‘hidden’ sources of income or does it need prior permission before monitoring my activities? Privacy centric answer would lean in favor of the latter. The answer would suggest that the State needs to have a priori justification to monitor a taxpayer’s online activity. And such surveillance can only take place for a limited time and for specific activities. For example, tracking phone calls or movement without listening to the content of phone conversations. Our income tax laws are designed to grant the State power to intrude into taxpayer’s lives and the threshold to intrude into taxpayer’s life isn’t high. 

For example, let me look at some provisions that have lately generated some concern. Currently, search and seizure operations are permitted under Sec 132, IT Act, 1961 if some designated officers such as the Principal Commissioner, Chief Commissioner or Principal Chief Commissioner have ‘reason to believe’ that certain documents, articles, gold, etc. that are relevant to proceedings under the IT Act, 1961 have not produced by the taxpayer. The search and seizure operations empower officers to enter any building, vessel, aircraft, etc. and search persons, seize book, articles, etc. Section 132(9B) also empowers the officers to provisionally attach property of the taxpayer. These are extensive powers that are at times used to browbeat political opponents or journalists that the State doesn’t particularly like. Does the Income Tax Bill, 2025 go a step forward and provide additional powers to the State? Yes. 

Clause 247, Income Tax Bill, 2025 largely mirrors Section 132, IT Act, 1961, except the latter also provides the officers powers to override access codes to virtual digital space and any computer system where the codes are not available. It is the digital equivalent of powers to break lock to enter a locked building where the keys to the lock are unavailable. The threshold under Income Tax Bill, 2025 remains the same as under the IT Act, 1961. The authorized officer must have a ‘reason to believe’ that some document or information contained in an electronic media is not being disclosed by the taxpayer in relation to an income or property. 

Reason to believe is the subjective opinion of the officer in question and as per courts, should be based on credible material. But there must be proximate relation between the material on which opinion is formed and the final opinion. However, the courts have repeatedly stated that it is a subjective standard, and they cannot substitute the officer’s view with their view. The threshold of ‘reason to believe’ thus doesn’t provide ample safeguards against intrusion of privacy by tax officers: physical and virtual.   

The broad scope of search and seizure powers under the IT Act, 1961 and now Income Tax Bill, 2025 are rightly criticized for being overbroad. But the pushback is never rooted in protection of privacy. Or if it is, privacy is only in unarticulated subtext. Once officers are authorized to conduct a search and seizure operation under Section 132, they have the power to break locks, almirahs, seize documents, and search persons thereby impinging on business freedoms, bodily autonomy, and basic right to be ‘left alone’. While the State can justify that taxation is a sovereign right and search and seizure powers are ancillary to tax administration. But the articulation of privacy rights is missing in this argument and counter argument. To what extent can the State intrude into a person’s life to secure tax collection? When can the State violate physical autonomy of a taxpayer? On what grounds? We don’t know. Not yet.    

Disclosing Additional Information 

Privacy in the context of income tax law further suffers due to powers of the State to demand additional information under certain circumstances. Search and seizure operation is ideally conducted if the officer believes that the taxpayer has not voluntarily disclosed the information demanded by the State. But sometimes the additional information that is demanded from the taxpayer may put privacy in jeopardy. The additional information is usually sought when the income tax return of a taxpayer is selected for scrutiny or audit. In such cases, the officers demand additional information. For example, if I claim that I paid an ‘X’ amount as medical expenses for myself, then the State can question the validity of the claim. Or the amount. Disclosing additional information may risk disclosing my private medical information to the State. While the State may claim that not disclosing the entirety of medical expenses and the exact disease may jeopardize taxpayer’s claim for medical expenses and tax deduction. Where should we draw the line? Not sure, but the question is worth asking for now. 

Carrying the Conversation Forward  

There are three distinct strands of tax privacy that I wish to articulate in this preliminary article on tax privacy. I hope to delve deeper into each of these strands in the future, but the summation on each of these aspects of tax privacy is as follows. 

To begin with, if a taxpayer consents to sharing personal financial information with the State, then it is not unreasonable to expect tax privacy. To begin with, State should only seek relevant information that is proximate to the purpose of ascertaining tax liability. It is unreasonable to assume that the State has a carte blanche to demand any financial information. 

Equally, it is a valid expectation that the State shall only use the said information for purpose of computing and assessing tax liability. The ‘purpose limitation’ test as data protection law informs us. Privacy in this context is breached if the State uses the information for a purpose other than tax.  

Finally, I wish to underline the once the State has secured certain information, keeping the information secure is also State obligation. However, this is only one aspect of privacy, and in fact, more an element of confidentiality and less of privacy. And yet we tend to focus unduly on the State not disclosing our income tax returns to the public, instead of questioning scope of its power to demand and collect information in the first place. 

Long Wait for GSTATs: July 2017 … and Counting. 

by

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

Provision is Declared Unconstitutional 

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

No Appeal Against the Decision  

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

Provisions are Amended 

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

Pre-Amendment

Section 109(3):

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

Section 109(9): 

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

Post-Amendment 

Section 109(3): 

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

Section 109(4): 

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

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

Benches, Chairperson, Website … and Other Puny Steps 

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

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

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

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

Constitutional Courts are Impatient  

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

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

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

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

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

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

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

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

by

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

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

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

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

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

IT Bill, 2025: Improves Readability, Not Comprehension  

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

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

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

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

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

Simplistic Understanding of Simplification  

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

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

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

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

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

In Search of a Big Idea 

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

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

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

Conclusion 

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

Skeletal Timeline of Income Tax Reform in India

by

1860-1886: 

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

1860: Income Tax Act, 1860 enacted in India

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

1863: Income Tax Act, 1860 ‘expired’ 

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

1873: Income Tax Act, 1869 ‘expired’  

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

1886: Income Tax Act, 1886 enacted with important changes 

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

1918-1961: 

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

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

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

1922: Predecessor to the Income Tax Act, 1961 enacted 

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

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

1941: Income Tax Appellate Tribunals were established 

  • First specialist tribunals constituted in India 

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

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

1958: Law Commission of India submits it report 

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

1959: Tyagi Committee submitted its report 

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

1961: Income Tax Act, 1961 was enacted 

Promise of IT Act, 1961

Promise of Income Tax Act, 1961: 

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

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

1961-Present: 

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

1963: Central Boards of Revenue Act, 1963 passed 

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

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

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

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

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

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

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

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

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

2017: Task Force on Direct Tax Code setup 

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

2019: Task Force submitted its Report 

  • Report was never released to the public 

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

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

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

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

Promise of Income Tax Bill, 2025: 

Nirmala Sitharaman promised the following in her Budget Speech of 2025 

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

Shimla HC Decodes Scope of Sec 43-B, IT Act, 1961

by

In a recent judgment, the Shimla High Court had to adjudicate on the conditions prescribed in Section 43-B, IT Act, 1961 for an assessee to claim deductions. The issue related to Section 43-B(f) which envisages deductions to an employer for payments made to employees on encashment of cash leaves.

Facts 

For the Assessment Year 2002-03, the assessee inter alia claimed expenses of Rs 45,00,000/-, a sum it paid to LIC on contribution to Credit Leave Encashment Trust. The Assessing Officer disallowed the claim of such expense and added it to the income of the assessee. The assessee was unsuccessful in appeal before the ITAT. The dates are relevant to understand the issue at hand: 

The fund was established on 29.10.2002 and contribution of Rs 45,00,000/- to LIC was made on the same date.

Provision for contribution of Rs 45,00,000/- was not made by the assessee after closure of financial year 2001-02, i.e. on 31.03.2002. 

The assessee was not following the mercantile system of accounting during the financial year 2001-02. 

The liability of payment of Rs 45,00,000/- did not accrue nor was it paid during the financial year 2001-02.    

Summary of arguments adopted by the assessee and the Revenue is as follows: the assessee argued that the payment of Rs 45,00,000/- was part of the entire past liability of Rs 1.80 crores assessed by the insurer. The liability was not a contingent liability. And since the liability was met before due date of submission of returns, i.e., 31.10.2002, it was a permissible deduction under Proviso to Section 43-B(f), IT Act, 1961. Revenue, on the other hand, contended that the amount was not deductible under the IT Act, 1961 and even if it was, since it was not ascertained during the relevant financial year could not be a permissible deduction under Proviso to Section 43-B, IT Act, 1961. 

Section 43-B, IT Act, 1961 

Section 43-B, IT Act, 1961 allows for certain deductions to an assessee only on actual payment. Section 43-B(f) states ‘any sum payable by the assessee as an employer in lieu of any leave at the credit of his employee;’ and the Proviso states: 

Provided that nothing contained in this section [[except the provisions of clause(h)]] shall apply in relation to any sum which is actually paid by the assessee on or before the due date applicable in his case for furnishing the return of income under sub-section (1) of section 139 in respect of the previous year in which the liability to pay such sum was incurred as aforesaid and the evidence of such payment is furnished by the assessee along with such return.

Shimla HC Answers Two Questions 

The first question that the Shimla High Court decided to answer was whether the contribution made by a corporate employer to a fund for payment of leave encashment to its employees was entitled to deduction. The High Court disagreed with the ITAT and held that it is not accurate to state that such a fund has not been statutorily recognized. The inclusion of Section 43-B(f), as per the High Court, proved otherwise. The High Court cited Exide Industries case to rightly conclude that amount of contribution made by an assessee towards a fund for payment of leave encashment to its employees was a deductible expense. 

The second question then was: did the assessee meet requirements of Section 43-B and its Proviso? The High Court answered in the negative. The High Court noted that Proviso allows only allows an assessee to claim a deduction if the sum payable as an employer in lieu of any leave was incurred by the assessee according to the regular method of accounting employed by him and the sum was actually paid in the previous accounting year. The second condition is not a correct interpretation of the Proviso, as it clearly states the payment can be made after the accounting year but before due date of filing returns. 

Nonetheless, the Shimla High Court denied the assessee’s claim for deduction on the ground that the liability of Rs 45,00,000/- had already been incurred as a past liability. The assessee’s assertion that the amount was part of a past liability of Rs 1.80 crores determined by the insurer, the High Court noted had not been substantiated. And since the finding of fact is not controverted the High Court denied assessee’s claim for deduction. 

Conclusion 

The insight this case offers us is that the payment towards a fund for encashment of leave is a permissible deduction under Section 43-B, IT Act, 1961. The payment can be made after the end of accounting year but before the due date to successfully claim deduction. But, the payment must be for satisfaction of a past liability incurred during the previous accounting year and the accounting method adopted by an assessee must reflect the liability. The observation that Section 43-B alongwith Proviso also requires payment before the end of accounting year does not align with a plain reading of the provision and does not hold on scrutiny.     

Issuance of Shares under Amalgamation Scheme is Not Transfer of Property: ITAT

by

The Rajkot Bench of ITAT recently ruled that issuance of shares under a scheme of amalgamation does not amount to transfer of capital assets under IT Act, 1961. The Assessing Officer had applied Sec 56(2)(vii)(c)(ii) of the IT Act, 1961 to assert that a skewed swap ratio was applied for transfer and valuation of shares, but the ITAT held in favor of the assessee. 

Facts 

The assessee was a public limited company. It filed its revised returns on 07.05.2015 declaring total income of Rs 4,74,48,046/- and book profit of Rs 5,20,68,396/- and it was selected for scrutiny. The Assessing Officer noted that the assessee company had amalgamated with three private limited companies with itself. The latter were owned by relatives of promoters of the assessee company.  During amalgamation, the assessee issued shares to shareholders of all three companies as per the scheme of amalgamation. 

The Assessing Officer took the view that a skewed swap ratio was chosen in the process of amalgamation and the assessee company transferred its shares to the beneficiaries at a discount. And the transfer of capital to such beneficiaries attracted Sec 56(2)(vii)(c)(ii) of the IT Act, 1961. Thus, the Assessing Officer held that the excess value of Rs 18,74,73,500/- transferred to the beneficiary, related parties should be added to the income of assessee. 

CIT(Appeals) on appeal filed by the assessee deleted the addition made by the Assessing Officer. And it was against the order of CIT (Appeals) that the Revenue approached the ITAT.  

Revenue’s Stand 

Revenue made two arguments and the latter appears rather strange. The first argument was that the share of assessee company was valued at Rs 1.82 per share while the amalgamated companies had a share price of Rs 10.65 per share. The Revenue argued that the difference of Rs 8.83 between two prices was passed over or given to the individual shareholder by adopting a colourable device and defeating the purpose of Sec 56(2)(vii)(c)(ii) of the IT Act, 1961. 

Revenue in its second argument conceded that the issuance or allotment of shares under a scheme of amalgamation does not amount to transfer of capital asset under Sec 47 of the IT Act, 1961. And no capital gains would be taxable in the hands of assessee. However, ‘the real income should be taxable in the hands of the assessee company.’ (para 11) 

What is real income in this case? And how did the Revenue suppose it was taxable if the transaction was not a taxable as per the applicable charging provisions of the IT Act, 1961? Even if one concedes that some benefit had occurred, in the absence of an express charging provision to tax such a benefit the entire case collapses. And yet the Revenue thought it was a fit case to file an appeal despite the CIT (Appeals) making an order that the no income had accrued under IT Act, 1961.    

Decision 

ITAT relied on multiple precedents to underline its three reasons for holding in favor of the assessee: 

First, ITAT held that the assessee company receives shares of the amalgamated company upon a statutorily valid and approved procedure of amalgamation under Companies Act, 1956. And once the share is issued at the court approved price, ‘then no one has the right to raise questions regarding one received more or less in value of shares.’ (para 14) ITAT added: 

… the new share is allotted as per the Amalgamation scheme under the supervision of the High Court after hearing of all stakeholders including the Government. The Scheme of amalgamation under which an exchanger ratio of shares is approved by the high court, and it is conclusive. So, question of skewed swap ratio or issuing shares at discounted rate does not arise.’ (para 20) 

Second, ITAT held that under Section 2(1B) read with Section 47 of the IT Act, 1961 transfer of shares during an amalgamation or even a fresh allotment of shares does not amount to transfer of a capital asset. And once there is no transfer of property, on merely receiving shares in lieu of shares previously held, Sec 56(2)(vii)(c)(ii) of the IT Act, 1961 cannot be applied. 

Finally, ITAT noted that Sec 56(2)(vii)(c)(ii) of the IT Act, 1961 does not apply to public limited companies but only to individuals and HUFs. 

ITAT’s decision in the impugned case is well-reasoned and decides the issue appropriately even if the decision in this case was straightforward. The case though is another instance of what I can term as unnecessary litigation by the Revenue Department. The ITAT’s decision correctly aligned with the CIT (Appeals) decision and the Revenue needn’t have appealed against the latter order pretending that the assessee had adopted a colorable device. The law and facts were straightforward to not require dedication of such extensive resources to this case.     

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.  

ESOPs-Related Compensation Present an Interesting Dilemma

by

Introduction 

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

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

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

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

Facts 

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

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

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

Characterizing the Compensation – Summary of Arguments  

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

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

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

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

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

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

ESOPs are not a Capital Asset – Madras High Court

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

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

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

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

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

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

ESOPs are not Perquisites – Delhi High Court 

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

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

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

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

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

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

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

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

ESOPs are Perquisites – Madras High Court 

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

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

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

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

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

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

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

Conclusion 

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

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

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

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.    

   

LinkedIn